On September 23, 2021, the Delaware Supreme Court issued a decision in United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Mark Zuckerberg, et al. and Facebook, Inc., C.A. No. 2018-0671-JTL, which set forth a “new” demand futility test designed to supplant the use of the Court’s prior Aronson and Rales tests. Demand futility is a key hurdle in most shareholder derivative cases to establish that the plaintiff has standing to pursue the lawsuit. Failure to establish demand futility results in an early dismissal of the case. The Facebook test, as it will be known, cleans up some confusion about how Aronson and Rales are applied, while ensuring that outcomes will stay consistent with what would have occurred under the prior tests.
The Facebook decision sustained a Court of Chancery ruling, which found that plaintiffs failed to plead demand futility in a case arising from the expenditure of litigation expenses and payment of fees when Facebook abandoned plans to reclassify stock. In the Court of Chancery, Vice Chancellor Laster described the Aronson and Rales demand futility tests and how their interpretation had evolved over time. (Del. Ch. Oct. 26, 2020). Vice Chancellor Laster concluded that the two tests no longer had separate utility in light of subsequent court interpretations and the enactment of a statute by the Delaware legislature designed to protect directors from liability for breaching their duty of care. Instead, his decision boiled them down to a single three-prong test. He explained:
Fundamentally, Aronson and Rales both address the same question of whether the board can exercise its business judgment on the corporat[ion]’s behalf in considering demand. For this reason, the Court of Chancery has recognized that the broader reasoning of Rales encompasses Aronson, and therefore the Aronson test is best understood as a special application of the Rales test. (Citations and quotation marks omitted.)
The Delaware Supreme Court affirmed this approach, and explained from a practical perspective what a plaintiff must establish to show that making a demand would be futile as to a majority of the board. The “new” demand futility test is a three-pronged approach that asks:
- whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;
- whether the director would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand; and
- 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.
“If the answer to any of the[se] questions is ‘yes’ for at least half of the members of the demand board, then demand is excused as futile.”
Notably, while the Delaware Supreme Court described this as a new test, it went out of its way to assuage practitioners that this was not a substantive change, explaining that both demand futility tests “‘address the same question of whether the board can exercise its business judgment on the corporat[ion]’s behalf’ in considering demand’; and the refined test does not change the result of demand-futility analysis.” Later in its decision, the Supreme Court reiterated that Aronson, Rales, and their progeny remain good law.
As a practical matter, we expect that Delaware corporations will latch onto some language in the opinion that reminds plaintiffs that pleading demand futility is no easy task, particularly in light of Section 102(b)(7), which exculpates directors for breaches of duty of care, and cannot be used as a path to expose directors to a substantial likelihood of liability or as a basis for finding demand futility.
Yet, despite likely efforts to make this decision seem like a sea change for stockholders, demand futility may still be established based on particularized pleading of non-exculpated breaches of fiduciary duties. Therefore, we do not see the Facebook decision as a significant change to current pleading practices. Plaintiffs have been cognizant of this heightened burden and plead their claims accordingly. Courts, too, understand that whether to apply Aronson or Rales “does not matter” because “under either approach, demand is excused if Plaintiffs’ particularized allegations create a reasonable doubt as to whether a majority of the board of directors faces a substantial likelihood of personal liability for breaching the duty of loyalty.”. Rosenbloom v. Pyott, 765 F.3d 1137, 1150 (9th Cir. 2014).
For example, Cohen Milstein represented stockholders who were able to establish demand futility in the Wynn Resorts litigation and similarly argued that the particular test applied does not matter. That litigation involved allegations that the company’s former CEO and Chairman, Steve Wynn (“Wynn”), had terrorized, sexually harassed, and sexually abused dozens of employees on company property. The incumbent board of directors were made aware of serious allegations against him, yet failed to stop his misconduct or protect company employees. Even more seriously, the directors were personally obligated to report instances of unsuitability to gaming regulators, yet they failed to act which jeopardized existing licenses and future business opportunities. Instead, the directors allowed Wynn to remain at the helm of his namesake company where he continued sexually harassing employees. In Wynn Resorts, the court concluded that plaintiffs had adequately pled demand futility because the “Board had actual knowledge of serious allegations that Steve Wynn was violating the law” and “faces a substantial likelihood of liability for its knowing and conscious inaction.” (Thomas P. DiNapoli. v. Stephen A. Wynn, et al., Case No. A-18-770013-B, (Eighth Jud. Dist. Crt., Clark Cnty., Nev.) Order Denying Defendants’ Motion to Dismiss/Granting Lead Plaintiffs’ Motion to Strike, Sept. 6, 2018).
In this case, the well-known proverb “the more things change, the more they stay the same” seems particularly apt. The two demand futility tests already had culminated in a reasonably consistent application of demand futility. The Delaware Supreme Court is now blessing what already had come to be.