Section 952 of Dodd-Frank sought to regulate the definition of director independence. The provision required the board of listed companies to consider certain "factors" in determining the independence of directors serving on the compensation committee.  The statute required that the board consider:  

• a director’s source of compensation, including any consulting, advisory, or compensatory fee paid by the issuer; and
• whether a director is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.

The statute left open the possibility that other factors would be required. 

In adopting Rule 10C-1, the Commission did impose a specific set of factors.  Instead, the Agency left the matter to the stock exchanges.  See 17 CFR 240.10C-1(b) ("In determining independence requirements for members of compensation committees, the national securities exchanges and national securities associations shall consider relevant factors").  

Nonetheless, the Commission provided the exchanges with some advice.  First, the Agency described the two factors specified in the statute as "the same matters as the prohibitions in Section 10A(m)’s definition of audit committee independence".  Exchange Act Release No. 67220 (June 20, 2012).  This is not, however, quite true.  

Section 10A(m) provides that directors on the audit committee cannot "accept any consulting, advisory, or other compensatory fee from the issuer."  The language of the requirement does not extend to fees.  

The language in Section 10C, however, is much broader.  Independence requires consideration of the "director's source of compensation," something that explicitly includes any "consulting, advisory or compensatory fee."  Since directors receive fees as compensation, the amount will need to be considered in determining the independence of directors serving on the compensation committee.  This appears to be a significant change in the current analysis used by the board in determining independence. 

In addition, the adopting release indicated that the exchanges will need to go beyond the two factors set out in the statute.  As the release stated: 

in response to concerns noted by some commentators that significant shareholders may have other relationships with listed companies that would result in such shareholders’ interests not being aligned with those of other shareholders, we emphasize that it is important for exchanges to consider other ties between a listed issuer and a director, in addition to share ownership, that might impair the director’s judgment as a member of the compensation committee. For example, the exchanges might conclude that personal or business relationships between members of the compensation committee and the listed issuer’s executive officers should be addressed in the definition of independence.

The need to consider personal relationships would require the board to consider friendship and other non-financial ties.  This is currently not a requirement of the rules of the stock exchange. 

The lingering question is why the requirement should be limited to directors on the compensation committee.  To the extent a director on the audit or nominating committee also has a disqualifying personal relationship with the CEO, the director should not be treated as independent.  The exchange should, therefore, consider application of these factors to all independent directors.  

With respect to "business" relationships between directors and officers, the NYSE takes the position that these relationships already must be considered in determining director independence.  See The NYSE and the Problems of Director Independence ("representatives of the NYSE advised [the Company] that, in interpreting its rules, the NYSE believes relationships between a director and a member of senior management that are material to either party should be considered by a board of directors in its evaluation of a director’s independence.").

Yet the listing standard is not so explicit.  The standard merely requires the board to consider relationships between directors and the company, not directors and executive officers.  See NYSE 303A.02 (requiring board to consider any "material relationship with the listed company").   Given this language, at least one company has taken the position that "[p]ersonal business relationships between individuals (as opposed to relationships with the company) generally are not relevant to the independence tests under the New York Stock Exchange rules because they do not create a material relationship between a director and the company."  The statement (and the position) was later modified after communications from the exchange.  

Nonetheless, the requirement that the board consider "business relationships" between directors and executive officers ought to be made explicit in the listing standards.  Moreover, given the NYSE's position, the factor should be made applicable to the consideration of independence for all directors, not just those serving on the compensation committee.  

This requires plaintiffs to allege the amount of the payment and enough information about the financial background of the director to show that the payment was material to that director. 

Of course, the financial condition of a particular director is often not readily accessible.  In other words, directors are sometimes treated as independent not because they are but because plaintiffs do not have access to the information required by the courts.  This is true even when the payments are significant in size.  For more on this topic, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty. 

The other implication of the doctrine is that rich directors are always independent, irrespective of the size of the payment. This might colloquially be called the "Bill Gates" defense. 

