Director Independence to Consider Pre-Suit Demand

The Delaware Supreme Court held in the seminal Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984), that in order to plead demand excusal, a plaintiff must plead particularized facts creating a “reasonable doubt” that either: 1) a majority of “the directors are disinterested and independent; or 2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” In circumstances “where the board that would be considering the demand did not make a business decision which is being challenged in the derivative suit” — such as where a majority of the directors who made the challenged decision are no longer sitting — Delaware applies the standard enunciated by the Delaware Supreme Court in Rales v. Blasband, 634 A.2d 927, 933-34 (Del. 1993).

Under Rales, a plaintiff alleging demand futility must plead particularized facts to create reasonable doubt about the ability of the board. These facts would be addressing the demand (i.e., the board at the time the complaint was filed) in order for the court to consider the demand impartially. Under either test, the plaintiff “must impugn the ability of at least half of the directors in office when it initiated [the action] … to have considered a demand impartially.”

'Sanchez'

The putative derivative action against the directors of Sanchez Energy alleged a “gross overpayment” in connection with a particular transaction. Two of the directors of Sanchez Energy, including the chairman, were interested in the transaction, and the question was whether, under Aronson, the plaintiffs had pled particularized facts raising a reasonable doubt as to the independence of one of the other directors. The court's analysis centered on director Alan Jackson, whose independence was challenged on “two related grounds”: first, that Jackson had been a close friend of the chairman for five decades and second, that “Jackson's personal wealth [was] largely attributable to business interests over which [the chairman] has a substantial influence.”

The Court of Chancery concluded that neither of these grounds was sufficient on its own to compromise Jackson's independence for demand excusal purposes, and thus dismissed the complaint. The Supreme Court, however, ruled that it was error to consider these two grounds as “entirely separate issues,” explaining that Delaware law “requires that all the pled facts regarding a director's relationship to the interested party be considered in full context in making the, admittedly imprecise, pleading stage determination of independence.”

Highlighting Jackson's close 50-year friendship with an interested party, the court explained that “when a close relationship endures for that long, a pleading stage inference arises that it is important to the parties.” The court deemed it significant that the plaintiffs also “pled facts regarding the economic relations” between Jackson and the chairman that supported their contention that the two directors were “confidants and that there is a reasonable doubt that Jackson [could have] act[ed] impartially in a matter of economic importance to [the chairman] personally.” The court determined that these allegations raised “a pleading stage inference that Jackson's economic positions derive[d] in large measure from his 50-year close friendship” with the chairman. Accordingly, the court concluded that the facts pled by the plaintiffs, taken together, created a reasonable doubt about Jackson's independence and thus adequately alleged demand excusal.

'Sandys'

Sandys involved a putative derivative action brought by a shareholder of Zynga, alleging that certain Zynga officers and directors were granted an exemption to the company's policy prohibiting sales by insiders until three days after an earnings announcement, and that these insiders sold stock prior to an earnings announcement that allegedly disclosed information which caused the company's stock price to plummet. The plaintiff alleged that the selling insiders breached their fiduciary duties by selling their shares while in possession of “adverse, material non-public information” and that the directors who approved the sale violated the duty of loyalty.

The defendants moved to dismiss based on the plaintiff's failure to make a pre-suit demand on Zynga's nine-member board. Applying the Rales test to evaluate whether at least five of the directors could consider a demand independently, the Court of Chancery determined that two of the company's directors — including Zynga's former CEO, chairman and controlling shareholder, Mark Pincus — participated in the transaction and were thus interested parties. The court then examined the independence of five other directors and found them all to be independent, so that demand was not excused.

The Delaware Supreme Court agreed with the Court of Chancery that Pincus and another director were interested in the transaction, but concluded that the plaintiff also pled particularized facts creating a reasonable doubt that three of the five other directors addressed by the Court of Chancery were independent.

The Supreme Court first focused on director Ellen Siminoff, who, along with her husband, co-owned a private jet with Pincus. In the court's view, “the most likely inference from the co-ownership of the private airplane between Pincus and Siminoff” is “not that the private airplane was a business venture — but that it signaled an extremely close, personal bond between Pincus and Siminoff, and between their families.” The court reasoned that “[c]o-ownership of a private plane involves a partnership in a personal asset that is not only very expensive, but that also requires close cooperation in use, which is suggestive of detailed planning indicative of a continuing close personal friendship” — the type of personal friendship that “one would expect to heavily influence a human's ability to exercise impartial judgment.”

