This is the fifth in a series of posts discussing certain issues and lessons for practitioners arising out of the recently settled dispute between CBS and its controlling stockholder.[1]  Relevant background can be found here and additional posts in this series can be found here.

Stock exchange rules and state corporate law often rely on the “independence” of a company’s board of directors as a mechanism for policing potential conflicts of interest that might arise between and among the company’s various constituencies.  While stock exchange rules tend to focus on the ongoing independence of directors from management to prevent management from behaving opportunistically at the expense of stockholders, state corporate law also focuses on the independence of directors from a particular stockholder in the context of a transaction with that stockholder and from other directors in the context of derivative actions against such other directors.

The recent dispute between CBS and its controlling stockholder, National Amusements (NAI), should serve as a reminder that determining whether a director is “independent” is context specific, depending on both the underlying facts and the matter under consideration:  a director can be independent for some purposes but not others.  And a director’s status as, or relationship with, a controlling stockholder should not necessarily disqualify that director from participating in deliberations or decisions on matters in which the controlling stockholder does not have an actual conflicting interest.  This post summarizes the applicable standards regarding independence and discusses how and when varying standards should be utilized in the context of controlled companies.

The Independence Rules of the New York Stock Exchange

The NYSE corporate governance standards are enumerated in Section 303A of the NYSE Listed Company Manual.  Among other things, Section 303A requires that a majority of the members of the board of directors of a NYSE-listed company be independent.[2]  A director is not independent under Section 303A “unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, stockholder or officer of an organization that has a relationship with the company).”[3]  If the reference to “no material relationship with the listed company” encompasses ownership of a substantial amount of stock, then this qualitative, general rule would result in all directors who are, or have material relationships with, a controlling (or other major) stockholder being ineligible from being determined to be independent.  But it seems clear from the quantitative bright line tests that follow, focusing on the director’s independence from management, that such a per se rule for such directors was not intended by the NYSE when drafting its independence rules.[4]  In fact, the commentary to Section 303A.02 of the Listed Company Manual specifies that a director’s status as, or material relationship with, a controlling stockholder would not, by itself, disqualify such director even under the qualitative, general rule: “Since the concern is independence from management, ownership of even a significant amount of stock, by itself, is not necessarily a bar to an independence finding.”[5]  What is more, directors who own stock in the listed company may actually have an increased incentive and power to police management, further strengthening the listed company’s corporate governance.[6] [7]

Of course, in many instances directors who are, or have a material relationship with, a controlling stockholder are also members of management, thus disqualifying such directors under Section 303A.  For example, during Sumner M. Redstone’s tenure on the board of directors of CBS, he maintained his position in management as Executive Chairman until his resignation on February 2, 2016. His employment as Executive Chairman during that period and receipt of compensation from CBS in excess of $120,000 until June of 2017 arguably continues to impact the NYSE independence analysis of the NAI-affiliated directors until June of 2020.[8]

Independence Considerations under Delaware State Corporate Law

“Independence” under state corporate law is less rules-based and more context specific. In particular, Delaware state courts generally only evaluate whether or not a director is “independent” when reviewing certain affiliated-party transactions or other board decisions that may raise the appearance of a conflict.[9]  It is in these situations where a director’s relationship with a controlling stockholder is potentially relevant. This raises two issues: (1) whether the controlling stockholder is disinterested/independent and, (2) if not, whether the director nominated by the controlling stockholder is sufficiently independent from that stockholder to nevertheless be independent.

As to the first question, Delaware courts, like the NYSE, have suggested that as a general matter director share ownership actually improves corporate governance.[10]  It is only if the controlling stockholder is to receive a benefit in the context of a particular transaction “to the exclusion of, and detriment to, the minority stockholders”[11] that the controlling stockholder will not be independent for purposes of the board’s consideration of that transaction.   While disabling conflicts of controlling stockholders are most often found in the context of a classic interested-party transaction, Delaware courts have recognized certain narrow circumstances in the controlled company context where sui generis conflicts of interest could arise even absent the controlling stockholder standing on both sides of a given transaction.[12]

As to the second question, even if the controlling stockholder has a conflict of interest in the context of a particular matter, there will sometimes be a question of whether one or more of its nominees to the board is nevertheless independent in that context.  Director independence under Delaware law requires a director’s decision to be “based on the corporate merits of the subject before the board rather than extraneous considerations or influences.”[13]  A director is presumed to be independent unless it is shown that the director is so beholden to a party interested in the decision before the board “that [the director’s] discretion would be sterilized.”[14]  However, the presumption of director independence is not rebutted by mere allegations of personal or professional relationships with a party interested in the decision before the board.[15]  The director’s affiliation with the interested party – including an interested controlling stockholder – must be substantial enough so that the director is “incapable of making a decision with only the best interests of the corporation in mind,” such as when a director feels like he or she “owes something” to the interested party.[16]

As a result, directors who are, or have relationships with, controlling stockholders are presumed independent under Delaware law absent (a) the controlling stockholder having a conflicting interest in a matter before the board and (b) a showing that such directors are so beholden to the controlling stockholder that they are unable to be impartial in such matter.

