I. Divergent Approaches to Reviewing Corporate SLCs
It was not until the 1970s that corporations commonly used SLCs to respond to derivative litigation. As a result, it is not surprising that it was 1981 before two significant courts of last resort announced their standards for reviewing the appointment and work of SLCs. New York was the first, declaring a more limited judicial review, followed shortly by Delaware, declaring a more careful review.
A. Auerbach Announced New York’s More Deferential Review
1. Auerbach Facts and SLC
In 1979, Auerbach v. Bennett became the first decision by a state’s highest court to review a corporation’s use of an SLC. The audit committee of the board of directors of General Telephone & Electronics Corporation, with the assistance of its outside auditor Arthur Andersen & Co., and with a prominent outside law firm retained to serve as special counsel, investigated the firm’s worldwide operations. It concluded that the firm and its subsidiaries had paid millions of dollars of bribes and kickbacks both abroad and in the United States, and that four of the thirteen board members “had been personally involved in certain of the transactions.” Nevertheless, there were no allegations or findings that these board members had profited personally from the challenged transactions. When the audit committee released its report, Auerbach, a shareholder, immediately filed a derivative action on behalf of the corporation against Arthur Andersen, the four personally involved directors, and the corporation itself. Auerbach alleged that the directors had violated their duties and sought to hold them to account for the inappropriate payments.
The board of directors responded to the derivative action by appointing an SLC, to which it delegated all its authority to deal with the claims raised in the derivative litigation. It appointed to the committee “three disinterested directors” who were disinterested in two ways. First, they were not appointed to the board until after the challenged transactions had occurred. Second, they had no prior affiliation with the corporation.
The SLC retained its own “eminent special counsel” and began by reviewing the prior work of the audit committee. It examined its “completeness, accuracy and thoroughness” by interviewing representatives of the audit committee’s outside counsel, reviewing the transcripts of testimony of ten corporate officers and employees before the Securities and Exchange Commission, and studying documents collected by and the work papers of outside counsel. The SLC also conducted individual interviews with the directors found to have personally participated in the questioned payments and with representatives of the outside auditor. It also sent questionnaires to each of the non-management directors. At the conclusion of its investigation, the SLC solicited legal advice from its own special counsel.
The SLC reported that the defendant Arthur Andersen had conducted its examination of the corporate affairs in good faith and in accordance with generally accepted auditing standards. It concluded that no corporate or shareholder interest would be served by the continued assertion of a claim against Arthur Andersen. It also concluded that none of the individual defendants had violated New York’s statutory standard of care, noting that none of them “had profited personally or gained in any way.” It concluded that the claims asserted in the derivative action were without merit, that “if the action were allowed to proceed, the time and talents of the corporation’s senior management would be wasted on lengthy pretrial and trial proceedings, that litigation costs would be inordinately high in view of the unlikelihood of success, and that the continuing publicity could be damaging to the corporation’s business.” The SLC ultimately concluded that it would not be in the best interests of the corporation for the derivative action to proceed, and it directed the corporation’s general counsel to take that position.
2. Deferring to the Business Judgment of the SLC
The New York Court of Appeals held that the disposition of the case on the merits “turns on the proper application of the business judgment doctrine, in particular to the decision of a specially appointed committee of disinterested directors acting on behalf of the board to terminate a shareholders’ derivative action.” The rule is based, at least in part, on “the prudent recognition that courts are ill-equipped and infrequently called on to evaluate what are and must be essentially business judgments.” The authority and responsibilities vested in corporate directors, both by statute and decisional law, “proceed on the assumption that inescapably there can be no available objective standard by which the correctness of every corporate decision can be measured, by the courts or otherwise.” Even if that were not the case, “by definition the responsibility for business judgments must rest with the corporate directors; their individual capabilities and experience peculiarly qualify them for the discharge of that responsibility.” As with other policy and management decisions, the decision whether and to what extent to explore and prosecute derivative claims “must be predicated on the weighing and balancing of a variety of disparate considerations” to determine “what course of action or inaction is best calculated to protect and advance the interests of the corporation.” This is the province of the board, not of the courts. As a result, “absent bad faith or fraud (of which there is none here) the courts must and properly should respect their determinations,” even if the results show that the decision “was unwise or inexpedient.”
The SLC merely presents a “special instance” of the application of the business judgment rule, which “applies in its full vigor to shield from judicial scrutiny the decision of a three-person minority committee of the board acting on behalf of the full board not to prosecute a shareholder’s derivative action.” Because the substantive decision reached by the SLC falls “squarely within the embrace of the business judgment doctrine,” the courts “cannot inquire as to which factors were considered . . . or the relative weight accorded them.” Accordingly, summary judgment for the defendants was appropriate because “the determination of the special litigation committee forecloses further judicial inquiry in this case.”
