Delaware, Independence and Director Compensation: Sutherland v. Sutherland (Part 2)

We are examining the reasoning in Sutherland v. Sutherland, a case involving a challenge to a special litigation committee that recommended the dismissal of a derivative action.

Plaintiff, among other things, challenged the independence of the lone director on the SLC. In the case of a special litigation committee, there is no presumption of independence (or good faith or reasonableness). As a result, the company carried the burden and the plaintiff is allowed discovery on the issue. Moreover, as the opinion noted, "one-member SLCs are less insulated from the influence of interested directors, and are closely scrutinized."

Plaintiff alleged that the director had a preexisting personal and business relationship with board members. The discovery process, however, revealed the largely di minimus nature of the relationship. As the opinion noted:

• The SLC provided a sworn interrogatory answer indicating Jeffrey had prepared periodic financial statements for Mark's wife's antique business, and that the amount billed and paid for that work did not exceed $ 5,000. Likewise, Jeffrey testified at his deposition that he performed accounting work for Mark's wife 10-15 years ago, that the financial statements were prepared monthly or quarterly, and that he had not seen or spoken with Mark or Mark's wife since Mark's relocation to Kansas City six years ago.

In other words, contrary to the demand excusal cases, limited discovery on the issue of independence was permitted, allowing the plaintiff to explore the relationships among the parties. It allowed the court to reasonably conclude that the relationship did not result in a lack of independence.

But the discovery process also shed light on another aspect of the relationship. The director on the SLC received fees for serving on the board. He was also paid his hourly rate of $250 for work on the committee, amounting to $64,000. His firm received another $25,000. As the court concluded: "there is no suggestion that the approximately $64,000 Jeffrey received for his work, and the $25,000 his firm received for its work, were so large as to render Jeffrey dependent upon or beholden to that compensation, thereby tainting his independence." The authority for the proposition? The cases in Delaware holding that directors fees do not deprive a director of his or her independence. These cases ignore the extraordinary amounts sometimes paid to directors and are inconsistent with the subjective materiality standard ostensibly applied by the same courts.

But the payments did not stop there. The plaintiff alleged that the director had a "secret financial relationship" with the defendant companies. The director took at least one "inventory trip" and, according to plaintiff, was paid his hourly rate. The reasons for the trip? As the opinion described, the director:

• viewed his attendance at the store inventory as part of his duties as a director. As [the director] explained, his counsel told him he was not on the board simply as an SLC member, but as a full member of the board. As such, counsel rightly informed [the director] that he should take an active role in informing himself of the companies' business. [The director's] visit to the store was left unmentioned in the report because it had not occurred at the time the report was written.

Nothing in the opinion provided any explanation why a "full member" of the board needed to do an "inventory check" or could not rely on the CEO or other officers for any necessary information about the inventory. Nor did the opinion disclose the amount paid or look to the total compensation paid to the director during the period of the investigation (and shortly afterwards). Plaintiff did not have the information apparently because defendants would not produce the documents related to the payments. As the plaintiff notes on brief:

• [Defendants] also actively concealed it despite the Court’s admonitions at the Stay Hearing about disclosure of any potential conflicts of interest or independence issues. [The director] and SLC Counsel did so by opposing discovery into time and billing records post-dating the filing of the Report that they knew would have revealed that ongoing relationship, steadfastly arguing they all were “irrelevant” because the investigation was concluded. Those records were very relevant and both Jeffrey and SLC Counsel knew it.

The defendants in their brief state that quite "appropriately, as a board member [the director] wanted to familiarize himself with the Companies’ businesses." As for the reasons for the compensation? The defendants noted (but the court did not) that the director "was compensated at his standard hourly rate for this trip because of time lost at his regular position . . . and because the Companies had no pre-existing policy for compensation to an outside director."

While it is possible that the payments arose out of the director's position on the board, the explanation provided by the defendants is little more than assertion, with no real attempt to explain the importance of the "inventory check." Moreover, the court apparently did not insist that the amounts be revealed or that defendants provide a more complete explanation for the payments. Instead, the court seemed to accept that any payment made to a director for any type of activity connected to the company could be recast as fees and treated as irrelevant for purposes of determining independence.

It is bad enough that Delaware courts ignore fees, irrespective of amount, in determining independence. This case suggests that they are willing to allow broad categories of payments to be recast as fees (and, as a result, rendered irrelevant). They are willing to do so despite thin explanations for the payments and despite the burden of proof resting with the company. They provide a road map for ensuring additional financial return to the members of a SLC. Finally, they allow for payments to be made after completion of the report without requiring disclosure of all of the details.

The law in Delaware says that management has the burden of showing independence in the case of membership on a SLC. The practice, however, suggests otherwise.

Various pleadings can be found at the DU Corporate Governance web site.