Tears of a Director: The Tightrope of Director Conflicts

Director-level conflicts of interest continue to be an issue that corporations must monitor and address. The negative implications associated with these types of conflicts, whether actual or perceived, in the context of board decisions can be significant and costly. While it can be a challenge for corporations to remain in tune with the different rubrics that must be considered when assessing potential conflicts and consequently, director independence, potential conflicts first need to be identified.

In that spirit, this article briefly summarizes the fiduciary duty of loyalty, discusses what it means to be an independent director for purposes of board decision-making, and shares a few strategies to help prevent and effectively manage director-level conflicts of interest. Notably, the discussion that follows is framed in the context of Delaware corporate law since this is where most US public companies are incorporated. Additionally, there is a significant body of precedent on corporate matters that provides detailed and substantive guidance on corporate governance issues, including director independence and director-level conflicts of interest.

Evolving Standards and the Fiduciary Duty of Loyalty

Directors are required to uphold certain fiduciary duties to each corporation and its shareholders. The two primary fiduciary duties, duty of care and duty of loyalty, shouldn’t be news to anyone, but the evolving standards that directors are held to can be. In the context of independence and conflicts of interest, the duty of loyalty is the one to focus on. This duty requires that directors act independently and avoid any self-dealing. Put another way, the duty of loyalty requires that directors avoid any action or relationship that may give rise to a conflict between the director’s personal interests and the interests of the corporation and its shareholders. See this Skadden article for a deeper dive into directors’ fiduciary duties.

A common scenario where plaintiffs’ attorneys allege violations of a director’s fiduciary duty of loyalty is after a significant board decision—like one related to a merger or acquisition or other strategic initiative—is met by negative stock movement after being received unfavorably by shareholders, regulators, or other stakeholders. Directors sitting on boards organized under Delaware law can take comfort in knowing that Delaware courts are reluctant to second-guess board decisions even if that business decision, in hindsight, turns out to have been unwise. For those of you keeping score, yes, I am referring to the business judgment rule. See this article from the Delaware Department of State for more information on the deference to the business judgment of directors.

One of the keys to being able to benefit from the business judgment rule is to ensure that board decisions are made by impartial and independent directors. Even the appearance of a director-level conflict of interest may call into question director independence and whether a decision was fair to the corporation. This is just the opening a plaintiff’s attorney is looking for to make a Section 220 books and records request in what is typically a precursor to litigation. Avoiding these expensive and time-consuming plaintiff machinations is even more reason for directors to raise any potential conflicts that may be the basis for calling into question their impartiality or independence.

Director Independence, in the Eye of the Beholder

Assessing director independence is a multi-faceted endeavor, and the considerations are largely dependent on the lens through which one is looking. For instance, the Securities and Exchange Commission (SEC), stock exchanges (e.g., NASDAQ and New York Stock Exchange), proxy advisory firms, and state corporate law all have their own criteria governing director independence. While the applicable independence tests specific to the SEC, stock exchanges, and proxy advisory firms are arguably prescribed, state corporate law isn’t.

Take Delaware for example, where the Delaware Court of Chancery typically hears questions about director independence and conflicts of interest. There, you have a body of case law that looks to the particular facts and circumstances when considering the question of independence, like a director’s financial interests and business relationships.

Delaware Courts’ Developing View of Director Independence

We have previously covered developments in Delaware courts’ view of director independence, including in the context of business and personal relationships. Delaware courts continue to look beyond traditional situations where independence was historically questioned, like financial relationships, and expand their view to include personal relationships, involvement with charities, overlapping business networks, and even shared ownership of aircraft. Two additional situations where Delaware courts have focused their independence assessment, and which may come as a surprise, are personal admiration and director income. In Re BGC Partners, Inc. Derivative Litigation addressed both situations.

