United States: Update On Director Independence

Last Updated: November 15 2019
Article by Arthur H. Kohn

Vice Chancellor Slights, of the Delaware Court of Chancery, included a slightly self-effacing, and only slightly humorous, note in his recent opinion in a fiduciary claim against the directors of Tesla, Inc., to the effect that the defendants have reason to believe that they drew the wrong judge in the case. The case relates to the 2018 incentive compensation award to Tesla's CEO, Elon Musk, that caps out at about $55 billion (that "b" is not a typo). The footnote concerns, in part, Vice Chancellor Slights' determination, in a separate recent claim alleging fiduciary breaches by the Tesla board, that members of Tesla's board were not independent.1

Vice Chancellor Slights' footnote and his opinions in the Tesla cases provide a useful occasion to recap a topic of recent interest in the Delaware courts: the law regarding director independence. In particular, the Delaware courts have focused on the circumstances in which personal relationships impact independence. The courts have wrestled with a facts and circumstances test, which creates practical challenges for practitioners.

Corporations regularly establish special committees in situations where a board's decision may be tainted by the actual, perceived or potential conflict of interest of a director, officer or controlling stockholder. If properly constituted, a special committee can help to ensure that fiduciary claims concerning the decision can be dismissed at the pleading stage before trial, thus providing significant legal and practical benefits. But establishing a special committee entails certain costs, including the financial expense of separate financial, legal and possibly other advisors for the special committee and the non-financial risks that arise from a special committee process.

This note reviews the recent case law on director independence. We think that the review should raise sensitivities about independence determinations in certain contexts. We suggest that special committees be seriously considered in connection with any transaction in which the overlapping business or personal relationships of a director may taint the independence of that director to withstand a claim of demand futility under Delaware law.

I. Evaluating Director Independence

Both Nasdaq2 and the New York Stock Exchange3 rules provide bright line guidance for how to determine whether each director is independent. The determination of a director's independence for purposes of the stock exchanges is binary — a director is either considered independent or is not — without reference to a specific decision that the director has made or may make.

In contrast, Delaware law generally does not provide similarly bright lines, and the determination of director independence under Delaware law involves a fact-intensive inquiry that is made on a transaction- or decision-specific basis. Thus, under Delaware law, a director may be independent with respect to one transaction or decision but lack independence with respect to another.

Under Delaware law, "[i]ndependence means that a director's decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences."4 A director lacks independence if he or she is "beholden" to the interested party or interested director(s), or is so under such party's or person's influence such that the director's "discretion would be sterilized."5 Delaware courts examine the totality of the factual allegations in each situation to evaluate whether a director's business or personal relationships "give rise to human motivations compromising the participants' ability to act impartially toward each other on a matter of material importance."6

Much of the case law in this area has concentrated on business relationships or other economic ties among directors, particularly in industries that foster tight networks of repeat players. But the Delaware courts have also emphasized that noneconomic factors can influence human behavior and therefore must be considered when evaluating director independence. Some of these factors have included close personal relationships, co-investment in significant assets, or – under certain circumstances — large philanthropic or charitable contributions. The courts have also looked to a company's filings regarding a director's independence under the stock exchange rules as a relevant factor when assessing director independence under Delaware law.

Network of Business Relationships

In the absence of allegations of self-dealing, a plaintiff seeking to show that a director was not independent must satisfy a materiality standard. For example, the Delaware Supreme Court has explained that "the existence of some financial ties between the interested party and the director, without more, is not disqualifying. The inquiry must be whether, applying a subjective standard, those ties were material, in the sense that the alleged ties could have affected the impartiality of the individual director."7 As a result, the Delaware courts have found that allegations that a director had certain limited financial ties to an interested party – without allegations that those ties were material to the director – were not enough to raise concerns about that director's independence.8

In Greater Pennsylvania Carpenters' Fund v. Giancarlo, the Court of Chancery examined whether three directors were independent of the company's controlling stockholder, where the stockholder sought to challenge a company's acquisition of another business affiliated with the controlling stockholder.9 There, the Court rejected challenges to the independence of each of the three directors. It was not sufficient that one director was a long-time partner of a venture capital firm that had co-invested in businesses with the interested party and that another director had served as CEO of other businesses in which a venture capital firm had invested alongside the interested party because the plaintiff did not show how such co-investments were material to the director. The Court also found that a third director was independent despite allegations that the director was a partner in a private equity firm invested in companies affiliated with the interested party, because they did not provide continuous ongoing revenue to or present an opportunity to profit from the transaction at issue for the private equity firm.

