Directors and management often operate in overlapping social and business networks, and care must be taken to understand the scope, depth, and duration of the personal and business relationships between directors and management, to ensure that the independence of directors is not compromised.

Key Takeaways: Typically, a director’s social and business relationships with management of a company do not strip the director of the director’s independence. However, care must be taken because in some circumstances such relationships can strip the director of his or her independence. The scope, depth, and duration of the personal and business relationships may lead a court to conclude that a director is not independent.

Summary: Directors and management often operate in overlapping social and business networks, which can be beneficial for them and for the companies that they serve. However, care must be taken to understand the scope, depth, and duration of the personal and business relationships between directors and management, to ensure that the independence of directors is not compromised.

In a Delaware Supreme Court decision, the court concluded that an outside director’s personal and business relationships with an insider created a reasonable doubt about the outside director’s independence when approving a related-party transaction. As a result, the court reversed a lower court’s ruling and thus allowed stockholders to proceed with a derivative lawsuit challenging the fairness of the transaction.

The derivative suit challenged transactions between the company and another entity that was owned by the company’s chairman and his son, who was the company’s president. The company’s board consisted of the chairman, the president, and three outside directors. In the suit, the plaintiffs had to show that a majority of the board was incapable of considering whether to bring the lawsuit. Because two of the five directors were insiders, this meant the plaintiffs had to show that at least one of the remaining three directors was not disinterested and independent.

The plaintiffs focused most of their attention on a director that had the following ties to management:

  • He and the chairman were “close friends for more than five decades”;
  • He had donated $12,500 to the chairman’s failed gubernatorial campaign;
  • Both the outside director and his brother worked as executives of a company in which the chairman was the “largest stockholder” and a non-independent director and with which the company did business; and
  • The director fees paid to the outside director constituted 30% – 40% of his total income.

The court said that allegations challenging a director’s independence must be “considered in full context” and that, while each allegation standing alone might have been insufficient, they collectively cast doubt on whether the outside director was independent of the chairman and his son. In reaching this decision, the court focused on (1) “a close friendship of over half a century” between the outside director and the chairman and (2) the fact that the chairman had “substantial influence” over the outside director’s (and his brother’s) employer, even though the chairman did not have the power to hire and fire the outside director.

So, while mere allegations that directors move in the same business and social circles as management, or that directors and management are close friends, is not enough to negate independence, there are circumstances where the scope, depth, and duration of the personal and business relationships may lead a court to conclude that a director is not independent.