Director Independence, Personal Relationships, and the Beach House Standard: In re Orchard (Part 3) 

We are discussing In re Orchard Enterprises, Inc. Stockholder Litigation, a decision by VC Laster.

In allowing the matter go to trial, the court was influenced by a variety of factors. There were alleged personal ties. There were alleged economic ties. And there was the director's purportedly unique role in the process. He was the chair of the special committee and alleged to be the "point person" for the target company. Trial will sort out the facts. The court could still find that the director met the standard for independence.

Nonetheless, the case has the capacity to significantly alter board behavior. The case provides some insight into the types of personal relationships that can result in a loss of director independence. Loss of independence can make it easier for derivative suits to go forward. They can result in the refusal of a court to give a board decision maximum deference. As a result, directors have an incentive to know about these relationships and minimize their presence on the board.  

Likewise, the case has the potential to intersect with the federal regulatory process. Public companies must determine whether directors meet the definition of independent. In doing so, boards of NYSE companies must consider any "material relationships" with the listed company. Material relationships can include business and personal ties between directors and management. As the Agency has noted 

  • Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE Arca’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board. 

The requirement is discussed here. Moreover, to the extent a business or personal relationship is considered but not deemed sufficient to affect independence, disclosure must occur. See Item 407(a) of Regulation S-K (providing instructions for disclosure "by specific category or type, any transactions, relationships or arrangements . . . that were considered by the board of directors under the applicable independence definitions in determining that the director is independent.").   

Orchard provides some insight into the types of relationships that can result in a loss of independence. Under the federal system, these relationships need to be considered and possibly disclosed. Increased disclosure of personal and business relationships between directors and management will in some circumstances engender criticism by shareholders, including "just say no" campaigns. They may facilitate legal challenges that center upon the independence of directors. These possibilities could result in a reduction in the nomination of directors with these types of relationships.    

Orchard is an isolated case. Nonetheless, the decision may have a large impact on the make up of boards. Directors with close personal relationships to management may become less common. In other words, boards will actually become more independent.  

Primary materials can be found at the DU Corporate Governance web site.


Director Independence, Personal Relationships, and the Beach House Standard: In re Orchard (Part 2) 

We are discussing In re Orchard Enterprises, Inc. Stockholder Litigation, a decision by VC Laster.

According to the opinion, Dimensional held 53% of the voting power of Orchard, rendering it the controlling shareholder. Dimensional, a private equity fund, was owned by JDS Capital, a firm founded by Joseph Samberg.  

As the Proxy Statement for Orchard described:  

  • Joseph D. Samberg has a direct minority membership interest in Dimensional Associates and is managing member of JDS Capital Management, LLC. As the managing member of JDS Capital Management, LLC, the ultimate parent of Dimensional Associates, Joseph D. Samberg may be deemed to have sole voting and sole dispositive power with respect to all of our equity securities that are owned of record by Dimensional Associates.

Proxy Statement, The Orchard Enterprises, Inc., 2010, at 104.   

Dimensional decided to acquire the remaining shares of Orchard. Donahue served as the chair of the special committee formed to negotiate with Dimensional and was described in the opinion as the "point man" for Orchard. Discovery revealed connections between Donahue and the Samberg family. According to the opinion:     

  • Discovery revealed that Donahue has long-standing ties to members of the Samberg family. Donahue and Jeff Samberg, who is Joseph‘s brother, have been business associates and personal friends for approximately twenty years. They attended the NCAA Final Four together every year from 1999 to 2008, and they have invested together in fifteen different companies, either directly or through Greylock Partners, a venture capital fund. Donahue and Arthur Samberg, Joseph and Jeff‘s father, are also long-time friends. 

In addition, Donahue "approached Dimensional about serving as a consultant" after the merger closed and in fact provided "post-closing consulting services", receiving annual compensation of $108,000. 

Shareholders challenged both the independence of, and the disclosure about, Donahue. In considering the contention, the court noted that it was not enough to show "past business and social connections between Donahue and the Samberg family."

Nonetheless, the allegations took on a "greyer hue" when coupled with "evidence concerning Donahue's consulting work for Dimensional regarding Orchard after the closing of the transaction. . ."  The court noted that the materiality of the connections was "even more significant" since the director played a "leading role" in the negotiation process. See Id. ("The factual record could support a finding at trial that Donahue was the committee's most influential figure, making his independence and disinterestedness all the more important."). Moreover, as chair of the special committee, he was paid more than the other directors. With respect to the disclosure issue, the court noted that the relevant inquiry was "not whether an actual conflict of interest exists, but rather whether full disclosure of potential conflicts of interest has been made."

The court found the evidence sufficient to create an issue of fact that could only be resolved through trial.  

  • At this stage of the case, in the context of a controller squeeze-out, it is not possible to rule as a matter of law on the materiality or completeness of the disclosures about Donahue. The plaintiffs have cited evidence which, if credited, could lead to findings of fact that would render the disclosures about Donahue incorrect or, alternatively, cause them to be viewed as misleading partial disclosures. The defendants have pointed to evidence which, if construed in their favor, could result in findings of fact that would lead to the disclosures being accurate. 

Primary materials can be found at the DU Corporate Governance web site.


Director Independence, Personal Relationships, and the Beach House Standard: In re Orchard (Part 1)

Delaware courts rely on a process standard when it comes to fiduciary duties. As long as matters are determined by "independent" directors on an "informed basis" the courts will essentially defer to the decisions. Even the duty of loyalty effectively devolves into process. Where the matter involves a conflict of interest, courts apply the duty of care when the transaction is approved by a board with a majority of independent and informed directors.  

Whatever the merits, the approach logically requires that the process be meaningful. On this score, the management friendly nature of the Delaware courts has prevented this from occurring.  

Director independence is the most obvious place where this can be seen. The courts assume directors are independent and disinterested. They dismiss challenges to independence on something resembling a motion to dismiss (usually motions for failure to make demand), denying shareholders discovery even when there is obvious evidence suggesting the possibility of a conflict. As a result, "independent" director in Delaware really means a director who may not be independent but has not allowed sufficient information to leak into the public domain to permit an alternative finding.

Nowhere is this more apparent than with respect to business and personal relationships between directors and management. Embarrassingly, courts in Delaware at one time categorically held that personal and business relationships were insufficient to impair independence. Thus, in Disney, the Supreme Court upheld as a matter of law the following conclusion by the lower court: “The fact that Eisner has long-standing personal and business ties to Ovitz cannot overcome the presumption of independence that all directors, including Eisner, are afforded.”

The Supreme Court backpedaled in Beam by concluding that the relationships could result in a loss of independence but adopted a seemingly impossible standard. To rebut the presumption of independence based upon personal relationships, shareholders were required to show that “the non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.”

Given the lack of discovery that usually occurs in these cases, the ability to show the strength of a business and personal relationship was almost impossible. The standard, therefore, largely eliminated consideration of outside business and personal relationships from the independence analysis. This issue is discussed at length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty

This was the approach taken by Delaware courts. In In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013), the court suggested the kind of information that would need to be uncovered to show a disqualifying friendship. As the court stated:  

  • Even in the context of personal, rather than financial, relationships, the materiality requirement does not mean that the test cannot be met. For example, it is sometimes blithely written that “mere allegations of personal friendship” do not cut it. More properly, this statement would read “mere allegations of mere friendship” do not qualify. If the friendship was one where the parties had served as each other's maids of honor, had been each other's college roommates, shared a beach house with their families each summer for a decade, and are as thick as blood relations, that context would be different from parties who occasionally had dinner over the years, go to some of the same parties and gatherings annually, and call themselves “friends.”

The reference to a "beach house" is a bit of a reminder that Delaware is gifted with some remarkable ocean front property. Nonetheless, with almost no fortune 1000 companies actually headquartered in Delaware (DuPont and Hercules excepted), the likelihood that the officers and directors will live in the state and have shared a beach house (at least in Delaware) is presumably small. 

The opinion effectively reaffirmed the difficulties imposed by the Delaware courts on shareholders in demonstrating a lack of independence. The court did not indicate how shareholders were, in the absence of discovery, supposed to know that the relevant parties "shared a beach house" or otherwise had a relationship that was as "thick as blood." (MFW involved expedited discovery but most cases addressing director independence do not). 

