April 27, 2017

Private Planes, Investors, and NASDAQ Rules: Delaware Supreme Court Gives Guidance on Director Independence

James G. McMillan, III

Under Delaware law, as under federal law, a corporate stockholder may assert a cause of action derivatively on behalf of a corporation for harms caused to the corporation by its directors and officers. However, a stockholder’s right to bring such a derivative action conflicts with a board of directors’ right to manage the business and affairs of a corporation. Therefore, a stockholder in a Delaware corporation who wishes to bring suit derivatively on behalf of a corporation must either make a demand on the corporation’s board of directors to bring the suit or be prepared to explain in the complaint why such a demand would be futile. Under Delaware Court of Chancery Rule 23.1, a derivative complaint must allege “with particularity” the plaintiff’s efforts to obtain the desired action from the board or must allege, also “with particularity,” “the reasons for the plaintiff’s failure to obtain the action or for not making the effort.” In most cases, the complaint sets forth the plaintiff’s reasons “for not making the effort,” usually alleging that demand on the board would be futile because a majority of the board members were either interested in the challenged transaction or lacked the required independence from an interested party. A complaint that fails to allege such “demand futility” with particularity will be dismissed under Rule 23.1.

A director who participates on both sides of the challenged transaction, or who obtains a benefit not shared with all stockholders, is interested in the transaction. A director who is financially “beholden to” an interested person, or who has a relationship with an interested person that would affect the director’s ability to exercise independent judgment, lacks independence. Demand on the board is excused, and a stockholder may bring suit derivatively, when a majority of the board members are either interested or lack independence. Many Delaware cases have focused on the types of relationships that render directors not independent.

In a recent case, Sandys v. Pincus, 2016 Del. LEXIS 627 (Del. Dec. 5, 2016), the Delaware Supreme Court reversed the Delaware Court of Chancery’s dismissal of a derivative suit based on failure to plead demand futility with particularity. The Court of Chancery found that the facts alleged in the complaint were insufficient to show that a majority of the members of the corporation’s board were either interested in the challenged transaction or lacked independence from an interested person. Four of the five members of the Delaware Supreme Court, sitting en banc, disagreed. The majority opinion, authored by Chief Justice Leo E. Strine, Jr., further defines the types of relationships that can render directors not independent.

In addition to discussing the Delaware Supreme Court’s opinion in Sandys v. Pincus, this article will refer to off-the-cuff remarks made by Chief Justice Strine at the Securities Regulation Institute in Coronado, California, on January 23, 2017, regarding Sandys v. Pincus and, more generally, the problems of director independence under Delaware law.

Summary of Facts

The complaint in Sandys v. Pincus alleged that several top managers and directors of Zynga, Inc. traded on inside information, selling 20.3 million shares of Zynga stock at $12 per share, for a total of $236.7 million, shortly before an earnings announcement disclosed information that caused the market price to drop 9.6 percent to $8.52 per share. The complaint also alleged that the insiders were aware at the time of the sale of additional negative information that, when disclosed three months later, caused Zynga’s market price to drop to $3.18 per share, for a total decline of 73.5 percent from the $12 sale price. The complaint asserted claims for breach of fiduciary duty against the insiders who participated in the sale and the directors who approved the sale.

The defendants included Mark Pincus, who was the former CEO, chairman, and controlling stockholder of Zynga, holding 61 percent of the company’s voting power. At the time the complaint was filed, the Zynga board of directors was composed of nine directors, two of whom, Pincus and defendant Reid Hoffman, had participated in the challenged transaction. Another, Don Mattrick, was Zynga’s CEO.

Based on the allegations in the complaint, the Court of Chancery found that at least five of Zynga’s directors—a majority of the board—were not interested in the transaction and were independent of Pincus. The Delaware Supreme Court disagreed as to the independence of three of those five: Ellen Simonoff, William Gordon, and John Doerr. The court found that, in addition to Pincus and Hoffman, who were interested in the transaction, Mattrick (the CEO), was not independent because Pincus, as the controlling stockholder, controlled Mattrick’s livelihood. Therefore, a majority of six of the nine board members were either interested (Pincus and Hoffman) or lacked independence from Pincus (Mattrick, Simonoff, Gordon, and Doerr), demand was excused as futile, and the complaint should not have been dismissed.

