On September 24, 2021, the Supreme Court of Delaware, in a unanimous en banc decision, connected, consolidated, and clarified crucial components of corporate counseling.

     The power to bring suit in the name of the corporation against directors or officers has traditionally been regarded as a prerogative of the board.  For this reason, and to forestall a flood of possibly-ungrounded litigation, courts are normally reluctant to allow a shareholder to bypass the board entirely and file a “shareholder derivative” suit without first making a “demand” on the board to examine, investigate, and possibly initiate litigation itself.

     Thus, Rule 23.1 of Delaware’s Court of Chancery requires a shareholder filing a derivative lawsuit to “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.”

     In United Food and Commercial Workers Union v. Zuckerberg, — A.3d –, 2021 WL 4344361 (Del.) (“Zuckerberg”) (download pdf), Delaware’s Justices adopted the three-part test enunciated in the same litigation by the Court of Chancery, 250 A.3d 862, 890 (Del. Ch. 2020), to define situations of “demand futility,” which justify a shareholder’s instituting a derivative lawsuit without alerting or consulting the board. (Accordingly, it affirmed the lower court’s holding that demand on Facebook’s board had not been excused.)

    This “universal test,” like its predecessors, requires the shareholder to show that, had a demand been made, a majority of the board could not have been trusted to evaluate and respond to it appropriately.  As the Chancery Court put it, “To determine whether a board of directors could properly consider a demand, a court counts heads. If the board lacks a majority of directors who could exercise independent and disinterested judgment regarding a demand, then demand is futile.”  250 A.3d at 877.

      In the process, the Delaware Supreme Court adjusted the interactions among (but did not overrule) its own, now-overlapping and -outdated, precedents from 1984, 1993, and 2015, in light of the exculpation-enabling provision that had been added to the Delaware General Corporation Law (DGCL) in 1995. 

      As the Court acknowledged, “[C]hanges in the law have eroded the ground upon which that framework [of caselaw] rested.  Those changes cannot be ignored, and it is both appropriate and necessary that the common law evolve in an orderly fashion to incorporate those developments.” Zuckerberg, at *16.

● Significance of Demand Futility

     Once a shareholder has convinced a Delaware court that demand was “futile” (or, “excused”), both parts of the test governing the board’s (or its special litigation committee’s) motion to dismiss the suit reverse mainstay, and markedly management-friendly, principles of corporate jurisprudence.  Zapata Corp. v. Maldonado, 430 A.2d 779, 789 (Del. 1981).

          ● First, although the usual standard of the “business judgment rule” creates a presumption that directors have fulfilled their duties of care and loyalty (which a plaintiff must overcome by showing particularized facts raising reasonable doubt in this regard), because in a demand futile situation the shareholder has had to incite the court’s suspicions of the directors’ motives and decision-making, it is now the board that bears the burden of demonstrating that its motion to dismiss is in the company’s best interest

      But even if the board carefully documents the independence of the members of the special litigation committee that it created to assess the merits of the lawsuit, and the diligence with which those directors reached the conclusion that the lawsuit should be dismissed, it must overcome Zapata’s second, and generally unpredictable, step:

            ● Under the second step, the court—which in most other contexts defers to the directors’ management expertise, particularly with regard to financial matters—“should determine, applying its own independent business judgment, whether the motion should be granted. This means, of course, that instances could arise where a committee can establish its independence and sound bases for its good faith decisions and still have the corporation’s motion denied. . . . The Court of Chancery should, when appropriate, give special consideration to matters of law and public policy in addition to the corporation’s best interests. ”  Id. (emphasis added).

     As the Chancery Court has recognized, “[I]t is unusual for the Court of Chancery to apply the second prong of the Zapata standard,” In re WeWork Litigation, 250 A.3d 976, 1013 (Del. Ch. 2020), which it elsewhere characterized as a “conceptually difficult step” that “it is difficult to rationalize in principle; but it must have been designed to offer protection for cases in which, while the court could not consciously determine on the first leg of the analysis that there was no want of independence or good faith, it nevertheless ‘felt’ that the result reached was ‘irrational’ or ‘egregious’ or some other such extreme word.”  Carlton Investments v. TLC Beatrice Holdings Int’l Holdings, Inc.,  1997 WL 305829 (Del. Ch.), at *2.