Nonetheless, the quote provided some guidance of sorts. It came up in In re Orchard. We will discuss the case in the next several posts.  

Primary materials on the case can be found at the DU Corporate Governance web site.


Duties of the Audit Committee: In re Kiang

The Commission filed an administrative action against a company alleging that it had misrepresented the identity of its CFO. According to the complaint, the company identified an individual in a number of quarterly filings as the acting CFO. The filings also contained certifications "that ostensibly bore the purported Acting CFO’s electronic signature when, in reality, the purported Acting CFO had not signed" the filings. Interestingly, a parallel criminal action was also filed in the case by the U.S. Attorneys Office. 

The issue raises an interesting question as to materiality. Misrepresenting the identity of an officer will not always matter to the market. The CFO, however, is a particularly important position so the market presumably pays more attention to the person serving in that position. Moreover, in this case, the SEC alleged that the CEO really performed the CFO's functions. Materiality could be less about mis-identifying the CFO and more about failing to disclose that the positions had been effectively combined.  

What made the claim particularly interesting, however, was the role of the chair of the audit committee in connection with the matter. According to the allegations of the SEC, the person designated as "Acting CFO" contacted the chair of the audit committee and informed the chair about the inaccurate disclosure. The audit chair allegedly contacted the CEO and, according to the complaint, was told: 

  • The purported Acting CFO had not actually served as the company’s Acting CFO; that [the CEO] had used the purported Acting CFO’s name on [the company's] public filings without the purported Acting CFO’s permission; told [the audit chair] not to worry about it because it was in the past; told [the audit chair] to not tell anyone about the purported Acting CFO, including the company’s Board of Directors or the public; and that, if she shared this information with anyone, [the company's] reputation would be affected negatively and its stock price would drop.

In re Kiang, Exchange Act Release No. 71824 (admin proc. March 2014).  

Thereafter, the audit chair allegedly signed an annual report that "contained a false Sarbanes-Oxley certification" providing that "based on [the CEO's] and the other certifying officer’s most recent evaluation of the company’s internal control over financial reporting--any fraud, whether or not material, involving management had been disclosed to the company’s auditors and to the company’s Audit Committee."

The Commission brought and settled an administrative action against the audit chair. The SEC alleged that the audit chair violated Section 13(a) for causing the filing of a Form 10-K that included a "false Sarbanes-Oxley certification." The audit chair was ordered to "permanently refrain from signing any Commission public filing that contains any certification required pursuant to the Sarbanes-Oxley Act of 2002."  

Thus, the chair of an audit committee was sanctioned only for a non-scienter based offense after learning about misrepresentations in filings about the identity of the CFO and failing to report the matter to the board. Given the knowledge of the alleged misrepresentation, this is a weak sanction.  

Moreover, the subsequent "failure" was not entirely clear. The chair of the audit committee signed a filing that included the traditional SOX certification. The certification includes a representation by the applicable officer that fraud had been disclosed to the auditor and the audit committee. In fact, the alleged fraud was disclosed to the chair of the audit committee, yet this was apparently not deemed sufficient.

The case suggests that disclosure to one director on the audit committee is not the same as disclosure to the entire committee. As a result, the case stands for the proposition that a director learning about fraud has an obligation to disclose the matter to the entire committee. The approach also suggests that officers executing a certification may not fulfill their obligation by informing only the chair. As a result, reports of fraud should go to all members on a committee.  


Be Careful of Title Inflation: Court Extends Right to Advancement to Non-Managerial “Vice-President”

A recent case in the US District Court for the District of New Jersey is worthy of consideration given the not uncommon corporate practice of bestowing fancy titles on employees.  Many companies engage in title inflation—handing out titles that have little to do with actual job responsibilities.  They should be careful when they do so as demonstrated by Aleynikov v. Goldman Sachs Group. In that case, the court held that an individual with the job title of “vice president” was entitled to advancement of legal fees exceeding $700,000 despite Goldman’s claim that the employee’s job title was the result of title inflation and that he was simply “a midlevel computer programmer with no managerial responsibilities.”  In its opinion the court considered the import of Delaware law permitting advancement and the proper interpretation of Goldman’s by-laws. 

DGCL Section 145(e) 6 authorizes the advancement of expenses being incurred in pending proceedings. Its aim is to provide "immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings." Del. Code Ann. tit. 8, § 145(a) & (b)).  Provision for advancement is typically made in a corporation’s articles or by-laws.  In this case, the relevant provision was found in Section 6.4 of GS Group's By-laws which state:

  • The Corporation shall indemnify to the full extent permitted by law any person made or threatened to be made a party to any action, suit or proceeding, whether civil, criminal, administrative or investigative, by reason of the fact that such person or such person's testator or intestate is or was a director or officer of the Corporation, is or was a director, officer, trustee, member, stockholder, partner, incorporator or liquidator of a Subsidiary of the Corporation . . . . Expenses, including attorneys' fees, incurred by any such person in defending any such action, suit or proceeding shall be paid or reimbursed by the Corporation promptly upon demand by such person and, if any such demand is made in advance of the final disposition of any such action, suit or proceeding, promptly upon receipt by the Corporation of an undertaking of such person to repay such expenses if it shall ultimately be determined that such person is not entitled to be indemnified by the Corporation. The rights provided to any person by this by-law shall be enforceable against the Corporation by such person, who shall be presumed to have relied upon it in serving or continuing to serve as a director or officer or in such other capacity as provided above.

The By-Laws define “officer” in relevant part as follows:

  • when used with respect to a Subsidiary or other enterprise that is not a corporation or is organized in a foreign jurisdiction, the term "officer" shall include in addition to any officer of such entity, any person serving in a similar capacity or as the manager of such entity. 

The case in question raised the issue of whether Sergey Aleynikov, who worked at Goldman, Sachs & Co. ("GSCo") could obtain advancement of legal fees from. Goldman Sachs Group, Inc. ("GS Group"- the parent company GSCo). GSCo. Is a New York limited liability partnership, and therefore is "a Subsidiary or other enterprise that is not a corporation" with-in the By-laws. Aleynikov claimed that because he held the title of "vice president" he was on officer under the By-Laws and hence entitled to advancement.

In the initial proceedings in the case the court stated:

  • A "vice president"—Aleynikov indisputably held that title—would ordinarily be considered an "officer" in a corporate context. In a non-corporate partnership entity like GSCo, however, "officer" and "vice president" have no fixed definition. Moreover, it does not appear that Aleynikov, a computer programmer, performed functions normally associated with the status of officer or manager. The definition of a non-corporate "officer" in GS Group's By-laws is circular and unhelpful. Aleynikov argues that I should therefore let the burden of ambiguity fall on GS Group, take the title of "vice president" at face value, and declare him eligible for advancement of fees. GS Group urges, however, that "vice president" can be something of a courtesy title in its industry. It further alleges that it has established a process of appointment that clearly distinguishes between officers and non-officers. If true, this would be highly relevant; an entity may decide whom to designate as an officer.

The court began its analysis by recognizing Delaware's strong statutory policy favoring advancement of fees and expenses which for the court suggested that the “By-Laws should be read liberally and expansively.”

In its defense, Goldman argued that established practices of GSCo. showed that GSCo had a practice of appointing its officers only by "formal resolution," and noted that there was no such resolution appointing Aleynikov. Goldman produced eleven "Written Consents of the General Partner of Goldman, Sachs & Co" which named or removed officers of GSCo.  However, Goldman did not produce any evidence that the appointment by resolution procedure for naming officers was established or documented, nor did it “explain how a reader of By-Laws Section 6.4 would know that, for a non-corporate subsidiary, specifically a New York limited liability partnership, an "officer" is, and only is, an individual who has been appointed by written resolution of the general partner.”  “Goldman thus proffers evidence of a practice, not a policy, with its roots apparently in regulatory, but anyway not indemnificatory, concerns. This evidence does not solve the definitional issue: the meaning of the term "officer" in Section 6.4 [3] of the By-Laws.”

So what about the title?  Aleynikov argued that because he held the title of "vice president" he was an officer under the "plain and commonly-understood meaning" of the term. Goldman replied that Aleynikov's job designation was simply the result of the common practice of title inflation.  “Vice president is merely a functional title, because it connotes a level of seniority between associate and managing director.”  The title is held by "thousands at the firm and across the financial services industry"' and the By-laws could not have been intended to cover so many.