With that in mind, we noticed a reference in a Delaware case from last year.  In MCG Capital Corp. v. Maginn, 2010 Del. Ch. LEXIS 87 (Del. Ch. May 5, 2010), the court had to consider the materiality of a large payment.  In finding that $750,000 was indeed material, the court noted the "Bill Gates" defense but rejected it because of the absence of evidence.  Id.  (“Admittedly, I have not been apprised of Maginn's net worth so I cannot make an exact determination as to the materiality of $ 750,000 to him. But I cannot conceive that it was so insignificant that he would simply overlook it for six years. There is nothing to suggest that he sits in the same economic strata as Warren Buffett or Bill Gates."). 

In Delaware, therefore, directors are independent even if they receive substantial fees, are friends of the CEO, serve on the board of non-profits that receive substantial contributions from the company (or its foundation), and if they are in the same economic strata as Bill Gates. 

The analysis in the case is not unlike the analysis used in Disney.  That is the case where the court found the board to be independent despite having directors with numerous financial and other connections to the company.  While the Delaware court considered the board independent, this is how the Economist described the same board: 

• Back then, Disney’s board might easily have been mistaken for a pair of Snow White’s dwarf pals (specifically, Sleepy and Dopey). At one point, its directors included an architect friend of Mr Eisner and a local schoolteacher. This made it a target of shareholder activists who, after a series of corporate scandals at other firms with insufficiently accountable bosses, campaigned for big changes in how all American firms were governed.

The analysis in Goldman is similar.  The court ignored a number of business, financial and other relationships between the Company (or its Foundation) and the directors.  At the pleading stage, plaintiffs are not obligated to show that directors lack independence, only that there is reasonable doubt about independence.  Hundreds of thousands of dollars of charitable contributions and hundreds of millions of dollars of business, in the unique eyes of the Delaware courts, was not enough to meet this burden. 

Primary materials, including the decision in the case, can be found at the DU Corporate Governance web site. 

The analysis in Goldman continues an unfortunate trend in the jurisprudence arising out of Delaware.  The courts have accepted the proposition that boards can receive considerable deference in their decision making if inhabited by a majority of independent directors.  This is particularly true with respect to decisions under the duty of loyalty.  Boards with a majority of independent directors are not obligated to show the fairness of the transaction but instead are given the benefit of the almost insurmountable presumption of the business judgment rule. 

The approach is flawed because it assumes away the influence of the interested director and any directors subject to his or her control.  But even without this concern, the approach is built around the idea that boards possess directors who are indifferent enough to the position that they can risk the irritation of management (and the possible loss of the position) in order to protect the interests of shareholders.

Delaware courts, however, already treat as independent directors who have considerable incentive to "reliably" support management.  These are directors who are friends of management or who receive substantial fees.  Goldman stretched the analysis even further to include as independent directors who sit on the boards of exempt organizations even where their exempt organization receives substantial contributions from the company.  Similarly, directors will be treated as independent even if they serve as an officer, principle, or manager of another entity that receives or obtains hundreds of millions of dollars of business from the company. 

Goldman, like Disney before it, shows that the term "independent" is mostly an arbitrary term that does not at all ensure the protection of the interests of shareholders.  The inevitable result of this system of jurisprudence will be further preemption of Delware law.  Already Congress has transferred some authority to the SEC to define the factors that boards of listed companies must consider in determining director independence.  Eventually it will be the federal definition that will matter more than the state one.    

Those who favor leaving governance issues at the state level should be the most concerned about this approach to jurisprudence.  In re Goldman represents a short term victory for management and a long term loss for Delaware.   

Primary materials, including the decision in the case, can be found at the DU Corporate Governance web site.

The contributions alleged to have deprived the directors of their independence for the most part came not directly from Goldman but from the Goldman Foundation.  The court, however, held that the plaintiffs had not cast “a reasonable doubt in regard to the Goldman Foundation’s independence from Goldman." 

Plaintiffs alleged that four of the eight board members “are or were managing directors of the Company.”  The court concluded that the careful language meant that at least one of the four directors “is no longer a managing director of Goldman; therefore, the Goldman Foundation’s board had at least four members unaffiliated with Goldman and at least one member who was no longer affiliated with Goldman.”  The court found this structure to be insufficient to demonstrate control by Goldman over the Foundation.  “Without more, I have no basis to make an inference that Goldman’s management dominated or controlled the Goldman Foundation.”