● Digression: Zapata and the “Enhanced Scrutiny” Standard

    The Chancery Court has also noted “practitioner concern about the reasonableness analysis” in Zapata’s second prong, “which marked the Delaware Supreme Court’s first deployment of something akin to the two-step standard of review that later emerged as enhanced scrutiny.”  In re EZCORP, Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245, at *27.   The Chancery Court’s decision in Zuckerberg acknowledged that “The development of enhanced scrutiny can be traced to Zapata. . . .”  250 A.3d at 881 n.9.

     As Delaware’s “’intermediate standard of review’”—between the deferential business judgment rule and the strict “entire fairness” standard (under which directors who had an actual conflict of interest with regard to a transaction, such as in some situations involving a controlling shareholder’s self-dealing, must satisfy the court that both the process and the terms of that transaction were objectively fair)—enhanced scrutiny “governs ‘specific, recurring, and readily identifiable situations [such as mergers or acquisitions of their company] involving potential conflicts of interest where the realities of the decisionmaking context can subtly undermine the decisions of even independent and disinterested directors,’ [and] requires that the [directors] ‘bear the burden of persuasion to show that their motivations were proper and not selfish’ and that ‘their actions were reasonable in relation to their legitimate objective.’”  Firefighters’ Pension System of the City of Kansas City, Missouri Trust v. Presidio, Inc., 251 A.3d 212, 249 (Del. Ch. 2021) (citations omitted).

     The Delaware Supreme Court held in 2015 that no matter which of these three standards of review applied to a particular situation, a shareholder derivative suit seeking monetary damages from directors who are protected by an exculpation provision in the company’s articles of incorporation “must plead non-exculpated claims [i.e., breaches of the duty of loyalty] to survive [the board’s] motion to dismiss.”  In re Cornerstone Therapeutics Inc. Shareholder Litigation, 115 A.3d 1173, 1175-76 (Del. 2015).

● Factual Background

      The decision in Zuckerberg resolved an issue that arose from the Facebook board’s approval in 2016, on the recommendation of a special committee of the board, of a stock reclassification proposed by Chair and CEO Mark Zuckerberg, to enable him to maintain his voting control while selling some of his Facebook stock to fund his philanthropic pursuits. 

     Thirteen separate actions brought by shareholders to challenge this initiative were collected as one class action by the Chancery Court.  Before trial, and at Zuckerberg’s request, the company abandoned the stock plan.

      Then, without making a demand on the board, the United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund (“Tri-State”) filed a shareholder derivative action with the Chancery Court, seeking judgments against the directors personally, both for Facebook’s costs (more than $20 million) of defending the plan, and for the legal fees (more than $68 million) that Facebook had paid, under the corporate benefit doctrine, to counsel for the class action plaintiffs.

● Legal Background

      Facebook and the directors moved to dismiss the derivative suit, on the grounds that Tri-State had not satisfied the demand futility requirements of either Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984), or Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993).

     Both of those decisions were decided after (and created specific pleading paths for shareholders to invite the Chancery Court to invoke) Zapata; and, both effectively require the shareholder to overcome the business judgment rule’s presumption that, had she actually made a demand, the directors would have, in determing whether to pursue legal action against company executives, fulfilled their fiduciary duties of care and loyalty to the company.

    Central to this inquiry is whether a majority of the directors are independent—that is, whether their judgment is, would be, or would have been compromised by a personal interest in the challenged transaction; by a personal connection to a someone who did have such a personal interest; and/or by the possibility of their significant personal liability for their role in, and/or (including negligence) in approving, the challenged transaction.  Buckley Family Trust v. McCleary, 2020 WL 1522549 (Del. Ch.), at *9.

● The Effect of Exculpation Provisions

     The last of these three elements of independence posed particular concerns in light of the 1986 addition to the Delaware General Corporation Law (DGCL) of Section 102(b)(7), in the Delaware Legislature’s swift response to the state Supreme Court’s groundbreaking imposition of personal liability on respected corporate directors for breaching their duty of care, in Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). 

     That subsection enabled companies to add to their articles of incorporation exculpation provisions such as the one that Facebook subsequently installed: “To the fullest extent permitted by law, no director of the corporation shall be personally liable to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director.”  Zuckerberg, at *9 n.120.

     Notably, Section 102(b)(7) appears to allow directors to be exculpated from liability only for breaches of their duty of care to the company.  It specifically negates any attempt to “eliminate or limit” directors’ liability for breaches of their “duty of loyalty”; “for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; or, “for any transaction from which the director derived an improper personal benefit.” 

