Director Independence – Keeping the Board and Board Actions Conflict-Free

This article was originally published on February 25, 2022, and has been updated as of July 24, 2024.

At a Glance

This guide provides a high-level explanation of Delaware law regarding director independence, including the types of relationships and circumstances that might raise questions of director independence.¹

Why is Director Independence Important?

A court’s conclusion regarding whether the majority of a company’s board is independent could affect:

The Standard of Review Applicable to a Challenged Transaction

• If independent directors approve a transaction, a stockholder challenge likely will be subject to the “business judgment rule,” which presumes the directors acted on an informed basis, in good faith and in the best interest of the company.
• A plaintiff may rebut the presumptions under the business judgment rule by showing that most of the directors approving the challenged transaction were either interested in the transaction or not independent of a person with an interest in the transaction.
• If a majority of directors are not independent, the entire fairness standard of review would apply, which is far more difficult for the company to satisfy.

Evaluating Special Committees for Controlling Shareholder Transactions

• Whenever a special committee of disinterested and independent directors negotiates and approves a transaction with a controlling stockholder, it becomes the plaintiff/stockholder’s burden to prove the deal was unfair.
• If the company and its directors are unable to establish the independence of the special committee, it remains the company’s burden to prove the entire transaction was fair.
• For a special committee to be independent, every member of the committee must be independent.

A Stockholder’s Entitlement to Pursue Derivative Litigation on Behalf of a Corporation Against Its Directors

• The court will consider whether a majority of the board:
  1. Received material personal benefit from the challenged transaction
  2. Has a substantial likelihood of liability for approving the challenged transaction
  3. Lacks independence from someone receiving a material benefit from the challenged transaction, or who themselves would face substantial likelihood of liability for the challenged transaction.

The Court’s Decision to Reject a Special Litigation Committee’s Recommendation to Dismiss Litigation Brought on Behalf of the Company

• If a special litigation committee moves to dismiss a derivative action, the court must investigate the independence of the committee members and the reasonableness and good faith of the committee’s investigation.

How Does the Law Define an Independent Director?

It is important to note that whether a director is deemed independent depends on the specific situation and requires a detailed examination of the facts. A director’s independence may be questioned if he or she receives material benefits from someone interested in the underlying transaction, and the loss of those benefits is likely to compromise the director’s ability to make unbiased decisions about the company.

A director is considered independent if:

• That director’s decisions are based on the corporate merits of the subject before the board rather than external factors or influences.
• The director has no economic or personal interest in the corporate transaction or action that requires board approval.
• The director is not financially or personally “beholden” to an interested party.²

What Types of Relationships Give Rise to Doubt Regarding a Director’s Independence?

Importantly, materiality matters. The conduct or relationship that calls a director’s independence into question must be material — meaning that it is reasonably likely to alter the decision-making process. 

• Cursory allegations of friendships, social relationships or prior business transactions with an interested party are insufficient to establish lack of independence.

Questions of director independence may arise based on:

Prior Personal Relationships and Communications

• Family Relationships. Where material familial interest exists between directors, the directors’ independence will be in question.³
• Social or Business Relationship. The relationship must be more than a thin social connection to raise concerns about independence. That said, financial dependence or significant business relations with a controlling stockholder can suggest a lack of independence.
  • Additionally, statements suggesting a close personal relationship can indicate a lack of independence. Broad language that expresses “gratitude,” “mutual respect,” “loyalty” or “affection” can be interpreted as indicating non-independence.
• Back-Channel Communications. Informal or undisclosed communications that could influence the director’s decisions can undermine director independence.

Compensation

• Pecuniary Self-Interest. A director has a financial self-interest so significant that it likely affects their ability to prioritize the company’s interests over their own personal gain.⁴
  • But, the mere fact that directors received fees for their service as directors is insufficient to compromise independence.⁵
• Relationship With Corporation. An employee relationship with the corporation also raises doubt that a director would act independently, particularly when the income derived from that position is substantial or the director’s primary source of income.⁶
• Financial Relationship. A financial relationship between the director’s business and the corporation is sufficient to raise doubt regarding that director’s ability to remain independent.⁷
  • Donations. Significant donations to a director’s charity or charitable cause with which the director is affiliated could call into question the director’s independence.⁸