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Boards Behaving Badly: A Delaware Primer

Letting stand some shareholder claims against infoUSA directors and CEO Vinod Gupta, Chancery Court's Chandler rips 10-K deception and offers a study in board conflicts. Were stock options for President Clinton properly granted?
Roy Harris, CFO.com | US
August 23, 2007

In a Delaware Court of Chancery case that he wrote "tests the boundaries of the business judgment rule," Chancellor William B. Chandler III dealt infoUSA Inc. a setback, and drew guidelines for director conflicts of interest, and for board disclosures of internal investigations.

His opinion, handed down in revised form on Aug. 20, also challenged the propriety of a 100,000-share stock option grant to former President Bill Clinton, which the judge said could be rescinded if the plaintiffs prove in a trial that infoUSA CEO Vinod Gupta awarded the options without board approval. The former president has served as a consultant to infoUSA.

Mainly, however, the 79-page ruling painted a picture of a nine-member infoUSA board that facilitated or tolerated "a garish collection of self-interested transactions, principally engineered by the CEO, and largest shareholder, Vinod Gupta," in Chandler's characterization of the claims. "Such extravagances included the lease of aircraft and office space for personal use, the provision of a yacht, and a collection of luxury and collectible cars that would leave James Bond green with envy."

Omaha-based infoUSA is a 35-year-old database marketing firm that is 41-percent-owned by Gupta, a large Democratic Party contributor who either personally, or using corporate assets, has provided services to former President Clinton and New York Sen. Hillary Rodham Clinton over the years, according to records filed in connection with Delaware suit. The company is incorporated in Delaware.

Chandler, known for his colorful opinions — but also for care in preserving Delaware's business judgment rule — seemed to use the case of In Re: INFOUSA Inc Shareholders Litigation as a primer for detailing where boards might cross over into bad faith or disloyalty. (The business judgment rule protects executives and directors from liability for their decisions as long as they act in good faith and with a sense of loyalty to shareholders, rather than personal self-interest.)

In addition to discussing possible conflicts of interest among certain infoUSA directors, the judge at one point sharply criticized directors for signing off on what appeared to be an inaccurate statement that appeared in the company's 2004 10-K, which was released on March 16, 2005.

While the 10-K statement said that about $1.5 million of payments to a contractor owned by Gupta were made for "usage of aircraft and related services," Chandler said, the directors had been given a report on Feb. 8 by audit-committee chair Vasant H. Raval, a professor in Creighton University's Department of Accounting, that presented quite another picture. The report revealed, said the judge, "that about 40 percent of these payments had no relationship whatever to aircraft, and were instead payments for the American Princess yacht, use of personal residences, and other undefined travel services." Added the judge: "At least as alleged, these arrangements resulted in a very sweet deal for Vinod Gupta: using infoUSA's money, he was able to purchase services from his own leasing company, pocket the profit on those services and then provide them to his personal friends and political associates."

Added Chandler: "No conceivable definition of candor will shoehorn such payments into services 'related' to the use of aircraft." Signing off on the expenditures in the 10-K as they did, according to the judge, entitles the plaintiffs "to a reasonable inference of bad faith due to the efforts taken by defendants to conceal their true nature."

Companies often study opinions in Delaware, the nation's largest state of incorporation, for guidelines on what activities by boards and executives may be challenged in the future. In recent cases, the court has written of its concerns in such areas as director independence and stock-option backdating and "spring-loading" — the granting of options on the expectation that expected positive news will raise the price — for example. In one recent case, Chandler criticized Tyson Foods for inadequate board disclosures about stock options.

In a prepared statement, infoUSA responded: "We are very pleased that the Delaware Chancery Court has agreed that many of the allegations advanced by plaintiffs' in this lawsuit were insufficient as a matter of law and were dismissed out of hand. With respect to what remains, the Court has held that plaintiffs must now establish that their allegations have a basis in fact. We firmly believe we will be completely vindicated as the legal process unfolds."

The shareholder derivative action against infoUSA was filed by two institutional holders, Cardinal Value Equity Partners LP and Dolphin Financial Partners LLC. And indeed, plaintiffs also took some buffeting from Chandler. In addition to throwing out several of their claims, the judge noted that plaintiffs "never solidly grapple" with the need to illustrate that a majority of the board was self-interested and lacked independence. That is important, the chancellor wrote, because in Delaware, plaintiffs pressing a derivative case must show that they could not get a fair hearing from the board for some reason, according to a standard called "demand futility."


Despite plaintiffs' failure to make their own strong demand-futility case, Chandler wrote, the complaint filed by lawyers for the two holders "contains allegations scattered throughout that allow me to determine that a majority of these directors were either interested or lacking in independence at the time Dolphin filed its first amended derivative complaint."

Indeed, to an unusual degree Chandler seemed to piece together the case where the plaintiffs hadn't. The court was presented with "a collection of related-party transactions that, taken individually, might fall within the business judgment of an independent board acting in good faith," he wrote. "Yet the Court should not be blind to the fact that, in this case, literally dozens of such transactions have taken place, each blessed or passively noted by a board of directors with close personal and professional ties to the principal beneficiary of such largess."

Going through the board list director-by-director, Chandler himself noted cases in which, for example, significant free office space was provided by infoUSA to two directors for use by their companies. Further, in the case of Prof. Raval, "his remuneration as a board member exceeds the average salary reported for a professor at Creighton University," Chandler wrote, and "he received a $50,000 grant from the V. Gupta School of Business Administration." Those factors, "as well as the presence of defendants on other boards that could affect his professional advancement, are sufficient to raise a reasonable inference necessary to call his independence into question."

An attorney representing Cardinal Value Equity Partners, R. Bruce McNew of the Wilmington, Del., firm of Taylor & McNew LLP, said the most important corporate lesson in Chandler's opinion was: "Make sure your public disclosures don't conflict with internal reports or investigations." Asked about the criticism Chandler reserved for plaintiffs, McNew responded: "He felt there was room for great improvement in the presentation of the claims." But McNew said he didn't see the opinion as breaking new ground, and added that it represented an extreme case of corporate behavior that is unlikely to be widely relevant. "There's no way most executives would let this happen at their own companies," he said.

Chandler reserved some of his strongest language for what he saw as the inadequate disclosure in the 10-K. In the case of infoUSA, when information about related-party transactions was later disclosed, board members in 2006 "were narrowly re-elected in a proxy contest that can only be described as an open revolt of unaffiliated shareholders," Chandler wrote. This "rising tide" of dissatisfaction suggested that the board-member defendants had been motivated "to conceal the true nature of the massive hidden perquisites being provide to Vinod Gupta, and that their failure of candor misled stockholders and damaged the company."

Among Delaware-incorporated companies, "shareholders are entitled to honest communication from directors, given with complete candor and in good faith." he wrote. "Communications that depart from this expectation, particularly where it can be shown that the directors involved issued their communication with the knowledge that it was deceptive or incomplete, violate the fiduciary duties that protect shareholders. Such violations are sufficient to subject directors to liability in a derivative claim."

Attorney McNew said the next step in the case will be discovery, followed by trial.




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