The Board of a Company is the Basis of Good Governance. When a new business is formed, entrepreneurs ask attorneys: “how many directors should I have?”. Others may also ask: “since this is a single-owner company do I need directors or managers?”. The reality is that if you want to look professional and trustworthy before customers, investors, and strategic partners, you should have a board of directors or at least a clear structure of corporate governance. If you have a single-owner company, you can have a single-member board.
Corporate governance speaks of the company’s organizational structure, where decisions are made after consideration of benefits and costs, advantages and disadvantages, and the company’s policies. Corporate governance exists for purposes of transparency, security, diligence.
Regarding the number of members that a board of directors or managers should have, it is always better to have an odd number to avoid deadlock. Deadlock is the circumstance where two directors or managers do not agree regarding the company’s relevant decisions, and there is no third member to serve as a tie-breaker. Even companies with only one member should consider having a team of managers or directors. The idea is to give the company a clear structure, promote the discussion of decisions, and demonstrate diligence.
What would happen if the only member of the company is another entity?
Whether the company has one or more members having an odd number of managers or directors is always the best. If a company has a single owner, and that owner is another entity with several owners or directors, one must understand how that entity makes decisions. If the owner of a company (Company A) is another company (Company B), it is important to understand that Company B as the single owner of Company A, makes all decisions through the persons that manage it. This means that a board of directors or the managers of Company B will decide the course of Company A. In this case, Company B may want to have an odd number of directors or officers to avoid a deadlock. In the end, what matters is the number of human beings deciding the destiny of the company.
How the owners of the company elect the directors or managers? Is it possible to avoid a deadlock?
The best strategy to avoid deadlock is to have an odd number of directors or managers. Additionally, to have a balanced board, one that makes decisions considering the interests of all the owners of the company, each owner of the company should have the possibility to elect at least one member of the board. In the case of a company with two owners, an option is to have each owner elect at least one director of their choice and agree on the election of a third member who is independent and will serve as a tie-breaker. Especially in this scenario, it is important to pay close attention to the terms of the company’s internal agreement and understand how will be elected the tie-breaker.
Two illustrate the importance of a clear agreement regarding a tie-breaker director’s election a recent Delaware can help us. In Franco v. Avalon Freight Servs, LLC, 2020 Del. Ch. LEXIS 359, the company center of the company was Avalon Freight Services LLC (“Avalon”), a maritime freight transportation services provider owned by a single member, GH Channel Holding LLC (“Holding”). Holding is governed by an LLC agreement (the “Holding LLC Agreement”). The Holding LLC Agreement stated that ownership and control would be distributed evenly between Harley Franco and Greg Bombard. Franco and Bombard being the two sole members of Holding’s board of directors, have equal control over Avalon’s sole member.
Franco and Bombard also agreed to control Avalon equally. Accordingly, under the Avalon LLC Agreement, Avalon would be managed by a board of five directors, two aligned with Franco, two aligned with Bombard, and one tiebreaker director. Additionally, according to the Avalon LLC Agreement, the fifth director (“Houghton”) would be mutually agreed upon and appointed by Bombard and Franco.
Later in their endeavor, Bombard and Franco were in deadlock, and relevant to this analysis, disagreed about replacing or not the fifth director. While Franco disagreed that Houghton should continue to serve in that role, Bombard wanted Houghton to retain his position. As a result of the conflict, Franco filed a lawsuit seeking a declaration that given his dissatisfaction with Houghton, his position should be vacated, and Franco and Bombard should mutually agree on a new person to fill the position. However, the Court of Chancery of Delaware denied Franco’s petition and explained the following:
– Limited liability companies (or any other when it comes to corporate governance) are creatures of contract, which means that disputes among conflicts between its members or owners are decided based on the terms of the parties’ bargained-for agreement. Accordingly, the role of the court is to interpret the contract and effectuate the parties intent.
– When a Delaware court interprets any contract, the goal is to prioritize the parties’ intentions as reflected in the four corners of the paper, the written agreement, and not external factors. Additionally, Delaware adheres to the objective theory of contracts so that the agreement’s language is interpreted as it would be understood by an objective, reasonable third party.
Under the Avalon LLC Agreement, Franco and Bombard agreed to elect a fifth tie-breaker board director mutually. The agreement’s plain language did not require that Franco and Bombard continue to agree, nor did it provide for any mechanism by which they should or could periodically evaluate their agreement.
‘Certainly, Franco and Bombard could have drafted it that way, by requiring that “the fifth director shall be mutually agreed upon at all times” or by providing that they must “continue to mutually agree” on Houghton’s appointment.’ Avalon Freight Servs. LLC, 2020 Del. Ch. LEXIS 359, *7
- By allowing any of the two, Franco or Bombard, to unilaterally displace the tie-breaker director, the court would have allowed one side to take control of the company. That situation would have forced Houghton to take the side of that threatening to remove him.
Finally, regarding the importance of tie-breaker in two-owners companies, the court explained:
Sophisticated parties who co-own a company in which ownership is closely tethered to control often include tiebreaker provisions as an ex ante dispute resolution mechanism, to prevent deadlock which may lead to dissolution. In one such mechanism, the owners have equal voices on the board, and give a swing vote to a third-party tiebreaker director. In the event of deadlock, the tiebreaker director can consider the company’s best interests without being beholden to either side, constrained by fiduciary duties but free of the owners’ competing interests. The presence of a tiebreaker director may also inspire the owners to manage their investment through cooperation and compromise, without resorting to the tiebreaker. Avalon Freight Servs. LLC, 2020 Del. Ch. LEXIS 359, *9
Key Take-Aways
- To promote transparency, security, and good corporate governance, all companies should have a board of directors.
- The owners elect the number of directors. However, it should promote the participation and recognition of all owners.
- The number of directors should be an odd number to avoid a situation of deadlock.
- The rules governing the election of directors should be clear for all the parties because it is a contract between the owners of the companies, and it will be strictly construed in the context of litigation.
