The Myth of Director Independence Under Delaware Law: The Payment of $376,733 Does Not Result in a Loss of Director Independence
Delaware does not require that companies include independent directors on the board. It does, however, provide considerable benefits if they do. Boards with a majority of independent directors can ordinarily defeat efforts to show demand futility in derivative suits. Likewise, these boards, when they approve transactions involving a conflict of interest (CEO compensation, for example), are entitled to have the matter reviewed not under the more demanding duty of loyalty but under the almost insurmountable duty of care. For a discussion of this shift in the burden, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.
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.