   (In response, shareholder derivative suits reframed as breaches of the duty of loyalty, or of the obligation of good faith, some claims that might once have been seen as violations of the directors’ duty of care, including directors’ failure to monitor corporate operations and react to “red flags.”  See In re Caremark International. Inc. Derivative Litigation, 698 A.2d 959, 970 (Del. Ch. 1996) (concluding that “a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and [compliance] reporting system, which the board concludes is adequate, exists”); Stone v. Ritter, 911 A.2d 362 (Del. 2006) (holding that the obligation of good faith is not a free-standing ground for liability, but instead an element of the duty of loyalty).

    In Zuckerberg, the Court considered: If directors would not face personal liability for their alleged misconduct because it would be covered by an exculpation provision, could they be seen as independent for purposes of the Aronson test?  If so, it would be more difficult for shareholders to plead that demand on the board would have been futile.

● The Aronson Test for Demand Futility

      Under the two “prongs,” or alternatives, of Aronson, if a majority of the board was not replaced between the alleged misconduct and a shareholder’s filing a derivative suit, the shareholder must, by offering particularized facts, create a reasonable doubt that “(1) [a majority of] the directors are disinterested and independent[,] [or] (2) the challenged transaction was otherwise the product of a valid business judgment.”  Zuckerberg, at *7, quoting 473 A.2d at 814.  

      The second option could involve allegations that directors had breached their duty of loyalty (including its component of good faith).  For instance, the Chancery Court found that this prong would encompass situations in which the plaintiff could produce particularized facts “’. . .  sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision,” including directors’ intentional violations of law, intentionally acting for a purpose other than the corporation’s best interests, or intentionally failing to fulfill a known duty to act.  Lenois v. Lawal, 2017 WL 5289611, at *10 (Del. Ch.) (citations omitted).

     The second prong might also (or only) encompass situations of alleged breach of the duty of care, such the board’s approval (as in Aronson) of an alleged waste of corporate assets, the potential personal liability for which would have rendered those directors unable to respond without bias to a demand.  

     Whether loyalty and/or care grounds the complaint, the Aronson Court observed that although “the mere threat of personal liability for approving a questioned transaction, standing alone, is insufficient to challenge either the independence or disinterestedness of directors, . . . in rare cases a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of liability therefore exists [for directors]” that would excuse the plaintiff’s failure to have made a demand on the board.  473 A.2d at 815 (emphasis added).

     Aronson also mentioned in passing that “if this is an ‘interested’ director transaction, such that the business judgment rule is inapplicable to the board majority approving the transaction, then. . . futility of demand has been established by any objective or subjective standard,” although it acknowledged that “drawing the line at [the disinterestedness and independence of] a majority of the board may be an arguably arbitrary dividing point.”  Id. at 815 and 815 n.8.

     The Chancery Court later elaborated that, “A decision approved by at least half of the corporation’s directors who would consider a demand, even when acting by committee, can be imputed to the entire board and thus triggers the Aronson test. . . . ”  Teamsters Union 25 Health Services & Insurance Plan v Baiera, 119 A.3d 44, 56 (Del. Ch. 2015). 

● The Rales Test for Demand Futility

      The non-independence of a majority of the board is even more explicitly stated in the Rales test, of which the Zuckerberg Court considered Aronson a “special application.”  Zuckerberg, at *7. 

     Although the Chancery Court had previously “commented on many occasions that the Aronson and Rales tests look different but they essentially cover the same ground,” Buckley Family Trust v. McCleary, 2020 WL 1522549 (Del. Ch.), at *9, it had also observed that “Delaware law has evolved to recognize Rales as the ‘general’ and ‘overarching test for futility,’” noting that “Aronson has been regarded as Rales’s narrower and circumstance-specific sister test. . . .”  Gottlieb v. Duskin, 2020 WL 6821613 (Del. Ch.), at *4.

     The Rales test applies when “the board that would be considering the demand did not make a business decision which is being challenged in the derivative suit.  This situation would arise in three principal scenarios: (1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced; (2) where the subject of the derivative suit is not a business decision of the board; and (3) where. . . the decision being challenged was made by the board of a different corporation.”  634 A.2d at 933-934.

     It also applies “where a derivative plaintiff challenges a decision approved by a board committee consisting of less than half of the directors who would have considered a demand, had one been made.” Teamsters Union 25 Health Services & Insurance 119 A.3d at 56-57.