3. The Prerequisite “Disinterested Independence” of the SLC
Auerbach made clear that the application of the business judgment rule to SLCs is conditional, although only the dissent used that precise word. The rule shields “the deliberations and conclusions” of the SLC “only if they possess a disinterested independence and do not stand in a dual relation which prevents an unprejudicial exercise of business judgment.” The SLC had the requisite “disinterested independence” because its three members were neither on the board at the time of the challenged transactions nor had any prior affiliation with the corporation. Nor were there other factual allegations that the SLC members were personally related to other board members, either defendant or non-defendant directors. Auerbach argued, and the dissent agreed, that facts about personal relationships were peculiarly within the knowledge of the defendants and the SLC, and might be revealed if the motion to dismiss were denied and the case were permitted to proceed to pre-trial discovery. Nevertheless, the court granted the motion to dismiss, stating that, “[n]otwithstanding the vigorous and imaginative hypothesizing and innuendo of counsel there is nothing in the record to raise a triable issue of fact as to the independence and disinterested status of these three directors.”
4. Even Imperfect Boards Have Appointment Power
An important question is whether the “disinterest” or “independence” of the SLC is compromised by interest or dependence on the board that appoints them. Auerbach argued that “any committee authorized by the board of which the defendant directors were members must be . . . legally infirm and may not be delegated power to terminate a derivative action.” The court rejected this argument, stating that, in the very nature of a corporation, only the board of directors has the authority, “on behalf of the corporation, to direct the investigation and to assure the cooperation of corporate employees, and it is only that same board . . . which had the authority to decide whether to prosecute the claims against defendant directors.” Here, the board properly delegated its authority to the SLC. To make the appointment, it followed “prudent practice in observing the general policy” that when individual board members “prove to have personal interests which may conflict with the interests of the corporation, such interested directors must be excluded while the remaining board proceed to consideration and action.”
Because management is vested in the board, it may appoint the SLC from its own ranks even “where some directors are charged with wrongdoing, so long as the remaining directors making the decision are disinterested and independent.” To disqualify the entire board would “render the corporation powerless to make an effective business judgment with respect to prosecution of the derivative action.” The “possible risk of hesitancy” of board members to investigate the activity of fellow board members “where personal liability is at stake” is an “inherent, inescapable, given aspect” of the corporate form. Indeed, a board’s attempt to delegate the authority to resolve derivative claims to an SLC “wholly separate and apart from the board would, except in the most extraordinary circumstances, itself be an act of default and breach of the nondelegable fiduciary duty owed by the members of the board to the corporation and to its shareholders, employees and creditors.” A judicial attempt to do the same thing “would similarly work an ouster of the board’s fundamental responsibility and authority for corporate management.”
5. Important Judicial Role Under Auerbach
Even under Auerbach’s limited standard of review, courts have an important role in assessing the composition and work of SLCs. First, they must address claims that SLC members are not “disinterested and independent.” Second, they must address claims that the SLC has not made a proper investigation of facts or law. Unlike the lack of judicial standards or competence to second guess an SLC’s business judgment, courts are generally “better qualified” than directors to make determinations about the “methodologies and procedures best suited to the conduct of an investigation of facts and the determination of legal liability.” These determinations do not “partake of the nuances or special perceptions or comprehensions of business judgment or corporate activities or interests. The question is solely how appropriately to set about to gather the pertinent data.” The SLC “may reasonably be required to show that they have pursued their chosen investigative methods in good faith.” Questions of good faith, or even fraud, may be raised by proof “that the investigation has been so restricted in scope, so shallow in execution, or otherwise so pro forma or halfhearted as to constitute a pretext or sham.”
B. Zapata Announced Delaware Goes Beyond the Business Judgment Rule
In 1981, just two years after Auerbach, the Delaware Supreme Court, in Zapata Corp. v. Maldonado, called for a more careful review of SLCs than Auerbach. Like Auerbach, Zapata held that courts will not automatically defer to the decision of an SLC to wrest control of a derivative suit that alleges a breach of fiduciary duties by directors. Unlike Auerbach, Zapata said that courts may exercise their own “business judgment” to determine whether to permit the derivative proceeding to remain in shareholder hands.
1. Facts and Chancery Finding of a Vested Right to Bring a Derivate Action
In June 1975, William Maldonado, a stockholder of Zapata Corporation, whose shares were traded on the New York Stock Exchange, instituted a derivative action on behalf of Zapata against ten of its officers and/or directors, alleging breaches of fiduciary duty by engaging in self-dealing. Without first demanding that the board pursue these claims, Maldonado filed suit, alleging that a demand would be futile because all the directors participated in the acts complained of and were named as defendants. Initially, Zapata neither sued to pursue Maldonado’s claims nor moved to dismiss his derivative suit. However, four years later, after four of the defendant-directors left the board, the remaining directors appointed two new “outside directors” and appointed them to serve as an SLC to investigate Maldonado’s claims. The board delegated to the SLC its full authority to take any action it deemed appropriate, explicitly providing that the SLC’s determination would bind the corporation without further review. The SLC investigated, concluded that the claims were “inimical to the Company’s best interests,” and caused Zapata to move in the alternative to dismiss the complaint or for summary judgment.
