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E-MailMichal Barzuza is Caddell & Chapman Professor of Law at University of Virginia School of Law. This post is based on a paper co-authored by Professor Barzuza and Quinn Curtis of University of Virginia School of Law. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.
In a new paper, Interlocking Board Seats and Protection for Directors after Schoon, we examine how interlocking board seats propagated corporate governance change in the aftermath of a surprising change in law. We identify firms’ response to the Delaware case Schoon v. Troy Corp which permitted a board to alter indemnification arrangements for a former director retroactively. We find that interlocking outside directorships played a role in predicting whether firms changed their indemnification arrangements after Schoon. We also identify other covariates associated with responsiveness: (i) a large proportion of outside directors; (ii) a designated independent lead director, and (iii) more board meetings in executive session are all associated with increased probability of response. It is surprising that outside director interlocks should determine response when information about the case was widely available to the public at large and to in-house counsels in particular.
The case involved a dispute between a corporation and one of its former directors. During the dispute, Troy Corporation amended its bylaws to exclude former directors from the section that promised advancement of legal expenses and then brought suit against the former director, arguing that it was under no obligation to advance the considerable costs of defending the suit. The court held that the protection of the bylaws did not vest until litigation was initiated and that the director was unprotected, even though the allegations in the suit occurred while the bylaw was in effect. Moreover, the decision was not limited to just former directors, but put current directors in jeopardy as well. As a result of the case, corporate directors suddenly had to worry that, in a dispute between themselves and the company, their indemnification and advancement protection might be stripped. The decision received wide attention from the legal community. Prominent law firms published memos explaining how companies could shore up their indemnification protection by amending bylaws or, better still, adopting personal contracts with their directors that would vest immediately. About 15 months after the decision, Delaware amended its corporate law to make indemnification and advancement vest immediately, unless the bylaws explicitly said otherwise, essentially reversing Schoon.
We examine firms’ response in the interim. Using a hand collected data set we construct a panel of monthly observations and use multi-period logit to estimate the effect of interlocking directorships. We find that once a firm changed its bylaws in response to Schoon, other firms with outside directors in common with the responding firm were likely to respond shortly afterwards. This effect is not present for inside directors or general director interlock, but only for firms with outside directors in common. Thus, it is not simply overlapping directorships that predict response, which might be endogenous, but interlocks among outside directors with a responding firm. We identify other effects consistent with outside directors playing an important role in the response to Schoon, finding that more outside directors, the presence of a designated independent director, and more meetings in executive session without insiders present are all associated with an increased propensity to adoption protection after Schoon.
There are at least two ways that sitting on the board of a responsive firm might have made a response at an outside director’s other firm more likely. First, it’s possible that an outside director might learn about the case from their service on another board. While the decision was publicized in the legal community, directors might have overlooked it until it came up at a board meeting, in which case they may ask why other boards on which they sit had not yet responded. Second, some firms may have adopted a “wait and see” approach, assuming that the Delaware legislature would act. Such an approach would have created risk for outside directors in the interim. But if an outside director sits on another board that has already responded, a general counsel saying “just wait” or “it’s not a big deal” may be less satisfactory to the board. Put differently, an interlock with a responding firm might increase a director’s leverage in convincing the board to respond to Schoon.
What’s interesting about these explanations is that they hint that general counsels may not be uniformly aggressive in defending the interests of outside directors. General counsels are charged with advising the entire board, but if a decision like Schoon disproportionately affects outsiders, then it’s worth remembering that general counsels are insiders and report to the CEO. Even if just some general counsels are less likely to fully vindicate the interests of outside directors, then outside directors might benefit from information and leverage they gain from their networks.
Finally our findings contribute to the literature on directors’ interlocks. They suggest that interlocks play a role in propagating change even in an informationally rich environment. In addition, and in contrast to other contexts in which interlocks have been shown to be important such as options backdating, our findings suggest that interlocks can play a positive role in firm governance by enhancing the effectiveness of outside directors.
The full paper is available for download here.
