INSIGHT: So You’ve Got A Shareholder-Nominated Director … Now What? Practical Considerations for General Counsel

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Jeffrey R. Katz Annie Hancock Keith MacLeod

By Jeffrey R. Katz, Annie Hancock, and Keith MacLeod

Jeffrey R. Katz is a partner in Ropes & Gray’s corporate department and the co-head of the firm’s special situations practice. Annie Hancock is an associate in Ropes & Gray’s litigation department. Keith MacLeod is an associate in Ropes & Gray’s corporate department.

Shareholder-nominated directors are joining the boards of public companies with increasing frequency. Adding a shareholder-nominated director to a board often presents company counsel with a number of challenging questions under Delaware corporate law, including:

  •   What affirmative information-sharing duties does the company have to the incoming shareholder-nominated director?
  •  May the shareholder-nominated director share confidential and/or privileged company information with the shareholder and, if so, under what circumstances?
  •  How can the incumbent board manage any adversity that develops with the shareholder and/or its director designee?
  •  When should the company treat the shareholder-nominated director as interested or lacking independence with respect to a major company transaction?
  •  How can the company mitigate the risk of liability where the presence of the shareholder-nominated director(s) prevents the board from pursuing a transaction on a disinterested and independent basis?
In resolving these questions, company counsel must strive to: (i) ensure that the shareholder-nominated director is aware of and faithfully carries out his or her fiduciary duties to the company and all of its shareholders (notwithstanding his or her relationship with the director-nominating shareholder) and (ii) minimize the incumbent board’s exposure arising from potential conflicts of interest between the shareholder and/or its director designee, on the one hand, and the company, on the other, while at the same time satisfying the company’s obligations to the shareholder and its director designee.

 

In this article, we use the term “shareholder-nominated director” to refer to directors who have been either elected to the board after being nominated by a shareholder in a proxy contest or appointed or elected pursuant to an agreement between the shareholder and the company. The control a shareholder wields over its director designees varies greatly. On one end of the spectrum, the shareholder may choose affiliated individuals who take direction from the shareholder. On the other end, the shareholder may choose unaffiliated individuals who, in the shareholder’s opinion, have the experience and vision to guide the company in the right direction but who will not be actively influenced by the shareholder. In the middle of the spectrum, the shareholder may choose individuals with varying degrees of independence from the shareholder.

When a shareholder is closely affiliated with its director designee (e.g., the director designee is a principal or employee of the shareholder or of the adviser to the fund that is the shareholder) and influences the director designee’s decisions on the board, company counsel may face difficult questions concerning (i) the sharing of confidential and/or privileged company information with the director designee and the shareholder and (ii) the director designee’s involvement in the board’s decisions regarding major company transactions. The goal of this article is to provide a brief introduction to navigating some of these questions under Delaware corporate law.

When May A Shareholder-Nominated Director Share Confidential and/or Privileged Company Information With The Shareholder?

After a shareholder secures the appointment or election of a director, company counsel may grapple with questions such as: (i) does the company have an obligation to share all company information, including confidential and/or privileged information, with the shareholder-nominated director and (ii) if so, is the shareholder-nominated director allowed to share that information with the shareholder? While the answer to both questions is generally yes, the company must consider all relevant facts and circumstances before reaching any decisions. See Kalisman v. Friedman, No. CV 8447-VCL, 2013 WL 1668205, at **4–6 (Del. Ch. Apr. 17, 2013); In re Dole Food Co., Inc. Stockholder Litig., No. CV 8703-VCL, 2015 WL 5052214, at **43–44 (Del. Ch. Aug. 27, 2015).

