Facebook Shareholders Suit Results in New Heightened Standard for Derivative Lawsuits
The Delaware Supreme Court recently adopted a new test in a case challenging the conduct of Facebook’s CEO Mark Zuckerberg making it harder for shareholders to pursue derivative claims to enforce the rights of the company.
Historically, shareholders were permitted to assert claims on behalf of the company if they could show that the company’s Board of Directors either can’t or won’t take action on its own to protect the rights of the company. A shareholder seeking to assert derivative claims on behalf of a corporation must show that (1) the shareholder made a demand on the board of directors to pursue the litigation and the board wrongfully refused the demand; or (2) making a demand would have been futile because a majority of the board could not impartially make a decision regarding the litigation.
For decades, there were two tests under Delaware law used to determine whether a shareholder had adequately pleaded “demand futility.” The ground recently shifted when the Delaware Supreme Court established a new three-part test to determine if making a demand on the board to take action would be excused as “futile.”
Under the new test, making a demand on the board to take action will be deemed futile if: (i) members of the Board received a material personal benefit from the alleged misconduct; (ii) the members of the Board face a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand; and (iii) the Board members lack independence. If the answer to any of the questions is ‘yes’ for at least half of the members of the Board, then making a demand on the Board to take action is excused as “futile.”
Background: Two Tests for Determining Demand Futility
Ordinarily, a corporation’s board of directors—not the shareholders—manage the operations and affairs of the corporation, including initiating litigation on behalf of the corporation. Under limited circumstances, shareholders are permitted to pursue legal claims on behalf of the corporation by making a demand on the board to pursue litigation, followed by a refusal by the board; or in the alternative, by demonstrating that such a demand would have been futile because the board was incapable of making an impartial decision.
For nearly two decades, the question of whether a formal demand on a company’s board of directors to take action was excused as “futile” was governed by two tests under Delaware law. Where the derivative claims challenged an affirmative decision by the board of directors who would consider the demand, the two-part test under Aronson v. Lewis applied.[1] In all other contexts, courts would apply the test established in Rales v. Blasband.[2]
The Aronson test applied where the shareholder sought to challenge a decision by the same board that would consider the demand. In that situation, the shareholder was required to plead facts creating a “reasonable doubt” that (1) the directors are disinterested and independent or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. In the Rales decision, the Delaware Supreme Court developed a different test to apply in circumstances where the derivative litigation did not seek to challenge an affirmative board decision or when a majority of the directors on the board that would consider the stockholder litigation demand had not participated in the challenged decision. The test in Rales required a shareholder plaintiff to plead facts creating a “reasonable doubt” that, as of the time the complaint was filed, “the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.”
Zuckerberg Decision and New Standard for Demand Futility
In United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Mark Zuckerberg, the Delaware Supreme Court criticized the Aronson test and adopted a new rule, which makes it harder for shareholders to bring a derivative lawsuit to enforce the rights of the company.
In that case, shareholders of Facebook challenged the Board of Director’s approval of Facebook’s stock reclassification plan that would have enabled founder Mark Zuckerberg to retain voting control of the company despite donating a significant portion of his shares to charity. The shareholders alleged that the board breached their duties of care and loyalty owed to the company by supporting Zuckerberg’s reclassification plan.
The Delaware Supreme Court affirmed the lower court’s decision ruling that the plaintiff failed to establish that demand on the Board would be excused as futile. In doing so, the Delaware Supreme Court established a new standard for assessing whether making a demand on the Board to take action would be excused as “futile.” The new test refines the standard in Aronson and Rales into the following three-part test determined on an individual director-by-director basis:
- Whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;
- Whether the director would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand; and
- 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.
Applying this new three part test, the Delaware Supreme Court concluded that the plaintiff failed to meet the burden because (i) it conceded that the remaining directors did not have a personal interest in the reclassification; (ii) it had not alleged that remaining directors did not have a personal interest in the reclassification; and (iii) no adequate ground existed to plead with particularity that the remaining directors lacked independence from Zuckerberg.
Conclusion
While the Court made clear that the Zuckerberg decision does not overturn Aronson or Rales, the impact of blending the two tests into the new three part “universal” demand futility test makes it more difficult to sue on behalf of a corporation without first making a demand on the board to take action on its own. This will make it more difficult for shareholders to pursue claims derivatively on behalf of the company.
While the law governing shareholder claims is shifting and evolving, officers and directors should continue to exercise their fiduciary duties with care and prudence especially in approving significant transactions that may be subject to litigation.
The attorneys with Gordinier Kang & Kim LLP have deep knowledge and experience advising officers, directors and shareholders regarding the rights and obligations of the company’s management. If you have questions about this opinion or how it may affect your business, please contact our legal team.
Disclaimer: GKK Insights is not intended as legal advice. Additional facts, facts specific to your situation, or future developments may affect the subjects contained above. Seek the advice of an attorney before acting or relying on any information herein.
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[1] Aronson v. Lewis, 473 A.2d 805 (1984).
[2] Rales v. Blasband, 634 A.2d 927 (1993).
