First Circuit Raises the Bar for Independent Directors
The U.S. Court of Appeals for the First Circuit has ruled that two fund directors may not have been independent because of the fund sponsor’s significance in the local capital markets. The Court applied a very broad standard, opining that a court must consider “realism in analyzing human dynamics” and whether past and potential future relationships raised a reasonable doubt that the directors “could objectively evaluate without demand ‘without regard for’ inappropriate influences.” Of the 11 directors, four were clearly interested because they were employed by the defendants. The Court ruled that two others may not have been disinterested because they worked for an entity that used an affiliate of the defendants several years earlier as a placement agent in a capital raise. Additionally, the Court said that the directors may have feared alienating the defendants which are affiliated with the largest local asset manager, which the Court described as an “unusually pervasive” force in local capital markets. The case did not apply the Investment Company Act’s definition of “interested person” (Section 2(a)(19)) because the funds, sold only to Puerto Rican residents, were exempt from the Act. The case was brought as a derivative suit by pension plans investing in closed-end funds.
OUR TAKE: What is the impact of this case? It would appear to make it more difficult to designate a director as “independent.” We expect more questions on the annual director questionnaires asking about any connections with fund sponsors and whether the fund sponsor dominates local capital markets. On the other hand, this case did not apply the more bright-line test of the Investment Company Act. It is unclear which standard a court would apply in future derivative actions.