CLIENT ALERT: Delaware Supreme Court Adopts Refined Test for Analyzing Demand Futility
United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, et al., No. 404, 2020 (Del. Sept. 23, 2021) (“Zuckerberg”)
In this en Banc opinion, the Delaware Supreme Court unanimously eschewed the long-standing test for determining demand futility set forth in Aronson v. Lewis, 473 A.2d 805 (Del. 1984) (“Aronson”) in favor of a “universal” test that incorporates principles from both Aronson and Rales v. Blasband, 634 A.2d 927 (Del. 1993) (“Rales”). The universal demand futility test adopted in this decision focuses primarily on whether directors are disinterested and independent with respect to the litigation demand rather than the decisions or actions being challenged in the litigation. The Court also held that claims exculpated by a corporation’s Section 102(b)(7) charter provision do not expose a director to a “substantial likelihood of liability” for purposes of the demand futility analysis.
Prior to Zuckerberg, the Delaware Supreme Court had established two tests—in Aronson and Rales—to determine whether directors can exercise independent and disinterested judgment regarding a pre-suit demand. Aronson applied when the directors who made the challenged decision also constituted a majority of the directors who would consider a pre-suit litigation demand and focused on the substance of the challenged transaction. The Rales test applied when no specific board decision was challenged (e.g., failure of oversight claims) or when a majority of the directors on the board that would be considering the litigation demand did not participate in the challenged decision. The Rales test focused on the independence of the decision regarding a litigation demand rather than the underlying business decision being challenged.
Zuckerberg involved a proposed reclassification of the shares of Facebook, Inc. (“Facebook”) that would have allowed Mark Zuckerberg to donate a majority of his Facebook stock to charity while still maintaining control of the company (the “Reclassification”). The Reclassification was challenged by Facebook stockholders and, shortly before trial, Facebook withdrew the Reclassification, rendering the lawsuit moot. Facebook spent more than $20 million defending the litigation and paid plaintiffs’ counsel more than $68 million in attorneys’ fees under the corporate benefit doctrine in a class action settlement.
After the Reclassification litigation concluded, another Facebook stockholder filed a derivative complaint seeking compensation for the money Facebook spent in connection with the prior action. The stockholder plaintiff argued that demand was futile, and defendants moved to dismiss the complaint under Court of Chancery Rule 23.1 for failure to make demand on Facebook’s board of directors or adequately plead demand futility. Although the Court of Chancery acknowledged—and the parties agreed—that the Aronson test applied because a majority of the board members who would have considered a demand also made the challenged decision to pursue the Reclassification, Vice Chancellor Laster determined that Aronson’s “analytical framework [was] not up to the task,” and instead chose to apply the Rales test while also “draw[ing] upon Aronson-like principles.” In applying this hybrid test, the Court of Chancery concluded that a majority of the Facebook board was capable of considering a demand and dismissed the claim under Rule 23.1.
In Zuckerberg, the Delaware Supreme Court endorsed the demand futility analysis applied by the Court of Chancery as the “universal test” for assessing demand futility. Therefore, it is no longer necessary to determine whether the Aronson test or the Rales test governs the demand futility inquiry. Under the refined test, courts will focus on the following three questions, applied 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” for at least half of the members of a demand board, then demand is excused as futile.
In affirming the Court of Chancery’s decision and adopting this approach to demand futility, the Court explained, “[t]he purpose of the demand-futility analysis is to assess whether the board should be deprived of its decision-making authority because there is reason to doubt that the directors would be able to bring their impartial business judgment to bear on a litigation demand.” The Court’s opinion thus provides more clarity for determining demand futility, by blending the previous tests from Aronson and Rales and appropriately “refocusing the inquiry on the decision regarding the litigation demand, rather than the decision being challenged,” while remaining consistent with Aronson, Rales, and their progeny. The refined test is especially helpful in situations where Aronson would have proved difficult to apply, such as when there has been turnover on a corporation’s board or director abstention.