Director Simonoff Was Not Independent Because of Co-Ownership of an Airplane With Pincus

The complaint alleged that director Ellen Simonoff, together with her husband, had “an existing business relationship with defendant Pincus as co-owners of a private airplane.” The Delaware Supreme Court found that “the most likely inference” from that alleged fact was that there was “an extremely close, personal bond between Pincus and Simonoff, and between their families.” The court accepted the plaintiff’s argument that “owning an airplane together is not a common thing” and that such co-ownership “suggests that the Pincus and Simonoff families are extremely close to each other and are among each other’s most important and intimate friends.” The court determined that co-ownership of an airplane “is suggestive of the type of very close personal relationship that, like family ties, one would expect to heavily influence a human’s ability to exercise impartial judgment.” The court maintained that the elevated pleading standard in the demand excusal context—“with particularity”—“does not require a plaintiff to plead a detailed calendar of social interaction to prove that directors have a very substantial personal relationship rendering them unable to act independently of each other.” The court thus concluded that the alleged facts were sufficient to support an inference that Simonoff was not independent of Pincus.

Directors Gordon And Doerr Were Not Independent Because of “Mutually Beneficial Business Relations” With Pincus

The complaint alleged that two other directors, William Gordon and John Doerr, were partners at Kleiner Perkins Caufield & Byers, an investment firm that controlled 9.2 percent of Zynga’s equity. Kleiner Perkins also invested in a company cofounded by Pincus’s wife. In addition, Kleiner Perkins and defendant Hoffman (who participated in the challenged transaction along with Pincus) coinvested in another company, Shopkick, Inc., and Hoffman served on Shopkick’s board with another Kleiner Perkins partner. The court accepted the plaintiff’s argument that “Gordon and Doerr have a mutually beneficial network of ongoing business relations with Pincus and Hoffman that they are not likely to risk by causing Zynga to sue them,” and rejected the defendants’ argument that “the relationships among these directors flowed all in one direction and that it is Pincus who is likely beholden to Gordon, Doerr, and Kleiner Perkins for financing.” The court determined that, “precisely because of the importance of a mutually beneficial ongoing business relationship, it is reasonable to expect that sort of relationship might have a material effect on the parties’ ability to act adversely toward each other.”

Gordon and Doerr Were Not Considered Independent under NASDAQ Listing Rules

The court also emphasized the fact that Zynga did not identify Gordon and Doerr as independent directors under the NASDAQ listing rules, although “Zynga did not disclose why its board made this determination.” Although the Delaware standard for director independence “does not perfectly marry with the standards of the stock exchange in all cases,” the NASDAQ criteria “are relevant under Delaware law and likely influenced by our law.” The court listed the relationships that automatically preclude a finding of independence under the NASDAQ rules, concluding that the “bottom line” is that “a director is not independent if she has a ‘relationship which, in the opinion of the Company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.’” The court determined that Delaware law “is based on the sensible intuition that deference ought to be given to the business judgment of directors whose interests are aligned with those of the company’s stockholders.” Thus, when a board of directors has determined that one of its members has a relationship that would interfere with her judgment in carrying out her responsibilities generally—even more so in the “high-salience context” of Rule 23.1, where the determination of independence “can short-circuit a merits determination of a fiduciary duty claim”—courts should exercise an “understandable skepticism.”

Thus, given their alleged relationship with Pincus and Hoffman and the fact that they were not identified as independent under the NASDAQ rules, the Delaware Supreme Court concluded that Gordon and Doerr lacked independence for purposes of demand excusal.