“The Court of Chancery denied the motions, holding that once the stockholder had gained authority to sue in a representative capacity, the board lacked the power to divest the stockholder of control over the litigation.” The derivative suit was created in equity, in the first half of the nineteenth century, “to provide the stockholder a right to call to account his directors for their management of the corporation, analogous to the right of a trust beneficiary to call his trustee to account for the management of the trust corpus.” It has a “dual nature,” in which the “stockholder asserts in the suit not only a right belonging to the corporation but also a right individual to himself,” although “the interest he sought to protect was primarily that of the corporation and only indirectly his own.” The stockholder’s individual right to assert the corporate claim “ripens” or “vests” when “he has made a demand on the corporation which has been met with a refusal by the corporation to assert its cause of action or unless he can show a demand to be futile.” Once the shareholder’s right vests, the corporation “no longer controls the corporate right to which the plaintiff ’s individual right attaches.” Because the corporation “refused to bring suit against its directors for an apparent breach of fiduciary duty to it, it can no longer control the destiny of this suit and cannot compel the dismissal of this action at this stage of the proceedings.”
2. Delaware Supreme Court Rejects a Vested Right to Maintain Derivative Action
On an interlocutory appeal, the Delaware Supreme Court “addressed a question of first impression: whether a board of directors could assert control over a derivative action after a stockholder had obtained the right to represent the corporation and proceed beyond the pleading stage.” The court reversed the Chancery Court’s holding that the derivative plaintiff acquired a vested right to maintain the action after establishing that making a demand on the corporation would have been futile. The broader question was “the power of the corporation by motion to terminate a lawsuit properly commenced by a stockholder without prior demand.” The specific question was whether the SLC had the “power to speak for the corporation as to whether the lawsuit should be continued or terminated.”
Echoing Auerbach, the Delaware Supreme Court began with the proposition that the corporate statute “is the fount of directorial powers” that gives the directors, not the shareholders, the power to manage the corporation, including the power to make decisions concerning whether to litigate. It rejected as “erroneous” the Court of Chancery’s “absolute rule” that “a stockholder, once demand is made and refused, possesses an independent, individual right to continue a derivative suit for breaches of fiduciary duty over objection by the corporation.” Disputes pertaining to control of the suit generally arise in one of two contexts, which “can overlap in practice.” First, a shareholder can sue the board after it has refused the shareholder’s demand to sue. A board’s decision “to cause a derivative suit to be dismissed as detrimental to the company, after demand has been made and refused, will be respected unless it was wrongful.” Stated differently, “when stockholders, after making demand and having their suit rejected, attack the board’s decision as improper, the board’s decision falls under the ‘business judgment’ rule and will be respected if the requirements of the rule are met.” “Absent a wrongful refusal, the stockholder . . . simply lacks legal managerial power.” Second, even without a prior demand, a stockholder may acquire an individual right to initiate an action if “it is apparent that a demand would be futile [because] the officers are under an influence that sterilizes discretion and could not be proper persons to conduct the litigation.”
3. Even in Demand Excused Situations, Imperfect Boards Have Appointment Power
Even in demand futility situations, there must be a “permissible procedure” by which a corporation “can rid itself of detrimental litigation.” If not, “a single stockholder in an extreme case might control the destiny of the entire corporation.” “To allow one shareholder to incapacitate an entire board of directors merely by leveling charges against them gives too much leverage to dissident shareholders.” At the same time, when examining the means of preventing shareholder abuse, one of which is an SLC, “potentials for abuse must be recognized.”
A board, “tainted by the self-interest of a majority of its members, can legally delegate its authority to a committee of two disinterested directors.” First, the statute expressly provides that a committee can exercise the full authority of the board if the board so provides. Second, “at least by analogy to our statutory section on interested directors, it seems clear that the Delaware statute is designed to permit disinterested directors to act for the board.” That statute provides that a contract or transaction between the corporation and one or more directors or officers is neither void nor voidable solely because the director or officer is present at the meeting authorizing it, if a majority of disinterested directors authorizes it in good faith after disclosure. Nor is it void or voidable if it is fair to the corporation when they approve or ratify it. The Delaware Supreme Court does “not think that the interest taint of the board majority is per se a legal bar to the delegation of the board’s power to an independent committee composed of disinterested board members.” Therefore, even an SLC appointed by a tainted board can properly act for the corporation “to move to dismiss derivative litigation that is believed to be detrimental to the corporation’s best interest.” The question is, what standard should the court use to review the motion.
