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Rales, Aronson and … Zuckerberg: Delaware Supreme Court Adopts Three-Part Demand Futility Standard

On September 23, 2021, the Delaware Supreme Court decided United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, et al., __ A.3d __, 2021 WL 4344361 (Del. Sept. 23, 2021). In affirming the Court of Chancery’s decision, the high Court concurred with the Court-below’s articulation of a new three-part standard to assess whether a derivative plaintiff meets her pleading burden to show that a pre-suit demand upon the board would have been futile.

Background and The Court of Chancery’s Decision

This action concerned derivative claims against members of the board of directors of Facebook, Inc. arising from their 2016 approval of a stock reclassification. As conceived, Facebook was to issue a new class of non-voting stock, which would enable founder Mark Zuckerberg to retain voting control while also donating large amounts of his stock to charity. After stockholders brought suit, Facebook abandoned the transaction on the eve of trial. Facebook had paid roughly $21.8 million to pursue the reclassification and defend the litigation. It also paid a fee award of $68.7 million to the stockholder-plaintiffs’ counsel. A stockholder-plaintiff then filed this follow-on derivative suit, alleging that a demand would be futile. 

On October 26, 2020, Vice Chancellor J. Travis Laster issued an opinion dismissing the action for failure to plead demand futility. See 250 A.3d 862 (Del. Ch. 2020). In so doing, the Court considered which of the two demand futility tests previously articulated by the Delaware Supreme Court should apply: Aronson (decided in 1984) or Rales (decided in 1993). 

The two-prong Aronson test, which applies when a stockholder challenges a board decision, considers whether “(1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” The Rales test, which governs when the litigation does not involve a challenge to a board decision or when a majority of the board has turned over since the board decision at-issue, considers on a director-by-director basis whether “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.” Under Rales, a director is disqualified for demand futility purposes where a plaintiff alleges particularized facts showing the director faces a “substantial likelihood” of personal liability from the corporation’s potential claims. 

The Court of Chancery reasoned, as had previous Chancery decisions, that the Rales test generally addresses the concerns that motivated Aronson, and that maintaining separate tests created the potential for doctrinal confusion. The Court explained, among other things, that Aronson was decided before the adoption of Section 102(b)(7) of the Delaware General Corporation Law, which allows corporations to exculpate directors for duty of care violations. In the context in which Aronson was decided, duty of care violations rebutting the business judgment rule under Aronson’s second prong could lead to personal monetary liability for directors. By contrast, in the present context of most corporations having Section 102(b)(7) provisions, directors generally no longer face a risk of personal liability for duty of care claims. 

Accordingly, the Court of Chancery reasoned that in the current legal context, a three-part test should apply. Specifically, a Court should consider the following 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 would face a substantial likelihood of liability on any of the claims that are 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 is 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.

Because the plaintiff failed to allege facts supporting that a majority of the board were disqualified under this standard, the Court of Chancery granted the defendants’ motions to dismiss.

The Supreme Court’s Decision

On appeal, the Supreme Court affirmed the Court of Chancery’s decision and adopted the three-part standard. Writing for the Court en banc, Justice Tamika R. Montgomery-Reeves reasoned that under current law, alleged violations of the duty of care that are exculpated should not prevent a director from considering a pre-suit demand. The Supreme Court agreed with the Court of Chancery that Aronson was a creature of the pre-102(b)(7) context in which it was decided:

At that time, if the business judgment rule did not apply, allowing the derivative litigation to go forward would expose the directors to a substantial likelihood of liability for breach-of-care claims supported by well-pleaded factual allegations. It is reasonable to doubt that a director would be willing to take that personal risk. Thus, demand is excused.

The Supreme Court reasoned that the weight of Delaware authorities post-Aronson held that an exculpated duty of care violation should not be disqualifying. The high Court’s own 2015 Cornerstone Therapeutics decision confirming that exculpated directors may be dismissed at the pleadings stage, even in cases where heightened scrutiny applied, further supported this result. Thus, under current law, where a corporation has a Section 102(b)(7) provision, there is no longer a “threat of liability and protracted litigation” for directors facing duty of care claims. The Court also reasoned that the stockholder-plaintiff “failed to provide a reasoned explanation of why rebutting the business judgment rule should automatically render directors incapable of impartially considering a litigation demand given the current landscape.”

Accordingly, the Supreme Court adopted the three-part test articulated by the Court of Chancery. It noted that, because this test is “consistent with and enhances Aronson, Rales, and their progeny, the Court need not overrule Aronson to adopt this refined test, and cases properly construing Aronson, Rales, and their progeny remain good law.”

Key Takeaways

It is settled that the board of directors’ authority to manage the corporation’s business and affairs includes considering whether the corporation should pursue potential litigation, and the fact that a director might be among the class of defendants in such an action is not inherently disqualifying. Consistent with these principles, the three-part test reflects the central concern of Aronson and Rales: whether a board majority appears capable of considering a pre-suit demand in good faith and without objective, potentially disabling conflicts of interest. This decision confirms that a director who is only alleged to have engaged in a grossly negligent decision-making process, but who is exculpated from such a duty of care claim under Section 102(b)(7), should not be disqualified from considering a demand. In addition, and as both the Court of Chancery and Supreme Court decisions anticipate, this standard also should simplify the demand futility analysis, particularly in situations involving changes in the composition of the board between the conduct at-issue and the time of suit.

Delaware Business Court Insider l September 29, 2021 



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