Victor Lewkow, Jeffrey Karpf and Laura Palmer of Cleary Gottlieb Steen & Hamilton LLP examine the independence of directors in the boardroom.
"Boards and their counsel should keep in mind that directors who are independent for regulatory purposes may be deemed interested with respect to certain non-ordinary course transactions."
Prudent selection of outside independent directors is an increasingly complicated process for US public companies to navigate. Choosing board members who will be sufficiently independent to serve in unpredictable situations is difficult given the variety of independence standards under which they might be scrutinised. This scrutiny can come not only from the courts (according to one recent study, well over 90 per cent of public company mergers are now challenged in litigation), but also from institutional and other shareholders, proxy advisory services, academics, “governance experts”, the media and the public.
Federal Securities Law and Stock Exchange Regulations
Although board independence requirements have historically been thought of as a state corporate law matter, the Sarbanes-Oxley Act of 2002 requires national securities exchanges, such as the New York Stock Exchange (NYSE) and Nasdaq, to promulgate their own audit committee independence standards. Both the NYSE and Nasdaq require that a listed company’s board include a majority of independent directors and that all audit committee members be independent. The NYSE and Nasdaq independence standards, while not identical, are very similar and both provide bright-line tests to determine which directors are not independent. While the exchanges also require that the board of directors determine that a director is independent under a more qualitative analysis, the general threshold rules operate mechanically and often get most of the attention when boards are evaluating the independence of prospective new members.
Unfortunately, if a company only evaluates potential directors’ independence under these relatively straightforward rules, it might not scrutinise relationships that could become problematic if a non-ordinary course situation were to arise in the future. In the event of a merger or shareholder derivative litigation, for instance, a committee of independent directors may be responsible for negotiating and deciding whether to approve the proposed transaction or determining whether it is in the company’s best interests to pursue the suit. Under these circumstances, a board member who satisfies the threshold stock exchange independence requirements would not necessarily be considered independent for purposes of state corporate law. Conversely, a director who does not meet a stock exchange’s independence standard might be considered independent for state law purposes in the context of a particular situation. Even if the board does consider all relevant circumstances at the time the director is selected, it cannot always predict how circumstances may change over time, or what types of situations requiring independence might arise in the future.
Delaware State Law
A majority of major US public corporations are incorporated in Delaware, where state corporate law is considered the most developed. Its court decisions are often looked to for guidance by the courts of other states. Delaware state law independence determinations rely on an analysis of specific facts and circumstances to determine a director’s independence in the context of a particular board decision. In different situations or even different procedural postures in the same lawsuit, the same facts can yield a different independence analysis. As the Chancery Court noted in London v Tyrell (2010), “It is conceivable that a court might find a director to be independent in the pre-suit demand context but not independent in the [context of a motion to dismiss] based on the same set of factual allegations made by the two parties.”
Shareholder Derivative Litigation.
Under Delaware law, shareholders may not pursue a derivative suit to assert a claim against a corporation unless (a) they first demand that the directors pursue the corporate claim and the directors have wrongfully refused to do so; or (b) demand is excused as futile because the directors are deemed incapable of making an impartial decision as to whether to pursue the claim. In the context of a pre-suit demand, the burden is on the plaintiff to overcome a presumption that the directors are capable of impartial action. In Beam v Stewart (2004) the Delaware Supreme Court found that, despite a close working relationship between the board members and the insider trading defendant Martha Stewart, a majority of the board members were capable of fulfilling their fiduciary duties to the company because “allegations of mere personal friendship or a mere outside business relationship, standing alone, are insufficient to raise a reasonable doubt about a director’s independence”.
Contrast that decision, in the context of determining whether demand was excused, to the Chancery Court’s analysis in In re Oracle Corp Derivative Litigation (2003), evaluating a special litigation committee’s motion to dismiss. In Oracle, the court found that the defendant company did not meet its burden of proving that the special litigation committee (SLC) members were independent. A court will only grant an SLC’s motion to dismiss, based on its determination that it is not in the best interests of the company to pursue the suit, if the SLC can establish its independence. In Oracle, shareholders instituted a derivative action alleging that four directors had engaged in insider trading in breach of their fiduciary duties. Two other directors, who had joined the board after the time of the alleged insider trading, were appointed as an SLC to investigate and ultimately concluded that the allegations were without merit. Before Oracle, courts traditionally looked solely at the “economically consequential relationships” of directors to determine whether the directors in question were “dominated and controlled” and, therefore, not independent. In Oracle, however, the court also looked at personal, charitable and business relationships (the so-called “‘thickness’ of the social and institutional connections”) and whether the SLC members might feel “beholden” to the defendant directors. The court noted that “the question of independence turns on whether a director is, for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind”. In Oracle, both SLC members were faculty members at Stanford University and served, along with one of the defendant directors, on the board of the same Stanford research institute. In addition, several defendant directors had contributed millions of dollars to Stanford, either directly or through charities or trusts they controlled. Due to the nexus of ties between the SLC members and the defendant directors, the court found that the SLC was not independent.
