“Constituency” directors are becoming an ever increasing presence in U.S. public corporations’ (“Corporation”) board rooms. The term “constituency” director refers to public company directors whose board membership is tied to one or more specific voting constituency or sponsor (i.e., a significant stockholder). This article focuses on potential challenges arising when hedge fund or private equity representatives serve as constituency directors.
Oftentimes constituency directors nominated by hedge funds or private equity firms are employees or principals (the “Designated Director”) of nominating firms (“Nominating Firms”). The Designated Director may be a principal of the Nominating Firm, with overall responsibility for the firm’s financial performance, or a portfolio manager or analyst with industry or company-specific expertise. In practice, Designated Directors would be expected to, and oftentimes do, have substantial ongoing interaction with their Nominating Firm.
The prevalence of Designated Directors on public company boards raises myriad questions regarding the fiduciary duty of loyalty and the sharing of information between parties. Hedge funds and private equity funds benefit from having a Designated Director on the board of a public company in which the firm has a significant ownership stake. Designated Directors may allow the Nominating Firm to better monitor and protect its investment, can ensure that a significant stockholder has a say on the board, and bring additional sophisticated financial and industry expertise thereby benefiting the board, the Nominating Firm, and all of the stockholders. With these benefits come potential legal complexities related to fiduciary duties. This article addresses challenges in the Designated Directors context, focusing primarily on the duty of loyalty under Delaware law.
The Duty of Loyalty
Under Delaware law, all directors owe a duty of care and a duty of loyalty to the Corporation and all stockholders. Duty of care “requires that directors of a Delaware corporation ‘use that amount of care which ordinarily careful and prudent men would use in similar circumstances,’ and ‘consider all material information reasonably available’ in making business decisions, and that deficiencies in the directors’ process are actionable only if the directors’ actions are grossly negligent.” In re TIBCO Software Inc. Stockholders Litig., 2015 WL 6155894, at *23 (Del. Ch. Oct. 20, 2015) (quoting In re Walt Disney Co. Deriv. Litig., 907 A.2d 693, 749 (Del. Ch. 2005)).
Of greater significance to this article is the duty of loyalty, which “mandates that the best interest of the corporation and its stockholders takes precedence over any interest possessed by a director . . . and not shared by the stockholders generally.” Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993). “Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests,” and instead must act with “undivided and unselfish loyalty to the corporation” and ensure that “there be no conflict between duty and self interest.” Id.
Designated Directors, who owe their position on the board to their own Nominating Firm, owe a duty of “uncompromising” loyalty to all the Corporations’ stockholders and cannot put the interests of the Nominating Firm above any other stockholders. Klaasen v. Allego Dev. Corp., 2013 WL 5967028, at *11 (Del. Ch. Nov. 7, 2013) (“corporate directors do not owe fiduciary duties to individual stockholders” but instead to “the entity and the stockholders as a whole”). Delaware law makes no allowances in the duty of loyalty when a director holds multiple fiduciary obligations. In re Trados Inc. S’holder Litig., 73 A.3d 17, 46–47 (Del. Ch. 2013).
Ramifications of Breaching the Duty of Loyalty
When a Designated Director approves of an action that may appear to benefit the Nominating Firm in a unique or non-ratable manner as compared to the other Corporation’s stockholders or otherwise appears to have acted in a non-independent or self-interested manner, the transaction generally will be subject to judicial review under the entire fairness standard rather than the business judgment rule. Delaware’s business judgment rule is a deferential standard of judicial review that creates a presumption that the directors acted on an informed basis, in good faith, and in the honest belief that the action was in the best interests of the corporation. Cede & Co., 634 A.2d at 361. Unless the plaintiff stockholder can rebut the business judgment rule at the pleading stage, the fiduciary duty claim will be dismissed so long as a “rational” business purpose can be attributed to the challenged board action. See, e.g., Sinclair Oil Corp. v. Levien¸ 280 A.2d 717, 720 (Del. 1971).
The business judgment rule can be rebutted by alleging facts that, if proven, would constitute a breach of loyalty. For example, allegations that the directors were self-interested in the challenged transaction—i.e., stood on both sides of the transaction or personally stood to gain a benefit not received by the stockholders generally—are sufficient to rebut the business judgment rule. The burden then shifts to the directors, who must prove that the challenged action was “entirely fair” to the corporation and its stockholders, which can be a difficult standard to satisfy. Cede & Co., 634 A.2d at 361.
