Conflicted Controllers, the “800-Pound Gorillas”: Part II—BGC

Gail Weinstein is senior counsel, and Brian T. Mangino and Andrew J. Colosimo are partners at, Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum authored by Ms. Weinstein, Mr. Mangino, Mr. Colosimo, Steven Epstein, Matthew V. Soran, and Randi Lally, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Independent Directors and Controlling Shareholders by Lucian Bebchuk and Assaf Hamdani (discussed on the Forum here).

In the past quarter, two important Court of Chancery decisions—Tornetta and BGC—have highlighted the “reflexive skepticism” with which the Delaware courts approach transactions involving conflicted controllers.

  • In Tornetta, a case of first impression according to the court, Vice Chancellor Slights held that unless a board’s decision on executive compensation for a controlling stockholder-CEO complies with the protections outlined in the seminal MFW decision, the entire fairness standard of review (which is the strictest standard) applies to the court’s evaluation of a stockholder challenge to the compensation. The court so decided notwithstanding that, until now, a) business judgment review has applied to compensation decisions made by independent directors and b) MFW-compliance has been required for business judgment review of conflicted controller transactions only in the context of transactions that are “transformational” for the corporation.
  • In BGC, Chancellor Bouchard applied what seems to be a more stringent standard than in the past for evaluating whether putatively independent directors can be presumed to be capable of acting independently from a controller in the context of evaluating demand (“Demand futility” means that a stockholder who wishes to bring claims against a controller need not first make a demand on the board—for the board to bring the claims on behalf of the corporation—if doing so would be “futile” because the directors’ conflicts or lack of “independence” suggest that they might not be capable of making the decision impartially.) The Chancellor appeared to focus on the sense of owingness that a director could feel toward a controller if the director’s general status or positions of importance in the company or the community were a result of his or her connection with the controller.

The court emphasized in these cases the potential for “coercive influence” by controllers—“800-pound gorillas” (in the words of Chief Justice Strine, quoted in Tornetta)-—over directors (who the controller typically can remove or not reappoint) and unaffiliated stockholders (who the controller can harm through retributive acts such as a squeeze-out merger or the cutting of dividends). There is “an obvious fear that even putatively independent directors may owe or feel a more-than-wholesome allegiance to the interests of the controller, rather than to the corporation and its public stockholders,” the Chief Justice had explained in a previous case. The court reinforced in Tornetta and BGC that this concern is not necessarily eliminated even where the controller has no intention to be coercive, the transaction is negotiated by “outside” directors, and/or the transaction is stockholder-approved.’

Below, we discuss BGC and offer practice points arising from the decision.

In In re BGC Partners, Inc. Derivative Litigation (Sept. 30, 2019), Chancellor Bouchard found, at the pleading stage of litigation, that there was “reasonable doubt” whether a majority of the directors who approved a conflicted controller transaction were independent of the controller. Based on the finding of possible non-independence of the four “outside” director-defendants, (i) the plaintiffs were excused from making demand on the board to bring this derivative action on behalf of the company (because demand is “futile” when made on directors who cannot be presumed to make the decision impartially) and (ii) the suit could not, under Cornerstone, be dismissed based on the exculpation provision in the company’s charter (because the challenged act of the directors advanced the self-interest of an interested party from whom they could not be presumed to be acting independently). As a result, Chancellor Bouchard declined the defendants’ motion to dismiss the case.

Key Points

  • The decision signals that the court may be more inclined now than in the past to find outside directors non-independent in the demand futility The court highlighted that, in the past few years, when considering the issue of demand futility, the Delaware Supreme Court, under “a de novo standard of review,” several times has overturned the Court of Chancery’s findings of director independence from a controller or other interested party. These Supreme Court decisions, the court wrote, “reinforce the importance of considering a plaintiff’s factual allegations holistically and affording [the] plaintiff all reasonable inferences.” BGC underscores that the evaluation must be based on “the constellation of facts,” considered “in totality,” relating to the director’s business and personal relationships with the controller or other interested party.
  • The court in this decision (as well as recently in Marchand) seems to indicate that there is a higher bar for a finding of independence of a director in the demand futility context than in other contexts. In determining that each of the directors may not have been independent of the controller, the court focused primarily on the facts that the directors (i) were “go-to” persons for membership on boards of the controller’s affiliates, and (ii) had overlapping social Significantly, the court did not view these as coincidences but as indicating that in reality the directors appeared to owe their general status or positions of importance to the controller.
  • It is unclear to what extent the process the directors engaged in to evaluate the challenged transaction influenced the court’s determination as to non-independence. The court did not characterize the special committee process in any way in the opinion and mentioned it at all only in the court’s lengthy recitation of the factual However, the facts as alleged indicated that the process was severely flawed. Indeedalthough the court did not articulate thisarguably, any director with independence from the controller would not have engaged in such a process.