But in fact there was more.  The allegations of control made by plaintiffs were far more detailed than what the court described in a single footnote in the opinion.  According to the complaint, all of the funding for the Foundation came from Goldman.  See paragraph 154.  The offices are located at Goldman's principle place of business.  See paragraph 155.  Six of the ten non-employee directors of the Foundation are members of boards of exempt organizations that received "substantial" donations from the Foundation.  See paragraph 156. 

Apparently, however, these factors were irrelevant.  Instead, the analysis suggested that independence of a corporate foundation depended solely on the number of "independent" directors of the foundation.  The approach provides a road map for corporations wanting to give contributions to exempt organizations supported by directors without resulting in a loss of independence. 

They need only set up a foundation that has a majority of "independent" directors then fund the foundation.  Moreover, with the court concluded that the Foundation was not under the control of Goldman, it presumably would have found payments made from the Foundation directly to the directors as having no impact on the independence analysis.   In other words, even those directors who obtain a pecuniary gain from the foundation would, under this analysis, still be independent of the company. 

The approach, therefore, sets the stage for treating as independent an even broader category of directors connected to exempt organizations. 

Primary materials, including the decision in the case, can be found at the DU Corporate Governance web site.

Four of the directors on the Goldman board were alleged to have lost their independence because of charitable contributions made by Goldman to non-profits where they had significant contacts.  Thus, one director chaired a campaign to raise money for the Chicago Lyric Opera House and served as a trustee for the University of Chicago.  The Goldman Foundation donated a “substantial” amount to the former and $400,000 to the latter. 

The court, however, found that this did not impair a director’s independence.  Where the director “did not receive a salary for his work and did not actively solicit donations from the defendant corporation,” the existence of contributions did not demonstrate that the director was “incapable of ‘exercising independent judgment.’”  Nor did plaintiffs provide a “ratio” of the donations by the Goldman Foundation to all donations in order to show the materiality of the amount.  “Crucially, the Plaintiffs fail to provide any information on how the amounts given influenced [director’s] decision-making process.”  

Using the same reasoning, the court found that plaintiffs had not established reasonable doubt where a a director chaired the board of a business school in India that received $1.6 million from the Goldman Foundation and sat on the board of a School of Management and Economics in China that received $3.5 million.  Similarly, reasonable doubt was not established for a director who served as an honorary trustee of a think tank that received $100,000, a director who sat on the board of a charitable organization that received $400,000, and a director who sat on a university board as an emeritus trustee paid $675,000.  

Finally, Goldman gave $200,000 to a University where one of the directors served as president.   The court conceded that the director’s livelihood “directly” depended upon fundraising abilities.  Plaintiffs, however, failed to show that the amount received as material.  As the court reasoned: 

• The Plaintiffs provide the amount donated to [the university], but do not give any additional information showing the materiality of the donation to [the university]. The Plaintiffs do not provide the percentage this amount represented of the total amount raised by [the university], or even how this amount was material to the [particular project that received the funds].  Additionally, the Plaintiffs’ allegations do not provide information that [the director] actively solicited this amount or how this or potential future donations would affect [the director]. The facts pled are insufficient to raise the inference that [the director] feels obligated to the foundation or Goldman management.
  

There are many many things wrong with this analysis. 

First, the court seemed to impose on plaintiffs an obligation to show that the funds were solicited by the relevant director for the particular non-profit.  Active solicitation is, for the most part, impossible to show based upon the information in the public domain.  More to the point, the donations speak for themselves.  The Goldman Foundation has an almost unlimited choice when it comes to donations.  The fact that the Foundation chose to give to non-profits directly connected to directors is sufficient to show at the pleading stage that there is a connection between the director and the contribution. Discovery might reveal that the correlation was entirely coincidental.  But at the pleading stage, plaintiffs demonstrated a sufficient nexus.  

Second, even had plaintiffs shown active solicitation of the gifts, the court made it clear that the real obligation was to show how the gifts influenced board behavior.  Because it is obvious that directors with strong connection to a non-profit would at least psychologically benefit from ensuring large gifts to the non-profit and in most case would benefit reputationally, the court was all but saying that these grounds were not a sufficient basis for showing a lack of independence.  It is reminiscent of the Disney decisions that for a time said that friendship was never a ground for showing a lack of independence.

