Changes to the North Carolina Business Corporation Act Affecting Boards of Directors and Officers
The North Carolina General Assembly recently approved a number of significant changes to the North Carolina Business Corporation Act (“NCBCA”), which the governor signed into law and which will take effect on October 1, 2018 (the “Act”).[1] The NCBCA, codified in Chapter 55 of the North Carolina General Statutes, is based upon the Model Business Corporation Act (the “Model Act”), and the 2018 amendments are intended to update the NCBCA based on changes made to the Model Act as well as selected changes in state laws in other jurisdictions. This Client Alert describes certain changes to the NCBCA made by the Act that affect boards of directors and officers.
Changes to the North Carolina Business Corporations Act
Limiting and Eliminating Director and Officer Duties to Bring Specified Business Opportunities to the Corporation
The business opportunity doctrine is derived from an officer's or director’s duty of loyalty to the corporation. This doctrine prohibits such a person from usurping an opportunity that belongs to the corporation. In order to avoid liability in North Carolina, an officer or director accused of usurping a corporate opportunity must show that the transaction was “just and reasonable” to the corporation because it was not an opportunity the corporation would have wanted. In determining whether the corporation would have wanted an opportunity, courts assess various factors, including how a director or officer was made aware of the opportunity and whether or not the corporation was positioned to take advantage of it. However, this approach creates a great deal of uncertainty as to when certain opportunities need to be reported to the corporation.
In order to address this uncertainty, the Act authorizes corporations to limit or eliminate, in advance, the duty of a director, officer or other person to bring specified business opportunities to the corporation and creates related safe harbors from liability. Specifically, Section 2 of the Act changes N.C. Gen. Stat. 55-2-02(b) by adding subsection (4) which permits a company to set forth in its articles of incorporation a provision limiting or eliminating any duty of a director, officer or other person to offer the corporation the right to have or participate in one or more specific classes or categories of business opportunities. Such a provision may specify particular procedures or approvals prior to the taking of such business opportunities by directors. However, in order for such provisions to provide a shield from liability, they must be in place prior to the pursuit or taking of the opportunity by the director, officer or other person. As such, it is advisable for corporations to adopt such provisions at the company’s formation, although the articles of incorporation can later be amended to include them if necessary. For example, if a new director or officer joins Company A and already has pre-existing investments in or relationships with other companies within the same industry as Company A, the articles of incorporation of Company A could be amended to include procedures for such new director or officer to be able to continue to pursue business opportunities through those other companies without fear of running afoul of the corporate opportunities doctrine with respect to his or her fiduciary duties to Company A.
Section 10 of the Act also provides a related safe harbor for directors in N.C. Gen. Stat. 55-8-30(d)(ii). This section states that a director is not liable for any failure to offer the corporation the right to have or participate in a business opportunity prior to the pursuit or taking of the opportunity by the director or other person if the corporation’s articles of incorporation included a provision authorized by N.C. Gen. Stat. 55-2-02(b)(4) and if the procedures and approvals required by the provision, if any, were complied with or obtained prior to the pursuit or taking of the opportunity by the director or other person. Additionally, Section 12 of the Act provides an identical safe harbor for officers in N.C. Gen. Stat. 55-8-42(d)(ii). Once again, this section requires that the provision must have been in place prior to the taking of the business opportunity by the officer and the procedures or approvals required by the provision must have been complied with.
Through these changes, the Act creates an attractive environment for investors. For instance, private equity sponsors forming a corporation in North Carolina can now, pursuant to N.C. Gen. Stat. 55-2-02(b)(4), place provisions in the corporation’s charter specifying that directors are not required to present certain business opportunities to the corporation. If a director of a corporation that the sponsor had the right to appoint is later accused of indirectly usurping a business opportunity that sponsor placed with another of its portfolio companies and that business opportunity falls within the parameters of the advance waiver provision in the articles of incorporation, the safe harbor mentioned above will protect the director from liability as long as the provision was in place prior to the taking of the opportunity by the sponsor and as long as all of the requirements of the provision have been fulfilled. Prior to the Act, corporations seeking to take advantage of such provisions would have had to have been organized in a jurisdiction such as Delaware that permitted advance waivers of corporate opportunities. Now, these amendments eliminate any perceived advantages that other jurisdictions may have over North Carolina with regard to the application of the business opportunity doctrine.
