Delaware Supreme Court Adopts New Test for Establishing Demand Futility. Directors Get Protected
Updated: Nov 8, 2021
Delaware’s Supreme Court has adopted a new three-part universal test to decide a whether pre-suit demand upon a company’s board should be excused as futile. The new test may make it easier for boards of directors to get dismissal of stockholder derivative suits on a motion to dismiss. The Court affirmed its commitment to the cardinal precept of Delaware law; absent extraordinary circumstances, directors, not stockholders, should control a company’s litigation decisions.
Facebook’s directors approved a stock reclassification that allowed Mark Zuckerberg to sell most of his Facebook stock while maintaining voting control of the company. A number of stockholders filed class action lawsuits challenging the reclassification. The suits were consolidated into a single action which was dismissed shortly before trial when Facebook abandoned the reclassification. Facebook spent more than $21 million tri defend the consolidated litigation, and paid counsel for the plaintiffs more than $68 million in attorneys’ fees pursuant to the corporate benefit doctrine.
A shareholder then brought this derivative action to recover the $90 million Facebook had spent on the prior class action. The complaint named Zuckerberg and five other individuals who served on Facebook’s board at the time the reclassification was approved as defendants.
Rather than making a pre-suit demand on the board, the shareholder said demand was excused as futile because the board’s negotiation and approval of the reclassification was not a valid exercise of its business judgment and a majority of the Facebook directors lacked independence from Zuckerberg. Facebook moved to dismiss the complaint, arguing the shareholder did not adequately allege a demand was futile.
Prior Tests for Demand Futility
For a stockholder to bring a derivative claim (an action asserted on behalf of the corporation), the stockholder must either make a demand on the board of directors or state particular facts establishing that demand would be futile. The purpose is to assess whether the board should be deprived of its decision-making authority because there is reason to doubt the directors would be able to bring their impartial business judgment to bear on a litigation demand.
Before this case, the Delaware Supreme Court had established two tests to determine whether a pre-suit demand should be excused as futile
The first, known as the Aronson test, was applied when the litigation challenged a decision by the same board that would be charged with considering a pre-suit demand. Under this test, a pre-suit demand was excused if the complaint stated specific facts which raised a reasonable doubt that either the directors are disinterested and independent, or the challenged transaction was otherwise the product of valid business judgment.
The second test, known as the Rales test, was applied in all other circumstances. Under this, demand is excused as futile if the complaint stated specific facts creating a reasonable doubt that, when the complaint was filed, a majority of the board could have properly exercised independent and disinterested business judgment in responding to the demand.
Section 102(b)(7) of the Delaware Corporation Law was enacted shortly after Aronson was decided. It permits Delaware corporations to adopt a corporate charter provision which protects directors from monetary liability for breaches of the duty of care. Before the enactment of this law, rebutting the business judgment rule through allegations of care violations exposed directors to a substantial likelihood of liability which could prevent them from independently and disinterestedly responding to a demand.
Following the adoption of the new law, courts struggled with whether a claim for breach of the duty of care could satisfy the Aronson test. This new decision resolves that question by holding that allegations that a director breached his or her duty of care cannot establish demand futility where a director is protected by the law and consolidates the two tests into a single test of universal application.
The New Universal Test for Demand Futility
Under the new test, courts evaluate three questions on a director-by-director basis:
1. Whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;
2. Whether the director faces a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand; and
3. Whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that would be 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 questions is “yes” for at least half of the members of the board who would be considering the demand, demand is excused as futile.
Importantly, the Delaware Supreme Court held that exculpated duty of care claims cannot give rise to a substantial likelihood of liability for the universal test adopted by the Court.
Finally, the Court emphasized that the demand futility inquiry is analytically distinct from an inquiry into the propriety of the transaction being challenged and should be conducted without reference to the standard of review applicable to the transaction. The Court explained that the question addressed by the demand futility test -- whether the board should be stripped of its decision-making authority because there is reason to doubt that the directors would be able to bring their impartial business judgment to bear on a litigation demand -- is a different consideration than whether the derivative claim is strong or weak because the challenged transaction is likely to pass or fail the applicable standard of review.
Applying the new test to the complaint on a director-by-director basis, the Delaware Supreme Court held the complaint failed to allege that pre-suit demand should be excused as futile and concluded that the Court of Chancery properly dismissed complaint for failing to make a demand on the board.