Alert September 28, 2021

United Food’s “New” Delaware Demand Futility Test: The More Things Change, the More They Stay the Same

On September 23, 2021, in United Food and Commercial Workers Union v. Zuckerberg et al., the Delaware Supreme Court restated and refined the demand futility test for bringing shareholder derivative claims when it affirmed the Court of Chancery’s decision. The case stemmed from earlier litigation and a related settlement concerning whether Facebook could engage in a share reclassification so that Chief Executive Officer Mark Zuckerberg could reduce his share ownership while retaining voting control. Facebook spent $21.8 million to defend the earlier suit, and it paid another $68.7 million in the settlement, which resulted in Facebook’s abandonment of the reclassification scheme. The plaintiff’s complaint alleged that the Facebook directors’ approval of the reclassification breached their fiduciary duties and sought to recoup the sum that Facebook spent defending and settling the suit.

The Court of Chancery ruled the plaintiffs had failed to show that demand was excused and dismissed the suit. The decision articulated a “new” three-part test, for finding demand futility if a majority of directors were conflicted due to one or more of the following: (1) receipt of a material benefit from the misconduct challenged in the at-issue litigation; (2) substantial likelihood of liability from the claims made in the litigation; or (3) lack of independence from someone who received a material benefit or faces a substantial likelihood of liability.

Derivative Suits Require a Plaintiff to Plead Demand Futility 

A fundamental principle of Delaware corporate law is that directors — not stockholders — are the proper managers of a corporation’s day-to-day affairs. Such affairs include the management of litigation, including decisions concerning whether to bring litigation at all. 

Derivative suits are essentially a relief valve for the ordinary rule when the corporation’s directors have failed to adequately protect the corporation’s welfare due to disabling conflicts of interest between the directors and the corporation. The hurdles in Rule 23.1 of the Delaware Court of Chancery Rules. (and in the case law interpreting Rule 23.1) require derivative plaintiffs to properly allege those conflicts of interest in their complaint. These hurdles are commonly called “demand futility” to reflect the rule that, absent a disabling conflict of interest, stockholders must demand that the board bring the claim at issue rather than bring the claim themselves.

Demand Futility Case Law Evolves

Director defendants can obtain dismissal of derivative cases if they can show a lack of “demand futility.” In the 1984 decision Aronson v. Lewis, the Delaware Supreme Court held that demand was not futile if “the directors are disinterested and independent” and “the challenged transaction was otherwise the product of a valid business judgment.” 

Subsequent decisions expanded on Aronson, which stated an incomplete test for demand futility because it did not encompass all possible transactions that might be challenged in a derivative suit. In Aronson, the board that would have considered any litigation demand (that is to say, the board in place at the time the derivative complaint was filed) was the same board that had approved the at-issue transaction. But Aronson did not explain what to do if the corporate board at the time of the suit was not involved in the challenged transaction, as was the case in the subsequently issued decision in Rales v. Blasband. 

In Rales, the derivative complaint challenged a transaction that had been undertaken by a pre-acquisition subsidiary. Because the defendant-acquiror board did not have a hand in approving the at-issue transaction, it made little sense in Rales to apply Aronson as written, and the Delaware Supreme Court stated that the test in such situations was to ask whether “the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” Since then, the Delaware courts have continued to refine Aronson and Rales, particularly in the wake of the Delaware legislature’s enactment of § 102(b)(7), the statutory provision permitting corporations to indemnify directors for violations of the duty of care such that stockholders could not obtain money damages from directors.

As those refinements piled up through the common law process, numerous Court of Chancery opinions have mused on, and even openly questioned, the increasingly complicated landscape of Aronson, Rales, and their progeny (though these same opinions recognized that “[t]he tests articulated in Aronson and Rales are complementary versions of the same inquiry” and “[u]nder either test, a plaintiff must impugn the ability of at least half the directors in office when plaintiff initiated its action to have considered a demand impartially”). The matter came to a head in United Food. 

United Food Reaffirms the Status Quo

In United Food, the Delaware Supreme Court held that:

[C]ourts 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.

While this three-part articulation of the standard for demand futility is new, United Food is in line with Delaware precedent. Numerous post-Aronson decisions have already explained what to do for those various times when it is difficult to apply Aronson. In particular, in decisions as early as Rales (which was organized into a two-part “interest” and “independence” test), Delaware courts have already applied the inquiries made in the three-part United Food test.

Part (i) of the United Food test, which asks “whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand,” is akin to the holding in Rales that “[a] director is considered interested where he or she will receive a personal financial benefit from a transaction that is not equally shared by the stockholders.”

Likewise, part (ii), “whether the director faces a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand,” is a rephrasing of the following from Rales: “[d]irectorial interest also exists where a corporate decision will have a materially detrimental impact on a director,” i.e., where the “the potential for liability . . . may rise to ‘a substantial likelihood.’”

And part (iii), “whether the director lacks independence . . . ,” was also present in Rales, which mandated inquiry into whether the plaintiff had “show[n] that the directors are ‘beholden’ to the [executives who allegedly committed the misconduct] or so under their influence that their discretion would be sterilized.”

Stay the Course

In sum, United Food did not substantively raise (or lower) the hurdles that a stockholder plaintiff must overcome in order to bring a suit against Delaware directors alleging a breach of fiduciary duty. And importantly, neither did United Food modify the underlying nature of that duty, which the Court of Chancery has called “the highest duty known to the law.”

Ultimately, Delaware directors should continue to:

  • Execute their duties with care and prudence. Although minor missteps generally do not result in a court judgment against the directors, a derivative lawsuit can be an unnecessary expense to the corporation and distraction to all involved.
  • Disclose any conflicts of interest for proper review. Particularly in the corporate opportunity context, proper disclosure and subsequent independent evaluation can prevent later litigation annoyances.
  • Use special committees and stockholder votes to approve significant transactions that may be subject to litigation. Even if a complaint is adequately pleaded for demand futility purposes, a transaction that is approved in due course by a properly constituted independent committee or by a stockholder vote will be subject to a quick dismissal for failure to state a claim.
  • Ensure that the corporation has an appropriate § 102(b)(7) provision. In H&N Management Group v. Couch, which was cited in United Food, the corporate charter lacked a § 102(b)(7) provision exculpating the directors from gross negligence. The court held that allegations that the board failed to adequately inform themselves before approving a fund management agreement or the purchase of the fund manager were properly pleaded allegations of gross negligence, and thus the directors faced a “substantial risk of liability.” Although most corporate charters contain a § 102(b)(7) provision, corporations without such provisions should closely consider whether adopting one may be in the corporation’s best interest.
  • Maintain sufficient D&O insurance. Directors should ensure that the corporation maintains sufficient directors’ and officers’ liability insurance that meets the needs and risks of the corporation.