Securities & Derivative Litigation: Quarterly Update - Q3 2021

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Delaware Supreme Court Articulates a New Standard for Demand Futility and Overturns Gentile v. Rosson

In the third quarter, two new cases from the Delaware Supreme Court altered the legal landscape of derivative actions brought against Delaware corporations. In an en banc opinion, captioned United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, et al.1, the Delaware Supreme Court unanimously set aside the previous seminal tests used for assessing demand futility, Aronson v. Lewis2 and Rales v. Blasband3. Notably, the newly articulated “universal test for assessing whether demand should be excused”4 focuses on whether directors are interested and independent with respect to the litigation demand rather than the decisions, actions or non-action being challenged in the litigation. The Delaware Supreme Court affirmed Vice Chancellor Laster’s opinion below, which determined that a majority of directors were capable of considering a demand. In reaching its conclusion, the Court of Chancery found that Aronson’s “analytical framework [was] not up to the task” and instead applied the Rales test “while ‘draw[ing] upon Aronson­-like principles.’”5

In affirming and adopting the Court of Chancery’s now-three part test, the Delaware Supreme Court applied on a director-by-director basis the following: (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 (clarifying that a claim exculpated by a corporation’s Section 102(b)(7) charter provision does not expose a director to such liability); and (iii) whether the director lacks independence from someone who received a material personal benefit or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand. In reaching its decision, the Court clarified that this “refined” test “is consistent with and enhances Aronson, Rales, and their progeny” and that cases “properly construing Aronson, Rales, and their progeny remain good law.”6

In addition to Zuckerberg¸ the Delaware Supreme Court decided another significant case in the third quarter, Brookfield Asset Management, Inc. v. Rosson, et al.7 in which it overruled its 2006 decision in Gentile v. Rossette,8 and therefore eliminated the “dual-natured” breach of fiduciary duty claims, which were viewed as being classified as simultaneously direct and derivative claims. The underlying facts arose from a private placement transaction in which TerraForm Power, Inc. sold shares of its common stock to its majority stockholder, an affiliate of Brookfield. Plaintiffs, former TerraForm stockholders, filed suit alleging that TerraForm’s board of directors and Brookfield breached their fiduciary duties by approving the private placement on terms that purportedly unfairly diluted the other common stockholders’ economic holdings and voting power. After the private placement, TerraForm was acquired by a third party in a merger that cashed out the plaintiffs’ shareholdings. In moving to dismiss, defendants argued that because the plaintiffs were no longer TerraForm stockholders, they had lost standing to pursue their claims. Although the Court of Chancery agreed that this type of overpayment claim is a “classic” derivative claim, it ultimately concluded that under Gentile, plaintiffs’ claims were both derivative and direct in nature, and therefore denied the motion to dismiss. 

In its opinion, the Supreme Court overturned Gentile, explaining that 15 years of experience with Gentile had shown that it conflicted with the predictable test for determining whether claims are direct or derivative in nature under Tooley v. Donaldson, Lufkin & Jennette, Inc.9 In determining whether a claim is derivative or direct under the Tooley test, the court must address two questions: “(1) who suffered the alleged harm (the corporation or the stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?”10 Where a claim related to an alleged overpayment, the economic and voting power dilution harming the shareholders is caused by a reduction in the value of the corporation itself and flows to stockholders indirectly. Under Gentile, however, a claim would nonetheless be treated as simultaneously direct in nature if: “(1) a stockholder having a majority or effective control causes the corporation to issue ‘excessive' shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controllingshareholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders.”11 The Supreme Court noted that courts have had difficulty applying this exception, and that it “detracts from Tooley’s stated goal of adding clarity to a difficult and important area of our law.”12 Practically, this decision will lead to greater predictability in determining whether a shareholder’s claims are direct or derivative. Moreover, plaintiffs may have a more difficult time asserting claims following a cash out merger and thus may reduce certain post-deal litigation.

