Director Independence Standards: Martha Stewart and Oracle Cases Scrutinize Director Relationships

Monday, November 1, 2004 - 01:00

In the current environment in which every decision made by a board of directors may be subjected to scrutiny, it is critical to insulate the directors making those decisions from a challenge to their independence. Two recent Delaware state court decisions involving Martha Stewart Living Omnimedia and Oracle highlight the importance of maintaining a board of directors that is free of "extraneous considerations or influences."1 These decisions reconfirm that, in the context of shareholder derivative litigation, the courts will go beyond a review of the factors identified in the recently adopted independence rules of the New York Stock Exchange and Nasdaq in evaluating the independence of directors.

The Martha Stewart and Oracle decisions also highlight the different procedural circumstances in which challenges to the independence of directors may arise. In the context of the consideration of whether a demand to commence litigation made upon a board of directors should be excused as futile, Delaware courts have generally been deferential in assessing the independence of directors. Accordingly, a plaintiff who alleges demand futility because of the personal relationships of outside directors with management has a relatively heavy burden to establish lack of independence. In contrast, in the context of the appointment of a special litigation committee established to consider whether derivative litigation is in the best interests of the corporation or should be terminated, Delaware courts undertake a more searching analysis. Here, courts will subject personal relationships between directors and members of management to increased scrutiny.

The Martha Stewart and Oracle opinions provide important guidance to directors and their counselors. These decisions must be considered in evaluating the independence of existing board members, selecting new board members, and in forming special board committees.

The Oracle Decision

At issue in the Oracle case2 was the independence of the two members of a special litigation committee ("SLC") formed by Oracle to investigate allegations of insider trading by certain of Oracle's officers and directors. The case arose in the context of the SLC's motion to dismiss a shareholders' derivative action filed against Lawrence Ellison, Oracle's Chairman and CEO; Jeffrey Henley, Oracle's Chief Financial Officer; and Donald Lucas and Michael Boskin, both board members (the "Trading Defendants"). In order to prevail on its motion to terminate the derivative action, the SLC had to establish that (1) its members were independent, (2) that they acted in good faith, and (3) that they had reasonable bases for their recommendations.3

At the center of the court's analysis of independence was the relationship of the Trading Defendants and the SLC members to Stanford University:

  • The SLC was comprised of two Stanford professors, Hector Garcia-Molina and Joseph Grundfest, both of whom also graduated from Stanford.4

  • Trading Defendant Michael Boskin was also a professor at Stanford who taught Grundfest when he was a Ph.D. candidate. Although the two did not socialize, they did remain in contact, in part because they were both senior fellows and steering committee members at the Stanford Institute for Economic Policy Research.5

  • Trading Defendant Donald Lucas was an alumnus of Stanford who had contributed millions of dollars to Stanford, both directly and indirectly. Lucas had donated $50,000 to Stanford in appreciation for a speech given by Grundfest, about half of which was allocated for use by Grundfest in his research.6

  • Trading Defendant Ellison contributed around $10 million to Stanford through a foundation and was considering donating his $100 million house and establishing a $170 million scholarship program around the time that the SLC members were added to the Oracle board.7

In considering these facts, Vice Chancellor Strine noted the unique position occupied by a special litigation committee, which is the last resort for a company to control a shareholders' derivative claim. In this regard, the court noted that "[o]ne of the obvious purposes for forming a special litigation committee is to promote 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 impartial group of independent directors."8 The Oracle court noted that "[i]n evaluating the independence of a special litigation committee, this court must take into account the extraordinary importance and difficulty of such a committee's responsibility."9 Without impugning the good faith of the SLC or the moral probity of its members, the Court nevertheless concluded that the SLC simply was not situated to objectively investigate the Trading Defendants:

[T]he SLC has not met its burden to show the absence of material factual questions about its independence. I find this to be the case because 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.10

Martha Stewart

In a more recent decision, arising out of Martha Stewart's travails, the Delaware Supreme Court addressed the crossroads of director independence and personal relationships in the context of the presuit demand requirement imposed on plaintiffs in a shareholder derivative suit.11 As in the Oracle case, the underlying suit involved allegations of executive misconduct, in this case on the part of Martha Stewart as Chairman and CEO of Martha Stewart Omnimedia, Inc., in connection with her handling of the media attention surrounding her sale of ImClone stock.12 The issue was whether the plaintiff's failure to make presuit demand on the board of directors to pursue the claim on behalf of the corporation was futile because of the directors' lack of independence.

