Limitations of Corporate Governance15/07/2020
Corporations are separate legal entities, wholly distinct from their shareholders. Shareholders elect the board of directors which, in turn, manages the business. Usually the board employs officers and managers to run the daily operations of the corporation. However, in small corporations, all of these shareholders, board, officers and managers may be one and the same. The related governance requirements have several disadvantages.
Corporations Governed by Statutes
Corporations are governed by federal and state statutes. One major reason business owners form corporations is to limit the owners’ liability to the amount of their investments. Another reason founders form corporations is because corporations are permitted to raise capital by selling stock to investors and have a long legal and case history to support this. With this corporate structure comes certain requirements.
Fiduciary Duty of Board
Officers and the board of directors have fiduciary duties to act in the best interest of the corporation. If they breach those duties by not exercising honest and prudent care, they can be held liable. This is why companies where shareholders elect non-shareholder directors often provide directors and officers, or D&O, insurance. D&O insurance does not protect against outright fraud, but it does protect against fallout from bad business decisions.
Corporations have higher administrative costs because of greater administrative requirements than those required of LLCs and limited partnerships. Corporate boards must either meet or create resolutions to enter into financial arrangements or contractual arrangements. Corporations must maintain corporate documentation, including stock purchases and sales, legal compliance and annual registration.
Maintenance of Separation
Corporations, shareholders and board directors and officers must follow all the corporate formalities, including keeping annual meeting minutes for both shareholders’ meeting and board of directors’ meetings, documenting major decisions as board-approved. Even corporations owned and governed by one shareholder in multiple director roles must adhere to all formalities. Shareholder-owners must sign all documents as their position, for example, “John Smith, President, ABC Company.” Failure to adhere to these rules could result in a creditor getting a judge to pierce the corporate veil. When a court or judge “pierces the corporate veil,” the court sets aside the corporate protection and allows the creditors to go after the personal assets of the shareholders.
Principal Agent Conflict
Conflicts arise when a corporation’s shareholders do not actively participate in the business and instead hire professional management to run the business. The manager represents the shareholders but often has different goals and perspectives. The manager acts in his best interest as an employee but not in the best interest of the shareholders. For example, a manager may make decisions that help him keep his job and a nice salary but that reduce the amount of profits that go to the shareholders. Shareholders must structure employment agreements to reduce or eliminate this conflict.