Directors and officers should always establish and adhere to policies and procedures in the exercise of corporate governance. Recent decisions have highlighted potential risks and pitfalls for directors and officers of a corporation if good corporate governance is not followed.
Under the internal affairs doctrine, corporate governance is determined by the law of the state in which a company is incorporated regardless of its principal place of business or the location in which the activity occurred. See Restatement (Second) of Conflict of Laws, §§302, 309 (1971).
A corporate fiduciary generally owes duties of care and loyalty to the entity, requiring adherence to the best interests of the entity and its owners. The duty of care requires a fiduciary to act in an informed and reasonable way. The duty of loyalty requires a fiduciary to act in good faith, again with emphasis on the best interest of the entity and its owners.
The general standard governing oversight of decisions by directors and officers is the business judgment rule, which presumes that in making a business decision the directors (and officers) of a corporation act on an informed basis, in good faith, and in the honest belief that the action taken is in the best interests of the company. Stream TV Networks, Inc. v. SeeCubic, Inc., C.A. No. 2020-0310 (Del. Ch. Dec. 8, 2020).
Liability for directors will frequently arise either when directors fail to undertake an adequate investigation, thereby failing to satisfy the presumption of the business judgment standard, or engage in transactions involving personal benefit and thereby taking such transaction outside of the scope of the business judgment standard.
Potential director liability for failure to properly investigate a transaction was raised in the leveraged buyout of Nine West. See In re Nine West LBO Securities Litigation, C.A. No. 20-MD-2941 (S.D.N.Y. Dec. 4, 2020). (Nine West was governed by Pennsylvania law, which, for these purposes, is consistent with the applicable law in Delaware.)
That case involved a merger of Jones Group, the distressed owner of various footwear and apparel brands, into Nine West Holdings, or NWH. As part of the transaction, Sycamore Partners intended to contribute $395 million into NWH after the merger. The merger further contemplated NWH taking on $200 million in indebtedness in addition to the $1 billion already on its balance sheet.
The terms of the transaction changed prior to closing. Sycamore’s equity contribution decreased from $395 million to $120 million. Sycamore arranged for additional debt that would increase Nine West’s debt load from $1.2 billion to $1.55 billion. Profitable business lines were to be sold off after the closing to a Sycamore affiliate for less than fair value.
The directors of the seller were aware of the potential for the additional debt burden and the carve-out of certain business lines from the transaction. While the directors approved the merger, they sought to exclude consideration of the impact of the potential additional debt and carve-out from the scope of their approval.
The directors were sued for breaching their fiduciary duties. The directors’ argument that their approval of the transaction excluded certain potential components, and that they were no longer directors at the time the suspect transactions were implemented, was not sufficient to obtain dismissal of the case.
The directors did not conduct an adequate investigation into whether the coordinated transactions, including the late change in deal terms, would render NWH insolvent. Because the directors failed to fulfill their investigatory obligations, the business judgment rule did not apply and could not shield them from potential liability.
A heightened standard of review of a transaction will also arise when directors have a personal interest in the transaction.
For example, in a transaction in which at least half of the directors are not disinterested or independent, the business judgment rule may not be applicable, and the burden will shift to the conflicted fiduciaries to demonstrate that the transaction satisfies the higher “entire fairness” standard of review. When the entire fairness doctrine is applicable, the defendants will bear the burden to demonstrate that their actions were appropriate.
A corporate entity may still benefit from a transaction despite the existence of conflicts among the directors. However, in order for a conflicted board to revive the business judgment standard of review under such circumstances, the board must implement the value-enhancing structure of an arm’s length transaction.
Two methods have been employed in Delaware courts to “cure” the infirmities of a transaction involving a conflicted board: The transaction may be subjected to an informed non-coercive vote of the majority of shares held by those free of conflict, or the board may appoint an unconflicted committee with full ability to negotiate and enter into any transaction. If a controlling stockholder is conflicted, the board will need both to install a special committee and conduct a vote of informed and uncoerced minority stockholders. Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015); Kahn v. M&F Worldwide Corp., 88 A.3d 635, 644 (Del. 2014); Salladay v. Lev, et al., C.A. No. 2019-0048 (Del. Ch. Feb. 27, 2020).
In Salladay, three of the six board members for the seller were found to have a buy side interest in the transaction, creating a conflict. The plaintiff did not allege the existence of a controlling conflicted shareholder, and thus either a vote of informed and uncoerced stockholders, or the installation of a special committee, could be implemented to “cleanse” the transaction and thereby reinstate the business judgment standard.
The recent decisions in Nine West and Salladay are reminders of the duties of directors to be diligent in fulfilling their obligations, including a review of any changes to deal terms shortly prior to closing that may alter the assessment of the transaction.
The board purported to implement a special independent committee to evaluate the transaction. The court ultimately determined, however, that the installation of the special committee was accomplished too late to avoid the imposition of the entire fairness standard of review.
Specifically, the court found that the disinterested committee needs to be installed from the inception of the transaction and that, in this instance, the special committee was constituted too late in the process to actively manage an arm’s length, unconflicted transaction.
In effect, the board’s pre-committee involvement established a price limitation that “set the field of play for the economic negotiations to come.”
The board’s reliance on the vote of disinterested shareholders was similarly unavailing. The court concluded that the notice to shareholders provided inadequate information regarding the consequences of rejecting the merger upon control of the entity. Accordingly, the court denied the defendants’ motion to dismiss the case.
The recent decisions in Nine West and Salladay are reminders of the duties of directors to be diligent in fulfilling their obligations, including a review of any changes to deal terms shortly prior to closing that may alter the assessment of the transaction, and to be proactive in taking steps to ensure that related party transactions are subject to appropriate arm’s length safeguards.
These concerns extend to officers as well. Delaware law provides that officers owe the same fiduciary duties as directors when acting within the scope of their authority and fulfilling their duties. Gantler v. Stephens, 965 A.2d 695 (Del. 2009).
Andrew G. Lizotte is a shareholder at Murphy & King in Boston, where he represents different factions in bankruptcy proceedings, including operating Chapter 11 businesses, committees of unsecured creditors, lenders, both liquidating and operating trustees, examiners and individuals.