Delaware Supreme Court adopts universal three-part test for assessing demand futility

8 October 2021 Reed Smith Client Alerts

Inicio Perspectivas Delaware Supreme Court adopts universal three-part test for assessing demand futility

In a recent precedential decision, United Food and Commercial Workers Union v. Zuckerberg et al., the Delaware Supreme Court unanimously affirmed the Delaware Court of Chancery’s dismissal of a derivative suit brought by a Facebook stockholder against Facebook’s board of directors, because the stockholder failed to make a pre-suit demand on the board to bring an action on behalf of Facebook and the complaint failed to “plead with particularity” facts that would establish that such a demand would be futile. In reaching such a conclusion, the Supreme Court adopted a new more stringent three-part universal demand-futility test that combines the demand futility factors under the well-established Aronson and Rales tests.

Autores: Brian M. Rostocki Benjamin P. Chapple

Case background

The dispute in United Food and Commercial Workers Union v. Zuckerberg et al. involved a Facebook stockholder (the Stockholder) who filed a derivative complaint in the Delaware Court of Chancery alleging that the Facebook, Inc. (Facebook) board of directors (the Board) violated their fiduciary duties when the Board voted in favor of a stock reclassification (the Reclassification) in 2016. The Reclassification would have allowed Mark Zuckerberg ‒Facebook’s controller, chairman, and chief executive officer ‒ to sell most of his Facebook stock while maintaining voting control of the company. Zuckerberg proposed the Reclassification to allow him and his wife to fulfill a pledge to donate most of their wealth to philanthropic causes. With Zuckerberg casting the deciding vote, Facebook’s stockholders approved the Reclassification.

The Stockholder’s claims also stemmed from Facebook’s settlement of a previous derivative suit, which involved questions of whether Facebook could engage in the Reclassification. Facebook spent $21.8 million to defend the earlier suit, and paid another $68.7 million in the settlement, which resulted in Facebook’s abandonment of the Reclassification. In addition to the Stockholder’s allegations that the Facebook directors’ approval of the Reclassification breached their fiduciary duties, the Stockholder sought to recoup the sum that Facebook spent defending and settling that earlier lawsuit.

The Stockholder did not make a litigation demand on the Board in the case at hand. Instead, the Stockholder pleaded that demand was futile because (i) the Board’s negotiation and approval of the Reclassification was not a valid exercise of its business judgment since it was not “fully informed” or “duly considered,” and (ii) a majority of the directors lacked independence because they were beholden to Zuckerberg.

The Supreme Court’s decision

Facebook and the other defendants moved to dismiss the Stockholder’s complaint under Court of Chancery Rule 23.1, arguing that the Stockholder did not make demand or prove that demand was futile. In October 2020, the Court of Chancery dismissed the Stockholder’s complaint under Rule 23.1, finding that the Stockholder failed to justify its decision to sidestep the Board and sue Facebook directly. In reaching that conclusion, the Court of Chancery blended two demand-futility tests articulated in Delaware’s Aronson v. Lewis and Rales v. Blasband rulings, thus creating a new universal three-part test.

The Stockholder appealed the Court of Chancery’s judgment to the Delaware Supreme Court, which affirmed the Court of Chancery’s decision to dismiss the derivative action and agreed with the lower court’s finding that the Stockholder should have first taken its demand for action to the Board before filing a derivative action in the Court of Chancery.

The Supreme Court emphasized that the demand futility analysis provides an important “doctrinal check” that ensures the board of a Delaware company is not improperly deprived of its decision-making authority, but still leaves stockholders with a path to sue derivatively if the board lacks independence:

While Delaware law recognizes that there are circumstances where making a demand would be futile because a majority of the directors “are under an influence which sterilizes their discretion” and “cannot be considered proper persons to conduct litigation on behalf of the corporation,” the demand requirement is not excused lightly because derivative litigation upsets the balance of power that the DGCL establishes between a corporation’s directors and its stockholders. Thus, the demand-futility analysis provides an important doctrinal check that ensures the board is not improperly deprived of its decision-making authority, while at the same time leaving a path for stockholders to file a derivative action where there is reason to doubt that the board could bring its impartial business judgment to bear on a litigation demand.

The Supreme Court adopted the new three-part demand-futility test that combines tests outlined in its Aronson v. Lewis and Rales v. Blasband decisions. The test set forth in Aronson applied where the complaint challenged an affirmative decision made by the same board considering the demand. Under Aronson, demand was excused as futile if the complaint alleged particularized facts that raised a reasonable doubt that: (1) directors were disinterested and independent; and (2) the challenged transaction was otherwise the product of a valid business judgment. In all other situations, the test in Rales applied and asked whether the plaintiff alleged particularized facts creating a reasonable doubt that, as of the time the complaint was filed, a majority of the board could have properly exercised its independent and disinterested business judgment in responding to a demand. Both previously espoused tests essentially addressed the same question ‒ whether the board could exercise its business judgment on a corporation’s behalf in considering a litigation demand.

From this point forward, the Supreme Court stated that Delaware courts should ask the following three questions on a director-by-director basis when evaluating allegations of demand futility:

(i) Would the director receive a material personal benefit from the alleged misconduct that is the subject of the litigation demand?

(ii) Would the director face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand?

(iii) Would the director lack 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?

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. It is no longer necessary to determine whether the Aronson test or the Rales test governs a complaint’s demand-futility allegations. Because the new three-part test is consistent with and enhances Aronson, Rales, and their progeny, the Supreme Court explained that it need not overrule Aronson to adopt this refined test, and cases properly construing Aronson, Rales, and their progeny remain good law.

Applying this refined test, the Delaware Supreme Court affirmed the Chancery Court’s dismissal of the Stockholder’s complaint, because it failed to meet the stringent requirements of pleading with particularity that a demand on the Board would be futile. The Stockholder conceded that two directors could have impartially considered the demand, and Facebook did not argue that three (Zuckerberg and two others) could have impartially considered the same. The Stockholder therefore was required to allege that two of the remaining directors could not impartially consider the demand. The Stockholder failed to meet this burden because (i) it conceded that the remaining directors did not have a personal interest in the Reclassification, (ii) it had not alleged that the remaining directors committed a breach of their fiduciary duties that was not exculpated by the provisions of Facebook’s corporate charter, and (iii) it was unable to adequately plead that the remaining directors lacked independence from Zuckerberg.

With this precedential opinion, the Delaware Supreme Court has now refined the standard for determining demand futility in all cases and has made it more difficult for investors and stockholders to sue on behalf of Delaware corporations without first making a litigation demand on the board.

Key takeaways

Control over litigation is typically within the business judgment of a company’s directors. Because a derivative action seeks to encroach on that role, Delaware law requires that, prior to bringing a derivative action on behalf of a corporation, a stockholder must either: (1) make a demand on the board to initiate litigation; or (2) show that such demand would be futile.
The impact of the Delaware Supreme Court’s decision in United Food will likely have far-reaching consequences, including both streamlining the demand-futility analysis and raising the bar for investors of Delaware companies to plead that demand is futile.
When evaluating demand futility, investors in Delaware companies should pay close mind to the new universal test from United Food and the three questions relating to demand futility. Going forward, in determining whether demand is futile, the court will consider:

(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 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.

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