We are discussing In re InfoUSA, a recent case arising out of the Delaware Chancery Court. The primary materials for the case, including the opinion, can be found at the DU Corporate Governance web site. Much of the case centers around alleged self dealing by the CEO. The court ultimately allowed the case to go forward not on the strength of the allegations relating to the self interested behavior but because plaintiffs had alleged sufficient facts cast reasonable doubt on the independence of the board of directors. To get there, however, the court had to take a very non-traditional approach towards the definition of independence.

Directors lose their independence when they are "beholden" to an interested director. When the case involves the CEO, a director is beholden where he or she receives a material amount of income from the company that can be terminated by the CEO. For a paper that goes into this topic in greater detail, Disloyalty without Limits: "Independent Directors" and the Elimination of the Duty of Loyalty, go here.

Where the director receives the payment directly (say in the form of compensation under a consulting agreement), the analysis is relatively straightforward. Plainitffs must show that the payments were material, with the test applied on a subjective basis. Payments made to an entity like a law firm are less straightforward. In general, the payments must either be material to the entity or must result in a material payment to the director. To show that they result in a material payment to the director is a particularly onerous burden at the pleading stage. In general, plaintiffs must show the amount of the payment that went to the director and the director's net worth.

This information is usually not available at the pleading stage so Delaware courts routinely dismiss these types of challenges, even when the payment to the entity is substantial. Thus, for example, Chancellor Chandler (the same one deciding InfoUSA) addressed the allegations that former Senator Mitchell, a director on the board of Disney, lost his independence in part because he was special counsel to a law firm that received $122,764 from Disney in 1996. The claim was summarily dismissed because "Plaintiffs have not indicated that Mitchell, as 'special counsel' (and not 'partner') shared in the legal fees paid to his firm." In re Walt Disney Co. Derivative Litig., 731 A.2d 342, 360 (Del. Ch. 1998), rev'd on other grounds, 746 A.2d 244 (Del. 2000). In other words, the court did not rule out the possibility that Mitchell received a material payment, only that the plaintiffs had not alleged facts that would establish that this occurred. The opinion had no comment on how plaintiffs were to learn about the revenue allocation policies of a law firm.

InfoUSA, in contrast, came out quite differently. One of the directors, Kaplan, was a partner in a law firm that received an fees from the company averaging $500,000 per year between 2002 and 2005. Plaintiffs, however, did not plead other facts showing the importance of the payment to the law firm or to Kaplan. See Defendants' Opening Memorandum, at 27 ("Moreover, Plaintiffs have not pled anything establishing the materiality of the fees paid to the law firm or Kaplan's interest in those fees."). Based upon the unreasonable standards imposed under Delaware law, the allegations of significant payments alone would ordinarily not be enough to get past a motion to dismiss.

The court, however, concluded otherwise, finding that the mere allegation of the payment of fees to the law firm (which it described as a "miniscule proportion of the firm's total revenues) was enough to cast doubt about Kaplan's independence. How did the opinion get around the usual requirement that plaintiffs allege the materiality of the payment to the partner? By emphasizing the "unique" relationship between a partner and his or her their law firm.

• "The payments, after all, constitute a miniscule proportion of the total revenues of Kaplan’s firm. Yet there is a unique relationship between a law firm and its partners. Legal partnerships normally base the pay and prestige of their members upon the amount of revenue that partners (and, more importantly, their clients) bring to their firms. Indeed, with law becoming an ever-more competitive business, there is a notable trend for partners who fail to meet expectations to risk a loss of equity in their firms. The threat of withdrawal of one partner’s worth of revenue from a law firm is arguably sufficient to exert considerable influence over a named partner such that, in my opinion, his independence may be called into question."

This common sense approach to the definition of independence has been sorely missing from the analysis used by the Delaware courts in the past. There is no doubt that a partner or principal who originates a large amount of business will likely benefit from that business, a proposition that goes well beyond partners in law firms. Such payments in general raise reasonable doubts about a director's independence, without the need to show exactly how much of the payment actually gets to the partner. One hopes that this portends a more realistic approach to the issue by the Delaware courts at the pleading stage.