Banking and Business Monthly – October 2021

On September 23, 2021, the Supreme Court of Delaware adopted a new universal three-part test to determine whether pre-suit demand upon a corporation’s board of directors should be excused as futile. The new test was adopted by the Court in United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, No. 404, 2020, 2021 WL 4344361 (Del. Sept. 23, 2021). This universal test combines the traditional demand-futility tests established in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), and Rales v. Blasband, 634 A.2d 927 (Del. 1993).

In this case, Tri-State brought a derivative action seeking to recover funds spent by Facebook on attorneys’ fees paid to plaintiffs’ counsel under the corporate benefit doctrine (about $68.7 million) and for its own defense (about $21.8 million) of a prior class action involving a stock reclassification which was subsequently withdrawn by Facebook, thus mooting the class action. Instead of making a pre-suit demand, Tri-State alleged demand was futile under the Aronson and Rales tests for demand futility. In a derivative action, on behalf of the corporation, the stockholder must (1) make a demand on the company’s board of directors or (2) show that demand would be futile. Lenois v. Lawal, 2017 WL 5289611 at *9 (Del. Ch. Nov. 7, 2021). Delaware courts previously relied on two separate tests to determine whether a demand would be considered futile.

The Aronson test applied where the complainant challenged a decision made by the same board considering the litigation demand. It required that the complaint allege particularized facts which raised reasonable doubt that either (1) the directors are disinterested and independent, or (2) the challenged transaction was otherwise the product of a valid business judgment.

The Rales test applied in all other circumstances. Under the Rales test, demand was excused as futile if the complaint alleges particularized facts which raised a reasonable doubt that a majority of the board could have properly exercised its independent and disinterested business judgment in responding to a demand. Both tests ultimately addressed the same question of whether the board can exercise its business judgment on the corporation’s behalf in considering a demand, so the Aronson test is properly viewed as an application of the broader Rales test.

Since Aronson, Delaware enacted Section 102(b)(7) of the General Corporation Law, which permits Delaware corporations to adopt a charter provision which insulates directors from monetary liability for breaches of the duty of care. Facebook had such a provision. Following the adoption of Section 102(b)(7), some courts questioned whether a claim for breach of the duty of care could satisfy the second prong of the Aronson test if a director is exculpated from liability for them such that they no longer pose a threat which neutralizes the director’s exercise of his or her business judgment.

The lower Court of Chancery in the Tri-State case resolved that question by holding that alleged duty-of-care violations do not satisfy the second prong of Aronson where a director is protected by a Section 102(b)(7) provision. It then dismissed the Tri-State action, determining that the plaintiff failed to allege adequate facts establishing demand futility. In so holding, the lower court combined elements of the Aronson and Rales tests to create a new three-part test to determine whether pre-suit demand is excused. The Delaware Supreme Court affirmed the Court of Chancery’s decision dismissing the Tri-State action and adopted the lower court’s new test. Under the Tri-State test, courts should now evaluate three questions for each director:

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 faces a substantial likelihood of liability on any of the claims that would be 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 would be the subject of the litigation demand or who would face a substantial likelihood of liability on 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 futile and excused. This universal test “refocuses the inquiry on the decision regarding the litigation demand, rather than the decision being challenged.” Tri-State, 2021 WL 4344361 at *16 (internal citations omitted). The Court stressed that Aronson, Rales, and cases construing them remain good law because the new three-part test is consistent with and enhances them. Tri-State, 2021 WL 4344361 at *17.

The Tri-State test and the additional clarity it provides is welcome news for directors of Delaware corporations. We can expect more Delaware corporations to adopt a Section 102(b)(7) charter provision. For further inquiries or questions, please contact me at smigala@lavellelaw.com or at (847) 705-7555.