However, in Sandys v. Pincus, the Delaware Supreme Court held that a network of business relationships between certain directors and the company's controlling stockholder raised reasonable doubts as to the impartiality of those directors.10 There, a stockholder of Zynga, Inc. ("Zynga") brought derivative claims for breach of fiduciary duty against certain directors and officers of the company who sold shares in a secondary stock offering. Shortly after the offering, the company's per-share trading price fell dramatically, and the plaintiff alleged that those who sold in the secondary offering did so improperly on the basis of their inside knowledge of the company's declining performance. The plaintiff further alleged that members of the Zynga board of directors breached their fiduciary duties by approving exceptions to certain lockup agreements and other trading restrictions, thereby permitting the allegedly wrongful stock sales. At the time the complaint was filed, the board was comprised of nine directors, only two of whom – Mr. Pincus, Zynga's founder, former chief executive officer and controlling stockholder, and Mr. Hoffman, an outside director – had sold shares in the secondary offering.

The Court of Chancery dismissed the complaint for failure to allege facts that would create a reasonable doubt as to the ability of a majority of the nine-member board to act independently of Mr. Pincus and Mr. Hoffman for purposes of considering a derivative demand. On appeal, the Delaware Supreme Court, in a 4-1 decision, reversed. Specifically, the Court held that the plaintiff had sufficiently alleged that two outside directors were not independent, in part because they were partners of a venture capital firm that, in addition to owning a 9.2 percent stake in Zynga, also had invested in a company co-founded by the interested director's wife and another company where an interested director was also a member of the board. The particular fact that the directors were partners of a venture capital firm which "compete[s] with others to finance talented entrepreneurs" weighed heavily on the court's determination. Although these connections did not make the directors beholden to the controlling stockholder and other sellers in the financial sense, the Court found they were evidence of a "network" of "repeat players" who shared a "mutually beneficial ongoing business relationship" where they would "cut each other into beneficial roles in various situations." Although noting that such relationships are "crucial to commerce and most human relations," the court found that this created "human motivations" that "might have a material effect on the parties' ability to act adversely to each other."11

The Court raised similar concerns in In re Oracle Corporation Derivative Litigation, where the plaintiff claimed that Larry Ellison breached 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. The court found several directors were not independent due to a "constellation" of factors. In particular, one director served on the Oracle board where he received substantial director fees only as a result of Ellison's support, was a major investor in a company whose chief technology officer served at Oracle's pleasure (and was also a senior executive at Oracle), was a partner in two venture capital firms in areas dominated by Oracle, and held high-level positions at another company that did substantial business with Oracle. A second director served on the boards of two portfolio companies that had substantial business relationships with Oracle and had been appointed CEO of a joint venture between Oracle and two other technology companies.12 While any one of these relationships alone might have been insufficient to call into question the director's independence, together they created a reasonable doubt the director was disinterested.

Thus, although the Delaware Chancery Court has been clear that the "law is settled that service on another board alongside the interested director, alone, is insufficient to raise a reasonable doubt as to a director's independence,"13 Chief Justice Strine has also pointed out in a speech that when directors serve on multiple boards together, they are more likely to develop ties that could call their independence into question.14 These concerns about a "network" of overlapping board membership can be particularly salient in certain industries, like venture capital investing in Silicon Valley.

Personal Relationships

Standing alone, a personal friendship between an interested party and a director generally will not result in the director automatically being incapable of making an independent judgment. Directors not infrequently enjoy friendly relationships among one another and, indeed, some level of collegiality may be indispensable to the functioning of an effective board. Thus, Delaware courts have long held that personal relationships do not in and of themselves render a director not independent. In Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, for example, the Court rejected a challenge to directors' independence that was based on allegations that the directors "moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as 'friends.'"15

Nevertheless, the Delaware Supreme Court's recent case law has stressed that "when evaluating director independence, personal relationships do matter."16 In Delaware County Employees Retirement Fund v. Sanchez, the Court found one director lacked independence because of the alleged facts that (1) the director had been a "close personal friend" of the interested party for fifty years, and (2) the director and his brother's primary employment was with a company over which the interested party had substantial control.17 The Court noted that these allegations went beyond "the kind of thin social circle friendship" that the Court has found to be insufficient to rebut the presumption of independence.18

As Chief Justice Strine has written elsewhere, "[a] couple of rounds of golf a year is one thing, shared family vacations every year for a decade is quite another, because the friendship may be more in the nature of a familial one."19 Therefore, when selecting directors for a special committee, General Counsel should not only identify whether these personal relationships exist, but should also ask follow up questions to determine the "thickness" of the relationship.

