MANAGEMENT TIP
Co-op directors held
to high standards
By James Baarda
USDA RBS Economist
james.baarda@usda.gov
Editor’s note: In the last issue we examined
the circle of seven responsibilities that
all directors have. This second article in a
series of three discusses standards of conduct
applied to directors and the sources of legal
liability imposed on directors when they
don’t meet the standards. It concludes with
a discussion of protections for individual
directors against personal liability. Just as
responsibilities can be divided into seven
distinct, yet related, items, standards of
conduct, liabilities and responses can be
viewed in seven steps.
Directors’ roles in
perspective
A number of responsibilities
are imposed on a
cooperative board of
directors, but where do individual directors
fit in? Four perspectives of directors’
roles help identify board and individual
director responsibilities. Starting
with the broadest perspective and narrowing
the view to the individual director
gives the following breakdown.
The cooperative is a business organization,
almost always a corporation.
All of the substantial rules governing
cooperative directors come from corporate
law.
The cooperative is a very special
kind of corporation. Cooperatives operate
according to appropriate cooperative
rules or principles. These unique
cooperative attributes define cooperatives’
unique objectives, they require
specialized income distribution and
financing techniques, they impose
unusual decisions on the board of directors
and they give cooperative directors
“something else to think about.”
Narrowing the perspective further,
the board of directors acts as a body.
The power to act on behalf of the
cooperative is given to the board of
directors as a body, not to individual
directors. No special power is given to
an individual board member to act officially.
As an individual, a board member
has no greater authority than an
ordinary cooperative member. The
board derives its authority from the
incorporation statutes, articles of incorporation,
bylaws, and the members.
These all identify the board of directors
as the governing body.
This perspective further defines an
individual director’s participation in the
cooperative. Decisions are board of
director decisions, so an individual
director must be able to work effectively
within the dynamics of the board to
influence board decisions. The board as
a whole will be effective only if procedures,
committee structures and interaction
is conducive to good decision-making.
If a director objects to a decision, it
is imperative that a negative vote be
recorded, otherwise the director will be
held to have agreed with the decision.
Responsibilities, standards of conduct
and possible liabilities fall on
board members as individuals. If the
standards of conduct are not met, individual
directors may be liable to shareholders
and members, to the cooperative,
to creditors, to patrons and to the
public through civil or criminal laws.
What are the standards of conduct by
which directors are measured?
2. Standards of conduct
Standards of conduct for corporate
directors have been developed over
many years by judicial decisions and
legislative action. Although cooperative
directors face numerous special problems,
no separate set of standards has
ever been developed for cooperative
directors. Therefore, corporate rules
generally apply to cooperative directors.
Standards applicable to cooperative
directors (as is the case with corporate
directors) are usually divided into three
“duties.” These are summaries of many
decisions and statutes and are stated in
general terms in this article. The three
duties are “duty of obedience,” “duty of
care” and “duty of loyalty.”
3. Duty of obedience
The term “duty of obedience”
sounds odd but is logical when
explained. The duty means first that
directors must perform their roles in
conformity with the statutes and terms
of the cooperative’s documented
requirements for the directors. The
authority given to the board of directors
is defined, as is the purpose of the
cooperative. Acts beyond those limits
are “ultra vires” and are not authorized.
Neither may the board make decisions
that are either themselves illegal
or that will cause the cooperative to do
something illegal. The duty of obedience
also implies that the board should
mandate necessary records and recordkeeping,
internal procedures, policies
and compliance programs, then supervise
the process to the extent necessary
to protect the cooperative from illegal
or improper actions.
4. Duty of care
The duty of care, also called the duty
of diligence, has developed in judicial
decisions but is also found in many corporate
statutes. Statutes typically
describe the duty of care in three parts:
good faith, prudence and judgment.
Directors are required to act in good
faith in all circumstances. Directors
must also exercise care that an ordinary
person in a like position would in similar
situations. Finally, a director must
make decisions for the cooperative in a
manner that he or she reasonably
believes to be in the best interests of
the cooperative. Directors have the
highest obligation to the cooperative
and stand in a relationship of trust a
fiduciary relationship. Good faith, conscientious
care and best judgments are
expected of each and every director.
Diligence and care raise two particular
challenges for cooperative directors.
Directors may fail in their duty if the
board does not adequately supervise
management. The board must devise
some way to be sure that management
and employees conduct themselves in
the cooperative’s affairs in an ethical and
legal manner. The board also establishes
the cooperative’s strategic direction and
evaluates management’s progress toward
the cooperative’s goals. In addition to
selecting top management (usually the
manager or CEO), the board’s duty of
diligence requires that the board evaluate
management’s performance, establish
succession plans and, if necessary,
dismiss top management.
