Benefits of Independent and Delaware Perspectives on Board Self-Evaluations

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DIRECTOR EFFECTIVENESS
Nathan Emeritz

By Nathan P. Emeritz

Nathan P. Emeritz is an associate at Morris, Nichols, Arsht & Tunnell LLP in Wilmington, Del. The views expressed in this article are those of the author and do not necessarily reflect the views of the firm or its clients.

Board self-evaluations are conducted by companies listed on the New York Stock Exchange and with increasing frequency by boards of other public and private companies. Feedback from director surveys and commentators suggests that, although directors are generally satisfied with the performance of their boards, a lack of independence has proved to be a meaningful hindrance to effective board self-evaluations (and to the concomitant improvement in effectiveness of those boards). Indeed, commentators and investors have begun to focus on the benefits of an external facilitator in a board self-evaluation and recommended the involvement of counsel that is independent of corporate insiders, familiar with boardroom dynamics, and expert in current corporate governance issues. Boards and their regular outside counsel seeking the benefits of board self-evaluations should consider this recommendation, as well as Delaware guidance on director independence and the use of outside advisors.

Surveys Regarding Lack of Independence in Board Self-Evaluations

As a general matter, surveys and commentary suggest that directors are satisfied with the performance and evaluation of their boards. Directors have, however, raised issues with certain aspects of the board self-evaluations. In particular, studies by PricewaterhouseCoopers LLC (“PwC”) and Stanford University’s Rock Center for Corporate Governance (the “Rock Center”) have presented evidence that a lack of independence has caused directors to hesitate to engage and to feel overshadowed by management and dominant directors.

A 2016 study by the Rock Center, the Miles Group and the Stanford University Corporate Governance Research Initiative found that of the directors surveyed, 53 percent “do not express their honest opinions in the presence of management,” 36 percent do not “strongly believe their board is open to new points of view,” 54 percent do not “strongly believe that their board tolerates dissent,” 46 percent believe that “a subset of directors has an outsized influence on board decisions,” and 21 percent (23 percent at private companies) were not satisfied with “the outcome of the board evaluation process.” Board of Directors Evaluation and Effectiveness (2016).

In open-ended responses, directors also stated that their respective board “strongly opposes any form of individual director assessment or feedback which is a lost opportunity for improvement,” that two factions of the board of two merged companies create a “dysfunctional” environment, that the board “does not talk to anyone other than the CEO,” and that “board membership is largely determined by the amount of investment by the respective venture firms [backing the companies].” Id.

The Rock Center study quoted CEO Stephen A. Miles of TMG, “There is clearly a sub-optimization happening in boards, and it has an impact on trust as well as overall board effectiveness.” Id. Commentary by the authors of that study recommends that boards should counter these issues by fostering trust, creating opportunities to give feedback, and setting expectations for directors’ contributions. Id.

In a 2014 study of board self-evaluations, PwC found that 10 percent of directors thought that a close relationship between the board chair and an underperforming director was an impediment to replacing the underperforming director. PwC’s 2014 Annual Corporate Directors Survey, Governance trends shaping the board of the future . In the 2016 iteration of that study, PwC found that only 49 percent of directors said their boards made changes as a result of board self-evaluations. PwC’s 2016 Annual Corporate Directors Survey, The swinging pendulum: Board governance in the age of shareholder empowerment .

Commentary Regarding Independent Counsel in Board Self-Evaluations

The foregoing surveys demonstrate that directors have identified a lack of independence as a shortcoming in board self-evaluations and have connected this shortcoming to their own reticence to engage fully and candidly in those board self-evaluations. Practical commentary and investors’ proposals have accordingly suggested incorporation of outside assistance in board self-evaluations. Engagement of an external facilitator may address the directors’ hesitations to engage and impediments to corporate improvement. Among the possibilities for such external facilitators (e.g., consulting, accounting, law and director-placement firms), independent law firms may add unique benefits from a legal perspective—particularly counsel familiar with the influence exerted by and on directors, management, investors and longstanding advisors.

Organizations representing both directors’ and investors’ perspectives have promoted the use of an independent outside party in board self-evaluations. In a 2016 report, a Blue Ribbon Commission of the National Association of Corporate Directors recommended, “Use a qualified independent third party on a periodic basis, to encourage candor and add a neutral perspective.” Report of the NACD Blue Ribbon Commission on Building the Strategic-Asset Board (2016). From the investor perspective, the rubric for a “robust” Governance QuickScore from Institutional Shareholder Services includes “an external evaluator at least every three years.” ISS Governance QuickScore 3.0 (Revised May 2015). In a review of disclosure formats for board self-evaluations, the Council of Institutional Investors stated that an independent corporate governance expert should be included every one to three years, as well as disclosure of the expert’s past relationships with the company and directors. CII Best Disclosure: Board Evaluation (Sept. 2014).

