Summary

Establishing a special committee is a common corporate governance practice in the context of transactions involving insiders, controlling stockholders or other related persons (so called “conflict transactions”). Special committees are designed to create a record of independent decision-making. That said, in other circumstances, special committees are not generally necessary or advisable and may be counterproductive. In most cases, a well-advised board can respond effectively to an unsolicited proposal or address an activist threat without a special committee. This memo addresses key points boards should bear in mind when considering whether to form a special committee and offers practical guidance and potential alternatives.

Special Committees Are the Exception, Not the Rule

Courts have long applauded boards for using special committees to evaluate conflict transactions by reviewing a properly constituted special committee’s decisions under the deferential “business judgment rule” standard of review. However, not every conflict transaction, and certainly not every strategic or business-critical situation, rises to the level of warranting the formation of a special committee. In fact, two recent developments in Delaware law have confined the situations in which special committees are likely to be used:

• First, the Delaware General Corporation Law (DGCL) now contains a statutory presumption of director disinterestedness. Under the statute, directors are presumed to be free of conflicts if they are not a party to the transaction and they have satisfied the applicable stock exchange’s independence criteria. That presumption can only be rebutted by substantial and particularized facts that the director has a material interest in the transaction or a material relationship with a person with a material interest in the transaction.
• Second, the DGCL now offers “safe harbor” protections from equitable relief or damages awards in controlling stockholder transactions (other than take privates) if they are either (1) approved by an independent board committee of at least two directors, or (2) approved or ratified by a majority of disinterested stockholders. Only take private transactions with controllers require both approvals.

Special committees are most appropriate in the presence of material conflicts of interest and in other contexts where the market or a court might otherwise question the board’s independence. In determining whether a material conflict exists, boards should consider whether any director is arguably standing on both sides of the transaction or would otherwise receive a substantial personal benefit misaligned with other stockholders. Potential material conflicts include a director having particularly close personal or business relationships with an interested party. However, directors merely owning equity awards in the company or being the target of an activist’s criticism would not, absent other factors, constitute a material conflict requiring the formation of a special committee. Moreover, a more efficient and less problematic approach may be to recuse the director.

Although management conflicts may not on their own taint a board’s decision, they can expose the transaction to enhanced scrutiny if conflicted members of management also sit on the company’s board or if the board relies predominantly on information or advice provided by the conflicted members of management. An executive director investing in the private equity fund taking a company private, such that he or she becomes part of the buyer group, for example, could give rise to a material conflict. However, top executives simply benefiting from change-of-control payments, retention bonuses or accelerated equity awards as a result of an M&A transaction would not create a disabling conflict. Boards should work closely with legal advisors to assess potential material conflicts in M&A transactions that could defeat application of the business judgment rule, or that otherwise cannot be addressed to the board’s satisfaction through the recusal of individual directors or having executive sessions that exclude management participants from portions of board meetings.

In the activist defense context, special committees can do more harm than good since they divide boards by design – the very dynamic activists seek to exploit. When faced with an activist threat, Delaware courts do not impose heightened fiduciary duties on boards beyond the traditional duties of care and loyalty. Since all directors have an inherent interest in the outcome of an activist attack, there is typically no conflict that warrants establishing a special committee.

Risks of Special Committee Overuse

Forming a special committee is not costless to a company and should not be viewed as a default approach or a shield from litigation. Establishing a special committee where the facts do not call for it can burden the company with an inefficient decision-making process and even risk jeopardizing a proposed transaction that could otherwise be in the best interests of stockholders. It can also cause serious rifts among board members as to who serves on the special committee and who does not.

Properly constituted special committees consist solely of independent and disinterested directors and have a clear mandate from the board. Special committees typically retain their own legal and financial advisors, independent from the company and the conflicted party. This can increase transaction expenses, increase the risk of leak, create conflicting advice among external advisors and slow down the transaction process. Forming a special committee unnecessarily may also signal vulnerability to the market and create an inaccurate appearance of material conflicts, which can, paradoxically, attract more litigation. As noted, over-delegating directors’ authority may also risk undermining the board’s cohesion.

These risks all illustrate the importance of considering all the relevant aspects of the question whether the formation of a special committee is advisable for evaluating a transaction or addressing an activist threat, or whether a less onerous decision-making process would be advisable.

Practical Guidance

Unless management has a material conflict in a particular situation, any transaction or activism defense process should engage key members of senior management. Subject to the board’s guidelines and preferences, the CEO, CFO and General Counsel are typically involved in the process, along with the Head of Business Development/Strategy and/or the Chief Human Resources Officer, as necessary.

In both M&A and activism defense situations, it is critical that the board and management be aligned on the company’s strategy and financial projections. Where management has a conflict, management will typically still play a role in creating the projections, but the board will take an active role in reviewing the projections (including, on occasion, asking management to run “sensitivities”). On very rare occasions where management’s conflicts are material, a special committee or board may engage an independent advisor to develop separate projections or review management’s projections. This, however, is the exception and not the rule.

Boards can always consider establishing transaction or ad hoc working groups, which may include the CEO and select directors particularly suited for the role (such as directors with more M&A experience and availability), to receive more frequent updates. These informal working groups (sometimes referred to as committees) typically do not have independent decision-making authority, but rather serve to facilitate the full board’s transaction oversight without incurring unnecessary costs and burdens. For example, these working groups rarely have standalone written charters or maintain detailed minutes of their meetings, and typically do not involve additional director compensation.

Activists also tend to make requests for the creation of special committees to oversee a strategic corporate review. The working group alternative could satisfy these requests while leaving the ultimate determination on the outcome of the strategic review with the full board.

Although special committees remain an essential safeguard for companies facing material conflicts of interest, their unnecessary use can impose costs, delays, and litigation and other risks. Boards can preserve their decision-making authority and oversight, set clear guidelines for management, and, where warranted, form internal working groups – reserving special committees for contexts where they are essential to protect independent decision-making and to advance the interests of stockholders.