Under Delaware law, Delaware corporations can include in their certificate of incorporations a clause that eliminates or limits a director’s personal liability to a corporation or its stockholders for monetary damages for breaches of fiduciary duty. 8 Del. C. § 102(b)(7). However, Section 102(b)(7) expressly precludes exculpation of breaches of loyalty, and therefore directors remain subject to personal liability for breaches of loyalty.
Designated Directors and the Duty of Loyalty
The question becomes: how can a Designated Director navigate the potentially competing loyalties owed to the Corporation and the Nominating Firm? As noted above, the Designated Director owes a duty of loyalty to the Corporation and its stockholders, which requires the Designated Director to perform his or her board duties without giving any special or preferential treatment to the Nominating Firm. At the same time, however, the Designated Director may face competing pressures emanating from the Nominating Firm. For example, the Designated Director’s compensation at the Nominating Firm may be tied in part to the firm’s investment returns associated with the Corporation. The Designated Directors may also owe fiduciary duties or contractual obligations to the Nominating Firm and investors in that firm, which could be seen to interfere with the Designated Directors’ obligations to the Corporation and its stockholders. “Because [constituency] directors are often affiliated with entities whose interests may differ from those of the stockholders as a whole, and because [constituency] directors are often dual fiduciaries who also owe a duty of loyalty to their differently situated entities, this standard poses particular risks to the [constituency] directors.” J. Travis Laster & John Mark Zeberkiewicz, The Rights and Duties of Blockholder Directors, 70 Bus. Law. 33, 49 (2015).
Many times, however, these hypothetical competing tensions do not elevate to an actual conflict because the interests of the Nominating Firm and the other stockholders are fully aligned. In re Synutra Intern., Inc., 2018 WL 705702, at *4 (Del. Ch. Feb. 2, 2018) (“The Delaware Supreme Court has held that a ‘charge that a director was nominated by or elected at the behest of those controlling the outcome of a corporate election’ does not rebut the presumption that a director was independent.”). Indeed, directors should be focused on enhancing long-term corporate value for all stockholders. In re Citigroup Inc. S’holder Deriv. Litig., 964 A.2d 106, 139 (Del. Ch. 2009) (“Ultimately, the discretion granted directors and managers allows them to maximize shareholder value in the long term by taking risks without the debilitating fear that they will be held personally liable if the company experiences losses.”). Where the Designated Director supports a particular value-maximizing corporate transaction that benefits all stockholders equally, there are no diverging interests and hence no potential conflict for the Designated Director. In re Trados, 73 A.3d at 46 (“If the interests of the beneficiaries to whom the dual fiduciary owes duties are aligned, then there is no conflict.”).
On the other hand, the interests of the Nominating Firm and Corporation’s other stockholders can diverge due to differing investment horizons or investment objectives. Id. For example, suppose the Nominating Firm wants to liquidate its position in the Corporation in the near term. The Nominating Firm would therefore prefer a particular corporate transaction that may have a short-term benefit (stock price appreciation) but, due to strategic reasons, would not maximize the value of the corporation over the long term. In that circumstance, a Designated Director who “also serves in a fiduciary capacity for [the Nominating Firm] can face a conflict of interest: the [Designated Director’s] duties to the corporation require that the director manage for the long term, while the [Designated Director’s] duties to the [Nominating Firm] require that the director manage for an exit.” Laster & Zeberkiewicz, at 50. What should the Designated Director do under the circumstances?
Given the serious potential reputational and financial consequences, public companies, Nominating Firms, Designated directors, and boards must all grapple with the question of how to avoid a potential violation of the duty of loyalty. The following topics are among the most relevant to consider.
Advocating for the Nominating Firm’s Preferred Course of Action on the Board
Assume the Corporation’s board is contemplating a particular transaction that the Nominating Firm strongly supports because it believes it will improve value for all stockholders. May the Designated Director advocate in favor of the transaction before the board without breaching the duty of loyalty? The answer should be “Yes”—–if the Designated Director is fully informed and honestly and objectively believes the transaction is in the best interests of the Corporation and all of its stockholders. Thus, while Designated Directors cannot blindly represent the positions of a Nominating Firm, they are permitted to advocate for a position which the Nominating Firm would favor, if that position is based on the honest and objective understanding that such position is in the best interest of the corporation and all of its stockholders. See, e.g., In re Lear Corp. S’holder Litig., 967 A.2d 640, 655 (Del. Ch. 2008) (“During their term of office, directors may take good faith actions that they believe will benefit stockholders, even if they realize that the stockholders do not agree with them.”).
