Has the Chancery Court Created a New Tort?
A recent decision by the Delaware Court of Chancery may have plowed fresh ground by establishing a new tort claim against corporate directors. Lee v. Pincus, C.A. No. 8458-CB (Del. Ch. Nov. 14, 2014), held that directors who released themselves from a lockup agreement gained a benefit that was not shared with stockholders and may be liable to those stockholders as a result. This "improper benefit" claim is at least novel, if not entirely unprecedented. Corporate directors need to understand the implication of this decision.
The plaintiff class, led by Wendy Lee, were stockholders of Zynga Inc., a producer of interactive online games. Zynga went public in December 2011. Most of the investors in Zynga prior to the initial public offering were subject to a lockup agreement that restricted their right to sell their Zynga stock until after May 28, 2012. However, the Zynga directors waived the lockup to permit a secondary offering in April 2012 by some, but not all, of those pre-IPO investors, including four Zynga directors. Those favored by the board's decision then sold their stock for $12 per share. When Zynga's stock price later fell to $6.09 per share when the lockup expired for everyone else, Lee sued. She claimed the four directors who sold their stock earlier had benefited by approximately $100 million. She wanted her share of that benefit.
The Court of Chancery first resolved a basic procedural issue. It held that the class had a direct claim against the defendants and not a derivative claim based on any harm to Zynga from the lockup waiver. This enabled the plaintiffs to avoid the requirements that govern derivative claims. While critical to the plaintiffs' case, that ruling is not at all controversial.
Much more significant is the court's decision that the plaintiffs had asserted a valid breach of fiduciary duty claim. This decision involved two subparts. First, the court held that the claim was not governed by the terms of the lockup agreement, but instead asserted a claim based on fiduciary duty principles. Second, the court decided what those principles required of directors under the facts of this case. That is the key to the decision.
The governing rationale for holding that the claim asserted a breach of fiduciary duty is that the selling directors gained a benefit that was not available to Zynga's stockholders—the higher market price that existed when the directors sold. While those directors had also agreed to extend the lockup as to other shares they owned, the court did not believe that detriment outweighed the benefit of selling before others could do so. Hence, the defendants' motion to dismiss was denied.
What does the decision mean going forward? Certainly it is not wrong for directors to confer a benefit on themselves. They do that every time they adopt a stock option plan or other compensation for themselves. Of course, there are fiduciary-based limits on such benefits. But those types of transactions are understood to be self-dealing and subject to scrutiny. Hence, they will usually be done with care to pass muster.
The decision in Lee was different, however. The benefit conferred did not come at the expense of the company. After all, Zynga itself lost nothing by waiving the lockup agreement. Nor did Zynga even lose any corporate opportunity. It had already done an IPO and presumably was in no position to publicly issue more stock so soon after that IPO. What, then, was the harm the court sought to remedy?
The plaintiffs' theory that the court accepted at this early stage is that if all the pre-IPO investors had been permitted to sell their Zynga stock at the same time as the defendant directors, the market price they received would have been somewhere between the $12 per share the directors got and the $6 per share market price a short time later when the lockups expired. Since the directors owed the duty of a fiduciary not to profit at the expense of their beneficiary, that duty was violated here.
Does this theory apply to every transaction that a corporation enters into with its directors? If the corporation sells an asset to a director at a fair price, does that become actionable if the price of the asset goes up a short time later? Of course this example may seem inappropriate when the corporation did receive compensation for its asset at the time of the sale. After all, it is settled law that the validity of director action is to be tested as of the time that action is taken. But is that distinction enough to make Lee inapplicable?
Properly understood, Lee is limited to its facts. The allegations of the complaint included the claim that the directors knew the price of Zynga stock would decline when they sold the huge amount of its stock involved in their secondary offering. That allegedly known fact distinguishes the asset sale transaction just discussed. Nonetheless, Lee does caution that directors need to appreciate the consequences of their decisions on stockholder values. They should avoid reaping benefits that might be at the expense of stockholders.