Corporate Governance

Delaware, Director Independence, and the Impossibility of Proving Actual Control

By J. Robert Brown

Delaware courts make liberal use of the demand requirement to dismiss derivative suits.  At the pleading stage, without the benefit of any discovery, shareholders carry the burden of showing reasonable doubt about the board's independence or the failure to engage in a valid exercise of business judgment.  This is, of course, the much cited test from Aronson v. Lewis, 473 A.2d 805 (Del. 1984).  In general, the business judgment component requires shareholders to show a procedural deficiency at the board level, an almost impossible thing to do at the pleading stage.  Much of the law in this area, therefore, turns on whether the board had a majority of independent directors.

In imposing the requirement of a majority, the Court in Aronson noted that the determination was not without controversy.  As the Court reasoned:

• We recognize that drawing the line at a majority of the board may be an arguably arbitrary dividing point. Critics will charge that we are ignoring the structural bias common to corporate boards throughout America, as well as the other unseen socialization processes cutting against independent discussion and decisionmaking in the boardroom. The difficulty with structural bias in a demand futile case is simply one of establishing it in the complaint for purposes of Rule 23.1. We are satisfied that discretionary review by the Court of Chancery of complaints alleging specific facts pointing to bias on a particular board will be sufficient for determining demand futility.

In other words, boards with a majority of independent directors could still, nonetheless, reflect an impermissible bias.  The paragraph left open the possibility that shareholders could show that despite its ostensible independence, the board was subject to the excessive control of the CEO.  

Yet in practice, this safety valve hasn't existed in any meaningful way.  Efforts to establish that the "independent" board was actually biased and controlled by the CEO have largely fallen on deaf judicial ears.  This can be seen from In re Dow Chemical Company, Civil Action No. 4349-CC, Del. Ch. Jan. 11, 2010. 

In that derivative suit, plaintiffs alleged that the board had entered into a contract to acquire Rohm & Haas without taking adequate precautions in connection with the financing of the transaction.  Specifically, plaintiffs alleged that the financing to acquire R&H was dependent upon the completion of a separate transaction with Kuwait (K-Dow) and that the agreement was "illusory."  See Plaintiffs' Opposition to Defendants' Motion to Dismiss, at 8 ("Motion"). 

The case turned on demand excusal.  Plaintiffs asserted, among other things, that the board was not independent.  The court, however, disagreed, characterizing the evidence as "no more than 'mere outside business relationship[s which] standing alone, are insufficient to raise a reasonable doubt about a director's independence.'" 

In addition, however, plaintiffs also asserted that the CEO controlled the board and gave as an example the board's decision to dismiss two officers at the request of the CEO.   As plaintiffs asserted on brief, "Liveris ordered the Board, overnight, to summarily terminate two dissident officers, Romeo Kreinberg and J. Pedro Reinhard, how had urged a long-term strategy upon the Board, which differed from Liveris's," (Motion, at p. 16), a directive that the "Board followed."  Complaint, at p. 16. (emphasis in original).  The Complaint listed Reinhard as "then-CEO and Director." 

In other words, at a pre-discovery stage of pleadings, the plaintiffs provided an example of control, one that at least raised the possibility of control.  The court, however, summarily dismissed the contention and in so doing conducted its own fact finding.  As the court concluded:

• For example, plaintiffs' argument that Liveris allegedly exercised influence by 'order[ing] the Board, overnight, to summarily terminate two dissident officers'—their best argument—falls short. Upon further investigation it is clear that valid business reasons existed to terminate those two officers; they held clandestine meetings and set up a proposed leveraged buyout—all behind the board's back. Not surprisingly, the board may not have wanted them at the company. On the contrary, plaintiffs paint a different picture, suggesting that the two officers were whistleblowers on the bribery charges brought by the SEC against Dow in early 2007. Pls.' Opp'n Br. at 16. The complaint, however, states that the officers were engaged in clandestine meetings without the full board or the CEO's knowledge. See Compl. ¶ 125. Thus, it is far from clear that the board acted as Liveris' puppets in deciding to fire them.

The need to undertake "further investigation" suggested additional fact finding.  Moreover, the court noted that the board "may not have" wanted the officers at the company.  In other words, even the court wasn't entirely sure of the motivation.  Finally, even if there were grounds for dismissal, the process of an overnight dismissal following a request from the CEO at least suggested control. 

The approach essentially reduces board analysis to a rote head count that makes no serious attempt to assess CEO influence.  In other words, the safety valve noted by the Court in Aronson, that "discretionary review by the Court of Chancery of complaints alleging specific facts pointing to bias on a particular board will be sufficient for determining demand futility," doesn't really exist.   

The irony in all of this is that the court in Dow Chemcial did not even need to make the finding about the lack of control.  The court concluded that the CEO, Liveris, was not interested in the transaction, making it irrelevant who he allegedly controlled.  Yet the impact of the dicta will make it far more difficult for shareholders challenging board behavior to show actual bias.  

Full post as published by The Race to the Bottom on February 19, 2010 (boomark / email).