Plaintiff Failed To Investigate the Directors’ Independence before Filing Suit

A recurring theme in the Sandys v. Pincus opinion is the plaintiff’s failure to conduct an adequate presuit investigation into the independence of the Zynga board of directors from the company’s controlling stockholder (Pincus). Although the plaintiff did exercise his right as a stockholder to seek books and records from the company regarding the challenged transaction, he did not seek books and records “bearing on the independence of the board.” The court determined that the “tools at hand” for drafting a complaint include not only traditional books-and-records demands, but “the tool provided by the company whose name has become a verb—or another internet search engine.” If the plaintiff had “Googled” the defendants, “he likely would have discovered more information about Simonoff’s relationship with Pincus.” The court noted that, although “an internet search will only have utility if it generates information of a reliable nature,” the court “can take judicial notice that internet searches can generate articles in reputable newspapers and journals, postings on official company websites, and information on university websites that can be the source of reliable information.” The court determined that the plaintiff’s “lack of diligence put the Court of Chancery in a compromised and unfair position . . . and the plaintiff is fortunate that his failure to do a pre-suit investigation has not resulted in dismissal.”

Justice Valihura’s Dissent Emphasizes the Presumption of Director Independence

In an unusual move, Justice Karen Valihura lodged a written dissent to the court’s ruling. She disagreed with the majority on the independence of directors Simonoff, Gordon, and Doerr. In her view, the plaintiff failed to allege facts showing the materiality of Simonoff’s co-ownership of the airplane or of Gordon’s and Doerr’s business relationships with Pincus and Hoffman. She emphasized that, in the demand-futility context, directors are presumed independent and that plaintiffs have the burden to plead facts “with particularity” showing that the alleged relationships were of a “bias-producing” nature.

As to Simonoff, she noted that the complaint alleged only a business relationship between Simonoffs and Pincus and that the only reference to a “close friendship” appeared in an unverified brief that could not be considered on a motion to dismiss based on the pleadings. Quoting Beam v. Stewart, 845 A.2d 1040, 1050 (Del. 2004), she determined that, “a reasonable inference cannot be made that a particular friendship raises a reasonable doubt ‘without specific factual allegations to support such a conclusion.’” In Beam, the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of a complaint that contained allegations that a director was a “longtime personal friend” or had a “longstanding personal relationship” with the controlling stockholder, Martha Stewart.

As to Gordon and Doerr, and Zynga’s failure to identify them as independent directors under NASDAQ rules, Justice Valihura reasoned that it is “not difficult to come up with a scenario where a director might be deemed ‘non-independent’ under the NASDAQ rules, or NYSE rules, yet deemed independent for demand futility purposes,” for example, if the designation were due to a relationship with the corporation or an executive other than the controlling stockholder. Given the plaintiff’s pleading burden and failure to explain why Gordon and Doerr were identified as not independent for NASDAQ purposes, Justice Valihura did not believe that the plaintiff was entitled to an inference that Gordon and Doerr were not independent for demand-futility purposes.

Finally, Justice Valihura noted that, “internet searches likely are not, in most cases, an adequate substitute for [books and records] demands made pursuant to 8 Del. C. § 220,” and that the majority “never identifies what information likely would have been discovered.” She noted that, on motions to dismiss, courts are “stuck with the limited factual allegations made by the plaintiff,” and that courts may not take judicial notice of facts outside the pleading unless they are not “subject to reasonable dispute,” and the parties are “given prior notice and an opportunity to challenge judicial notice of that fact.”

Chief Justice Strine’s “Off the Cuff” Comments

On January 23, 2017, Chief Justice Strine, the author of the Sandys v. Pincus opinion, took part in a “conversation” at the Securities Regulation Institute in Coronado, California, where he discussed issues raised by the opinion along with other issues of director independence.

The Chief Justice stated the view that some personal relationships are akin to family relationships and urged courts and boards of directors to “dig in” and not just “check the box” on exchange independence standards. He distinguished cases in which directors serve on other boards together or attend weddings (as in the Delaware Supreme Court’s 2004 Stewart case), which may signal nothing more than a social or economic circle or peer group. Rather, he asked, who owns a plane together? Co-owning an airplane or a boat is “a big deal.” The Chief Justice stressed that boards should give advance consideration to the likelihood of litigation—it happens to every public company—and think, “who are our really independent directors”—the individuals who could be trusted to make a decision about whether to sue a fellow board member.

