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Sandys v. Pincus, No. 9512-CB (Del. Ch. Feb. 29, 2016) (Bouchard, C.)

February 29, 2016

In dismissing a derivative suit for failure to demonstrate demand futility, Chancellor Bouchard traced the boundaries between direct and derivative claims, as well as where to apply the Aronson and Rales tests for demand futility.

The case involved a secondary offering of shares of Zynga, Inc., a video game developer. In March 2012, the Zynga board approved the offering at $12 per share, and released certain officers and directors from trading restrictions, allowing them to sell in the offering. Less than a month after the secondary offering ended, Zynga announced poor quarterly earnings. The stock price fell to $8.52, and continued to fall, reaching $2.29 by October 2012.

An eight-member board of directors had approved the secondary offering (the “Secondary Offering Board”). Four members of the Secondary Offering Board sold shares in the offering (the “Secondary Offering Participants”).

By the time of the complaint, two directors had left the board and been replaced, and the company had added a ninth director (the “Demand Board”). Although six members of the Secondary Offering Board remained on the Demand Board, only two Secondary Offering Participants remained on the Demand Board.

The plaintiff’s complaint contained three counts:

  1. The Secondary Offering Participants possessed materially adverse, non-public information about the company, and misused that information, breaching their fiduciary duties (the “Brophy claim”).
  2. The Secondary Offering Board breached their duty of loyalty by approving the offering and removing the restrictions that otherwise would have prevented the Secondary Offering Participants from selling shares.
  3. All defendants breached their duty of care by failing to install controls to ensure that the company’s disclosures and other public communications about the secondary offering were accurate (the “Caremark claim”).

In analyzing the defendants’ motion to dismiss under Court of Chancery Rule 23.1, the Court first determined whether each count was derivative. The Court treated the Brophy and Caremark claims as quintessentially derivative, but observed that the duty of loyalty claim in Count II tracked a claim raised directly in a related class action. Chancellor Bouchard concluded that Count II was derivative because the plaintiff sought “to recover for reputational harm to Zynga and for any liability” it might incur in other federal and state litigation challenging the secondary offering.

The Court next determined whether the Aronson or Rales test for demand futility should apply to each count. Once again, the Court’s analysis of the Brophy and Caremark claims was concise.  The Secondary Offering Participants’ “decision to sell shares was an individual choice, not a [business] decision of the board,” thus Rales applied to the Brophy claim. Similarly, the Caremark claim involved an alleged failure of board oversight, not a board business decision.

As to Count II, the Court admitted that “a good argument could be made” that Aronson should apply, but the Court instead applied the Rales test. Chancellor Bouchard reviewed the Rales decision, noting that the Delaware Supreme Court had outlined “three principal scenarios” where the Rales test should apply: “(1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced, (2) where the subject matter of the derivative suit is not a business decision of the board, and (3) where…the decision being challenged was made by the board of a different corporation.”

The Chancellor explained that “none of the exceptions identified in Rales applies here,” but that “enough of the interested members of [the Secondary Offering Board] were replaced (and an additional director was added) so that the Demand Board had a majority of directors (seven of nine) who derived no personal financial benefit from the challenged transaction.” Thus, the Demand Board could “impartially consider a demand, even when less than a majority of them were replaced.”

Applying the Rales test to each defendant in each count, the Court found that in each instance a majority of the Demand Board was disinterested and independent. Therefore, the plaintiff had “failed to demonstrate that demand would have been futile with respect to any of the claims,” and the defendants’ motion to dismiss was granted.

The full opinion is available here