While accepting the reality of title inflation, this argument failed to sway the court.   First, if the title was handed out in the “bounteous” way alleged by Goldman, it would not prevent individuals given that title in a corporate entity from being covered by the By-Laws, as the court felt it was clear that corporate vice-presidents are officers.   “So even taking Goldman's account at face value, it cannot be just the sheer number of vice presidents, or the industry's over-exuberance in bestowing the title, that bars Aleynikov’ s  position from consideration.”  “It may be the case that Goldman (or the industry of which it is a part) has been profligate in conferring the title of vice president. If so, Goldman must bear the consequences of that profligacy. Goldman might easily have chosen to be more sparing with job titles, or to confer them in some other way. It might easily have drafted its By-Laws to restrict indemnification to a well-defined class. It did not.”

The court then went on to apply “ordinary rules of contract interpretation, finding “it likely that the average person in the street would consider a vice president to be an officer.  The court noted the manner in which Delaware applies contract rules in the context of a business's bylaws or organizational agreements:

  • In general terms, corporate instruments such as charters and bylaws are interpreted in the same manner as other contracts. Absent ambiguity, their meaning is determined solely by reference to their language. To demonstrate ambiguity, a party must show that the instruments in question can be reasonably read to have two or more meanings. And "[m]erely because the thoughts of party litigants may differ relating to the meaning of stated language does not in itself establish in a legal sense that the language is ambiguous." 
  • Ordinarily, when corporate instruments are ambiguous, the court must consider the relevant extrinsic evidence in aid of identifying which of the reasonable readings was intended by the parties. There are situations, however, when this general rule is inapplicable. For example, when a court is asked to construe a limited partnership agreement drafted solely by the corporate general partner, it will resolve all ambiguities against the general partner as drafter and in favor of the reasonable expectations of the public investors.  Harrah's Entertainment, Inc. v. JCC Holding Co., 802 A.2d 294, 309-10 (Del. Ch. 2002)
  • Under Delaware law, the doctrine of contra proferentem has particular force with respect to the governing or constitutive documents of a business organization. Almost by definition, a person who joins such an organization will not have had the opportunity to negotiate the terms of such documents. "[W]here the contract in dispute is an entity's organizing document, like the Partnership Agreement, a dispositive order following motion practice may be appropriate even where the contract is ambiguous." Stockman, 2009 Del. Ch. LEXIS 131, 2009 WL 2096213 at *5 (emphasis added; interpreting an indemnification and advancement provision in a partnership agreement).
  • When an agreement . . . makes promises to parties who did not participate in negotiating the agreement, Delaware courts apply the general principle of contra proferentem, which holds that ambiguous terms should be construed against their drafter. The contra proferentem approach protects the reasonable expectations of people who join a partnership or other entity after it was formed and must rely on the face of the operating agreement to understand their rights and obligations when making the decision to join

Thus, because the By-Laws were ambiguous as the meaning of “officer” that ambiguity was resolved against the drafter—here Goldman.  The fact that Aleynikov had not read the By-Laws was irrelevant--“Goldman cannot escape from its burden as drafter by recourse to Aleynikov’ s ignorance of his rights. Whether or not Aleynikov actually read and relied on the By-Laws—and realistically, how many employees do?—he was entitled to rely on the rights granted by the By-Laws. “For these reasons, the court construed By-Laws Section 6.4[3] against its corporate drafter, Goldman, and held that the term "officer" encompassed Aleynikov's position as a vice president of GSCo. 

The case sounds a note of caution for companies that have engaged in title inflation.  Handing out fancy titles may make both employee and employer feel good, but it has lasting implications.  If a company choose to engage in the practice, it should careful consider the language in its charter documents that create rights to indemnification and advancement.  Inattention to these matters may lead, as it did in this case, to a company being forced to advance funds to an individual the company believes has stolen its property—a “galling” result indeed.


The Continuing Problem of Vote Tallies

When shareholders of JP Morgan were seeking to separate the position of chairman and CEO, Broadridge announced that it would no longer provide running tallies of the vote to the shareholder proponent of the resolution.  We discussed the incident here.  A monopoly on the tallies can have advantages.  Corporations will know which proposals or directors are in trouble and can move resources around to meet the challenges.  (See the discussion here).  There are, however, other ways that the information can be used.

In Red Oak Fund, L.P. v. Digirad Corp., C.A. No. 8559-VCN (Del. Ch. Aug. 5, 2013), plaintiffs challenged the results of a contested election for directors.  Among other things, plaintiffs alleged disclosure violations.  The opinion characterized one set of allegations this way:  

  • Defendants repeatedly reported non-public preliminary totals of the voting which Defendants knew to be inaccurate because of their having allowed the counting of treasury shares that should not have been voted.  These numbers supported management’s assertion that the election would be "not even close.”

Whatever the truth (these are only allegations), the case illustrates some of the consequences of allowing issuers to have a monopoly on running tallies.  They can decide to publicize the information when it is in their interest, resulting in a competitive advantage in any contest.  There is also at least a risk that some companies will misstate running tallies in an effort to influence the outcome of an election. 

The only way to insure a balanced and accurate use of the information is to provide it to both sides in a contest (or to require continuous disclosure by a neutral party).  Allowing only one side to have the information conflicts with the regulatory goal of impartiality. 


The Phenomena of "Almost" Zombie Directors

JP Morgan Chase recently held its annual meeting.  The attention mostly focused on the proposal designed to separate the positions of chair and CEO.  The proposal failed by a large margin. 

Less noticed perhaps, three of the directors who served on the risk management committee of the board received a significant percentage of negative votes.  David Cote received support from 1.67 billion shares, with 1.13 billion voting against.  Ellen Futter received support from 1.47 billion shares, while 1.3 billion voting against.  Finally, James Crown received support from 1.59 billion shares and opposition from 1.18 billion.  The negative percentages were calculatedto be 47% for Futter, 43% for Crown and 41% for Cote. 

The directors were not zombie directors.  This is a term used for directors who have a majority of the voting shares cast against them but nonetheless remain on the board.  The three JPMorgan directors may have received a sizeable negative percentage but did not have a majority of the shares cast against them. 

In these circumstances, directors are not required to submit letters of resignation.  The company's majority vote provision only requires a resignation where a director fails to receive a majority of the votes cast in a non-contested election.  Moreover, the general rule is that directors cannot remove directors.  As a result, there was no collective decision for the board to make with respect to continued service on the board. 

At the same time, however, the significant negative vote likely put pressure on the individual directors to reevaluate their continued service on the board.  In this case, two of the directors (Futter and Cote) announced in July that they would retire.  Cote had five years of service; Futter 16.  Crown, the chair of the risk committee, did not, however, retire.  Part of the explanation may have been the need to ensure some degree of continuity on the risk committee.   

The resignations essentially provided the board with increased discretion.  Vacancies on the board can be filled by the board.  The board is apparently already seeking replacements.  As the WSJ stated: 

  • J.P. Morgan in the weeks before the annual meeting started its search for new directors, said people familiar with the effort. The board's presiding director, Lee Raymond, told shareholders at the meeting to "stay tuned" for potential changes to the makeup of the risk committee. He said the board would need "time to digest" the results and give a "tempered analysis of what we need."

The matter may not be completely finished.  Crown's continued service on the board will come under review when the nominating committee considers the slate of directors that will be submitted to shareholders at the next annual meeting.   By then, the risk committee will presumably be staffed with additional directors who have developed experience in the area.  The argument for continuity may be less strong.   


Board Composition and the Growing Social Divide

Boards of public companies are not diverse.  As we have noted on this Blog often, they contain few people of color (about 10%) and few women (about 15%).  The numbers are worse with respect to small public companies. 

Commissioner Aguilar has consistently and repeatedly given this issue high profile in speeches and talks.  Most recently, in May, he gave a speech on the subject before the Women's Executive Circle of New York.  Emphasizing the lack of women on corporate boards, his stats on education alone put paid to any notion that there are not enough qualified candidates.  According to the U.S. Department of Education, women in the current graduating class of 2013 make up:

  • 61.6% of all associate’s degrees;
  • 56.7% of all bachelor’s degrees;
  • 59.9% of all master’s degrees; and
  • 51.6% of all doctorate degrees.