New York Courts Will Enforce Federal Forum Provisions

Next, New York courts are not shying away from enforcing federal forum provisions. By way of background, in March 2018, the United States Supreme Court held in Cyan, Inc. v. Beaver County Employees Retirement Fund13 confirmed that state courts have concurrent jurisdiction for claims brought under the Securities Act of 1933. Thereafter, in March 2020, in Salzberg v. Sciabucucchi,14 the Delaware Supreme Court upheld a federal forum provision in a company’s charter finding that the provision was facially valid under the Delaware statute governing contents of certificate of incorporation. State courts in California then continued to enforce federal forum provisions, providing additional comfort to entities incorporated or organized in Delaware.15

Recently, a New York state court enforced the federal forum provision, granting the motion to dismiss based on the federal forum provision in the corporate charter. In Hook v. Casa Systems, Inc.,16 Defendant Casa Systems, Inc. a global communications technology company, had its initial public stock offering in December 2017. In 2018, Casa’s stock plummeted. Securities litigation brought under Sections 11 and 15 of the Securities Act ensued in both New York state court and in Massachusetts,17 where its only American office is located. 

On August 30, 2021, New York Supreme Court Judge Margaret Chan granted the defendants’ motion to dismiss, stating that the federal forum provision in the company’s charter is valid and enforcement. Notably, Judge Chan stated that because the company is a Delaware corporation, and “the issues of internal corporate governance are determined by the law Delaware as the state where Casa is chartered,”18 the Salzberg decision should be applied to the present matter. Nonetheless, Judge Chan went onto say that “to the extent it can be argued that the issue of the validity of the [federal forum provision] in this securities litigation does not concern the internal affairs of the corporation, the application of New York law would not result in a different outcome.”19 Indeed, the court ruling is an additional example of the respect given to charter provisions around the country, not just in Delaware.  

Derivative Cases Regarding Diversity Continue to Be Dismissed 

Earlier this year and against the backdrop of protests regarding racial injustice sweeping the U.S., we highlighted that certain derivative cases had been filed that targeted allegedly false statements in proxy statements or codes of conduct about a “commitment to diversity” allegedly in violation of Section 14(a) of the Exchange Act.20 The focus in the past year has been on derivative actions against prominent companies like Facebook, Inc., Oracle Corp., Qualcomm, and Monster Beverage Corp. Nonetheless, court decisions have continued to dismiss such claims on motions to dismiss, including, for example, most recently in an August 30, 2021 opinion in the NortonLifeLock case21 and the September 1, 2021 opinion in the OPKO Health case.22   

On August 5, 2021, a shareholder filed a shareholder derivative suit against the board of directors of cyber safety company, NortonLifeLock, as well as against the company as nominal defendant.23 Having copied and pasted pictures of the board members into the complaint, the complaint alleged, among other things, derivative claims for breaches of fiduciary duty, abuse of control, unjust enrichment, and violation of Section 14(a) of the Securities Exchange Act of 1934 for “repeatedly [making] misrepresentations in the company’s public statements by claiming to have a policy of being committed to diversity and inclusion at the Company” while “[i]n reality. . . . NortonLifeLock’s Board and senior executive officers remain devoid of any Blacks and any meaningful representation of other minorities.”24 The basic theory is that NortonLifeLock’s proxy statement filed in connection with the 2018, 2019, and 2020 annual shareholders’ meetings were materially misleading.25 After defendants filed a motion to dismiss, on August 30, 2021, the Chief Judge Richard Seeborg of the Northern District of California granted the motion to dismiss without prejudice.26 As the Court explained, while Plaintiff attempted to “tar the entire Demand Board as disqualified” such allegations “rest[] on unduly conclusory assertions that, as Board members, they all necessarily had knowledge of, and are responsible for, the discrepancies between the assertions in the proxies and the alleged true state of affairs.”27 In addition, the court went onto say that the “complaint here simply does not plausibly plead an actionable false statement” and stating that allegations failed to establish that demand on the board would have been futile.28 Ultimately, plaintiff’s claim under Section 14(a) was dismissed for failure to allege demand futility and/or for failure to state a claim. Plaintiff’s common law claims were dismissed without prejudice to refiling in Delaware.  

