In recent years, corporate directors have faced an increased risk of shareholder derivative litigation, often based on claims of mismanagement or oversight failures. Insurance premiums have increased in kind, but a recent Delaware Supreme Court decision reverses this trend.
Directors’ exposure to potential liability has increased as courts — once more deferential to boards — have increasingly permitted shareholders to pursue claims against directors and conduct expansive discovery in support of those claims. A recent Delaware Supreme Court decision may help curb this worrying trend.
In United Food and Commercial Workers Union v. Zuckerberg, et al., the Delaware Supreme Court articulated a clear “universal” test for determining whether shareholders can proceed with derivative suits against corporate directors. The test will likely reinvigorate the traditional deference given to boards of directors and help bolster directors’ defenses to strike suits, especially in litigation related to board-level corporate decisions. The decision also underscores the importance of courts rejecting conclusory allegations about directors’ alleged lack of independence from other directors.
Derivative Litigation Remains an Extraordinary Measure
It is a “cardinal precept” of Delaware law that the board of directors, not shareholders, manage the affairs of the corporation, including decisions about whether to bring litigation on the corporation’s behalf. Shareholder derivative litigation seeks to displace the board’s authority and assert a corporate litigation claim, typically against the company’s directors and officers. Allowing shareholders to usurp the board’s prerogative constitutes an extreme measure, and acts as a corporate governance safety valve that is to be used sparingly.
Accordingly, courts require shareholders to either make a litigation demand on the company’s board; or show that making such a demand would be futile. The Zuckerberg decision reiterated that demand requirement is a substantive requirement that “provides a safeguard against strike suits” and “assures that the shareholders affords the corporation the opportunity to address an alleged wrong without litigation and to control any litigation which does occur.”
Few shareholders make a litigation demand, implicitly recognizing that boards are unlikely to endorse claims that are cooked up by plaintiffs’ lawyers. As a result, shareholder derivative litigation relating to challenged board decisions or alleged mismanagement usually centers on the adequacy of a plaintiff’s showing that a pre-suit litigation on a board would be futile. This is what the Zuckerberg decision addresses.
Demand Futility Analysis Hinges on Three Questions
The Zuckerberg decision provides a straightforward standard for courts to apply when assessing demand futility allegations. The new universal test should provide clarity for courts, especially those outside of Delaware that are less accustomed to applying Delaware law. As articulated by the Delaware Supreme Court:
[F]rom this point 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 board at the time the complaint was filed, then demand is excused as futile.
The plaintiffs in Zuckerberg did not make a pre-suit litigation demand on Facebook’s board of directors and, instead, argued that demand was excused as futile. The plaintiffs alleged that Facebook’s board of directors breached their fiduciary duties by improperly negotiating and approving a share reclassification that would allow Mark Zuckerberg — Facebook’s allegedly controlling shareholder, chairman of the board and CEO — to sell most of his Facebook stock while maintaining voting control of the company. The plaintiffs alleged that demand was excused because a majority of the board faced a substantial likelihood of personal liability under this theory or lacked independence from Zuckerberg, who allegedly received a personal benefit from the share reclassification. The suit sought to recover, among other things, the costs of defending and settling class-action litigation relating to the share reclassification.
The Delaware Supreme Court’s discussion of the three prongs of its new test in Zuckerberg provides a roadmap for how the analysis should play out in future cases.
Whether a Director Received Material Personal Benefit Is Often a Straightforward Question
The first prong of the test — whether the director received a material personal benefit from the alleged misconduct — will typically present a straightforward analysis focused on personal benefits received by directors from a corporate transaction. The situation in Zuckerberg is a good example. There was no dispute that Zuckerberg received a personal benefit from the disputed share reclassification plan, which would have allowed him to sell most of his Facebook stock while maintaining voting control of the company. This rendered Zuckerberg “interested” in the litigation and incapable of considering a demand. Other directors who received no such benefits, however, did not meet this prong of the test.
Exculpated Duty of Care Claims Do Not Present a Substantial Likelihood of Liability
The second prong of the Zuckerberg test focuses on whether a director is “incapable” of impartially considering a demand because they themselves face a substantial likelihood of personal liability in the litigation.
Resolving arguable doctrinal ambiguity, the Zuckerberg decision confirmed that only non-exculpated claims can meet this burden, regardless of whether the litigation challenges a board-level decision or some other form of alleged misconduct. The Zuckerberg plaintiffs argued that demand was futile because the board’s negotiation and approval of the share reclassification violated their duty of care; in other words, their decision to approve the transaction was not “protected by the business judgment rule” because “[t]heir approval was not fully informed” or “duly considered.”
The problem for the plaintiffs, however, was that Facebook’s charter contained a section 102(b)(7) provision that exculpated Facebook’s directors from liability for violations of the duty of care. In light of the provision, the Delaware Supreme Court rejected the plaintiffs’ argument that a violation of the duty of care could present a “substantial likelihood of liability” for purposes of the demand futility analysis. The court explained that, with the threat of personal financial liability removed, “exculpated breach of care claims no longer pose a threat that neutralizes director discretion” or “render[s] directors incapable of impartially considering a litigation demand.”
Due to the near-universal adoption of exculpation provisions by public Delaware corporations, Zuckerberg provides a significant limitation on the types of claims that can serve as a basis to excuse demand.
Vague and Conclusory Allegations Do Not Show That a Director Lacks Independence
The Zuckerberg decision contains important analysis of factors that may show a director’s lack of independence from an interested director (the third prong of the new test). The decision reiterates that Delaware courts will not accept vague and conclusory allegations that a director lacks independence from an interested director. Rather, Delaware law requires particularized allegations showing that any ties between directors be material — financially or personally — to the director, while taking into account the director’s personal situation, including their business relationships and personal wealth and stature. Notably, the Delaware Supreme Court rejected many allegations popular in derivative complaints in recent years. The court found that:
- Allegation that director was founder and CEO of company that purchased advertisements and access to user data from Facebook was not enough to show that director lacked independence.
- Allegation that director shared personal interest in philanthropy and donated to same foundation as Zuckerberg was not enough to show that director lacked independence.
- Allegation that director was early investor, longest tenured board member and was “instrumental to Facebook’s business strategy and direction” was not enough to show that director lacked independence.
- Allegation that director’s investment fund received unspecified benefits from its “high-profile association with Facebook” was not enough to show that director lacked independence.
- Allegation that director was “close friend and mentor” to Zuckerberg was not enough to show that director lacked independence.
The board at the time the complaint was filed is what matters.
Zuckerberg also resolved questions about which board matters for purposes of assessing demand futility allegations related to a challenged corporate transaction. The universal three-part test announced in Zuckerberg resolves longstanding doctrinal confusion by making clear that the demand futility inquiry focuses, in all instances, on the directors in place at the time the litigation was filed. Doing so “refocuses the inquiry on the decision regarding the litigation demand, rather than the decision being challenged.”