United Food and Commercial Workers Union v. Zuckerberg, et al., No. 2018-0671-JTL, 2021 WL _______ (Sep. 23, 2021)
Background
Shareholder litigation comes in two possible forms. Direct” shareholder suits arise out of causes of action belonging to the shareholders in their individual capacity. It is typically premised on an injury directly affecting the shareholders and must be brought by the shareholders in their own name. In contrast, a “derivative” suit is one brought by the shareholder on behalf of the corporation. The cause of action belongs to the corporation as an entity and arises out of an injury done to the corporation as an entity. The shareholder is merely acting as the firm’s representative. Our focus here is on derivative litigation.
The law governing derivative litigation has many complexities, most of which result from the collision of two basic principles. On the one hand, the derivative cause of action belongs to the corporation. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions.
Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit.
Accordingly, both Delaware Rule of Civil Procedure 23.1 and the essentially identical Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.[1] The requisite demand can take any form, although most jurisdictions require that it be in writing. The demand need not be in the form of a pleading nor a detailed as a complaint, but rather simply must request that the board bring suit on the alleged cause of action.
Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation.[2] The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement. More precisely, it depends on whether demand is required or excused as futile.
Delaware requires demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware Supreme Court set forth the following test for demand futility:
[T]he Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.[3]
The Court’s use of a reasonable doubt standard has been the subject of much criticism:
The reference to “reasonable doubt” summons up the standard applied in criminal law. It is a demanding standard, meaning at least a 90% likelihood that the defendant is guilty. If “reasonable doubt” in the Aronson formula means the same thing as “reasonable doubt” in criminal law, then demand is excused whenever there is a 10% chance that the original transaction is not protected by the business judgment rule. Why should demand be excused on such a slight showing? Surely not because courts want shareholders to file suit whenever there is an 11% likelihood that the business judgment rule will not protect a transaction. Aronson did not say, and later cases have not supplied the deficit. If “reasonable doubt” in corporate law means something different from “reasonable doubt” in criminal law, however, what is the difference?, and why use the same term for two different things?[4]
In defense of the reasonable doubt standard, the Delaware Supreme Court rather weakly argued that “the term is apt and achieves the proper balance.”[5] Somewhat more helpfully, the court rephrased the test by reversing it: “the concept of reasonable doubt is akin to the concept that the stockholder has a ‘reasonable belief’ that the board lacks independence or that the transaction was not protected by the business judgment rule.”
The Aronson standard proved awkward in some cases, such as when there had been a turnover in board composition, where the complaint alleged inaction rather than action, and so on. In Rales v. Blasband, Plaintiff brought a double derivative suit on behalf of a parent corporation with respect to the sale of subordinated debentures by its wholly owned subsidiary. Because the derivative suit did not challenge a decision by the parent corporation’s board, the court held that the Aronson standard did not apply:
Instead, it is appropriate in these situations to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. If the derivative plaintiff satisfies this burden, then demand will be excused as futile.[6]
The court noted three scenarios in which this test is to be used in lieu of the Aronson standard: (1) where a majority of the board that made the challenged transaction has been replaced by disinterested and independent members; (2) where the litigation arises out of some transaction or event not involving a business decision by the board; and (3) where the challenged decision was made by the board of a different corporation.
As former Delaware Chief Justice Leo Strine explained in an opinion written earlier in his career during his stint as a Vice Chancellor:
At first blush, the Rales test looks somewhat different from Aronson . . .. [The Rales] inquiry makes germane all of the concerns relevant to both the first and second prongs of Aronson. For example, in a situation when a breach of fiduciary duty suit targets acts of self-dealing committed, for example, by the two key managers of a company who are also on a nine-member board, and the other seven board members are not alleged to have directly participated or even approved the wrongdoing (i.e., it was not a board decision), the Rales inquiry will concentrate on whether five of the remaining board members can act independently of the two interested manager-directors. This looks like a first prong Aronsoninquiry.