      In any of those cases, the particularized facts in the shareholder’s complaint must create a “reasonable doubt that, as of the time the complaint is filed,” a majority of the board “could have properly exercised its independent and disinterested business judgment in responding to a demand.”  634 A.2d at 934.

     Referring to the second of its three numbered situations, the Rales Court specifically noted that, “The Board did not approve the transaction which is being challenged. . .  In fact, the . . .  directors have made no decision relating to the subject of this derivative suit. Where there is no conscious decision by directors to act or refrain from acting, the business judgment rule has no application.”   Thus, the second prong of the Aronson test (concerning whether the transaction was the product of the board’s “valid business judgment”) was also inapplicable.  634 A.2d at 933.

      (In 1934, Ogden Nash’s “Portrait of the Artist as a Prematurely Old Man” concluded,   “[T]he suitable things you didn’t do give you a lot more trouble than the unsuitable things you did./ The moral is that it is probably better not to sin at all, but if some kind of sin you must be pursuing,/ Well, remember to do it by doing rather than by not doing.”)

     Effectively, Rales requires the shareholder to satisfy the first prong of the Aronson test (i.e., to contest the independence and disinterestedness of directors) with regard to a majority of the board at the time the shareholder instituted her derivative lawsuit.

●  Decoupling “Valid Business Judgment” from the Possibility of Personal Liability

     Before the Delaware Supreme Court, Facebook’s directors argued that, even if the shareholder could meet the second prong of the Aronson test (“the transaction was [not] the product of a valid business judgment”), demand should not be excused because the company’s exculpation provision insulated them from personal liability, thereby preserving the impartiality with which they could have considered a demand.

     Yet Tri-State asserted that the “valid business judgment” criterion should be applied without regard to the directors’ potential liability (or exculpation).

     The Court suggested that the second prong of the Aronson test, which it had enunciated eleven years before Section 102(b)(7) had been added to the DGCL, “used the [‘valid business judgment’] standard of review as a proxy for whether the board could impartially consider a litigation demand,” because at the time that decision had been issued, “rebutting the business judgment rule through allegations of [duty of] care violations exposed directors to a substantial likelihood of liability,” and, “It is reasonable to doubt that a director would be willing to take that personal risk.”  Zuckerberg, at *10.

      On the other hand, if the shareholder could not satisfy the second prong of Aronson by showing a breach either of the duty of care or of the duty of loyalty, the business judgment rule’s protective presumption would remain, so that “allowing the derivative litigation to go forward would expose the directors to a minimal threat of liability.”  Because the directors would thus be considered capable of impartially evaluating a demand, the situation would not qualify as “demand futile”: the shareholder would be required to make such a demand, rather than filing her complaint.  Id. 

     Thus, after reviewing Court of Chancery decisions addressing the application of this prong to shareholder derivative suits involving claims for which directors would be exculpated from liability under Section 102(b)(7), the Delaware Supreme Court affirmed the lower court’s decision in Zuckerberg, which had held that demand is not excused in such situations. 

      That is, “[E]xculpated care violations no longer pose a sufficient threat to excuse demand under the second prong of the Aronson test.  Rather, the second prong requires particularized allegations raising a reasonable doubt that a majority of the demand board is subject to a sterilizing influence because directors face a substantial likelihood of liability for engaging in the conduct that the derivative claim challenges.”  Id. at *15.

●  The New, “Universal” Test for Demand Futility

     In place of Aronson and Rales, the Zuckerberg Court adopted as a new “universal test for assessing whether demand should be excused as futile,” the three-factor test, involving the assessment of the board on a “director-by-director basis,” id. at *17, that had been enunciated by the Court of Chancery:

      “If the answer to any of the [following] questions is ‘yes’ for at least half of the members of the demand board [i.e., the board as of the time the shareholder filed her suit, as opposed to the directors in place when the alleged misconduct occurred], then demand is excused as futile.” 

     ● (1) whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;

     ● (2) whether the director would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand; and

     ● (3) 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.  Id.

    The Zuckerberg test’s focus on the independence of the “demand board” avoids not only problems of how to treat directors who had abstained from the board’s vote to approve alleged misconduct, but also questions of whether to apply the Aronson test rather than the Rales test to  directors who joined the board after the alleged misconduct had occurred.