4. An Equitable Standard of Review in Demand Excused Situations
The standard of review should include the “equitable considerations” concerning the use of an SLC that qualify its statutory power to act on behalf of the corporation. Two competing concerns must be balanced. On the one hand, if corporations can use SLCs to “consistently wrest bona fide derivative actions away from well-meaning derivative plaintiffs,” the derivative suit “will lose much, if not all, of its generally-recognized effectiveness as an intra-corporate means of policing boards of directors.” On the other hand, if “corporations are unable to rid themselves of meritless or harmful litigation and strike suits, the derivative action, created to benefit the corporation, will produce the opposite, unintended result.” The task is to “find a balancing point where bona fide stockholder power to bring corporate causes of action cannot be unfairly trampled upon by the board of directors, but the corporation can rid itself of detrimental litigation.”
Zapata said that Auerbach does not reflect the proper balance. Under the Auerbach view that defers to the business judgment of the SLC, the issues are simply whether the committee has been independent, acted in good faith, and conducted a reasonable investigation. “The ultimate conclusion of the committee, under that view, is not subject to judicial review.” However, a proper balance permits review even in situations in which the SLC had been independent, acted in good faith, and conducted a reasonable investigation. When a derivative plaintiff has been excused from making a demand on the corporation, there is “sufficient risk in the realities of [the] situation . . . to justify caution beyond adherence to the theory of business judgment.”
Unlike Auerbach, Zapata was not willing to accept the “possible risk of hesitance” of one board member to investigate another as an “inherent, inescapable, given aspect” of the corporate form. Instead, concern for that risk animated Zapata’s stricter standard of review:
[W]e must be mindful that directors are passing judgment on fellow directors in the same corporation and fellow directors, in this instance, who designated them to serve both as directors and committee members. The question naturally arises whether a “there but for the grace of God go I” empathy might not play a role. And the further question arises whether inquiry as to independence, good faith and reasonable investigation is sufficient safeguard against abuse, perhaps subconscious abuse.
An SLC’s neutrality was of particular concern in Zapata because, if the corporation’s motion were granted, the merits of the shareholder’s underlying claim would never be reached, even though he had already been excused from making demand on the board.
The court struggled for an appropriate analogy. The nature of the corporation’s motion “finds no ready pigeonhole, as perhaps illustrated by its being set forth in the alternative” as a motion to dismiss or a motion for summary judgment. “It is perhaps best considered as a hybrid summary judgment motion for dismissal because the stockholder plaintiff ’s standing to maintain the suit has been lost.” However, it is not strictly either “since the question of genuine issues of fact on the merits of the stockholder’s claims are not reached.” It is analogous to a settlement, in which the same is true. In determining whether to approve a proposed settlement of a derivative action when directors are on both sides of the transaction, the court “is called upon to exercise its own business judgment.” In this case, “the litigating stockholder plaintiff facing dismissal of a lawsuit properly commenced ought . . . to have sufficient status for strict Court review.”
Zapata announced its now-famous and oft-criticized two-step review of motions to dismiss in demand excused situations. First, the court should inquire into the independence and good faith of the committee and the bases supporting its conclusions. The corporation has the “burden of proving independence, good faith and a reasonable investigation, with no presumption of independence, good faith and reasonableness.” Second, even if the corporation meets its burden and establishes that the “committee was independent and showed reasonable bases for good faith findings and recommendations, the Court may proceed, in its discretion, to the next step.”
The second step provides, we believe, the essential key in striking the balance between legitimate corporate claims as expressed in a derivative stockholder suit and a corporation’s best interests as expressed by an independent investigating committee. The Court should determine, applying its own independent business judgment, whether the motion should be granted. . . . The second step is intended to thwart instances where corporate actions meet the criteria of step one, but the result does not appear to satisfy its spirit, or where corporate actions would simply prematurely terminate a stockholder grievance deserving of further consideration in the corporation’s interest.”
In taking this next step, a court “must carefully consider and weigh how compelling the corporate interest in dismissal is when faced with a non-frivolous lawsuit.” A court also “should, when appropriate, give special consideration to matters of law and public policy in addition to the corporation’s best interests.” If the court’s “independent business judgment” is satisfied, it may grant the motion to dismiss, “subject, of course, to any equitable terms or conditions the Court finds necessary or desirable.”
Zapata acknowledged that stricter review presents “a danger of judicial overreaching,” but concluded that the alternatives are “outweighed by the fresh view of a judicial outsider.” The final judgment whether to maintain a particular lawsuit “requires a balance of many factors—ethical, commercial, promotional, public relations, employee relations, fiscal as well as legal.” These factors are within the reach of the Court of Chancery, “which regularly and competently deals with fiduciary relationships, disposition of trust property, approval of settlements and scores of similar problems.”
5. Zapata in Perspective
Zapata was criticized both for undermining the business judgment rule and for the way it described each of its two steps of review. It has generally been confined to cases in which demand is excused, which are relatively few because of the high bar to establish that demand would have been futile and is therefore excused. If a plaintiff makes a pre-suit demand, the demand is deemed a tacit concession “that the board was able to properly consider that demand.” Accordingly, the more deferential business judgment rule applies to the denial of the demand, and the plaintiff challenging the denial “must allege with particularity ‘facts that give rise to a reasonable doubt as to the good faith or reasonableness of [the Board’s] investigation’ and deliberations.”