Co-Ownership of a Significant Asset

Recent Delaware case law highlights co-ownership of a unique asset with an interested director as indicative of a close personal relationship weighing against the conclusion that a director could act in an impartial and disinterested manner. In Sandys v. Pincus, for example, the Court found that one of the outside directors was not independent of the CEO because they co-owned a private airplane together.20 Although the investment was not alleged to be material to either director, it did reflect that the two directors enjoyed a significant personal relationship that would compromise independence. The Court noted that an airplane "requires close cooperation in use, which is suggestive of detailed planning indicative of a continuing, close personal friendship."21 This "unusual fact" of co-ownership thus "signaled an extremely close, personal bond" that, "like family ties, one would expect to heavily influence a human's ability to exercise impartial judgment."22 The Court thus concluded that co-ownership of the airplane created an inference that the director could not act independently.

Another recent case also analyzed co-investment of a unique asset as an indicator that a director lacked independence. In Cumming v. Edens, the Court of Chancery denied a motion to dismiss a derivative action where it concluded that a number of directors were not independent based on their business and other relationships with the interested director.23 The Court's conclusion that the board lacked independence was based on individualized findings with respect to each of the directors, but in one instance the Court's finding of non-independence was based primarily on the fact that the company's founder and co-chairman invited the director to join the ownership group for a professional basketball team. The Court noted that the director had been invited to join the interested party "in a relatively small group of investors who would own a highly unique and personally rewarding asset" and that the director assisted in an effort to build a new arena for the team they co-owned.24 Although the joint ownership would not necessarily require the two directors to work together on the management of the team, it was "revealing of a unique, close personal relationship."25

Philanthropic Contributions

In In re Oracle Corp. Derivative Litigation, the Court found that indirect ties, such as philanthropic contributions, could also affect director independence.26 The Oracle board, faced with a derivative lawsuit alleging insider trading by a number of directors, appointed a Special Committee consisting of two eminent Stanford University professors who joined the board following the challenged actions. The Special Committee retained independent counsel, who interviewed 70 witnesses, reviewed documents, held 35 substantive meetings with the Special Committee, and prepared a report of over 1,000 pages. The Chancery Court nonetheless found that the directors on the Committee were not independent and permitted the derivative lawsuit to go forward.

During discovery, facts emerged showing that two of the defendant directors had substantial relationships with Stanford on whose faculty the purportedly independent directors served. One director defendant had contributed millions of dollars to the university both personally and through a foundation that he controlled. Another director defendant also made significant financial contributions to Stanford through a foundation that he controlled, and was contemplating additional contributions to form a scholarship program in his name. A third defendant director was also a Stanford faculty member and had taught one of the committee members. The Court discussed these connections between the defendant directors and the special committee members through their mutual affiliation with Stanford, and even though the special committee members had not solicited the contributions, the Court concluded that the ties were "so substantial that they cause reasonable doubt about the [Special Committee]'s ability to impartially consider whether [certain defendants] should face suit."27

Since Oracle, several other cases have further delineated the extent to which philanthropic or charitable donations to a cause associated with a director made by an interested individual or entity might serve as a basis to reasonably doubt whether the director was beholden to the interested donor. In In re J.P. Morgan28 and In re Goldman Sachs,29 the Court found that contributions made by the affected company to a director were insufficient to call into question the director's independence where the plaintiffs failed to allege that the contributions were important to the director, or how they influenced the director, or how the contributions could or did affect the decision-making process. In Goldman Sachs, in particular, the Court noted that while the donations were made to a charity on which the director served as trustee, the director did not receive a salary for his philanthropic role and the donations were not the result of active solicitation by the director.

However, in Cumming v. Edens, the Court found that a director was not independent based on the facts both that she received "substantial and clearly material director fees" from service on boards at the behest of the interested director and that her primary employment was with a non-profit that received substantial support from the interested director, even though the director did not solicit the donations and plaintiff was not able to quantify the contributions precisely.30

II. Conclusion

The independence determination in the Tesla claims involved allegations concerning each of the foregoing factors other than the last. Vice Chancellor Slights specifically notes, at the beginning of his independence analysis, that "in this case, the Board did not form a special committee to consider the transaction." While the determination to form a special committee must be made on a case by case basis, recent decisions of the Delaware courts suggest that an independent committee and the membership of that committee should be given serious consideration in any context involving potential independence issues arising from personal relationships or any of the other factors noted above.


[1] Tornetta v. Musk, C.A. No. 2018-0408-JRS (Del. Ch. September 20, 2019) and In re Tesla Motors, Inc. S'holder Litig., 2018 WL 1560293 (Del. Ch. Mar. 28, 2018). See, e.g., Delaware Chancery Court Denies Motion to Dismiss and Permits Discovery into 22.1% Minority Stockholder's Controller Status, at https://www.clearymawatch.com/2018/04/delaware-chancery-court-denies-motion-dismiss-permits-discovery-22-1-minority-stockholders-controller-status/.

