Recent Delaware case law offers useful guidance regarding options for management of potential conflicts. Those cases demonstrate that conflicts can be mitigated by board or stockholder actions and that such measures for managing conflicts should be thoughtfully tailored to the circumstances. This post focuses on guidance from Delaware courts regarding measures that can be implemented at the board-level for management of potential conflicts, including the role of disinterested and independent directors, the effect of abstentions and recusals, and the use of an independent committee. The courts’ guidance is particularly valuable in light of the current market challenges driving at least some companies to consider insider deals and transactions at lower or uncertain valuations, which may raise the specter of self-dealing and lead to litigation that is less likely to be resolved through deference to a board’s business judgment. This post is intended to be followed by two similarly structured articles that will focus, next, on conflict-management measures at the stockholder level and, finally, on the board- and stockholder-level measures arising under Delaware’s framework for management of conflicts in controlling stockholder transactions.
Disinterested and Independent Directors
Delaware views corporate law through a board-centric lens. This underpins policies of robust deliberation and the inclusion of independent perspectives, even going so far as to encourage the presence of any dissenting views. Thus, when certain directors may have a conflict-creating interest in a board decision, Delaware law would frown on exclusion of unconflicted directors and smile on their active inclusion.
In a hearing regarding a $263 million acquisition financing by private company Dealersocket, Inc., Vice Chancellor J. Travis Laster addressed the role of disinterested directors. Perry v. Sheth, C.A. No. 2020-0024-JTL (Del. Ch. Jan. 17, 2020) (TRANSCRIPT) (“Dealersocket”) (granting directors’ petition for books and records under Section 220(d) of the DGCL). In that case, the company’s majority stockholder, which had appointed a majority of the sitting directors, wanted the board to approve the acquisition of a third-party entity, as well as a related financing that would be generally open to stockholders for one day at a low valuation. The court found that two co-founders, who were directors and unaffiliated with the majority stockholder, had been frozen out of deliberations related to the acquisition and financing, such that the interested directors were “effectively taking action as a shadow board.” The court was critical of this alleged “plan to bake everything outside the boardroom before presenting what would effectively be a fait accompli to the directors for their up or down vote,” noting that Delaware is a “board-centric system.” On a preliminary record, the insiders were found to have not been “giving sufficient respect to the directors who wanted more information and wanted to understand the deal.” A rhetorical explanation followed:
Now, someone who wasn’t attracted to the board-centric model might say “Who really cares? The [affiliated] people knew what they were going to do. They were going to approve this deal and ram it through anyway. They had the supervoting rights at the board level. They could do it. It didn’t matter what [the co-founders] would say.” But that is not the model that we in Delaware believe people need to be following. We proceed on the premise that if proper procedures were followed, then even a director in the minority could, like the 12th juror, sway the rest of his board colleagues to what he believed was the right answer.
The Delaware Supreme Court also addressed the importance of candid deliberations involving disinterested directors with respect to an $18 billion merger of public company equals Towers Watson & Co. and Willis Group Holdings Public Limited Company. City of Ft. Myers General Employees’ Pension Fund v. Haley, No. 368, 2019 (Del. June 30, 2020) (“Towers Watson”) (reversing dismissal, following extensive discovery in a related appraisal action). The merger, representing a 9 percent discount to the Towers pre-announcement trading price and drawing criticism from Towers investors, had been negotiated by the Towers chief executive officer (who was also a director). The court found that the disinterested Towers directors were unaware that the Towers CEO had been offered, during price negotiations, a five-fold increase over his current compensation package for the three years following the deal (from approximately $24 million to $140 million). Although the court noted that mergers of equals with disaggregated stockholder bases would generally be expected to receive business judgment deference, and although the court may have accepted that the CEO kept the Towers board generally apprised of negotiations, the court held that the CEO’s undisclosed “deepened interest in the transaction” was material to a reasonable director. Thus, the court concluded that the CEO-director’s failure to disclose his material interest had the effect of undermining the deference typically afforded to a majority disinterested board in such a context. The court further explained that, in such circumstances, the other directors must be aware of the exact nature of the conflict and appropriately oversee the conflict.
