Dela. Supreme Court tightens test for demand futility in derivative lawsuits

(Reuters) – It’s been a tough week for longstanding precedents – and for shareholders alleging corporate misconduct – in the Delaware Supreme Court.

On Monday, the judges in the Brookfield Asset Management Inc v. Rosson case explicitly overturned a 15-year-old case that allowed shareholders to bring direct claims against controlling shareholders for dilution of the value of their shares. According to the new ruling, the plaintiffs’ lawyers are instead confronted with more difficult procedural derivative lawsuits.

Then, on Thursday, the Supreme Court passed a new test that will make it difficult for shareholders in derivative suits to prove that board members cannot be trusted to sue on behalf of the company. The Supreme Court ruling in the United Food and Commercial Workers Union and Participating Food Industry Employers Tristate Pension Fund v. Mark Zuckerberg set the court’s precedent in 1984 Aronson v. Lewis, who I will explain, allowed shareholders to proceed with derivative suits by accusing board members of approving colored transactions.

But the ruling effectively closed a path that Aronson had opened up for plaintiffs’ attorneys to sue company boards of conflicting deals. Aronson may still be a good law, but it doesn’t do much good to shareholders after Thursday’s decision.

The Zuckerberg case, as you must have guessed, is a shareholder lawsuit against members of Facebook’s board of directors who approved a 2016 reclassification plan to allow Facebook’s founder, CEO, and majority shareholder to sell shares to support its charitable foundation finance while maintaining his voting rights.

Facebook subsequently dropped the plan after a series of shareholder lawsuits – but not before spending more than $ 90 million to defend the reclassification and then paying the plaintiffs’ attorneys whose lawsuit resulted in the lawsuit being closed. The Tri-State Fund’s derivative lawsuit alleged that Facebook board members violated their duties of due diligence and loyalty by supporting Zuckerberg’s abandoned reclassification plan.

As you know, shareholders can only bring legal action on behalf of the company if they can prove that the Management Board cannot or does not want to act alone. The tri-state fund attorneys alleged that after the 1984 Aronson Test, there would have been no point in asking the directors of Facebook to file a lawsuit over the reclassification plan.

The Aronson test applies if the majority of the directors who would evaluate a shareholder claim were directors at the time of the contested transaction. Aronson offered shareholders two avenues for determining the futility of claims: they could prove that a majority of the board disagreed, or they could show that the transaction was too problematic to qualify for a business assessment. Tri-state shareholders argued that either route resulted in pointless demand in the Facebook case.

Vice Chancellor Travis Laster dismissed Tri-State’s arguments in a ruling last October that cast doubt on Aronson’s viability.

The crux of Laster’s point was that an amendment to the Delaware Code of Business Conduct undermined the reasoning behind the 1984 judgment. The Aronson Court, he said, had used post-business rejection as a sort of proxy for board members’ personal liability risk, arguing that board members were at higher risk and therefore could not be relied on if the board were not entitled to it Subordination for the underlying transaction will have to make an independent decision as to whether the company has a cause for action.

But two years after Aronson was ruled, Laster said, Delaware was enacting a provision that allows corporations to protect directors from monetary damage for breach of their fiduciary duties. These so-called exculpatory provisions apparently reduced the directors’ liability for lawsuits resulting from encumbered transactions. As Laster recounted, Delaware began to wonder if it was still reasonable to base the futility of the claim on the standard of review of the underlying business if board members were not in danger of monetary damage.

Laster said the answer was no: “Aronson is intrinsically broken because later developments in case law have not made the core premise on which Aronson depends,” he wrote.

Laster proposed an alternative, three-part test for the futility of the inquiry, which he said was Aronson and a follow-up case, the Rales v. 1993 blow band, harmonized. Courts should determine whether the director has obtained personal gain from the alleged wrongdoing by the shareholders; whether the members of the management board were exposed to a significant liability risk for claims of the shareholders; and whether the director is dependent on someone – presumably a majority shareholder – who has benefited from the disputed transaction. If the answer is yes for the majority of the board, shareholders can move on.

The Delaware Supreme Court agreed that exculpatory provisions undermined Aronson’s essential logic. In a unanimous opinion from Judge Tamika Montgomery-Reeves, the court categorically stated that claims that fall under such provisions cannot be the basis for the futility of claims.

“When Aronson was ruled, there were reasonable doubts that directors had violated their due diligence obligations, exposing them to a significant likelihood of liability and lengthy litigation, which cast doubts about their ability to impartially consider demand,” wrote Montgomery-Reeves. “The ground has shifted since then, and excused due diligence claims no longer pose a threat that neutralizes the director’s discretion.”

Given this attitude, said the Supreme Court, it took over the three-part test of vice for the futility of demand. The vice test, Montgomery-Reeves said, mixed up the precedent of Aronson and Rales to answer the crucial question of whether directors can be trusted to act in the company’s best interests.

The whole point of the analysis, she wrote, “is to assess whether the board of directors should be deprived of its decision-making power because there is reason to doubt that the directors would be able to apply their impartial judgment to a legal claim.”

Vice’s “nifty” test will answer that question, the court said – and it doesn’t even require the judges overthrow Aronson because, according to Thursday’s opinion, it “improves Aronson, Rales and their offspring.”

Neither the Tri-State Counsel Willem Jonckheer from Schubert Jonckheer & Kolbe nor the Facebook Board Counsel William Savitt from Wachtell, Lipton, Rosen & Katz responded to my email inquiries.

Delaware court observer Kyle Compton Wagner of Chancery Daily said in a warning about the Zuckerberg ruling that it was the most momentous week for shareholder derivatives since it went online. I suspect shareholders will feel the aftermath for a long time.

Continue reading:

Del. Supreme Court sets precedent for direct shareholder claims

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