Similarly, in London v Tyrell, the court denied an SLC’s motion to dismiss, citing, among other factors, material questions as to the SLC members’ independence. The court noted that “when an SLC member has no personal interest with respect to the disputed transactions, the court scrutinizes the members’ relationship with the interested directors, as that would be the source of any independence impairment that might exist”. The question, the court stated, is whether the SLC member “can make a totally unbiased decision”, which might not be possible if the member feels that he “owes something to the interested director”. The court elaborated that “this sense of obligation does not need to be of a financial nature.” In London, one member of the SLC was found not to be independent because his wife was the cousin of one of the director defendants, even though his wife and her cousin were “not close”. The other member of the SLC was considered not to be independent because one defendant had served as CEO of a company founded by the SLC member and had made significant contributions to the successful sale of that company. As a result, the court found that there was “a strong possibility” that the SLC member might feel a sense of obligation to the defendant director and, therefore, not be independent.
Under Delaware law, independence also plays a key role in many M&A transactions where a controlling shareholder, director or officer stands on both sides of the transaction, making the transaction subject to judicial review under the strict “entire fairness” standard. For example, in Southern Peru Copper Corporation Derivative Litigation (2011), the Chancery Court examined a recommendation by a special committee of the Southern Peru board established to evaluate a proposal from its majority shareholder, Grupo Mexico, that Southern Peru purchase Grupo Mexico’s 99 per cent stake in another company. “Entire fairness” review requires the defendant to “demonstrate that the deal was entirely fair to the other stockholders”. One way the burden can be shifted to the plaintiff is if the defendant can establish that an independent board or special committee approved the transaction.
The court found the Southern Peru special committee was not “well-functioning” and therefore would not shift the burden of proving “entire fairness” to the plaintiffs. The court was troubled by the fact that the SC had a limited mandate, leading it to operate under a “controlled mindset” that compromised its independence and, therefore, effectiveness. The court also examined at length the fact that one of the four directors on the special committee had been appointed by Cerro, a 14 per cent shareholder. While a director appointed by a significant minority shareholder may often be independent of the majority shareholder and have the same interests as the public stockholders, in this case the Cerro director’s independence was found to have been compromised because Cerro was seeking registration rights for its Southern Peru shares at the same time that the special committee was evaluating the proposed acquisition. If the special committee did not approve the merger, Cerro would not receive registration rights and its investment would remain illiquid. In addition, the court was troubled that at the same time the Cerro board member was negotiating a transaction based on the transaction’s claimed long-term value for Southern Peru, Cerro was seeking to exit its investment and thus had no long-term interest in the company.
Full Circle Back to Stock Exchange Regulations
In a footnote to the 2003 Oracle decision, then-Vice Chancellor (now Chancellor) Strine compared the Delaware law analysis to the-then recently enacted NYSE and Nasdaq independence standards, noting that the exchange rules “reflect a narrower conception of who… can be an independent director” because those definitions are “blanket labels.” However, he also noted that the exchange rules “recognize that factors other than the ones explicitly identified… might compromise a director’s independence, depending on the circumstances”. The commentary to the NYSE rules note that “material relationships [with the listed company] can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others” and that “the concern is independence from management”. In 2010, in the context of a merger between The Stanley Works and The Black & Decker Corporation (B&D) the NYSE questioned one special transaction committee member’s independence from management because he and the CEO were co-investors in a real estate development. After some back and forth between the NYSE and B&D, B&D issued a press release stating that “representatives of the NYSE advised [B&D] that, in interpreting its rules, the NYSE believes relationships between a director and a member of senior management that are material to either party should be considered by a board of directors in its evaluation of a director’s independence”.
Pursuant to provisions of the Dodd-Frank Act of 2010, the NYSE and Nasdaq are implementing rules, effective as of 1 July 2013, requiring that compensation committees also be comprised solely of independent directors. The NYSE rules state that a board “must consider all factors specifically relevant to determining” independence for the purposes of being a compensation committee member. While the NYSE rules remain relatively mechanical, the acknowledgment of the importance of considering “all factors,” together with these other recent developments, could indicate that the NYSE is also moving towards a more qualitative analysis when evaluating director independence.
Determining whether an outside director is independent under any given set of circumstances can be a difficult task for a board of directors and its counsel. Boards and their counsel should keep in mind that directors who are independent for regulatory purposes may be deemed interested with respect to certain non-ordinary course transactions. On the other hand, some directors who are not independent under bright-line stock exchange tests might well be independent for state law purposes in dealing with a particular situation.