Although the court held that the plaintiff created reasonable doubt that Siminoff would have been able to impartially evaluate a demand to sue a close friend, it noted that it was not discarding the oft-stated principle that friendships and outside business relationships, without more, are each insufficient to raise a reasonable doubt of a director's ability to exercise independent business judgment. But the “unusual fact” of co-owning an airplane suggested a very substantial personal relationship that raised sufficient doubt about impartiality to support demand excusal.

Addressing two other board members — William Gordon and John Doerr — the Supreme Court noted the plaintiff's allegations that both directors were partners at venture capital firm Kleiner Perkins Caufield & Byers, which controlled approximately 9.2% of Zynga's equity, and invested in a company co-founded by Pincus's wife. Additionally, defendant Reid Hoffman — one of the two directors given an exemption to sell in the secondary offering and thus found to be interested in the transaction — and Kleiner Perkins had investments in Shopkick, “and Hoffman serve[d] on that company's board along with yet another partner at Kleiner Perkins.” Moreover, as publicly disclosed by Zynga, the company's board determined that Gordon and Doerr were not independent under the NASDAQ Listing Rules, though Zynga did not disclose why its board made this determination.

With regard to the board's independence determination, the Supreme Court clarified that while “the Delaware independence standard is context specific and does not perfectly marry with the standards of the stock exchange in all cases,” NASDAQ's independence criteria “are relevant under Delaware law and likely influenced by [Delaware] law.” The court highlighted that, under the NASDAQ rules, “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 independence judgment in carrying out the responsibilities of a director.'” Such a determination, the court stated, has “important relevance” to an independence analysis under Delaware law; because Delaware accords deference to directors under the business judgment rule, if Delaware law “is to have any integrity, Delaware must be cautious about according deference to directors unable to act with objectivity.”

Having established the significance of an independence determination under NASDAQ's rules, the court presumed that “the Zynga board did not lightly classify Gordon and Doerr as having a relationship” that would interfere with their exercise of independent judgment. The court acknowledged that it did not know the reason behind the Zynga board's independence determination. Nonetheless, it noted that in the case of Zynga — which has a controlling shareholder, Pincus, who controls 61% of the voting power — “if a director cannot be presumed capable of acting independently because the director derives material benefits from her relationship with the company that could weigh on her mind in considering an issue before the board, she necessarily cannot be presumed capable of acting independently of the company's controlling stockholder.”

Finally, the court assumed that Zynga's board likely considered the directors' business relationships, as described herein, in determining that Gordon and Doerr were not independent under NASDAQ rules. The court agreed that due to the importance of such “mutually beneficial ongoing business relationship[s],” it is reasonable to expect that these types of relationships might materially impact the parties' ability to act adversely toward one another, such as by authorizing litigation. Given the plaintiff's pleading of such close business relationships and the company's own determination that Gordon and Doerr were not independent, the court concluded that a reasonable doubt as to these directors' independence existed under Rales. Because the plaintiff created a reasonable doubt that a majority of Zynga's board could impartially consider a demand implicating Pincus, the court reversed the Court of Chancery's dismissal.

Significance of 'Sandys'

Like Sanchez, the Delaware Supreme Court's opinion in Sandys emphasizes that, while a “thin social-circle friendship” with an interested director would not compromise a director's independence under Delaware law, a close personal and/or business relationship, considered as a whole, may create an inference that a director could not impartially consider a pre-suit demand. Sandys further clarifies that, at least in cases involving a controlling shareholder, a company's determination that a director is not independent pursuant to stock exchange listing rules may be relevant to the independence determination under Delaware law.

Accordingly, companies that have concluded, for any reason, that one or more of their directors are not independent under relevant stock exchange rules should note that: 1) this determination may, in some circumstances, affect their ability to challenge demand futility allegations; and 2) identifying a director as not independent without disclosing the reason will likely weigh against the director in pre-suit demand independence evaluations.

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Joseph M. McLaughlin is a partner and Yafit Cohn is counsel at Simpson Thacher & Bartlett. This article also appeared in the Delaware Business Court Insider, an ALM sibling of this publication.

Universally known as the demand requirement, Delaware Chancery Rule 23.1 compels dismissal of any shareholder derivative complaint that does not allege with particularity the efforts taken by the plaintiff to demand the desired action by the board or, alternatively, facts explaining that a demand was not made because it would have been futile.

