Special Litigation Committee Not Independent and Misapplied Delaware Corporation Code

A two-member special litigation committee of a company board that recommended dismissal of a derivative action was not independent and did not have a reasonable basis for its conclusion, ruled the Delaware Chancery Court. One committee member had a familial relationship with the company’s CFO, while the other member had a professional relationship with the CFO. Applying the Delaware Supreme Court’s test for demand-excused derivative cases, Chancellor Chandler concluded that there were material questions on whether the special litigation committee was independent and whether it conducted a good faith investigation of reasonable scope that yielded a reasonable basis for its decisions.

The chancery action was governed by the 1981 Delaware Supreme Court opinion in Zapata Corp v. Maldonado, which established a two-part analysis that must be applied when a special litigation committee recommends dismissal of a derivative action. The first analysis, which is mandatory, is a judicial review of the committee’s independence and whether it conducted a good faith investigation of the claims and reached a reasonable conclusion. The second analysis, which is discretionary, is whether the company’s best interests would be served by dismissing the suit. Since he decided the case based on the mandatory analysis, the Chancellor declined to conduct the discretionary analysis.

More broadly, the court emphasized that the independence inquiry under Zapata is critically important if the special litigation committee process is to remain a legitimate mechanism in Delaware corporate law. Committee members should be selected with the utmost care to ensure that they can, in both fact and appearance, carry out the extraordinary responsibility placed on them to determine the merits of the derivative suit and the best interests of the corporation, acting as proxy for a disabled board. In this case, the independence prong of the Zapata standard was not satisfied.

A member of a special litigation committee does not have to be unacquainted or uninvolved with fellow directors to be regarded as independent, noted the court, but a member is not independent if he or she is incapable of making a decision with only the best interests of the corporation in mind. Essentially, this means that the independence inquiry goes beyond determining whether members are under the domination and control of an interested director. Independence can be impaired by lesser affiliations, said the court, so long as those affiliations are substantial enough to present a material question of fact as to whether the committee member can make a totally unbiased decision. For example, independence could be impaired if members sense that they owe something to the interested director based on prior events. This sense of obligation need not be of a financial nature.

Further, special litigation committee members are not given the benefit of the doubt as to their impartiality and objectivity. They bear the burden of proving that there is no material question of fact about their independence. The composition of a committee must be such that it fully convinces the court that the committee can act with integrity and objectivity, because the situation is typically one in which the board as a whole is incapable of impartially considering the merits of the suit.

Here, said the Chancellor, it is undisputed that neither committee member had a personal stake in the challenged transactions centered on an equity incentive plan. Yet, there was a material question as to their independence based on their relationships with the CFO.

The spouse of one committee member was the CFO’s cousin. This association could influence the member’s objectivity, said the Chancellor, who cited an earlier holding of Vice Chancellor Strine that familial relationships between directors can create a reasonable doubt as to impartiality.

The other committee member had a professional association with the CFO in that he had hired the CFO as an internal auditor for a six-year stint in 1993 for a company he co-founded. Their professional relationship was reinstated when the CFO asked the founder to serve on the board.

Under Delaware law, the independence of a special litigation committee member may be impaired if that member feels he or she owes something to an interested director. Noting that this sense of obligation does not have to be financial in nature, the court found a material question of fact as to the committee member’s independence because his earlier associations with the CFO may have given rise to a sense of obligation or loyalty to him.

The court also questioned the reasonableness of the committee’s conclusion regarding the duty of care claims. The committee found that the action should not be pursued on the basis of duty of care claims because Section 102(b)(7) of the Delaware Corporation Code protects directors from personal liability, in the form of money damages, for gross negligence. The court found this to be an unreasonable conclusion because the committee failed to consider that the requested relief in plaintiffs’ complaint is not limited to money damages since it specifically requests that the equity incentive plan be rescinded.

Under Delaware law, noted the court, exculpatory provisions do not bar duty of care claims in remedial contexts such as in injunction or rescission cases. It thus was unreasonable, said the court, for the committee to conclude that the duty of care claims should not go forward solely on the basis of § 102(b)(7). Indeed, the court emphasized that the committee simply failed to understand that Delaware law permits a suit seeking rescission to go forward despite a § 102(b)(7) provision protecting directors against monetary judgments.