He noted a number of advantages of better gender balance on boards, including the fact that "gender diverse boards improve their ability to attract and retain other talented women."

The talk was nicely juxtaposed against recent data on the changing demographic balance in the US.  According to the NYTimes, the Census reported that in the year ending July 1, 2012, more white Americans died than were born in the US.  The non-Hispanic white population nonetheless expanded by 175,000, or 0.09 percent because of immigration.  This segment represents about 63% of the population. 

This can be compared with the demographic shifts of Asians, Hispanics, and African-Americans.  According to the article:

  • "The census population estimates released Thursday also affirmed that Asians were the fastest-growing major ethnic or racial group. Their ranks grew by 2.9 percent, or 530,000, with immigration from overseas accounting for 60 percent of that growth."
  • "The Hispanic population grew by 2.2 percent, or more than 1.1 million, the most of any group, with 76 percent resulting from natural increase" and "blacks [increased] by 559,000, or 1.3 percent."

In other words, the US is becoming more and more diverse, with the shift accelerating.  Yet as this demographic trend continues, boards of public companies stand out in sharp contrast, with their racial membership largely unchanged. 

It is hard to believe that this sort of indifference to the surrounding demographic changes can really be profit maximizing behavior.  If it is more likely explained by a preference on boards for "reliable" directors, those who have served or are serving as CEOs of other companies or who were members of the CEO's social circle.  Thus, the lack of diversity is not about making money but about ensuring control over the board.  See Essay: Neutralizing the Board of Directors and the Impact on Diversity.


Boilermakers Local 154 – Best Interests of Whom? A Rebuttal.


The debate on the Delaware Chancery Court’s decision in Boilermakers Local 154 Retirement Fund v. Chevron Corporation, C.A. No. 7220-CS (Del. Ch. Jun. 25, 2013) has centered not on whether it is the correct decision based on the law and the facts, but whether Delaware courts should be the situs for internal affairs litigation involving Delaware corporations.  The question centers around an apparent conclusion that the Delaware courts are “management friendly” and therefore are not an appropriate forum to determine matters of Delaware law.  To the extent true, stockholders, when they invest in a Delaware corporation, should be willing to take that risk.

A principal objection is that the Board of Directors of Chevron and FedEx, defendants in the suit, adopted the bylaws forum selection amendment without seeking stockholder approval.  That, arguably, changed the contract between the existing stockholders and the corporation. Chancellor Strine found that “both Chevron’s and FedEx’s certificates of incorporation conferred on the boards the power to adopt bylaws under 8 Del. C. § 109(a). Thus, all investors who bought stock in the corporations whose forum selection bylaws are at stake knew that (i) the DGCL allows for bylaws to address the subjects identified in 8 Del. C. § 109(b), (ii) the DGCL permits the certificate of incorporation to contain a provision allowing directors to adopt bylaws unilaterally, and (iii) the certificates of incorporation of Chevron and FedEx contained a provision conferring this power on the boards.”  Rejecting the “vested rights” view, Strine stated, “when stockholders have authorized a board to unilaterally adopt bylaws, it follows that the bylaws are not contractually invalid simply because the board-adopted bylaw lacks the contemporaneous assent of the stockholders.”

Is this the correct decision or the incorrect decision?  Did the stockholders of Chevron and FedEx in fact have a vested right in the corporate bylaws that did not contain a forum selection provision – vested rights that were breached when the two Boards unilaterally amended the bylaws to adopt the forum provision?

The most significant decision regarding vested rights was handed down almost two centuries ago in Dartmouth College v. Woodward, 17 U.S. 518 (1819).  In 1769 King George III of Great Britain granted a charter to Dartmouth College. This document spelled out the purpose of the school, set up the structure to govern it, and gave land to the college.  In 1816, more than thirty years after conclusion of the American Revolution, the New Hampshire legislature attempted to alter Dartmouth’s charter to effectively convert the school from a private to a public institution. The College's book of records, corporate seal, and other corporate property were removed.

The Dartmouth College trustees objected and sought to have the legislative actions declared unconstitutional.  In an opinion written by Chief Justice John Marshall issued on February 2, 1819, the U.S. Supreme Court ruled that Dartmouth College’s corporate charter qualified as a contract between private parties – the King and the trustees – with which the legislature could not interfere.  Even though the United States were no longer royal colonies, the Court held that the colonial contract was still valid because the U.S. Constitution (Article I, section 10, clause 1, the Contract Clause) prohibits states from passing laws that impair contracts. The fact that the British government had commissioned the charter did not transform the school into a civil institution.

Chief Justice Marshall’s opinion emphasized that the term “contract” referred to transactions involving individual property rights, not to “the political relations between the government and its citizens.”

Dartmouth College changed corporate law forever, although perhaps not in the way the Dartmouth College trustees envisioned.  States reviewed their statutes authorizing the formation of corporations and made modifications in response to Dartmouth College.  Today, the Delaware General Corporation Law (DGCL) at 8 Del. C. § 1106, the Colorado Business Corporation Act at § 7-101-102, the Model Business Corporation Act (MBCA) at § 1.02, and all other state laws contain a specific reservation of power to the legislature to amend or repeal the corporate law, the effect of which is binding on all corporations then in existence.  The language of § 1.02 of the MBCA is illustrative:

The [name of state legislature] has power to amend or repeal all or part of this Act at any time and all domestic and foreign corporations subject to this Act are governed by the amendment or repeal.

As noted by Chancellor Strine, § 109(a) of the DGCL specifically reserves the right to corporations for the certificate of incorporation to include a provision allowing the Board of Directors to amend the bylaws.  The certificates of incorporation of both Chevron and FedEx did.  (Colorado and other states provide a blanket authority to the Board to add, change or delete a provision of the bylaws “at any time.”  It does not require reservation of a right in the articles of incorporation.  See, e.g., C.R.S. § 7-110-201.) 

Additionally, forum selection provisions are almost universally included in contracts and are upheld if rational.  Broker-dealer contracts for decades have mandated that customer disputes be subjected to arbitration and have been upheld by the U.S. Supreme Court.  (See Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987)).  During the recent term, the Supreme Court upheld a credit card agreement by which American Express required all merchants using its credit card services to resolve their disputes through individual arbitration and not a class action.  (See American Express Co. v. Italian Colors Restaurant, No. 12-133, 570 U.S. ___ (2013)). 

The Chevron and FedEx Boards both reached a similar conclusion with their forum selection bylaws provisions – that it was in the best interests of their respective corporations to avoid expensive and potentially inconsistent multi-forum litigation and to consolidate litigation in a single jurisdiction.  Under the DGCL and their certificates of incorporation, they had a right to make that determination.

Is this a management friendly result?  In Delaware, the business judgment rule is based on DGCL § 141(a) and has been expressed in a number of cases interpreting the DGCL, including Aronson v. Lewis, 473 A.2d 805 (Del. 1984).  In that case, the Delaware Supreme Court described the business judgment rule in connection with demand futility in the derivative action context as follows (citations omitted):

In our view the entire question of demand futility is inextricably bound to issues of business judgment and the standards of that doctrine’s applicability. The business judgment rule is an acknowledgment of the managerial prerogatives of Delaware directors under Section 141(a).  It is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts. The burden is on the party challenging the decision to establish facts rebutting the presumption.  [Emphasis supplied.]

Section 8.30(a) of the MBCA, as well as a number of state corporation laws modeled after it (see, e.g., C.R.S. 7-108-401(1)), is similar and defines the directors’ standard of conduct as follows:

Each member of the board of directors, when discharging the duties of a director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation.    [Emphasis supplied.]

Directors are not supposed to act in the best interests of stockholders; their mandate is to act in the best interests of the corporation.  On the other hand, are litigious stockholders acting in the best interests of the corporation?  Or in the best interests of the class action attorneys?  Why would it be in a corporation’s best interests to subject itself to multi-forum litigation for the convenience of the stockholders who choose to bring litigation?  Arguably, the corporation and all of its stockholders will be better served by focusing internal affairs litigation in a single forum, as exemplified in the Chevron and FedEx bylaws.  That choice is permissible under the DGCL when the power is reserved in the certificate of incorporation.  Where directors determine that it is in the best interests of the corporation to adopt a forum selection bylaw, they have the right to do so.