In these cases, the directors holding the majority viewpoint were not only expected to be honest and transparent, but independent directors were also expected to have the opportunity to dissent or provide informed oversight. This counsels in favor of deal-planning and deliberative processes that include disinterested directors and directors who may very well propose alternative paths or formally dissent. In particular, insiders conducting side conversations, without subjecting those conversations to a deliberative process at validly convened board meetings, may be viewed as constituting a “shadow board” or having a material self-interest that could undermine the effectiveness of the entire board process. Moreover, excluding disinterested voices represents lost opportunity in that the inclusion of disinterested and independent directors at meetings, and documentation of their views in meeting minutes, could also provide support for the ultimate board decision.
In a case involving the termination of the lululemon athletica inc. CEO, however, Vice Chancellor Joseph Slights addressed directors’ use of informal and un-minuted discussions in addition to formal board meetings and minutes and when such discussions may be permissible. Shabbouei v. Potdevin, C.A. No. 2018-0847-JRS (Del. Ch. Apr. 2, 2020) (“lululemon”) (granting motion to dismiss, following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220). The lululemon decision demonstrates the importance of context and the flexibility that the Court of Chancery has when exercising its equitable powers. In this case, the court cut through challenges to the board’s process and, while acknowledging that “this court has been suspicious of a board’s choice to conduct un-minuted meetings in other circumstances,” determined that in those circumstances, the board’s decision to have meetings that excluded the company’s CEO through the use of “‘off the record conversations’ to encourage ‘an open dialogue on the facts’ concerning what should be done about the Company’s CEO is entitled to deference.”
Abstention and Recusal
In circumstances where inclusion of independent or disinterested directors is infeasible or viewed as insufficient, the impact of boardroom conflicts may be softened by recusal of certain directors. Directors should, however, be thoughtful about whether abstention from the formal vote will be sufficient to cleanse a potential conflict, or whether those directors should recuse themselves from board deliberations, external negotiations, and other activities along the way.
This issue has been addressed in two recent decisions by Vice Chancellor Laster. Most recently, in litigation related to the $1.236 billion public-company merger of NCI Building Systems, Inc. and another company with the same significant stockholder, Vice Chancellor Laster addressed the effect of recusals by directors who were affiliated with that significant stockholder. Voigt v. Metcalf, C.A. No. 2018-0828-JTL (Del. Ch. Feb. 10, 2020) (“NCI Building Systems”) (denying a motion to dismiss, following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220). The court explained that the interested directors, who represented four of the company’s 12 directors and abstained from the ultimate vote approving a transaction but otherwise participated at the planning stages, potentially could have recused themselves and eliminated the effect of their interest in the transaction. Such a cleansing effect, however, might only have been attainable through recusal from both the vote and the process leading to that vote. The court noted that directors may not avoid liability if they accept a personal benefit in a transaction, are closely involved from the beginning of the transaction, or play a role in negotiating, structuring, or approving the transaction. Those interested directors had discussed the merger with other directors who were found to have had a relationship with the significant stockholder; participated in the discussions where the board determined to pursue the merger; after formation of a special committee, met with the committee’s financial advisor; presented the stockholder’s views on the merger to the full board; and argued for terms that favored the stockholder. Based on the favorable inferences to which plaintiffs are entitled at a pleading stage, the court concluded that the affiliated directors’ abstentions had been “cookie-cutter,” by which they “did not absent themselves from the process entirely.”
The discussion of recusals in NCI Building Systems picked up on Vice Chancellor Laster’s earlier comments regarding the board’s approval of a $1.3 billion asset purchase by Pilgrim’s Pride Corporation from its majority stockholder. In re Pilgrim’s Pride Corp. Deriv. Litig., C.A. No. 2018-0058-JTL (Del. Ch. Mar. 15, 2019) (denying a motion to dismiss, following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220). In that case, five directors nominated by the controller (to the nine-director board) argued that they should not face any potential liability because they were not sufficiently involved in the negotiation or approval of the transaction. The court rejected that defense but discussed the effect of recusals under Delaware case law:
A director can avoid liability for an interested transaction by totally abstaining from any participation in the transaction. “Delaware law clearly prescribes that a director who plays no role in the process of deciding whether to approve a challenged transaction cannot be held liable on a claim that the board’s decision to approve that transaction was wrongful.” But this is “not an invariable rule.”