Even though Zapata’s two-step review is generally limited to situations in which demand has already been excused, it may be particularly instructive for LLCs. It is significant that, even in the context of a publicly held corporation, it applied the broader principle that equity may disregard something even if it is technically legal. Its call for more careful review of SLCs may have even greater vitality for LLCs. First, LLCs do not present the foundational rule that management is centralized in a board of directors. Second, LLC law has developed primarily in the context of closely held firms rather than in the context of publicly held firms. As discussed below, Obeid v. Hogan recently applied Zapata to LLCs and characterized it as an early example of a broader shift to a more careful review of the work of insiders. It treated the presumptive intent of the owners as paramount, an inquiry much more feasible in closely held firms than in public companies. According to Obeid, Zapata subjects SLCs in LLCs to a standard of review that represents a middle ground between the “maximal deference” of the business judgment rule and the strictest review of the entire fairness standard.
C. Oracle Requires Close Scrutiny of SLC Independence
Zapata’s two-tier review addressed the risk of insiders investigating one another in the important but narrow context of a motion to dismiss a properly commenced derivative proceeding. The broader question is what constitutes independence for an SLC member. Here, again, the Delaware courts have taken the lead in setting a higher bar for SLC independence. Delaware’s high watermark for the independence requirement is In re Oracle Corp. Derivative Litigation, which explicitly followed Zapata while criticizing its doctrinal formulation. Because Oracle also involved a publicly held corporation, its stricter approach to independence may be especially meaningful for SLCs in closely held LLCs without the inhibiting formalities of boards of directors.
1. Basic Facts
Shareholders of Oracle Corporation brought a derivative action in Delaware against certain Oracle directors and officers for insider trading. In December 2000, Oracle issued public guidance about projected earnings for the third quarter of the 2001 fiscal year (“3Q FY 2001”), which ran from December 1, 2000, to February 28, 2001. The plaintiffs alleged that this guidance was a “rosy” projection that was materially misleading when it was issued and became more so as time passed. In January 2001, four directors (the “Trading Directors”), including Lawrence Ellison, Oracle’s Board Chairman, CEO, and largest stockholder, sold almost $1 billion of their Oracle stock for $30 or more per share. On March 1, 2001, the company announced that both earnings and growth would be significantly lower than the earlier guidance. The stock market reacted swiftly and negatively to the news, and the price of the stock dropped by 21 percent in a single day and closed at $16.88, an amount significantly lower than $30-plus prices at which the Trading Directors had sold. The plaintiffs alleged that the Trading Directors had inappropriately engaged in insider trading because they had material, non-public information showing that Oracle would not meet the earnings guidance it had disclosed to the public. The plaintiffs also sued the members of the board during 3Q FY 2001 who did not trade (the “Non-Trading Directors”) on the ground that their “indifference to the deviation between the company’s December guidance and reality was so extreme as to constitute subjective bad faith.”
In summer 2001, two Stanford professors were recruited to the board to enable them to serve as SLC members. One was Hector Garcia-Molina, a distinguished professor of computer science, and the other was Joseph Grundfest, a distinguished law professor and expert on corporate governance who had previously served as a Commissioner of the Securities and Exchange Commission. They were recruited primarily by two of the Trading Directors, one of whom, Michael Boskin, was himself a distinguished professor in Stanford’s economics department and who had previously served as chairman of the President’s Council of Economic Advisers. While they were “wooing” him to join the board, Grundfest performed his own “due diligence.” Among other things, he met with the other two Trading Directors, including Mr. Ellison, and questioned them about other recently filed litigation based on the same events. Their responses gave him sufficient “confidence” to join the board. He testified that this did not mean that he had concluded that the class action had no merit. On the other hand, he did conclude “that these were reputable businessmen with whom he felt comfortable serving as a fellow director,” and that he had received “very impressive answers to difficult questions regarding the way Oracle conducted its financial reporting operations.” Both professors joined the board on October 15, 2001, which was after the allegedly misleading guidance, after the stock sales in question, after a correcting press release, and more than six months after the books had been closed on the quarter in question.
The following February, Oracle formed an SLC, consisting solely of the two professors newly appointed as directors, to investigate the Delaware derivative action and to determine “whether Oracle should press the claims raised by the plaintiffs, settle the case, or terminate it.” For their service on the SLC, they were compensated at an hourly rate that was below their normal consulting rates. The SLC retained a number of advisors, the most important of which was a major national law firm that had not before performed any material amounts of work, either for Oracle or for any of the individual defendants.
“The SLC’s investigation was, by any objective measure, extensive.” It resulted in a report of over 1,100 pages that considered the situation of each of the Trading Directors and concluded that none of them had possessed material, non-public information. It also concluded that they had not acted with scienter in making their January trades. In short, it concluded that there was no merit to the “allegations that the Trading [Directors] had breached their fiduciary duty of loyalty by using inside information about Oracle to reap illicit trading gains.” Consistent with this determination, the report also concluded there was no reason to sue the Non-Trading Directors. Accordingly, the SLC filed a motion to end the Delaware derivative suit, which the plaintiffs resisted.
