The wildcard in family-controlled firms: undue influence

The limited liability company is a great construct; an efficient vehicle for commerce, through which to pursue an overall aim (purpose) and to distribute wealth (however defined) over an extended period. What's more, mixed levels of ownership are possible; greater economies of scale are attainable (beyond what a sole trader or entrepreneur could typically achieve); and, importantly for absentee shareholders, liability is limited to the extent of the capital invested. 

Though they offer many benefits, the limited liability company is not without flaws—it is a social construction after all, and a complex dynamic one at that. The motivations, priorities and interests of various interested parties (shareholders, directors, managers and staff, amongst others) are often different. Contexts change, and egos can get in the way as well. Left unbridled, differences can fester, morale can suffer and, in more extreme cases, the company can be torn apart. Wynyard Group and Carillion are two recent example but there are many others. Family firms are not immune to such challenges. In fact, when the wildcard of family dynamics is added to the mix, family firms are actually more, not less, susceptible. Though not always visible, the spectre of undue influence often lurks as a contributing factor, as the following discussion reveals:

Failure to differentiate the roles of 'shareholder' and 'director': Let's start with some definitions. A shareholder is a person or entity that owns shares in a company. Ownership of shares affords certain rights, such as, selecting directors, receiving dividends and participating in major decisions. But those rights do not extend to running the business. That is the responsibility of managers, a delegation via the directors. In family firms, the roles of shareholder, director and manager can become blurred, especially when an influential family member holds multiple roles.​

The most common expression of undue influence that I've seen over the years relates to decision-making at the board table: a director with a significant shareholding 'expects' to influence significant decisions in their favour because they own a large parcel of shares. The important distinction that is lost (sometimes it is 'conveniently' neglected) in such situations is that the board meeting is not a proxy for a shareholder meeting. Shareholders and directors vote differently. Shareholder voting is conducted on a 'one vote per share' basis, whereas each director has a single vote at the board table. Regardless of whether directors hold shares or not, every director has an equal say.

If situations like this arise, they need to be nipped in the bud. If they are not, board meetings become a farce; the other directors puppets. This is far from acceptable, especially when the duty of acting in the best interests of the company (not any particular shareholder) is factored in. In most cases that I have observed, attempts to exert such [undue] influence tends to stem from ignorance and a desire to do what they think is fair, not malice. Usually, a quiet discussion with the director concerned is often all that is needed to resolve the matter. Another family member or an outsider (an independent director if there is one, or some other trusted advisor) are useful candidates for this task.

Treating the company as little more than a personal bank account:​ If I had a dollar for each time I've seen this in family firms... Recently, while observing a board meeting as part of an advisory engagement, a director asked, "Why are we always so short of cash when we are supposedly highly profitable?". The discussion that followed was both enlightening and disturbing—and, sadly, it was not the first time that I'd heard it play out. One director with banking access had been buying personal items with company funds and, from time to time, had been taking 'petty cash' for personal use. He saw nothing wrong with this because "it's my firm anyway".

If a director or shareholder uses company funds to acquire personal items, or uses the company bank account as if it were their own, they are acting in their own interests (whatever those may be). Their actions may put the viability of the company at risk as well. Neither of these motivations is permissible in law. Any shareholder wanting money from the company needs to ask the company, not just take it (that's theft!). Valid payment options include shareholder salaries (payment for effort/services rendered), dividends (a share of the profits), donations (but these may be taxable) and director's fees. ​The company may also agree to lend money to the shareholder. Regardless of the motivation or the payment option, a written policy which outlines the rules and conditions pertaining to payments to shareholders can help mitigate misunderstandings.

Employment of family members and related matters: ​Another expression of undue influence is the situation in which a family member 'pulls rank' to secure employment for themselves or another family member. While any family member may nominate anyone else (including other family members), to foist a particular person onto a manager is completely unreasonable. If managers are to be held accountable for performance, they  need to be free to make reasonable employment decisions themselves, in accordance with employment policy. In family firms, it is a good idea to add a section entitled 'Employment of family members' in the policy, to set out the rules the be applied whenever a family member is being considered for a role. 

While none of these examples of undue influence is unique to family firms, they are usually more visible (and often more destructive) in family firms. Once discovered, they need to be resolved. If not, family relationships can become strained, even to the point of breaking down. Actions that families might consider taking to prevent or at least mitigate the types of problems summarised here include:

• ​A set of written policies, that specify various operating boundaries. Employment of family members and payments to family members are two areas in which policies can be especially beneficial.
• A shareholder's agreement, which specifies how family members will interact with the company in matters relating to the company including acquiring and disposing of shares, employment, major decisions, dividends and voting rights, amongst others.
• A functional board of directors (and associated governance framework), to set strategy, approve policy and oversee the operation of the firm (in accordance with the approved strategy and policy).
• A communications framework, which outlines both the frequency and form of communications between the company and shareholders (and other stakeholders including non-shareholding family members).

Boards wanting to explore matters mentioned here should get in touch directly to arrange a private briefing.

This article is the second of three on the topic, 'Governance in family-controlled companies'. The first explored some items that are currently front-of-mind for many directors and shareholders of family-controlled firms. The third article, which will present recommendations to improve board effectiveness, will follow in late 2018.