The Delaware Courts’ Evolving View of Director Independence
January 11, 2022
In September 2021, the Delaware Supreme Court in United Food and Commercial Workers Union v. Zuckerberg revamped the test for pleading “demand futility” in shareholder derivative suits for the first time in decades. At the same time, the court’s decision reinforces Delaware courts’ increasing focus on the independence of directors, not only when the board is sued in a shareholder derivative action but also in other conflict situations in which independent directors are called on to exercise their business judgment on behalf of the company.
As explained below, the Delaware courts’ view of what constitutes “independence” continues to evolve and has become a heavily fact-specific analysis, which requires careful consideration not only of the traditional “economic” conflicts but also of personal relationships and other non-traditional factors.
The Zuckerberg Decision
Zuckerberg arose from a decision by Facebook’s board in 2016 to pursue a stock reclassification that would have enabled Mark Zuckerberg to donate a large portion of his Facebook shares to charity while retaining voting control of the company. Faced with class action litigation, Facebook abandoned the reclassification, and the class action was rendered moot. Another Facebook stockholder then brought the derivative lawsuit in Zuckerberg, claiming damages on behalf of the company for the nearly $90 million Facebook spent defending and settling the class action.
Delaware Court of Chancery Rule 23.1 requires a stockholder who wishes to assert derivative claims on behalf of a corporation to show that either (i) a pre-suit demand was made on the corporation’s board of directors to bring the claims directly and such demand was wrongfully denied, or (ii) such demand is futile and excused because a majority of the corporation’s directors are incapable of impartially considering the demand.
The Zuckerberg plaintiffs alleged that demand was excused as futile because a majority of the Facebook directors lacked independence from Zuckerberg and so could not impartially consider a litigation demand. In addressing this argument, the Delaware Supreme Court announced a new test to apply in such cases, which requires courts analyzing demand futility to evaluate three questions on a director-by-director basis:
- Whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand.
- Whether the director faces a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand.
- Whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that would be the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.
Unless a majority of the board at the time the shareholder derivative suit lacks independence on any of these three prongs, the suit should be dismissed.
Applying this new test to the nine directors on the Facebook board at the time the lawsuit was filed, the Delaware Supreme Court’s decision came down to a close analysis of whether three directors’ relationships with Zuckerberg were sufficiently independent under the test’s third prong. Although the court ultimately found that the Zuckerberg plaintiff failed to raise a reasonable doubt about these directors’ independence, the court’s analysis highlights the evolving evaluation of director independence under Delaware law, with courts carefully scrutinizing director relationships.
Evaluating Independence Under Delaware Law
Delaware jurisprudence traditionally focused on financial factors to assess a director’s independence. A plaintiff asserting that a director lacked independence because of personal relationships was required to clear a high bar beyond mere allegations of friendship. In 2004, for example, the Delaware Supreme Court articulated the director independence test in Beam ex rel Martha Stewart Living Omnimedia, Inc. v. Stewart as requiring a derivative complaint to plead with particularity facts creating “a reasonable doubt that a director is…so ‘beholden’ to an interested director…that his or her ‘discretion would be sterilized’” (citing Rales v. Blasband (1993)). The court elaborated that while a personal friendship or “outside business relationship” might influence a demand futility inquiry, a materiality standard must be satisfied by showing that the relationship is actually of a “bias-producing nature.”
Since then, however, the Delaware courts have been increasingly willing to find that non-traditional factors meet this test, as explained below. This trend was summed up by the Delaware Supreme Court’s decision 15 years after Beam in Marchand v. Barnhill (2019), in which the court explained that Delaware law “cannot ignore the social nature of humans or that they are motivated by things other than money, such as love, friendship, and collegiality.”
Shared Asset Ownership
Beam’s progeny of cases remained generally unremarkable until Sandys v. Pincus in 2016, when the independence of a director was questioned based on the single fact that the director co-owned a private airplane with the company’s controlling stockholder. In Sandys, the Delaware Supreme Court in a split decision reversed the Court of Chancery and found that certain directors of a company were not independent because of personal and professional connections to the company’s controlling stockholder. The Delaware Supreme Court found the co-ownership of a plane to be so unusual in nature as to demonstrate actual bias since it “requires close cooperation in use, which is suggestive of detailed planning indicative of a continuing, close personal friendship.”
