Independent directors are the key players in derivative litigation. They can decide whether a lawsuit against their company’s directors or officers should proceed or not. And they can seize control of a case from the plaintiffs who originally filed it.

But changing standards of director independence threaten the power independent directors traditionally exercised over derivative litigation. Some new standards — such as those created by Sarbanes-Oxley and recent stock exchange rules — impose more stringent independence requirements but are, at least, clear and objective.

Two recent Delaware decisions, however, created new independence hurdles of uncertain height and breadth. These decisions — In re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003) and In re eBay, Inc. Shareholders Litigation, No. 19988-NC, 2004 Del. Ch. 4 (Del. Ch. Feb. 11, 2004) — raise a troubling question: Can companies ever have truly independent directors?

The Importance of Independent Directors in Derivative Actions

A derivative action is an unusual species of shareholder lawsuit. Its purpose is to enforce a company’s cause of action against its own directors or officers. See Rales v. Blasband, 634 A.2d 927, 932-33 (Del. 1993).

Because a derivative action seeks to enforce a corporate claim, a plaintiff normally must, before suing, demand that the company’s board of directors commence litigation against the alleged wrongdoers. See Del. Ch. Ct. R. 23.1; Fed. R. Civ. P. 23.1; Cal. Corp. Code § 800. Demand on the board is excused only when it would be “futile” — usually because the company’s directors are not disinterested or independent. See Aronson v. Lewis, 473 A.2d 805, 814-18 (1984).

A company’s independent directors may, in response to a demand or after the commencement of litigation, investigate derivative allegations and decide whether it is in the company’s business interests to pursue a corporate claim. If the directors are truly independent, and they perform a reasonable investigation, their decision — to pursue a claim or to seek its dismissal — is entitled to deference under the business judgment rule.

New Director Independence Rules

Congress, the New York Stock Exchange, and NASDAQ all recently imposed heightened director independence requirements. These changes, made in response to revelations of corporate wrongdoing, generally provide that an independent director may not have certain financial or business relationships with his company. For example, Sarbanes-Oxley bars directors who serve on audit committees from providing accounting, consulting, legal, investment banking, or financial advisory services to their companies. The new NYSE and NASDAQ rules say, among other things, that a director is not independent if, within the last three years, he was employed by the listed company, he received more than $60,000 (NASDAQ) or $100,000 (NYSE) a year from the listed company for services other than as a director, or his employer received payments from the listed company totaling more than $200,000 (NASDAQ) or $1 million (NYSE) a year.

These new rules make it harder for a director to qualify as independent. But at least they are clear. Any company that wants independent directors — in order to respond to derivative actions, for example — can apply these standards and know, with a great deal of confidence, whether its directors will pass muster.

The Oracle Decision

The Oracle decision, by contrast, erected amorphous barriers to director independence. Oracle involved an attack on the independence of two outside board members who investigated derivative allegations of insider trading. The two board members — both prominent professors at Stanford University — conducted what the court conceded was an “extensive” investigation. Oracle, 824 A.2d at 925. They (assisted by independent counsel) interviewed seventy witnesses, reviewed “an enormous amount of paper and electronic records,” and produced a 1110-page report (excluding exhibits) which exonerated the accused wrongdoers and recommended dismissal of the action. Id. 925-28.

Under prior Delaware law, Oracle’s two board members would have qualified as independent unless they were “dominated and controlled” by the alleged wrongdoers. See, e.g., Aronson, 473 A.2d at 815-17. The Oracle court candidly admitted that “[n]othing in the record” suggested that the two Stanford professors were dominated or controlled by defendants. Oracle, 824 A.2d at 937. But the court nonetheless rejected their investigation, concluding that the professors failed two new independence tests.

Business Associations

The court found that Oracle’s two board members were not independent due to ties between the alleged wrongdoers and Stanford University. One of the alleged insider traders was also a Stanford professor; a second was a Stanford alumnus and significant donor; and a third was a major financial contributor. These ties, the court found, created “a social atmosphere painted in too much vivid Stanford Cardinal red.” Id. at 947.

