Unlike a board in the pre-suit demand context,  SLC members are not given the benefit of the doubt as to their impartiality and objectivity. They, rather than plaintiffs, bear the burden of proving that there is no material question of fact about their independence. The composition of an SLC must be such that it fully convinces the Court that the SLC can act with integrity and objectivity, because the situation is typically one in which the board as a whole is incapable of impartially considering the merits of the suit.

The shift in the burden should have some impact on the outcome but the court made it very clear that identical factual allegations in the two contexts could result in different outcomes.

Thus, it is conceivable that a court might find a director to be independent in the pre-suit demand context but not independent in the Zapata context based on the same set of factual allegations made by the two parties. This is not because the substantive contours of the independence doctrine are different in these two contexts. Rather, it is primarily a function of the shift in the burden of proof from the plaintiff to the corporation when the suit moves from the pre-suit demand zone to the Zapata zone.

The description is an accurate description of the law in Delaware but hard to square legally.  The same allegations at the demand excusal stage must be made without the benefit of discovery.  Thus, the issue is only whether plaintiffs have raised sufficient concern to proceed with a further examination of the relationship.  This ought to require a low standard of proof.

In contrast, litigation surrounding the special litigation committee takes place after discovery.  In other words, the court in this case was acknowledging that the standard of review is higher for pre-discovery allegations than for post-discovery ones.  If anything, the analysis should be the other way around.

In any event, it should be plain that the admission that identical allegations can result in diametrically opposite findings with respect to director independence demonstrates that the determinations of board independence in Delaware does not mean that they are independent at all.

In other words, Salvatori had a past history with Tyrrell, the interested director, but there there was no affirmative evidence of any continuing relationship.  Nonetheless, the court concluded that reasonable doubts existed about the director's independence.

As noted, the independence of an SLC member may be impaired if that member feels he owes something to an interested director.  That sense of obligation does not have to be financial in nature. In this case, I believe there is a material question of fact as to Salvatori’s independence because his earlier associations with Tyrrell may have given rise to a sense of obligation or loyalty to him. Salvatori appears to have been satisfied with the price he received for QuesTech, and he continues to feel that Tyrrell was an important factor in securing that price. In saying this, I do not find that Salvatori in fact does feel a sense of obligation to Tyrrell, but there is certainly a strong possibility that he does, and that is enough under Zapata to preclude dismissal.

The conclusion contrasted sharply with allegations of excessive closeness made at the demand excusal stage where shareholders retained the burden.  In those circumstances, courts almost never find non-financial, non-family relationships to be sufficient to show a lack of independence.  In short, allegations of these same facts would likely not suffice to show a lack of independence at the demand excusal stage.

The Chancery Court acknowledged the lack of certainty as to whether the relationship really deprived the director of his independence.   

• I admit that it is not possible, at this stage of the proceedings, to say unequivocally that Vinter’s independence is impaired. On the one hand, the relationship between Vinter’s wife and Tyrrell does not seem to be particularly close. They do not frequently associate with one another as some cousins are wont to do. On the other hand, they do see each other regularly, albeit infrequently, at family functions. For example, each year Vinter and his wife attend a large family party at Tyrrell’s in honor of Tyrrell’s mother, who has passed away. Vinter also testified in his deposition that, while he did not see Tyrrell on a regular basis or personally discuss Tyrrell’s work with him before joining the iGov board, he “sort of knew where he was at any given time . . . .” Thus, the familial relationship appears to be close enough that Vinter has been kept apprised of Tyrrell’s comings and goings through the family grapevine.

Nonetheless, in a case where the burden rested with the board, these facts were enough to cause the court to question the director's independence.

• To my mind, there is a material question of fact as to how much Vinter’s family association with Tyrrell may have influenced his objectivity. I cannot say with certainty that Vinter would not have considered the potentially awkward situation of showing up to Tyrrell’s annual party after the family rumor mill had spread the word that Vinter had recommended that a lawsuit should proceed against the host. Therefore, I am not convinced, as I must be under Zapata, that Vinter’s recommendation would have been solely influenced by considerations of iGov’s best interests.

In other words, a not particularly close family relationship through the wife raised sufficient doubts about director independence.

