A special committee of independent directors can reduce risk Featured

10:24am EDT October 17, 2011
A special committee of independent directors can reduce risk

The challenging economic climate in Michigan and throughout the United States is forcing businesses to make many important and often difficult decisions. Examples are numerous: Should we sell the company? Should we incur debt to get us through? Should we raise additional capital? Should we liquidate?

In addition, whistle-blower rules spawned by the Sarbanes-Oxley Act of 2002 and, more recently, the Dodd-Frank Wall Street Reform and Consumer Protection Act make it increasingly likely that companies will have to investigate claims of financial or other wrongdoing involving management to determine whether the claims have merit. The board of directors of a corporation is typically responsible for making these important decisions.

Decisions on such matters are often fraught with conflicts of interests. The CEO and board member may be accused of participating in a scheme to inflate earnings. A significant shareholder who has a representative on the board may be pushing to sell the company. A director may be employed by a shareholder offering to lend money to or invest in the business. And, because these decisions are often controversial (and may involve potentially significant amounts of money), they are fertile ground for lawsuits against a company and its board members. However, if the board of directors properly structures the decision-making process using a special committee of independent directors, it can reduce both the risk of being sued at all and the risk of a bad outcome if a lawsuit is filed.

While the board of directors is generally responsible for making significant decisions concerning the management of the business and affairs of a corporation, boards generally can delegate their decision-making authority on most matters to committees. The board can determine the specific individuals who will serve on a committee, the specific powers of the committee, and the spending authority of the committee. This gives a board a powerful tool early in the decision-making process to establish a group uniquely qualified to address the particular situation the board is confronting.

The need for a special committee

A special committee of independent directors is designed to avoid allegations that the directors breached their fiduciary duties to the corporation and its shareholders. Under general corporate law, directors of a corporation have two primary fiduciary duties: a duty of loyalty and a duty of care. If directors fulfill their fiduciary duties of loyalty and care, decisions that they make are given deference by the courts and will not be overturned or result in liability for damages to the directors even if the decisions turn out to have been unwise or result in adverse consequences. This is generally referred to as the “business judgment rule.” A corollary of the business judgment rule is that corporate laws generally create a presumption in favor of directors that they have satisfied their fiduciary duties if a business decision is challenged. Therefore, a shareholder challenging a board decision must overcome that presumption by alleging facts that would show that the directors breached their duties of loyalty or care.

The duty of loyalty prohibits self-dealing by directors. It requires that directors make decisions based on what is in the best interests of the corporation and its shareholders, without regard to any other external considerations. The law generally focuses on two important concepts: directors must be both disinterested and independent.

A director will be considered disinterested if he or she will not gain any financial benefit from a transaction that would not otherwise be received by all shareholders of the corporation. A disinterested director cannot be involved on both sides of a transaction. And, a disinterested director cannot be accused of or involved in the conduct or actions subject to a complaint. Therefore, a director who is buying assets from or loaning money to the corporation would not be considered disinterested. Likewise, if the director owns or is a significant shareholder in a company that is buying assets from or loaning money to a corporation, he or she would not be considered disinterested. An interest in a transaction may be indirect. A CEO who will receive a promotion, pay increase or a nice severance package if the company is sold may be considered to have an interest in a sale transaction. A director who will be retained as a consultant for the buyer may be considered to have an interest in the sale of a corporation.

The concept of financial benefit includes the avoidance of loss. If a director is a significant owner in a company that has a material ongoing business relationship with the corporation that would end if the corporation were sold, the director likely would not be disinterested in a decision concerning the sale of the company.

Independence is slightly different and involves a consideration of the totality of the circumstances. A person can be disinterested but not independent. Independence tends to focus more on relationships and other external factors that could influence a director’s decision making. Familial and business relationships can cause a director to not be considered independent. For example, a director may have no personal interest whatsoever in a transaction, but if the director’s brother or sister was a participant in the transaction, that director likely would not be considered independent. Interlocking board positions where a director’s compensation might be influenced by someone involved in a transaction with the corporation can also destroy independence. A founding member and controlling shareholder of a corporation who is also the chair of the board may be so dominant that it destroys the independence of other directors. Corporations cannot assume that a director will be considered independent for fiduciary duty purposes if the director satisfies the independence requirements of the Nasdaq Stock Market or New York Stock Exchange. State laws differ in their approach to independence for fiduciary duty purposes.

To avoid risk, a board can create a special committee of independent directors, each of whom are both disinterested and independent. The earlier in the process the board establishes the committee, the less likely that any potential conflicts will affect the decision-making process. To appoint a solid committee, directors must commit to cooperation, honesty and full disclosure. The lines for determining whether a person is disinterested and independent are often fuzzy, and the lines can change over the course of an investigation or negotiation. Committee members should not take offense if they are asked to step down from the committee if facts or circumstances come to light that would suggest they may no longer be considered disinterested or independent. Creation of a special committee of independent directors to handle a matter is designed to insulate all of the directors — not just those who serve on the committee — from liability for business decisions.

The need for independent advisors

The duty of care obligates directors to inform themselves with all reasonably available information before making a decision. Directors must use reasonable diligence both in gathering and considering the relevant information. Directors also must act in good faith and in a manner they reasonably believe to be in the best interests of the corporation.

Directors generally may rely on experts and other advisors when making a decision. A director may rely in good faith upon information presented by anyone as to matters the director reasonably believes are within such other person’s professional or expert competence and who has been selected with reasonable care on behalf of the corporation. Directors often rely upon auditors with respect to compliance with accounting rules, lawyers with respect to compliance with laws and regulations, and investment advisors with respect to the market terms and fairness of transactions. It is therefore important that directors actively consider who they are using as advisors and whether it is reasonable to rely upon those advisors.

Certain relationships may taint the independence of advisors and cause conflicts of interests. If a court determines that a conflict of interest should have been obvious or considered by the directors, it may determine that the directors did not satisfy their duty in relying on the advisor. For example, directors may rely on in-house counsel with regard to matters involving compliance with laws. However, a court may not consider it reasonable for directors to rely on in-house counsel while investigating an alleged violation of law where in-house counsel was involved in the actions alleged to have violated the law. Similarly, directors should consider whether an advisor has a close relationship with management before relying upon that advisor in connection with an investigation of management conduct or decisions.

By empowering a special committee of independent directors to engage its own advisors, the board can ensure that the committee can review the relationships each advisor may have with the corporation. This can help eliminate potential conflicts of interests that a court may find to be problematic and constitute a breach of the directors’ fiduciary duties. Moreover, hiring independent advisors may also be beneficial by giving a fresh set of eyes the opportunity to review and analyze the issue.

Not every decision, or even most decisions, that a board confronts would justify consideration of creating a special committee of independent directors. Special committees are often appropriate when facing major decisions concerning the direction or finances of a corporation, or when conflicts of interests involving directors are clear or possible.  Common sense and intuition are good indicators of when a board should consider forming a special committee — if you immediately pause because of the magnitude of or relationships involved in a matter, then it is probably worth considering whether to form a special committee of independent directors.

Jeffrey A. Ott is a partner at Warner Norcross & Judd LLP. He concentrates his practice in corporate and securities law, regularly advising publicly traded and privately held companies. He also focuses on mergers and acquisitions and related business transactions. He can be reached at jott@wnj.com or (616) 752-2170.