Corporate Governance

Fiduciary Duties of Officers and Directors: Gantler v. Stephens and the Problem of Stock Exchange Rules on Director Independence (Part 7)

By J. Robert Brown

We are examining the recent decision by the Delaware Supreme Court in Gantler v. Stephens. The case is a state law matter, turning on Delaware's interpretation of fiduciary obligations.  Nonetheless, the facts raise concerns that go beyond state law and suggest weaknesses in the rules of the stock exchange or in the enforcement of the rules of the stock exchanges.

The stock exchanges require that listed companies have a majority of independent directors on the board.  Moreover, listed companies must have audit, nominating and compensation committees that consist only of independent directors.  The definition of independent under state law and the rules of the stock exchange vary, although there are many overlaps.

The company at issue in this case, First Niles, was listed on Nasdaq's SmallCap Market.  Nasdaq imposes the traditional governance requirements including the need for the specified committees and the need for independent directors. The definition of independent specifically picks up directors who:

• hav[e] a relationship which, in the opinion of the issuer's board of directors, would interfere with the exercise of independent judgement in carrying out the responsibilities of a director.

First Niles disclosed in its proxy statement that it conformed to these governance requirements.  Among the directors listed as independent was P. James Kramer.  Kramer was also listed as a member of the audit, nominating and compensation committee.

While he met the Nasdaq definition of independent (according to the board), he did not meet the Delaware definition (at least based upon the pleadings).  The Delaware Supreme Court concluded that his economic ties to the companies resulted in a loss of independence.  As the Supreme Court stated:

• Director Kramer’s alleged circumstances establish a similar disqualifying conflict. Kramer was the President of William Kramer & Son, a heating and air conditioning company in Niles that provided heating and air conditioning services to the Bank. It is reasonable to infer that Kramer feared that if the Company were sold his firm would lose the Bank as a client. The loss of such a major client would be economically significant, because the complaint alleges that Kramer was a man of comparatively modest means, and that his company had few major assets and was completely leveraged.

In other words, the director that the Delaware Supreme Court agreed was not independent (assuming the truth of the facts alleged), was considered independent under the Nasdaq standards and could, therefore, sit on the compensation committee and approve the CEO's compensation.  This illustrates why the standards imposed by the exchanges for board independence are often meaningless and do little to protect the interests of shareholders.

So what happened in this case?  With respect to the Nasdaq standards, either the board did not consider Kramer's relationship with the company or the board considered it but decided it was not one that would "interfere with the exercise of independent judgment."  In other words, Nasdaq leaves the matter entirely to the board, with little apparent oversight.  Said another way, there is really no guarantee that the representations made by companies about director independence are meaningful. 

It is perhaps why the SEC now requires companies to disclose "by specific category or type, any transactions, relationships or arrangements . . . that were considered by the board of directors under the applicable independence definitions in determining that the director is independent."  By forcing disclosure, the SEC has caused boards to take their analysis of director independence more seriously, something that would not be necessary were there adequate oversight and enforcement by the exchanges.

Primary materials from the Chancery Court can be found on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on February 16, 2009 (boomark / email).