Connolly v. Gasmire: “Independent and Disinterested” Under the Aronson Test

In Connolly v. Gasmire, 2008 Tex. App. LEXIS 4930 (July 2, 2008) shareholders John Connolly and Anne Molinari filed a derivative suit against several current and former Odyssey Healthcare, Inc. board members.  The 14th District Court in Dallas County dismissed the suit because plaintiffs failed to show that demand was futile.  Plaintiffs appealed to the 5th District Court of Appeals of Texas.  The Court of Appeals affirmed and dismissed the case.  Odyssey Healthcare is one of the largest hospice providers in the United States and allegedly participated in billing fraud that resulted in a $13 million settlement with the U.S. Department of Justice.

On appeal to 5th Circuit, the shareholders sought to show that demand was futile under the Aronson test.  The Aronson test excuses a demand when there is reasonable doubt that (1) the majority of the directors are independent and disinterested; or (2) the transaction was the product of a valid exercise of business judgment.

Under the first factor of the Aronson test, the majority of directors must be independent and disinterested.  The court rejected the shareholders’ first claim that a director lacks independence if he or she is a member on the compliance committee, audit committee, or compensation committee.  The Membership alone does not render a director too interested to consider a shareholder’s demand. 

The shareholders also claimed that a director is not independent if he or she gains a substantial return from insider trading transactions.  The court rejected this contention and held that a substantial return does not support the conclusion that the directors were interested or that they face a substantial likelihood of liability for those sales.
The court also reaffirmed that mere personal friendship among directors did not create a reasonable doubt about a director’s independence.  See, e.g., Beam v. Stewart.  The shareholders argued that many of the directors had prior relationships that prevented them from being independent.  For example, director Burnham co-founded Odyssey with directors Gasmire, Cross, and Steffy.  Directors Rash, Feldstein and Steffy are all members of the board for Providence Healthcare Company.  Directors Cross and Steffy co-founded Intensiva Healthcare Corporation; and director Feldstein is a director and Rash is the chairman of Pre-Veinor Resources, Inc.  The court refused to find that these relationships defeated independence.

Finally, the shareholders claimed that the board of directors’ high level of experience and expertise elevated their duty, and by not complying with the rules and regulations of the healthcare industry, they breached that duty, causing demand to be futile.  The court rejected that assertion and held that heightened experience and expertise did not result in lack of director independence.  Since the court found no grounds to support the shareholders’ allegations, it found the directors were independent and disinterested.

The court then applied the second factor of the Aronson test that excuses a demand if the transaction was the product of a valid exercise of business judgment.  The shareholders alleged the board did not act honestly in their business decisions because they knew about the defects in their internal controls.  They further allege that the board would have known about the Medicare and Medicaid violations but did not act.  The court held that the board is not required to be aware of every fact; it need only be reasonably informed.  Therefore, the court concluded the shareholders failed to raise a reasonable doubt as to the second factor of the Aronson test.

Since the shareholders’ failed to prove demand futility under the Aronson test, the Court of Appeals affirmed the trial court’s dismissal without prejudice.

The primary materials for this post are available on the DU Corporate Governance web site.