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Delaware Supreme Court Holds That Directors Can Still Be Friends

April 1, 2004
Lewis H. Lazarus

While Martha Stewart's criminal trial has garnered its share of headlines, a derivative claim brought by a stockholder of her company has generated an opinion by the Delaware Supreme Court that clarifies the standards by which Delaware will measure the independence of a director for purposes of assessing demand futility. In Beam v. Stewart, No. 501, 2003 (Del. March 31, 2004) (en Banc) the Delaware Supreme Court affirmed the Court of Chancery's dismissal of a claim that Stewart had breached her fiduciary duties of care and loyalty by illegally selling Imclone stock and by mishandling the attendant media publicity, causing injury to Martha Stewart Living Omnimedia, Inc. ("MSO") and its stockholders. The Supreme Court ruled that plaintiffs had failed to plead facts sufficient to cast a reasonable doubt on the ability of a majority of the six-member MSO board objectively to determine whether to pursue a potential claim against Stewart, and on that basis affirmed the dismissal by the Court of Chancery of plaintiff's complaint.

Standard for Independence

In so holding, the Delaware Supreme Court emphasized that directors of a Delaware corporation are presumed to have acted consistent with their fiduciary duties. Plaintiffs thus have a burden to plead facts raising a reasonable inference that a director is so beholden to a fellow director that his or her "discretion would be sterilized." Plaintiffs here so pled as to one director who as an officer received substantial compensation from MSO. But as to the other four directors, plaintiffs simply alleged friendship, including having attended a wedding reception hosted by Stewart's personal attorney for his daughter. The Supreme Court held that "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." Id. at 13. Plaintiff failed to "plead facts that would support the inference that because of the nature of the relationship or additional circumstances other than the interested director's stock ownership or voting power, the non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director." Id. at 16-17.

Oracle Distinguished

The Delaware Supreme Court also rejected plaintiff's efforts to analogize the

facts of her complaint with the facts of In re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003). In Oracle, the Court of Chancery had rejected the report of a special litigation committee ("SLC") established to investigate whether the corporation should dismiss a claim against certain of its directors for breach of fiduciary duty. Without passing on whether the substantive standard of independence in an SLC context differs from the standard in a case involving pre-suit demand, the Supreme Court did note that in the former case the SLC bears the burden of demonstrating its independence with the directors required to demonstrate that they, like Caesar's wife, are above reproach while in the latter independence is presumed. Id. at 23.

Court Encourages Use of Inspection Rights

Finally, the Supreme Court observed that plaintiff had failed to take advantage of means at her disposal to learn more facts which may have enabled her to meet her pleading burden and raise sufficient doubts about the independence of the directors. Section 220 of the Delaware General Corporation Law permits a stockholder to demand inspection of the books and records of the corporation where she suspects mismanagement affecting her interests as a stockholder. Among the items the Supreme Court identified as legitimate areas of inquiry in this case were irregularities or 'cronyism' in the process for nominating board members; the independence of the nominating committee, if any, from management; and whether Stewart controlled the nominating process. Id. at 24-25. The Court noted that plaintiffs in the celebrated Disney case had likewise failed to make a demand for books and records, had their original complaint dismissed but with leave to replead, and after exercising their inspection rights were able to plead facts sufficient to raise a reasonable doubt as to the good faith of a majority of the Disney board in a new complaint which survived a motion to dismiss.