April 1, 2015
Albert H. Manwaring, IV
Delaware Business Court Insider

On Feb. 11, The Wall Street Journal reported that General Motors (GM) was evaluating a potential nominee to its board from four hedge funds, collectively holding more than 34 million of GM's shares. According to the report, the potential nominee's agreement with the funds included compensation in the form of a percentage of the funds' profits from their investment in GM. The potential nominee was seeking to join GM's board to urge GM to return more cash to its shareholders and boost its stock price. One of the funds backing the potential nominee stated that GM had too much cash on its balance sheet, and needed to return more of its capital to shareholders through dividends and share buybacks.

In the past, GM has resisted returning cash to shareholders. GM is currently facing a number of significant near-term demands on its resources, including reserving billions of dollars to end a U.S. Department of Justice investigation in connection with its ignition recall, to address strict global emission standards to combat global warming, and to retool the Cadillac to better compete against its German counterparts. GM indicated that it would evaluate the potential nominee "based on the best interest of all shareholders." Activist shareholders are increasingly having greater success in running slates of directors in proxy contests, targeting larger companies, and collecting significant amounts of cash to return to shareholders. GM, which is a Delaware corporation, is considering this potential hedge fund nominee to its board with the same objective, and faces the attendant conflict issues arising from the so-called potential "constituency director."

The Conflict

These targeted large companies have complained that special compensation improperly motivates constituency directors to promote corporate action to benefit the constituent shareholders, who nominated the director to the board, at the expense of the best interests of the corporation and all of its shareholders. Corporate law commentators have also recognized that special compensation creates the potential for conflicts of interest that induce a constituency director to subordinate his or her judgment for the corporation and its shareholders as a whole in favor of the interests of the constituent shareholders that are paying his or her special compensation and nominated the director to the board. Prominent corporate lawyers and influential members of the Delaware judiciary have noted the potential for activist hedge fund investors to focus on short-term actions to turn a quick profit, which increases the risk of jeopardizing the long-term sustainability of the company. (See "The Rights and Duties of Blockholder Directors," by J. Travis Laster and John Mark Zeberkiewicz, 70 Bus. Law. 33, 49-50 (2015).) Paying special compensation to activist hedge fund constituency directors only exacerbates this potential conflict of interest, and causes resentment that may divide the board.

On the other side of the fence, activist investors respond that their focus benefits all shareholders equally as even a short-term increase in share price maximizes shareholder value. Putting aside the short-term versus long-term focus issue, with proxy advisers backing activist slates of directors, query whether it is helpful or necessary to provide even greater incentive for constituency directors to abandon their fiduciary duties to the corporation and all of its shareholders as a whole in favor of the hedge fund constituency shareholders through special compensation.

In the case of GM, the objective of the potential hedge-fund board nominee to have GM return cash to its shareholders through a share buyback appears to conflict with the near-term cash needs of GM to pay for its ignition recall issues, to comply with global emission standards, and to retool the Cadillac to better compete. Paying the potential board nominee percentage compensation that is contingent on the hedge funds receiving profits from their investment in GM only exacerbates the conflict.

Delaware Corporate Law Issues

Constituency directors, who receive special compensation to promote corporate action to benefit constituent shareholders, present a number of potential problems under Delaware corporate law. First, the potential conflict of interest of constituency directors, and in particular those receiving special compensation from their constituent shareholders, exposes them to increased potential liability for breach of the fiduciary duty of loyalty. Special compensation further induces a constituency director to subordinate his or her judgment for the corporation and all of its shareholders in favor of the interests of the constituent shareholders. A constituency director, who acts to benefit the constituent shareholder that is paying for his or her service on the board at the expense of the interests of the corporation and its shareholders as a whole, has engaged in a self-interested transaction that may breach his or her fiduciary duty of loyalty, as in Cede & Co. v. Technicolor, 634 A.2d 345, 361 (Del. 1993). A constituency director, who fails to act in the best interests of the corporation and its stockholders, may also be liable for breach of the duty of good faith, which is a component of the duty of loyalty under Delaware law. (See, e.g., Stone v. Ritter, 911 A.2d 362, 369 (Del. 2006).)

Second, a constituency director liable for breach of the duty of loyalty or good-faith is not subject to protection applicable for breach of the fiduciary duty of care under the exculpatory provision in Section 102(b)(7) of the Delaware General Corporation Law (DGCL). Further, a bad-faith action in breach of the duty of loyalty may result in the loss of the right to statutory indemnification if the director did not act "in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation" under Section 145 of the DGCL.

Finally, Delaware's board-centric approach to collective decision-making under DGCL Section 141, and a director's virtually unfettered right to access corporate information under DGCL Section 220(d) to fulfill his or her oversight fiduciary duties, can result in additional problems in the constituency director context. Indeed, despite a director's right to corporate information, management is often reluctant to provide the constituency director access to corporate information to pursue his or her goal of immediate change to accomplish the constituent shareholder's short-term objectives. Moreover, in their quest to achieve immediate change, constituency directors often have a different view from other directors and management regarding how much and how fast management should provide them with corporate information, creating tension between the constituency directors and the remainder of the board and management. There is also a tendency by other directors and management to view the constituency director as an adversary, and to thus seek to limit his or her participation in board meetings or actions. While directors have an undeniable right to participate in board meetings and actions under Delaware law, there is also a well-established right for a board to delegate issues to a disinterested committee of the board and also to obtain a more deferential standard of review when tested under Delaware law. But left unanswered under Delaware law is how far the board can go to avoid the interested constituency director's participation or access to committee information, and how long can the committee be maintained to exclude the constituency director from the board's decision-making.

In sum, constituency director nominees to the board present challenging conflict issues that must be carefully considered under Delaware law. Special compensation to constituency directors only exacerbates these potential conflicts of interest, the difficulty in balancing the director's right to corporate information versus perceived obstructionist requests that interfere with management, and the difficulty balancing the director's right to participate in board decisions with a board or committee's right to deliberate free of directors with a direct conflict of interest in the matter being discussed or acted upon.

Delaware Business Court Insider  |  April 1, 2015