The Management Friendly Nature of Delaware Decisions: In re MFW Shareholders Litigation (Director Independence in Delaware)(Part 2B) 

We are discussin In re MFW Shareholders Litigation.

The offer between M&F and MFW was considered by a special committee of the board of MFW.  Shareholders challenged the independence of the directors assigned to the committee.  After concluding that directors meeting the standards of the NYSE were presumptively independent, the court examined the actual challenges to the independence of directors on the special committee.

One director, Byorum, was an officer at Stephens, an investment bank.  Plaintiff alleged that the director had a personal and business relationship with the Perelman.  The allegations foundered first on the problem of establishing subjective materiality.

While working at the investment bank, according to plaintiffs, Byorum "initiated" a transaction for an entity owned in part by M&F.  An affiliate of Stephens received a retainer of $100,000.  The court faulted plaintiff for failing to show that the $100,000 was material to Stephens "much less to Byorum on a personal level given her personal economic and professional circumstances."  In effect, the director was wealthy ("The plaintiffs acknowledge that Byorum is wealthy: they describe her as a banking 'big shot' and point out that she owns a house in the Hamptons.") and that was enough to render the amount immaterial.

With respect to allegations of a disqualifying personal relationship, the allegations foundered on the impossible standard set out in Beam v. Stewart

  • The allegations of friendliness—for example, that Byorum has been to Perelman's house—are exactly of the immaterial and insubstantial kind our Supreme Court held were not material in Beam v. Stewart. The plaintiffs do not specify the nature of the business relationship between Byorum and Perelman during Byorum's time at Citigroup, beyond claiming that Byorum would "come into contact" with him in her capacity as a senior executive. This vague relationship does not cast her independence into doubt: the plaintiffs have made no showing that Byorum has an ongoing relationship with Perelman that was material to her in any way.

While the precise allegations are difficult to discern (the briefs are heavily redacted in this area), the court's analysis effectively rendered irrelevant personal interactions (visits to Perelman's house) in determining whether a director had a disqualifying personal relationship.   

Dinh, another director on the committee, also was alleged to have had personal and business.  According to the allegations, he cofounded Bancroft, a law firm in Washington DC, that advised M&F and one of the entities partially owned by MacAndrews, receiving "approximately $200,000 in fees in total from these two companies between 2009 and 2011." 

Again the court emphasized the failure to show the materiality of the payments on a subjective basis.  The court again noted the absence of any evidence that the $200,000 paid to Dinh's firm was material to Dinh, "given his roles at both Georgetown and Bancroft."  Moreover, the court concluded that the fees paid to the firm were "a fraction of what would need to be paid for Dinh no longer to be considered an independent director under the New York Stock Exchange rules, and would not fund Bancroft's total costs for employing a junior associate for a year."  Finally, plaintiffs failed to offer "any evidence that might show that this payment was material in any way to Dinh, given his personal economic circumstances."

In addition, the court examined personal and business relationships.  Dinh was a professor at Georgetown Law Center.  The plaintiffs alleged that Dinh had a close personal and business relationship with Barry Schwartz, the President and CEO of MFW.  Schwartz sat on the Board of Visitors of the Georgetown University Law Center and had allegedly asked Dihn to join "the board of another Perelman corporation, Revlon, in 2012."

Nonetheless, the court considered the information insufficient to impair independence.

  • Dinh was a tenured professor long before he knew Schwartz.  And there is no evidence that Dinh has any role at Georgetown in raising funds from alumni or other possible donors, or any other evidence suggesting that the terms or conditions of Dinh's employment at Georgetown could be affected in any way by his recommendation on the merger.  Likewise, the fact that Dinh was offered a directorship on the board of Revlon, another Perelman company, after he served on the MFW special committee does not create a genuine issue of fact regarding his independence.

The offer of the board seat would only be relevant, the court seemed to suggest, if it amounted to a quid pro quo.  See Id. n. 65 ("If Dinh's directorship of Revlon were to be relevant to his independence at the time of the MFW transaction, the plaintiffs would need to provide record evidence creating a triable issue of fact that he was offered the directorship before the special committee approved the deal, or that it had at least been discussed with him before this time. The only record evidence is to the contrary."). 

The approach, however, essentially disregarded the role of the appointment in illustrating the relationship between Schwartz and Dinh.  Even in the absence of a quid pro quo, the appointment at least raised the possibility that Schwartz and Dinh had a close business and/or personal relationship.  Yet this was not explored in any meaningful way by the court.

The third challenge was to Webb.  Plaintiff alleged that, almost a decade before, Perelman and Webb conducted business together by turning around failed thrifts.  Webb was alleged to have been the President and Chief Operating Officer of their investment vehicles and was alleged to have made a "significant" amount of money in turning around the thrifts. 

Irrespective of the role played by Perelman, the court did not need to go any further than the conclusion that Webb was "seriously rich."

  • The profit that Webb realized from coinvesting with Perelman nine years before the transaction at issue in this case does not call into question his independence. In fact, it tends to strengthen the argument that Webb is independent, because his current relationship with Perelman would likely be economically inconsequential to him. And, there is no evidence that Webb and Perelman had any economic relationship in the nine years before this merger that was material to Webb, given his existing wealth. Therefore, the only challenge that the plaintiffs may make to Webb's independence is the existence of a distant business relationship—which is not sufficient to challenge his independence under our law.

That Perelman allegedly had a role in Webb's ability to become wealthy was not considered important by the court.

Whatever the resolution of the independence analysis for each specific director, the allegations suggested that, in the aggregate, the special committee had considerable contact (in the present or in the past) with the controlling shareholder or other persons connected to the transaction.  The court did not examine the matter in the aggregate.  

Primary materials in this case can be found at the DU Corporate Governance web site.


Miller v. Palladium Industries: Advancement Bylaws Permit Timely Discretion by Board of Directors  

In Miller v. Palladium Indus., C.A. No. 7475-VCN, 2012 Del. Ch. LEXIS 292 (Del. Ch. Dec. 31, 2012), plaintiff (“Miller”), the former President, CEO, and director of defendant, Palladium Industries, Inc. (“Palladium”), and its operating subsidiary, Vision-Aid, Inc. (“Vision-Aid”), filed suit against Palladium when Palladium refused to advance legal fees and expenses to support Miller’s defense in a suit against him by Vision-Aid for breach of fiduciary duty, misappropriation, waste, and conversion. The court granted Palladium’s motion for judgment on the pleadings and held, as a matter of law, that Palladium was not required to advance Miller’s legal expenses.

In 2002, Palladium amended its bylaws to encourage the advancement of legal fees and expenses to officers and directors involved in any legal action as a result of his or her fiduciary role. Amended bylaw Article X, Section 1 gave officers and directors a contractual right to indemnification and expense advancement prior to the final disposition of any such proceedings. However, Section 1 was subject to provisions set forth in Sections 2 and 5 of Article X that required advancement denials be made within thirty days of a request and that advancement was required, “unless otherwise determined by the [Board].” 

According to the complaint, Palladium’s board of directors (“Board”) in April 2012 denied Miller’s advancement request. The Board based its decision to deny on (1) Palladium’s lack of sufficient operating funds; (2) Miller’s influence on Palladium’s already impaired financial condition; (3) the high likelihood Miller would be required to repay any advancement; (4) Miller’s failure to provide collateral to secure potential repayment; and (5) the inherent conflict in financing opposition to the company’s claims.  

Miller subsequently brought suit under 8 Delaware Code § 145(e) (“Section 145(e)”) of Delaware’s General Corporation Laws. Section 145(e) permits, “but does not require,” the advancement of legal fees and expenses.

Miller asserted that the qualified language of bylaw Article X, Sections 2 and 5 did not specifically apply to the contractual right to indemnification and advancement provided for in Section 1. However, the court determined that the language “unless otherwise determined by the [Board],” gave the Board unambiguous authority to deny Miller’s advancement request. The court interpreted the bylaws according to their plain and ordinary meaning, construed to give meaning to all provisions. In doing so, the court interpreted the language to mandate payment of advancement requests absent a timely contrary directive by the Board. The court also noted that there was no alternate interpretation of “unless . . . determined by the [Board]” since Section 1 contains explicit language subjecting the right to advancement to the provisions of Sections 2 and 5.  In accordance with the plain language interpretation of Palladium’s bylaws, because the Board took active measures to promptly deny Miller’s advancement request within the prescribed thirty-day threshold, the court denied and dismissed Miller’s advancement claim as a matter of law.