The Sandys decision thus offered insight into the types of personal relationships that could be inferred to affect director independence under Delaware law. Subsequently applying Sandys, the Court of Chancery in Cumming v. Edens (2018) determined that one director was not independent primarily because the company’s founder and co-chairman invited the director to join the ownership group for a professional basketball team, “a highly unique and personally rewarding asset.”
In 2019, the Court of Chancery denied the defendants’ motions to dismiss in In re BCG Partners, Inc., Derivative Litigation because a majority of the defendant-directors could have been considered lacking independence from a controlling stockholder.
For one director who had known the controlling stockholder approximately 20 years, the complaint alleged that the director and controlling stockholder had attended public events together, the director’s wife honored the controlling stockholder’s sister at a gala, and the controlling stockholder arranged a private museum tour for the director’s wife and granddaughters when the transaction in question was under consideration. The court accordingly found plaintiffs had adequately pled a “constellation of facts” showing that the relationship was not a “thin social-circle friendship.”
The case subsequently proceeded to trial in October 2021 after the Court of Chancery found that fact issues still existed following completion of discovery with respect to the directors’ independence on summary judgment, even though the evidence was “not overwhelming.” As for the director with the longstanding 20-year relationship with the controlling stockholder, although the court ultimately found “no apparent close social or familiar ties,” it did find the director’s deposition testimony highly praising the controlling stockholder as an “inspiration” and a “wonderful…good human being” sufficient to qualify as the kind of “exceptionally glowing” admiration that could cast doubt on the director’s impartiality.
In re BCG Partners, Inc. also made clear that traditional financial considerations such as the materiality of the compensation the director receives from the company still impact the independence analysis. The court found one director non-independent because his directorship compensation constituted a high percentage of his total income. Similarly, in Klein v. HIG Capital (2018), the Court of Chancery excused demand as futile when the plaintiff pled facts that the director’s consulting fees from the company exceeded both his CEO compensation and the independence threshold established by the NASDAQ rules. As Sandys advised, a company’s decision as to whether a certain director is independent under the relevant stock exchange rules may affect whether that director is considered independent for purposes of Delaware law.
Overlapping Business Networks
In re Oracle Corp. Derivative Litig. (2018) involved an allegation against Larry Ellison for breaching his fiduciary duties to Oracle by causing it to purchase the shares of another company in which he had a significant interest at an unfair price. A previous 2018 opinion found several directors were not independent for the purposes of demand futility on the basis of their multiple shared board memberships with Ellison – while the Court of Chancery explained in Cumming v. Edens that “service on another board alongside the interested director, alone, is insufficient to raise a reasonable doubt as to a director’s independence,” it noted in Oracle that multiple overlapping board memberships could lead to the creation of a “network” of ties raising such doubt.
Similarly in In re Homefed Corp. Stockholder Litig. (2020) and Voigt v. Metcalf (2020), plaintiffs adequately pled the directors lacked independence when the board members also served in executive and consulting roles with the controlling stockholder in addition to their director roles or had served on the boards of the controlling stockholder’s portfolio companies.
In its 2021 opinion in In re Oracle Corp. Derivative Litig., the Court of Chancery largely drew from the same facts that had supported its finding of the directors’ lack of independence for the purposes of demand futility in finding that the directors lacked independence with respect to alleged breaches of fiduciary duties.