Failure to include an independent perspective may be discouraging to directors: “adopting only an internal mechanism throughout a board lifecycle may refrain board members from revealing some aspects that could be problematic, thus eroding the real picture.” Maria Cristina Ungureanu, Board Evaluation – A Window into the Boardroom (Harvard Law School Forum on Corporate Governance and Financial Regulation, May 31, 2013). Ungureanu recommended:

In line with general best practice an external evaluation should take place at least every three years within the board cycle. Several companies engage an external consultant more often, either annually or once every two years. . . . Specialization and independence of the external evaluator are key. Regular use of an external specialized consultant can improve board performance assessments by bringing an objective view and by providing a ‘best practice’ perspective.
Id. Ungureanu further noted, “Given the potential conflicts, the external facilitator should neither have an ongoing nor recent relationship with the company. … The involvement of the external party in the process can have several levels: it could offer independent advice to the board throughout the process, or simply act as impartial facilitator.” Id.

Commentary from a legal perspective is in accord. Gibson, Dunn & Crutcher LLP attorney John Olson recommended, “Boards that have not previously used an outside party to assist in their evaluations should consider whether this would enhance the candor and overall effectiveness of the process.” John Olson, Getting the Most from the Evaluation Process, Harvard Law School Forum on Corporate Governance and Financial Regulation, June 6, 2016). Olson noted that a new perspective can “enhanc[e] the effectiveness of the process and the value it provides to the board.” Id.

In our experience, increasingly, at least once every few years, boards that use questionnaires are retaining a third party, such as outside counsel or another experienced facilitator, to compile the questionnaire responses, prepare a summary and moderate a discussion based on the questionnaire responses. The desirability of using an outside party for this purpose depends on a number of factors. These include the culture of the board and, specifically, whether the boardroom environment is one in which directors are comfortable expressing their views candidly. In addition, using counsel (inside or outside) may help preserve any argument that the evaluation process and related materials are privileged communications if, during the process, counsel is providing legal advice to the board.
Id. Olson identified confidentiality and collegiality as key issues to keep in mind while structuring board self-evaluations and considering whether to bring in independent counsel in the process.

Simpson Thacher & Bartlett LLP attorneys Avrohom Kess and Yafit Cohn observed the potential benefits in terms of confidentiality:

Boards should ask themselves whether, given the circumstances of the company and the issues facing the board, the directors would be comfortable and forthcoming with an internal facilitator. Additionally, boards should bear in mind that hiring a third-party has the benefit of enhancing the objectivity of the process, may make directors feel more assured that confidentiality will be honored, and may empower directors to voice concerns that may not have otherwise surfaced.
Avrohom Kess and Yafit Cohn, Optimizing Board Evaluations, Harvard Law School Forum on Corporate Governance and Financial Regulation, Aug. 16, 2016). Kess and Cohn also noted downsides of an external facilitator, including the potential for additional costs, directors’ discomfort with an outsider combing through corporate records, and the possibility of a generic approach to all boards and problems. These two lawyers concluded, “In cases where the board elects to hire a third-party facilitator, the facilitator should be one that is respected and trusted, experienced in conducting board evaluations, and well-versed in evolving governance practices.” Id.

Several of these commentators have also noted the issues that arise when board self-evaluations are conducted internally. As the Rock Center found, directors are less likely to express honest opinions in front of management. Board of Directors Evaluation and Effectiveness. Thus, a board structuring self-evaluations should consider whether the dynamics at the company are conducive to directors’ providing honest feedback to members of management. See Olson, Getting the Most from the Evaluation Process. In addition, boards might consider the difficult position of a general counsel or corporate secretary, who has been tasked with assisting in the critique of directors and will be answerable to those same directors going forward in the management of the company.

KPMG has noted that at private companies, “conflicts may be more subtle and difficult to ferret out.” KPMG, Exceptional Private Company Boards Get the Basics Right (2015). KPMG went on to recommend, “Establishing and setting a rhythm for meaningful board evaluations and committee rotation helps the board stay on top of its own responsibilities.” Id.

Delaware Guidance Regarding Independence and Advice in the Boardroom

A board focused on improving its performance can glean significant guidance from Delaware law regarding the benefits of independence in the boardroom, the impact of advisors’ conflicts and the influence that may be exerted by investors and management. Delaware case law, developed under a range of circumstances in litigation, may contain lessons translatable to the design, implementation, and benefits of board self-evaluations.

