Here, Brian Hoffmann - a partner at the law firm McDermott Will & Emery - talks about the role of special committees in family-owned businesses.

Here, Brian Hoffmann - a partner at the law firm McDermott Will & Emery - talks about the role of special committees in family-owned businesses, particularly when it comes to matters related to M&A, for example.

Based in New York, Hoffmann focuses his practice on complex corporate matters including hostile takeovers, proxy fights, sales and divestitures, cross-border transactions, management and leveraged buyouts, acquisitions of distressed companies, and domestic and international capital markets fund-raising activities.

The issues raised in this article are significant in the context of high net worth families as many will have acquired their wealth through a successful business venture or now own their own companies. The issue of governance is intensifying in the world of wealth management and Family Wealth Report welcomes reader responses.  

Recent studies have shown a correlation between corporate governance and success in family owned businesses. Not surprisingly in recent years - objectively viewed - governance in family-owned businesses has improved.

One of the keys to the improvement is the greater use of independent directors in family-owned businesses.  The laws relating to fiduciary duties suggest this trend should be taken a step further by using special committees of independent directors for certain major corporate decisions by family-owned businesses.

For purposes of this article, we take a Delaware-centric view of the law.

Properly structuring and developing corporate governance practices for family-owned businesses requires an in-depth understanding and familiarity with the applicable standards of fiduciary duty. In general, the same legal standards of review pursuant to which the actions and omissions of directors of public companies are reviewed and evaluated, are applicable to the directors of private enterprises and family-owned businesses. Standards of fiduciary duty for public and private directors fall into two principal categories: the duty of loyalty and the duty of care.

The fiduciary duties of care and loyalty

The duty of care requires directors of both public and private companies to act prudently and fully inform themselves in overseeing the business of a corporation and managing the strategic decision-making process relating to corporate opportunities.

Compliance with the duty of care requires active diligence and oversight on the part of directors.  Directors must attend regular meetings, take time to understand the terms of material transactions, and make decisions only after discussion and review, including input from legal and financial experts as appropriate.

Directors have an obligation to inform themselves of all material information reasonably available to them before making strategic decisions on behalf of a corporation. Compliance with the duty of care may be scrutinized more closely for directors of public companies, given the additional disclosure that public companies have to make in their filings with the Securities and Exchange Commission, but is generally no more or less burdensome for directors of private companies.  Complying with the duty of care for a director of a family business, however, may be significantly more difficult given that the likelihood of conflicts of interest is often much greater in the private company context.

Unless family member directors are grossly negligent, or act with “reckless indifference to stockholder concerns or act in a manner that is completely irrational with respect to their decision-making process,” a breach of the duty of care would likely not be triggered under Delaware law (see: Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).)

In evaluating risk mitigation strategies and proper governance practices, the fiduciary duty of loyalty likely will be of potential greater concern in the context of family-owned enterprises than the duty of care because of the greater incidence of conflicts of interest.

The duty of loyalty requires directors to act, at all times, in good faith and in the best interests of the stockholders of a corporation. The duty of loyalty may be implicated in many types of matters involving private entities, including divestitures, mergers, acquisitions, reorganizations and management succession.

In the context of family businesses, duty of loyalty issues often arise in the form of conflict of interest transactions, when a director family member has a material economic interest or familial stake in a particular transaction or corporate decision.

In theory, the exercise of an interested director’s judgment with respect to a conflict of interest transaction or corporate decision is compromised by the presence of personal financial incentives or other benefits. Examples of this in the family-owned business context would involve choosing a new chief executive from candidates from different branches of the family or a sale of the company with different forms of consideration for the shareholders.  

The business judgment rule and the value of outside directors

Generally, so long as the directors of a public corporation or family business comply with the basic fiduciary duties of loyalty and care, they will be afforded the protections of the business judgment rule.

The crux of the business judgment rule is that a court will not substitute its judgment for that of the board of directors if a decision can be attributed to any “rational business purpose” (see Unocal Corp. v. Mesa Petrol. Co., 493 A.2d 946, 954.) 

This is significant because the business judgment rule is generally very deferential to board decisions and, in practice, a court’s review under the business judgment rule will be much more permissive in upholding board decisions related to strategic investments, merger and acquisition transactions and other corporate matters.

When an actual conflict of interest exists for certain major corporate decisions, however, the Delaware courts will not apply the business judgment standard of review, but rather, will apply the “entire fairness” standard of review – the highest standard of judicial review under Delaware law.

To comply with this standard of review in the sale of control context, absent proper corporate governance procedures and protections, the board of directors must demonstrate both fair price and fair process regarding the transaction in question. 

The implementation of certain processes, like the use of a properly functioning special committee comprised of independent directors and/or provisions requiring approval by a majority of the minority stockholders however, are frequently used to demonstrate fair process and will flip the burden of proof back to the plaintiffs to show that that the process was not fair.

Further, obtaining a fairness opinion from an independent financial advisor is often used to demonstrate fair price and flip the burden back to plaintiffs to show that the price was not fair.