2. Vice Chancellor Strine Invokes Zapata but Avoids Its “Oxymoronic” Second Step
Vice Chancellor Strine said he was bound to decide the case under Zapata’s two-step analysis, although he was critical of the way Zapata explained each step. Under the first step, in order to prevail on its motion to “terminate” the derivative action, the SLC must persuade him that its members were independent, that they acted in good faith, and that they had reasonable bases for their recommendations. Under the second step, even if the SLC met its first-step burden, Vice Chancellor Strine had the discretion to “undertake my own examination of whether Oracle should terminate and permit the suit to proceed if I, in my oxymoronic judicial ‘business judgment,’ conclude that procession is in the best interests of the company.”
He never got to step two because he held that the SLC failed to meet its step-one burden. Zapata “instructed” him to “apply a procedural standard akin to a summary judgment inquiry” when ruling on the SLC’s motion to “terminate.” The SLC must show that “there is no genuine issue as to any material fact and that [it] is entitled to dismiss as a matter of law.”
Candidly, this articulation of a special litigation committee’s burden is an odd one, insofar as it applies a procedural standard designed for a particular purpose—the substantive dismissal of a case—with a standard centered on the determination of when a corporate committee’s business decision about claims belonging to the corporation should be accepted by the court.
In this “first-step stage of proceedings,” the SLC itself is under examination, “not the merits of the plaintiffs’ cause of action.” If there is a material fact question about the SLC’s independence, good faith, or reasonable basis for its recommendation, its motion to terminate would be denied. Because he found that the SLC failed the step-one independence inquiry, he denied its motion to dismiss without ever reaching the questions of good faith or reasonable basis.
3. Failing the Independence Test
Oracle is fascinating because some of the nation’s most prominent and most respected lawyers and professors, working for one of the world’s richest and most respected corporations, run by some of the world’s most successful entrepreneurs, failed the independence test they knew they had to pass. They failed in large part because Vice Chancellor Strine appears to have raised the bar for independence. At the very least, he probed more carefully for independence than the Zapata court had occasion to.
a. “Indeterminate” Contextual Approach. Vice Chancellor Strine said that the Delaware Supreme Court’s test for independence could be summarized as turning “on whether a director is, for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind.” The problem, he said, was that the test had not been applied consistently. In order to be “faithful” to the “essential spirit” of the Delaware Supreme Court’s decisions, it is necessary to take a “contextual” approach that considers the function of SLCs. The contextual approach “undoubtedly results in some level of indeterminacy, but with the compensating benefit that independence determinations are tailored to the precise situation at issue.”
At the outset, Vice Chancellor Strine rejected the SLC’s argument that its members are independent if they are free from “the domination and control” of the interested parties. Under the domination and control test, Oracle’s SLC would win. To apply this test “would serve only to fetishize much-parroted language, at the cost of denuding the independence inquiry of its intellectual integrity.” He refused to consider independence solely through the lens of economically consequential relationships.
Delaware law should not be based on a reductionist view of human nature that simplifies human motivations on the lines of the least sophisticated notions of the law and economics movement. Homo sapiens is not merely homo economicus. We may be thankful that an array of other motivations exist that influence human behavior; not all are any better than greed or avarice, think of envy, to name just one. But also think of motives like love, friendship, and collegiality, think of those among us who direct their behavior as best they can on a guiding creed or set of moral values.
The law should also consider “the social nature of humans.” Directors are generally people “deeply enmeshed in social institutions” that have norms and expectations “that, explicitly and implicitly, influence and channel the behavior of those who participate” in them.
The law should recognize that trust plays an important role in the success of many business firms and that many transactions within a firm are largely protected by a “governance mechanism . . . that is almost entirely not legally enforceable.” Inside a particular firm, “[s]ome things are ‘just not done,’ or only at a cost, which might not be so severe as a loss of position, but may involve a loss of standing in the institution.” The law cannot assume that corporate directors serving on SLCs “are, as a general matter, persons of unusual social bravery, who operate heedless to the inhibitions that social norms generate for ordinary folk.”
If a majority of the directors cannot impartially consider a demand to proceed against insiders, an SLC is “a last chance for a corporation to control a derivative claim.” To evaluate an SLC’s independence, “a court must take into account the extraordinary importance and difficulty of such a committee’s responsibility.” It is much more difficult to cause a corporation to sue a friend, relative, colleague, or boss, than it is to disapprove an act that has not yet occurred. In the case of an SLC, only a subset of the board bears the weight of the moral judgment “that there is reason to believe that the fellow director has committed serious wrongdoing and that a derivative suit should proceed against him.” “A small number of directors feels the moral gravity—and social pressures—of this duty alone.” It is “critically important” that the SLC’s “fairness and objectivity cannot be reasonably questioned.” Both the court and the shareholders must have “confidence in the integrity of corporate decision making by vesting the company’s power to respond to accusations of serious misconduct by high officials in an independent group of directors.”
