A stockholder would like to bring a derivative claim on behalf of the corporation.
A shareholder filing a derivative suit must either: (1) allege that the board rejected their pre-suit demand; or, (2) allege with particularity why the stockholder was justified in not having made such a demand. (Grimes v. Donald, 673 A.2d 1207 (Del. 1996))
One ground for alleging with particularity that a demand would be futile is that a reasonable doubt exists that the board is capable of making an independent decision to assert the claim if a demand were made. The basis for claiming excusal would normally be that: (1) a majority of the board has a material financial or familial interest; (2) a majority of the board is incapable of acting independently for some other reason such as domination or control; or (3) the underlying transaction is not the product of a valid exercise of business judgment. (Grimes v. Donald, 673 A.2d 1207 (Del. 1996))
The directors of a corporation are entitled to a presumption that they were faithful to their fiduciary duties. It is the plaintiff's burden to overcome this presumption by alleging particularized facts creating reasonable doubt regarding a director's independence. (Beam Ex Rel. M. Stewart Living v. Stewart, 845 A.2d 1040 (Del. 2004))
Courts should ask the following three questions on a director-by-director basis when evaluating allegations of demand futility: (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 or would face a substantial likelihood of liability on any 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 demand board, then demand is excused as futile. (United Food & Commercial Workers Union & Participating Food Indus. Emp'rs Tri-State Pension Fund v. Zuckerberg, 262 A.3d 1034 (Del. 2021))
Determining whether facts have been pled supporting an inference that a director cannot act independently of an interested director requires looking at all the pled facts together and not in isolation. (Delaware Cnty. Emps. Ret. Fund v. Sanchez, 124 A.3d 1017 (Del. 2015) )
If a corporation has a provision in its certificate of incorporation pursuant to 8 Del. C. § 102(b)(7), which limits the liability of directors for breaches of the duty of care, then allegations that the directors violated the duty of care on claims for which their liability has been so limited do not suffice to establish a substantial likelihood of personal liability for the purpose of establishing demand futility. (United Food & Commercial Workers Union & Participating Food Indus. Emp'rs Tri-State Pension Fund v. Zuckerberg, 262 A.3d 1034 (Del. 2021))
Establishing that a director lacked independence from another person requires showing material ties between the director and the person such that the objective discharge of duties by the director could not be carried out. Mere claims of personal friendships or outside business relationships are insufficient. (United Food & Commercial Workers Union & Participating Food Indus. Emp'rs Tri-State Pension Fund v. Zuckerberg, 262 A.3d 1034 (Del. 2021))
In Zimmerman v. Braddock, C.A. No. 18473-NC, (Del. Ch. Sept. 8, 2005), the Delaware Court of Chancery explained that insider trading on the part of the directors would excuse the plaintiff's failure to make a demand by establishing that the directors faced a substantial likelihood of personal liability.
In Grimes v. Donald, 673 A.2d 1207 (Del. 1996), the Delaware Supreme Court held that a shareholder filing a derivative suit must either: (1) allege that the board rejected their pre-suit demand; or, (2) allege with particularity why the stockholder was justified in not having made such a demand. A claim that a demand is futile can be based on facts alleging a basis for reasonable doubt that the board is capable of making an independent decision to assert the claim if the demand were made (at 1216):
A stockholder filing a derivative suit must allege either that the board rejected his pre-suit demand that the board assert the corporation's claim or allege with particularity why the stockholder was justified in not having made the effort to obtain board action. This is a "basic principle of corporate governance" and is a matter of substantive law embodied in the procedural requirements of Chancery Rule 23.1.
One ground for alleging with particularity that demand would be futile is that a "reasonable doubt" exists that the board is capable of making an independent decision to assert the claim if demand were made. The basis for claiming excusal would normally be that: (1) a majority of the board has a material financial or familial interest; (2) a majority of the board is incapable of acting independently for some other reason such as domination or control; or (3) the underlying transaction is not the product of a valid exercise of business judgment. If the stockholder cannot plead such assertions consistent with Chancery Rule 11, after using the "tools at hand" to obtain the necessary information before filing a derivative action, then the stockholder must make a pre-suit demand on the board.