Presumption of Fairness in Challenges to Board of Directors Compensation
When a board of directors approves their own level of compensation, an unavoidable conflict of interest arises. North Carolina law requires that such conflict of interest transactions be approved by disinterested directors, shareholders or be shown to be fair to the corporation in order to remain valid. In the latter situation, the burden of proof regarding fairness is placed on the shoulders of the interested directors. Thus, since a disinterested director or shareholder approval often is not feasible, the potential exists for frivolous claims to arise regarding a board’s level of compensation. Since these claims are unlikely to be dismissed at summary judgment and since the board of directors will bear the burden of proof regarding the fairness of their compensation decisions, the time and money costs of defending the board’s decision are such that a corporation may choose to settle even if the board’s compensation is appropriate.
In order to forestall these types of situations, Section 7 of the Act alters N.C. Gen. Stat. 55-8-11 and provides that, unless the articles of incorporation or bylaws provide otherwise, the board of directors, without regard to personal interest, may fix the compensation of directors for services in any capacity, and such compensation will be presumed to be fair to the corporation unless proven not to be fair by a preponderance of the evidence. Notably, this provision shifts the burden of proof from the board of directors to those challenging the fairness of their compensation. Claimants will now be required to allege facts that, if proven true, would be sufficient to overcome that presumption of fairness. For instance, a claimant might allege that, based upon reputable board compensation surveys, the amount of compensation fixed by the board of directors is materially out of proportion to the compensation of directors for comparable companies.
Thus, the Act creates a scenario in which challenges to board of directors compensation are much more likely to be dismissed at the summary judgement stage of litigation. This reduces the likelihood of nuisance settlements and disincentivizes frivolous claims while leaving meritorious claimants with the ability to pursue their causes of action. However, it is important to note that, while this amendment automatically applies to public corporations, private corporations must include provisions incorporating a presumption of fairness in their articles of incorporation in order to obtain the protections envisioned by the Act.
Creation of Subcommittees
Prior to the Act, North Carolina law did not expressly authorize boards of directors or committees to create subcommittees to exercise the power of a full committee. However, the need to create subcommittees has grown significantly since the adoption of the Sarbanes-Oxley Act in 2002 (“Sarbanes-Oxley”). This demand increased because, in the wake of Sarbanes-Oxley, the New York Stock Exchange and Nasdaq formally required public company boards of directors to use committees of independent directors for many essential areas of business, including in audit, nominating and compensation decision-making. Additionally, boards of directors of corporations are being asked to pay more attention to topics like climate change and cybersecurity. These factors have increased the pressure and workloads for independent directors in key committees. One method of addressing these increased demands has been to divide the work among subcommittees of smaller groups of directors. However, previous North Carolina law only allowed the informal creation of subcommittees by subordinating one committee to another in the relevant committee charter documents.
Section 9 of the Act updates N.C. Gen. Stat. 55-8-25 to allow committees designated by a corporation’s board of directors to create subcommittees of the full committee on an ad hoc basis. Specifically, the rewritten section provides that, unless the articles of incorporation, the bylaws or the resolution of the board of directors designating the committee provide otherwise, a committee, by the action of a majority of its members then in office when the action is taken, may create one or more subcommittees consisting of one or more members of the committee. Additionally, the section provides that the committee may delegate any or all of its powers and authority to one or more subcommittees. Thus, by providing a formal avenue for the creation of subcommittees, the Act allows North Carolina corporations to more efficiently meet the increased demands on the board of directors.
Appointment of Alternate Committee Members
Before the Act, N.C. Gen. Stat. 55-8-25 provided that a board of directors could create committees and appoint one or more members to serve on those committees; however, it did not address the issue of advance appointment of alternate committee or subcommittee members. Although the absence or disqualification of a committee member does not necessarily prohibit a committee from performing its duties, having the ability to appoint alternate committee members in advance permits committees to continue effectively accomplishing their duties without the necessity of convening a special meeting of the full board of directors to approve a short-fuse replacement. Such alternates may allow committees to maintain a quorum when board numbers are small, provide objective expertise in special committees and ensure that the interests of local subsidiaries are represented in national or international corporations with global board members when those primary directors are prevented from attending by the demands of their other duties.