The primary materials for this case may be found on the DU Corporate Governance website.


The Problem of Zombie Directors (Part 2)

We noted in the last post that majority vote provisions do not, for the most, part allow shareholders to actually defeat or remove directors.  Instead, they force the directors to submit a letter of resignation to the board.  We noted, however, that boards have a number of reasons why they are unlikely to accept these letters of resignation.

Directors who do not receive a majority of the votes cast but remain on the board are sometimes termed "Zombie Directors."  A recent analysis by the Council on Institutional Investors indicated that, in 2012, there were 41 Zombie Directors. 

Zombie Directors fall into two categories:  Those not receiving a majority of the votes cast at companies with a majority vote provision and those not receiving a majority of the votes cast at companies without majority vote provisions. 

The difference is significant.  In the latter case, there is no required letter of resignation (although the Zombie Director could voluntarily submit one).  Thus, the Zombie Directors have been elected under the plurality system.  Without a letter of resignation, the board is left with the default rule that it cannot remove incumbent directors. 

The board is not, however, powerless.  The board can decide not to renominate the Zombie Director the following year.  This authority notwithstanding, companies without majority vote provisions confront the same structural concerns that militate against a decision declining to renominate.  It is, therefore, likely that in most cases Zombie Directors will be renominated. 

With majority vote provisions themselves providing no real authority and state law unlikely to impose meaningful standards of review on the retention of Zombie Directors, the board, at this stage, has little incentive to replace Zombie Directors.  That may, however, change.  The CII has compiled data in this area.  Calpers has begun to look into the issue.  Pressure continues on large public companies to implement majority vote provisions and at least force boards to take a position on Zombie Directors (in the post-Jobs era, Apple adopted a majority vote provision), although greater attention may need to be given to the implementation of these provisions at smaller public companies. 

Pressure from investors may make it harder for boards to keep Zombie Directors in office.  Nonetheless, it illustrates a profound weakness in the governance structure.  Shareholders can successfully vote against directors but the act has little independent value.  Only with a second, post-election campaign against the Zombie Director will shareholders likely see the decision at the ballot box implemented.


The Problem of Zombie Directors (Part 1)

Majority vote provisions are a relatively recent innovation.  Under the laws of most states, directors are elected by a plurality of the votes cast.  See DCGL 216(c).  That means that the candidates who receive the most number of votes are elected, irrespective of the number of no votes (designated as "withheld" on the proxy card).  To the extent that the number of candidates equals the number of vacancies on the board, the nominees in a plurality system always win. 

Pressure has been brought on public companies to change this dynamic.  Shareholders have sought the implementation of "majority vote" provisions.  The pressure has, for the most part, worked for the largest public companies.  Of the 100 largest US companies in 2012, according to a study by Shearman & Sterling,  91 had these provisions.  The number, however, drops off signifcantly for smaller public companies.  According to another study, only 43% of the S&P 1500 have majority vote provisions in place. 

Although these provisions create the appearance that shareholders have a say in board membership, that perspective is for the most part a myth.  These provisions generally require directors not receiving a majority of the votes cast to submit a letter of resignation (they must resign because, even without majority support, they were, under the plurality standard, elected).  The board (without the presence of the "defeated" candidate) then must decide whether to accept the resignation. 

The effect of a majority vote provision, therefore, is to give to the board the authority to remove an incumbent director.  This flies in the fact of the general rule that directors cannot remove other directors.  A few states permit directors to remove other directors in limited circumstances but Delaware for the most part does not.  A majority vote provision, therefore, augments the authority of the board, not the authority of shareholders. 

Moreover, there are structural reasons to believe that most of the time the board will decline to accept the resignation.  First, directors may be defeated because of the perceived mismanagement of the company.  To accept the resignation would amount to a vote of no confidence on the CEO, something directors will mostly want to avoid.  Moreover, this may be particularly since the the CEO will be on the board and, potentially, part of the deliberative process.

Second, accepting the resignations will potentially empower shareholders to seek a repeat performance in future years.  The directors who agreed to accept the letter may find themselves submitting letters following subsequent elections.  

Third, those on the board may disagree with the reasons shareholders were unhappy enough to vote against the directors.  If, for example, shareholders are unhappy with the board refusing to accept a merger offer and, as a result, cast a majority against directors deemed responsible, the remainder of the board may think the judgment unfair.  They may believe that the merger is not in the best interests of shareholders.  In these circumstances, they may also decline to accept the letter of resignation.

Moreover, as a matter of state fiduciary obligations, Delaware courts have already signaled that they will give the board broad discretion to decline to accept a letter of resignation.  It may be enough to find that the directors have "knowledge and experience" valuable to the board.  Since the defeated directors were nominees of the board, it is highly likely that the board believes these directors have "knowledge and experience" valuable to the board.  

This has given rise to the phenomena of the "Zombie" Director.  Defeated but still serving.  We will look at this phenomena in the next post. 


Listing Standards, Director Independence, and the Obligation to Consider Personal and Business Relationships

As we have discussed extensively on this Blog, the stock exchanges recently adopted listing standards that govern compensation committees.  As part of the listing standards, the exchanges were required to set out the relevant factors that the board had to consider in determining director independence. 

The Commission in the adopting release for Rule 10C-1 instructed the exchanges to consider whether the factors should include "personal and business" relationships between directors and executive officers.  Commentators on the proposed listing standards recommended that the factor be included.  The NYSE acknowledged that the board was required to consider personal and business relationships when determining independence. 

Nonetheless, the exchanges opted not to include personal and business relationships as an explicit factor.  They took the position that that listing standards already required board consideration of these relationships and, as a result, they did not need to be explicitly included in the standard.  See NYSE Comment Letter ("Commentary to Section 303A.02(a) explicitly notes with respect to the board’s affirmative determination of a director’s independence that the concern is independence from management, and NYSE MKT and NYSE Arca have always interpreted their respective director independence requirements in the same way. Consequently, the NYSE Exchanges do not believe that any further clarification of this requirement is necessary."). 

The Commission, in adopting these standards, stated specifically that these factors had to be considered.  As the Commission explained:

Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board.

The comment by the SEC clarified the need to consider these factors.  Yet the factor did not actually appear in the listing standard.  The "geography" of the requirement, however, matters and the failure of the Commission to require explicit inclusion in the listing standard may impair compliance.  

In complying with annual legal requirements, directors are typically given a questionnaire and asked for the relevant information.  See In re WR Grace & Co., 53 SEC 235, 240 (1997) ("The Company provided Grace, Jr. with directors' and officers' questionnaires ("D&O Questionnaires') in the course of preparing its 1992 Form 10-K and 1993 proxy statement and its 1993 Form 10-K and 1994 proxy statement.").  Often, these forms track the language in the relevant statutes or listing requirements. 

Because the listing requirements do not explicitly refer to “personal and business” relationships, some questionnaires may not specifically ask for the information.  They may simply request that directors disclose "material relationships with the issuer."  Directors may not realize that they have to set out  personal and business relationships with executive officers.  The result is that the factors will not be disclosed to, or considered by, the board when determining director independence.

Lawyers who know about the requirement will presumably insure that the factor is covered by the D&O Questionnaire.  Less aware lawyers may not.


Delaware, Director Independence, and Personal Relationships

The stock exchanges just declined in their listing standards to explicitly include "personal and business relationships" between management and directors as a relevant factor in determining independence.  The main reason for not doing so is that directors already have to consider any material relationships.  By implication they already have to weigh personal and business connections between officers and directors. 

In the absence of an explicit standard, however, boards may be influenced by the standard for director independence used state law.  In Delaware, personal relationships are almost never material in the determination of independence.  The state law standard was set down in Beam v. Stewart, 845 A.2d. 1040 (Del. 2004).  In that case, the Court set out a test that could almost never be met both because of the standard adopted and because of the pleading burden. 

As the Supreme Court reasoned: 

To create a reasonable doubt about an outside director's independence, a plaintiff must plead facts that would support the inference that because of the nature of a relationship or additional circumstances other than the interested director's stock ownership or voting power, the non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.

In Beam, the Court found that evidence suggesting a close friendship between a director and CEO was not material.  Moreover, the Court rejected even the possibility that personal relationships could arise from interaction on the board, characterizing them as structural bias.  The Court's approach effectively imposed a standard that made friendship and other non-family personal relationships irrelevant to an independence determination.  

