Delaware’s New Universal Demand-Futility Test

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On Sept. 23, the Delaware Supreme Court endorsed a new universal three-part demand-futility test in United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, et al. (Zuckerberg).[1] This universal test combines the traditional demand-futility tests established in Aronson v. Lewis[2] and Rales v. Blasband.[3]

Background: the Zuckerberg case

The Zuckerberg case arose after the board of directors of Facebook Inc. voted in favor of a stock reclassification (reclassification) that would allow Facebook’s controller, chairman, and chief executive officer, Mark Zuckerberg, to sell most of his Facebook stock while maintaining voting control of the company. Facebook’s stockholders, with Zuckerberg casting the deciding votes, approved the reclassification. However, not long after, numerous stockholders filed lawsuits alleging that Facebook’s board of directors violated its fiduciary duties by approving a purportedly one-sided deal. The lawsuits were consolidated into a single class action. Facebook ultimately withdrew the reclassification and mooted the class action. In total, the company spent about $21.8 million defending the class action and $68.7 million in attorneys’ fees paid to plaintiffs’ counsel under the corporate benefit doctrine.

Another stockholder, the United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund (Tri-State), filed a derivative complaint in the Court of Chancery seeking compensation for the money Facebook spent in connection with the class action. Tri-State did not make a demand under Court of Chancery Rule 23.1 and instead argued that demand would be futile.

The Aronson and Rales tests

Derivative suits seek to “deprive the board of control over a corporation’s litigation asset.”[4] “In order for a stockholder to divest the directors of their authority to control the litigation asset and bring a derivative action on behalf of the corporation, the stockholder must” either (1) make a demand on the board or (2) demonstrate that demand would be futile.[5] The Aronson and Rales tests were used by Delaware courts to determine whether demand was futile. The Aronson test applied where the complaint challenged a decision made by the same board considering a litigation demand.[6] Under the Aronson test, demand was excused as futile if the complaint alleged particularized facts that raised a reasonable doubt that “(1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid business judgment.”[7]

The Rales test applies in all other situations.[8] Under the Rales test, demand was excused as futile if the complaint alleged particularized facts that created a “reasonable doubt that, as of the time the complaint is filed,” a majority of the board “could have properly exercised its independent and disinterested business judgment in responding to a demand.”[9] Ultimately, these tests address the same question, “‘whether the board can exercise its business judgment on the corporat[ion]’s behalf’ in considering demand.”[10]

The Delaware Supreme Court’s reasoning in Zuckerberg and the new universal demand-futility test

On appeal to the Delaware Supreme Court, Tri-State argued that the Court of Chancery erred in holding that exculpated duty-of-care violations do not satisfy the second prong of Aronson.[11] At issue was that Facebook’s charter contained a Section 102(b)(7) (of the Delaware General Corporation Law) clause, thereby insulating its directors from duty-of-care claims such that they faced no risk of personal liability. The Delaware Supreme Court disagreed with Tri-State’s argument and affirmed the Court of Chancery’s decision. The Aronson case was decided before Section 102(b)(7) was adopted in 1995; thus, the court noted:

When Aronson was decided, raising a reasonable doubt that directors breached their duty of care exposed them to a substantial likelihood of liability and protracted litigation, raising doubt as to their ability to impartially consider demand. The ground has since shifted, and exculpated breach of care claims no longer pose a threat that neutralizes director discretion. These developments must be factored into demand-futility analysis, and Tri-State has failed to provide a reasoned explanation of why rebutting the business judgment rule should automatically render directors incapable of impartially considering a litigation demand given the current landscape.[12]

Further, the court rejected Tri-State’s argument that because the entire fairness standard or review applies ab initio to a conflicted-controller transaction (like the one at issue in Zuckerberg), demand is automatically excused under Aronson’s second prong.[13]

Most importantly, the Delaware Supreme Court adopted a three-part universal test, which blends elements of the Aronson and Rales tests. This test requires courts to assess the following on a director-by-director basis:

(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

(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[14]

Under this test, demand is excused as futile if the answer to any of the questions is “yes” for at least half of the members of the demand board.[15] As the court noted, “The purpose of the demand-futility analysis is to assess whether the board should be deprived of its decision-making authority because there is reason to doubt that the directors would be able to bring their impartial business judgment to bear on a litigation demand.”[16] This universal test now “refocuses the inquiry on the decision regarding the litigation demand, rather than the decision being challenged.”[17]

The court stressed that Aronson, Rales, and their progeny remain good law because the new three-part test is consistent with and enhances these cases.[18]

Conclusion

Going forward, the new test will be applied, eliminating the need to determine whether the Aronson test or the Rales test governs a complaint’s demand-futility allegations. The court’s ruling in Zuckerberg affirms that “the demand requirement is not excused lightly because derivative litigation upsets the balance of power that the [Delaware General Corporation Law] establishes between a corporation’s directors and its stockholders.”[19]

[1] No. 404, 2020, 2021 WL 4344361 (Del. Sept. 23, 2021).

[2] 473 A.2d 805 (Del. 1984).

[3] 634 A.2d 927 (Del. 1993).

[4] Aronson, 473 A.2d at 811.

[5] Lenois v. Lawal, 2017 WL 5289611, at *9 (Del. Ch. Nov. 7, 2021).

[6] Zuckerberg, 2021 WL 4344361, at *7 (citing Rales, 634 A.2d at 933).

[7] Aronson, 473 A.2d at 814.

[8] Zuckerberg, 2021 WL 4344361, at *7.

[9] Rales, 634 A.2d at 934.

[10] Lenois, 2017 WL 5289611, at *9 (quoting Kaplan v. Peat, Marwick, Mitchell & Co., 540 A.2d 726, 730 (Del. 1988)).

[11] Zuckerberg, 2021 WL 4344361, at *8.

[12] Id. at *12.

[13] Id. at *13.

[14] Id. at *17 (internal citation omitted).

[15] Id.

[16]Zuckerberg, 2021 WL 4344361, at *16.

[17]Id. (internal citation omitted).

[18] Id. at *17.

[19] Id. at *7.

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