With these advantages in mind, the Act in Section 9 updates N.C. Gen. Stat. 55-8-25 to add subsection (g) which empowers a corporation’s full board to designate one or more directors as alternate members of any committee, who may replace any absent member at any meeting of the committee, or a subcommittee of the committee, during the member’s absence. Such designated alternates could also fulfill the roles of members who have been disqualified, for instance, by conflicts of interest regarding the decision that the committee is making. For example, if the committee is deciding whether or not to enter a contract with a company owned by one of the committee members, an inherent conflict of interest would disqualify that committee member. Nevertheless, under the new NCBCA provision, an alternate committee member designated ahead of time by the full board would be immediately available to step into that position. This would allow the committee or subcommittee to continue the business at hand without having to take the time to appoint an alternate before moving forward, thus serving to increase the efficiency of boards of directors.
Prohibiting Retroactive Impairment of Rights to Indemnification and Advancement of Expenses
North Carolina law has long provided for corporations to indemnify officers or directors for liabilities incurred in a legal proceeding. Specifically, N.C. Gen. Stat. 55-8-51 grants corporations the authority to indemnify directors as long as they have acted in good faith, reasonably believed that their conduct in their official capacity was in the corporation’s best interests [2] and, in the case of any criminal proceeding, as long as they had no reasonable cause to believe their conduct was unlawful. Moreover, under N.C. Gen. Stat. 55-8-52, indemnification is mandatory for reasonable expenses incurred by directors when they are wholly successful, on the merits or otherwise, in the defense of any proceeding to which they are a party because they are or were a director of the corporation. Additionally, N.C. Gen. Stat. 55-8-53 grants corporations the ability to pay expenses incurred by a director in defending a proceeding in advance, as long as the advancement is approved by the board in specific cases or if the advancement is authorized or required in any provision in the articles of incorporation, bylaws or applicable resolution or contract. Additionally, other sections of the NCBCA, including N.C. Gen. Stat. 55-8-56, provide for indemnification and advancement of expenses on behalf of officers, employees and agents.
Prior to the changes implemented in the Act, North Carolina law was silent as to limitations on a corporation’s power to retroactively curtail rights to indemnification and advancement of expenses. However, a recent highly publicized case in the Delaware Chancery Court held that a former director’s advancement right had been eliminated by amendments to the corporation’s bylaws following his departure from the corporation’s board. This decision created uncertainty as to whether North Carolina corporations could similarly curtail or eliminate these rights subsequent to their initial guarantee.
Section 13 of the Act eliminates this uncertainty by adding a new subsection (d) to N.C. Gen. Stat. 55-8-58 that provides that a right of indemnification or advancement of expenses that is in effect at the time of an act or omission shall not be eliminated or impaired with respect to that act or omission by an amendment of the articles of incorporation or bylaws or a resolution of the directors or shareholders, adopted after the occurrence of the act or omission, unless the provision creating the right and in effect at the time of the act or omission explicitly authorizes the elimination or impairment of the right after the act or omission has occurred. Essentially, unless the original provision securing the right to the individual allows for elimination or impairment after the act or omission in question has occurred, corporations cannot subsequently curtail or eliminate those rights. Thus, the Act ensures that individuals who agree to serve as an officer or director of a North Carolina corporation, in reliance on, among other things, the corporation’s commitment in its charter, bylaws or board resolution to indemnify them and advance their expenses, can rest assured that the corporation will be required to fulfill its promises.
As is outlined above, the Act makes significant changes designed to increase the efficiency and attractiveness of serving as a director or officer of a North Carolina corporation, thereby making this state a more inviting place to do business. While the amendments do not take effect until October 1, 2018, we recommend that North Carolina corporations and their directors and officers understand their impact as the changes provide useful tools to improve board efficiency and attract qualified individuals to serve on boards of directors and as officers. Additionally, corporations may wish to consult their legal advisers regarding whether any portion of the legislation should be taken into account by the corporation now even though not yet effective. Further information regarding these and other provisions in the Act can be found here.
Special thanks to contributing writer Mark Rothrock, current student at the Duke University School of Law.
If you have questions about the recent changes in the Act or questions about the information in this Alert, please contact Dave Clement, Justin Truesdale or the Smith Anderson lawyer with whom you normally work.
[1] Senate Bill 622 (Session Law 2018-45), https://www.ncleg.net/Sessions/2017/Bills/Senate/PDF/S622v5.pdf.
[2] When acting in all other cases outside of their official capacity, N.C. Gen. Stat. § 55-8-51(a)(2)(ii) requires that a director’s conduct at least not be opposed to the corporation’s best interests.
Professionals
Attorney