A recent decision of the Delaware Supreme Court – in Kahn v. M&F Woldwide Corp., 88 A.3d 635 (Del. March 14, 2014) - highlights the benefits of special committees used in conjunction with majority of the minority vote provisions to reduce the level of judicial scrutiny applicable to board decisions in the context of M&A transactions to the business judgment rule.

In the decision, Justice Holland held that the business judgment rule rather than the entire fairness standard applies for going-private transactions with a controlling stockholder in instances where there is (i) negotiation and approval by a properly functioning special committee of independent directors fully empowered to say no that fulfills its duty of care, and (ii) approval by an uncoerced, fully informed vote of a majority of the minority stockholders. One of the key takeaways from Kahn v. M&F Woldwide Corp. is that properly structured special committees are instrumental in maintaining the business judgment rule as the appropriate standard of review by Delaware courts for decisions by directors in material transactions.

The application of special committees to family businesses

The advantages of special committees in the context of succession and M&A transactions is particularly relevant to family-owned businesses since the sale of a family-owned business and succession are often two alternatives to the complex issues associated with replacing a founding family member or a family member who has served as a long-term executive officer in a family business.

When a family-owned business is sold or the process of succession is initiated utilizing proper corporate governance structures to manage this process, it is more likely to result in an appropriate outcome, while recognizing and accounting for the complex relationships between stakeholder groups due to family elements and dynamics.

In both succession and M&A transactions, special committees allow stakeholders to buy in to the process and protect their interests. This corporate governance mechanism is especially important for succession planning, which is a long-term process with the possibility of multiple conflicts of interest among family members interested in leadership.

Why would a family cede total control and put truly independent directors on the board?  Because if it does not, some day they might wish they had.  Consider a family-owned business well beyond its second generation.  Through the growth of the family and its generosity in providing equity ownership to key managers over the years, while still controlled by the family the company has in excess of 100 shareholders.  The board consists exclusively of family members and employees.  There is a consensus among the family that the time has come to sell the business.  The chairman of the board, until recently the CEO, and a member of the founding family leads the negotiations.  The most attractive acquirer, a private company, has offered a package of cash and equity in the combined entity.  Because of the US securities laws, the acquirer has determined that only accredited investors are eligible to elect equity in the combined enterprise.  In addition, the acquirer is insisting on a consulting agreement with the chairman of the board in order to get a non-compete agreement from the chairman.  It is time to structure the transaction.  The simplest structure would be a merger which would require board approval, a board recommendation to the shareholders and a majority shareholder vote.  The board, however, believes it has a potential conflict.  All the board members are eligible to elect equity in the combined entity as consideration.  On top of that, the chairman has the consulting agreement. What do they do?   

Because it is too late in the process to appoint independent directors, get them up to speed and have them involved in the sale process (and potentially walk into a lawsuit) the board turns to other structuring alternatives. 

To keep the board from having to take any action on the transaction, the acquisition is structured as a stock purchase with a contingent squeeze-out merger if the acquirer is able to purchase at least 90 per cent of the stock.  However, if the acquirer is unable to purchase at least 90 per cent, the transaction would fail or need to be restructured imposing certain delay and potential risk that the transaction might never be completed.

How could a properly working special committee have helped in the above circumstances?  If there was a special committee in place from the beginning with an appropriate grant of authority it could have worked with the chairman in negotiating the transaction. 

It could have observed how the price and structure was reached and ultimately approved the transaction (if it was comfortable with its fairness). 

The special committee could have made the recommendation to the stockholders while the full board, while disclosing its conflicts, refrained from recommending a vote one way or the other.  While this process (absent a majority of the minority vote), particularly if coupled with an independent fairness opinion, likely would not result in a judicial review using the business judgment rule, but likely would shift the burden to the plaintiff of proving that the transaction was not entirely fair in any litigation brought against the company and its board.  Generally, shifting the burden goes a long way to ultimately prevailing in the litigation.

Conclusion

Despite the clear value of special committees in mitigating litigation risk and ensuring proper corporate governance and decision making, family businesses have lagged behind their public company counterparts.

The use of special committees among public companies has been steadily increasing. A 2007 study by Boone and Mulherin found that for sale transactions of publicly traded companies, a special committee was utilized 34 per cent of the time, whereas, in 2003 this figure stood at a paltry 15 per cent. 

While we have been unable to find more recent studies on the matter, based on our observation of the market, we believe the use of special committees in public corporations has continued to increase.  

If family-owned companies are to be able to take advantage of the benefits of independent directors and special committees they will need to plan ahead.  Being in the midst of an acquisition transaction or a derivative litigation where an independent special committee has great legal utility is not the time to recruit independent directors. 

They need to have been recruited and integrated in to the board to have real benefit.  If they are in place and integrated the company has that great asset; optionality.  They can take advantage of the legal protection of a special committee or, determining that the risk to the process out-weighs the legal risk, they can have the full board involved in the matter.  But at that point at least the family has a choice.