Using Pleading Standards to Terminate the Search for Independence under Delaware Law

Yesterday, we discussed the result oriented pleading standards used by Delaware courts to dismiss challenges to director independence.  Take Khanna v. McMinn, 2006 Del. Ch. LEXIS 86 (Del. Ch. May 9, 2006)  as a typical example. The case contains many interesting insights into the analysis used by the Delaware courts that will be addressed in later posts. Remember that this is an issue initially addressed solely on the pleadings. Plaintiffs only need to demonstrate  a “reasonable doubt” about a lack of independence, albeit with some degree of particularity. Lets examine the analysis applied to one of the directors in this case.  

A director of Covad Communications was alleged not to be independent because he sat on the board of a vendor that received $2.2 million from Covad in 2004.  While the relationship was not per se material, it would seem that the facts at least presented doubt about independence, doubt that would justify further inquiry through discovery. 

Not to the Delaware Chancery Court.  Plaintiffs had failed to describe the relationship between the two companies, including whether they “have entered into a long term contract.” Nor did plaintiffs reveal how the vendor's business might be “taken away.” As the court summed up: “Put simply, even considering [the director’s] ties to [the vendor], the Plaintiffs have not alleged particularized facts sufficient to demonstrate that [the director’s] independent discretion would be compromised.”

The opinion effectively concluded that it was not enough to show a significant amount of money flowing between two companies and an interlocking director.  Instead, plaintiffs were expected to produce information about the relationship between the two companies.  They were also expected to show how funds to a vendor could be "taken away," despite the general recognition that the CEO of a company has the power to control the day to day business of a company, including the use of and payments to vendors.  

The decision of the court, therefore, terminated any additional examination into the director's independence.  The analysis did not rule out the possibility that the director in fact lacked independence.  Indeed, it expressly left the possibility open.  The plaintiffs simply hadn't met the court's unrealistic burden.  The possibility existed, therefore, that the board of Covad Communications in fact did not contain a majority of independent directors and ought not, therefore, receive the benefit of demand excusal.  This case is discussed in my article on the subject here.  We'll give more examples in subsequent posts.

Comments

[Steve]

I don't believe the Khanna plaintiff ever pleaded the vendor relationship connection in the complaint. See 2006 WL 1388744, at *17 (“The Plaintiffs, in their answering brief, however, assert for the first time that Crandall’s independence is compromised by his ties to BEA Systems, a Covad vendor….”). This may be harsh pleading practice, but that’s not unique to Delaware corporate law. Also, Khanna advised that “in several instances during the course of analysis, the Court identifies facts that the Plaintiffs did not plead in their attempt to obtain demand excusal. This is not intended to set forth a requirement that each of the absent facts be pleaded in order that demand be excused; on the contrary, the Court’s intent is only to point out facts that, if alleged, could significantly increase the likelihood of a finding of interestedness or lack of independence.” Id. at 16 n.101.