In Beam Ex Rel. M. Stewart Living v. Stewart, 845 A.2d 1040 (Del. 2004), the Delaware Supreme Court held that it is the shareholder's burden to overcome the presumption that a director was faithful to their fiduciary duties by alleging particularized facts creating reasonable doubt of a director's independence (at 1048-1049):
The key principle upon which this area of our jurisprudence is based is that the directors are entitled to a presumption that they were faithful to their fiduciary duties.16 In the context of presuit
[845 A.2d 1049]
demand, the burden is upon the plaintiff in a derivative action to overcome that presumption.17 The Court must determine whether a plaintiff has alleged particularized facts creating a reasonable doubt of a director's independence to rebut the presumption at the pleading stage.18 If the Court determines that the pleaded facts create a reasonable doubt that a majority of the board could have acted independently in responding to the demand, the presumption is rebutted for pleading purposes and demand will be excused as futile.
In United Food & Commercial Workers Union & Participating Food Indus. Emp'rs Tri-State Pension Fund v. Zuckerberg, 262 A.3d 1034 (Del. 2021) ("Zuckerberg"), the plaintiffs filed a derivative action seeking the recovery of almost $90 million that Facebook had spent pursuant to a previous lawsuit. That previous lawsuit involved a challenge to a stock reclassification that Facebook had undertaken in order to permit Mark Zuckerberg to liquidate most of his Facebook stock while maintaining voting control of the company. The Court of Chancery noted that there were problems applying the analytical framework of prior caselaw to the facts of the case. In reaching a determination as to whether a making a demand for litigation to the board would be futile, the Court of Chancery instead fashioned a three-part test that built on and consolidated the framework from prior caselaw.
The Delaware Supreme Court adopted the Court of Chancery's test, holding that changes in other relevant law required an evolution of the common law standard, and also holding that the newly adopted "refined" test is consistent with earlier caselaw and leaves that existing caselaw in place as good law. The Delaware Supreme Court's refined test looks, on a director-by-director basis, to three factors in determining demand futility: (1) whether the director received 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 the claims that would be the subject of the litigation demand, and (3) whether the director lacks independence from someone who (i) received a material personal benefit from the alleged misconduct that would be the subject of the litigation demand, or (ii) would face a substantial likelihood of liability on any claims that are the subject of the litigation demand. If any one of these three factors is met for at least half of the members of the demand board, then a pre-litigation demand is excused as futile (at 1058-1059):
This Court adopts the Court of Chancery's three-part test as the universal test for assessing whether demand should be excused as futile. When the Court decided Aronson, it made sense to use the standard of review to assess whether directors were subject to an influence that would sterilize their discretion with respect to a litigation demand. Subsequent changes in the law have eroded the ground upon which that framework rested. Those changes cannot be ignored, and it is both appropriate and necessary that the common law evolve in an orderly fashion to incorporate those developments. The Court of Chancery's three-part test achieves that important goal. Blending the Aronson test with the Rales test is appropriate because "both ‘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.
Further, the refined test "refocuses the inquiry on the decision regarding
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the litigation demand, rather than the decision being challenged." Notwithstanding text focusing on the propriety of the challenged transaction, this approach is consistent with the overarching concern that Aronson identified: whether the directors on the demand board "cannot be considered proper persons to conduct litigation on behalf of the corporation" because they "are under an influence which sterilizes their discretion." The purpose of the demand-futility analysis is to assess whether the board should be deprived 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. That 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. It is helpful to keep those inquiries separate. And the Court of Chancery's three-part test is particularly helpful where, like here, board turnover and director abstention make it difficult to apply the Aronson test as written.
Finally, because the three-part 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.
Accordingly, from this point forward, courts should ask the following three questions on a director-by-director basis when evaluating allegations of demand futility:
(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 faces a substantial likelihood of liability on any of the claims that would be 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 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 demand board, then demand is excused as futile. It is no longer necessary to determine whether the Aronson test or the Rales test governs a complaint's demand-futility allegations.
8 Del. C. § 102(b)(7) permits corporations to limit the liability of their directors for breaches of the duty of care to the corporation by including a clause to that effect in their certificates of incorporation. The duty of care requires fiduciaries to inform themselves of material information prior to making business decisions and act prudently in carrying out their duties. In Zuckerberg, Facebook's certificate of incorporation contained such a clause. Thus, Facebook's directors had been exculpated from liability for violations of the duty of care in at least some instances ("exculpated care violations"). The Delaware Supreme Court considered whether the alleged exculpated care violations could be the basis of a finding that a director faced substantial likelihood of liability for a claim for the purposes of the test for demand futility. The Court held that exculpated care violations do not establish that a director faces a substantial likelihood of liability for a claim (at 1053-1054):
This Court's opinion in In re Cornerstone Therapeutics, Inc. Stockholder Litigation, changed the landscape even more. Before Cornerstone, there was some uncertainty about how to apply a Section 102(b)(7) provision when deciding a motion to dismiss under Court of Chancery Rule 12(b)(6). Some courts held that an exculpation clause could warrant dismissing a complaint alleging care claims. Others, particularly where the entire fairness standard of review might apply, ruled that more factual development was needed
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to determine whether the director's breach would be exculpated. Thus, a complaint alleging exculpated care violations might compromise a director's ability to impartially consider a litigation demand by exposing them to the distraction of protracted litigation, public scrutiny, and potential reputational harm, even if the risk was low that the director would be found liable for breaching their fiduciary duties.