In a decision written by Chief Justice Leo E. Strine Jr., for the second time in 15 months, the Delaware Supreme Court in December 2016 reversed a Court of Chancery decision dismissing a derivative complaint for failure to plead demand excusal. In Sandys v. Pincus, 2016 WL 7094027 (Del. Dec. 5, 2016), the court held that the shareholder plaintiff had offered allegations creating reasonable doubt as to a majority of the board's independence to consider a demand to bring suit. Like the Delaware Supreme Court's 2015 decision in Delaware County Employees Retirement Fund v. Sanchez , 124 A.3d 1017 (Del. 2015), Sandys signals that Delaware courts will closely scrutinize personal and business relationships that are asserted as compromising a director's ability to consider a pre-suit demand impartially.

Demand Standards

The Delaware Supreme Court held in the seminal Aronson v. Lewis , 473 A.2d 805, 814 (Del. 1984), that in order to plead demand excusal, a plaintiff must plead particularized facts creating a “reasonable doubt” that either: 1) a majority of “the directors are disinterested and independent; or 2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” In circumstances “where the board that would be considering the demand did not make a business decision which is being challenged in the derivative suit” — such as where a majority of the directors who made the challenged decision are no longer sitting — Delaware applies the standard enunciated by the Delaware Supreme Court in Rales v. Blasband , 634 A.2d 927, 933-34 (Del. 1993).

Under Rales, a plaintiff alleging demand futility must plead particularized facts to create reasonable doubt about the ability of the board. These facts would be addressing the demand (i.e., the board at the time the complaint was filed) in order for the court to consider the demand impartially. Under either test, the plaintiff “must impugn the ability of at least half of the directors in office when it initiated [the action] … to have considered a demand impartially.”

'Sanchez'

The putative derivative action against the directors of Sanchez Energy alleged a “gross overpayment” in connection with a particular transaction. Two of the directors of Sanchez Energy, including the chairman, were interested in the transaction, and the question was whether, under Aronson, the plaintiffs had pled particularized facts raising a reasonable doubt as to the independence of one of the other directors. The court's analysis centered on director Alan Jackson, whose independence was challenged on “two related grounds”: first, that Jackson had been a close friend of the chairman for five decades and second, that “Jackson's personal wealth [was] largely attributable to business interests over which [the chairman] has a substantial influence.”

The Court of Chancery concluded that neither of these grounds was sufficient on its own to compromise Jackson's independence for demand excusal purposes, and thus dismissed the complaint. The Supreme Court, however, ruled that it was error to consider these two grounds as “entirely separate issues,” explaining that Delaware law “requires that all the pled facts regarding a director's relationship to the interested party be considered in full context in making the, admittedly imprecise, pleading stage determination of independence.”

Highlighting Jackson's close 50-year friendship with an interested party, the court explained that “when a close relationship endures for that long, a pleading stage inference arises that it is important to the parties.” The court deemed it significant that the plaintiffs also “pled facts regarding the economic relations” between Jackson and the chairman that supported their contention that the two directors were “confidants and that there is a reasonable doubt that Jackson [could have] act[ed] impartially in a matter of economic importance to [the chairman] personally.” The court determined that these allegations raised “a pleading stage inference that Jackson's economic positions derive[d] in large measure from his 50-year close friendship” with the chairman. Accordingly, the court concluded that the facts pled by the plaintiffs, taken together, created a reasonable doubt about Jackson's independence and thus adequately alleged demand excusal.

'Sandys'

Sandys involved a putative derivative action brought by a shareholder of Zynga, alleging that certain Zynga officers and directors were granted an exemption to the company's policy prohibiting sales by insiders until three days after an earnings announcement, and that these insiders sold stock prior to an earnings announcement that allegedly disclosed information which caused the company's stock price to plummet. The plaintiff alleged that the selling insiders breached their fiduciary duties by selling their shares while in possession of “adverse, material non-public information” and that the directors who approved the sale violated the duty of loyalty.

The defendants moved to dismiss based on the plaintiff's failure to make a pre-suit demand on Zynga's nine-member board. Applying the Rales test to evaluate whether at least five of the directors could consider a demand independently, the Court of Chancery determined that two of the company's directors — including Zynga's former CEO, chairman and controlling shareholder, Mark Pincus — participated in the transaction and were thus interested parties. The court then examined the independence of five other directors and found them all to be independent, so that demand was not excused.

The Delaware Supreme Court agreed with the Court of Chancery that Pincus and another director were interested in the transaction, but concluded that the plaintiff also pled particularized facts creating a reasonable doubt that three of the five other directors addressed by the Court of Chancery were independent.