By disqualifying directors on the basis of social and business connections, the Oracle court disregarded prior Delaware decisions which held that director independence was not compromised by ties to “family, friends and business associates.” E.g., In re Walt Disney Co. Derivative Litig., 731 A.2d 342, 354 n.18 (Del. Ch. 1998). The court criticized these earlier decisions for “giv[ing] little weight to ties of friendship in the independence inquiry.” Oracle, 824 A.2d at 939. The court argued that “motives like love, friendship, and collegiality” and “the social nature of humans” can undermine a director’s independence in ways comparable to financial or business relationships. Id. at 938-39.

Where does this test leave independent directors? Can’t plaintiffs always argue that directors share some feelings of “friendship” and “collegiality?” After all, even directors who are complete strangers to other directors and officers at the beginning of their tenure might develop feelings of “friendship” and “collegiality” over time.

Social Pressures

The Oracle court also found that the two board members’ independence was compromised by a generalized social aversion to accusing one’s peers. Here, too, the court disregarded prior Delaware decisions. See Aronson, 473 A.2d at 815 n.8, 818.

The Oracle court did not have any evidence of actual pressure being applied to the board members. But the court repeatedly emphasized how “hard” it would be for one director to accuse another of serious wrongdoing: “It is no easy task to decide whether to accuse a fellow director of insider trading.” “Some things are ‘just not done.’” “[A]ccusing such a significant person in [the] community of such serious wrongdoing is no small thing.” Oracle, 824 A.2d at 921, 938, 945.

These concerns, of course, arise virtually every time a director considers suing another director or officer. The Oracle decision offers no guidance regarding the proper scope or application of its new rule.

The eBay Decision

The eBay decision arose out of an attempt to recover profits earned by certain eBay officers and directors on the sale of “hot” IPO stocks allocated to them by an investment bank. The bank allegedly allocated the stocks in order to secure subsequent investment banking engagements. Plaintiffs claimed that demand on eBay’s directors would be futile, and the court agreed — again for reasons not found in prior Delaware cases.

“Huge” Financial Benefits

Most directors receive some form of compensation for their services. This fact has never been seen as compromising a director’s independence. See, e.g., Walt Disney, 731 A.2d at 360. But, in eBay, the court found that eBay’s directors had received “huge financial benefits” “potentially” worth “millions of dollars,” mostly in the form of vested and unvested stock options. eBay, 2004 Del. Ch. LEXIS at *7-*9, *11. This high level of compensation, the court concluded, would make it impossible for a director to “objectively and impartially” consider bringing a claim against the accused wrongdoers. Id. at *11.

What’s the difference between regular director compensation and “huge” director compensation? Does the answer turn on the absolute value of the compensation? Does it depend on the amount of compensation in relation to each director’s personal financial situation? Does it matter whether stock options are unvested or earned? What if the value of stock options has varied greatly over time? When should their value be measured? The eBay decision does not answer these questions. Accordingly, companies have no way of knowing, with certainty, whether their director compensation programs might inadvertently have the effect of destroying director independence.

Positions “Owed” to Alleged Wrongdoers

The eBay decision also breaks new ground in the area of “domination and control.” Prior decisions acknowledged that many directors are “nominated by or elected at the behest of those controlling the outcome of a corporate election.” Aronson, 473 A.2d at 816. These directors did not lose their independence simply because they “owed” their positions to others. See id. at 815-16.

But, in eBay, the directors and officers accused of wrongdoing allegedly owned or controlled “about one-half of eBay’s outstanding common stock.” eBay, 2004 Del. Ch. LEXIS 4 at *10. This gave the accused directors and officers “the ability to control . . . the election of directors,” and made any other director “beholden [to them] for his current and future position on eBay’s board.” Id. at *10-*11.

Of course, many companies (including several very prominent ones) have large blocks of shares concentrated in the hands of a few individuals — typically founders or early investors, many of whom serve as officers or directors. eBay seems to say that these companies can never have truly independent board members because the directors of such companies can always be removed by a few powerful shareholders.

Conclusion

The Oracle and eBay decisions make it difficult for companies to know whether their directors are, or could ever be, truly independent. These decisions create tremendous uncertainty and new opportunities for derivative action abuse. Only one thing is clear – there is more to worry about now.