Background. BGC Partners, Inc. (a public company) paid $875 million to acquire Berkeley Point Financial LLC (a private company) (the “Transaction”). BGC and Berkeley both were affiliates of Cantor Fitzgerald, L.P. and both were controlled by Howard Lutnick, who was the CEO and Chairman of BGC and also controlled Cantor Fitzgerald and many of its affiliated companies. The Transaction was approved by a special committee of outside directors of BGC but was not subject to approval by BGC’s stockholders. After the closing, two BGC stockholders brought suit, alleging that Lutnick (standing on both sides of the transaction) had BGC overpay for Berkeley because his economic interest in Berkeley (60%) far exceeded his economic interest in BGC (13.8%). According to the Complaint, Lutnick’s ownership interests meant that he would receive almost 47% of each dollar that BGC overpaid in the Transaction. The plaintiffs also alleged that the outside directors of BGC acted in bad faith in allowing the overvalued sale to happen. The defendants moved to dismiss. They asserted that the plaintiffs, who had not made a demand on the board to bring the derivative claims on behalf of BGC, had failed to establish that demand would have been futile. In addition, the director defendants argued that the claims against them should be dismissed, under Cornerstone, given the protection for independent directors set forth in the exculpatory provision in BGC’s charter. However, the court found that there was “reasonable doubt” as to the directors’ independence, and it therefore ruled that (i) demand was excused and (ii) the claims were not dismissible under Cornerstone.

Discussion

The presence of a controller who stood on both sides of the challenged transaction was obviously relevant to the inquiry on demand futility. A stockholder who wishes to bring a derivative claim on behalf of the corporation must first make a demand on the board for the board itself to bring the suit. If demand is not brought, the court will dismiss the case unless the plaintiffs establish that it would have been “futile” to make the demand. The BGC plaintiffs did not make a demand and claimed futility. The “Aronson test” of futility applied which required a court determination that the facts alleged by the plaintiffs created a “reasonable doubt” as to whether a majority of the directors that would have considered a demand if it had been made were “disinterested” (as to the challenged transaction) and “independent” (of any party that was self-interested in the transaction). If a director is not both disinterested and independent, he or she could not have been expected to impartially exercise their discretion whether to bring suit. The court reaffirmed that demand is not automatically excused simply because there is a conflicted controller. However, the court emphasized that the presence of a controller is “not irrelevant” to the inquiry—“our law is not blind to the practicalities of serving as a director of a corporation with a controlling stockholder” and the “threat of implicit coercion because of the controller’s ability to not support the director’s re-nomination or re-election [or to cause the director’s removal].”

When the Complaint was filed, BGC’s board consisted of five members: Lutnick, three outside directors who served on the Special Committee (Moran, Bell, and Curwood), and a new outside director (Richards) who had not considered the Transaction. The parties agreed that Richards was disinterested and independent, and that Lutnick was not. Thus, demand futility turned on whether there was a “reasonable doubt” as to the disinterestedness and independence of at least two of Moran, Bell and Curwood.

The court first reviewed well-established general principles relating to the determination of the independence of directors in the context of a controller transaction. In this context, reasonable doubt about independence can arise from a director’s feeling “subject to [the controller]’s dominion or beholden to [the controller].” When assessing independence, the court further emphasized the potential personal connections and feelings between an outside director and the controller. “[O]ur law cannot ignore the social nature of humans or their possibly being motivated by love, friendship, and collegiality,” the court wrote. At the pleading stage, the court stated, a plaintiff cannot “just assert that a close relationship exists” between a director and an interested party, but “when the plaintiff pleads specific facts about the relationshipsuch as the length of the relationship or details about the closeness of the relationshipthen this Court is charged with making all reasonable inferences from those facts in the plaintiff’s favor.” The independence judgment must be made based on whether the “constellation of facts” (that is, the allegations “in totality,” including with respect to both business and personal connections) create a reasonable doubt as to independence.

