Delaware Supreme Court Adopts Universal 3-Part Test to Assess Demand Futility

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Highlights

  • The Delaware Supreme Court has adopted a new three-part test as the "universal test for assessing whether demand should be excused as futile."
  • When a company has adopted a Section 102(b)(7) provision, directors do not face a substantial likelihood of liability for duty of care claims, and consequently demand is not futile.
  • The decision reaffirms that directors, not stockholders, should normally control a company's litigation decisions.

In a Sept. 23, 2021, decision that may make it easier for Delaware boards of directors to obtain an early dismissal of derivative suits brought against them, the Delaware Supreme Court in United Food and Commercial Workers Union v. Zuckerberg et al., No. 404, 2020, announced a new three-part test as the "universal test for assessing whether demand should be excused as futile." In so doing, it blended the two traditional demand futility tests from Aronson v. Lewis1 and Rales v. Blasband.2

Background

The underlying case involved the fallout from challenges to a 2016 decision by the board of directors of Facebook Inc. to approve a stock reclassification that would allow Facebook Chairman and CEO Mark Zuckerberg to sell most of his Facebook stock while maintaining voting control of the company. After its approval, more than a dozen complaints were filed challenging the plan, claiming that the board violated its fiduciary duties by negotiating and approving a purportedly one-sided deal that put Zuckerberg's interests ahead of those of Facebook. These cases were consolidated into one class action but, shortly before trial, Zuckerberg requested that the reclassification be withdrawn, which mooted the fiduciary duty class action. Another stockholder then brought a derivative suit after the settlement of the class action, essentially seeking to recoup the $80-plus million that Facebook had spent on attorneys' fees.

Before bringing suit, the stockholder did not make demand under Court of Chancery Rule 23.1.

Duty of Care Claims Insufficient to Establish Demand Futility

The plaintiff alleged that the defendants breached their duty of care in negotiating and approving the reclassification. Both the plaintiff and defendants agreed that the Aronson test applied because the complaint challenged a decision made by the same board that would consider the litigation demand. In such circumstances, demand is excused as futile if the complaint alleges particularized facts that raise 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.3

Facebook's charter, however, contained a Section 102(b)(7) clause, which insulated the directors from duty of care claims such that the defendants faced no risk of personal liability. In such circumstances, the Court of Chancery held that exculpated care claims do not excuse demand under Aronson's second prong.

On appeal, the plaintiff contended that the language in Aronson's second prong focused on whether "the challenged transaction was ... the product of a valid business judgment," regardless of whether the directors faced substantial liability. The Delaware Supreme Court disagreed, and after reviewing past cases applying Aronson, determined that this prong used the standard of review as a proxy for whether the board could impartially consider a litigation demand. The reason it likely did so was that Aronson was decided before Section 102(b)(7) was adopted in 1995, such that prior to that, if care violations rebutted the business judgment rule, then directors would be exposed to a substantial likelihood of liability. Consequently, the Supreme Court rejected the argument that "rebutting the business judgment rule should automatically render directors incapable of impartially considering a litigation demand." As a result, the Supreme Court also confirmed that demand is not futile under the second prong of Aronson simply because entire fairness applies to a controlling stockholder transaction.

In affirming the Court of Chancery's decision, the Supreme Court reiterated that disinterested and independent directors are in the best position to manage the corporation's affairs and that they could decide that it is not in the corporation's best interest to spend the time and money to pursue a claim, even one that is likely to succeed.

Adoption of Universal Three-Part Demand Futility Test

The Supreme Court also agreed with the Court of Chancery that it was time "to move on from Aronson entirely." It adopted the Court of Chancery's three-part test, which combined the Rales and Aronson tests, as the universal test for whether demand should be excused as futile. Thus, going forward, courts should ask the following three questions on a director-by-director basis when evaluating allegations of demand futility:

(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 faces a substantial likelihood of liability on any of the claims that would be 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 would be 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.

If the answer to any of the questions is "yes" for at least half of the members of the demand board, then demand is excused as futile.

According to the Supreme Court:

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. That is a different consideration than whether the derivative claim is strong or weak because the challenged transaction is likely to pass or fail the applicable standard of review. It is helpful to keep those inquiries separate.

Concluding Thoughts

According to the Delaware Supreme Court, the three-part test is a refined test that is "consistent with and enhances Aronson, Rales, and their progeny," and as a result, cases "properly construing Aronson, Rales, and progeny remain good law." Even so, the case makes clear that depriving the board of its ability to control litigation involving the corporation should be the exception, not the rule, and that as long as a corporation has adopted a Section 102(b)(7) provision, duty of care allegations will be insufficient to plead demand futility.

Notes

1 473 A.2d 805 (Del. 1984).

2 634 A.2d 927 (Del. 1993).

3 In all other circumstances, the Rales test applied, under which demand is excused if the complaint alleges particularized facts creating a reasonable doubt that, at the time the complaint is filed, a majority of the board could have exercised its independent and disinterested business judgment in responding to a demand.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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