FACEBOOK ESCAPES SHAREHOLDER DERIVATIVE SUIT AS COURT QUESTIONS VALIDITY OF ARONSON AND FINDS PLAINTIFF FAILED TO SUPPORT CLAIMS OF DEMAND FUTILITY

Oct 15 2021

In United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, et al., C.A. No. 2018-0671 (Del. Ch. Oct. 26, 2020), the Delaware Court of Chancery (the “Court”) dismissed a derivative suit brought by the stockholders (the “Plaintiffs”) of Facebook, Inc. (“Facebook”) because the Plaintiffs failed to adequately plead demand futility under Court of Chancery Rule 23.1. The derivative suit accused members of the Facebook board of directors (the “Board”) and Facebook CEO, Mark Zuckerberg, of breaching their fiduciary duties of care and loyalty by pursing and approving a stock reclassification proposal that would have allowed Zuckerberg to retain voting control of Facebook while donating a significant portion of his common stock to charitable causes. The Court discussed the two primary tests for determining demand futility in derivate actions – Aronson and Rales – and determined that demand futility turns on whether, at the time of filing the complaint, the majority of a board of directors is disinterested, independent, and capable of impartially evaluating a litigation demand to bring suit on behalf of a company.

In December 2010, Zuckerberg took the Giving Pledge, which calls on wealthy business people to donate a majority of their wealth to philanthropy or charitable causes. In March 2015, Zuckerberg developed a plan to complete the Giving Pledge by making annual donations of Facebook stock worth $2–3 billion. He realized that donations of this magnitude would quickly cause him to lose voting control of Facebook. To avoid this result, Zuckerberg proposed a reclassification of Facebook’s shares into a three-tier structure, distributing two new Class C shares on a one-time basis to each outstanding Class A and Class B share (the “Reclassification”). The Class C shares would be publicly tradable but grant no voting power. The Reclassification would triple Facebook’s outstanding shares and allow Zuckerberg to liquidate stock without giving up his voting power.

In August 2015, the Board appointed a special committee (the “Committee”) to evaluate and negotiate the Reclassification. However, according to the suit, the Committee approved the Reclassification plan (i) without ever negotiating with Zuckerberg in earnest, and (ii) with one member of the Committee regularly engaged in back-channel communication with Zuckerberg about what the Committee was doing and how to overcome specific concerns of the other Committee members. After the Committee recommended the Reclassification plan, it was approved by the Board and stockholders, including Zuckerberg’s 4.7 billion votes. Excluding Zuckerberg’s voting power, approximately 75% of Facebook stockholders voted against the Reclassification. Following the Board and stockholder approvals, certain Facebook stockholders brought litigation directly challenging the Reclassification (the “Reclassification Suit”). On the eve of trial in the Reclassification Suit, the Board agreed to withdraw the Reclassification proposal at Zuckerberg’s request.

In this derivative suit the Plaintiffs’ claimed the Board breached its fiduciary duties in approving the Reclassification, failed to recover the money expended defending the Reclassification, and engaged in actions that caused Facebook reputational damage. The Plaintiffs maintained that the pursuit and defense of the Reclassification cost Facebook over $90 million and other damages, including significant reputational harm.

Under Delaware law, stockholders can only file a derivative suit on behalf of a company if either: (i) they demanded that the directors of the company pursue the corporate claim and the directors wrongfully refused to do so; or (ii) demand is excused because the directors are incapable of making an impartial decision regarding the litigation, Ainscow v. Sanitary Co. of Am., 180 A. 614, 615 (Del. Ch. 1935). These doctrines of “demand refusal” and “demand excusal” are codified by Court of Chancery Rule 23.1, which imposes a pleading requirement on any plaintiff that seeks to assert a derivative claim. Rule 23.1 states that when a stockholder seeks to assert a derivative claim, the complaint must “allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and the reasons for the plaintiff’s failure to obtain the action or for not making the effort.” Ct. Ch. R. 23.1(a). In this case, the Plaintiffs chose not to make a pre-suit demand and therefore, the question before the court was whether such demand was excused because the directors were incapable of making an impartial decision regarding the litigation.

Before analyzing whether the Plaintiffs’ demand was futile, the Court detailed the shortcomings of the seminal case Aronson v. Lewis,473 A.2d 805, 811 (Del. 1984) (“Aronson”). The Court even questioned whether Aronson’s demand futility test was still useful. The test articulated in Aronson applies only when the directors who committed the alleged wrong are the same directors who would consider a plaintiff’s litigation demand. Under Aronson, a plaintiff must plead facts that create a reasonable doubt that the directors are disinterested and independent, and that the board’s action was a valid exercise of business judgment. The Court explained that Aronson has proved to be narrow and inflexible in application, and that Delaware’s evolving jurisprudence has “dismantled the logic of Aronson.” Alternatively, the broader framework articulated in Rales v. Blasband, 634 A.2d 927, 932 (Del. 1993) (“Rales”) has proven to be broad and flexible, both encompassing Aronson and applying to situations not addressed by Aronson, such as when a board fails to act or when a board’s membership has changed. Rales requires a plaintiff to plead that a majority of directors are “either interested in the alleged wrongdoing or not independent of someone who is.”

In applying Rales to determine whether the Plaintiffs’ demand was excused, the Court considered, for each director, whether such director (i) received a “material personal benefit from the alleged misconduct,” (ii) faced “a substantial likelihood of liability on any of the claims,” and (iii) lacked “independence from someone who received a material personal benefit from the alleged misconduct” or “who would face a substantial likelihood of liability on any of the claims.” Based on the allegations in the complaint, the Court made “pro-plaintiff assumptions” that three out of the nine directors could not be disinterested and independent with respect to Plaintiffs’ demand. Zuckerberg would have received a material benefit in the Reclassification and both Sheryl Sandberg and Marc Andreessen, lacked independence from Zuckerberg. Finally, the Court determined that a majority of Facebook’s directors were independent and disinterested for purposes of considering a potential demand and, therefore, demand was not excused and the claim was dismissed.