Calling the Cavalry: Special Purpose Directors in Times of Boardroom Stress

Gregory V. Varallo is the President of Richards Layton & Finger, PA. and Frank M. Placenti leads the Corporate Governance Practice at Squire Patton Boggs LLP. This post is part of the Delaware law series; links to other posts in the series are available here.

Over the last three decades, the demands placed on public company directors have increased exponentially. In addition to ordinary course audit committee, compensation committee, compliance and business oversight work, directors are now expected to animate the company’s sustainability programs, focus a keen eye on boardroom diversity and “refreshment,” understand cyber and other enterprise risks, and assure that the company is operating in accordance with evolving standards of corporate social responsibility.

Then, often without warning, into this crowded docket parachutes an existential crisis, transformational transaction, corporate restructuring, intrusive governmental investigation or enterprise-threatening lawsuit. When these events occur, and they do with increasing frequency, even the best boards can find their time and resources strained. A Board may also find that its directors lack the specific experience and/or the legally required independence to handle the issues presented by these “special situations.”

Since neither panic nor abdication is an option, Boards must find a way to deal with the incremental demands and conflicts of interest presented in these special situations. In many cases, legal counsel will advise the board to form a “special committee” to deal with one or more of the issues. These special committees are essentially task forces created to manage a situation on a fully delegated basis (meaning that the Committee steps into the shoes of the full board and has final authority over the matter), or to do a full work up on the issues and return to the Board with a recommendation. The type of special committee that will be formed will reflect nuanced legal analysis, considerations of conflict and independence, and the nature of the task at-hand.

Regardless of the remit of the special committee, it must be staffed with directors. Therein can lie the rub—or even more than one rub. First, directors are often busy people, and many with full-time “day jobs.” The thought of spending dozens, if not hundreds of hours in special committee work can be daunting. Second, these assignments often involve complex forensic investigations, or in-depth analysis of the corporation’s legal rights and obligations that are outside the direct experience of directors originally selected for service based upon their general business or industry knowledge. Third, the work of a special committee can be stressful, intense and unpleasant. More than one director has been heard to say that they “did not sign up” for the rigors of special committee work. Fourth, those directors on the tip of the spear are most often the ones subject to direct participation in any attendant litigation. There may be few enthusiastic volunteers for the prospect of intrusive document production and deposition preparation—to say nothing of the specter of being sued personally in litigation where few good things are likely to be said about you and your net worth is, at least theoretically, placed at risk. Fifth, but often assuming greatest legal primacy, can be the reality that sometimes none of the existing directors are free from a real or perceived conflict of interest, which can disqualify them from service on a committee if its output is to be respected by courts and regulators.

One or more of these factors may make adequate and conflict-free staffing of a special committee unachievable. In these instances, it can be advisable for a board to augment its ranks with additional directors who have the time, qualifications, independence and temperament to run into the fire that can often surround special committee work. This article will refer to these intrepid souls as “special purpose directors.”

Types of Special Purpose Directors

Just as there is more than one type of special situation, there is more than one type of special purpose director. Ideal qualifications will vary depending on the nature of the work to be performed and the company’s circumstances. If the corporation is in financial extremis, the cadre of individuals willing to serve will likely be smaller. Thus, the concept of “ideal” may yield to a healthy measure of pragmatism, tempered by the reality that any director added to the board must have the integrity, rectitude and qualifications to do the work and serve the corporation’s interests.

Many special purpose directors will have extensive experience earned from prior board service or from work as a board-level legal, financial, crisis management or investment banking advisor. In other cases, special purpose directors can be chosen for their distinguished reputations earned as judges or lawyers with experience in business litigation. Regardless of the particular context, qualified candidates will often have seen similar fact patterns, possess an understanding of methods and approaches to be employed to resolve difficult circumstances, and have a thorough understanding of the legal backdrop against which they will be operating.

Common Elements of Special Committee Work

As described below, there are several types of “special committees.” The directors who serve on these committees step in to similar roles, regardless of the type of committee involved, or the genesis of the engagement. In the vast majority of cases, the committee is formed to address a conflict of interest. Thus, the first unifying element of any special committee service is the need to be thoroughly independent from the persons and transactions which may be at stake. Under the law of many jurisdictions, including importantly the law of Delaware, where many public companies are formed, the concept of “independence” is fact-specific, and does not end with an examination of “independence” for stock exchange listing purposes. Thus, social and other less direct relationships may form the basis to disqualify a director as not sufficiently “independent’ to do this work, even when the director is otherwise “independent” under listing standards. It follows that the first order of business when considering any committee is a thorough vetting of relationships and entanglements of potential members that could potential threaten independence.