Often, questions about a director’s
performance revolve
around what the director
knows. Generally,
ignorance does not
excuse a director from
liability. Directors must
know what they are
doing or they cannot
satisfy their duty of care.
The knowledge requirement is usually
divided into two important parts.
Directors will be held accountable for
what they know and what they should
know. A director who is actually ignorant
of a fact is not excused if the law
requires that the fact should have been
known by the director.
How is a director to gain this knowledge?
Directors are sometimes said to
have a duty to inquire about facts which
are required for them to carry out all of
their responsibilities. Directors have a
right to inspect all books and records.
They have the additional
duty to understand the
financial condition of the
cooperative and its business
operations. Directors
are presumed to
know what is in the
cooperative’s books and
records. As a general
statement, directors will
be charged with knowledge
of what it is their
duty to know.
5. Duty of loyalty
Loyalty is perhaps the most troublesome
area of liability in corporate law,
including cooperative law. It is troublesome
because it is not well understood,
and the presence of disloyalty or conflicts
of interest is devastating to a director’s
personal position of trust in the cooperative.
As has been mentioned, directors
occupy a position of highest trust and
confidence upon which the cooperative
and the entire membership relies. That
position must be protected in any action
taken and in any decisions made.
Several kinds of behavior are prohibited
by the duty of loyalty. Self-dealing,
where the director makes a special profit
by doing business with the cooperative,
is a breach of the duty of loyalty.
As discussed in the previous article,
directors of cooperatives are placed
almost automatically in a position of
dealing with the cooperative. This is
not a problem if handled properly. In
fact, a common statutory provision
describes permissible situations. A typical
provision states “No director, during
the term of his office, shall be a party to
a contract for profit with the association
differing in any way from the business
relations accorded a regular member or
holders of common stock of the association
or others, or differing from terms
generally current in that district.” Conflicts
of interest situations always pose
special challenges.
The duty of loyalty imposes other
restrictions on directors. A director will
violate the duty of loyalty by dealing
with someone directly who could have
otherwise dealt with the cooperative.
This is called “appropriating the cooperative’s
opportunity.” Loyalty also
requires the highest degree of honesty
and fair dealing with the cooperative
and on the cooperative’s behalf.
Directors are often in a position
where they could violate the final aspect
of the duty of loyalty: that of confidentiality.
Directors are privy to information
about the cooperative that may not
be public. This is particularly the case
where directors have access to information
about the affairs of other members
of the cooperative. Directors are under
strict prohibitions about either divulging
confidential information to anyone else
or using it for their own benefit regardless
of the harm to the cooperative.
Generally, a violation of the duty of
loyalty, typically in situations referred
to as conflicts of interest, is the quickest
and surest way to make a director
liable for wrongdoing.
6. The business judgment rule
Directors constantly exercise judgment
on behalf of the cooperative, and
sometimes that judgment does not lead
to the best outcomes for the cooperative.
Unexpected events can turn a good
plan bad. Or directors may simply make
a mistake in judgment. What happens
when directors’ actions lead to losses or
other detriment to the cooperative?
Normally, courts will not interfere
with the internal operations of a business
to replace the judgments of the
directors with the court’s own judgment
on business matters after the fact. The
business judgment rule says that, absent
fraud or self-dealing, business judgments
made by directors will not be
overturned by the courts and will not
lead to director liability. Directors do
not and cannot guarantee the success of
the cooperative or each decision made.
Courts have generally given three
reasons for the business judgment rule.
Few members would be willing to
serve as cooperative directors if they
faced personal liability for good faith
errors in judgments that results in
harm to the cooperative. Courts also
recognize that courts themselves are
ill-equipped to make business judgments
for directors and that secondguessing
board decisions is not an efficient
way to monitor directors. Finally,
a cooperative cannot be managed efficiently
if directors are not given wide
latitude in law to handle the cooperative’s
affairs.
It is important to understand the limits
of the business judgment rule. Courts
usually say that the authority of directors
is absolute when they act within the law,
and questions of policy and internal management
are in the absence of nonfeasance,
misfeasance or malfeasance left
wholly to their discretion. The rule is not
a protection if the offending action was
an abuse of the board’s discretion, was
tainted with board member conflicts of
interest or was a result of the directors’
abdication of their duties to the cooperative.
Courts will step in and hold directors
liable for their actions when directors
are guilty of willful abuse of their
discretionary powers, or bad faith, or of
neglected duty, or of perversion of the
purposes of the corporation, or when
fraud or breach of trust is involved. Otherwise,
directors are not personally liable
for mistakes while exercising their
informed, best judgment.
