Corporate Governance

Fiduciary Duties of Officers and Directors: Gantler v. Stephens (Evolving Standards for Director Independence?) (Part 3)

By J. Robert Brown

We are examining the recent decision by the Delaware Supreme Court in Gantler v. Stephens. 

Plaintiffs alleged that the board had an entrenchment motive for turning down a merger and opting for a reclassification instead.  It wasn't enough to show that the merger would deprive the directors of their position.  Plaintiffs had to produce "other facts" that would demonstrate an entrenchment motive.  Moreover, it wasn't enough to demonstrate that some directors had a sufficient conflict, it had to be a majority.  Plaintiff succeeded in showing that three out of the five directors had the requisite conflict of interest.

With respect to the CEO and Chairman, the Court noted that, in addition to his position as an officer, plaintiffs alleged sufficient facts to show that in fact he had acted in his own self interest.  As the Court described:

• Stephens never responded to Cortland’s due diligence request. The Financial Advisor noted that Stephens’ failure to respond had caused Cortland to withdraw its bid. Even after Cortland had offered First Niles an extension, Stephens did not furnish the necessary due diligence materials, nor did he inform the Board of these due diligence problems until after Cortland withdrew. Cortland had also explicitly stated in its bid letter that the incumbent Board would be terminated if Cortland acquired First Niles. From these alleged facts it may reasonably be inferred that what motivated Stephens’ unexplained failure to respond promptly to Cortland’s due diligence request was his personal financial interest, as opposed to the interests of the shareholders. That same inference can be drawn from Stephens’ response to the First Place bid: Count I alleges that Stephens attempted to “sabotage” the First Place due diligence request in a manner similar to what occurred with Cortland.

The other two directors found to be interested (based upon the pleadings) were not officers but did have economic ties to the company.  One of the directors, P. James Kramer, had been a director since 1994.  He also ran a heating and air conditioning company that provided services to the company.  As the Court concluded:

• It is reasonable to infer that Kramer feared that if the Company were sold his firm would lose the Bank as a client. The loss of such a major client would be economically significant, because the complaint alleges that Kramer was a man of comparatively modest means, and that his company had few major assets and was completely leveraged. Because Kramer would suffer significant injury to his personal business interest if the Sales Process went forward, those pled facts are sufficient to support a reasonable inference that Kramer disloyally voted to terminate the Sales Process and support the Privatization Proposal.

The complaint merely stated that Kramer's company provided services.  It did not disclose the dollar amount or the size of the heating and air conditioning company.  There is no real evidence concerning the actual importance of the account with the Bank and in fact one could imagine the account being insignificant.  After all, how often does a bank need heating and air conditioning services?  Moreover, establishing that the payment was material usually requires this type of evidence.  Yet in this case, the Court determined that the pleadings were sufficient. 

In fact, the main argument by plaintiffs with respect to Kramer was that he was a man of modest means and it was the fees (and the loss of the fees in the event of a merger) that created the conflict of interest.  Clearly the Supreme Court was more willing to rest its decision of interest based upon a business relationship that had no supporting facts than on fees.  The reason is obvious.  Finding that fees were material and caused a director to be interested would open the floodgates, particularly given the size of fees often paid to directors in public companies (approximately $700,000 to directors of Goldman in 2007).

Similarly, the other director found to be interested was Ralph A. Zuzolo, a principal in a law firm bearing his name and the president of a real estate title company.  As the Court noted:  "Zuzolo’s law firm frequently provided legal services to the Bank, and American Title provided title services for nearly all of the Bank’s real estate closings."  Again, however, there was no evidence as to the amount actually paid or the relative importance of the account to the law firm or title company.

The case suggests the possibility that the courts in Delaware may be lowering the pleading standards necessary to challenge the independence of directors, something long overdue (see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty).  Of course, this is only one case and one cannot draw a line with a single point.  Nonetheless, it raises the possibility that the Delaware courts will make it easier for plaintiffs to challenge director independence which, in turn, will force companies to implement higher standards for director independence if they want to succeed on a motion to dismiss.

Primary materials from the Chancery Court can be found on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on February 12, 2009 (boomark / email).