This can be contrasted with the non-special litigation context, where shareholders retain the burden.  This same director would no doubt have been treated as independent. It is true, as the court noted, that "in the pre-suit demand context, plaintiffs can often meet their burden of establishing a lack of independence with a simple allegation of a familial relationship."  Yet on this point, the courts have been far from consistent.  See In re Oracle Corp., 824 A.2d 917, 939 (Del. Ch. 2003) ("Without backtracking from these general propositions, it would be less than candid if I did not admit that Delaware courts have applied these general standards in a manner that has been less than wholly consistent. Different decisions take a different view about the bias-producing potential of family relationships, not all of which can be explained by mere degrees of consanguinity."). 

Moreover, largely identical relationships have been found not to raise doubts about independence.  See Seibert v. Harper & Row, Publishers, Inc., 1984 Del. Ch. LEXIS 523, 1984 WL 21874 at *3 (Del. Ch. Dec. 5, 1984) (a director was not disabled from considering a demand where the director's cousin was a fellow director and a corporate manager).

This case demonstrates that allegations of family ties may or may not impair independence.  Allegations at the special committee stage will suffice; the same allegations at the demand excusal will not.  It is all but an admission that in some cases, directors with family relationships will be treated as independent even when they are not.  

Whatever the merits of this approach (and there aren't many), the standard ought to be premised upon a rigorous notion of independent directors.  Yet in fact it is not.  As we have noted often, Delaware allows non-independent directors to be treated as independent through the use of unreasonable pleading standards, a subjective definition of materiality, an all but impossible test for non-family friendships, and the categorical exclusion of fees. 

The result of this approach was made clear in a decision rendered earlier this year, London v. Tyrell, Civ. Action No. 3321-CC, Del. Ch., March 11, 2010.  The case was a thoughtful opinion involving the court's rejection of a report from a special litigation committee recommending that a derivative suit be dismissed. 

In employing the standard under Zapata, the court considered the independence of the directors serving on the committee.  The facts indicated doubt about their independence.  Nonetheless, the court had to wrestle with the fact that the evidence was, frankly, nowhere near enough to overcome the presumption of independence.  The court ultimately found a lack of independence, relying mostly on the burden of proof that, in the case of special litigation committees, remains with the board. 

The case revolved around the 2007 Equity Plan adopted by the board.  The plan called for the issuance of 300,000 options to various directors and senior executives.  Plaintiffs challenged the plan, alleging that it "was designed to substantially reduce their ownership interests in iGov and increase defendants’ interests to a level that would permit defendants to entrench themselves as iGov directors and managers."

Following a denial of a motion to dismiss for failing to make demand, the board formed a two person Special Committee to consider the litigation.  Discovery was stayed during the investigation.  The Committee ultimately recommended that the case be dismissed.  Plaintiffs asserted that the Committee recommendations had not met the standards set out in Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981).  Zapata allows a court to review the independence of SLC members and consider whether the SLC conducted a good faith investigation of reasonable scope that yielded reasonable bases supporting its conclusion.  Even where the process is deemed appropriate, the court may exercise its own business judgment to determine whether the corporation’s best interests would be served by dismissing the suit. 

After reviewing the evidence, the court concluded that there was a material question of fact as to the independence of both SLC members based on their relationship to Michael Tyrrell, iGov’s President, Chief Operating Officer, and Treasurer.  Of concern was the fact that the first SLC member, John Vinter, was married to Tyrrell’s cousin.  In addition, the court concluded that the SLC’s second member, Vincent Salvatori, had earlier associations with Tyrell that may have given rise to a sense of obligation or loyalty to Tyrrell.  As the court observed:

• In sum, the independence inquiry under Zapata is critically important if the SLC process is to remain a legitimate mechanism in our corporate law. SLC members should be selected with the utmost care to ensure that they can, in both fact and appearance, carry out the extraordinary responsibility placed on them to determine the merits of the suit and the best interests of the corporation, acting as proxy for a disabled board. In this case, I am not satisfied that the independence prong of the Zapata standard has been met.

The court also had concern with the reasonableness of the investigation.  Conducting a reasonable investigation required an investigation of "theories of recovery asserted in the plaintiffs’ complaint."  This required the Committee to "explore all relevant facts and sources of information that bear on the central allegations in the complaint." In addition, "the SLC must show that it correctly understood the law relevant to the case."

In this case, the court indicated a number of concerns with the investigation.  First, the Committee recommended that the duty of care claim be dismissed because of the presence of a waiver of liability provision.  The court found this unreasonable because this waiver of liability provision only eliminated money damages, not other kinds of relief.  The plaintiffs had sought additional relief, including recisssion of the 2007 Plan. 