The court noted that in certain scenarios, such as where directors conspire for a wrongful result and then recuse themselves on the vote or where a recused director is “closely involved” from the beginning of a transaction in a way that renders it unfair, a recusal would be insufficient. Likewise, the court stated that if a recused director accepted and refused a demand to return a benefit from a self-interested transaction, then the director could be seen to have ratified the result and would be subject to full potential liability. The interested Pilgrim’s Pride directors not only voted on the transactions, but were also found to have discussed the transaction with the controller from the early stages and advocated the controller’s position during the planning process, and thus were not dismissed from the litigation.
Vice Chancellor Sam Glasscock took a similar view of abstentions in his decision regarding the multi-billion-dollar public company transactions involving Charter Communications, Inc., Liberty Broadband Corporation (Charter’s largest stockholder), and two other companies. Sciabucchi v. Liberty Broadband Corp., C.A. No. 11418-VCG (Del. Ch. July 26, 2018) (denying the motion to dismiss a complaint based on public disclosures). There, four Charter Communications directors, who were affiliated with Liberty Broadband (on a board of 10 directors), approved Charter’s acquisition of the two other companies, but recused themselves from the final vote on Charter’s issuance of equity to Liberty Broadband. The court found that, because the acquisitions (which were viewed as favorable to Charter) were conditioned on the issuance to Liberty Broadband (which was viewed as unfavorable to Charter), the four affiliated directors had “played a role in securing the approval of the challenged [issuance] transactions” and had approved a deal structure that the court found to have been structurally coercive.
And most recently, Chancellor Andre Bouchard favorably cited NCI Building Systems when addressing a $1.75 billion, public-company tender offer by which a 40 percent stockholder of Coty Inc. increased its ownership to 60 percent. In re Coty Inc. Stockholder Litigation, Consol. C.A. No. 2019-0336-AGB (Del. Ch. Aug. 17, 2020) (denying a motion to dismiss following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220). In that case, the court found that Coty directors affiliated with the significant stockholder may have participated in a key board meeting before the tender offer was approved and that those directors’ relationships with members of a special committee, which was formed to evaluate the tender offer, may not have been disclosed or vetted in connection with formation of the special committee. Although the affiliated directors had excused themselves from the portion of a board meeting when the tender offer was approved, their incomplete disclosures regarding relationships with the special committee directors were included in a recommendation statement distributed by the company. Based on these facts and inferences in favor of the plaintiff-stockholders, the chancellor concluded that it was reasonably conceivable that the affiliated directors had not totally abstained from the process by which the tender offer was approved.
To implement lessons from these cases in potentially conflicted transactions, counsel may want to consider options early in a transaction planning process, such that the board has an opportunity to consider extensive and limited recusals from inflection points in the process. Directors may also want to reconfirm their understanding of any relationships between independent directors and interested directors, which could create the basis for inferences related to the effectiveness of a recusal.
An even more robust and formal method of injecting a disinterested perspective into a board process is the designation of a committee of independent directors. The authorizing resolutions for such a committee could provide as little power as the ability to duly convene a meeting for purposes of holding executive sessions and conferring about an independent position on the potential board action. Alternatively, subject to Section 141(c) of the DGCL, the resolutions could broadly provide the independent committee with a veto over specified corporate actions, the ability to retain and pay for advisers answerable only to the committee, the power to give direction to the company’s officers, employees and agents, and even the power to consider alternatives or authorize transactions. The extent of authority granted to a committee, and the committee’s exercise of its authority, has in recent cases affected the court’s perception of whether that committee had a sterilizing effect on interested directors or a controlling stockholder.
One element of the committee designation process that has received great attention in Delaware case law is the timing of the designation. In litigation over the $90 million acquisition of public company Intersections, Inc. by iSubscribed Inc., Vice Chancellor Glasscock found that both an independent committee and disinterested stockholder vote had been flawed and therefore ineffective to shift the standard of review from entire fairness to business judgment. Salladay v. Lev, C.A No. 2019-0048-SG (Del. Ch. Feb. 27, 2020) (“Intersections”) (denying a motion to dismiss, complaint based largely on public disclosures). In this case, at least half of the board was conflicted in light of rollover arrangements, consulting agreements with the buyer, and participation in a convertible note. The court stated that such a conflict could be cleansed by an independent board committee, thereby returning the litigation standard of review to business judgment deference (so long as there is not a controlling stockholder conflict). Drawing on case law related to Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”), however, the court in Intersections concluded that the committee must be in place before any substantive economic negotiations begin. The court found that the committee had been formed after management had suggested a price range to the buyer that could be acceptable to the board, and the buyer’s first offer and final price started at the bottom and ended just under the middle of management’s suggested range. This indicated to the court that the discussions preceding committee formation had “formed a price collar” and, quoting the Delaware Supreme Court, had “set the field of play for the economic negotiations.”