In In re Oracle Corp. Deriv. Litig. (2003), the Court of Chancery also found it notable that multiple defendant directors and special committee members shared indirect ties through their mutual philanthropic contributions to the same university, although other cases have since limited the importance of such contributions when assessing director independence. For instance, a director’s independence was upheld despite receiving donations from the company in question in In re J.P. Morgan (2005) and In re Goldman Sachs (2011) when the plaintiffs failed to allege facts showing that the contributions were important to the director, how they influenced the director, or how the contributions could or did affect the decision-making process. Similarly, the Zuckerberg court rejected the plaintiff’s allegation that Reed Hastings, founder of Netflix, lacked independence from Zuckerberg because of a track record of donating to similar causes. The court maintained that “[t]here is no logical reason to think that a shared interest in philanthropy would undercut Hastings’ independence.”
Applying Zuckerberg in a December 2021 decision, the Court of Chancery in In re Kraft Heinz determined that generally pointing out linkages between a director’s charitable activities and the interested parties was not sufficient to undermine independence. In that case, although at one point in time the director’s private foundation held more than 12% of its portfolio in a fund controlled by the interested stockholder and the director chaired a nonprofit that received donations from entities controlled by that interested party, the court noted that without more information (such as whether the foundation was still invested in the fund when the derivative litigation was filed, whether the interested party had a role in the donations to the nonprofit and whether those donations were material), these allegations were insufficient to cast doubt on the director’s independence.
A Shifting Status Quo
While personal relationships have become more important in the independence analysis, it nonetheless remains true that not just any allegation of friendly relations will suffice to call into question a director’s independence. The Zuckerberg court, for example, in response to the plaintiff’s allegations that Peter Thiel harbored a “sense of obligation” to Zuckerberg for not removing Thiel from the Facebook board in the face of public scandal, countered that plaintiffs failed to allege that remaining a Facebook director was “financially or personally material to Thiel.” Moreover, the court made short shrift of the plaintiff’s theory of “founder bias” that allegedly rendered Thiel and Hastings non-independent, noting that even if true, it would not necessarily disqualify the directors as long as they were acting in good faith.
In re Kraft Heinz similarly rejected non-independence arguments against directors on the basis of personal relationships. There, plaintiffs attempted to allege a transitive theory of independence by stating that two directors were beholden to Warren Buffet, who was in turn beholden to the interested stockholder and its partners. Although Buffet had walked one of the directors down the aisle at her wedding, the court rejected an argument that she could not act impartially with respect to the litigation demand. The court similarly rejected plaintiffs’ arguments that Buffet lacked independence from the co-founder of the interested stockholder simply because Buffet had once attended that co-founder’s birthday party and co-attended several professional workshops.
In Franchi v. Firestone (2021), the Court of Chancery dismissed a shareholder challenge to a transaction approved by an independent special committee. The plaintiffs argued that the directors lacked independence from controlling shareholder Carl Icahn and pointed out that one director had made a documentary about Icahn and another had served on multiple boards of Icahn-controlled companies. Notwithstanding these “unusual” facts, Chancellor McCormick found it a “closer call” warranting dismissal.
Key Takeaways for Boards in 2022
- The independence analysis under Delaware law is distinct from, and more nuanced, than under stock exchange rules. While the Delaware courts have noted that independence for purposes of stock exchange rules is one factor they consider, the Delaware law analysis is more holistic and fact-specific and considers, in addition to the traditional financial factors, such things as personal friendships or other relationships of a “bias-producing nature.”
- Independence of directors is critical under Delaware law in a number of situations, including when the board is sued in a shareholder derivative action or when the board is asked to consider a related-party transaction. The Delaware courts have developed doctrines, including the demand futility test announced in Zuckerberg and the “MFW test” – which requires the approval of an independent special committee of directors for obtaining business judgment review of controlling stockholder squeeze-outs and other conflicted controlling stockholder transactions – that place a premium on the independence of directors in managing litigation risk.
In evaluating director independence, Delaware courts have not hesitated to scrutinize closely personal relationships, taking into account facts such as co-ownership of unique assets, personal admiration, longstanding and overlapping business network ties, and shared philanthropic contributions. Boards should give serious consideration to these factors when selecting new directors or constituting special committees for the purposes of potentially conflicted transactions. It is advisable to stay aware of potential independence issues raised by interconnected personal relationships as Delaware courts continue to focus on this issue.