The Delaware Supreme Court’s recent decision in Gantler v. Stephens reemphasizes that, when considering the merits of a sale of a company, even non-management “outside” directors must be aware of potential conflicts of interest which might be viewed as affecting their independence—especially when one of the options implicates management’s own interests.

The breach-of-fiduciary suit alleged that ,after starting a process to solicit bids for the sale of the company, management and the board abandoned that process to pursue an alternative that benefited management and the directors at the expense of public shareholders.

Strikingly, the court found that abandoning the sales process—even apart from the subsequent approval of the going-private alternative—could itself constitute a breach of the directors’ duties. While purporting to reaffirm the traditional understanding that commencement of a process to “shop” the company does not give rise to an affirmative duty to sell, a combination of factors led the court to hold that, under the specific (and perhaps unusual) circumstances alleged, litigation over the decision not to sell should proceed to discovery.

The decision also covers a variety of other important issues, including the point that the fiduciary duties of corporate officers are essentially identical to those of directors, but this article will focus only on certain practical lessons which can be drawn from the alleged facts that prevented the outside directors from successfully invoking the protections of business-judgment rule at the very outset.

First, independent directors need to take control of the process when management’s own interests become involved. Here, no structural attempt was made to address the conflicts presented by management’s support for a going-private alternative. A single outside director was designated to chair a special committee, but he died, and the committee was never reconstituted. The conflicts the court found to affect the loyalty of two of the outside directors (that they were principals of vendors that did substantial business with the company, which was potentially at risk following a change of control) were perhaps not that substantial, but the lack of any recognition of other,more obvious, conflicts may have given the court a particularly jaundiced view of the directors’ independence.

Indeed, it was alleged that management had engaged in deliberate sabotage and had driven away a potential bidder, identified by the company’s financial adviser, by repeatedly failing to provide promised due diligence– thus illustrating the risks created by the directors’ failure to supervise or monitor management contacts with potential acquirers in a conflict situation. Even if particular outside directors are deemed independent for the purposes of stock-exchange listing rules, the board should carefully consider their independence in the context of the particular transaction (or alternatives) at hand.

Second, independent directors need to ensure that alternatives are thoughtfully considered and that this consideration is documented. Here, the only firm thirdparty bid that was obtained was allegedly rejected without any substantive discussion. While the bid’s terms were not necessarily so overwhelming (they included only a modest premium to market price) as to make rejection unjustifiable, no reasoned justification for the rejection appeared in the record. Even though the court formally held only that the allegations could establish a breach of the duty of loyalty, and declined to reach the separate issue of the duty of care, the court’s conclusion on the loyalty issue may have been colored by its perception of a sloppy and careless process. Since unacknowledged conflicts of interest provide a motive and explanation for process failures, the failures may themselves serve as indirect evidence suggesting disloyalty.

Third, from a risk management perspective, it is significant that the board in this case did not unanimously support the path taken. The dissenting director, who was also a substantial shareholder, ultimately left the board and joined with other shareholders in filing suit. Thus, the complaint had inside detail on the alleged flaws in process that might have been unavailable to a typical plaintiff. The lack of consensus should have made the majority and its advisers even more focused on ensuring that an appropriate and careful decision process was both followed and documented.

While the extent of process breakdown alleged here might have been unusual, the decision serves to refocus attention on the importance of process, including examination of even seemingly minor potential director conflicts, in anticipation of the next wave of transactional activity.

Stuart H. Gelfond is a corporate partner and David B. Hennes is a litigation partner resident in the New York office of Fried Frank Harris Shriver & Jacobson LLP.

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