A. Equal Information Rights for All Directors

As a general rule, all directors—including directors designated by a shareholder—must have (i) proper notice of board meetings, (ii) the opportunity to attend and speak at board meetings, and (iii) access to the corporate information that will enable them to fulfill their fiduciary duties. J. Travis Laster & John M. Zeberkiewicz, The Rights and Duties of Blockholder Directors, 70 The Bus. Law. 33, 41, 45 (Winter 2014/2015). A director’s right to information “includes ‘equal access to board information.’” Kalisman, 2013 WL 1668205, at *3 (quoting Moore Bus. Forms, Inc. v. Cordant Holdings Corp., C.A. No. 13911, 1996 WL 307444, at *5 (Del. Ch. June 4, 1996)). There are three limitations on this right of equal access to board information that have been recognized: (i) a director may, through an ex ante agreement with the company and the other directors, contract away at least some of his or her right to equal access, (ii) the ongoing work of a special committee, as discussed below, and its communications with its separate legal counsel are protected from disclosure to the directors not serving on the special committee, and (iii) privileged information with respect to a matter on which a director is adverse to the company can be withheld from that director. SeeKalisman, 2013 WL 1668205, at **4–5; Moore, 1996 WL 307444, at **5–6. When adversity between the company and a director develops, the board should promptly and clearly communicate such adversity to the director so that a court could not find the director to have maintained a reasonable expectation that he or she was a client of the board’s counsel with respect to the subject matter of such adversity. SeeKalisman, 2013 WL 1668205, at *5. The notion that there may be sufficient adversity between a company and a shareholder to allow information to be sequestered from the director designees of that shareholder was reinforced in a recent Delaware Court of Chancery decision, In re CBS Corp. Litigation, No. CV 2018-0342-AGB, 2018 WL 3414163 (Del. Ch. July 13, 2018). There, the board of directors of CBS Corporation (“CBS”) had formed a special committee to respond to the request of National Amusements, Inc. (“NAI”), the controlling shareholder of CBS, that CBS consider a combination with Viacom Inc., in which NAI also holds a controlling interest. In re CBS Corp., 2018 WL 3414163, at *2. The court found that, given that NAI had requested CBS’s consideration of a combination with another NAI-controlled entity, the CBS directors designated by NAI could not have had a reasonable expectation that they were the clients of either the special committee’s counsel or CBS counsel with respect to the special committee’s consideration of the potential combination. See id. at **6–7. They were therefore entitled to neither the communications between the special committee and its separate counsel nor the communications between the special committee and/or its separate counsel, on the one hand, and CBS counsel, on the other. See id.

Where one of the three limitations above does not apply, freezing out another director—even if that director is actively engaged in a proxy contest against the incumbent board—may be a breach of fiduciary duty. SeeKalisman, 2013 WL 1668205, at **1, 3–4; Moore, 1996 WL 307444, at **4–6.

B. Equal Information Rights for Director-Nominating Shareholders

When a shareholder-nominated director is clearly the representative of the shareholder, the shareholder is generally entitled to receive the information that the director receives. See Moore, 1996 WL 307444, at *4; Kalisman, 2013 WL 1668205, at *6. Since the shareholder-nominated director generally has access to all company information, this effectively means that the shareholder likewise has access to all company information. In light of the reality and general acceptability of the shareholder-nominated director’s sharing of confidential and/or privileged company information with the shareholder, company counsel should seek, before the shareholder-nominated director takes office, to have the shareholder sign an NDA restricting the shareholder’s disclosure and use of such information.

This general entitlement of a shareholder to the same information received by its director representative, however, assumes an alignment of interests between the company and the shareholder. See Kalisman, 2013 WL 1668205, at **5–6; see alsoKLM v. Checchi, No. C.A. 14764-NC, 1997 WL 525861, at **1–2 (Del. Ch. July 23, 1997). Where, in contrast, the shareholder will “use the information to the detriment of the corporation and its stockholders or to benefit themselves improperly,” sharing the information with the shareholder, or allowing the shareholder-nominated director to share the information with the shareholder, may be a breach of fiduciary duty. See In re Dole Food Co., 2015 WL 5052214, at *43. Even where the shareholder intends to use the information for the company’s benefit—for example, where the shareholder hopes that the disclosure of the information will improve the company’s corporate governance—sharing the information with the shareholder may still be a breach of fiduciary duty if the shareholder is adverse to the company at the time the information is shared. See Shocking Techs., Inc. v. Michael , Civ. A. 7164-VCN, 2012 WL 4482838, at *10 (Del. Ch. Oct. 1, 2012), vacated on other grounds, 2015 WL 3455210 (Del. Ch. May 29, 2015). Examples of the bases on which a shareholder could be adverse to the company include where the shareholder is (i) in a commercial dispute with the company and (ii) evaluating an investment in the company. See Holdgreiwe v. Nostalgia Network, Inc., No. CIV. A. 12914, 1993 WL 144604, at **4, 6–7 (Del. Ch. Apr. 29, 1993); Shocking, 2012 WL 4482838, at **7, 10.