     By the time the Delaware Supreme Court issued its decision in Zuckerberg, the Chancery Court had already applied its own test to resolve another situation, in which the parties disagreed over whether the Aronson test or the Rales test applied: there, the Chancery court had noted that its third option “distills key questions necessary to resolve demand futility under both tests.”  Berteau v. Glazek, 2021 WL 2711678 (Del. Ch.), at *25-26.

● Interpretations and Implications

            ● Definitional Concerns.  The crucial terms of the Zuckerberg test—“material personal benefit” (not necessarily limited to financial gain, but possibly including favors, sexual or otherwise) and “substantial likelihood of liability,” are undefined.

      In fact, although Aronson’s illustration of a “substantial likelihood of liability” was a “rare” situation in which a transaction is “so egregious on its face that board approval cannot meet the test of business judgment,” 473 A.2d at 815, Rales had held that, for purposes of impugning a director’s independence, must only “make a threshold showing, through the allegation of particularized facts, that [its] claims have some merit.”  634 A.2d at 984.

      Moreover, courts are still grappling from case to fact-sensitive case to enunciate the elements and degree of interpersonal connections that would compromise a director’s independence generally, and/or her disinterestedness with regard to a particular transaction.

           ● The Extent of Exculpation.  It is unclear whether a director whose conduct, though legal, has involved her assumption of extreme and unnecessary physical or mental risks, or has embarrassed the company (perhaps by generating a controversy that causes, or threatens to cause, boycotts of the company’s products or services), has breached a non-exculpable duty of loyalty.  If so, the director could be subject to personal liability, and would not be regarded as independent for purposes of a demand futility analysis.

Factor 2 Not Redundant.  As the Delaware Supreme Court indicated, its new test de-emphasizes Aronson’s second prong, although a director’s potential personal liability for the challenged transaction remains relevant to his ability to respond appropriately to a demand, under Zuckerberg’s Factor 2.  Zuckerberg, at *16.

     If a company’s articles of incorporation contain exculpation provisions, a director would be effectively immunized from personal liability for everything but a breach of the duty of loyalty.  In that case, Zuckerberg’s Factor 2 could be satisfied only by challenging his conduct, including his approval of a transaction, on the grounds of his alleged breach of loyalty (or, good faith).

     However, if a director had violated his duty of loyalty by approving a particular transaction, would he not also have violated one or both of Factor 1 (receiving a material personal benefit) and Factor 3 (being closely connected to someone who received such a benefit, or who faced a substantial likelihood of liability with regard to the transaction)?

     In other words, is Factor 2 a redundant portion of the Zuckerberg test for demand futility?

     Not necessarily, if the loyalty breach relates to a director’s “duty to monitor” (or, “duty of attention”) under Caremark and Stone, as discussed above.  A director could have neglected to ensure the installation of even a basic monitoring system, and/or failed to heed its warning(s), without receiving an improper personal benefit, or being connected to someone who did.

     Yet such cases are not common: the Court of Chancery recognized in Caremark that its “test of liability—lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight—is quite high,” 698 A.2d at 971, and characterized such a cause of action as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”  Id. at 967.

            ● Factor 3, and Eligibility for Exculpation.  When examining whether a director lacks independence from someone who. . . would face a substantial likelihood of liability,” the court would presumably review that director’s personal connections to any officers accused who had been accused of misconduct by the shareholder, because, unlike directors, officers have generally not been seen as eligible for exculpation, and would thus remain potentially liable for their own involvement.  See Gantler v. Stephens, 965 A.2d 695, 709 n.37 (“Although legislatively possible, there currently is no statutory provision authorizing comparable [to Section 102(b)(7)] exculpation of corporate officers.”).

          ●  Factors 2 and 3, and the Possibility of Indemnification (and/or Insurance).  Although not only directors but also officers may be indemnified by the corporation for personal liability, DGCL 145(a) provides that this relief can only be made available to someone who fulfilled the duty of loyalty, by “act[ing] in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe the person’s conduct was unlawful.”

     However, even if indemnification, like exculpation, could negate the “substantial likelihood of liability,” it might not be available for some breaches of the duty of care, so directors (and officers) might still be potentially liable for their involvement (or negligent non-involvement, as the case might be) in a particular transaction or situation, complicating a shareholder’s effort to establish that the situation was demand-futile.

    A similar analysis would probably apply to the availability of any directors’ and officers’ (D&O) insurance secured by the corporation or the executives themselves, which would probably contain the same exclusions (and perhaps others as well).