Joint CEO and chair?
Under public company practice, controlled by the Securities and Exchange Commission and listing organization rules, companies require a majority of independent directors, and entirely independent compensation and audit committees. These requirements reflect the ongoing balancing between insider control and protection of outside shareholders.
A related aspect of such balancing is splitting the offices of chief executive officer and board chair. CEOs traditionally also served as chairs. Analytically, that is a difficult position to defend. The board is charged with overseeing the operation of the business, including direction and compensation of corporate officers, and disciplining corporate misconduct. Can a board led by a CEO adequately perform those functions?
As noted in a recent excellent article by Sullivan & Cromwell partner Francis Aquila, the trend is toward separating the functions, and by 2015 the S&P 500 companies were about evenly split between unifying the posts and separating them. Annoying to advocates of separating the offices, however, there was no corresponding improvement in corporate performance based on splitting roles, according to Aquila
Companies are different. What is right for your company? Analysis should proceed based on an evaluation of strengths, weaknesses and gaps in your board. Separating the functions can lead to communication disconnects, loss of focus in vital technical expertise, and interference with stellar economic performance.
Aquila identifies appropriate moments when a division can be best effected: governance scandal suggesting need for change; departure of a company leader; undertaking new corporate strategy; significant acquisition or business combination; and in conjunction with normal CEO succession.
And, if you have a sitting CEO/chair, absent an external event or normal succession point, there has to be an awkward sense of CEO demotion (notwithstanding the typical CEO announcement that bringing in a chair has his full blessing).
Splitting the functions also creates the following problem: Who does what? In making two jobs out of one, you must define functions. Additionally, when you split the CEO and chair roles, you do not decrease CEO compensation. In the current environment focusing on director compensation, companies should consider increased governance cost in bringing in a separate chair.
Although about half of the S&P 500 companies have split leadership at the top, splitting these roles does not automatically satisfy the requirement of an independent majority of directors. If both the CEO and separate chair are insiders, you now have two non-independent directors rather than just one.
Companies with a unified CEO/chair often name a “lead director.” The lead director is designed as counterbalance to the combined position at the top. Lead directors, virtually always independent by SEC standards, typically will set agendas, preside at meetings of the independents, and serve as communications conduits with the CEO.
Finally, there are investor relations to consider. Aside from SEC disclosure requirements for any senior management changes, a company must make sure that its message to its major shareholders is delivered clearly, in order to quell any concerns.
Who is an independent director? There are complex definitional standards in SEC and self-regulatory organization regulations. However, those standards are not the end of the analysis.
In a December Delaware Supreme Court case (Zynga, Inc.), a stockholder sued for breach of fiduciary duty against directors and officers who sold shares just before a steep drop in the share price. The stockholder brought the action without first making demand on the board to investigate. The law requires that demand must first be brought unless the bringing of that demand is “futile.” A demand is futile if there is an insufficient number of independent directors to investigate the claimed breach of duty.
Consequently, the court needed to determine who were independent.
The court showed a nuanced appreciation of what “independence” means. One director co-owned a private airplane with the controlling shareholder. The court opined that such a relationship “suggests” that the “families are extremely close to each other and are among each other’s most important and intimate friends,” because an airplane is an asset that “requires close cooperation in use, which is suggestive of detailed planning indicative of a continuing, close personal friendship.”
Most interesting to business attorneys is the court holding that two directors affiliated with the venture firm Kleiner Perkins could not be independent because that firm owned 9 percent of company equity, and because there were other Kleiner Perkins investments in different companies wherein the controlling shareholder and his wife were founders or directors.
In that circumstance, a “mutually beneficial ongoing business relationship … might have a material effect on the parties’ ability to act adversely toward each other.” Chief Justice Leo E. Strine Jr. seemed particularly taken with the fact that the defendant owned 61 percent of Zynga and was the kind of “talented entrepreneur” that a firm like Kleiner Perkins would want to finance, and do deals with, in the future.
Was this dicta, or a holding that future potential business links can destroy current independence? The overall sense of the decision is that the very nature of the VC relationship to an entrepreneurially driven company can, in some circumstances, render directors non-independent, at least for purposes of Delaware corporate law.
The Zynga directors were affiliated with the VC firm but not formally “designated” to represent it. Directors often sit on boards in which the firms that designate them have investments in that company. Is it ever possible in Delaware to be “independent” as a matter of state law if you are a designated representative of an institutional investor?
A study of the issue, published in Lexology in late 2016, notes that shareholders will “naturally expect its nominee director to demonstrate loyalty and advocate on the shareholder’s behalf,” but that “the nominee director [also] owes specifically legal duties to the corporation that are founded upon good faith, candor, confidentiality and the best interest of the corporation.”
Applying Strine’s opinion, one might conclude that the two roles — designee and generally responsible director — are fundamentally antagonistic. The reality of capital formation in the marketplace, however, makes such arrangements ubiquitous, and accommodated as a practical matter.
The Delaware rule is that the director’s duty is owed to the corporation, but in a sale context that duty requires maximizing all shareholder value (the so-called “Revlon duty”). Designated directors have the same duties as all other directors, and the protection in a sales setting is that the Revlon duty is invoked. This leaves in place, with a wink, all the numerous other decisions to be made by the board, which, over time and in the aggregate, will bear upon such things as the value of the enterprise and the logical timing of any liquidity event.
Boards and insolvency
Lastly, we turn to the definition of the director’s duty while sitting on the board of a company in financial distress.
In a case decided in the U.S. Bankruptcy Court of Delaware in January, directors were sued derivatively by their company’s bankruptcy trustee. The company had been struggling, and finally its bank sent a foreclosure notice, swept receivables, and forced the company to lay off its employees. The company was attempting to sell assets to third parties, but shortly after the layoffs the company filed a Chapter 7 (liquidating) proceeding.
The directors sought dismissal. Delaware law seems to be settled that directors need not shift their duty of loyalty from shareholders to creditors in the face of “deepening insolvency” or entry into the “zone of insolvency.” (Law in other jurisdictions may differ.)
The court refused to dismiss the case. Its decision was simple: This isn’t a matter of a deepening insolvency; this is a matter of actual insolvency. If you are broke, if you’re forced to fire your employees, there is no “zone” involved. You have arrived at ground zero.
Even so, the directors argued, they are protected from suit in two ways: first, the operating agreement of the debtor (an LLC) provides exculpation for directors, and, additionally, the business judgment rule protects directors who act in good faith and without self-interest, providing they are not in breach of the duties of due care and of loyalty.
The court refused to dismiss because each of the protections is an affirmative defense, to be adjudicated in the litigation, and cannot support dismissal on the pleadings. (The court further held that since the trustee did not plead to the business judgment rule, it would not dismiss the complaint based on the defendants’ alleged compliance in any event.)
The risk is clear: If directors allow insolvency to creep up on them, passing some ill-defined line where they arrive in actual insolvency, Delaware law permits a derivative claim for breach of director fiduciary duty.
Where is that line? The day before the bank swept receivables? Having received several prior waivers from the bank, how were those directors to know that the day prior to the sweep was “the day” they found themselves over the liability line?
Stephen M. Honig is a partner at Duane Morris in Boston.