The court's inquiry focused on Stewart's personal relationships with three of the board's directors:

  • Arthur Martinez, who was the former CEO of Sears, Roebuck and a personal friend of Stewart. While at Sears, Martinez developed a relationship with Stewart's company, which marketed substantial merchandise through Sears.13

  • Darla Moore, who was a longstanding friend of Stewart. Moore attended the wedding of Stewart's personal lawyer (Stewart was also in attendance).14

  • Naomi Seligman, who was also a director of John Wiley & Sons ( a publishing house). According to a report in the Wall Street Journal, Seligman contacted the CEO of John Wiley & Sons at Stewart's behest to express concern over a story that was critical of Stewart.15

Chief Justice Veasey, writing for the Court, noted that in the context of presuit demand, directors are entitled to a presumption that they have fulfilled their fiduciary duties.16 This presumption may be overcome, however, by demonstrating that a director stands to reap a benefit or suffer a detriment as the result of his decision.17 With this in mind, the Court concluded that the nature of the personal relationships at issue, with no other facts suggesting lack of independence, was insufficient to excuse presuit demand:

A variety of motivations, including friendship, may influence the demand futility inquiry. But, to render a director unable to consider demand, a relationship must be of a bias-producing nature. Allegations of mere personal friendship or a mere outside business relationship, standing alone, are insufficient to raise a reasonable doubt about a director's independence.18

Significantly, Chief Justice Veasey emphasized the individual directors' standing in the business community, appearing to infer from that status that they had a greater interest in fulfilling their fiduciary duties and thereby protecting their individual reputations than in using their position as director to protect a personal friend.19 Likewise, the members of the SLC in the Oracle case pointed to their status as tenured professors of Stanford as evidence of their independence. Nevertheless, in distinguishing the two cases, Chief Justice Veasey noted, "Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the burden of establishing its own independence by a yardstick that must be 'like Caesar's wife'-'above reproach.'"20 Chief Justice Veasey then distinguished the Martha Stewart case as follows:

We need not decide whether the substantive standard of independence in an SLC case differs from that in a presuit demand case. As a practical matter, the procedural distinction relating to the diametrically-opposed burdens and the availability of discovery into independence [in the SLC context] may be outcome-determinative on the issue of independence. Moreover, because the members of an SLC are vested with enormous power to seek dismissal of a derivative suit brought against their director-colleagues in a setting where presuit demand is already excused, the Court of Chancery must exercise careful oversight of the bona fides of the SLC and its process. Aside from the procedural distinctions, the Stanford connections in Oracle are factually distinct from the relationships present here.21

Conclusion

The Martha Stewart and Oracle decisions highlight the importance of having directors that are truly independent so that their decisions will withstand scrutiny in the face of judicial review. Thus, in selecting independent board members, directors and their counsel should conduct appropriate due diligence, including thorough questioning of board candidates to establish that the candidate is genuinely independent. The analysis should not be limited to the criteria set forth in rules on corporate governance adopted by the NYSE or Nasdaq. Instead, board candidates should be probed to identify any relationships potentially impacting that individual's independence from management, as well as other board members. An even more searching inquiry should be conducted prior to the selection of members of a special board committee. By doing so, boards of directors should be able to minimize their potential exposure to shareholder litigation.

1 Aronson v. Lewis, 473 A.2d 805, 816 (Del. 1984).
2 In re Oracle Derivative Litigation, 824 A.2d 917, (Del. Ch. 2003).
3 Id. at 928
4 Id. at 923-24.
5 Id. at 930-31.
6 Id. at 931-32.
7 Id. at 932-35.
8 Id. at 940.
9 Id.
10 Id. at 942. Recently, a Report of Investigation by the Special Committee of the Board of Directors of Hollinger International Inc. included a detailed review of the charitable donations made by Holinger at the direction of its Chief Executive Officer, Conrad Black, to organizations connected with board members. While not drawing conclusions, the report "raise[d] questions regarding the independence" of the company's directors, including such well-respected individuals as Henry Kissinger and Henry Kravis' wife.
11 Beam v. Stewart, et al., 845 A.2d 1040 (Del. 2004).
12 Id. at 1044.
13 Id. at 1045.
14 Id.
15 Id. at 1045-46.
16 Id. at 1048-49.
17 Id. at 1049.
18 Id. at 1050.
19 Id. at 1047.
20 Id. at 1055 (quoting Louis v. Fuqua , 502 A.2d 962, 967 (Del. Ch. 1985).
21 Id.

Timothy E. Hoeffner is a Partner and Jonathan I. Shapiro is an Associate in the Philadelphia office of Saul Ewing LLP. Please email the authors at thoeffner@saul.com or jshapiro@saul.com with questions about this article.