However, it is not only the lack of a legal conflict of interest, which qualifies a special committee director, but a true willingness and ability to act independently. Thus, the Courts will look not only to independence of a director “on paper” but also observe his or her actual conduct during the course of the committee assignment to determine that director’s independence “in fact.” The corollary, of course, is that individuals who are disinclined towards conflict perhaps might be wise to demur, as the job often requires making tough decisions, without worrying about who’s feelings might be hurt, or whether the director’s peers or a controlling shareholder might think better or worse of the decision maker.

Finally, special committee work invariably requires substantial time commitments from directors, and sometimes nearly round the clock access, especially in the transactional setting. Directors who would find attending potentially dozens of meetings over a few months inconvenient or difficult might be wise to decline service.

Types of Special Committees

Special committees are most often formed to address conflicted situations, and less often simply for the efficiency of managing a project in a smaller group. They typically arise in three different settings: (i) transactions with a related party or where another type of conflict exists; (ii) forensic investigations; and (iii) so called “special litigation committees” formed to supplant the right to conduct a shareholder’s derivative action. Each of these is addressed separately below.

Transactional Committees

Transactional committees are almost always formed in circumstances where a controlling shareholder makes a proposal to transact with the company, or in other circumstances where there are conflicts of interest between one or more members of the board and the interests of the company and all of its shareholders. Such “interested transactions” typically receive special (and higher levels of) scrutiny when challenged in court, and the work of a well-functioning special committee may lead to more favorable treatment in the ensuing litigation. As in all special committee work, the real independence of special committee members is crucial here, since they are likely to be called upon to negotiate directly with one or more of their fellow board members, or their agents. Courts will test not only for the independence factors considered by the NYSE and Nasdaq stock exchange rules for committee service, but will also examine social and other relationships to determine whether a director has the requisite independence to serve on a special committee. In situations in which a controlling shareholder has heavily influence board selection, existing board members may have personal or business relationships that would suggest that their service on the committee would be inadvisable. If the number of available directors is either none or very small, then adding one or more special purpose directors may be advisable.

A special committee may also be useful in the context of a corporate restructuring or bankruptcy, particularly one in which the equity interests of one of more persons on the board may be affected. There, special purpose directors with relevant expertise can augment the ability of the board to deal with the complexities and conflicts often presented in these situations.

Investigatory Committees

Investigatory committees are typically formed in response to a shareholder “demand” that the board investigate a matter and take action, or alternatively, upon a whistleblower or other complaint about the company, its accounting, its officer corps, in response to a governmental, regulatory or stock exchange investigation (or where one seems imminent) or in other situations giving rise to the need for a thorough and independent investigation of one or more individuals’ behavior or corporate business practices. In the context where a committee is formed in response to a shareholder demand, the well-functioning and independent committee formed to investigate such a demand is likely to be entitled to favorable treatment in court if a lawsuit is eventually brought, provided only that its investigation is thorough and its conclusions rational. Likewise, a forensic committee formed to investigate a whistleblower or similar allegation or complaint may burnish the company’s position in a subsequent regulatory or other investigation or indictment, and its conduct could give rise to beneficial treatment of the corporation under the federal sentence guidelines should the worst happen. Accordingly, such committees must be comprised of individuals whose independence and integrity are beyond reproach, given the circumstances in which such committees are often formed.

Special Litigation Committees

Special litigation committees are often formed to determine whether claims asserted by stockholders in a derivative suit should continue, be dismissed, or be compromised. Often, such committees are formed after the defendants litigate and lose a motion to dismiss the litigation, so more so than any other type of committee, reviewing courts are highly likely to subject the independence and disinterestedness of the members of such a committee to thorough and searching review. Similarly, should such a committee wish to be taken seriously should it determine to recommend dismissal of the underlying case, it will be important for the committee to have been thorough and to have retained appropriate expert advisors in connection with its work.

Is Adding a Special Purpose Director Even Legal?

Assuming the company’s corporate documents enable the appointment of additional directors (which is discussed in the following section) the law accommodates, and in some senses encourages, using independent directors to assist with special circumstances. Indeed, courts have demonstrated that they are more likely to accept the output of a freshly-stocked special committee of qualified independent directors who have no pre-existing conflict or interest in the transaction.

Perhaps the prototype case involved a special litigation committee investigation of a private company known as TLC Beatrice. The Company was enmeshed in a lawsuit with its former financiers, and, given the interests of the then -current members of the board, determined to add two new directors to constitute a committee. After a search, the board determined to add the Hon. William Webster, former director of the FBI, the CIA and a former Eighth Circuit judge, and the Hon. Clifford Alexander, former Secretary of the Army. Webster and Alexander conducted a thorough investigation and recommended a settlement of the litigation, which was presented, over objection to the Court of Chancery in Delaware. The court concluded that, while the judge might have reached different decisions on certain issues than the committee, that the members of the committee were clearly independent, were well counseled, and had reached rational conclusions entitling their work to deference.