[2] NASDAQ Listing Rules 5005(a)(20) and 5605(a)(2) ("An independent director is one who is not an executive officer or an employee of the company and who does not have a relationship that, in the opinion of the board of directors, would interfere with exercising independent judgment in carrying out a director's responsibilities.").

[3] NYSE Listed Company Manual, Section 303A.02(a)(i) ("An independent director is one who the board of directors affirmatively determines has no material relationship with the company, either directly or as an officer, partner or stockholder of a company that has a relationship with the company.). The NYSE Listed Company Manual also warns that boards of directors making independence determinations should "broadly consider all relevant facts and circumstances." NYSE Listed Company Manual, Commentary to Section 303A.02(a).

[4] Aronson v. Lewis, 473 A.2d 805, 816 (Del. 1984).

[5] Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993) (citing Aronson, 473 A.2d at 815).

[6] Sandys v. Pincus, 152 A.3d 124, 126 (Del. 2016). Put differently, a director is not independent if particularized facts support an inference that the relationship between the challenged director and the interested director is "so close that one could infer that the non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director." Robotti & Co. v. Liddell, 2010 WL 157474, at *12 (Del. Ch. Jan. 14, 2010).

[7] Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014).

[8] See In re Gaylord Container Corp. S'holder Litig., 753 A.2d 462, 465 n.3 (Del. Ch. 2000) (no issue of fact concerning director's independence where director's law firm "has, over the years, done some work" for the company because plaintiffs did not provide evidence showing that the director "had a material financial interest" in the representation); White v. Panic, Del. Ch., C.A. No. 16800, mem. op. at 18, Lamb, V.C. (Jan. 19, 2000), aff'd, 783 A.2d 543 (Del. 2001) ("A plaintiff [who has failed to] allege[ ] particular facts indicating that [the money] allegedly paid to [the director] or his firm was so material as to taint [the director's] judgment .... [fails] to create a reasonable doubt about his independence.").

[9] Greater Pa. Carpenters' Fund v. Giancarlo, C.A. No. 9833-VCP (Del. Ch. Sept. 2, 2015) (Transcript), aff'd, No. 531, 2015 (Del. Mar. 11, 2016) (Order).

[10] Sandys v. Pincus, 152 A.3d 124, 126 (Del. 2016).

[11] Id. at 134.

[12] In re Oracle Corporation Deriv. Litig., C.A. No. 2017-0337-SG (Del. Ch. Mar. 19, 2018).

[13] Cummings at *17

[14] Ann Lipton, https://lawprofessors.typepad.com/business_law/2018/03/tulanes-30th-annual-corporate-law-institute.html

[15] Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, 845 A.2d 1040, 1051 (Del. 2004).

[16] Park Employees' & Ret. Bd. Employees' Annuity & Benefit Fund of Chicago on behalf of BioScrip, Inc. v. Smith, 2017 WL 1382597, at *10 (Del. Ch. Apr. 18, 2017) (citing Sandys v. Pincus, 152 A.3d 124 (Del. 2016)).

[17] Delaware County Employees Retirement Fund v. Sanchez, 124 A.3d 1017 (Del. 2015).

[18] Id. at 1022. The Court recently made similar observations in In re Oracle Corporation Derivative Litigation, C.A. No. 2017-0337-SG (Del. Ch. Mar. 19, 2018) (noting that the director and her husband have known the defendant director since the late 1980s, have had "numerous interactions over the subsequent years, including lunch," and own two condos on a Hawaiian island in which the defendant director owns a 98% stake).

[19] Leo E. Strine, Jr., Documenting The Deal: How Quality Control And Candor Can Improve Boardroom Decision-making And Reduce The Litigation Target Zone (The Business Lawyer 2015).

[20] Sandys v. Pincus, 152 A.3d 124, 126 (Del. 2016).

[21] Id. at 130.

[22] Id. at 130.

[23] Cumming v. Edens, 2018 WL 992877 (Del. Ch. Feb. 20, 2018).

[24] Id. at *17.

[25] Id.

[26] In re Oracle Corp. Deriv. Litig., 824 A.2d 917 (Del. Ch. 2003).

[27] Id. at 942. The Court did not indicate whether it would have reached the same result if those relationships had been fully disclosed, but the opinion suggests that it would not have mattered given the significance of the relationships, and the perceived lack of candor certainly did not help the Special Committee in making its case.

[28] In re J.P. Morgan Chase & Co. S'holder Litig., 906 A.2d 808 (Del. Ch. 2005).

[29] In re Goldman Sachs, 2011 WL 4826104 (Del. Ch. Oct. 12, 2011).

[30] Cumming v. Edens, 2018 WL 992877 (Del. Ch. Feb. 20, 2018).

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