As for the duty of loyalty claim, the court determined that the SLC had not conducted "a reasonably thorough investigation into defendants’ process for adopting the 2007 Plan" and, as a result, did not have a "reasonable bases for concluding that the process was fair." Likewise, the court concluded that there was a material question of fact as to whether the SLC had a reasonable basis for determining that the option exercise price used in the 2007 Plan was fair. 

Based upon the first prong of the Zapata test, the Court denied the SLC's motion to dismiss the derivative claim. 

The primary materials for this case may be found on the DU Corporate Governance website.

This authority, however, must be considered in light of Yucaipa v. Riggio, a case we will discuss soon on this Blog, and Selectica.  Selectica allowed companies to set triggers on a poison pill as low as 5%.  Yucaipa (the primary materials are here) upheld the right to use poison pills to prevent shareholders from organizing and agreeing on a common slate of directors, at least where the collective ownership of those in the group exceeded the poison pill trigger. 

We can forsee, therefore, an attempt by companies to limit access not through bylaws but through poison pills.  First, companies may try to set them at less than 5%.  Second, a low trigger will mean that nominating groups that exceed the 3% threshold may find themselves at risk for triggering the poison pill. 

It remains to be seen what will happen but the potential is clear. 

The most unexpected and severe requirement was the three year holding period.  The release is replete with statistics about the number of companies that have 3% shareholders (or two 1.5% shareholders) but there is no statistical analysis on how the three year holding period will impact those statistics.  More importantly, unlike many other portions of the release, the explanation was not strong.  The release noted that the "decision is based on our belief that holding securities for at least a three-year period better demonstrates a shareholder’s long term commitment and interest in the company."

That, of course, is a legitimate position.  But it doesn't explain the three year period.  For that, the Commission relied to some extent on the comments.  Yet commentators didn't really support a three year period.  As the release noted:

• We also based our decision to have a holding period longer than one year on the strong support of a variety of commenters.  For instance, we received comments that advised that we should “adopt a more reasonable holding period of at least two years,” and “a minimum holding period of at least two years is appropriate” because a “shorter holding period would allow shareholders with a short-term focus to nominate directors who, if elected, would be responsible for dealing with a company’s long-term issues.” Another commenter stated that “three years would be a more reasonable test with respect to longevity of stock ownership.” Although two commenters suggested even longer holding periods, we believe that a three year holding period reflects our goal of limiting use of the rule to significant, long-term holders and appropriately responds to commenters’ suggestions regarding the length of the holding period. In this regard, as noted previously, some commenters suggested a two year holding period, but others stated it should be “at least” two years. Given the support expressed for a significant holding period, we believe a three year holding period, rather than one or two years, strikes the appropriate balance in providing shareholders with a significant, long-term interest with the ability to have their nominees included in a company’s proxy materials while limiting the possibility of shareholders attempting to use Rule 14a-11 inappropriately, as discussed further below.

The Commission also reasoned that the three year period helped eliminate anyone with "a change of control intent with regard to the company."  The longer period, therefore, acted as "another safeguard against shareholders that may attempt to inappropriately use Rule 14a-11 as a means to quickly gain control of a company."

While the reasoning is sound enough, it could easily have justified a two rather than three year period.  Indeed, when Senator Dodd proposed amendments to the Commission's access authority, he proposed a two year holding period.

What is likely is that the Commission, rightfully, is reacting to the sensitivity of access.  The authority for the rule narrowly survived an attempt in Congress to limit its reach to 5% shareholders and shareholders with a two year holding period.  This reflected the fact that even Democrats were under pressure to reduce its impact.  The provision that came out of Congress ultimately gave the Commission all but unlimited authority, but the sensitivity could not be ignored.  By increasing the holding period, the Commission emphatically took away most of the concern that access would be a mechanism used by short term investors, perhaps the group feared the most by issuers.

Over time, evidence will develop about the impact of the three year threshold.  For now, it is a restriction designed to make access more palatable and on that score, probably a necessary one.     

What are the remaining roadblocks?  First, the Court emphasized over and over that this was a policy adopted by the board.  It left open the possibility that if adopted as a bylaw by shareholders (say under Rule 14a-8), the outcome might be different. 

