Home Legal and Regulatory Issues So you Want to be a Corporate Director? Practical Considerations of Director Liability
So you Want to be a Corporate Director? Practical Considerations of Director Liability

So you Want to be a Corporate Director? Practical Considerations of Director Liability

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By Bill Ojile, Senior Vice President – Chief Legal & Administrative Officer, Alta Colleges, Inc.

When you think about boards of directors, it conjures up images of powerful people sitting at a long, sleek table in an oak-paneled, top-floor room debating weighty issues crucial to the corporation. While the popular culture perception of a board meeting may not match the reality of the typical corporate board meeting, the intuitive understanding that a board member has the responsibility to act fairly and for the interests of the shareholders has its grounding in the law. This article will explore the general responsibilities of a director to the corporation and its shareholders. After discussing those general responsibilities, the article will examine the unique obligations that directors of for-profit post-secondary education institutions have under United States Department of Education rules.

Fiduciary duties

As a general proposition of state law, the affairs of a corporation are managed by or under the direction of the corporation’s board of directors. The articles of incorporation and bylaws of a corporation will specify the responsibilities of the corporation’s directors. How a director fulfills those responsibilities are referred to as the director’s fiduciary duties. “Fiduciary” in this context means a position of trust, operating on behalf of others. In this circumstance, directors act on behalf of the corporation’s shareholders. The duties of loyalty, care and candor comprise the fiduciary duties of a director.

Loyalty: A director is expected to act in good faith in discharging his or her duties as a director. This means that the director must act in the best interests of the company and its shareholders in making decisions, doing so in a reasonable and honest manner. If a company is insolvent or near insolvency, the directors also need to consider the best interests of the company’s creditors. As the company approaches insolvency, the directors’ focus must shift from maximizing shareholder value to maximizing remaining corporate value for the benefit of creditors. A director must avoid conflicts of interest with the company. For example, a conflict of interest will occur when a director’s consulting business submits a proposal to do work for the company.

To avoid conflict of interest, the director must recuse himself or herself from any board deliberations or decisions that may directly or indirectly involve the consulting contract.

Directors also must not pursue corporate opportunities for their own benefit. Where a corporation has both financial ability and interest to take advantage of an opportunity within its business sector, a director who pursues that opportunity for his/her own benefit violates his/her duty of loyalty to the company.

Care: A director must obtain all necessary information required to act in an informed manner. If such information is not provided, the director must insist upon receiving the additional information before voting on a matter. The Board is expected to act with deliberation and diligence, and board members discharging their duties are expected to act as reasonable, competent and prudent persons. Board process and practice can assist in ensuring that board members act with due care. Practices such as regularly scheduled meetings, disseminating board materials well in advance of a meeting, adequate preparation and meeting attendance can demonstrate due care by the director. Directors can rely in good faith on corporate records, financial statements, reports prepared by officers or board committees, and experts chosen by the company with reasonable care. But, in all decisions the minutes should demonstrate that the board exercised prudence in its decision-making process. This will include having sufficient information in the board materials to support the decision, asking appropriate questions and allowing adequate time for deliberation.

Candor: A director must disclose all material information known to that director on an issue if the material information may have relevance to an issue under consideration by the board or shareholders. Directors must also ensure that the company provides complete and accurate information to its shareholders.

Business judgment rule

You have shown up to all board meetings, took your responsibilities seriously and generally managed to stay awake and participate during the meetings. Can you be held personally liable if the board makes a decision later questioned by shareholders or a third-party? Courts will apply the “business judgment rule” in reviewing directors’ decisions. That rule provides that when directors act with requisite care, loyalty and candor, the directors’ rational business decisions are presumed made in good faith, and a court will not substitute its judgment for that of the directors. Essentially, the law presumes the directors are informed and experienced in the business of the corporation, and that the board’s decisions should be afforded deference absent a showing of gross negligence by the board. In demonstrating that a board has exercised business judgment, a key inquiry is the adequacy of the decision-making process undertaken by the board.

The business judgment rule provides no protection for unintelligent or unadvised decisions by a board, and decisions of this nature will expose board members to personal liability

Elements a court will analyze to determine whether the board’s actions were grossly negligent, include:

  • Did the board take an active and direct role in the deliberations?
  • Did the board act on an informed basis and seek out information reasonably available to them and relevant to their decision?
  • Did the board act in a deliberate and knowledgeable fashion?
  • Did the board engage and rely upon expert advisors?
  • Did the board identify and explore alternatives?
  • Did the board have an honest belief its actions were in the best interests of shareholders?
  • Did the board disclose all germane facts to shareholders?

The business judgment rule only applies to actions of a board; it does not protect a board when the board fails to act.

Indemnification

A director threatened with or subject to a pending legal action – whether civil, criminal, administrative or investigative – because of the director’s service on the board can receive indemnification from the company. This means that the company can cover the costs associated with defending the claim against the director (including attorneys’ fees) and any judgment, settlement, fine or penalty. Generally a state’s corporation laws will define the director’s right to indemnification, and the company will recognize that obligation in the company’s bylaws or through an individual indemnity agreement with the director. The obligation of indemnification extends only to good faith decisions, those decisions believed by the director to be lawful and actions taken by the director in the best interests of the company. Directors & officers’ (D&O) liability insurance will assist a corporation in meeting its indemnification obligations to directors who find themselves subject to a legal claim due to their role as directors.