7. Minimizing risk
An easy but inadequate suggestion
for avoiding problems as a cooperative
director is to understand and appreciate
the responsibilities listed in the first
article in this series, know and adhere
to all standards of conduct in this article
and make no mistakes that may be
detrimental to the cooperative. The
first two suggestions are in the control
of each director and are, in fact, the
best defenses to legal challenges to
director performance.
Protection is best when a proactive
attitude is adopted by each director to
know the responsibilities and standards,
understand what it means for the director’s
performance and identify particularly
sensitive issues in the cooperative,
for the board of directors and regarding
the director’s own personal performance.
Directors may also give attention to
several other actions and practices that
are beneficial to their performance.
Board structure, proper use of committees,
effective board discussions and
leadership, flows of information from
management to the board and good
board-management relations can avoid
a number of problems. Directors may
rely on experts, advisors, employees,
and board committees, within certain
limits. Reliance does not relieve directors
of their responsibilities but does
show care and diligence.
Reliance on others must, of course,
be justified and cannot amount to abdication
of responsibilities and duties.
Director training is key to effective
directorship. Effective training programs
must go far beyond indoctrination
by management about the cooperative’s
business from management’s
viewpoint.
Compliance programs can be helpful,
and in some cases are necessary, to
implement directors duties of care and
management monitoring. Compliance
programs are formalized internal programs
to monitor certain types of
behavior to be sure neither the cooperative
nor employees violate some law or
fail to take a required action. These
programs are typically designed around
legal requirements such as environmental
issues, antitrust and securities laws,
financing issues, or special problems
that may be sensitive for a particular
cooperative. To be effective, the board
must insist on workable programs, must
monitor their implementation and
insist on full support by management at
all levels. In some cases, a poor compliance
program is more likely to cause
problems than no program at all.
Legal audits are another technique
directors may use to assist them in
their duties. A legal audit can include
review of the cooperative’s legal structure
and documents that govern the
cooperative internally as well as its
relationships with members and others,
analysis of assets and liabilities,
evaluation of potential claims against
the cooperative, a thorough examination
of procedures in place and recommendations
for changes needed to
address weaknesses.
Whatever action is taken, the overall
attitude of directors should be active,
positive, creative and dynamic. The
great responsibilities imposed on cooperative
directors and the associated
potential for liability should not lead to
a defensive posture.
Indemnification
Legal challenges to cooperative
directors and litigation involving directors
cannot always be avoided. The
trauma of such actions against directors
is significant. In one regard, the burdens
can be relieved somewhat in most
circumstances.
Legislation has been used in many
states to allow a corporation (and presumably
a cooperative) to indemnify
directors who are subject to legal
action that requires expenditures of
sometimes substantial sums in defense.
Indemnification in this context simply
means that the cooperative pays for
costs incurred by a director who is
responding to legal actions for some
act as a director.
In addition to authorizing indemnification
and describing procedures for
indemnification, statutes usually establish
standards of conduct permitting
indemnification. A cooperative may not
be permitted to indemnify a director
where the director’s conduct in question
fails to meet certain standards of
conduct. For example, directors who
cause harm to the cooperative by selfdealing
or fraud against the cooperative
cannot demand indemnification when
they are sued for such actions. When
contemplating indemnification, a board
considers not only the applicable statutory
requirements and restrictions, but
also determines under what circumstances
the cooperative should or
should not indemnify a director.
indemnification, statutes usually establish
standards of conduct permitting
indemnification. A cooperative may not
be permitted to indemnify a director
where the director’s conduct in question
fails to meet certain standards of
conduct. For example, directors who
cause harm to the cooperative by selfdealing
or fraud against the cooperative
cannot demand indemnification when
they are sued for such actions. When
contemplating indemnification, a board
considers not only the applicable statutory
requirements and restrictions, but
also determines under what circumstances
the cooperative should or
should not indemnify a director.
Insurance
Cooperatives can purchase insurance
to protect the cooperative and its directors
in case costs are incurred defending
litigation against directors. Usually
called D & O insurance because it covers
both directors and officers, the
insurance is often in the form of two
policies. One covers directors to the
extent the cooperative does not fully
indemnify them for their costs. The
other covers the cooperative itself for
the indemnification made to directors.
As with nearly any insurance
arrangement, each policy will be tailored
to the needs of the cooperative.
Terms will be negotiated that include:
level of coverage, exclusions, claims or
occurrences methods, deductibles and
general claims procedures.