The Delaware Supreme Court has noted that longstanding relationships can undermine directors’ independent judgment. Indicia of such thick connections between directors in litigation may include decades-long friendships, sharing a private airplane, posting website endorsements and vacation photographs. Sandys v. Pincus, 152 A.3d 124 (Del. Dec. 5, 2016); Greater Pa. Carpenters’ Pension Fund v. Giancarlo, 135 A.3d 77 (Del. 2016); Del. Cty. Empls. Ret. Fund v. Sanchez, 124 A.3d 1017 (Del. 2015); see also In re IAC/InterActiveCorp Class C Reclassification Litig., C.A. No. 2017-0208-JTL (Del. Ch. June 2, 2017) (TRANSCRIPT). By questioning whether board effectiveness could benefit from changes in composition, including by examining directors’ independence and probing for stagnation in board deliberations, the board self-evaluation process can create a forum for potentially addressing important concerns. In that regard, Delaware case law can outline and illustrate issues that diligent boards may wish to consider in their self-evaluations.

Over the past decade, Delaware courts have focused more closely on board advisors’ incentives. The Delaware Supreme Court and, more often, the Delaware Court of Chancery have held that the reliability of expert guidance depends on the independence and board oversight of the expert advisor. RBC v. Jervis, 129 A.3d 816 (Del. 2015); Houseman v. Sagerman, 2014 BL 106313 (Del. Ch. Apr. 16, 2014); In re Good Tech. S’holder Litig., C.A. No. 11580-VCL (Del. Ch. May 12, 2017). In the context of board self-evaluations, directors are also well-advised to confirm that their external facilitators are similarly independent—or at least that the advisors have disclosed any material relationships. See Ungureanu, Board Evaluation – A Window into the Boardroom; CII, Best Disclosure: Board Evaluation.

Finally, the concerns that have been raised in commentary and director surveys regarding the inhibiting effect of dominant directors, management and investors, have long been a point of focus in Delaware law. See Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173 (Del. 1986); Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). Case law and articles written by members of Delaware courts describe the precarious position in which independent directors may find themselves if unprepared to resist such domineering executives and controlling stockholders. See Leo E. Strine Jr., Documenting the Deal: How Quality Control and Candor Can Improve Boardroom Decision-Making and Reduce the Litigation Target Zone , 70 Bus. Law. 679 (2015). These issues often arise in a conflict or management buyout-style transaction but have also manifested themselves in other circumstances in Delaware Court of Chancery litigation. Although clear differences exist between the board self-evaluation and MBO contexts, the directors’ need to be prepared and well-advised by independent experts is common to both scenarios.

Methods of Involving Independent Counsel in Board Self-Evaluations

There is merit to these commentators’ recommendations that boards should engage outside counsel that is independent of corporate insiders, familiar with boardroom dynamics, and expert in identifying situation-specific conflicts in corporate governance. Subject to boardroom culture and current events at each company, Delaware law firms (and other independent firms that do not typically act as general outside counsel) may be uniquely situated to fill this role.

Law firms with a focus on Delaware law are frequently immersed in questions related to director independence, management influence, stockholder activism, and other potential conflicts. This narrow practice, which frequently involves short-term special assignments, allows such law firms to maintain greater independence from corporate insiders than firms that act as regular outside counsel. The skills required by this practice also overlap with those necessary for board self-evaluations, for instance conducting director interviews, establishing committee procedures, structuring organizational documents, quickly becoming acquainted with a company’s business, and navigating contentious management and activist dynamics. Thus, companies considering a board self-evaluation might consider whether such a law firm would offer the benefits of independence, experience and attorney-client privilege to directors, management, significant stockholders, and general outside counsel.

If regular outside counsel has been assisting the board with its evaluation process, independent counsel could work in collaboration with regular counsel to identify potential conflicts, review questionnaires or discuss surveys with directors. In this role, independent counsel could put directors at greater ease to candidly discuss sensitive topics. Independent counsel could also insulate the working relationships among directors, management and general outside counsel, which must continue productively after completion of the board self-evaluation.

Alternatively, independent counsel could conduct board self-evaluations periodically as a refresher from the regular internal or external facilitator. Maria Ungureanu outlined possibilities for such a process:

Particularly if conducted by an external consultant, the evaluation process includes a review of board documentation, governance documents, charters, minutes, agendas and observations of board meetings. This part of the assessment is very important both as a preparation ahead of the discussions with the board members, and for enabling a complete assessment of the board functioning. Major facts happen during the year at the level of the board. These are to be acknowledged by the external advisor and brought back to board members’ analysis during the interviews.

A final issue for consideration by boards conducting self-evaluations: the increasing disclosure around board self-evaluations. This disclosure creates additional incentives for companies to improve their board self-evaluations. Investor-focused organizations, such as ISS and CII, offer higher ratings for companies that include independent advisors. Failure to take seriously board self-evaluations, the proposals mentioned above and effective disclosure may compound already difficult issues that may arise in a proxy contest, interested transaction or protracted litigation.

Conclusion

Public and private companies have engaged thoughtfully in board self-evaluations as an opportunity to improve board effectiveness. Directors are positive about many (but not all) aspects, yet investor focus on disclosure around those processes may drive greater expectations. The use of independent counsel could, therefore, represent an appropriate and widely supported improvement to board self-evaluations.

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