Delaware Supreme Court Endorses a New Three-Part Demand Futility Test
By: Marie C. Bafus , Jennifer C. Bretan , Catherine Kevane , Dean Kristy , Felix S. Lee
On September 23, 2021—in United Food and Commercial Workers v. Zuckerberg—the Delaware Supreme Court endorsed a new universal three-part demand futility test. The decision will likely have far-reaching consequences, including both streamlining the demand futility analysis and raising the bar for plaintiffs to plead that demand is futile.
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.
Prior to the Zuckerberg decision, Delaware espoused two tests to determine whether demand was futile. The test set forth in Aronson v. Lewis 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 v. Blasband applied and asked whether 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.
At the end of the day, both tests essentially addressed the same question—whether the board could exercise its business judgment on a corporation’s behalf in considering a litigation demand.
The Zuckerberg case arose from a proposed stock reclassification plan that would have allowed Facebook CEO Mark Zuckerberg to satisfy his pledge to donate nearly all of his wealth (including Facebook stock) to charity without losing voting control of Facebook. The plan was eventually abandoned following a stockholder suit challenging the transaction. Subsequently, plaintiff brought the instant action to recover litigation fees that Facebook spent defending itself in the reclassification litigation. Instead of making a demand prior to bringing suit, plaintiff alleged that demand would have been futile under Aronson, based on the allegations that the stock reclassification plan was not a product of valid business judgment and that a majority of directors was not disinterested and independent.
The Court of Chancery dismissed the action for failure to allege demand futility. In so doing, it held that, because Facebook had a Section 102(b)(7) clause which exculpated directors from liability for monetary damages related to breaches of the duty of care, plaintiff could not rely on exculpated care violations to establish that demand was futile under the second prong of the Aronson test. The Court of Chancery further questioned the continued viability of the Aronson test, and, dismissing the case, applied a new three-part test blending aspects of Aronson and Rales.
Plaintiff appealed to the Delaware Supreme Court arguing, among other things, that the Court of Chancery erred by holding that exculpated duty of care violations do not satisfy the second prong of Aronson. The Delaware Supreme Court rejected plaintiffs’ arguments and affirmed the Court of Chancery’s decision.
First, the Court agreed that duty of care claims exculpated under
Section 102(b)(7) do not satisfy the second prong of Aronson because they do not expose directors to a substantial likelihood of liability. In so holding, the Court noted that “[w]hen Aronson was decided, raising a reasonable doubt that directors breached their duty of care exposed them to a substantial likelihood of liability and protracted litigation, raising doubt as to their ability to impartially consider demand. The ground has since shifted [following the General Assembly’s enactment of Section 102(b)(7)], and exculpated breach of care claims no longer pose a threat that neutralizes director discretion.”
Second, the Court rejected plaintiff’s argument that demand is excused under the second prong of Aronson simply because entire fairness applies ab initio to a controlling stockholder transaction such as the one at issue in Zuckerberg. In so holding, the Court noted that “the theory that demand should be excused simply because an alleged controlling stockholder stood on both sides of the transaction is ‘inconsistent with Delaware Supreme Court authority that focuses the test for demand futility exclusively on the ability of a corporation’s board of directors to impartially consider a demand to institute litigation on behalf of the corporation – including litigation implicating the interests of a controlling stockholder.’”
Third, the Court adopted the Court of Chancery’s three-part test as the “universal test” for assessing whether demand should be excused as futile. The test, which blends elements from both the Aronson and Rales tests, requires courts to assess on a director-by-director basis:
“(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 these questions is “yes” as to at least half of the members of the board considering the demand, then demand is excused as futile. The Court noted that the refined test appropriately “refocuses the inquiry on the decision regarding the litigation demand, rather than the decision being challenged.”
That said, the Court specifically noted that, because this test “is consistent with and enhances Aronson, Rales, and their progeny, the Court need not overrule Aronson … and cases properly construing Aronson, Rales, and their progeny remain good law.”
The Zuckerberg decision will likely have an immediate and far-reaching impact on derivative actions. The new “universal” demand futility test not only refocuses the analysis on the demand board’s ability to impartially consider the demand, but it also streamlines and clarifies the demand futility analysis and removes any debate over which test ultimately applies. Moreover, the new test will likely raise the bar for plaintiffs to successfully plead demand futility, including in cases involving a conflicted controller transaction.