The court characterized recent Supreme Court decisions as having applied a “de novo standard of review” for independence. The court reviewed the recent Supreme Court decisions on independence:

  • In Sanchez, the Supreme Court indicated that the Court of Chancery had erred by considering a director’s business relationships and personal friendships “as entirely separate issues” rather than recognizing that the director’s “economic positions derive[d] in large measure from his 50-year close friendship with [the interested party].”
  • In Sandys, the Supreme Court held that a director was not independent of the controller because they owned a private airplane together—which was “not a common thing” and suggested that the two were “extremely close.”
  • In Marchand, the Supreme Court found that there was reason to doubt that a former employee (“WR”), who had been at the company for 28 years and had risen to the position of CFO, could impartially decide whether to sue the company’s CEO. The CEO’s family had (i) run the company for generations and was responsible for WR’s career success and (ii) spearheaded an effort that resulted in a $450,000 donation to a college in WR’s honor and a facility at the college being named for him. These facts supported a pleading-stage inference of “very warm and thick personal ties of respect, loyalty and affection” that supported an inference that WR would not act independently of the CEO.

The court determined there was “reasonable doubt” as to the independence of each of the directors. The court stated that it was “guided” by the recent Supreme Court decisions and explained as follows:

  • Moran. Moran’s professional and personal relationship with Lutnick spanned twenty years. Moran had served on at least one Cantor Fitzgerald-affiliated board for sixteen of the past twenty years—which the court stated, suggests that Lutnick “trusts, cares for, and respects” Moran, and that it would be “important to Moran to maintain a good relationship with Lutnick, who has the unilateral ability to terminate the perquisites of Moran’s board service to Cantor affiliates, which yielded Moran $931,986 (mostly in cash) over the past five ” (The court did not discuss the fact that there were no allegations as to the materiality of this compensation to Moran and that this compensation appears to be at an average level for directors of comparable companies.) In addition, Moran appeared to have a close personal relationship with Lutnick, according to the court. The court cited that Moran and his wife had appeared at public events with Lutnick, including a black tie gala in 2007 at which they were photographed together “in a staged setting”; in 2014, Moran’s wife honored Lutnick’s sister (who had co-founded the Cantor Fitzgerald Relief Fund with Lutnick) at another gala event; and Lutnick had once offered to help arrange a private tour of the Tate Museum of Art in London for Moran’s wife and granddaughters. These alleged facts suggested that the personal relationship between Moran and Lutnick was “close” and “not simply a thin social-circle friendship.”
  • Bell. Bell had served with Lutnick on two Cantor-affiliated boards (including BGC) over the previous ten In 2015, Lutnick placed Bell’s name on a publicly-filed list of potential board appointees to another Cantor affiliate. Bell “appears to be another of Lutnick’s go-to choices for board appointments on companies he controls,” the court wrote. As such, “it would be important to Bell not to compromise her good relationship with Lutnick, who has the unilateral power to discontinue the benefits Bell has received from serving on Cantor-affiliated boards,” particularly since there are “specifically alleged facts suggesting that these board appointments have been financially material to Bell.” The plaintiffs conducted a search of publicly-available information and determined that Bell’s board compensation from BGC of $266,000 in 2017 represented over 30% of her annual income in recent years. Bell also was Provost at Haverford College from 2007 to 2012 and Lutnick had donated over $65 million to Haverford over the past twenty-five years. The court concluded that “it can reasonably be inferred that these donations benefitted Bell professionally as Provost of Haverford, and deepened her personal relationship with Lutnick given his self-professed ‘Love’ for Haverford College and its people.” The court noted that Bell was first appointed to a Cantor-affiliated board during her tenure as Provost of Haverford, and that, although she had left Haverford a few years ago, past benefits may establish “a sense of owingness” upon which a reasonable doubt as to a director’s independence may be premised.
  • Curwood. Curwood had served with Lutnick on the BGC board for the previous ten years. Also, in 2015, Lutnick placed Curwood’s name on a publicly-filed list of potential appointees to another Cantor affiliate’s board. Curwood had received more than $1.3 million as a BGC director, including $938,000 over the past five years. There were specific allegations that his board compensation, which Lutnick “ha[d] the unilateral power to discontinue,” was financially material to himbased on his primary employment being president of a group that paid all of its executives collectively $62,000 in 2015 and his other employment being with an investment group run out of his residence in New Hampshire which had no internet presence, and as an occasional Harvard and University of Massachusetts lecturer and an environmental journalist. Curwood also had served with Lutnick on the Board of Managers of Haverford College and, since 2000, he had served on a group that encourages financial support to Haverford. “Given Lutnick’s extraordinary generosity to Haverford, and Curwood’s own deep ties to Haverford, it stands to reason that Curwood naturally would be reluctant to support bringing a lawsuit against Lutnick.”
  • Dalton. Dalton had served on three Cantor Fitzgerald-affiliated boards (including BGC) over a period of twenty He received more than a total of $2 million for service on these boards and for at least the previous five years had derived 40-50% of his income from Cantor Fitzgerald-affiliated entities. Unlike the other three directors discussed above, there were no allegations of a deep personal relationship between Dalton and Lutnick. However, the court concluded that, at the pleading stage, it was reasonably conceivable that Dalton, too, could not be presumed to have acted independently of Lutnick, given “how lucrative his Cantor-affiliated board positions have been to him and Lutnick’s unilateral power to decide who should serve on those boards.”