Instead, the court was all but saying that charitable contributions do not impair independence unless there was a pecuniary benefit to the director.  Because directors who sit on non-profits are almost always unpaid, rarely if ever will there be a direct pecuniary benefit.  The court, therefore, was all but saying that director sitting on the board of a nonprofit would never lose his or her independence because of contributions made by the company.  This, therefore, represents another category of directors likely to be "reliable" yet treated by the Delaware courts as independent.  

Primary materials, including the decision in the case, can be found at the DU Corporate Governance web site. 

One director on the Goldman board was alleged to be the CEO of a company that borrowed a considerable amount from Goldman.  Those allegations were not enough to raise reasonable doubt about director independence.  The court considered other types of business relationships and also found that they did not raise the requisite reasonable doubts.  In doing so, the court advanced an analysis not previously used in Delaware.   

Plaintiffs also alleged that Goldman had "invested at least $670 million in funds managed by” another director.  The amount was significant and presumably generated a not insubstantial asset management fee. 

In assessing the impact of this business relationship, the court abandoned the traditional approach used by the Delaware courts.  The court did not consider the materiality of any income obtained by the director as a result of Goldman's investment.  Instead, the court used a new standard.  It would impair the director's independence if it was necessary for the director's "livelihood."   As the court stated:   “[T]he complaint does not allege that Friedman relies on the management of these funds for his livelihood; that contention, if buttressed by factual allegations in the complaint, might reasonably demonstrate lack of independence.”

The meaning of "livelihood" was not spelled out by the court.  A conventional defintion looks to what is necessary to sustain one's existence.  The standard seems far more narrow that materiality, which merely seeks to determine whether the amount is "important."  The approach suggests that directors can receive substantial economic benefits from the company where they sit on the board yet still be treated as independent. 

Primary materials, including the decision in the case, can be found at the DU Corporate Governance web site. 

Boards of public companies at one time consisted mostly of insiders and other persons with material financial relationships with the company (suppliers, lawyers, customers, etc).  These directors could be counted on to reliably support the CEO.  As the need for board independence grew, however, these categories of directors gradually disappeared.  While the definition of independent director evolved, the central theme was that it did not include directors who had significant economic ties to the company. 

In re Goldman, however, provided an avenue for the return to the board of these directors.  the court did so by simply finding that the significant relationships did not impair director independence. 

One of the Goldman directors served as chairman and CEO of ArcelorMittal, a large integrated stell and mining company.   Plaintiffs alleged that  “Goldman has arranged or provided billions of euros in financing to [this director's] company” and that “[d]uring 2007 and 2008 alone, [Goldman] had made loans to ArcelorMittal [sic] in the aggregate amount of 464 million euros.”  By any standards, the relationship looked significant.  Nonetheless, the court concluded that the business relationtionship was not sufficient to cast a "reasonable doubt" about the independence of the director.  

• Goldman is an investment bank. The fact “[t]hat it provided financing to large . . . companies should come as no shock to anyone. Yet this is all that the plaintiffs allege.”  The Plaintiffs fail to plead facts that show anything other than a series of market transactions occurred between AcelorMittal and Goldman. For instance, the Plaintiffs have not alleged that AcelorMittal is receiving a discounted interest rate on the loans from Goldman, that Mittal was unable to receive financing from any other lender, or that loans from Goldman compose a substantial part of ArcelorMittal’s funding.

In other words, the court considered the size of the loan largely irrelevant.  Independence would be lost if plaintiffs could allege at the pleading stage that the loans was made on favorable terms (presumably more favorable than would have been given by other lenders) or that it was a "substantial part" of the overall funding of the company (irrespective of the company's particular need for funding). 

The ability to show that a loan was more favorable was, in most cases, an impossible standard at the pleading stage.  Any "discount" on the interest rate would not be apparent from the actual rate charged by Goldman.  Even if the company obtained a loan at the market rate of interest, the rate could still have been discounted if the company had a higher risk profile.  Only by knowning the actual considerations used by Goldman to price the loan could a plaintiff determine whether the terms were excessively favorable.  That kind of information at the pleading stage would not likely be available.  

More importantly, however, the analysis ignored the obvious reality.  ArcelorMittal would presumably not have borrowed the money from Goldman unless it was on the most favorable terms possible.  In other words, if ArcelorMittal could have gotten the loan from another lender on better terms, it presumably would have done so.  Thus, at the pleading stage, when plaintiffs only must show a reasonable doubt about independence, the presumption ought to be that ArcelorMittal in fact received a loan from Goldman on the most favorable terms possible.  That ought to be enough to establish reasonable doubt, with discovery ultimately available to determine whether the loan was as favorable or more favorable than what other lenders would have provided. 