In Re BGC Partners, Inc. Derivative Litigation: Court Considers a Director’s Personal Admiration and Personal Income as Factors in Independence Assessment

Background

In In Re BGC Partners, Inc. Derivative Litigation (2019), then-Chancellor Andre G. Bouchard denied the defendants’ motion to dismiss a stockholder’s derivative suit challenging the fairness of a transaction. At issue was the $875 million paid by BGC Partners, Inc. (BGC)—a public company controlled by Howard Lutnick, the chairman and CEO of BGC—to acquire Berkeley Point Financial LLC, a private company also controlled by Lutnick. The plaintiffs were two stockholders of BGC. The defendants named in the case were Lutnick, as chairman and CEO of BGC; four BGC outside directors; and two entities that—along with Lutnick—sat on top of a complicated web of affiliated entities and appeared on both sides of the transaction.

As a reminder, when a shareholder brings a derivative suit, the plaintiff must first make a demand on the company’s directors or plead demand futility. Demand is futile if there aren’t enough disinterested directors to listen to the shareholder’s concerns in an unbiased way. Demand is not futile as a matter of law if a majority of the board of directors are independent and uninvolved in the transaction in question.

Defendants in the BGC case filed motions to dismiss on the basis that: (i) plaintiffs failed to establish that it would have been futile for them to make a demand on BGC’s board to decide whether BGC should pursue the claims itself, and (ii) the outside directors asserted that the claim brought against them should be dismissed for failure to state a claim for relief. At the heart of the complaint was the argument by plaintiffs that the directors who approved the transaction, which consisted of Lutnick and three outside directors (William Moran, Linda Bell, and Stephen Curwood), weren’t independent and wouldn’t be impartial in bringing litigation derivatively.

Plaintiffs Just Had to Show It Was “Reasonably Conceivable” That Directors Weren’t Independent 

To establish demand futility in Delaware, a plaintiff can’t merely state that a close relationship exists. However, when the plaintiff pleads specific facts about the relationship—like the length of the relationship or details about the closeness of the relationship—then the court is required to make all reasonable inferences from those facts in the plaintiff’s favor. The court must also consider a plaintiff’s allegations in their totality and not in isolation from each other.

In Lutnick’s case, it would be impossible to argue that he wasn’t disinterested or independent. He stood on both sides of the transaction and the defendants conceded to this point. The question then was whether the three outside directors who approved the transaction were independent.

The courts denied the defendants’ motion to dismiss and found the plaintiffs successfully pleaded facts that created a reasonable doubt that the three outside directors lacked independence. The court considered the following:

• Moran’s and Lutnick’s professional relationship spanned approximately 20 years, including service on four different boards affiliated with a firm owned by Lutnick. Further, the court pointed to the record, which showed that (i) Moran and his wife attended public events with Lutnick, including a black-tie gala where the three of them were photographed together in a staged setting; (ii) Moran’s wife honored Lutnick’s sister at a different gala; and (iii) Lutnick offered to help arrange a private tour of a museum in London for Moran’s wife and granddaughters at the time that the transaction was under consideration.
• In Bell’s case, the court also pointed to an existing professional relationship with Lutnick, but particular attention was given to her income. The court noted that the plaintiffs searched publicly available information for Bell’s personal financial information, including a disclosure that identified her compensation received as a BCG director in comparison to her annual income in recent years during which she has served as provost, dean of the faculty, and a professor of economics at Barnard College. This director’s board compensation represented over 30% of her annual income in recent years during which she served in different roles at Barnard College, a college where Lutnick was also a significant donor.
• Curwood, similar to Bell, had served with Lutnick on several boards affiliated with a firm owned by Lutnick, and his BGC director compensation made up a large portion of his total income. Moreover, Lutnick was very generous in contributing to organizations to which Curwood had connections.

Discovery Yields Interesting Data Points, Including “Teary-Eyed” Deposition Testimony

Since the defendants were not successful in getting the case dismissed, the plaintiffs were free to conduct discovery, which included deposing Moran, among others. Moran’s deposition testimony was notable because he described Lutnick as an “inspiration” and mentioned he was worried that he might get “teary-eyed” when speaking about how Lutnick was a “wonderful . . . good human being.” The director went on to say that he was “proud to be associated with a man [like Lutnick].”

Outcome

At the summary judgment stage, Vice Chancellor Lori W. Will found that Bell could have independently considered a demand, but disputes of fact remained regarding Curwood’s and Moran's independence that prevented summary judgment on that issue, though “the evidence [was] not overwhelming.”