Whether a Designated Director Should Recuse Himself or Herself from Voting on the Potential Board Action
Assume the board is considering a particular transaction. The Designated Director believes he or she has a disabling conflict that compromises his or her ability to comply with the duty of loyalty with regard to the proposed transaction. What can he or she do?
The Designated Director’s safest course of action may be to fully disclose the conflict to the board; remove himself or herself from any discussions concerning the matter; and abstain from the board vote. See Kahn v. Stern, 2017 WL 3701661, at *8 (Del. Ch. Aug. 28, 2017) (explaining that to plead a claim for breach of loyalty, “the Complaint must contain ‘sufficient facts to show that a majority of the Board of directors breached their fiduciary duty of loyalty’”) (emphasis in original); DGCL § 144(a) (providing safe harbor for a transaction between a corporation and a director or the corporation and an affiliate of the director where the interested director discloses the conflict to the entire board and the transaction is approved by a majority of disinterested directors). It is important to note, however, that where a conflicted director abstains from voting, the board action cannot be approved by written consent due to the unanimity requirement of DGCL § 141(f); Solstice Capital II, Ltd. P’ship v. Ritz, 2004 WL 765939, at *1 (Del. Ch. Apr. 6, 2004).
In this way, the Designated Director ensures that the board action was approved by a majority of disinterested directors free from any suggestion that the Designated Director somehow tainted or improperly influenced the board’s decision. See, e.g., Yucaipa Am. All. Fund II, L.P. v. Riggio, 1 A.3d 310, 326 (Del. Ch. 2010) (noting that the independent directors failed to hold discussions outside the presence of the conflicted director); Emerald Partners v. Berlin, 2003 WL 21003437, at *28 (Del. Ch. Apr. 28, 2003) (“The single flaw in the non-affiliated directors’ decision-making process was their failure to insist that [the conflicted directors] absent themselves entirely from that process.”), aff’d 840 A.2d 641 (Del. 2003).
Sharing of Confidential Information Between the Corporation and the Nominating Firm
As a board member, the Designated Director is entitled to the same information that is provided to the other directors. Schoon v. Troy Corp., 2006 WL 1851481, at *1 n.8 (Del. Ch. June 27, 2006) (A director’s right to information is “essentially unfettered in nature”); Intrieri v. Avatex Corp., 1998 WL 326608, at *1 (Del. Ch. June 12, 1998) (“a sitting director is entitled to … receive whatever the other directors are given.”). Can the Designated Director share confidential information he or she learned as a board member with the Nominating Firm? The answer is it depends.
It is a breach of the duty of loyalty for a Designated Director to share the Corporation’s confidential information with the Nominating Firm if such communication would harm the Corporation. See Shocking Techs., Inc. v. Michael, 2012 WL 4482838, at *8–11 (Del. Ch. Oct. 1, 2012) (disclosure of confidential information in a way that harmed the corporation was a breach of the duty of loyalty). However, there are circumstances where Delaware law permits the Designated Director to share the Corporation’s confidential information with the Nominating Firm.
For example, in the 2013 case of Kalisman v. Friedman, the Delaware Chancery Court held that the corporation could not deny a Designated Director, who also served as the principal at a hedge fund which owned 13.9% of the public corporation, access to company information, including attorney-client privileged material, out of fear that the Designated Director would share the information with the Nominating Firm. 2013 WL 1668205, at *5 (Del. Ch. Apr. 17, 2013). In dicta, the court stated “[w]hen a director serves as the designee of a stockholder on the board, and when it is understood that the director acts as the stockholder’s representative, then the stockholder is generally entitled to the same information as the director.” Id. at *6.
Suppose the Designated Director gains confidential information from the Nominating Firm regarding the Corporation. Must the Designated Director disclose the information to the Corporation? Again, it depends.
If a Designated Director gains confidential information from his or her Nominating Firm that is relevant to the action being contemplated by the board, the duty of loyalty may require disclosure of such information. Big Lots Stores, Inc. v. Bain Capital Fund VII, LLC, 922 A.2d 1169, 1184 (Del. Ch. 2006) (a director does not have a general duty to disclose but rather a duty to disclose in “circumstances in which the director is personally engaged in transactions harmful to the corporation, but beneficial to the director”). The required disclosure of information about the Nominating Firm could be detrimental to the firm and should be considered when deciding whether to nominate Designated Directors.
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As set forth above, the increasing prevalence of constituency directors on U.S. public company boards, and Designated Directors in particular, requires careful and proactive navigation of potential conflict issues.