Mechanics for Adding Special Purpose Directors

Adding one or more new directors to deal with an emergent matter may be relatively easy—or quite difficult—depending on the company’s fundamental corporate documents.

As a general rule, directors are elected by shareholders. However, holding an unscheduled public company shareholders meeting to elect new directors to staff a special committee is generally neither attractive nor feasible.

Fortunately, the articles of incorporation of many public companies establish the size of the board as a range, leaving to the bylaws or a board resolution the task of specifying the precise number of directors who will serve at any given time.

When this statement of a range of possible board sizes is coupled with charter or bylaw provisions that allow the board to: (i) increase the board’s size within that range; and (ii) fill the resulting vacancies by board appointment, the necessary tools exist to add special purpose directors without a shareholders meeting.

In these circumstances, the process is relatively straightforward:

  • The board adopts a resolution to amend the Bylaws to increase the size of the board to a number within the range permitted by the corporate charter, thereby creating one or more vacancies, and
  • The board adopts a second resolution to fill those vacancies with the special purpose director(s).

In cases where the charter does not create enough potential “space” for the desired number of new directors, vacancies can be created by the resignation of one or more existing directors, although securing these resignations can be politically-charged and may or may not be feasible.

How Are Special Purpose Directors Found

Many “regular” directors are identified by accessing the existing directors’ networks, although the use of traditional executive search firms and nominations by interested and active shareholders are increasing. Special purpose directors are, on the other hand, more commonly identified by accessing the networks of the company’s legal, financial or crisis management advisors who have knowledge of individuals with the temperament, experience and mindset to take on the work presented in challenging circumstances. Search firms are rarely used in this context.

This type of networking is entirely acceptable, although care should be taken to understand the nature of any business or personal relationships between the candidates and the advisors that might call the candidate’s independence into question.

Common Concerns About Special Purpose Directors

Despite their practical and legal benefits, there can be a hesitancy to utilize special purpose directors. Some boards (or controlling shareholders) will be worried that injecting “strangers” in the mix introduces uncertainty as to the likely outcome of an investigation or transactional effort. In other cases, boards are concerned about how to manage the addition of directors to a board to undertake a special project once that project is complete. There are also some complexities concerning the proper approaches to compensating special purpose directors. Each of those concerns can be addressed.

Choosing Directors Who are Known to the Board or its Advisors

Boardrooms are not accustomed to welcoming “wild cards,” and times of stress would not seem to be an ideal occasion to begin doing so. While it would defeat the purpose to seek advance understandings as to a director’s pre-disposition on the matters at hand, selecting individuals known to the directors or the company’s advisors to be reasonable, deliberate and thoughtful can provide reassurance. Selecting persons with well-known reputations for rectitude and integrity can also add comfort.

The Pre-Positioned Resignation

In the classic movie White Christmas, Bing Crosby famously asked the musical question: “What do you do with a general when he has stopped being a general?” The same question arises with respect to special purpose directors.

When the matter that motivated their retention relates to a sale of the company, the chapter has its own built-in ending. These directors will generally exit at the close of the transaction. In other situations, their tenure would continue until the next Annual Meeting of Shareholders, and perhaps even longer if they were added to a classified board. The perceived awkwardness of having these directors outstay their welcome is one of the common objections to adding special purpose directors in the first place.

Happily, this concern can be managed quite readily by having the special purpose director pre-position a resignation that can be accepted by the board at the conclusion of the matter that lead to the director’s addition.

While such an advance agreement to resign must be publicly disclosed under applicable SEC rules, the disclosure may actually be beneficial. Making clear that a director will not be seeking to secure long-term tenure on the Board may actually add to their appearance of independence.

Compensation Approaches

Today’s public company directors commonly receive 50% or more of their compensation in the form of stock or other equity-based award. Generally, these awards vest over time and directors are either encouraged or mandated to own a stated amount or value of stock in the Company.

These arrangements will often need to be modified in the case of a director whose tenure is not expected to be long term. However, compensation arrangements that have contingency or “success fee” components are inconsistent with the need for directors to do (and be seen to be doing) the right thing without regard to personal benefit.

This tension will require some creative approaches to compensation. In cases where liquidity is not tight, compensation could include a greater cash component tied to the increased time that a special purpose director will almost always need to devote to their work. If the director is staffing a special committee, a combination of a monthly stipend for that committee (with or without a per-meeting fee) will often be sufficient. In some cases, modest equity awards that would not create a perceived windfall or motivation to drive the Company to conclude an undesirable transaction could also be used.

Conclusion—The Benefits of Special Purpose Directors

Special committee work is challenging, time-consuming and high stakes work. If the committee is not properly staffed with qualified, independent and well-advised directors, the entire effort can be compromised, or worse, undertaken in vain.

Special purpose directors with the time, temperament, independence and relevant experience can go a long way toward assuring that the committee will generate a product that will be respected by the courts and regulators as well as other relevant corporate constituencies.

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