Before joining any corporate board, a director candidate should obtain specific information about the company’s D&O insurance coverage. Board members should take interest in the scope and amount of D&O insurance coverage the company secures on an annual basis. Crucially important for the company is working with an insurance broker knowledgeable about the company’s business sector and the current and possible future risks faced by industry participants.

Issues unique to directors of for-profit colleges

State law sets forth the fiduciary duties of a corporate director and defines the situations in which a director may be subject to civil liability for the director’s corporate decisions. A director may also have civil or criminal liability under federal law and regulation in certain situations. For instance, the 2002 Sarbanes-Oxley Act had a number of statutory provisions that addressed board of director duties and responsibilities. Similarly the Higher Education Act and Department of Education regulations provide for potential liability for directors of for-profit post-secondary education institutions in certain instances.

Closed schools:

Department of Education regulations covering school closures provide for the possibility that “principals” of a for-profit post-secondary education institution (defined to include directors) may incur personal liability for student loan discharges resulting from the closure.

While the possibility of potential personal liability of a director is remote, nonetheless the fact that the Department’s regulations provide for such an outcome is significant.

A student can obtain a student loan discharge when either the student could not complete the program due to school closure or where the student withdraws from school within 90 days of school closure. If the student certifies that one of these circumstances occurred and that the student could not complete the program at another school through either teach out agreement or credit transfer, the student will qualify for loan discharge from the Department. Students qualifying can obtain significant relief: all loans and fees for the entirety of the student’s enrollment and the recoupment of any payments made on the loans. The student can pursue loan discharge regardless of whether the school provided the student with options for completing the program. The student is under no obligation to accept an offer for program completion provided by the school.

Analyzing what could give rise to director liability in a school closure situation first requires consideration of how the school closed. If school management – supported by the board of directors – executes a plan to suspend enrollments and complete the education of existing students prior to closure, and assuming students accept one of the options offered by the school for students to complete their education, no loan discharges will result from the school closure. In such an orderly process of school closure no possibility of director personal liability will exist.

One possibility of director liability will exist when the school closure results in loan discharges. Despite the best efforts of school management, if a school closes for financial reasons before completing the education of its current students, loan discharges likely will happen. The Higher Education Act empowers the Department to “pursue any claim available to such borrower against the institution and its affiliates and principals…” Upon discharge, the student assigns to the Department all rights the student may have under contract or applicable law. This provision provides the basis for the Department to seek re-payment from the school or from affiliates of the school. But, concepts of general corporate law come back into play in determining whether a director will have personal liability resulting from a closed school. If the director can demonstrate the decisions of the board showed requisite business judgment and that the director acted in accordance with the director’s fiduciary obligations, the Department would be hard pressed to prove a director personally liable.

Since the Department steps into the shoes of the discharged borrower, the Department could pursue claims against directors only if the discharged borrower had an independent basis under contract or state law to assert such claims. Unclear is the extent to which the Higher Education Act empowers the Department to “pierce the corporate veil” as a means to hold the directors personally liable for debts of the school corporation. To “pierce the corporate veil” means to disregard the corporate entity due to some conduct by the owners, such as failure to follow corporate formalities and treating the corporation as the “alter ego” of its owners. In such a case, a court will look to the personal assets of the owners to satisfy corporate obligations.

Another situation, which may give rise to an argument for individual director liability is board conduct prior to the school declaring bankruptcy. The goal of bankruptcy is to preserve and dispose of assets in an efficient manner for the benefit of the company’s creditors. Where directors/controlling shareholders take corporate actions prior to the declaration of bankruptcy in order to divert corporate assets for their benefit and to the detriment of creditors who may have contractual rights, those actions may support the Department attempting to “pierce the corporate veil.”

Such actions by the board if taken when the company was technically insolvent or where the corporation did not receive adequate consideration will constitute fraudulent conveyances. In such a situation, the bankruptcy trustee could make a case that the directors breached their duty of loyalty to the company when they approved the self-interested transaction, exposing those directors to personal liability. This certainly would be the case for an interested director who participated in the vote, but could also apply to any director if the rationale supporting their decision is not adequate. The Department would appear to have an argument for pursuing directors personally where the directors of a school corporation engaged in a fraudulent conveyance as a means to divert assets pre-bankruptcy for the benefit of shareholders (including the directors) and as a means to avoid school loan discharge liability.