The Supreme Court first focused on director Ellen Siminoff, who, along with her husband, co-owned a private jet with Pincus. In the court's view, “the most likely inference from the co-ownership of the private airplane between Pincus and Siminoff” is “not that the private airplane was a business venture — but that it signaled an extremely close, personal bond between Pincus and Siminoff, and between their families.” The court reasoned that “[c]o-ownership of a private plane involves a partnership in a personal asset that is not only very expensive, but that also requires close cooperation in use, which is suggestive of detailed planning indicative of a continuing close personal friendship” — the type of personal friendship that “one would expect to heavily influence a human's ability to exercise impartial judgment.”

Although the court held that the plaintiff created reasonable doubt that Siminoff would have been able to impartially evaluate a demand to sue a close friend, it noted that it was not discarding the oft-stated principle that friendships and outside business relationships, without more, are each insufficient to raise a reasonable doubt of a director's ability to exercise independent business judgment. But the “unusual fact” of co-owning an airplane suggested a very substantial personal relationship that raised sufficient doubt about impartiality to support demand excusal.

Addressing two other board members — William Gordon and John Doerr — the Supreme Court noted the plaintiff's allegations that both directors were partners at venture capital firm Kleiner Perkins Caufield & Byers, which controlled approximately 9.2% of Zynga's equity, and invested in a company co-founded by Pincus's wife. Additionally, defendant Reid Hoffman — one of the two directors given an exemption to sell in the secondary offering and thus found to be interested in the transaction — and Kleiner Perkins had investments in Shopkick, “and Hoffman serve[d] on that company's board along with yet another partner at Kleiner Perkins.” Moreover, as publicly disclosed by Zynga, the company's board determined that Gordon and Doerr were not independent under the NASDAQ Listing Rules, though Zynga did not disclose why its board made this determination.

With regard to the board's independence determination, the Supreme Court clarified that while “the Delaware independence standard is context specific and does not perfectly marry with the standards of the stock exchange in all cases,” NASDAQ's independence criteria “are relevant under Delaware law and likely influenced by [Delaware] law.” The court highlighted that, under the NASDAQ rules, “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 independence judgment in carrying out the responsibilities of a director.'” Such a determination, the court stated, has “important relevance” to an independence analysis under Delaware law; because Delaware accords deference to directors under the business judgment rule, if Delaware law “is to have any integrity, Delaware must be cautious about according deference to directors unable to act with objectivity.”

Having established the significance of an independence determination under NASDAQ's rules, the court presumed that “the Zynga board did not lightly classify Gordon and Doerr as having a relationship” that would interfere with their exercise of independent judgment. The court acknowledged that it did not know the reason behind the Zynga board's independence determination. Nonetheless, it noted that in the case of Zynga — which has a controlling shareholder, Pincus, who controls 61% of the voting power — “if a director cannot be presumed capable of acting independently because the director derives material benefits from her relationship with the company that could weigh on her mind in considering an issue before the board, she necessarily cannot be presumed capable of acting independently of the company's controlling stockholder.”

Finally, the court assumed that Zynga's board likely considered the directors' business relationships, as described herein, in determining that Gordon and Doerr were not independent under NASDAQ rules. The court agreed that due to the importance of such “mutually beneficial ongoing business relationship[s],” it is reasonable to expect that these types of relationships might materially impact the parties' ability to act adversely toward one another, such as by authorizing litigation. Given the plaintiff's pleading of such close business relationships and the company's own determination that Gordon and Doerr were not independent, the court concluded that a reasonable doubt as to these directors' independence existed under Rales. Because the plaintiff created a reasonable doubt that a majority of Zynga's board could impartially consider a demand implicating Pincus, the court reversed the Court of Chancery's dismissal.

Significance of 'Sandys'

Like Sanchez, the Delaware Supreme Court's opinion in Sandys emphasizes that, while a “thin social-circle friendship” with an interested director would not compromise a director's independence under Delaware law, a close personal and/or business relationship, considered as a whole, may create an inference that a director could not impartially consider a pre-suit demand. Sandys further clarifies that, at least in cases involving a controlling shareholder, a company's determination that a director is not independent pursuant to stock exchange listing rules may be relevant to the independence determination under Delaware law.

Accordingly, companies that have concluded, for any reason, that one or more of their directors are not independent under relevant stock exchange rules should note that: 1) this determination may, in some circumstances, affect their ability to challenge demand futility allegations; and 2) identifying a director as not independent without disclosing the reason will likely weigh against the director in pre-suit demand independence evaluations.

*****
Joseph M. McLaughlin is a partner and Yafit Cohn is counsel at Simpson Thacher & Bartlett. This article also appeared in the Delaware Business Court Insider, an ALM sibling of this publication.