Why is director independence important?

A court’s conclusion of whether the majority of a company’s board is independent could affect:

• The standard of review applicable to a challenged transaction: A plaintiff may rebut the presumptions under the business-judgment rule by showing that most of the directors approving the challenged transaction were either interested in the transaction or not independent of a person with an interest in the transaction. Such a showing would trigger the entire-fairness standard of review, which is far more difficult for the company to satisfy.
• The court’s assessment of a special committee in charge of reviewing a challenged transaction: Whenever a special committee of disinterested and independent directors negotiates and approves a transaction with a controlling stockholder, it becomes the plaintiff/stockholder’s burden to prove unfairness. If the directors and company are unable to establish the independence of the special committee, the burden to prove entire-fairness remains with the corporate defendants.
• A stockholder’s entitlement to pursue derivative litigation on behalf of a corporation against its directors: The court will consider whether a majority of the board: (1) received material personal benefit from the challenged transaction; (2) has a substantial likelihood of liability for approving the challenged transaction; or (3) lacks independence from someone receiving a material benefit from the challenged transaction, or who themselves would face substantial likelihood of liability for the challenged transaction.
• The court’s decision to reject a special litigation committee’s recommendation to dismiss litigation brought on behalf of the company: If a special litigation committee moves to dismiss a derivative action, the court must investigate the independence of the committee members and the reasonableness and good faith of the committee’s investigation.

How does the law define an independent director?

As In re Oracle Corp., 824 A.2d 917, 932-39 (Del. Ch. 2003) indicates, a director is considered independent if:

1. The director’s decisions are based on the corporate merits of the subject before the board, rather than extraneous considerations or influences.
2. The director has no economic or personal interest in the corporate transaction or action that requires board approval.
3. The director is not financially or personally “beholden” to an interested party.

 What types of relationships give rise to doubt regarding a director’s independence?

Importantly, materiality matters. The conduct or relationship that calls a director’s independence into question must be material — meaning that it is reasonably likely to alter the decision-making process. Cursory allegations of friendships, social relationships, or prior business transactions with an interested party are insufficient to establish lack of independence.

Questions of director independence may arise based on:

• Prior relationships: Where material familial interest exists between directors, the directors’ independence will be in question. Mizel v. Connolly, No. 16638, 1999 WL 550369, at *4 (Del. Ch. July 22, 1999); In re Cooper Cos., 2000 WL 1664167, at *6 (Del. Ch. Oct. 31, 2000) (holding that a director’s family relationship with an interested board member created a reason to doubt the director’s ability to act impartially).
• Compensation:
  • Pecuniary self-interest that is of material importance such that it is improbable that the director could perform fiduciary duties without being influenced by overriding personal interest. In re General Motors (Hughes) S’holders Litig., 2005 WL 1089021 (Del. Ch. May 4, 2005).

    But, the mere fact that directors received fees for their service as directors is insufficient to compromise independence.

    Grobow v. Perot, 539 A.2d 180, 188 (Del. 1988) (overruled on other grounds) (holding that allegations that directors were paid for their services do not establish a financial interest sufficient to find that directors lack independence).

  • An employee relationship with the corporation also raises doubt that a director would act independently, particularly when the income derived from that position is substantial or the director’s primary source of income.

    Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993) (“there is a reasonable doubt that [an employee director] can be expected to act independently considering his substantial financial stake in maintaining his current offices.”); Mizel, 1999 WL 550369, at *3 (“Since [the employee-directors] each derive their principal income from their employment at [the corporation], it is doubtful that they can consider the demand on its merits without also pondering whether an affirmative vote would endanger their continued employment.”)

  • A financial relationship between the director’s business and the corporation is sufficient to raise doubt regarding that directors ability to remain independent.

    In re info USA, Inc. S’holders Litig., 953 A.2d 963, 991 (Del. Ch. 2007) (“Plaintiffs contend that infoUSA’s payments to Kaplan’s law firm are material enough to raise a reasonable doubt as to his lack of interest and independence. I agree... [t]he threat of withdrawal of such business is certain enough, in the case of a legal professional, to raise a reasonable doubt as to a director’s independence.”).

  • Significant donations to a director’s charity or charitable cause with which the director is affiliated could call into question the director’s independence. See In re Goldman Sachs Grp., Inc. S’holder Litig., 2011 WL 4826104, at *8-10 (Del. Ch. Oct. 12, 2011).