Top Top 10 Reasons Why “Independent” Directors Are Not Independent Under Delaware Law

Delaware law provides substantial benefits to companies with boards consisting of a majority of independent directors.  In the case of transactions not involving a controlling shareholder, courts analyze conflict of interest transactions under the duty of care and the business judgment rule.  In demand excusal cases, demand will not be excused where the board has a majority of independent directors.  Yet despite providing these advantages, an analysis of Delaware decisions indicates that, in practice, the test (and the application of the test) for independence does not ensure that directors are in fact independent.  This issue is discussed at length here.   

The topic is a large one and will be addressed throughout the life of this Blog.  Still, we start today with a list of the top reasons why directors treated as independent under Delaware Law are in fact often not independent. 

1. Delaware courts use a subjective test for defining director independence then disregard it when convenient (such as the categorical exclusion of fees);

2. Delaware courts effectively exclude from the analysis of independence personal relationships (other than those arising from family bonds);

3. Delaware courts largely treat as independent directors employed by non-profit organizations where the non-profit receives substantial contributions from the company (or its employees);

4. Delaware courts impose unreasonable pleading standards, frequently terminating the analysis of independence at the motion to dismiss stage, precluding the use of discovery as a means of uncovering a director’s actual relationship with the company or CEO;

5. Delaware courts typically examine each allegation of non-independence in isolation, without weighing all of the factors together;

6. Delaware courts make factual determinations in connection with the analysis of independent directors on motions to dismiss;

7. Delaware courts discourage challenges to independence by all but requiring plaintiffs to first invoke their inspection rights, a step that adds costs and delay without yielding appreciable benefits;

8. Delaware courts rely on the standards employed by the stock exchanges to justify findings of independence, without discussing the differences in the standards;

9. Delaware courts routinely disregard information suggesting a lack of independence at the motion to dismiss stage; and

10. Delaware courts routinely require, on a motion to dismiss, that plaintiffs produce information about independence that cannot be obtained in the public domain.

The Problem of Director Fees

Irrespective of where one stands on corporate governance issues, independent directors have attained an almost talismanic role. The NYSE requires that the boards of listed companies have a majority of independent directors. Delaware provides that conflict of interest transactions approved by a majority of independent directors are  entitled to the protection of the business judgment rule, eliminating judicial review of fairness.  

Both Delaware and the NYSE employ definitions that do not ensure directors are independent.  There are numerous examples but an obvious one concerns fees paid to directors. The NYSE definition provides that a director will not be independent if he or she receives more than $100,000 from the company in direct compensation  during any 12 month period within the prior three years. In computing this amount, however, the definition specifically excludes "director and committee fees." The Delaware courts have likewise adopted something approaching a categorical rule that fees do not deprive directors of their independence.

A study of director pay by The Corporate Library of the 25 highest paid directors in 2004-2005 revealed that those directors received compensation ranging from $1.169 million to $5.873 million. Despite the sums, a number of directors on the list were labeled independent in their company's proxy statement. For example, the table included five directors from Telewest.   According to the Corporate Library Study, the five received compensation in excess of $1 million each. The same proxy statement labeled all five directors as independent.  Moreover, the trend in compensation is upward. The study (examining 16,623 directors of public companies) concluded that the average increase was 39.77% from 2003/2004 to 2004/2005. 

Common sense would suggest that such significant amounts of compensation would, at least in some cases, create doubt as to whether directors could make decisions “based on the corporate merits of the subject . . . rather than extraneous considerations or influences,” Aronson, 473 A.2d at 816, or amount to a disqualifying "material relationship with the listed company." NYSE Manual 303A.02. 

It has not always been easy to figure out what directors earn from the proxy statements of public companies. That should change. Implementation of the amendments to Item 402 of Regulation S-K now require that companies provide a table showing total compensation paid to directors. See Item 402(k) of Regulation S-K. This blog will follow this development and provide examples of highly paid directors treated as independent.

Personal Relationships and Director Independence

In In re Oracle Corp. Derivative Litig., 824 A.2d 917  (Del. Ch. 2003), the Delaware Chancery Court for the first time found that directors on a Special Litigation Committee lacked independence because of non-family, non-financial relationships.  The case invovled two professors at Stanford University and their consideration of a derivative suit brought against, among others, another professor from the same university and an individual who had apparently considered significant donations to the university in the past. 

Whether the reasoning survives the analysis in Beam v. Stewart, 845 A.2d 1040 (Del. 2004), is an open question.  This case forced corporations to recognize the importance of corporate governance. More importantly, the case spoke directly to corporate director accountability to shareholders. To learn more about the case please see the link to the following article. The primary material for this case may be found on the DU Corporate Governance website.