At the same time, the incumbent board should not simply sequester information from a shareholder-nominated director. To balance where disclosure to a shareholder may be a breach of fiduciary duty against where failure to disclose to that shareholder’s director designee may also be a breach of fiduciary duty, it is imperative that company counsel probe any potential conflicts of interest between the company and the shareholder and assess the relationship between the shareholder and the director designee. Although directors may prefer consensus and congeniality, they should openly discuss at board meetings any potential adversity between the company, on the one hand, and individual shareholders and/or their director designees, on the other, and collectively determine the proper course of action. Convening “shadow” board meetings to conduct company business and consulting outside counsel without the knowledge of other directors would violate the equal access information rights of such other directors. See Kalisman, 2013 WL 1668205, at *5.

Where the shareholder’s interests on a matter appear to diverge from the company’s interests, the board should assess the extent of the shareholder-nominated director’s affiliation with the shareholder and consider the need to: (i) advise the shareholder-nominated director that (A) the company views him or her as adverse and will be withholding certain information from him or her and (B) he or she may consult separate counsel on the matter, (ii) request that the shareholder-nominated director sign an NDA with the company to restrict the director’s disclosure of information to the shareholder (or, if the director refuses to sign an NDA, let the meeting minutes reflect that he or she was reminded of his or her confidentiality obligations to the company), and/or (iii) create a special committee to address the matter in confidence from the shareholder-nominated director. A special committee must be established using proper board governance procedures. SeeSBC Interactive, Inc. v. Corp. Media Partners, No. CIV.A. 15987, 1997 WL 770715, at *6 (Del. Ch. Dec. 9, 1997). This means voting openly, with the knowledge of the director(s) to be excluded from the committee, to establish the committee pursuant to Section 141(c) of the Delaware General Corporation Law. SeeMoore, 1996 WL 307444, at *6; SBC, 1997 WL 770715, at *6. A validly formed special committee can retain its own legal counsel and, at least while the committee goes about its work, can protect communications with that counsel from disclosure to the directors who are not members of the committee. SeeMoore, 1996 WL 307444, at *6; Kalisman, 2013 WL 1668205, at *5.

Managing The Approval Process For Major Transactions Where The BoardIncludes One Or More Shareholder-Nominated Directors

In many instances, the shareholder who has successfully placed one or more directors on the board will have previously advocated for or against a sale of the company or another major strategic transaction. If such a transaction is pursued and then challenged, and a majority of the board is not found to be disinterested and independent with respect to the transaction, the transaction would be evaluated under the onerous “entire fairness” standard of review. In re Trados Inc. S’holder Litig., 73 A.3d 17, 36, 44 (Del. Ch. 2013). To satisfy entire fairness, the company must demonstrate that “the transaction was the product of both fair dealing and fair price.” Id.

To determine whether entire fairness would apply to the review of a transaction and, if so, how to lower the standard of review or at least shift the burden of proof, company counsel should carefully analyze whether each director—whether shareholder-nominated or not—is disinterested and independent with respect to the transaction. If a director is found to be interested or to lack independence, company counsel should then assess the implications for the disinterestedness and independence of the board as a whole. Again, open discussion of potential conflicts is critical. A director’s undisclosed interest in a transaction could make that transaction subject to entire fairness even where a majority of the board is disinterested and independent with respect to that transaction . See Orman v. Cullman, 794 A.2d 5, 22–23 (Del. Ch. 2002); see alsoCinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1168 (Del. 1995).

A. Assessing The Disinterestedness And Independence Of Shareholder-Nominated Directors

A director’s mere nomination by a shareholder does not conclusively determine whether the director would be interested or lack independence in considering a transaction. See Orman, 794 A.2d at 23–24, 25 n.50. To make such a determination requires an analysis of the role of the shareholder in the transaction and the relationship between the shareholder-nominated director and the shareholder.