The Delaware court has essentially stepped back in time.  The court has allowed directors to be treated as independent despite these substantial business relationships.  In other words, they are treating as independent the very class of directors that the definition of independence was largely designed to eliminate. 

Primary materials, including the decision in the case, can be found at the DU Corporate Governance web site. 

The idea is that a board with a majority of independent directors is not beholden to the person with the conflict of interest (usually the CEO) and make a decision that is in the best interests of shareholders.  As long as there are a majority of independent directors, courts should defer to their decisions.

Management, however, has a competing set of pressures.  It prefers directors who are in fact "reliable," that is unlikely to interfere with or overturn the their decisions.  See Essay: Neutralizing the Board of Directors and the Impact on Diversity 

Reliability, however, is the antithesis of independent.  Yet there are categories of directors who are both "reliable" and considered independent.  For example, Delaware courts do not really take into account friendship when determining director independence.  As a result, boards are often populated by people with social ties to management yet treated as independent.

Similarly, the courts do not take into account all material income streams when determining independence.  Fees, for example, don't count in determining independence.  Directors can, therefore, earn more than than $1 million in total compensaiton (see Apple for example), yet be treated as independent.  All of this is chronicled in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.  

A recent case has added two additional categories of "reliable" yet "independent" directors.  In In re Goldman, the court essentially held that persons associated with non-profits would not lose their independence even when the company where they served as director contributed sizable and material amounts of money to their non-profit.  It was if the contributions were irrelevant to the director, something anyone who sits on a nonprofit board knows is not the case.

In addition, the court held that directors who were officers (or principles) at other entities would not lose their independence even where the entity had substantial business relations with the company where they served on the board.  Thus, plaintiffs alleged that one of the directors also served as CEO of a company that borrowed a substantial amount from Goldman.  The court found the relationship insufficient to create a reasonable doubt about director independence.  

The analysis in Goldman expands the categories of directors who have substantial connections to the company that can be terminated by the CEO yet are treated as indendent of the CEO. 

We will explore this case in greater detail in the next few posts.  Primary materials can be found at the DU Corporate Governance web site. 

The definition of independent, therefore, is all important.  Yet in fact, Delaware employs a definition that in practice does not guarantee directors are in fact independent.  Take directors fees.  While in theory a director loses his or her independence if receiving a material income stream from the company (because it can be terminated by the CEO), the analysis does not apply to fees.  This is the case even if the payments are subjectively material to the director.  As one Delaware case explained, to hold otherwise would discourage "regular folk" from sitting on the board.

This can be seen from the decision in Security Police and Fire Professionals of America Retirement Fund v. Mack, 2010 NY Slip Op 20499 (S. Ct. Dec. 9, 2010), a New York case applying Delaware law.  In that case, the court had to consider whether fees deprived directors of their independence.  The fees paid to directors varied from $ 325,000 to $ 376,733.  Relying on Delaware law, the court first noted that "[t]he allegation that directors are paid fees for their services, without more, does not establish lack of independence." 

The "more" that was needed had nothing to do with the importance of the fees to the individual directors.  Instead, to establish that the payments resulted in a loss of independence, plaintiffs had to show that they were not "usual and customary."  In other words, when it came to fees, the courts declined to apply the test of subjective materiality, the standard applicable to all other payments made by the company to directors.  As for usual and customary, the court determined that plaintiffs had not alleged that these payments were outside the realm of usual and customary.  Apparently $ 325,000 to $ 376,733 was on its face customary.

The approach shows the intellectual weakness in the approach used by the Delaware courts.  The law in is premised on the idea that independent boards can protect the interests of shareholders because they are free from influence of executive management.  The law in turn seeks to ensure a lack of excessive influence by disqualifying any material income stream controlled by the CEO. 

But when it comes to fees -- fees in the vicinity of $400,000 -- the courts apply a completely different test that in no way looks to the degree of control exercised by the CEO.  Instead, the courts simply ask whethe the amounts are typical of what other companies pay, a standard divorced from the degree of influence possessed by management.  In short, treating at least some of these directors as guardians of the interests of shareholders is at best misguided and at worst misleading.