Second, its not enough to show that the board refused to accept the letters of resignation.  The Court emphasized that this did not render inspections automatic.  Beyond a credible basis, shareholders needed to make additional showings.  Borrowing from Pershing Square, these included the requirement that:    

• that the information it seeks is necessary and essential to assessing whether a director is unsuitable to stand for reelection. Finally, access to board documents may be further limited by the need to protect confidential board communications. Thus, accepting that a desire to investigate the "suitability of a director" is a proper purpose does not necessarily expose corporations to greater risk of abuse.

In other words, even with a proper purpose and credible basis, access could still be denied if the documents requested were not "necessary and essential" or if they threatened to expose confidential board communications. 

Indeed, in Pershing Square, L.P. v. Ceridian Corp., 923 A.2d 810 (Del. Ch. 2007), the case used by the Supreme Court to develop the requisite standard, the Chancery Court refused to allow access to the requested document even though shareholders alleged a proper purpose.  The court viewed the harm of disclosure as outweighing any benefits.  As the court noted: 

• The potential harm to, and chilling effect on, the candid communications between high ranking executives and the board is significant. "If any stockholder can make public the preliminary discussions, opinions, and assessments of board members and other high-ranking employees, it will surely have a chilling effect on board deliberations" and on important relations and communications between directors and executives.

Given that most board proceedings are confidential, there is plenty of room for companies to deny inspection rights and raise as a primary defense the need to maintain secrecy.

Similarly, the requirement that the documents be necessary and essential provide ample room to deny inspection rights. 

In short, the Court was correct to overturn the analysis used by the Chancery Court.  But in its place is an approach that does not guarantee access to the materials that will enable shareholders to explore the actual reasons the board opted to refuse to accept the letters of resignation.  Indeed, the decision of the Court illustrates this in practice.  Although City of Westland Police met all of the requirements articulated by the Supreme Court, the Court nonetheless affirmed the Chancery Court's decision to deny inspection rights. 

Primary materials on this case are posted on the DU Corporate Governance web site.

Plaintiff argued that these types of decisions ought to be reviewed under the compelling justification standard set out in Blasius.  After all, the failure to accept the letters of resignation could easily have been said to interfere with the exercise of the franchise.  Had the plaintiff won on that issue, boards would have been required to meet a high standard in justifying the refusal.  The higher standard would potentially have made majority vote provisions meaningful. 

The Court, however, decided otherwise.  In dispensing with the argument, the Court gave only a single sentence of reasoning.  "We have concluded that Westland's Blasius argument lacks merit, because it improperly attempts to shift to Axcelis Westland's burden to establish a "proper purpose" for a Section 220 inspection."

But of course, it did no such thing.  The proper purpose requirement was met by showing that companies had a majority vote policy and that the directors refused to accept the letters submitted under the policy.  Applying the Blasius standard would do nothing more than give the board an affirmative defense, much the way that the board always has the right to establish that the shareholder's purpose is really improper. 

Instead, the Court opted for a different standard of review.  The issue was:

• whether the directors, as fiduciaries, made a disinterested, informed business judgment that the best interests of the corporation require the continued service of these directors, or whether the Board had some different, ulterior motivation.

In other words, plaintiffs had to show that the refusal to accept the letters of resignation was somehow a violation of the board's business judgment.  As has been described often and loudly, this is a process standard that ignores substantive behavior.  As long as the board uses proper process, any justification will do.  In short, the decisions will not be subject to meaningful review.  Directors will need to do little more than hold a meeting, conclude that the expertise and qualifications of the defeated directors are valuable, and decline to accept the letters of resignation.

The case demonstrates that majority vote provisions are a myth and do not actually give shareholders the power to defeat directors.  Preemption in this area will need to be a mandatory requirement that defeated directors either not be seated or resign within a short time (90 days in the Model Act). 

Primary materials on this case are posted on the DU Corporate Governance web site.

• completely rejected the idea that shareholders and companies should be allowed to opt out of the access regime;
• rejected the need for triggering events that had to occur before access became available, something that figured prominantly in the 2003 proposal;
• refused to set aside the right to access during a proxy contest;
• declined to exempt from access investment companies, controlled companies, companies voluntarily registering under Section 12(g), and non-accelerated issuers (although the rule provided for a delay for small companies);
• Limited the board's ability to exclude candidates,
• Allowed the board to disqualify candidates who were not independent based on the objective rather than subjective criteria adopted by the exchanges;
• Refused to require that nominees be independent or unaffiliated with the nominating shareholder or group; and
• Refused to limit the right of losing nominees to stand for reelection the following year.