The court appeared to view each director’s various connections with Lutnick as not being “coincidences” but evidencing a depth of relationship (and sense of obligation on the director’s part). We note that, arguably, the relationship factors in BGC do not self-evidently lead to a conclusion of non-independence. For example, with respect to Moran, while Lutnick was responsible for his serving on Cantor Fitzgerald-affiliated boards, there was no allegation that the compensation he received was material to him. Also, the purportedly deep personal relationship between them was based only on their having appeared in a photo together at a gala, his having honored Lutnick’s relative at an event, and his having been willing to help arrange a private tour of a museum. In the case of Bell, the court found a deep personal relationship and allegiance to Lutnick partly based on her having been the provost for five years at the college to which Lutnick had donated a very substantial sum over a period of 25 years. Similarly, in the case of Curwood, the court found that a deep personal relationship was suggested by his having been on a committee to encourage financial giving at the college to which Lutnick was a substantial donor. The court focused not only on each director’s interest in continuing to receive compensation for board service that (in some cases) appeared to be financially material, but also on the director appearing to have attained status, prestige or positions of importance due to the relationship with Lutnick. These were sufficient, at the pleading stage, for a conclusion that the director may not have been capable of acting independently of Lutnick.

BGC (and another recent decision, Marchand) appear to suggest that there is a higher standard for a finding of independence of a director in the demand futility context than in other contexts. A board’s determination whether to authorize litigation on the company’s behalf is in substance a quasi-judicial function and thus may demand a more rigorous definition of “independence.” The Supreme Court addressed this directly in Marchand (June 18, 2019), where it overturned the Court of Chancery’s finding of independence. The Supreme Court found that the plaintiff, WR, could not be presumed to be independent of the CEO with respect to deciding whether to bring derivative litigation against the CEO—even though WR had recently voted against the CEO’s interests in supporting the separation of the Chairman and CEO roles that he held. Chief Justice Strine wrote: “The Court of Chancery ignored that the decision whether to sue someone is materially different and more important than the decision whether to part company with that person on a vote about corporate governance, and our law’s precedent recognizes that the nature of the decision at issue must be considered in determining whether a director is independent.” The BGC holding appears to reinforce this concept.