The question in Oracle was “whether the SLC “can independently make the difficult decision . . . whether the [T]rading [Directors] should face suit for insider trading-based allegations of breach of fiduciary duty.” A decision to sue “would have potentially huge negative consequences for the Trading [Directors], not only by exposing them to the possibility of a large damage award but also by subjecting them to great reputational harm.” A decision to sue would likely be “accompanied by a recommendation that they step down as fiduciaries until their ultimate culpability was decided.” The “mindset and talent” of the SLC members “influence, for good or ill, the course of the investigation. Just as there are obvious dangers from investigators suffering from too much zeal, so too are dangers posed by investigators who harbor reasons not to pursue the investigation’s targets with full vigor.” The nature of the investigation is also important. Oracle’s SLC “could not avoid a consideration of the subjective state of mind of the Trading [Directors].” The SLC would make judgments about culpability, no matter how objective the criteria they attempted to use.
b. Facts Indicating Failure to Satisfy Independence Test. Vice Chancellor Strine found the lengthy SLC Report shockingly insufficient on the independence issue. On the one hand, it disclosed that one of the Trading Directors was a professor at Stanford and that another of the Trading Directors was a donor to Stanford. It also disclosed that the latter made a $50,000 donation to Stanford Law School after Grundfest delivered a speech at the request of a venture capital firm in which that defendant’s son was a partner, and that half of the donation was allocated for Grundfest’s use in his research. Nevertheless, in view of the “modesty of these disclosed ties, it was with some shock that a series of other ties among Stanford, Oracle, and the Trading [Directors] emerged during discovery.” “Noticeably absent from the SLC Report was any disclosure of several significant ties between Oracle or the Trading [Directors] and Stanford University, the university that employs both members of the SLC.” The “plain facts are a striking departure from the picture presented in the Report.”
A brief review of these “plain facts,” which Vice Chancellor Strine discussed at greater length, is sufficient for purposes of this article. In short, Trading Director Boskin, who was a Stanford professor, was a former teacher of Grundfest, and both were senior fellows and steering committee members at the Stanford Institute for Economic Policy and Research (“SIEPR”). The two published working papers under the SIEPR rubric, and SIEPR helped to publicize their research. In the month in which the SLC was formed, Grundfest addressed a meeting of some of SIEPR’s largest benefactors. Trading Director Lucas’s ties to Stanford were “far, far richer” than the SLC Report had indicated. Among other things, Lucas was the chairman of a foundation, established by his brother’s will, which had given $11.7 million to Stanford, and which was used in part to establish a center at Stanford Medical School in the Lucas name and for which Lucas served as lead director. Lucas also contributed $4.1 million of his personal funds, and more specifically had been a “generous contributor to not one, but two, parts of Stanford important to Grundfest: the Law School and SIEPR.” Trading Director Ellison was “a major figure in the community in which Stanford is located,” and one of “the wealthiest men in America.” Stanford had been a beneficiary of almost $10 million in grants from an Ellison Foundation that Ellison served as sole director. While Ellison was its CEO, Oracle made more than $300,000 in donations to Stanford. In addition, Stanford made a proposal to Ellison for a $170 million gift to create a Stanford program analogous to Oxford’s Rhodes Scholarship, and three of the four Trading Directors were proposed members of the program board. There had also been reports discussing Ellison’s intent to donate his $100 million home to Stanford, about which he later changed his mind. Even after one of his children was denied admission, Ellison was publicly considering creating further endowments at Stanford.
Vice Chancellor Strine said that the “question is whether these ties . . . would be of a material concern to two distinguished, tenured faculty members whose current jobs would not be threatened by whatever good faith decisions they made as SLC members.” His conclusion was that the Stanford connections “would be on the mind of the SLC members in a way that generates an unacceptable risk of bias.” Therefore, the SLC failed to meet its “burden to show the absence of a material factual question about its independence.”
The “ties among the SLC, the Trading Defendants, and Stanford are so substantial that they cause reasonable doubt about the SLC’s ability to impartially consider whether the Trading Defendants should face suit.” As SLC members, Grundfest and Garcia-Molina were already being asked to consider whether the firm should level extremely serious allegations against a fellow board member. As to Boskin, both SLC members were being asked to press insider trading claims against a fellow professor. Grundfest had “an even more complex challenge than Garcia-Molina [because] Boskin was a professor who had taught him and with whom he had maintained contact over the years.” Given his extraordinary ties to Boskin, Grundfest “would have more difficulty objectively determining whether Boskin engaged in improper trading than would a person” without those ties.
The SLC did not provide evidence that Grundfest was a “very special person who is capable of putting these kinds of things totally aside.” Vice Chancellor Strine did “not infer that Grundfest would be less likely to recommend suit against Boskin than someone without these ties.”
