Too Few Degrees of Separation Can Spell Trouble for Directors

Think that a total absence of business ties between you and other board members makes you truly independent in the eyes of the law? Well, it doesn’t, according to a ruling last year by Delaware Chancery Court vice chancellor Leo Strine. “At bottom,” Strine wrote in a case involving allegations of insider trading against four directors of Oracle Corp., “the question of independence turns on whether a director is, for any substantial reason [his italics], incapable of making a decision with only the best interests of the corporation in mind.”

Strine’s opinion found such a “substantial reason”: The two members of Oracle’s special litigation committee (SLC) who effectively exonerated their four co-directors of any wrongdoing had far more overlaps with the board members they were investigating than they volunteeredu00e2u20ac”specifically, the extent of their connections with, and at, Stanford University. Opined a palpably piqued Strine: “In view of the modesty of these disclosed ties, it was with some shock that a series of other ties among Stanford, Oracle, and the Trading Defendants emerged” after the SLC made its report.

Strine denied the SLC’s request to terminate the suit, a so-called derivative action in which shareholders demanded that Oracle sue the company’s board for the return of whatever profits the directors had made on contested stock sales. His ruling carried particular weight because it came from Delaware, where half of all publicly traded U.S. companies are registered. “There are very few things that go out of that court that other judges are not sympathetic to,” says Charles Elson, director of the University of Delaware’s John L. Weinberg Center for Corporate Governance.

Since Strine’s ruling, the plaintiffs have dropped their claim against the two outside directors named in the suit but not against the two who work for the company.

The ruling has cast a shadow over how and to what extent directors may relate to one another when they’re not in the boardroom. Worries Lawrence Hamermesh, director of the Widener Institute of Delaware Corporate Law: “It’s quite possible to get carried away with independence. The concept of trust and collegiality is important to boards.”

Indeed, a Delaware Supreme Court ruling in March that affirmed the dismissal of a derivative action brought against the directors of Martha Stewart Living Omnimedia did find that a personal friendship between the company’s founder and one of her directors did not render that director incapable of objectivity. Where the Oracle case was different, however, was that non-business connections among directors outside the boardroom included gifts of several million dollars by one of the directors being investigated to the university that employed both of the directors doing the investigating.

The Oracle case began with the 2001 sale of some 30 million shares by inside directors Larry Ellison (CEO and then chairman) and Jeffrey Henley (CFO and now chairman) and outsiders Donald Lucas, a venture capitalist, and Michael Boskin, a professor of economics at Stanford and a former chairman of the Council of Economic Advisers. The four unloaded all this stock just one to two months before the company announced that revenues and earnings for its fiscal third quarter would not meet expectations. The earnings announcement rocked Wall Street; the stock dropped 21% in a day. Plaintiffs’ attorneys moved in fast with a number of suits, all of which were stayed while Oracle’s board formed the SLC to investigate the merits of the derivative suit brought in Delaware, where the company is incorporated.

It’s rare for an SLC to conclude that the plaintiffs have a case, but it does happen. Last year an SLC at ICN (now Valeant Pharmaceuticals) recommended that the company proceed with claims against former chairman and CEO Milan Panic and several directors and executives to recover some $48 million paid out to them in bonuses.

Obviously an SLC needs to represent the highest standards of independence and objectivity if its recommendations are to be convincing. And that’s where Oracle’s SLC ran into trouble.

The committee consisted of just two directorsu00e2u20ac”Hector Garcia-Molina, chairman of the computer science department at Stanford, and Joseph Grundfest, a professor of law and business at the university’s law school and a former commissioner of the Securities and Exchange Commission. Both had joined the Oracle board after the alleged insider trading took place. Nevertheless, there were close ties between the SLC members and the defendants that perhaps should have sounded a warning bell. Among them: Defendant Boskin was also a Stanford professor, and defendant Lucas had given $50,000 in stock to the law school after Grundfest delivered a speech to a venture capital group at Lucas’s behest.