Cornerstone eliminated any uncertainty and held that where a corporation's charter contains a Section 102(b)(7) provision, "[a] plaintiff seeking only monetary damages must plead non-exculpated claims against a director who is protected by an exculpatory charter provision to survive a motion to dismiss, regardless of the underlying standard of review for the board's conduct." Thus, under current law a Section 102(b)(7) provision removes the threat of liability and protracted litigation for breach of care claims. As such, Cornerstone eliminated "any continuing vitality from Aronson's use of the standard of review for the challenged transaction as a proxy for whether directors face a substantial likelihood of liability sufficient to render demand futile."
Accordingly, this Court affirms the Court of Chancery's holding that exculpated care claims do not satisfy Aronson's second prong. This Court's decisions construing Aronson have consistently focused on whether the demand board has a connection to the challenged transaction that would render it incapable of impartially considering a litigation demand. When Aronson was decided, raising a reasonable doubt that directors breached their duty of care exposed them to a substantial likelihood of liability and protracted litigation, raising doubt as to their ability to impartially consider demand. The ground has since shifted, and exculpated breach of care claims no longer pose a threat that neutralizes director discretion. These developments must be factored into demand-futility analysis, and Tri-State has 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. For these reasons, the Court of Chancery's judgment is affirmed.
The Delaware Supreme Court held that showing that a director lacked independence from another person requires showing material ties between the director and the person such that the objective discharge of duties by the director could not be carried out. Mere claims of personal friendships or outside business relationships are insufficient (at 1060-1061):
"The primary basis upon which a director's independence must be measured is whether the director's decision is based on the corporate merits of the subject before the board, rather than extraneous considerations or influences." Whether a director is independent "is a fact-specific determination" that depends upon "the context of a particular case." To show a lack of independence, a derivative complaint must plead with particularity facts creating "a reasonable doubt that a director is ... so ‘beholden’ to an interested director ... that his or her ‘discretion would be sterilized.’ "
"A plaintiff seeking to show that a director was not independent must satisfy a materiality standard." The
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plaintiff must allege that "the director in question had ties to the person whose proposal or actions he or she is evaluating that are sufficiently substantial that he or she could not objectively discharge his or her fiduciary duties." In other words, the question is "whether, applying a subjective standard, those ties were material , in the sense that the alleged ties could have affected the impartiality of the individual director." "Our law requires that all the pled facts regarding a director's relationship to the interested party be considered in full context in making the, admittedly imprecise, pleading stage determination of independence." And while "the plaintiff is bound to plead particularized facts in ... a derivative complaint, so too is the court bound to draw all inferences from those particularized facts in favor of the plaintiff, not the defendant, when dismissal of a derivative complaint is sought."
"A variety of motivations, including friendship, may influence the demand futility inquiry. But, to render a director unable to consider demand, a relationship must be of a bias-producing nature." Alleging that a director had a "personal friendship" with someone else, or that a director had an "outside business relationship," are "insufficient to raise a reasonable doubt" that the director lacked independence. "Consistent with [the] predicate materiality requirement, the existence of some financial ties between the interested party and the director, without more, is not disqualifying."
Like the Court of Chancery below, we hold that Tri-State failed to raise a reasonable doubt that either Thiel, Hastings, or Bowles was beholden to Zuckerberg.
In Heineman v. Datapoint Corp., 611 A.2d 950 (Del. 1992), a shareholder argued for demand futility regarding a claim that a substantial investment by the corporation in a firm had injured stockholders to the financial benefit of a majority of the directors. The Court of Chancery dismissed the claim based on the plaintiff's failure to meet the demand requirement. The Delaware Supreme Court found the dismissal to be an abuse of discretion, holding that the facts alleged raised a reasonable doubt as to the disinterestedness of the directors (at 954):
Apart from the hyperbole, the factual assertions allege an "arrangement" by a majority of Datapoint's board to divert a substantial amount of the corporation's assets to an arbitrage pool whose participants include entities in which a majority of the directors hold an interest. That Datapoint entered into this arrangement with the approval of its board and the specifics of the agreement are assertions of fact. That particular members of Datapoint's board have interests in partnerships which have risk-free access to Datapoint's contribution to the arbitrage panel is also a statement of fact.