The case went to trial in October 2021, was dismissed in 2022, was appealed, and was recently upheld.

Specific to the assessment of director independence in the context of demand futility at trial, Vice Chancellor Will found that Curwood could not have impartially considered a demand to sue Lutnick. The decision explained that Curwood understood Lutnick had the power to remove him from his position on the board and that Curwood valued the stability and personal freedom that his board position created.

The more interesting outcome was Moran's. The plaintiffs had argued that Moran’s “teary-eyed” deposition testimony about his respect for Lutnick cast doubt on Moran’s ability to consider a demand to sue him. However, Vice Chancellor Will noted that “stripped of the inference favoring their position and with the burden of proof upon them, the plaintiffs’ argument falls flat.” She went on to say, “I am convinced that Moran’s emotional testimony was driven by his own connection to the 9/11 tragedy. Nothing in the record suggests that Moran’s respect for Lutnick was so personal or of such a ‘bias producing’ nature that it would have clouded Moran’s judgment were he asked to sue Lutnick.”

When the dust settled, defendants walked away with a victory, but as we all know, these victories come at a cost, whether that be litigation expense, distraction from managing the business, or keeping management and directors up at night. Further, this case serves as a reminder of how director independence may be scrutinized by plaintiffs’ attorneys and how nuanced Delaware courts’ assessments of director independence can be.

Strategies to Help Prevent and Effectively Manage Conflicts of Interest 

As illustrated in this article, conflicts of interest have the potential to undermine the integrity of the board’s decision-making and expose the company, as well as individual directors, to litigation. To address this issue, here are a few strategies to help prevent and effectively manage director-level conflicts of interest.

1. Address Director-Level Conflicts of Interest in Corporate Policies

Company codes of conduct will undoubtedly include a general conflicts of interest section. While some do better than others, these policies do not typically go into detail regarding director-level conflicts of interest. If your company doesn’t already, it could consider establishing a resource that focuses directors on areas of risk, provides guidance to directors to help them recognize and deal with ethical issues like conflicts of interest, and provides mechanisms to report any potential issues or ask questions. Some companies take the approach of building this into their corporate governance guidelines (e.g., Whirlpool or Charles River Laboratories), and others decide that a standalone set of director conflict of interest guidelines (e.g., Take-Two Interactive or Apple) makes the most sense for them.

2. Encourage Transparency Through Training

It’s easy to ask directors to disclose any potential conflicts of interest. The challenge is how to do so in a way that translates into directors openly disclosing any potential conflicts of interest to the company. This is not to say that directors would intentionally look to avoid disclosure. Rather, it is more a matter of education about what types of director-level conflicts they should be on the lookout for. A brief walkthrough of a case like the one discussed in this article can be the basis for a fruitful discussion with the board well in advance of any actual potential conflict of interest arising. As a practice point, this type of discussion may be worthwhile holding in parallel with your company’s annual director and officer questionnaire process or review of the company’s code of conduct.

3. Engage Outside Counsel

Companies—and more specifically boards or board committees—that are evaluating director-level conflicts should consider involving counsel to assist with the training, identification, and management of these types of conflicts. The rationale for involving counsel, especially in the case of significant board decisions, is to ensure that discussions are protected by attorney-client privilege. If a potential conflict is identified, outside counsel can help in structuring a process to manage the conflict.

4. Maintain a Written Record

The presence of a director-level conflict doesn’t necessarily deprive the entire board from being able to benefit from the business judgment rule, but as illustrated in this article, each director and board member’s activities in the decision-making process can become the subject of significant scrutiny. Consequently, it’s best to ensure the company maintains a contemporaneous written record, which not only demonstrates due diligence but also serves as a vital tool in case companies need to defend against challenges from plaintiffs’ attorneys. As to how detailed that record needs to be, this is another place where outside counsel can be of great help.

Parting Thoughts

Director-level conflicts of interest are a persistent concern in corporate governance, but with the right strategies in place, companies and directors can effectively prevent and manage these issues. In addition, keeping directors up to date on the latest evolution of Delaware’s view of director independence can lead to better and more timely management of potential director-level conflicts of interest.