When, however, there are allegations that a majority of the board that must consider a demand acted wrongfully, the Rales test sensibly addresses concerns similar to the second prong of Aronson. To wit, if the directors face a “substantial likelihood” of personal liability, their ability to consider a demand impartially is compromised under Rales, excusing demand.[7]
In United Food and Com. Workers Union v. Zuckerberg,[8] the Delaware Chancery Court (per Vice Chancellor J. Travis Laster), took note of the criticism that Aronson has been subject to over the years and proposals that the courts should abandon Aronson and adopt Rales as the general standard. In UFCWU, VC Laster proposed just such a move:
Both [the Aronson and Rales] tests remain authoritative, but the Aronson test has proved to be comparatively narrow and inflexible in its application, and its formulation has not fared well in the face of subsequent judicial developments. The Rales test, by contrast, has proved to be broad and flexible, and it encompasses the Aronson test as a special case.[9]
VC Laster went on to explain that:
In using the standard of review for the challenged transaction as a proxy for the risk of director liability and hence the test for demand futility, Aronson was a creature of its time. Subsequent jurisprudential developments severed the linkage between these concepts. Under current law, the application of a standard of review that is more onerous than the business judgment rule does not render demand futile. Similarly, the availability of exculpation means that a standard of review that is more onerous than the business judgment rule may not result in a substantial likelihood of liability.[10]
Laster reviewed these changes in detail, explaining how they had called into question the continuing utility of Aronson.
In addition to its declining doctrinal relevance, the Aronson test has always been an awkward way of getting at the core problem in the derivative suit context. Recall that we are dealing here not with a lawsuit brought to redress an injury done to the shareholder but rather one done to the corporate entity. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions. Consequently, the law governing derivative litigation must balance the competing policies of deference to the board’s decision-making authority and the need to hold erring directors accountable.
The core question thus is: Do we trust the board of directors to make a good faith decision about the merits of the lawsuit in question. If so, the board should be allowed to control the case. If not, the shareholder should be allowed to go forward.
Aronson gets at that question only indirectly. In contrast, as Laster explained, Rales does so directly:
The significant advance made by Rales was to refocus the inquiry on the decision regarding the litigation demand, rather than the decision being challenged. . . . The Rales decision thus asked directly “whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations.”
Under Rales, a director is disqualified from exercising judgment regarding a litigation demand if the director was interested in the alleged wrongdoing, such as when the director received a personal benefit from the wrongdoing that was not equally shared from the stockholders. A director also is disqualified from exercising judgment regarding a litigation demand if another person was interested in the alleged wrongdoing, and the director lacks independence from that person. Although these aspects of the Rales inquiry look to the relationship between the alleged wrongdoing and the directors considering the litigation demand, they do so for purposes of analyzing the directors’ ability to evaluate the litigation demand, not to determine the standard of review that would apply to the alleged wrongdoing.[11]
On appeal, the Delaware Supreme Court (per Justice Montgomery-Reeves) affirmed.[12]
Facts
In 2016, Facebook proposed a stock reclassification that would allow founder and controlling shareholder Mark Zuckerberg to dispose a substantial amount of his shares while still retaining voting control of the company. Numerous shareholder suits were challenging the proposal, which were consolidated into a single class action. Shortly before the trial was scheduled to begin, Facebook withdrew the proposal and settled the case. Facebook spent almost $22 million defending the class action, including over $17 million on attorneys’ fees. The settlement included payments to the plaintiffs’ lawyers of over $68 million.
A Facebook shareholder, the United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund (UFCWU), filed a derivative suit claiming that Facebooks’ board of directors “breached their fiduciary duties of care and loyalty by improperly negotiating and approving” the reclassification. The new suit was brought derivatively on behalf of the corporation to recover the money Facebook had spent defending and settling the original class action.
The plaintiff did not make demand before filing the derivative suit. When the defendants moved to dismiss the suit for failure to do so, plaintiff claimed that demand should be excused as futile. VC Laster granted the motion. Plaintiff appealed.
Held
Affirmed.