A reminder of the irrelevance of personal relationships at the state level occurred in In re Bj's Wholesale Club S'holders Litig., 2013 Del. Ch. LEXIS 28 (Del. Ch. Jan. 31, 2013).   In that case, plaintiffs challenged the independence of the board.  One of the directors was alleged to have had a disqualifying personal relationship.  The court summarily dismissed the contention.  "This type of allegation does not raise a reasonable doubt as to the independence of a director under Delaware law."  

The authority?  Beam.  And in describing the lesson from Beam, the Chancery Court characterized the decision as one where "directors were independent despite having longstanding personal and professional relationships to allegedly interested directors".  In other words, the court read Beam to hold that "longstanding personal and professional" relationships were not enough to impair independence.    

The SEC has made clear that the relationships have to be considered in determining director independence.  See Exchange Act Release No. 68639 (Jan. 11, 2013) ("Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board."). 

The standards at state law will not necessarily provide comfort to boards applying listing standards imposed by the exchanges.  Moreover, to the extent directors with strong personal and business ties to management are characterized as independent in proxy statements, the company may find itself susceptible to a cause of action under the antifraud provisions, irrespective of the opinion of the Delaware courts.   


Corporate Governance, Rule 10C-1, and the SEC: The NYSE, Director Independence, and the Need to Consider Personal Relationships (Part 7B)

We are discussing the new listing standard adopted by the NYSE and approved by the SEC.  Specifically we are addressing the debate over whether the NYSE should list as an explicit factor the need to consider business and personal relationships between executive officers and directors. 

In response to Rule 10C-1, the NYSE added a new subsection that required the board, in considering director independence for those serving on the compensation committee, to consider: 

all factors specifically relevant to determining whether a director has a relationship to the listed company which is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member 

The provision then listed the two factors mandated by Congress (compensation and affiliation) but noted that the board was "not limited" to these factors.  A new paragraph of commentary to the provision discussed compensation and affiliation but made no mention of personal or business relationships.  

In explaining the decision not to include any specific reference to personal and business relationships, the exchange had this to say

The NYSE Exchanges note that the existing independence standards of the NYSE Exchanges all require the board to make an affirmative determination that there is no material relationship between the director and the company which would affect the director’s independence. Commentary to Section 303A.02(a) explicitly notes with respect to the board’s affirmative determination of a director’s independence that the concern is independence from management, and NYSE MKT and NYSE Arca have always interpreted their respective director independence requirements in the same way. Consequently, the NYSE Exchanges do not believe that any further clarification of this requirement is necessary.

The analysis ignored the fact that the existing language was susceptible to an interpretation that it extended only to relationships with the issuer.  Indeed, this was more than an academic concern.  Moreover, the new language for directors on the compensation committee repeated that the board had to consider whether the director "has a relationship to the listed company".  While the NYSE had taken the position that personal and business relationships had to be considered, the interpretation was not explict and presumably unknown to some issuers

Finally, the absence of any specific reference was in conflict with the standards for selecting a compensation consultant.  When hiring a compensation consultant, committees were explicitly required to consider "[a]ny business or personal relationship of the compensation consultant, legal counsel, other adviser or the person employing the adviser with an executive officer of the listed company."  In other words, the provision made the need to consider business and explicit relationships between executive officers and consultants explicit.  No similar language appeared in the requirements of director independence.

The Commission acknowledged the issue in the release approving the NYSE's amendments to the listing standards.  The Commission first noted that its statement in the release adopting Rule 10C-1 that the exchanges consider adding business and personal relationships was not designed to be mandatory.  "[T]he Commission did not require exchanges to reach this conclusion and thus NYSE’s decision that such ties need not be included explicitly in its definition of independence does not render its proposal insufficient." 

Nonetheless, the Commission noted the importance of considering these factors.  

Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board.

The statement by the Commission clarified that boards needed to consider business and personal relationships when determining director independence in general, not just in connection with the compensation committee. 

The statement is a step forward.  An SEC release now explicitly provides that personal and business relationships must be considered in determining director independence.  Moreover, the consideration applies to all directors, not just those on the compensation committee.  Boards will be able to learn about this interpretation without having to contact the NYSE directly. 

At the same time, however, the interpretation is buried in a release about listing standards for compensation committees.  It is not an obvious source to check for anyone seeking to understand the definition of director independence in the NYSE rules.   

This is an example where commentators called for an explicit reference to personal and business relationships, the NYSE acknowledged that they must be considered, and the Commission affirmed the position.  Yet when it comes to the language of the listing standard, there is no explicit reference and the confusing language remains.     


Lipton on Boards of Directors in 2013

Having just completed my first week of teaching Corporations, I thought it might be a good idea to briefly review Martin Lipton’s “Some Thoughts for Boards of Directors in 2013,” which was posted over at The Harvard Law School Forum on Corporate Governance and Financial Regulation on December 31, 2012.  By way of background for anyone not familiar with Lipton, you can find his official profile here, and Wikipedia notes (here):

In 1979 Lipton authored “Takeover Bids in the Target’s Boardroom”, the seminal article advocating the right of a board of directors to take into account the interests of all the constituencies of the corporation, a position adopted by the Delaware Supreme Court in 1985, and in more than thirty other states by statute or judicial decision and in the Companies Act 2006 of Great Britain…. In 1982 Lipton created the Shareholders Rights Plan or poison pill, which has been described by Ronald Gilson of the Columbia and Stanford Law Schools as "the most important innovation in corporate law since Samuel Calvin Tate Dodd invented the trust for John D. Rockefeller and Standard Oil in 1879." 

Lipton starts his post by bemoaning that: “The assault on the director-centric model of corporate governance continues in the shareholder activist and political arenas ….”  He then goes on to note 8 key issues facing boards in 2013:

  1. Short-Termism;
  2. Shareholder Activism;
  3. Balancing the Roles of Business Partner and Monitor;
  4. CEO Succession Planning;
  5. Board Composition;
  6. Special Investigations;
  7. Say on Pay; and,
  8. Corporate Governance “Best Practices”

While the entire post is clearly worth reading, what caught my attention was the following:

The workload and time commitment required for board service continues to escalate; the 2012 Public Company Governance Survey of the National Association of Corporate Directors reported that public company directors spent on average over 218 hours performing board-related activities, compared to the 155 hours reported in 2003.

First of all, anyone following our Director Compensation Project, wherein we noted that, “More than a dozen public company boards had directors whose compensation averaged more than $500,000 in 2011,” will realize that this equals a very nice hourly rate for at least some directors.  Second, I believe one seriously has to question whether directors, no matter how much expertise and brilliance they bring to the job, can carry out all their monitoring duties by devoting what amounts to roughly 4 hours per week to the job.  Lipton notes that there has been a rise of presumably full-time corporate governance board secretaries, and this may be a step in the right direction, but I continue to wonder whether the complexities of overseeing at least the largest of corporate enterprises might not require us to reconsider the entire part-time director model.  Obviously, this is not a new idea.  For example, Ronald J. Gilson & Reinier Kraakman wrote, in “Reinventing the Outside Director: An Agenda for Institutional Investors,” 43 STAN. L. REV. 863, 885 (1991):

We propose to create a novel position, that of the professional outside director, that would exist prior to, and apart from, the election of other directors to the boards of portfolio companies…. the new position would require a full-time commitment, and would obligate each expert to serve on the boards of perhaps six portfolio companies.


Director Independence, the Stock Exchanges, and the Role of the SEC (Part 2)

We are discussing the requirements that the exchanges adopt listing standards that set out the factors that must be considered in determining the independence of directors serving on the compensation committee.  The NYSE proposal is here; the Nasdaq proposal is here.

The Nasdaq proposal made some important strides.  The exchange proposed making compensation committees mandatory.  In addition, the exchange proposed to prohibit directors on the compensation committee from receiving any non-board related compensation, a requirement also applicable to the audit committee. 

But neither of the exchanges required that, as a relevant factor, boards take into account the fees paid to directors.  Moreover, they failed to do so despite the command in Section 10C that the factors include consideration of "the source of compensation of a member of the board of directors of an issuer".  Fees constitute compensation.