In addition, the Chief Justice said that, when a deal is anticipated, it is important for a board to switch from routine, “short-form” minutes to “long-form” minutes, and that the board should flag the change and state why it is being made. Boards that launch without explanation into long-form minutes do not look credible because the minutes are “lumpy”—too much on x and nothing on y. That is why short-form, but thoughtful, “contextual” minutes are best and should be maintained in most situations. When there is a reason to start including more detail, the board should state so and state why. According to the Los Angeles-San Francisco Daily Journal, the Chief Justice suggested that it might even be wise to record key meetings to ensure that events are recalled accurately. “I’d much rather have a tape recording of the meeting . . . than to have somebody doing bad minutes or taking bad notes,” Strine said.

According to the Daily Journal, the Chief Justice also urged corporate attorneys to step in while boards are formed to head off director conflicts that can be raised in derivative lawsuits. He said that attorneys must be willing to probe deeply into relationships among directors through their own external research and direct questioning of potential board members. “Uncomfortable questions need to be asked,” Strine said.

Key Takeaways

Beware of “Mutually Beneficial Business Relations” Between Directors and Controlling Stockholders

Traditionally, a director lacks independence from an interested person if the director is “beholden to” the interested person. Under Sandys v. Pincus, the reverse may be true; a director may lack independence because the interested person is beholden to the director. The allegation that the interested person has an obligation to the director can lead to an inference of “mutually beneficial business relations” such that the director is deemed unable to exercise independent judgment and is disabled from considering a presuit demand for board action against the interested person. The key takeaway is that corporate counsel must consider obligations flowing in both directions, and not just obligations that otherwise independent directors owe to controlling stockholders.

Beware of Co-Ownership of Significant Assets Between Directors and Controlling Stockholders

Under Sandys v. Pincus, co-ownership of a significant asset, such as a private airplane or a boat, whether for a business purpose or otherwise, can lead to an inference that a close personal relationship akin to family exists, and that a director in such a relationship is not independent for purposes of demand excusal. The key takeaway is that corporate counsel should inquire about and investigate the existence of co-owned assets in determining whether a board of directors has a majority of truly independent directors.

Directors Who Are Not Independent under Exchange Rules Are Unlikely To Be Found Independent for Demand-Excusal Purposes

The Delaware Supreme Court did not go so far as to say that a director who is not independent under NASDAQ or other exchange rules is per se not independent for demand-excusal purposes, but Sandys v. Pincus strongly suggests that it is unwise to assume otherwise. Under Sandys, a company’s board should consider disclosing the reasons for its determination that a director is not independent under exchange rules, and should be prepared to explain why such a director should be considered independent for demand-excusal purposes. Although plaintiffs have the burden of pleading particular facts that create a reasonable doubt regarding independence, the mere fact that a director is not independent under exchange rules may be sufficient to meet that burden in future cases.

Plaintiffs’ Lawyers Should Seek Books and Records Related To Board Independence

In Sandys, the plaintiff conducted a presuit investigation by seeking corporate books and records related to the challenged transaction. At that time, a majority of the board members had participated in the challenged transaction, so a majority of the board was interested and unable to consider a demand to sue themselves. The plaintiff, assuming that demand was futile under those circumstances, did not seek books and records regarding board independence. However, the composition of the board changed before the complaint was filed so that only two of the nine board members who would have considered a demand at that time—the so-called demand board—had participated in the transaction. As a result, it was a “close call” whether the board was disabled, and the plaintiff was “fortunate” that the dismissal of his complaint under Rule 23.1 was reversed on appeal. The key takeaway for plaintiffs’ lawyers is that they should always seek information about board independence when demanding books and records in prederivative-suit investigations.

Plaintiffs’ Lawyers Should Always “Google” the Members of the Demand Board

In Sandys, the court scolded the plaintiff for his “cursory” presuit investigation into board independence, insisting that the plaintiff “likely would have discovered more information” if he had conducted an Internet search of reliable sources. The court determined that it could “take judicial notice” that such resources “can be the source of reliable information.” Many derivative and class-action complaints over the years have quoted newspaper and magazine articles in alleging corporate wrongdoing. The Delaware Supreme Court suggests in Sandys that plaintiffs can also rely on reputable Internet sources in pleading demand futility.

James G. McMillan, III

Mr. McMillan is a senior attorney in the Wilmington, Delaware, office of Pepper Hamilton LLP.