The Delaware Supreme Court recently clarified its demand futility jurisprudence, an area of Delaware corporate law that has confused members of the bar, academics, and shareholders for nearly thirty years. This clarification came from the court’s recent decision in United Food and Commercial Workers v. Zuckerberg, a case concerning a stockholder’s complaint over past actions by the Facebook board of directors.1No. 404, 2021 WL 4344361 (Del. Sept. 23, 2021).
In 2016, Facebook’s board voted to allow Mark Zuckerberg “to sell most of his Facebook stock while maintaining voting control of the company.”2Id. at 1 (Zuckerberg wanted to do so to “fulfill a pledge to donate most of [his] wealth to philanthropic causes”). Shortly thereafter, stockholders filed lawsuits alleging that this vote of approval violated the board’s fiduciary duties by favoring Zuckerberg’s interests over those of the company.3Id. This initial claim developed into a class-action lawsuit but settled prior to trial.4Id. In total, “Facebook spent more than $20 million defending against this class action and paid plaintiffs’ counsel more than $68 million in attorneys’ fees.”5Id. After the settlement, another Facebook stockholder filed a lawsuit, repeating many of the claims from the initial class-action lawsuit, but also seeking damages for the costs Facebook incurred in defending the initial lawsuit.6Id.
This new plaintiff filed a specific type of lawsuit involving what is known as a demand futility claim. While normally a board of directors controls a company’s litigation, plaintiffs may initiate a demand futility lawsuit to try and get around this. Basically, plaintiffs in these cases argue that they must bring the litigation themselves because it would have been pointless to demand the board initiate litigation.7Marie C. Bafus et al., Delaware Supreme Court Endorses a New Three-Part Demand Futility Test, JDSupra (Sept. 28, 2021), https://perma.cc/XB86-PFSX. If the plaintiff stockholders can persuade the court that such a demand would have been pointless, or “futile,” the lawsuit will be allowed to proceed.
Prior to the decision in Zuckerberg, Delaware courts struggled to distinguish between and correctly apply two separate tests for a demand futility claim. The first of these stemmed from the court’s decision in Aronson v. Lewis.8473 A.2d 805 (Del. 1984). In that case, the court proclaimed that a demand futility claim may proceed if the facts alleged create a reasonable doubt that: “(1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.”9Id. at 814. Importantly, this test was established only to govern a challenge to an “affirmative decision made by the same board considering the demand.”10Bafus et al., supra note 7.
If plaintiffs wanted to, as the basis of its demand futility claim, challenge the general decision-making of the board, rather than just a particular decision, Rales v. Blasband was to govern.11634 A.2d 927 (Del. 1993).The test in that case required plaintiffs to allege facts creating “a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.”12Id. at 934.
For nearly thirty years, questions lingered about how and when to apply Aronson and Rales. For example: what if there was board turnover in the time between the complaint and the action (or inaction) complained of? Do these tests apply equally for action and inaction? How many particular decisions need to be complained of to move the test from Aronson to Rales? Does the reasonable doubt standard apply individually to both prongs of Aronson? Is the reasonable doubt standard mentioned in Aronson the same as the criminal law standard of reasonable doubt?13See Stephen M. Bainbridge, A Brief Essay on Delaware Vice Chancellor Laster’s Argument for Replacing Aronson with Rales, ProfessorBainbridge.com (Oct. 27, 2020), https://perma.cc/N2UL-QR3B.
The decision in Zuckerberg helps to answer these questions by clarifying the standard for demand futility claims going forward. In particular, the court in Zuckerberg decided to resolve the confusing dichotomy created by Aronson and Rales and instead created a universal test for demand futility claims. Going forward, courts should ask three questions of each director:
- Did the director receive a material personal benefit from the alleged misconduct?;
- If the requested litigation were to occur, would the director face a substantial likelihood of liability?; and
- Did the director lack independence from someone who received a material personal benefit from the alleged misconduct or someone who would face a substantial likelihood of liability if the requested litigation were to occur?
“If the answer to any of the questions is “yes” for at least half of the members of the demand board, then demand is excused as futile.”14United Food and Com. Workers v. Zuckerberg, No. 404, 2021 WL 4344361, at *17 (Del. Sept. 23, 2021).
There are several important takeaways from the Zuckerberg decision. First, the court has clarified many looming issues in the critically important area of derivative lawsuits. Since shareholders and boards are constantly vying for control, and Delaware law inspires an enormous amount of American corporate law, the decision is likely to have massive ramifications for corporate litigation going forward. Second, the decision showcases the Delaware court’s willingness to correct its past mistakes for the sake of clarity. In adopting the universal standard, the court acknowledged the problems posed by its previous decisions, going so far as to call its Aronson opinion “broken.”15Id. at *16. Finally, in an era where Delaware courts have began to appear more open to allowing shareholder suits against boards of directors,16See, e.g., In re The Boeing Co. Derivative Litig., C.A. No. 2019–0907–MTZ, 2021 WL 4059934 (Del. Ch. Sept. 7, 2021); see also Edward B. Micheletti et al., Delaware Courts Expand Plaintiffs’ Rights in Section 220 Cases, Skadden, Arps, Slate, Meagher & Flom LLP (June 25, 2021), https://perma.cc/N64K-WKSM. this decision reaffirms general protection of boards of directors. The plaintiffs in Zuckerberg argued that duty of care violations may satisfy the demand futility requirement that a director must face “a substantial likelihood of liability,” regardless of the corporation having a protective section 102(b)(7) provision. But the Delaware Supreme Court rejected this argument, making clear that 102(b)(7) provisions still protect directors in these situations.17Zuckerberg, 2021 WL 4344361, at *10–12. Thus, the decision should be of comfort to Delaware directors as it further insulates them from shareholder litigation.