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How independent is independent enough?

It has become common practice for private equity firms investing in US public companies to negotiate special governance arrangements, including the nomination of a number of independent directors. Meredith Brown and William Regner of Debevoise & Plimpton ask just how independent these directors really are.

When private equity firms invest in publicly held companies, they often negotiate special governance arrangements, including as to composition of the board of directors.  Sometimes the private equity firm will get the right to nominate one or more directors, and often there will also be an agreement to nominate a specified number of “independent” directors, mutually acceptable to the company and the private equity firm. 

What happens when the private equity firm is asked to suggest an “independent” director?&nbsP; Often, it turns to a trusted businessperson who, while having no economic ties to the firm or its portfolio companies, is well known to the firm’s principals through prior business dealings or social ties – sometimes ungraciously called a “house independent,” if the relationship is cozy enough.
A recent Delaware case, involving a special litigation committee formed by Oracle Corporation, suggests that a “house independent” – even one considered “independent” for purposes of stock exchange rules – may not be independent enough to deal with serious conflict issues.

A special litigation committee (“SLC”) is a group of independent directors formed to consider whether a shareholder derivative action – a lawsuit brought by shareholders asserting claims on behalf of the corporation – should proceed.  If the SLC is independent and concludes after careful review not to proceed with the litigation, the SLC’s motion to terminate the action is likely to be granted.

The Oracle SLC was formed to consider shareholder derivative litigation claiming that Oracle CEO Larry Ellison and several other Oracle directors had breached their duties to the company by engaging in insider trading – selling Oracle shares before an earnings shortfall became public.  Oracle’s SLC consisted of two directors, both of whom had joined the board well after the alleged insider trading. 

Counsel for the SLC interviewed 70 witnesses, with SLC members participating in several of the key interviews.  The SLC produced an 1,100-page report, concluding that the defendants did not have any material nonpublic information about the earnings shortfall and that Oracle should not pursue the claims against the defendants.  The SLC moved to terminate the derivative litigation.

The Delaware Chancery Court denied the motion, finding that the SLC had failed to demonstrate that no material factual question existed regarding its independence.  The court noted that: both SLC members were both professors at Stanford; one of the defendants was a professor at Stanford, who had taught one of the SLC members; another defendant was a big donor to Stanford (one of his gifts was $50,000, made after an SLC member gave a speech at the defendant’s request); and Ellison himself was reported to be considering giving $170 million to Stanford.  The court found  “a social atmosphere painted in too much vivid Stanford Cardinal red for the SLC members to have reasonably ignored it.”  To the court, the connections suggested that “material considerations other than the best interests of Oracle could have influenced the SLC’s inquiry and judgments.”

The court reached its conclusion even though the two SLC members had tenure at Stanford and so weren’t vulnerable to being fired, had no fund-raising responsibilities at Stanford, and weren’t shown to be controlled by any of the defendants.  Although prior Delaware cases had held that personal friendship, absent a showing of control or a material economic relationship, was not enough to show a lack of director independence, the court noted that economic interest is not the only human motivation: “homo sapiens is not merely homo economicus.”

Will private equity firms now propose complete strangers to the boards of portfolio companies?  That’s unlikely: private equity firms will probably want to have some first-hand basis for believing in the trustworthiness of even an “independent” candidate – which requires some kind of relationship.  What private equity firms must remember, however, is that a “house independent,” depending on the nature and extent of any ties with the private equity firm, may not be able to act as an independent director in a situation in which the company has a serious conflict of interests with the private equity firm – e.g., serving on an SLC if there’s derivative litigation against the private equity firm, or serving on a special committee to consider a going private transaction involving the firm.  Private equity firms should also remember that relationships with directors may in some contexts be disqualifying, even if they’re not economic relationships.

Debevoise & Plimpton, an international law firm, was founded in 1931. The firm, which now has more than 500 lawyers, provides international services in corporate, litigation, tax, and trusts and estates law. Debevoise & Plimpton offices are located in New York, Washington, DC, London, Paris, Frankfurt, Moscow, Hong Kong and Shanghai.

Meredith M. Brown
mmbrown@debevoise.com

William D. Regner
wdregner@debevoise.com