Delaware Supreme Court Adopts Three-Part Demand Futility Test

On September 23, 2021, the Delaware Supreme Court, in United Food & Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, No. 404, 2020 (Del. Sept. 23, 2021), affirmed the Court of Chancery’s dismissal of a shareholder derivative lawsuit which sought to recover costs incurred by Facebook related to a proposed stock reclassification plan.  In doing so, the Delaware Supreme Court adopted a new, three-part demand futility test outlined by the Court of Chancery.

The stockholders alleged that Facebook’s board of directors breached their fiduciary duties in connection with a proposed stock reclassification plan.  The proposed plan would have permitted Facebook CEO Mark Zuckerberg to donate a substantial portion of his company shares but retain his voting control of Facebook.  The plan was never enacted; however, the stockholders sought to recover costs incurred by Facebook to defend and settle a challenge to the proposed plan.

The Court of Chancery dismissed the suit for failing to adequately allege demand futility, and held that Facebook’s Section 102(b)(7) exculpation clause prevented the stockholders from relying upon exculpated duty of care violations to establish demand futility under the second prong of the Aronson test.  While dismissing the case, the Court of Chancery crafted and applied a new, three-part demand futility test.  The new test is comprised of aspects drawn from the traditional Aronson and Rales tests.  The stockholders appealed the dismissal.

The Delaware Supreme Court affirmed the Court of Chancery’s holdings that duty of care claims exculpated under Section 102(b)(7) do not excuse demand under the second prong of the Aronson test, and that demand is not automatically excused when entire fairness review applies to a transaction. Importantly, the Delaware Supreme Court adopted the three-part test outlined by the Court of Chancery.  According to the Delaware Supreme Court, the new, three-part test is “the universal test for assessing whether demand should be excused as futile.”  Under this new test, when evaluating allegations of demand futility, courts should consider:

(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.

The test is applied on a director-by-director basis, and “[i]f 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.”  While adopting the new test, the Delaware Supreme Court noted that the new test is “consistent with and enhances Aronson, Rales, and their progeny,” as such, “cases properly construing Aronson, Rales, and their progeny remain good law.”

The full decision can be found here.