In addition, neither proposal explicitly required that the board, in determining director independence, take into account personal or business relationships between directors and executive officers.  The Nasdaq simply rejected the factor.  As it reasoned:

As discussed in the "Purpose" section above, Nasdaq reviewed its current and proposed listing rules and concluded that these rules are sufficient to ensure the independence of compensation committee members. Therefore, Nasdaq determined not to propose further independence requirements, other than those discussed above.

The NYSE did not explicitly add a reference to personal and business relationships to the proposed listing standard.  Instead the proposal would require consideration of “all factors specifically relevant to determining whether a director has a relationship to the listed company which is material to that director's ability to be independent from management in connection with the duties of a compensation committee member . . .”  The reference to a relationship with "the listed company" left unclear the importance of personal or business relationships between directors and officers that were otherwise unconnected to the issuer.   

The ambiguous language in the NYSE proposal could also be compared to the language used to describe the factors that had to be considered when the compensation committee selected a consultant.  In those circumstances, directors had to consider "[a]ny business or personal relationship of the compensation consultant, legal counsel or other adviser with a member of the compensation committee" and "[a]ny business or personal relationship of the compensation consultant, legal counsel, other adviser or the person employing the adviser with an executive officer of the listed company."  In other words, the need to consider personal and business relationships in those circumstances was made explicit.

These issues are discussed in greater detail in Comment Letters: The Definition of Independent Directors Under the Listing Rules of the Stock Exchanges.  Indeed, the  proposals generated a number of comments.  The comments for the NYSE Proposal are here.  The Comments for the Nasdaq proposal are here.  These letters point out a number of concerns with the proposed rules.

The SEC ordinarily must rule on a proposald from an SRO within 45 days.  The Agency, however, issued a release that extended the period for approval until January 13.   Specifically, the Commission sought more time "to consider the coment letters that have been submitted".  

This is a new area for the Commission.  An attempt in the 1980s to impose listing standards on the exchanges (one share, one vote) was shot down by the courts.  Congress tampered with the definition of independent director for audit committees but gave the Commission little flexibility with respect to implementation. 

Section 10C, however, gives the Commission broad authority to prescribe the factors that must be considered in determining director independence on the compensation committee.  Like it or not, the Agency now has a primary role in determining director independence.  The outcome of the proposed listing standards will provide considerable insight into the role the SEC intends to take in this area. 


Director Independence, the Stock Exchanges, and the Role of the SEC (Part 1) 

The holy grail of corporate governance for the last several decades has been independent directors.  Improvements in the governance area have focused on the increased need for, and role of, independent directors on the board.  Under Delaware law, independent directors are not required but are encouraged.  They provide additional protections from derivative suits (in general demand is not excused if a majority of the directors are independent).  For public companies, the stock exchanges require a majority of independent directors. 

Independent directors are intended to be independent of the company and, presumably the CEO.  In theory they are in a better position to protect the interests of shareholders.  But this in turn depends upon the definition of independence.  To the extent the definition is too porous, as some have suggested, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty, directors will not be in a position to presumptively act in the interests of shareholders. 

Nonetheless, the definitions have been left to the Delaware courts and the stock exchanges.  Perhaps dissatisfied with these definitions, Congress has increasingly stepped into the fray.   In SOX, Congress provided that independent directors had to meet certain additional requirements in order to serve on the audit committee.  These were implemented in Rule 10A-3, 17 CFR 240.10a-3

Congress, however, went even further in Dodd Frank with respect to the concept of director independence, at least for those serving on the compensation committee.  Congress added Section 10C to the Exchange Act.  The provision requires that director independence be determined after consideration of "relevant factors."  The Section specified two of them:  the director's "source of compensation" and whether the director "is affiliated" with the company.  Congress, however, left open that there would be other factors that had to be considered and left to the SEC to resolve the matter. 

The Commission implemented these requirements in Rule 10C-1.  17 CFR 240.10C-1.  The rule commanded the exchanges to set out the "relevant factors" necessary for determining director independence.  Moreover, the adopting release more or less instructed the exchanges to include as a factor the consideration of business and personal relationships between directors and management.  As the release stated:

in response to concerns noted by some commentators that significant shareholders may have other relationships with listed companies that would result in such shareholders’ interests not being aligned with those of other shareholders, we emphasize that it is important for exchanges to consider other ties between a listed issuer and a director, in addition to share ownership, that might impair the director’s judgment as a member of the compensation committee. For example, the exchanges might conclude that personal or business relationships between members of the compensation committee and the listed issuer’s executive officers should be addressed in the definition of independence.

The exchanges dutifully proposed a new listing standard.  The NYSE proposal is here; the Nasdaq proposal is here.  We will discuss the proposals in the next post.  Some of these issues are discussed in  detail in Comment Letters: The Definition of Independent Directors Under the Listing Rules of the Stock Exchanges.


Corporate Governance and the Problem of Executive Compensation: The Role of the SEC (Director Independence) (Part 3)

We are discussing Rule 10C-1.  The rule requires the exchanges to adopt listing standards that regulate compensation committees.  The rule was adopted in Exchange Act Release No. 67220 (June 20, 2012).

Section 952 of Dodd-Frank sought to regulate the definition of director independence. The provision required the board of listed companies to consider certain "factors" in determining the independence of directors serving on the compensation committee.  The statute required that the board consider:  

  • a director’s source of compensation, including any consulting, advisory, or compensatory fee paid by the issuer; and
  • whether a director is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.

The statute left open the possibility that other factors would be required. 

In adopting Rule 10C-1, the Commission did impose a specific set of factors.  Instead, the Agency left the matter to the stock exchanges.  See 17 CFR 240.10C-1(b) ("In determining independence requirements for members of compensation committees, the national securities exchanges and national securities associations shall consider relevant factors").  

Nonetheless, the Commission provided the exchanges with some advice.  First, the Agency described the two factors specified in the statute as "the same matters as the prohibitions in Section 10A(m)’s definition of audit committee independence".  Exchange Act Release No. 67220 (June 20, 2012).  This is not, however, quite true.  

Section 10A(m) provides that directors on the audit committee cannot "accept any consulting, advisory, or other compensatory fee from the issuer."  The language of the requirement does not extend to fees.  

The language in Section 10C, however, is much broader.  Independence requires consideration of the "director's source of compensation," something that explicitly includes any "consulting, advisory or compensatory fee."  Since directors receive fees as compensation, the amount will need to be considered in determining the independence of directors serving on the compensation committee.  This appears to be a significant change in the current analysis used by the board in determining independence. 

In addition, the adopting release indicated that the exchanges will need to go beyond the two factors set out in the statute.  As the release stated: 

in response to concerns noted by some commentators that significant shareholders may have other relationships with listed companies that would result in such shareholders’ interests not being aligned with those of other shareholders, we emphasize that it is important for exchanges to consider other ties between a listed issuer and a director, in addition to share ownership, that might impair the director’s judgment as a member of the compensation committee. For example, the exchanges might conclude that personal or business relationships between members of the compensation committee and the listed issuer’s executive officers should be addressed in the definition of independence.

The need to consider personal relationships would require the board to consider friendship and other non-financial ties.  This is currently not a requirement of the rules of the stock exchange. 

The lingering question is why the requirement should be limited to directors on the compensation committee.  To the extent a director on the audit or nominating committee also has a disqualifying personal relationship with the CEO, the director should not be treated as independent.  The exchange should, therefore, consider application of these factors to all independent directors.  

With respect to "business" relationships between directors and officers, the NYSE takes the position that these relationships already must be considered in determining director independence.  See The NYSE and the Problems of Director Independence ("representatives of the NYSE advised [the Company] 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.").

Yet the listing standard is not so explicit.  The standard merely requires the board to consider relationships between directors and the company, not directors and executive officers.  See NYSE 303A.02 (requiring board to consider any "material relationship with the listed company").   Given this language, at least one company has taken the position that "[p]ersonal business relationships between individuals (as opposed to relationships with the company) generally are not relevant to the independence tests under the New York Stock Exchange rules because they do not create a material relationship between a director and the company."  The statement (and the position) was later modified after communications from the exchange.  

Nonetheless, the requirement that the board consider "business relationships" between directors and executive officers ought to be made explicit in the listing standards.  Moreover, given the NYSE's position, the factor should be made applicable to the consideration of independence for all directors, not just those serving on the compensation committee.