If the transaction would be between the company and the shareholder, the shareholder-nominated directors may be interested in the transaction depending on the extent of their affiliation with the shareholder. Of course, if the shareholder is another company, a director who is an executive of that other company would stand on both sides of a transaction with it. See id. But, even where a shareholder-nominated director does not have an employment relationship with the shareholder or where the transaction would not be between the company and the shareholder, the director may have an interest in the transaction if the director would receive a benefit, or suffer a detriment, as a result of the transaction that would not be generally shared with, or suffered by, the other shareholders of the company. See id.; see also Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, 845 A.2d 1040, 1049 (Del. 2004). For the existence of such a benefit or detriment to make a director interested in the transaction, the benefit or detriment must be “of a sufficiently material importance, in the context of the director’s economic circumstances, as to have made it improbable that the director could perform her fiduciary duties … without being influenced by her overriding personal interest.” Chester Cnty. Emps.’ Ret. Fund v. New Residential Inv. Corp., 186 A.3d 798, 798 n.6 (Del. 2018) (quoting In re Trados Inc. S’holder Litig., C.A. No. 1512–CC, 2009 WL 2225958, at *6 (Del. Ch. July 24, 2009)). Thus, the same personal benefit – for example, an officer position in a transaction-surviving entity – that may influence a director who is a career executive may not also make a director who is a billionaire fund manager interested in the transaction. See Orman, 794 A.2d at 25 n.50.

A director who does not have an interest in a transaction could nonetheless lack independence with respect to it. A director lacks independence when he or she is unable to base a decision “on the corporate merits of the subject before the board rather than extraneous considerations or influences.” Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1375 (Del. 1995) (quoting Aronson v. Lewis, 473 A.2d 805, 816 (Del. 1984)). A lack of independence can result from the director being controlled by another. See Orman, 794 A.2d at 25 n.50. Control can result where either a shareholder dominates the director or the director is beholden to a shareholder. Id. A shareholder may dominate a director “through close personal or familial relationship or through force of will.” Id. A director may be beholden to a shareholder where the shareholder has the sole power to decide whether the director continues to receive a benefit on which the director is dependent or that is of subjective material significance to him or her. See id. Even where a shareholder does not control a director, the director may still be considered to lack independence if he or she owes fiduciary duties to the shareholder—for example, because the director is the investment adviser to the fund that is the shareholder—that compete with those fiduciary duties owed by the director to the company. See In re PLX Tech. Inc. Stockholders Litig., C.A. No. 9880-VCL, at *30 (Del. Ch. Sept. 3, 2015) (telephonic ruling on defendants’ motion to dismiss).

In evaluating whether a shareholder-nominated director’s control by a shareholder precludes the director from making a decision on the corporate merits or whether a shareholder-nominated director’s dual fiduciary duties compete, it is important to remember that there is a presumption that the incentives of a significant holder of a company’s equity are aligned with those of the other shareholders, i.e., to maximize the value of the company. See id. at *26. This presumption, however, is rebuttable. For example, it may be rebutted by a showing that the shareholder requires liquidity or has a short-term investment strategy that may lead it to favor a near-term sale over long-term growth. See id. at **26–27. In the case of a shareholder that is a fund, the liquidity focus may result from the impending termination date of the fund, redemption pressure from limited partners, or the adviser’s interest in redeploying capital after the investment in the company has hit a certain return percentage.

Entire fairness would apply to the review of a transaction if the directors who are interested in it or lack independence with respect to it make up a majority of the board or, though a minority of the board, dominate or control a majority of the board. See Orman, 794 A.2d at 22-23. Conflicted directors could make up a majority of the board where, in a proxy contest, a shareholder won a majority of the board’s seats and each of its director designees is interested in the transaction or suffers from disabling control by, or conflict with fiduciary duties owed to, the shareholder. Where the conflicted directors do not make up a majority of the board, the challenge to a transaction, in order to have entire fairness apply, would have to demonstrate specifically how the conflicted directors dominated or controlled a majority of the board. See Aronson, 473 A.2d at 816, overruled on other grounds, Brehm v. Eisner, 746 A.2d 244 (Del. 2000); see alsoIn re Cornerstone Therapeutics Inc, Stockholder Litig., 115 A.3d 1173, 1183 n.38 (Del. 2015). The director-nominating shareholder’s majority ownership of the company would not be enough on its own to conclude that the directors are unable to make a decision independent from the shareholder; there would have to be other evidence that the directors were beholden to the shareholder. See id. Where the conflicted directors neither make up, nor dominate or control, a majority of the board and the board is therefore able to act on a disinterested and independent basis, the conflicted directors should still, “in keeping with high standards of directorial conduct,” consider recusing themselves from board discussion and votes on the matter on which they are conflicted. See McMillan v. Intercargo Corp., 768 A.2d 492, 503–04 (Del. Ch. 2000).