Grundfest and Garcia-Molina spelled all this out in the report they delivered, which found that the directors had sold their shares within a permissible window and had possessed no material inside information that would motivate them to unload the shares. They concluded that Oracle should not pursue any claims against the fouru00e2u20ac”or against the rest of the board for allowing the stock sales to take place.

The filing of the report enabled the plaintiffs to engage in limited discovery and to bring any new evidence of other ties to Strine’s attention. They submitted a reply to the SLC’s report, and that is when, as a lawyer might put it, everything hit the fan.

In rejecting the SLC’s recommendation, Strine pointed out that the new evidence showed that the relationship SLC member Joseph Grundfest had with defendant Michael Boskin was more than a case of two professors plying their trade on the same campus.

When Grundfest was a Ph.D. candidate at Stanford in the 1970s, Boskin was his teacher, and the two had remained in contact. Both were senior fellows and at the time they served on the SLC were members of the steering committee at the Stanford Institute for Economic Policy Research (SIEPR).

More troubling to the judge were the connections that both SLC members had to defendant Donald Lucas, which they had not mentioned in their report. For one thing, Lucas, a Stanford alumnus, was a director of a foundation, named for his late brother, that had donated $11.7 million to Stanford since 1981. He had also given $4.1 million of his own money to the university. Included in those donations were $149,000 for the law school and $424,000 for SIEPR, which is home to the Donald L. Lucas Conference Center. Lucas is chairman of SIEPR’s advisory board. “It is inarguable that Lucas is a very important alumnus of Stanford and a generous contributor to not one, but two, parts of Stanford important to Grundfest: the Law School and SIEPR,” said Strine.

Oracle CEO Larry Ellison had strong Stanford ties too, Strine noted, even though Ellison hadn’t attended the school. As sole director of the Ellison Medical Foundation, he had pledged or paid $10 million to Stanford for medical research, and Oracle itself had donated $300,000 to the university. Further, Strine wrote that Ellison “was considering making donations of his $100 million house [upon his death] and $170 million for a scholarship program as late as August 2001, at around the same time period the SLC members were added to the Oracle board.” (Ultimately Ellison changed his mind about both.)

Nobody suggests that either Grundfest or Garcia-Molina was swayed by any of these links. Indeed, Strine went out of his way to say that his finding that the SLC lacked independence was not “a conclusion that the two accomplished professors who comprise it are not persons of good faith and moral probity.” But he did say that they were simply too conflicted to be able to assess the behavior of Boskin, Ellison, Henley, and Lucas objectively. “It is no easy task to decide whether to accuse a fellow director of insider trading,” he said. “For Oracle to compound that difficulty by requiring SLC members to consider accusing a fellow professor and two large benefactors of their university of conduct that is rightly considered a violation of criminal law was unnecessary and inconsistent with the concept of independence recognized by our law. The possibility that these extraneous considerations biased the inquiry of the SLC is too substantial for this court to ignore.”

Strine was scheduled to hear the defendants’ motion for summary judgment to dismiss the case this summer and is expected to make a ruling by year’s end. Other derivative actions related to the stock sales are still pending in California state court and federal district court.

Strine’s broadened definition of impartiality lives on as a red light to all boards. Directors need to be far more rigorous when looking for independent outsiders either as board members or, more particularly, as members of committees where impartiality is critical. “Rather than form an SLC whose membership was free from bias-creating relationships, Oracle formed a committee fraught with them,” Strine wrote. Post-Oracle, all directors should reveal any relationships they have to one another, including those through nonprofit organizations, says attorney Brian Pastuszenski, who co-chairs the securities litigation practice at Testa Hurwitz & Thibeault in Boston.

Strine observed that the law “cannot assumeu00e2u20ac”absent some proof of the pointu00e2u20ac”that corporate directors are, as a general matter, persons of unusual social bravery, who operate heedless to the inhibitions that social norms generate for ordinary folk.” In other words, we’re all affected by the social milieu in which we find ourselves. So just to be on the safe side, maybe you should break up that standing golf foursome after board meetingsu00e2u20ac”and don’t even think of making a friendly wager on the outcome.