These allegations paint a picture of directors funneling corporate assets to their private use, a practice at clear variance with the directors' fiduciary obligation. Mills Acquisition Co. v. Macmillan, Inc., Del.Supr., 559 A.2d 1261 (1989); Weinberger v. UOP, Inc., Del.Supr., 457 A.2d 701 (1983); Sterling v. Mayflower Hotel Corp., Del.Supr., 93 A.2d 107 (1952); Guth v. Loft, Inc., Del.Supr., 5 A.2d 503 (1939). The claims of director self-dealing supported by particularized facts raise a reasonable doubt as to director disinterest to the extent that the challenged transaction may result in a benefit to the affected directors "which is not equally shared by the stockholders." Pogostin v. Rice, Del.Supr., 480 A.2d 619, 624 (1984). Dismissal of this claim for failure to make demand represents a too stringent application of the standards governing demand and, in our view, constitutes an abuse of discretion.
The shareholder argued that the directors had inappropriately approved a transaction in which said directors had been reimbursed for their expenses incurred in a proxy contest by which the directors had taken control of the corporation. The Court of Chancery held that facts had not been alleged that raised a reasonable doubt as to whether the challenged transaction was the product of valid business judgment. The Delaware Supreme Court disagreed, holding that dismissal was an abuse of discretion and that a reasonable doubt had been raised (at 953):
This conclusory treatment does not satisfy the "highly factual nature of the inquiry" in which the Court of Chancery must engage when a demand defense is raised. Perot, 539 A.2d at 186. We read the complaint to allege that a majority of the board, after assuming their positions through a successful proxy contest, reimbursed themselves for the costs incurred in that battle by voting funds from the corporate treasury in excess of $1 million. It may be that this reimbursement never occurred or, if so, was justified for some as yet undisclosed reason. No answer has been filed contesting the allegations of the amended complaint, and they must accordingly be viewed as true in this procedural posture, Id. In our view the "well pleaded" allegation of paragraphs 18 and 19 of the amended complaint recite sufficient facts of apparent self-dealing to raise a reasonable doubt concerning director-disinterest. The complaint alleges a successful contest for corporate control, with the victors in that contest using their newly acquired positions to cause the corporation to reimburse the costs of waging that contest. Proof of these facts at trial would represent a prima facia case of director self-dealing. Weinberger v. UOP, Inc., Del.Supr., 457 A.2d 701, 710 (1983) ("When directors of a Delaware corporation are on both sides of a transaction, they are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain."). While countervailing evidence might incline the fact finder to discredit the allegations, at this juncture the Court is not engaged in a weighing of evidence. The plaintiff need only raise a reasonable doubt that the business judgment rule applies. And though he is not required to plead a prima facia case of breach of fiduciary duty in order to avoid the demand requirement, once he does make such allegations he has carried his burden and demand is excused. We conclude, therefore, that the court's dismissal of this claim was an abuse of its discretion.
In Zimmerman v. Braddock, C.A. No. 18473-NC (Del. Ch. Sept. 8, 2005), the Delaware Court of Chancery considered whether the plaintiff shareholder had made out a prima facie claim of insider trading by the defendants, which would excuse the plaintiff's failure to make a demand by establishing that the directors faced a substantial likelihood of personal liability. The defendant directors of Priceline.com had sold company stock while allegedly having material, non-public information about the poor state of the company that contradicted their optimistic public statements. The Court found that plaintiff had made out a prima facie claim, looking in part to the sheer size of the trades in question (at 26-28):
Accepting all the well-pled allegations the Plaintiff has presented as true, the Plaintiff has made out a prima facie case that the Selling Defendants sold Priceline stock with the benefit of the Company's adverse material, confidential information. To proceed on an insider selling claim, a plaintiff must shows "that each sale by each individual defendant was entered into and completed on the basis of, and because of, adverse material non-public information." For motion to dismiss purposes, the Plaintiff has met this burden. A reasonable inference from the Plaintiff's allegations is that the Selling Defendants had knowledge — directly and by imputation — of Priceline and WebHouse's problems. In addition, it is a reasonable inference that the public was not aware of Priceline's true predicament because its problems — even if they had been partially disclosed — were likely overshadowed by the public hyperbole of Priceline's executives.82 While perhaps
the "bespeaks caution" doctrine — to be considered in greater detail later — may provide a defense, it is both context-relative and fact-specific, and, given the Plaintiff's well-pled allegations, needs the benefit of a more developed factual record for assessment.
