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In re Fitbit, Inc. Stockholder Derivative Litigation, C.A. No. 2017-0402-JRS (Del. Ch. Dec. 14, 2018) (Slights, V.C.)

December 14, 2018

In this memorandum opinion, the Court of Chancery denied a motion to dismiss a derivative complaint for breach of fiduciary duty, finding that Plaintiffs met the test for demand futility and had stated a viable claim for breach of fiduciary duty under Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949) (“Brophy”), which permits a corporation to recover from its fiduciaries for harm caused by insider trading. 

Plaintiff stockholders alleged that certain of the directors of Fitbit, Inc. (“Fitbit” or the “Company”) and its CFO breached their fiduciary duties by using insider knowledge of a faulty product to personally profit from the sale of the Company’s stock in connection with its initial public offering (the “IPO”) and a subsequent secondary offering (the “Secondary Offering” and, together with the IPO, the “Offerings”). Specifically, Plaintiffs alleged that Fitbit’s proprietary “PurePulse” technology, which accounted for 80% of the Company’s revenue, was “wildly inaccurate” and did not perform as represented by the Company. The Plaintiffs alleged that the Company’s board of directors (the “Board”), with knowledge of the issues with the “PurePulse” technology, manipulated Fitbit’s Offerings to prop up the stock’s active trading and to permit certain insiders to profit directly from the Offerings based on insider knowledge. First, the Board was alleged to have structured the IPO to permit insiders to sell from their personal holdings an unusually large percentage of the stock being offered to the market (the directors constituting such Board, the “Director Defendants”). Second, in advance of the Secondary Offering just a few months later, the Board allegedly voted to waive “lock-up” agreements intended to prevent insiders from selling more shares for a period of time after the IPO. As a result, insiders, including certain Board members and Fitbit’s CFO (the “Selling Defendants”), were able to transfer large numbers of shares before the expiration of the lock-up agreements, during which time the issues with the “PurePulse” technology were not known to the public. In connection with the Offerings, the Selling Defendants netted proceeds of approximately $386 million. Approximately two months after the Secondary Offering, the problems with Fitbit’s PurePulse technology were revealed to the public through a consumer class action (the “Class Action”). Just two days after the Class Action was filed, Fitbit’s stock price dropped 33% from $30.96 per share to $20.25 per share. On March 1, 2016, the earliest date the Selling Defendants would have been able to sell their shares under the lock-up agreements, Fitbit’s stock traded at $12.35 per share. At the time the Plaintiff stockholders filed their consolidated Second Amended Complaint, which was the operative complaint that was the subject of Defendants’ motion to dismiss, Fitbit’s stock traded at $5.00 per share.

Plaintiffs alleged the following two causes of action: (i) a derivative claim for breach of fiduciary duty against the Selling Defendants under Brophy; and (ii) a derivative claim for breach of fiduciary duty against all Defendants for allowing the Selling Defendants to sell stock in the Offerings based on insider information and against the Director Defendants for waiving the lock-up agreements.

The Court first analyzed Plaintiffs’ demand futility arguments and found that they had properly alleged demand futility. The proper demand Board was determined to be the Board at the time the first Complaint was filed (the “Demand Board”), under Braddock v. Zimmerman, 906 A.2d 776 (Del. 2006). The Board was deemed interested in the Offerings because a majority of the Demand Board faced a substantial likelihood of liability that the Fitbit insiders: (i) possessed material, nonpublic company information; and (ii) used that information improperly by making trades because they were motivated, in whole or in part, by the substance of that information. The Court found that Plaintiffs had adequately alleged that the Selling Defendants’ knowledge of the PurePulse technology flaws was material and nonpublic. Plaintiffs pointed to internal documents showing that PurePulse’s flaws were so significant that the Company could not resolve them and that the Company’s CEO and CFO made efforts to keep these failures confidential by directing employees to destroy documents in which management recounted the problems and the failed efforts to solve them. This was in contrast to public statements made about the accuracy and dependability of the technology. The Court also found that Plaintiffs had adequately alleged that the Selling Defendants acted with scienter because the Complaint alleged that four of the seven directors sold stock in the Offerings, the timing and size of the sales indicated the Selling Defendants sought to make trades on nonpublic information, and the Board adjusted the terms of the Secondary Offering to benefit the Selling Defendants.

Lastly, the Court addressed Plaintiffs’ breach of fiduciary duty claim, which alleged that: (i) all Defendants permitted the Selling Defendants to trade in the Offerings based on insider information; and (ii) the Director Defendants waived the lock-up agreements that would have otherwise prevented the Selling Defendants from making their trades. The Court found that Plaintiffs alleged with the requisite particularity that the Director Defendants voted to approve the waivers of the lock-up agreements and that four of seven Director Defendants were beneficiaries of the waivers when they sold shares in the Secondary Offering. The Court found that the fact that the sales were for a small percentage of the Selling Defendants’ total holdings was immaterial given the size of the profits from the purportedly illicit sales.

The Court also found that the Section 102(b)(7) exculpatory provision in Fitbit’s certificate of incorporation does not provide director exculpation for any transaction from which the director derived an improper personal benefit, implicating their duty of loyalty. Given the well-pled insider trading allegations, the Court held that the complaint could not be dismissed based upon the exculpatory provision.

The full opinion is available here