The allegedly egregious board process for evaluating the Transaction presumably also influenced the court’s determinations as to the directors’ non-independence. The court did not discuss the BGC Special Committee process at all in its analysis of the directors’ independence. However, the court recited in a lengthy summary of the factual background of the case numerous alleged facts that indicated that the directors had engaged in a severely flawed process. It seems likely that the egregious nature of the processone which, arguably no independent director would have engaged incould have influenced the court’s view of the directors’ independence. The process flaws were as follows (according to the plaintiffs’ allegations, which, at the pleading stage, the court was obliged to accept as true):

  • The amount Cantor proposed be paid for Berkeley increased from the low $700 million range to the $875 million purchase price, over a five-month period, without any apparent justification, and the special committee’s minutes did not reflect that the committee had “pushed back” on the increase in the purchase price;
  • The special committee’s own financial advisor’s valuation of Berkeley indicated that the purchase price should be $720 million at most (and the advisor had outlined eight reasons why the purchase price overvalued Berkeley);
  • An initial public offering (completed three months after closing of the Transaction) of the entity into which Berkeley was merged implied a valuation for Berkeley of only $563 million;
  • Lutnick himself was the lead negotiator for the Transaction, and he had attended multiple BGC special committee meetings, had withheld information from the special committee, and had directed certain changes in the financial advisor’s valuations; and
  • Neither the special committee nor BGC had considered any alternative transactions.

We note also that the court characterized Lutnick as a person who had a reputation as being “a Wall Street bruiser” and “famously sharp-elbowed.” Thus, presumably, the court viewed Lutnick as someone who likely would want to exert his influence over the other directors and/or to seek retribution if they did not support him.

The court held that, based on the directors’ not being independent of Lutnick, the plaintiff’s claims were not dismissible (under Cornerstone) based on BGC’s exculpation provision. The court noted that the BGC special committee directors were protected by a Section 102(b)(7) exculpatory provision in BGC’s charter. When a director is protected by such a provision, the court wrote, a plaintiff can survive a motion to dismiss by that director defendant by pleading facts supporting a rational inference that the director had been self-interested in the transaction, had “acted to advance the self-interest of an interested party from whom [that director] could not be presumed to act independently,” or had acted in bad faith. As discussed above, the court found that the plaintiffs had pled facts supporting a reasonable inference that (i) Moran, Bell and Curwood, by voting to approve the Transaction, had acted to advance the self-interest of an interested party who stood on both sides of the Transaction (Lutnick) and with respect to whom they could not be presumed to act independently and (ii) Dalton, because of his “lucrative” Cantor-affiliated directorships that were financially material to him, also could not be presumed to be act independently of Thus, the claims against these directors were not dismissible based on the exculpation provision.

Practice Points

  • A controller should consider the benefits of having some number of independent directors on the board. To avoid a situation where a majority of the directors may be deemed by the court not to be independent, a controller may want to consider appointing persons to the board who do not have other relationships with the controller and should therefore be viewed by the court as clearly independent of the controller. The approval by a majority of those directors of a conflicted transaction could then result in business judgment review under MFW if the transaction is also subject to approval by the minority stockholdersor, if not, at least in a shift to the plaintiffs of the burden of proof under the “entire fairness” standard for the transaction. (See the similar point made above relating to the Tornetta decision.)
  • A controller and the board should be aware of the kind of relationships that the court may view as establishing a reasonable doubt as to a director’s ability to be independent of the BGC reflects that directors appointed to numerous boards by the controller, and directors with whom the controller has an extensive business or personal relationship, may well be considered to be not independent of the controller. The determination is relevant both for purposes of a court deciding whether demand on the board to bring a derivative action is futile and therefore excused, and deciding whether a director may be dismissed from the case based on the exculpatory provision that appears in the charter of most companies. The board should proactively seek the information required to make a judgment in advance about possible non-independence or interestedness of directors with respect to proposed transactions. The evaluation of independence and interestedness of directors is, of course, critical if the controller seeks to structure the transaction to be MFW-compliant in order to obtain review under the business judgment standard.
  • The board process is likely to influence the court on the issue of independence of the directors. A board process that is so flawed that arguably no director who was actually independent would have engaged in it may well influence the court’s view of the directors’ independence. We note that, among the flaws in the BGC board process, was that the controller was the lead negotiator for the transaction as to which he stood on both Recently, in Olenik v. Lodzinski (2018), the court was not troubled by the CEO of a company, who had close ties to the controller, being the lead negotiator for a transaction in which the controller was conflicted. In Olenik, however, there appeared to be a good reason for the selection of the CEO for that role, given his unique expertise and track record in the industry. Moreover, and most importantly, the overall factual context in that case included an effectively functioning special committee of independent directors that actively oversaw the negotiating process.
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