Turning Due Diligence Tables: What Prospective Directors Should Know Before Agreeing to Serve

Every prospective director of a public company should conduct his or her due diligence before agreeing to serve on a board. Some private company boards also have outside directors who should consider similar action.

Directors of public companies labor under not only the watchful eye of Wall Street and shareholders, but also the scrutiny of Congress, the U.S. Securities and Exchange Commission (SEC), state attorneys general, news media and national stock exchanges. The Sarbanes-Oxley Act of 2002 and both the New York Stock Exchange (NYSE) and Nasdaq have standards for corporate governance and independence and further define the duties and qualifications of directors who serve public companies. Most public companies are proactive to ensure that they are maintaining the highest standards and observing "best practices" in these critical areas with a commensurate time commitment expected of board members.

Previous corporate governance changes may have legal implications for directors by raising the standard of care a director must observe. Therefore, if you are asked to serve (or continue to serve) as a director of a public company, it is important to be fully informed about its internal policies, practices and procedures so that you may claim the protection of the business judgment rule throughout your tenure.

The following documents provide a starting point for a potential director who wants to learn more about a public company before deciding to serve as one of its directors. This list should be supplemented based on the nature of the public company's business and the industry in which it operates (for example, if the company is in the securities business, you would want to ask for all of its filings with the relevant exchange and state of incorporation).

• SEC Filings. You should begin your review with the company's certificate or articles of incorporation (the charter) and bylaws. These documents, along with state corporate law, generally define the scope of authority of a company's directors and scope of indemnification and exculpation a director can expect. You should also review the company's most recent Form 10-K and all SEC filings (particularly all Form 8-Ks pertaining to material events) since the most recent Form 10-K was filed. These documents will provide information regarding the company's financial performance, recent sales of its securities, and any material acquisitions or other transactions. You should also ask additional questions if there have been amended or late filings, particularly if the company has ever restated its financial statements. Most documents that a public company files with or furnishes to the SEC are available on the SEC's website.
• NYSE and Nasdaq Listing Standards. NYSE and Nasdaq each requires companies to adopt a code of business conduct and ethics for directors, officers and employees, which covers such topics as conflicts of interest, corporate opportunities, confidentiality, fair dealing, insider trading and reporting illegal or unethical behavior. NYSE also requires companies to adopt corporate governance guidelines to address director qualification, responsibilities, access to management and independent advisors, and compensation. It is important that you are comfortable with a company's level of compliance with these codes prior to agreeing to serve.
• Insurance and Indemnification. Despite the protection afforded by the business judgment rule, lawsuits for errors, omissions and other wrongful acts of directors are increasingly common. You will want to familiarize yourself with the company's Director and Officers (D&O) insurance policy to understand what types of acts and omissions are covered (or excluded) by the policy and the limits of its coverage. Moreover, you will want to review any indemnification agreements the company has with its directors (in addition to indemnification provisions contained in state corporate law, the charter and bylaws) to assess the adequacy of the indemnification, including whether your expenses will be advanced prior to resolution of any conflicts or proceedings. Insurance and indemnification documents should also be reviewed by your counsel as it's important for directors to understand the specifics and negotiate terms that best suit their needs. For a more in-depth discussion of D&O insurance issues, please see the Law360 article "Tips For Negotiating Strong D&O Insurance Protection" by Holland & Knight Partner Thomas H. Bentz Jr.
• Committee Documents. NYSE and Nasdaq corporate governance rules require companies to have an audit and risk committee, a nominating/corporate governance committee and compensation committee, each composed solely of independent directors. If you anticipate serving on a board committee, then you should review that committee's charter for guidance regarding its authority and the standards by which members must conduct themselves. You should additionally review board, board committee and shareholder meeting minutes, as well as records of all action taken by the board and shareholders without a meeting in the past three years. You may also want to obtain a list of all related-party transactions with the company's directors so that you can make your own determination of the other committee members' independence.
• Audit Information. You should review all management letters issued by the company's independent auditors for at least the last three years and any response letters sent by company counsel regarding contingent liabilities for the same period. You should also obtain the name and phone number of each audit partner, the head of internal audit, company counsel and any other independent members of the audit committee in case questions arise during your review of the company's financial statements, auditor management letters or attorney response letters. In addition, you should ask the company to identify all "financial experts" who serve on the audit committee.
• Analyst Reports. You should review analyst reports from the last 12 months to become aware of the perceived strengths and weaknesses of the company in the marketplace and better understand trends in trading of the company's stock.
• Correspondence. Correspondence to or from lenders, including compliance certificates, should be reviewed to ensure that there are no potential defaults under applicable loan agreements or credit facilities. Any correspondence between the company and the SEC, NYSE or Nasdaq, state securities regulators, and other federal and state regulatory and self-regulatory authorities with jurisdiction over the company should also be reviewed to determine if there are any unresolved issues that could result in the delisting of its shares or lead to other problems.
• Board Documents. You should thoroughly understand your responsibilities and expectations and any key information presented to board members. This includes:
  • the board's meeting schedule, any committees to which you would be appointed and any required travel
  • complete board packages presented to the directors for any board and committee meetings from the past year
  • whether there is a formal orientation process before joining the board and, if so, a description thereof
  • the company's strategic plan
  • director compensation policies and agreements, including a description of the compensation proposed for you, as well as the term of service if elected
  • a list of the other directors and contact information for each
  • recent board evaluation results
  • conflict avoidance policies and procedures that will be applicable to the board's consideration of you, your performance and your compensation, along with reviews and compensation of management as a group

Additionally, you should consider having a conversation with the lead independent director about the strengths and weaknesses of the board and current management, the management succession plan, board culture, time commitment, relationship with any closely affiliated companies and primary strategic risks for the company.

Holland & Knight routinely assists parties in navigating corporate governance matters. For more information or questions about a specific matter, please contact the authors.