All of these are areas where, had there been compromise afoot, the Commission could have come out differently.   There are still plenty of restrictions on access will reduce the rule's initial effectiveness.  But this approach does not reflect the influence of those on the Commission opposed to access, it is the way the Commission enters a new, and controversial area -- slowly and delicately.  Instead, time and time again, the rule reflects the wisdom of those who favor access but want to make sure that the implementation is deftly done.    

• We have concluded that the ability to include shareholder nominees in company proxy materials pursuant to Rule 14a-11  must be available to shareholders who are entitled under state law to nominate and elect directors, regardless of any provision of state law or a company’s governing documents that purports to waive or prohibit the use of Rule 14a-11.  . . .  if state law or a provision of the company’s governing documents were ever to prohibit a shareholder from making a nomination (as opposed to including a validly nominated individual in the company’s proxy materials), Rule 14a-11 would not require the company to include in its proxy materials information about, and the ability to vote for, any such nominee. The rule defers entirely to state law as to whether shareholders have the right to nominate directors and what voting rights shareholders have in the election of directors.

The irony in this is that the Delaware Supreme Court in Axcelis just made clear that the board had the authority to determine the suitability of directors.  Yet with a stroke of the pen, that authority has been removed, at least with respect to nominees that qualify under the access rule.

Delaware has, in the last two decades, done a yeoman's job in minimizing board duties and eviscerating shareholder rights.  While a Van Gorkom or Unocal was possible in the 1980s, Disney and other similar cases show that this is no longer the case.  Delaware may have always has a pro-management approach to corporate law, but cases such as Citigroup, Selectica, and Axcelis, suggest that the approach has shifted much further in that direction.  The approach is almost singularly responsible for the transfer of governance rights from the states to the federal government. 

Thus, Delaware's profligacy has essentially resulted in a loss of authority for the other 49 states.  Nor is there any hint that the process will slow.

Because shareholders did not nominate directors as a result of the federal proxy rules, state authorities never seriously considered restrictions on the right of shareholders to nominate directors.  Access, however, has flipped the issue back to the states.  The Commission has made it clear that nominees can be excluded where the shareholder is prohibited under state law.  To the extent, for example, Delaware wants to limit the right of shareholders to nominate (by, say, imposing an ownership threshold), it will have to do so explicitly.  It can no longer rely on federal law and the expenses associated with the proxy process to accomplish the same purpose.

Delaware has shown an amazing ability to respond quickly to developments disliked by management through legislative initiatives.  It will be interesting to see whether the legislature responds by amending the Delaware code to allow companies, in their foundational documents, to restrict the ability to nominate directors based upon ownership thresholds and holding periods. 

But first, we need to give credit where credit is due.  If it weren't for the take no prisoners attitude among the opponents to access, we would not be where we are today.  We would be dealing with a far less acceptable provision, one likely compromised by the need to compromise.  So we note a debt a gratitude to:

• The Chamber of Commerce for threatening litigation which essentially resulted in Congress including in Dodd Frank the unequivocal (and essentially unlimited) authority for the Commission with respect to access;
• The majority of the Commission in 2007 that declined to accept the modest proposal to allow an access bylaw, something that would have not been effective but would have taken the wind out of the sails of the pro-access movement. 
• The minority of the current Commission who opposed access at the time of proposal and at the time of adoption.  By making the opposition so clear and so intractable, there was no real reason to try to have the ultimate proposal adopted by the Commission reflect the views and interests of the dissenting commissioners.  Had the opposition been more willing to compromise, access would have contained far more compromises and would have been much weaker. 

These were major contributions to the development of access.  In truth, some form of access was inevitable (see The SEC, Corporate Governance, and Shareholder Access to the Board Room) but the precise contours were far from clear and could easily have resulted in a provision that was far less useful to shareholders. 

Because management vets the "independent" directors and because "independent" directors have an economic incentive to remain on the board (the payment of fees), there is always an argument that they are not truly independent and more likely to look out for the interests of management rather than shareholders.

This changes with access and the increased election of directors nominated by shareholders.   If these directors want to remain on the board, they have to act in the best interests of shareholders rather than management.

Access will be used only gradually and few access candidates will win in the beginning.  But over time, directors will know that if they are not sufficiently solicitous towards the views of shareholders, they will engender an access challenge and will potentially lose their position.  They have suddenly been given an incentive to act in the best interests of shareholders.

For a more detailed discussion of the promise of access, go here.