A recent memorandum from Wachtell Lipton took issue with the contention that friends of the CEO (or other directors) should not serve as independent directors.  As the memorandum stated:  

• friends can and should be independent directors. There is absolutely no basis for second-guessing a board’s reasonable determination that a friend of the CEO, or a friend of another director, is independent. 

It may be the case that friends of the CEO bring to the board some skills or knowledge base that would be useful.  It may also be the case that friends of the CEO in some instances contribute to the collegial nature of the board. 

But that is not the issue.  The issue is whether close friends of the CEO should be counted as independent.  The answer is (as in the case with family relationships) at least sometimes, no.  Depending upon the nature of the friendship (live in companion, best friends from elementary school, etc), there can be serious doubt as to whether the director can decide matters free of the relationship.

Does this mean such an individual cannot be on the board?  Again, no.  Boards of exchange traded companies need only have a majority of independent directors.  There is plenty of room for friends, even close ones, just not in the 51% that are supposed to be independent. 

The Complaint alleges (the outside directors have not settled or otherwise resolved the case so the allegations in the Complaint are unproven) that the outside directors became aware of possible disclosure issues.  One concerned business activity with a related entity (a company allegedly controlled by the CEO).

An  investigation was initiated to look into the matter.  The investigation was conducted by a prominent outside law firm (and eventually a second prominent outside law firm).  The fatal mistake in the eyes of teh Commission was that the outside directors allegedly allowed the CEO to supervise the investigation.  As the Complaint stated:

• Instead of conducting an independent investigation into [the Company's] relationship with TAP [the controlled company], [the three outside directors] allowed [the CEO] to commission and control an investigation into the issue, which essentially allowed senior management to investigate itself. . .  [The CEO controlled]  inquiry, including the flow of documents and information and access to witnesses.  [The outside directors] were never involved in the investigation.

The CEO also "updated" the Audit Committee on the investigation. 

The report for the investigation ultimately recommended disclosure of the relationship with the controlled entity.  Nonetheless, the Commission viewed the investigative report as incomplete.  As the Complaint alleged:   

• The report made no findings about the legitimacy or business purpose of the arrangement. It merely noted that [the Company's] "management believes that the prices TAP [the controlled entity] charged were fair prices established in good faith" and based on the information provided (which was provided by [the Company's] management) the firm found no evidence that [the Company's] relationship with TAP was designed to create artificial gains or losses. The report made no findings regarding Brooks' involvement with TAP, or [the Company's] failure to inform its auditors about the arrangement.  [The outside directors] received the law firm's report, but did not question any of the key issues.

Eventually, according to the Complaint, the outside directors learned that the initial law firm had resigned.  The resignation letter (sent to the outside directors) called the firm's report "into question."  The firm indicated that it had "discovered previously undisclosed information about the [Company's relationship with the controlled entity], which raised 'further questions bearing on issues of control and relatedness that warrant further review.'"

A second law firm and consulting firm was hired to look into the issue, with "coordination" left to the CEO.  The Commission also alleged that this process was deficient.  As the Complaint stated:

• Given that [the CEO] controlled [Consultant's] investigation and the investigation relied upon information he provided, [Consultant's] investigation was not independent and its findings were not reliable. Despite [the first law firm's] resignation and revelation [the CEO] withheld information from [the first law firm], the Audit Committee still allowed [the CEO] to oversee and control [the Consultant's] inquiry into [the controlled entity].

The fact that it was a second firm, in the opinion of the Commission, heightened the duties of the board.  As the Complaint further stated:

• Even though [the Consultant's] inquiry was conducted on the heels of [the first law firm's] resignation, [the outside directors] did not question or meet with [the Consultant] during its investigation. Nor did they ever question [the CEO] about the parameters of [the Consultant's] investigation, or about the information [the CEO] was providing to [the Consultant]. Moreover, they did not question the report's findings.

The Complaint, therefore, indicates that the antifraud provisions (under theories of secondary liability) may impose a duty on outside directors to adequately supervise internal investigations that could affect the disclosure process. 

For more detail, see the Litigation Release in SEC v. Krantz, Litigation Release No. 21867 (SD Fla Feb. 28, 2011) as well as the Complaint.

