October 25, 2021

Volume XI, Number 298

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October 25, 2021

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Delaware Supreme Court Adopts New Three-Prong Test for Demand Futility

In United Food & Commercial Workers Union & Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, No. 404, 2020, — A.3d –, 2021 WL 3433261 (Del. Sept. 23, 2021), the Delaware Supreme Court adopted a new three-pronged test for determining whether pre-suit demand by a stockholder plaintiff would have been futile.  This new test builds up and refines the Aronson and Rales demand futility tests for derivative claims.  The Court’s decision comes on the heels of Brookfield Asset Mgmt. v. Rosson, where the Court clarified derivative standing by overruling the oft-criticized direct-and-derivative “dual-natured” claim under Gentile v. Rossette (see blog article here).  This decision is another step toward simplifying Delaware law with respect to derivative claims.

Plaintiff-petitioner in this case asserted its derivative claim in the Court of Chancery against members of a prior slate of directors of Facebook (the “Decision Board”), alleging that they breached their duties of care and loyalty by improperly negotiating and approving a stock reclassification.  The reclassification attempted to issue a new class of non-voting shares that founder Mark Zuckerberg could sell for his philanthropic efforts, without relinquishing his voting control.  Instead of pleading demand on the Facebook board (the “Demand Board”) to take action prior to filing suit, the Plaintiff-petitioner chose instead to plead that such demand would have been futile because the reclassification was not a valid exercise of business judgment and a majority of the Facebook board faced a substantial likelihood of liability and/or lacked independence.

Defendants moved to dismiss under Court of Chancery Rule 23.1.  The Court of Chancery agreed with defendants, holding that the complaint did not adequately plead demand futility.  The Delaware Supreme Court affirmed the lower court’s decision on appeal.  In doing so, it clarified how demand futility is determined under Rule 23.1.

There were two tests for demand futility under Delaware law—the Aronson and the Rales tests.  Under the Aronson test (from Aronson v. Lewis, 473 A.2d 805 (Del. 1984)), which applied here, the complaint must allege particularized facts that raise a reasonable doubt that (1) the directors are disinterested and independent, and (2) the challenged transaction was otherwise the product of valid business judgment.  The Court of Chancery found that the second prong of this test “focuses on whether a director faces a substantial likelihood of liability.”  Plaintiff-petitioner here ceded that the complaint did not adequately plead bad faith, so the thrust of its appeal was alleging a breach of the duty of care.  But because Facebook has a 102(b)(7) provision in its articles of incorporation, exculpating directors from duty of care claims, the success of plaintiff-petitioner’s appeal depended on the Court holding that the second prong of the Aronson test applies to claims where directors faced no risk of liability.  The Court, however, held that exculpated care violations do not satisfy Aronson’s second prong.

The Court then addressed a major issue identified by the lower court—that the current demand futility framework is lacking in some key instances.  When a complaint challenges a decision made by the same board that would have fielded the litigation demand, the Aronson test applies.  In all other circumstances, the Rales test applies.  Under the Rales test (from Rales v. Blasband, 634 A.2d 927 (Del. 1993)), the question is whether, as of the time the complaint is filed, a majority of the demand board could have properly exercised its independent and disinterested business judgment in responding to a demand.  But when the members of the board change between the challenged decision and the demand, there is a gap in the framework.

This case exemplified the weakness in the demand futility framework.  Here, there were nine directors on the Demand Board, six of them whom were on the Decision Board.  This would trigger the Aronson test as the board is not comprised of a new majority.  But one of the six directors withheld from voting on the reclassification.  Under a strict reading of Aronson, that director would not be under scrutiny because the test only focuses on the challenged decision, which the director was not a part of.  Aronson also fails to account for the new members of the Demand Board, all of whom could be incapable of fairly considering a demand.

To address the weakness in the demand futility tests, the Vice Chancellor combined the two tests into a three-prong test, asking:

(i) whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;

(ii) whether the director would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand; and

(iii) whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that is the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.

The Court agreed with this approach and adopted it as the new “universal test for assessing whether demand should be excused as futile.”  The Court stated that this approach treated Rales as the general demand futility test, while drawing upon Aronson-like principles when evaluating whether particular directors face a substantial likelihood of liability as a result of having participated in the decision at issue.  Further, the refined test “refocuses the inquiry on the decision regarding the litigation demand, rather than the decision being challenged,” which, in the Court’s view, is consistent with the spirit of Aronson and Rales.  Note that this decision does not overturn Aronson or Rales, as the Court clarifies that cases properly construing the two tests and their progeny remain good law.

Copyright © 2021, Sheppard Mullin Richter & Hampton LLP.National Law Review, Volume XI, Number 284
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About this Author

John Stigi securities law  corporate attorney Sheppard Mulli, law firm
Partner

John Stigi is a partner in the Business Trial Practice Group in the firm's Century City and New York offices, and leader of the firm's Corporate/Securities Litigation Team.

Mr. Stigi's practice focuses on securities class action and shareholder derivative action defense, SEC investigation defense, internal corporate investigations, complex contract and commercial litigation, and M&A and corporate governance litigation.  He has extensive experience representing issuers, officers, directors and auditors in all areas of securities, corporate...

310-228-3717
Eugene Choi Orange County Corporate Lawyer Sheppard Mullin Law Firm
Associate

Eugene Choi is an associate in the Corporate Practice Group in the firm's Orange County office. 

Areas of Practice

Eugene's practice encompasses a variety of corporate and securities matters, including mergers and acquisitions, public and private securities offerings, private equity, venture capital financing, business formation and structuring, joint ventures, and corporate governance matters.

He previously served as a law clerk to the Honorable Karen L. Valihura of the Delaware Supreme Court.  He is a Chartered Alternative Investment Analyst (CAIA...

714-424-2834
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