Similarly, a shareholder filed a shareholder derivative lawsuit in the Southern District of Florida against the board of directors and the OPKO, a diversified healthcare company, as a nominal defendant, arising from the alleged failure to diversity its board of directors and executive management team.29 The plaintiffs allege, among other things, that the individual defendants have “repeatedly refus[ed] to nominate, appoint, and/or hire Black or Latinx individuals or other underrepresented minorities to the Board or Black individuals to the executive management team[.]” Specifically, Plaintiffs allege that, despite OPKO’s purported commitment to “a healthy work place[,]” “zero Black or Latinx individuals currently reside on [OPKO]’s Board and zero Black individuals work on [OPKO]’s executive management team.”30 The plaintiffs even turn to citations of complaints regarding reviews left on websites like Niche and Glassdoor and point to a settlement for discrimination at one of OKPO’s subsidiaries.31 In sum, plaintiffs allege the 2018, 2019, and 2020 Proxy Statements were materially misleading because OPKO had no interest in addressing the alleged lack of racial diversity and discriminatory practices regarding the nomination and appointment of minority Board and executive team candidates, bringing claims for breaches of fiduciary duty and violations of Section 14 of the Exchange Act.32 In granting the motion to dismiss, the Court stated that the complaint was “replete with conclusory allegations” and “offer[ed] no particularized facts.”33 The court went onto say, “[a]t most, these circumstantial statements evince an exculpated lack of due care.”34 The complaint was dismissed without prejudice.

Although such lawsuits have not found much traction, companies and their boards should continue to carefully examine the diversity of their directors and officers as well as individuals in management positions overseeing diversity efforts.  

Footnotes

1) United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, et al., No. 404, 2020, --- A.3d ----, 2021 WL 4344361 (Del. Sept. 23, 2021). 

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

3) 634 A.2d 927 (Del. 1993). 

4) Zuckerberg, 2021 WL 4344361, at *16.

5) Id. at *15-16. 

6) Id. at *16-17. 

7) No. 406, 2020, 2021 WL 4260639 (Del. Sept. 20, 2021).

8) 906 A.2d 91 (Del. 2006). 

9) 845 A.2d 1031 (Del. 2004). 

10) Id. at 1033.

11) Gentile, 906 A.2d at 100.

12) Brookfield Asset Management, Inc., 2021 WL 4260639, at *17.

13) 138 S. Ct. 1061 (2018). 

14) 227 A.3d 102 (Del. 2020).  

15) See, e.g., Order, Wong v. Restoration Robotics, Inc., No. 18-CIV-02609 (Cal. Super. Ct., San Mateo Cnty., Sept. 1, 2020); Order, In re Dropbox Inc. Sec. Litig., No. 19-CIV-05089 (Cal. Super. Ct. San Mateo Cnty, Dec. 4, 2020). 

16) Hook v. Casa Systems, Inc. et. al, No. 654548/2019, 2021 WL 3884063 (N.Y. Sup. Ct., N.Y. Cnty. Aug. 30, 2021).

17) The cases against Casa in the Massachusetts Superior Court were dismissed.  SeeHook, 2021 WL 3884063, at *2. 

18) Id. at *3. 

19) Id. 

20) J. Jacobsen & A. Liu, Securities and Derivative Litigation: Quarterly Update, Dechert LLP (Apr. 14, 2021). 

21) EllieMaria Toronto Esa v. NortonLifeLock Inc., et al., No. 3:20-cv-05410, 2021 WL 3861434 (N.D. Cal. Aug. 30, 2021). 

22) Lee, et al., v. Frost, et al., No. 1:21-cv-20885-CMA, 2021 WL 3912651 (S.D. Fla. Sept. 1, 2021).

23) EllieMaria Toronto Esa v. Pilette, et al. No. 5:20-cv-05410, 2020 WL 4556829 (N.D. Cal. Aug. 5, 2020).

24) Id. ¶¶ 6-7. 

25) Id. ¶¶ 98, 118, 121, 125, 134 & 209. 

26) EllieMaria Toronto Esa v. NortonLifeLock Inc., et al., No. 3:20-cv 05410, 2021 WL 3861434 (N.D. Cal. Aug. 30, 2021). 

27) Id. at *4. 

28) Id. at *5.   

29) Lee, et al., v. Frost, et al., No. 1:21-cv-20885-CMA, 2021 WL 3912651 (S.D. Fla. Sept. 1, 2021). 

30) Id. at *2. 

31) Id. 

32) Id. at *3. 

33) Id. at *8. 

34) Id.

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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