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As discussed above, both the stock exchange independence rules and Delaware law recognize that the economic interests of large stockholders are usually aligned with those of other stockholders and therefore the existence of directors who are, or have relationships with, a controlling stockholder can often improve corporate governance.  Accordingly, when considering how and when varying standards of independence should be utilized in the context of a controlled company, boards would be wise to consider the specific facts and circumstances at issue.  Context matters – and in many instances directors remain independent under both stock exchange independence rules and Delaware law irrespective of their status as, or relationship with, a controlling stockholder.

[1] Cleary Gottlieb was litigation and corporate counsel for NAI in the matters discussed herein.

[2] Section 303A.01 of the Listed Company Manual.

[3] Section 303A.02(a)(i) of the Listed Company Manual.

[4] See Section 303A.02(b) of the Listed Company Manual for the bright line independence tests.

[5] Commentary to Section 303A.02(a) of the Listed Company Manual.  Similarly, ownership of stock of the listed company is not disqualifying by itself under the analogous independence standards of NASDAQ.  See NASDAQ IM-5605.

[6] See Exchange Act Release No. 34-47672 (April 11, 2003) (citing several commenters arguing “that directors who own or represent institutions that own very significant economic stakes in the listed companies are often effective guardians of stockholders’ interests not only as members of the full board but also of compensation and nominating committees, while directors whose only stake in the membership on the board is the director’s fee may be unduly loyal to management.”).

[7] It should be noted, however, that while directors who are, or have material relationships with, controlling stockholders may be deemed independent under Section 303A.02, they are unlikely to meet the heightened NYSE independence requirements for membership on the Audit Committee.  See Sections 303A.06 and .07 of the Listed Company Manual.

[8] Note that despite being a “controlled company” (i.e., a company of which more than 50% of the voting power for the election of its directors is held by a single person, entity or group) under NYSE listing standards to which NYSE’s independence requirements do not apply, CBS has historically had, and continues to have, a majority of independent directors on the CBS Board (as well as an independent Compensation Committee and Nominating and Governance Committee). See, e.g., CBS Corp., Form S-4 (Oct. 5, 2005) (“[D]espite being a ‘controlled company,’ CBS. Corp will have a majority of independent directors on its board of directors and will have an independent compensation committee and an independent nominating and governance committee.”).

[9] The two scenarios in which director independence under Delaware law is most often at issue are (a) stockholder derivative claims and (b) M&A, financing or commercial transactions where a controlling stockholder, director or officer stands on both sides of the transaction.

[10] See, e.g., In re Synthes, Inc. Shareholder Litigation, 50 A.3d 1022, 1035 (Del. Ch. 2012) (“Controlling stockholders typically are well-suited to help the board extract a good deal on behalf of the other stockholders because they usually have the largest financial stake in the transaction and thus have a natural incentive to obtain the best price for their shares.”).

[11] Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del.1971).

[12] See, e.g., In re Synthes at 1036 (“It may be that there are very narrow circumstances in which a controlling stockholder’s immediate need for liquidity could constitute a disabling conflict of interest irrespective of pro rata treatment.”); In re Morton’s Restaurant Group, Inc. Shareholders Litigation, 74 A.3d 656, 666-67 (Del. Ch. 2013) (stating that the narrow circumstances where a controlling stockholder’s desire to sell would create a disabling conflict of interest include a “fire sale” in which the controller is pressured to sell quickly and forgo additional value).

[13] See Aronson v. Lewis, 473 A.2d 805, 816 (Del. 1984).

[14] Rales v. Blasband, 634 A2.d 927, 936 (Del. 1993).

[15] See, e.g., Kahn v. M&F Worldwide Corp., 88 A.3d 835, 649 (Del. 2014) (“Bare allegations that directors are friendly with, travel in the same social circles as, or have past business relationships with the proponent of a transaction or the person they are investigating are not enough to rebut the presumption of independence.”); Aronson at 816 (“[I]t is not enough to charge that a director was nominated by or elected at the behest of those controlling the outcome of a corporate election. That is the usual way a person becomes a corporate director. It is the care, attention and sense of individual responsibility to the performance of one’s duties, not the method of election, that generally touches on independence.”).  But see In re Tesla Motors, Inc. Stockholder Litigation, 2018 WL 1560293, 17 (Del. Ch. 2018) (finding a director lacked independence from a controlling stockholder/CEO where such director sat on the board of, and invested in, other entities controlled by such controlling stockholder/CEO and received investments from such controlling stockholder/CEO in the director’s venture capital firm).

[16] In re Oracle Corp Derivative Litigation, 824 A.2d 917, 937 (Del. Ch. 2003 (quoting Parfi Holding AB v. Mirror Image Internet, Inc., 794 A.2d 1211, 1232 (Del. Ch. 2001)); London v. Tyrrell, 2010 WL877528, 12 (Del. Ch. 2010).