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Questioning an Independent Director’s Independence
May 2, 2023
Historically, when courts reviewed the independence of a company’s outside directors they have focused upon the business relationships and economic links between the director and the company for which the director will serve as a board member. Increasingly, however, courts are also scrutinizing the relationships between an independent director and the person who nominated the director, to better evaluate the director’s independence. These developments concerning how a director’s independence from a company is appropriately evaluated highlight the need for general counsel to conduct appropriate due diligence prior to accepting the nomination of a proposed independent director.
Traditional objective criteria for determining a director’s independence, such as whether the director is employed by the company; is related to an insider; holds equity interests in the company; conducts business with the company, are easily quantifiable. However, recently more subjective and less visible relationships, such as the identity and relationships of the parties responsible for appointing the independent director, have increasingly been used as a basis to challenge a director’s independence.
Gaining or losing a directorship can have a big financial impact on an individual director. In some instance, a person’s overt desire to establish, maintain, or strengthen a relationship with the nominating party can support an inference that the director is not truly independent.
Professors Jared Ellias, Ehud Kamar and Kobi Kastiel recently published a controversial article entitled The Rise of Bankruptcy Directors (Southern California Law Review, Vol. 95, No. 5, 2022). The article examines an independent director’s allegiance to the party that appointed the director to corporate boards in chapter 11 bankruptcy cases. The article concluded that an ostensibly independent director might nonetheless be indebted to the party responsible for their appointment, which could result in a lesser recovery for creditors in chapter 11 cases. Specifically, the article hypothesizes that some independent directors may refrain from being as diligent or critical as they should be in evaluating or investigating company transactions that involve insiders and/or related parties.
The professors submitted that there is an increased need today to focus on the “true” independence of such board members. One reason is that chapter 11 debtors increasingly assert that a court should not permit creditors to conduct costly investigations of company transactions during the course of the bankruptcy case because a committee of independent directors will satisfy such oversight role in a more cost effective and less disruptive manner.
Elias, Kamar and Kastiel further argue that certain directors suffer from a structural bias because they are “repeaters” – directors regularly nominated by private-equity sponsors and law firms. The article suggests that obtaining future directorship appointments may require not upsetting the source of the director’s appointment.
An example is the case of shoe retailer Nine West Holdings, Inc. In August 2017, the company needed to commence a Chapter 11 bankruptcy case and hoped to emerge promptly from court protection. But, there was danger of creditor litigation alleging that the company’s controlling shareholder had plundered the company. Because the board had a conflict of interest, the board appointed two bankruptcy experts to the board who claimed that, because they had no prior ties to the company or its equity sponsor, they were independent and could handle the investigation. The bankruptcy court allowed the new directors to take control of the litigation and ultimately settle the claims. A creditors’ trust subsequently sued the board alleging that certain directors were closely aligned with the equity sponsor and therefore lacked sufficient independence (Nine West LBO Securities Litigation S.D.N.Y. 2020).
Most recently, in a non-bankruptcy case, Goldstein v. Denner, the Court of Chancery of Delaware found that two directors’ current and past relationship with a venture capital fund may have compromised the directors’ independence. The court cited the article by Elias, Kamar and Kastiel and found the directors were repeat players in the biopharma and healthcare sector. Because the venture capital fund was an activist, which creates opportunities to put candidates on boards, it could reward directors nominees that are aligned with the fund’s interests.
What is the takeaway? The general counsel should closely scrutinize the relationships between the independent director and the party responsible for their appointment — especially when relying on an independent committee of the board to investigate transactions where the insider board members have a conflict.
By Kenneth A. Rosen and Scott Cargill
Kenneth A. Rosen is a partner and Chair Emeritus in the Bankruptcy & Restructuring Department of Lowenstein Sandler LLP.
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