The inference I draw is subtly, but importantly, different. What I infer is that a person in Grundfest’s position would find it difficult to assess Boskin’s conduct without pondering his own association with Boskin and their mutual affiliations. Although these connections might produce bias in either a tougher or laxer direction, the key inference is that these connections would be on the mind of a person in Grundfest’s position . . . .
Grundfest would be put in the position of choosing between causing serious legal harm to a person with whom he shares several connections or being suspected of favoritism. Grundfest also presented the “same concerns” with respect to Trading Director Lucas, who was SIEPR’s Advisory Board Chair and a major benefactor, and who also made a significant contribution to the law school after Grundfest made a speech at his request.
As for both Grundfest and Garcia-Molina, “service on the SLC demanded that they consider whether an extremely generous and influential Stanford alumnus should be sued by Oracle for insider trading.” “A reasonable professor . . . would obviously consider the effect his decision might have on the University’s relationship with Lucas, it being (one hopes) sensible to infer that a professor of reasonable collegiality and loyalty cares about the well-being of the institution he serves.” Vice Chancellor Strine distinguished between Grundfest and Garcia-Molina, saying that “Grundfest would have had to be extremely insensitive to his own working environment not to have considered Lucas an extremely generous alumni benefactor of Stanford, and at SIEPR and the Law School in particular.” Even as to Garcia-Molina, there was little doubt he knew of the relative magnitude of Lucas’s generosity to Stanford. “Furthermore, Grundfest comprised half of the SLC and was its most active member. His non-independence is sufficient alone to require a denial of the SLC’s motion.” “In view of the ties involving Boskin and Lucas alone, I would conclude that the SLC has failed to meet its burden on the independence question. The tangible facts about Ellison merely reinforce this conclusion.”
In summary, “two Stanford professors were recruited to the Oracle board in summer 2001 and soon asked to investigate a fellow professor and two benefactors of the University.” The connections “would weigh on the mind of a reasonable [SLC] member deciding to level the serious charge of insider trading against the Trading [Directors].”
[T]his does not mean that the SLC would be less inclined to find such charges meritorious, only that the connections identified would be on the mind of the SLC members in a way that generates an unacceptable risk of bias. That is, these connections generate a reasonable doubt about the SLC’s impartiality because they suggest that material considerations other than the best interests of Oracle could have influenced the SLC’s inquiry and judgments.
To emphasize, to fail the independence test does not require either a showing of bad faith on the part of SLC members or a finding that their connections make them less inclined to find the derivative action meritorious. It requires only the lesser showing that the connections would be “on the mind” of the SLC members in a way that generates an “unacceptable risk” of bias. It is not necessary that the direction of the bias be established. The bias might be one way or the other, or, as Vice Chancellor Strine said in Oracle, unknowable. It is sufficient to show that the connections “generate a reasonable doubt about impartiality” because they “suggest that material considerations other than the best interests of Oracle could have influenced the SLC’s inquiry and judgments.” Even if the SLC members are “persons of good faith and moral probity,” they may nevertheless not be “situated to act with the required degree of impartiality.” Stockholders should not be forced to rely on SLC members “who must put aside personal considerations that are ordinarily influential in daily behavior in making the already difficult decision to accuse fellow directors of serious wrongdoing.”
4. Summary and Impact of Oracle
Although Vice Chancellor Strine said that he was bound to apply Zapata, he criticized its formulation and avoided its controversial second step by deciding there was insufficient independence. Cases before and after Oracle have mentioned the importance of social relationships to independence. Oracle’s essential contribution is that, for social relationships to be disqualifying, they need not create a bias one way or the other, only a hesitancy. The test is whether, taking into account the totality of economic and social considerations, the SLC member is in a position that requires him or her to “put aside personal considerations that are ordinarily influential in daily behavior” when making decisions about accusing fellow directors of serious wrongdoing. If the answer is yes, the SLC’s subjective good faith and the reasonableness of its conclusions are not sufficient to justify terminating the derivative proceeding. In short, Oracle seems to require the neutrality of SLC members, not merely their independence as it had been defined previously.
As mentioned earlier, empirical studies have indicated that the standard of review for the work of an SLC matters in the real world. It is still not clear how much Oracle has influenced legal doctrine, even in Delaware. The Delaware Supreme Court has neither repudiated Oracle nor given it a full-throated endorsement. However, Oracle appears to have influenced business practice. The fact that the nation’s best and brightest failed the independence test when the stakes were so high has apparently captured the attention of many boards and the lawyers who represent them. Not surprisingly, they prudently consider Oracle as tightening the requirements for SLC independence when insiders are accused of serious wrongdoing. After Oracle, once derivative suits are properly commenced, boards have much greater incentive to settle with the shareholders who bring them. Oracle also suggests a stricter independence test that can be applied more broadly to SLCs in both corporations and LLCs.