B. Mitigating Risk Presented By A Board That Is Interested Or Lacks Independence

In the event that a majority of the board cannot be regarded as disinterested and independent with respect to a transaction, the company may mitigate the risk of liability for that transaction by (i) forming a special disinterested committee excluding the conflicted directors and/or (ii) making complete and accurate disclosure to shareholders. The combination of a special committee and approval by a majority of fully informed disinterested shareholders is a powerful tool that may cleanse otherwise conflicted major transactions.

i. Formation of a special disinterested committee

Where, because of the board’s lack of disinterestedness and independence, the standard of review of a transaction is entire fairness, the board, which would otherwise have the burden to demonstrate the fairness of the transaction, can, by having the transaction negotiated and approved by a well-functioning special committee that is disinterested and independent, shift the burden to the plaintiff to prove the unfairness of the transaction. In re Tele-Commc’ns, Inc. S’holders Litig., No. Civ. A 16470, 2005 WL 3642727, at *8 (Del. Ch. Dec. 21, 2005).

To ensure that the independence of a special committee withstands scrutiny, the committee should have (i) the ability to engage independent outside legal and financial advisors, (ii) a clearly delineated mandate and scope of authority, including the authority to address the conflict of interest, and (iii) compensation that is determined in advance, fully disclosed to shareholders, and independent of the committee’s ultimate recommendation. To protect the integrity of the special committee and the validity of its actions, it is critical that the board establish the committee using proper board governance procedures as described above. To ensure that a court would find the committee to have been well-functioning, the committee should meet frequently and ask for any information helpful to the decisions it must make. See Kahn v. M & F Worldwide Corp., 88 A.3d 635, 653 (Del. 2014).

ii. Complete and accurate disclosure to shareholders

Complete and accurate disclosure to shareholders regarding actual or potential conflicts of interest and the steps taken to address any such conflicts is critical. Where there has been “a fully informed, uncoerced vote of the disinterested stockholders” in favor of a change-of-control transaction, the business judgment rule, rather than entire fairness, standard of review applies and insulates the transaction from all attacks other than on the grounds of waste, even if there was not a disinterested and independent board majority approving the transaction. Singh v. Attenborough, 137 A.3d 151, 151 (Del. 2016); see alsoCorwin v. KKR Fin. Holdings LLC, 125 A.3d 304, 308–09 (Del. 2015). In these circumstances, “dismissal [of claims challenging the transaction] is typically the result … because it has been understood that stockholders would be unlikely to approve a transaction that is wasteful.” Singh, 137 A.3d at 152. Where (i) there is a shareholder who stands on both sides of the transaction or has an incentive that is not shared by the other shareholders and (ii) that shareholder holds a controlling stake in the company or a significant minority stake that could support a claim that the shareholder controls the company, the board should consider conditioning the transaction on approval by a majority of the disinterested shareholders. See In re Rouse Props., Inc., No. CV 12194-VCS, 2018 WL 1226015, at **1, 19 (Del. Ch. Mar. 9, 2018); Kahn, 88 A.3d at 644-45.

Conclusion

A variety of questions under Delaware corporate law may arise when a shareholder-nominated director joins a company’s board. These questions often involve considerations of fiduciary duties that pull in countervailing directions, nuanced assessments of the relationship between the shareholder-nominated director and the shareholder and between the shareholder-nominated director and the rest of the board, and individualized analysis of the alignment of interests between a director-nominating shareholder and the other shareholders with respect to a given transaction.

Jeffrey R. Katz is a partner in Ropes & Gray’s corporate department and the co-head of the firm’s special situations practice. Annie Hancock is an associate in Ropes & Gray’s litigation department. Keith MacLeod is an associate in Ropes & Gray’s corporate department.

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