The Complaint (which contains only allegations since the case hasn't settled or otherwise been resolved on the merits) criticized the outside directors on the audit committee because they did not understand their function.  As the document stated, the outside directors "made little or no effort even to understand their Audit Committee responsibilities."

In addition, however, the outside directors were told by their auditors about problems with the Company's system of internal controls.  One auditing firm resigned and, on the same day, issued a material weakness letter to the committee concerning the internal controls.  As the complaint stated:

• The auditors' concerns focused on understaffing in [Company's] accounting department, [Company's] lack of a comprehensive or formal inventory management system, and the Company's failure to disclose TAP [a company allegedly controlled by the CEO] as a related entity. In its material weakness letter, [the firm] stated "there is currently no review process in place to ensure that data is entered into the system accurately and that inventory balances at any point in time are stated fairly. We recommend that the Company acquire and implement a comprehensive inventory management system to assist management in properly managing and controlling inventory in a consistent and organized manner."

The replacement auditors likewise reported problems with the Company's controls to the audit committee.  Again, as the complaint stated: 

• [The auditors] informed the Audit Committee that [the Company's] inventory tracking system was inadequate and that the Company needed a comprehensive inventory management system. In late March or early April 2004, [the firm] told [the Company] and the Audit Committee to retain a CFO for the Company's Florida operations, a Director of Financial Reporting, a cost accountant responsible for inventory cost accounting and reporting, and they wanted a new financial expert, instead of [one of the outside directors], to serve on the Audit Committee.

The outside directors apparently failed to heed the concerns expressed by the auditors, but not entirely.  The company did hire a new controller. 

Problems with inventory valuation ultimately had serious consequences.  The Complaint alleged that the inventories were overvalued:

• by approximately $24 million in 2003 and approximately $30 million in 2004, and caused the Company to materially overvalue its inventories by approximately $33 million in its quarterly report as of September 2005. By overvaluing its inventories, DHB also materially overstated its reported gross profit and net income during these periods.

In other words, the Commission is sending a very clear message that directors must know their duties and must heed warnings about failures in the system of internal controls. Audit committees cannot assume that the auditor will correct the problem.  Failing to do so can result in charges under the antifraud provisions.

For more detail, see the Litigation Release in SEC v. Krantz, Litigation Release No. 21867 (SD Fla Feb. 28, 2011) as well as the Complaint.

The issue of director independence came up in SEC v. Krantz.  The SEC asserted in the Complaint (the case has not settled or been tried, so these are only allegations) that the outside directors at DHB lacked sufficient "impartiality" to serve as independent directors on the audit committee.  As the complaint described:

• They were [the CEO's] longtime friends and neighbors, with personal relationships with [the CEO] that spanned decades. [A director] lived close to [the CEO], and he and his family went out to dinner with [the CEO] and the [the CEO's] family two or three times a month.  A director and his family had a social relationship with [the CEO] and the [the CEO's] family, and regularly attended [the CEO's] family social functions. [A director] had a relationship with [the CEO] starting in 1998 or 1999, and was [the CEO's] insurance agent before [the CEO] asked him to join [Company's] board.

In addition, the outside directors allegedly had various business dealings with the Company and/or the CEO. 

Yet the Company's proxy statement in 2004 represented that these directors met the applicable standard for independence.  See DHB Proxy Statement filed in 2005 states ("In 2004, each of these Committees was comprised of three directors, [the three outside directors], who are not officers of DHB and who are all independent directors as defined under Section 121(A) of the listing standards of the American Stock Exchange and under Rule 10A-3 under the Securities Exchange Act of 1934, as amended.").

There are two ways to interpret the characterization in the 2004 proxy statement.  First, the characterization was wrong and the directors were not independent under the stock exchange rule.  Second, the directors were in fact independent under the stock exchange rules.  In the former case, the problem is one of enforcement.  In the latter case, the problem is the stock exchange definition.   Either way, its suggests issues with director independence at the exchange level. 

For more detail, see the Litigation Release in SEC v. Krantz, Litigation Release No. 21867 (SD Fla Feb. 28, 2011) as well as the Complaint. 

The court attempted to explain the difference in the standards applicable in the context of special litigation committees and demand excusal.  

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.