Another notable factor in Delaware courts’ analysis of a committee’s effectiveness is the scope of its authority. Chancellor Bouchard addressed that issue in a case arising when Baker Hughes engaged in transactions with its controlling stockholder pursuant to which it repurchased $1.5 billion worth of stock from the controller, terminated lockups so that the controller could sell $2.5 billion in stock in a secondary offering, and renegotiated commercial arrangements with the controller. In re Baker Hughes, a GE Company Deriv. Litig., Consol. C.A. No. 2019-0201-AGB (Del. Ch. Oct. 8, 2019) (TRANSCRIPT) (denying a motion to dismiss). The court found that, although a committee of independent directors had approved the transaction in accordance with a stockholders agreement, the board had only given the committee a veto right and had not delegated its full power to approve the transaction. The court rejected an argument that the board decision had been a formality, noting that the board decision was still required and was still a fiduciary one over which the directors could act with discretion. This designation of partial authority stood in contrast to committee designations in earlier Delaware case law where the committee had been given sole authority with respect to a particular board decision and conflicts at the board level were cleansed by that delegation.
Finally, the independence of the advice given to a committee can also weigh on the evaluation of the committee’s cleansing effect. In NCI Building Systems, Vice Chancellor Laster found that allegations about the potential conflict of the special committee’s financial advisor were weak but noted that they added to the “overall picture” of a controlled process. There, the significant stockholder had an existing relationship with the committee’s financial advisor, and the committee relied on management to vet and hire that financial advisor, instead of interviewing and selecting financial advisor candidates on its own. The committee’s use of the company’s existing legal counsel, and the significant stockholder’s relationships with management, also did not suffice to demonstrate the stockholder’s control but factored into that conclusion.
It is understandable that management and investors may adopt the views that a corporation can benefit from having directors who have the greatest knowledge of a potential transaction (e.g., stockholder-affiliated directors may have unique ability to identify and persuade new investors, or management directors may have unique insight of synergies with a potential strategic partner), a committee process can also be cumbersome (indeed, it is at times intended to slow down a process to ensure that appropriate consideration has been given to available options), and dire circumstances can potentially necessitate choices that would appear unpalatable on a clearer, sunnier day. However, the potential for or appearance of conflicts may accompany experience-driven knowledge or a streamlined process. These are dueling considerations that Delaware judges acknowledge boards face when forced to balance the desire for the least litigation risk and the best transaction terms, or the “right board process” and the “board process right now.” But Delaware law also mandates standards of review on litigation claims related to potentially conflicted decisions, such that a complete record of the board’s decision, demonstrating that the directors took the course of action they believed to be the best for the company, may only come to light after discovery or trial under the entire fairness standard of review. Thus, the decision whether to delegate board power to an independent committee can be difficult but also quite significant.
Potential conflicts around the boardroom receive significant attention from Delaware courts, which focus judicial review primarily on the process for decision making – not the actual results – around key corporate actions. Delaware judges have acknowledged that the potential for conflicts can be symptomatic of the long careers, extensive relationships, and deep expertise that directors often (and are encouraged to) bring to bear on effective corporate management. There is, therefore, a delicate balance between encouraging qualified individuals to serve as directors, potentially getting the benefit of their viewpoints in sensitive transactions, and installing fiduciary guardrails against self-interest. We view the range of board-level options for management of potential conflicts, which has been explored in recent Delaware cases, as commensurate with the range of potential conflicts involved in that balancing act.
This post comes to us from Nate Emeritz, who is of counsel, and Brian Currie and Jason Schoenberg, who are associates, at the law firm of Wilson Sonsini Goodrich & Rosati, P.C. in Wilmington, Delaware. The views expressed herein are those of the authors and do not necessarily reflect the views of the firm or its clients. This is the first in a series of three articles regarding Delaware case law on board- and stockholder-level measures for managing potential conflicts.