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Chancery Applies 'Rales' in Dismissing Derivative Claim

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April 4, 2016
Morris James LLP
Delaware Business Court Insider

In Sandys v. Pincus, C.A. No. 9512-CB, (Del. Ch. Feb. 29, 2016), the Delaware Court of Chancery considered the uncommon scenario of analyzing whether a demand made upon Zynga Inc.'s board of directors pursuant to Rule 23.1 would have been futile when the actions being challenged occurred at a time when Zynga's board was composed of several different directors. While a majority of the Zynga directors had not turned over between the time of the challenged actions and the time the litigation, enough of the interested directors were replaced in that period so that, at the time the derivative litigation was initiated, the Zynga board was populated by a majority of disinterested and independent directors. In considering whether demand on the Zynga board should be excused, the court analyzed this novel issue when determining what test should apply.

In 2011, Zynga's initial public offering (IPO) hit the market. As a condition to the IPO, certain Zynga executives and directors agreed to sale restrictions on their Zynga shares. In April 2012, Zynga issued a secondary offering of shares. Notwithstanding the sale restrictions, Zynga's underwriters, the board's audit committee and a majority of the board agreed to waive the restrictions in order to allow the Zynga executives and directors to sell their shares in the secondary offering. Subsequent to the approval of the secondary offering, the Zynga board was expanded from eight directors to nine directors. In addition, two of the directors who benefited from selling their shares in the secondary offering left the board and were replaced prior to the initiation of the derivative litigation. In April 2014, the derivative litigation was commenced, asserting claims against (1) the Zynga directors who participated in the secondary offering for breach of fiduciary duties for misusing confidential information when engaging in the secondary offering, (2) the Zynga directors for approving the secondary offering and allowing certain directors and executives to participate despite sale restrictions on their shares, and (3) the Zynga directors and executives at the time of the secondary offering for failing to put controls in place to ensure adequate public disclosures while avoiding material omissions in those disclosures.

Prior to initiating the derivative litigation, the plaintiff stockholder failed to make a demand to initiate litigation on the Zynga board. Instead, the plaintiff pleaded that demand upon the Zynga board was futile, alleging that a majority of the Zynga directors were either interested in the subject issues challenged in the complaint or lacked independence. Delaware courts apply one of two tests to claims of demand futility. The test set forth in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), requires the pleading of facts that create reasonable doubt as to whether the directors are disinterested or independent, or that the challenged transaction was the result of the exercise of valid business judgment. However, in situations where a board is asked to consider a demand challenging actions or decisions that the board did not take, a different test is applied. In these situations, the court applies the test set forth inRales v. Blasband, 634 A.2d 927 (Del. 1993), which requires a demonstration of reasonable doubt that the board could have properly exercised its independent and disinterested judgment in responding to the demand at the time the derivative litigation was commenced.

The court performed its demand futility analysis on each of the derivative claims individually, applying the Rales test in each instance. The court held that the Rales test should apply to the first claim as it was leveled against the Zynga directors who participated in the secondary offering. The court held that since only two of the nine directors presently sitting on the board participated in the secondary offering, the Zynga board was not conflicted in considering a demand regarding the plaintiff's claim. The second claim targeted all of Zynga's directors who approved the secondary offering. Unlike the first claim, the second claim did attack a business decision made by the Zynga board. In determining that Rales should apply to this unique circumstance, the court focused on the change in composition of the board since that approval. Two of the approving directors had been replaced by three disinterested directors. Accordingly, while less than a majority of the directors sitting on the Zynga board at the time the secondary offering was approved was replaced, enough of the interested directors were replaced so that the present Zynga board is composed of seven (of nine) directors who derived no benefit from the secondary offering. While this factual circumstance was not expressly contemplated by the Supreme Court in Rales, the chancellor noted that the Rales analysis was appropriate under the circumstances. The third claim articulated an In re Caremark International Derivative Litigation, 698 A.2d 959, claim against the directors, for failing to exert the proper oversight relating to the public disclosures made in connection with the second offering. Since that claim did not implicate a business decision of the board, it was a claim that should be analyzed under the Rales test.

What makes this case novel is the impact the director turnover during the period between the challenged actions and the litigation had on the demand futility analysis. While less than a majority of the directors changed during the period, the court found that the turnover of interested directors allowed the court to apply the Rales test in this instance. As the chancellor noted, "The utility of the Rales test is not that it examines different subject matter from that of the Aronson test, but that it provides a cleaner, more straightforward formulation to probe the core issue in the demand futility analysis for each board member who would be considering plaintiff's demand: 'whether there is a reason to doubt the impartial[ity] of the directors, who hold the authority under 8 Del. C. Section 141(a) to decide [for the corporation] whether to initiate, or refrain from entering, litigation.'"

Delaware Business Court Insider  |  March 30, 2016

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