Class-Designated Director Structures: Pros and Cons
Under the Canada Not-for-profit Corporations Act (the "CNCA"), the default rule is that all voting members elect the entire board of directors at each annual meeting. Some organizations vary this default rule because it can result in a loss of board continuity if the entire, or substantially the entire, board is replaced at one annual meeting or because the default rule can expose the organization to a hostile take-over. The possibility of a hostile take-over is much greater in an organization in which there is a large membership body but a low membership turn-out at elections. In these conditions, there is widespread member apathy. Apathy creates an opportunity for a small group (measured as a proportion of the overall membership) to organize a coup - particularly if proxies can be used to obtain votes from members who are too indifferent to attend in person or who can be recruited by the dissident group to become members specifically to support the dissident slate of directors.
One method of deterring a hostile take-over is the use of a bifurcated class structure or class-designated directors.
1. Overview of Class-Designated Directors
Briefly, a class-designated director structure works like this. The articles provide for a fixed number of directors and two or more classes of members. Each class of members has the exclusive right to elect a portion of the overall board. Each class of members can also remove any of the directors it elects and replace these directors with individuals more to their liking. The election of the directors of each class can take place at the same annual meeting (except that each class votes separately with respect to its designated portion of the board) or at separate meetings of each class.
Suppose that, under its articles, a corporation has a fixed number of nine directors and three classes (A, B and C) of members. Under the articles, each class has the right to elect annually three directors (called the class A, B and C directors respectively). The class A members have the right to elect or, at any time by ordinary resolution of the class A members, replace any or all of the class A directors. The class B and C members have parallel rights. Alternatively, the corporation may have only two classes of members, each having the right to elect a portion of the board (for example, the class A members electing five class A directors and the class B members electing four class B directors).
In some circumstances, a class-designated board structure can be useful.
2. Uses of Class-Designated Directors
The potential uses or advantages of a class-designated board structure include:
● The corporation can offer a wide membership (which may lead to higher annual membership dues). The wider membership can elect a portion of the board but not all, or even a majority of the board. That is, the wider membership can have either control of the board or merely a voice on the board. There is structural flexibility.
● The remainder of the board (perhaps a majority of the board seats) can be elected by a separate class of members, the composition and loyalty of which are more stable than the membership at large. For example, the separate class could consist of the directors themselves, founding members or members contributing large amounts of annual funding.
● The corporation can structure itself to get the best of both the (a) stability of a closed membership (where the only members consist of directors) and (b) fund-raising advantages of a wide membership and participation in the governance of the corporation (without the risk of a hostile take-over).
3. Creating a Class-Designated Board Structure
To create a class-designated board structure, the articles of the corporation must be amended to provide as follows:
● A fixed number of directors. Since the board seats must be divided among two or more separate classes of members, it is important to fix the overall number of directors and avoid a floating board. Otherwise, there will be confusion. If the board is increased, which class elects the additional directors? If only one class elects the additional directors, that class has a strong incentive to elect the maximum number of directors, thereby diluting the proportion of the directors elected by other classes of members.
● Two or more classes of members, each with separate voting rights. Each class would have the exclusive right to elect a fixed number of directors on the board. In addition, the class would have the exclusive right, exercisable at any time by ordinary resolution of the class, to remove any of the directors that it elects or to fill vacancies in the directors it has elected. Alternatively, these vacancies could be filled by the other directors elected by the same class.
● No amendments to the number of directors or the voting rights of the class can be made without the approval by special resolution of each class of members. The rights of a class of members are illusory if the other class can unilaterally amend the articles to remove or vary the rights.
● On other issues, the classes could vote together as a single class.
4. Disadvantages
A class-designated board structure introduces a level of complexity that may be unwarranted in many organizations. If none of the advantages described at Part 3, above, apply, the corporation should not adopt a structure more complex than it needs unless there are compelling reasons to do so. Complex structures created added work, not only at the creation stage but also ongoing administrative burdens to ensure that elections are held in accordance with the separate voting rights.
Also, a class-designated board structure can be difficult to amend or unwind. An amendment or collapse of the structure requires a separate special resolution (i.e. at least two-thirds) of each class of members, which can be difficult to obtain if members with vested interests become adverse to change.