Derivative Suits, Delaware and the Race to the Bottom: Schoon v. Smith (Part 1)

For a corporate governance blog, the Delaware courts are a relentless source of material. We spent much of last week discussing Portnoy v. Cryo Cell, a case that found abuse of the election process by management yet essentially imposed a heavy financial penalty on plaintiff. We noted that the case will certainly be in the running for one of the most anti-shareholder decisions by Delaware courts in 2008.

No sooner did the discussion finish than the Delaware Supreme Court issued another candidate for that august list. In Schoon v. Smith, the Delaware Supreme Court addressed whether a single director had the authority to bring a derivative suit. Needless to say, anyone aware of the race to the bottom in Delaware can predict the outcome of the case without having to read the opinion. The pro-management bias of the Delaware courts necessarily dictates that it would never expand the use of derivative suits. Unsurprisingly, therefore, the Supreme Court concluded that equity does not require that individual directors be given the right to bring derivative suits.

But the worst thing about the case and the analysis is the disingenuous nature of the Court's reasoning. The case makes statements that it presumably knows are a misreading. We see this most clearly in connection with the discussion of "independent" directors. In many ways, the opinion is a paean to independent directors. They are quasi trustees, with an obligation to engage in the most "scrupulous observance" of their duties. Directors must make decisions based upon the merits "rather than extraneous considerations or influences."

It sounds good but in practice the courts in Delaware, as we have noted time and time again, havemade a charade of the concept of independence. The courts use excessive pleading standards (including a denial of any discovery even when plaintiffs present evidence that suggest a disqualifying relationship), inconsistent standards (a material financial relationship disqualifies but not when it comes to fees), and have adopted a standard for friendship that all but makes it impossible to assert non-independence on the basis of close, non-familial relationships. To assert that "independent" directors are enough to protect shareholders in the context of derivative suits is disingenuous and a charade.

This case is an example. The Plaintiff alleged that all four of the other directors lacked independence. In addition to the CEO (who was also a controlling shareholder), the Plaintiff alleged that one director was an officer. The other two were close personal friends of the CEO. Based upon the impossible standard in Beam v. Stewart, it is almost certainly the case that these friends will still qualify as independent. By denying the single director the right to bring an action, the Court has all but cut off any hope of a derivative suit. In other words, the Court has left in the hands of a board consisting of two officers and two close friends of the CEO the authority to "protect" shareholders.

Allowing a director the inherent right to bring a derivative suit would have been authority rarely used but would have provided a safety valve in these types of circumstances. Moreover, even to the extent the Court applied the demand futility rules to the suit brought by the single director (Plaintiff argued that it should), the director would presumably be in a better position to know the facts that impaired a director's independence (particularly actual examples of control of "independent" directors), facts particularly difficult for a shareholder to uncover absent some form of discovery. The appellant's brief specifically referenced the director's awareness of and access to information that would otherwise be privileged.

A single director bringing a derivative suit would have been a rare event. In most cases, the entire slate of directors would be nominated by management and inevitably elected. Such directors would have little incentive to sue their bretheren on the board. The only reason this case went forward was that Schoon was elected not by the controlling shareholder but by the Class B shareholders. As a result, Schoon was the only director truly independent of the CEO. In those circumstances, the Delaware Supreme Court makes clear that when truly independent directors are elected to the board, it intends to tie their hands and prevent them from acting in the best interests of shareholders.

For another discussion of that case written by Steve Haas, who occasionally comments on this Blog, go here. Note Steve Bainbridge's thoughtful comment. We have posted the opinion and redacted briefs on the DU Corporate Governance web site.