Delaware Law Updates
{ Banner Image }

Lee v. Pincus et al., C.A. No. 8458-CB (Del. Ch. Nov. 14, 2014) (Bouchard, C.)

November 14, 2014

In this memorandum opinion, the Court of Chancery partially granted defendants’ motion to dismiss, holding that (i) plaintiff had stated a claim for breach of fiduciary duty against the Director Defendants because it was reasonably conceivable that half of the directors who approved the decision to restructure lockup restrictions received an unfair benefit; and (ii) plaintiff had not stated a claim for aiding and abetting because plaintiff failed to plead facts from which it was reasonably inferable that the Underwriter Defendants knowingly participated in a breach of fiduciary duty.

Defendant Zynga Inc. (“Zynga”) is a Delaware corporation based in San Francisco, California that is in the social gaming industry.  It has eight members on its board of directors, each an individual named defendant.  Defendant Morgan Stanley & Co. LLC (“Morgan Stanley”) is a Delaware limited liability company based in New York.  Defendant Goldman, Sachs & Co. (“Goldman”) is a New York limited partnership based in New York.  Morgan Stanley and Goldman (the “Underwriter Defendants”) served as lead underwriters in Zynga’s IPO and the secondary offering.

In December 2011, Zynga completed its initial public offering.  Before the IPO, Zynga’s directors, officers, employees, and most other pre-IPO investors agreed to lockup restrictions preventing them from selling their Zynga stock until after May 28, 2012.  Plaintiff stockholder alleged that a few months after the IPO was completed, the board of directors waived a portion of the lockup restrictions in a discriminatory manner.  The allegations were that this selective waiver of lockup restrictions allowed some pre-IPO stockholders to sell a portion of their holdings almost two months before other pre-IPO stockholders were able to, at a significantly higher price.

In March 2012, the board unanimously voted to approve a restructuring that would stagger the lockup expirations.  The Underwriter Defendants consented to the restructuring.  As a result, four Zynga directors received lockup waivers, in addition to waivers from a “blackout” policy, and were able to participate in a secondary offering to the public in which they each sold millions of dollars of Zynga stock.  This resulted in profits to the four directors ranging from $3.8 million to $192 million.  The secondary offering closed in April 2012 at a price of $12.00 per share.  The Underwriter Defendants each made over $5.3 million in fees during the secondary offering.  Plaintiff’s shares remained locked up until May 29, 2012, at which time the price for Zynga’s stock had declined to $6.09 per share.

Plaintiff made two claims: (i) that Zynga’s directors breached their fiduciary duty of loyalty by approving a self-dealing waiver of the lockups to the unfair benefit of half the members of the Zynga board; and (ii) that the Underwriter Defendants, whose consent was necessary to waive the lockups, aided and abetted these breaches of fiduciary duty.

Zynga and the Director Defendants moved to dismiss Count I under: (i) Court of Chancery Rule 23.1 for failure to make a pre-suit demand upon Zynga’s board or to plead facts excusing such demand; and (ii) Court of Chancery Rule 12(b)(6) for failure to state a claim upon which relief may be granted.  The Underwriter Defendants moved to dismiss Count II under Court of Chancery Rule 12(b)(6) for failure to state a claim upon which relief may be granted.

Plaintiff sought to bring the action on behalf of a class of
Zynga stockholders who were subject to the lockups and prohibited from selling shares in the secondary offering.  The Court agreed that Count I was properly asserted as a direct claim because the decision to restructure the lockups allegedly gave certain pre-IPO stockholders preferential treatment over others, and because it was not the whole universe of Zynga’s public stockholders who were affected by the Director Defendants’ actions.  Consequentially, plaintiff was not required to satisfy the pleading requirements of Rule 23.1.

The Court next addressed whether Claim I was governed by fiduciary duty principals or by contract law, and concluded that it was “quintessentially a fiduciary duty claim.”  There are certain circumstances under which fiduciary duties may be preempted by contractual obligations set forth in a contract between the corporation and its stockholders, when a contract “expressly” addresses an issue and thereby creates a right that is “solely a creature of contract.”  Defendants argued that plaintiff improperly asked the court to rewrite the Exercise Agreement, to insert a provision that would divest the corporation of its discretion regarding waiver of the lockup restrictions.  The Court disagreed, holding that the core issue here was “whether the existence of the Exercise Agreement, and the company’s rights under that agreement, superseded the Director Defendants’ general fiduciary obligations to Lee as a Zynga stockholder.”  In the Court’s view, “the fact that the putative class members’ shares were governed by contracts containing lockup restrictions [did] not eliminate the fiduciary duties of Director Defendants to act loyally to all Zynga stockholders––especially when the challenged action did not involve the exercise of any contractual right governing Lee’s shares but instead involved modifications to the contractual provisions governing their own shares.”

The Court denied the motion to dismiss Count I under Rule 12(b)(6) because the plaintiff pled facts sufficient to rebut the business judgment standard of review and because it was reasonably conceivable that the transaction was not entirely fair.  Plaintiff successfully rebutted the business judgment standard of review by pleading that four of the eight Zynga directors had a personal financial interest in the lockup restructuring and it was reasonably conceivable that they received a benefit through the restructuring, and thus, they were not disinterested and independent directors.

The Court rejected the defendants’ claim that no director received a benefit in the lockup restructuring because: (i) they agreed to subject a greater percentage of their stock to extended lockups than the percentage that they could sell in the secondary offering; and (ii) the average market price at which they could first sell their pre-IPO shares in the secondary offering was less than the market price at which those subject to unmodified lockups could first sell their pre-IPO shares.  While accepting the proposition that “it is appropriate to consider the effect of the entire transaction on a director when determining whether a particular director is interested,” the Court here found it could not conclude “that it [was] not reasonably conceivable that half of the Director Defendants had a personal financial interest in the lockup restructuring or that they received an unfair benefit as a result of that transaction.”  The Court held that the Director Defendants engaged in self-dealing by standing on both sides of the transaction.  If a director engages in self-dealing, they are “interested” by virtue of receiving a benefit in the transaction, whether or not such benefit is “material.”  Accordingly, the Court denied the motion to dismiss Count I for failure to state a claim.

The Court granted the Underwriter Defendants’ motion to dismiss Count II for failure to state a claim, because “the allegations of knowing participation in the Amended Complaint [were] conclusory.”  Under Delaware law, a claim for aiding and abetting includes four elements: “(i) the existence of a fiduciary relationship, (ii) a breach of the fiduciary’s duty, (iii) knowing participation in the breach by the non-fiduciary defendants, and (iv) damages proximately caused by the breach.”

The Court reaffirmed that knowing participation is a stringent standard to meet in an aiding and abetting claim.  It requires a demonstration that the third party acted with the knowledge that the conduct they advocated or assisted constituted a breach of fiduciary duty.  Plaintiff alleged that the Underwriter Defendants profited from the secondary offering, which was only made possible by their waiver of the lockups, and that they were fully aware of the breach of fiduciary duties this would result in.  The Court held that “plaintiff has failed to plead any facts from which it [was] reasonably inferable that the Underwriter Defendants knew when they provided their consent to modify the lockup restrictions that such action would facilitate a breach of fiduciary duty by the Director Defendants.”  The fact that their consent was necessary for the waiver, without more, was insufficient.

The full opinion is available here