Independent Directors and Friendship: A Reply

I’d like to thank Jay and his students for inviting me to guest blog here to share the Delaware perspective (the Dark Side?). Jay’s recent posts on director independence and Delaware’s pleading standards are excellent and raise many good points, many of which I agree with. Rather than respond specifically to his criticisms, I’d like to offer some more general points on Delaware’s director independence cases from a different perspective.

The Delaware courts are confronted with a constant dilemma. On the one hand, I assume everyone agrees that Delaware doesn’t want fiduciary breaches to go unpunished. On the other hand, it doesn’t follow that it should be open season on companies and their directors. Derivative litigation generally falls within the authority of the board of directors to manage the business and affairs of the corporation. Delaware courts also are keenly mindful of the costs imposed on the system by strike suits. For these reasons, there have to be gate-keeping rule in place (lest we clog the courts and keep enriching the plaintiffs’ bar and the defense counsel). If one accepts these premises, then the Delaware courts are probably doing a good job in striking a balance.

I think what emerges from the Court of Chancery decisions addressing director independence and disinterest is an onerous (and, at times, frustrating) pleading standard for demand futility that is employed in a very fact-specific manner with a few clear rules at both ends of the spectrum. In particular, a financial interest in a transaction (other than non-controlling stock ownership) usually renders a director interested. Mere allegations of friendship, however, are not enough. Otherwise, the gate-keeping function falls apart. I think the Delaware position is compelled by the problem of line-drawing in this area.

What kind of personal relationship must be shown? Are we talking about college fraternity brothers, the best man in the CEO’s wedding, or neighbors (and if neighbors, must they be next-door neighbors or just live in the same, exclusive water-front golf community)?  And what happens if otherwise perfectly independent directors become friends with the CEO after joining the board? Do they lose their independence if board meetings become too collegial? Obviously, I’m being facetious, but it’s a slippery slope, which is why the structural bias argument was rejected in Aronson v. Lewis in favor of case-by-case review. See generally Michael P. Dooley & E. Norman Veasey, The Role of the Board in Derivative Litigation: Delaware Law and the Current ALI Proposals Compared, 44 Bus. Law. 503 (1999). Plus, there’s the normative argument (made by a lot of academics) that we want boards to be collegial.

Lastly, let’s not forget the all-important, but less-than-scientific, “smell test” that is always applied in the Delaware Court of Chancery. From a practitioner’s perspective, the fact that we have these “loose” or intangible connections among directors doesn’t prevent them from doing their jobs. Most corporate counsel advising boards in the post-SOX/Enron climate probably agree that (i) there’s a real fear of personal liability among directors (regardless of whether it is substantiated) and (ii) reputational constraints play a role in directors’ decisions. The likelihood of a lawsuit and judicial scrutiny can be powerful. Finally, I think it’s worth noting a (perhaps unintended) consequence of Delaware’s heightened pleading standard: it should encourage companies to add more independent directors to their boards.

Delaware case law is quite clear that a board will retain authority to manage derivative litigation as long as a majority of the board is disinterested and independent—even if “independence” is less than pristine in the view of Delaware’s critics. If this encourages boards to add more “independent” directors, then I think most of us agree that that is a positive result.