Sabrina M. Hendershot
In a rare reversal of a Court of Chancery decision, the Delaware Supreme Court revived a pension fund’s derivative complaint, holding that demand on the board would have been futile. In Delaware County Employees Retirement Fund v. Sanchez, Chief Justice Strine, writing for the court en banc, found that a director’s quarter-century friendship and significant business ties supported a pleading-stage inference that the director lacked independence. This opinion serves as an important reminder for boards to be mindful of personal relationships in assessing director independence.
Sanchez involved a joint venture transaction between a private company, Sanchez Resources, LLC, which was owned by the family of A.R. Sanchez, Jr., and the publicly traded Sanchez Energy Corporation, in which the Sanchez family was a significant stockholder. A.R. Sanchez is the Chairman of Sanchez Energy’s board of directors (the “Chairman”), and his son, A.R. Sanchez, III, is President and CEO of Sanchez Energy’s board.
Sanchez Energy shareholders brought a derivative suit against the company’s five directors, alleging that they approved the transaction with Sanchez Resources on unfair terms designed to benefit Sanchez Resources while depleting the assets of Sanchez Energy at the expense of its shareholders.
The plaintiffs did not make a pre-litigation demand on Sanchez Energy’s board with respect to the transaction, as is generally required under Rule 23.1, nor did they exercise their right to inspect the company’s books and records through Section 220 of the DGCL. Instead, the plaintiffs argued that demand was futile and should be excused under both prongs of the test articulated in Aronson v. Lewis. Under Aronson, in order for demand to be excused, a plaintiff must plead particularized facts creating a “reasonable doubt” as to whether: (1) the directors are disinterested and independent; and (2) the challenged transaction was a valid exercise of business judgment.
There was no dispute that two of the five directors, the Chairman and his son, were interested because they both held ownership interests in Sanchez Resources. Therefore, the focus was on whether any of the other three directors were interested. Two of the directors, Gilbert A. Garcia and Alan G. Jackson, had a longstanding friendship and significant financial ties to the Sanchez family. However, the Court of Chancery rejected the plaintiff’s claims on two independent grounds. First, Vice Chancellor Glasscock concluded that the plaintiffs had not alleged specific facts regarding the nature and extent of the relationships between the directors or how they would impact director decision-making. Additionally, he explained that as a minority shareholder, the plaintiffs could not meet the test of “actual control over the transaction at issue” and thus allegations that the directors exercised direct control over day-to-day management and operations of the Company were irrelevant. For these reasons, the Court of Chancery determined that the plaintiffs could not overcome the presumption that the directors were independent.
The Delaware Supreme Court, citing their de novo standard of review, disagreed and reversed. The Supreme Court explained that although the Court of Chancery put forth a “thorough and careful” examination of the facts, to examine those facts in isolation rather than on the whole missed the mark of an independence analysis. The Court then focused on allegations relating to director Jackson.
The Chairman and Jackson have been friends for more than fifty years. Consistent with that friendship, when the Chairman ran for Governor, Jackson donated $12,500 to his campaign. Though the Court has previously announced in cases like Beam v. Stewart, that loose allegations that directors are “within the same social circles” are not enough, the Court found the instant situation distinguishable. In this case, Jackson and the Chairman have been friends for five decades —the sheer duration of which can be characterized as “precious” and “rare.”
Additionally, the Chairman had substantial influence as both a director and the largest shareholder of a parent company that wholly owned an insurance brokerage subsidiary from which Jackson derives much his personal his personal wealth. The subsidiary employs both Jackson —and Jackson’s brother — full time. The subsidiary also provided brokerage services to Sanchez Energy and other Sanchez-family affiliates and Jackson and his brother both serviced that work.
The Supreme Court held that the Court of Chancery erred when it treated the facts related to Jackson and Sanchez’s longtime friendship and the facts regarding their business relationship as entirely separate issues. Instead, when considered in their totality, the Court held that these facts supported a pleading-stage inference in favor of the plaintiffs that Mr. Jackson could not act independently of the Chairman. Furthermore, while it would have been ideal for the plaintiffs to use Section 220 to gather more information about the transaction, the Court “cannot hold the plaintiffs’ failure to undertake additional investigation against them when, as here, the facts pled in the complaint support an inference that a majority of the board lacked independence.”
It is important to note that this opinion was decided in the context of the defendants’ motion to dismiss, thus it is still unknown how the Court of Chancery will hold on remand with a more developed record. Moving forward, however, it is important for Delaware corporations to be aware of close personal relationships between their directors and any party with a financial stake in a contemplated transaction. Because directors and officers often operate in overlapping social and business networks, it is important for corporations to regularly examine the composition of their boards and committees (as well as that of their subsidiaries) so they may determine which of their directors, officers, or shareholders could have a financial interest in a transaction or have ongoing personal relationships that could compromise their independence in approving a transaction. This circumstance is most likely to occur in small boards. Because Delaware law generally gives deference to decisions approved by a majority of independent directors, corporations should also carefully consider whether to hire a greater number of outside directors.
Sabrina Hendershot is the External Managing Editor of the Delaware Journal of Corporate Law and President of the Delaware Law Transactional Law Honor Society. Sabrina also serves as a Josiah Oliver Wolcott Fellow to Justice Collins J. Seitz, Jr. of the Delaware Supreme Court.
Suggested Citation: Sabrina M. Hendershot, Director Independence Analysis Refined, Del. J. Corp. L. (Nov. 13, 2015), www.djcl.org/blog.