Reasoning
The Supreme Court emphasized the centrality of a demand requirement with teeth as a gateway to derivative litigation:
[T]he demand requirement is not excused lightly because derivative litigation upsets the balance of power that the DGCL establishes between a corporation’s directors and its stockholders. Thus, the demand-futility analysis provides an important doctrinal check that ensures the board is not improperly deprived of its decision-making authority, while at the same time leaving a path for stockholders to file a derivative action where there is reason to doubt that the board could bring its impartial business judgment to bear on a litigation demand.[13]
(This is, by the way, a point I made at some length in my book Corporation Law and Economics at 399-404, in which I discussed the application of my director primacy theory to derivative litigation.)
In operationalizing that policy, the Court noted that there had been an important doctrinal shift since Aronsonwas decided; namely, the adoption of FGCL § 102(b)(7), which allows corporations to adopt provisions in their articles of incorporation exculpating monetary liability for duty of care claims against directors. Almost all public Delaware corporations have adopted such provisions.
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.[14]
After disposing of plaintiff’s various objections to that conclusion, the Court turned to the question “whether the three-part test for demand futility the Court of Chancery applied below is consistent with Aronson, Rales, and their progeny.”[15] VC Laster’s version of the Rales test stated:
(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 would face a substantial likelihood of liability on any of the claims that are 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 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.[16]
Oddly, although the test is phrased in the conjunctive (“and”), it seems clear that the court intends it to be applied in the disjunctive: “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.”[17]
The Supreme Court adopted “the Court of Chancery’s three-part test as the universal test for assessing whether demand should be excused as futile,”[18] explaining:
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.[19]
The court concluded by denying that this amounted to a dramatic change in the law, arguing that “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.”[20]
[1] Federal Rule 23.1 contemplates that demand may be made on shareholders in appropriate cases. A few jurisdictions require demand on shareholders, at least in some cases. See, e.g., Heilbrunn v. Hanover Equities Corp., 259 F.Supp. 936 (S.D.N.Y.1966) (demand on shareholders excused where wrongdoers hold a majority of corporation’s stock); Mayer v. Adams, 141 A.2d 458 (Del.Supr.1958) (demand on shareholders excused where alleged wrong could not be ratified by shareholders).
[2] See Levine v. Smith, 591 A.2d 194, 207 (Del.1991) (“The demand requirement is not a ‘mere formalit[y] of litigation,’ but rather an important ‘stricture[ ] of substantive law.’ ”); see also Barr v. Wackman, 368 N.Y.S.2d 497, 505 (1975) (“demand is generally designed to weed out unnecessary or illegitimate shareholder derivative suits”).
[3] Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984).
[4] Starrels v. First Nat’l Bank of Chicago, 870 F.2d 1168, 1175 (7th Cir.1989) (Easterbrook, J., concurring) (citations omitted).
[5] Grimes v. Donald, 673 A.2d 1207, 1217 (Del.1996).
[6] Rales v. Blasband, 634 A.2d 927, 934 (Del.1993).
[7] Guttman v. Huang, 823 A.2d 492, 501 (Del. Ch. 2003).
[8] 250 A.3d 862 (Del. Ch. 2020).
[9] Id. at 877.
[10] Id. at 880.
[11] Id. at 887.
[12] United Food and Commercial Workers Union v. Zuckerberg, et al., No. 2018-0671-JTL, 2021 WL _______ (Sep. 23, 2021).
[13] Id. at 22.
[14] Id. at 31.
[15] Id. at 37.
[16] Id. at 37-38 (emphasis supplied).
[17] Id. at 41. Interestingly, the same problem arose in Aronson, where the test was phrased in the conjunctive. There was some confusion as a result as to whether a plaintiff needed to create a reasonable doubt as to both prongs. In its subsequent Levine v. Smith opinion, 591 A.2d 194 (Del.1991), the court made clear that the test is in the disjunctive, such that satisfying either prong suffices. Id. at 205.
Note that the United Food and Commercial Workers Union court used the phrase “at least half” rather than “a majority.” See, e.g., Kohls v. Duthie, 791 A.2d 772 (Del.Ch.2000) (holding that demand was excused even though only half of the board was deemed incapable of impartially assessing the litigation).
[18] United Food and Commercial Workers Union, at 38.
[19] Id. at 39.
[20] Id. at 40.