Recognizing the rarity of circumstances supporting disregard of the corporate entity and the difficulty the Department would have proving such a case, the Department’s regulations provide more immediate and practical incentives for directors and other principals to ensure that a closed school fulfills its loan discharge obligations. The Department can prevent certain individuals from owning or holding future executive positions, including that of a director, by rendering subsequent institutions those individuals make seek to own or work for ineligible for participation in the Title IV program. These regulations – called the Past Performance Rules – provide that an institution is deemed not financially responsible where a person who exercises substantial control over that institution also exercises or exercised substantial control over an institution that owes a liability for a violating Title IV, HEA program requirement and where no agreement for repayment has been executed with the Department. “Substantial control” means direct or indirect ownership of 25 percent or more of the institution (includes combined family ownership and voting trusts); acting as a director, the CEO or other executive officer of the institution; or acting a director, the CEO or other executive officer of an entity owning 25 percent or more of the institution. The Department’s regulations allow an individual deemed to have substantial control to demonstrate that no “control in practice” of the institution exists. But, there is no guidance on what constitutes control in practice and what the Department would have to find to absolve individual from the past performance rules based on this exception.

The Department also has the power to suspend or debar a director. By doing so, the Department can exclude them from participating in federal “covered transactions.” Participation in Title IV programs is considered a covered transaction. The Department can suspend someone when immediate action is required to protect the public interest. The Department can debar1 an individual for a variety of reasons, but relevant here is the failure to pay a substantial debt owed to a federal agency. Debarment can be imposed for up to three years and it can apply to both schools and principals, including directors. Obviously, the Department’s regulations provide for due process, including notice and the opportunity for an administrative hearing for any institution or individual the Department seeks to suspend or debar.

Gainful employment rules: The Department released its revised gainful employment rules in October 2014. Those rules contain a requirement for “certification signed by [the institution’s] most senior executive officer” on several issues. Since the “most senior executive officer” of a school corporation is more than likely on that institution’s board of directors, consideration of the import of these new rules is relevant to the subject of this article.

The rules require the most senior executive officer of the institution to certify that:

  • Each eligible GE program the institution offers is approved by a recognized accrediting agency;
  • Each eligible GE program the institution offers is programmatically accredited, if such accreditation is required by a Federal governmental entity or by a governmental entity in the State in which the institution is located or by any State where the institution is authorized; and,
  • Each eligible program the institution offers satisfies the licensure or certification requirements of those States so that a student who completes the program and seeks employment in those States qualifies to take any licensure or certification exam that is needed for the student to practice or find employment in an occupation that the program prepares students to enter.

Schools annually will make these certifications. The Department makes clear in its commentary on the rules that it will use an inaccurate certification as the basis for enforcement action of some type: “The certification requirements have the added benefit of creating an enforcement mechanism for the Department to take action if a required approval has been lost, or if a certification that was provided was false. Further, Federal and State law enforcement agencies may be able to prosecute any misrepresentations made by institutions in their own investigations and enforcement actions.” Unstated here is whether the Department or other law enforcement agencies will pursue personal liability for those individuals making the certifications on behalf of their institutions.

These certifications call to mind the certifications by the Chief Executive Officer and Chief Financial Officer required by the Sarbanes-Oxley Act. In order to ensure the accuracy of the certifications and give the certifying executive officers comfort, public companies have created significant internal Sarbanes compliance processes. These include sub-certifications made by various responsible managers addressing the accuracy of reporting from their areas of responsibility; disclosure committees where senior managers meet regularly to ensure that the corporation has met its disclosure obligations and that any potential code of conduct violations are identified, investigated and disclosed if required; and, regular review of internal controls. A senior executive officer making the certifications required by the Department will want to establish similar processes to ensure the accuracy and completeness of the annual certifications. This will also create a record of reasonable due diligence by the certifying officer.

Conclusion

To avoid personal liability, a director needs to seriously consider the obligations that a director has to the company, its shareholders and to fellow board members. This includes adequately reviewing and preparing for board meetings, asking good questions and demanding complete information. Do not allow management or interested directors to rush important decisions and ensure that the board consults with experienced advisors if the nature of the issue under consideration warrants such advice. Understand the D&O coverage the company has secured. In considering director liability based upon obligations the director has under Department of Education rules, directors can avoid liability through the proper exercise of fiduciary duties in ensuring the school acts responsibly in a closed school situation and in making annual certifications.



Bill Ojile

BILL OJILE is Senior Vice President – Chief Legal & Administrative Officer for Alta Colleges, Inc. in Denver, CO. Ojile is responsible for the legal, compliance, regulatory, human resources, corporate governance and governmental affairs of the company. Before joining Alta in 2006, Ojile served as Senior Vice President, Chief Legal Officer and Secretary for Valor Communication Group, Inc. in Irving, TX from 2000-2006. He received his Bachelors of Science degree in accounting from the University of Nebraska-Omaha and his law degree from the University Of Nebraska College Of Law.


Contact Information:Bill Ojile // Senior Vice President – Chief Legal & Administrative Officer Alta Colleges, Inc. // 10249 Church Ranch Way Broomfield CO 80021 // 303-846-1836 // bojile@westwood.edu

Citation
1Accrediting bodies can also debar individuals. For instance, the Accrediting Council for Independent Colleges and Schools (ACICS) Accreditation Criteria provide: “The Council may bar a person… from being an owner or senior manager of an ACICS-accredited institution if that person was an owner or manager of an institution that lost it its accreditation as a result of a denial or suspension action or that closed without providing a teach-out or refunds to students matriculating at the time of closure.”

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