When the sheer size of the trades (collectively, approximately $248 million dollars) is combined with the Plaintiff's well-pled allegations of insider trading culpability, the Selling Defendants, for motion to dismiss purposes, can be viewed as facing substantial personal liability even though the materiality of the trades (or the consequences of an action challenging them) to the Selling Defendants has not been specifically pled. If the proceeds from the trades were not material to the directors, this would undercut suspicion of their trades and would frustrate the
Plaintiff's efforts to demonstrate that the loyalty of those directors is in doubt. The question with regard to demand futility is whether the trading directors could impartially consider a shareholder's demand upon the corporation to pursue a claim against them based on their trades. In light of the allegations in the Second Amended Complaint and the value of the Selling Defendants' trades, it is a reasonable inference that the Selling Defendants would be personally and significantly concerned about, and opposed to, any such demand and, thus, interested in whether the Priceline Board would pursue a claim based on their trades. Thus, the Second Amended Complaint alleges that the Selling Defendants are interested.
In Delaware Cnty. Emps. Ret. Fund v. Sanchez, 124 A.3d 1017 (Del. 2015), the Delaware Supreme Court held that determining whether facts have been pled supporting an inference that a director cannot act independently of an interested director requires looking at all the pled facts together and not in isolation (at 1019):
Determining whether a plaintiff has pled facts supporting an inference that a director cannot act independently of an interested director for purposes of demand excusal under Aronson can be difficult. And this case illustrates that. But in that determination, it is important that the trial court consider all the particularized facts pled by the plaintiffs about the relationships between the director and the interested party in their totality and not in isolation from each other, and draw all reasonable inferences from the totality of those facts in favor of the plaintiffs. In this case, the plaintiffs pled not only that the director had a close friendship of over half a century with the interested party, but that consistent with that deep friendship, the director's primary employment (and that of his brother) was as an executive of a company over which the interested party had substantial influence. These, and other facts of a similar nature, when taken together, support an inference that the director could not act independently of the interested party. Because of that, the plaintiffs pled facts supporting an inference that a majority of the board who approved the interested transaction they challenged could not consider a demand impartially. Therefore, we reverse and remand so that the plaintiffs can prosecute this derivative action.
The Delaware Supreme Court held that while allegations of a "thin social-circle friendship" would not be enough, absent other factors, to find that the presumption of directorial independence had been overcome, more significant social ties, such as those in issue in the case, where the social ties in question had existed for over half a century, could overcome the presumption (at 1022-1024):
Here, the plaintiffs did not plead the kind of thin social-circle friendship, for want of a better way to put it, which was at issue in Beam. In that case, we held that allegations that directors “moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as ‘friends,’ ... are insufficient, without more, to rebut the presumption of independence.” In saying that, we did not suggest that deeper human friendships could not exist that would have the effect of compromising a director's independence. When, as here, a plaintiff has pled that a director has been close friends with an interested party for a half century, the plaintiff has pled facts quite different from those at issue in Beam. Close friendships of that duration are likely considered precious by many people, and are rare. People drift apart for many reasons, and when a close relationship endures for that long, a pleading stage inference arises that it is important to the parties.
The plaintiffs did not rely simply on that proposition, however. They pled facts regarding the economic relations of Jackson and Chairman Sanchez that buttress their contention that they are confidantes and that there is a reasonable doubt that Jackson can act impartially in a matter of economic importance to Sanchez personally. It may be that it is entirely coincidental that Jackson's full-time job is as an executive at a subsidiary of a corporation over which Chairman Sanchez has substantial influence, as the largest stockholder, director, and the Chairman of an important source of brokerage work. It may be that it is also coincidental that Jackson's
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brother also works there. It may be coincidental that Jackson and his brother both work on insurance brokerage work for the Sanchez Public and Private Companies there. And it may be coincidental that Jackson finds himself a director of the Sanchez Public Company. But rather certainly, there arises a pleading stage inference that Jackson's economic positions derive in large measure from his 50–year close friendship with Chairman Sanchez, and that he is in these positions because Sanchez trusts, cares for, and respects him. If that is true, there is of course nothing wrong with that. Human relationships of that kind are valuable. In this context, however, where the question is whether the plaintiffs have met their pleading burden to plead facts suggesting that Jackson cannot act independently of Chairman Sanchez, these obvious inferences that arise from the pled facts require that the defendants' motion to dismiss be denied. In other words, using
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the precise parlance of Aronson, the plaintiffs pled particularized facts, that when considered in the plaintiff-friendly manner required, create a reasonable doubt about Jackson's independence.