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

(Reuters) – It’s been a tough week for longstanding precedent – and for shareholders claiming corporate wrongdoing — in the Delaware Supreme Court.

On Monday, in Brookfield Asset Management Inc v. Rosson, the justices explicitly overturned a 15-year-old case that allowed shareholders to bring direct claims against controlling shareholders for diluting the value of their shares. Under the new ruling, plaintiffs’ lawyers are stuck with more procedurally challenging derivative lawsuits instead.

Then on Thursday, the Supreme Court adopted a new test that will make it harder for shareholders in derivative lawsuits to show that board members can’t be trusted to decide whether to sue on behalf of the corporation. The Supreme Court’s opinion in United Food and Commercial Workers Union and Participating Food Industry Employers Tristate Pension Fund v. Mark Zuckerberg didn’t exactly overturn the court’s precedent in 1984’s Aronson v. Lewis, which, as I’ll explain, allowed shareholders to proceed with derivative suits by accusing board members of approving tainted transactions.

But the ruling effectively shut down an avenue that Aronson had provided to plaintiffs’ lawyers suing corporate boards over conflicted deals. Aronson may still be good law, but it’s not much good for shareholders after Thursday’s decision.

The Zuckerberg case, as I’m sure you’ve guessed, is a shareholder derivative suit against Facebook board members who approved a 2016 stock reclassification plan designed to allow Facebook’s founder, CEO and majority shareholder to sell off shares to fund his charitable foundation while preserving his voting power.

Facebook subsequently dropped the plan after a raft of shareholder suits – but not before spending more than $90 million to defend the reclassification and then pay the plaintiffs’ lawyers whose litigation led to its abandonment. The Tri-State fund’s derivative lawsuit alleged that Facebook board members breached their duties of care and loyalty when they backed Zuckerberg’s aborted reclassification plan.

Shareholders, as you know, can only sue derivatively on the corporation’s behalf if they can show that the board can’t or won’t take action on its own. The Tri-State fund’s lawyers asserted that, under the 1984 Aronson test, it would have been futile to ask Facebook’s directors to bring a lawsuit over the reclassification plan.

The Aronson test applies when a majority of the directors who would evaluate a shareholder demand were board members at the time of the contested transaction. Aronson offered two paths for shareholders to establish demand futility: They could prove that a majority of the board was conflicted or they could show that the transaction was too problematic to qualify for business judgment deference. Tri-State shareholders contended that both routes led to demand futility in the Facebook case.

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

Laster’s key point was that a change in Delaware’s corporate code has undermined the rationale of the 1984 ruling. The Aronson court, he said, used business judgment deference as a sort of proxy for board members’ personal liability risk, reasoning that if the board was not entitled to deference for the underlying transaction, directors were at higher risk and therefore not be relied upon to make an independent decision about whether the corporation has a cause of action.

But two years after Aronson was decided, Laster said, Delaware enacted a provision that allows corporations to shield directors from money damages for breaching their fiduciary duties. These so-called exculpatory provisions obviously reduced directors’ liability risk from lawsuits stemming from tainted transactions. So, as Laster recounted, Delaware began to ask whether it was still reasonable to base demand futility on the standard of review for the underlying deals if board members weren’t facing money damages.

Laster said the answer was no: “Aronson is broken in its own right because subsequent jurisprudential developments have rendered non-viable the core premise on which Aronson depends,” he wrote.

Laster proposed an alternative, three-part test for demand futility that, he said, harmonized Aronson and a successor case, 1993’s Rales v. Blasband. Courts should determine whether the director received a personal benefit from the misconduct alleged by shareholders; whether the board members faced substantial risk of liability for shareholders’ claims; and whether the director is dependent on someone – presumably a controlling shareholder – who benefited from the deal at issue. If the answer is yes for a majority of the board, shareholders can proceed.

The Delaware Supreme Court agreed with Laster that exculpatory provisions have eroded Aronson’s essential logic. The court, in a unanimous opinion written by Justice Tamika Montgomery-Reeves, held categorically that claims covered by such provisions cannot be the basis of demand futility.

“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,” Montgomery-Reeves wrote. “The ground has since shifted, and exculpated breach of care claims no longer pose a threat that neutralizes director discretion.”

In light of that holding, the Supreme Court said, it was adopting Laster’s three-part test for demand futility. The Laster test, Montgomery-Reeves said, blended Aronson and Rales precedent to address the crucial question of whether directors can be trusted to act in the best interests of the corporation.

The whole point of the analysis, she wrote, “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.”

Laster’s “refined” test will answer that question, the court said — and it doesn’t even require the justices to overturn Aronson because, according to Thursday’s opinion, it “enhances Aronson, Rales, and their progeny.”

Neither Tri-State counsel Willem Jonckheer of Schubert Jonckheer & Kolbe nor Facebook board counsel William Savitt of Wachtell, Lipton, Rosen & Katz responded to my email queries.

Delaware court-watcher Kyle Compton Wagner of the Chancery Daily, said in an alert about the Zuckerberg ruling that this has been the most consequential week for shareholder derivative litigation since he began publishing. I suspect shareholders will be feeling the aftereffects for a long time.

Read more:

Del. Supreme Court ditches dicey precedent on shareholders’ direct claims

Opinions expressed here are those of the author. Reuters News, under the Trust Principles, is committed to integrity, independence and freedom from bias.

Our Standards: The Thomson Reuters Trust Principles.