The Delaware Court of Chancery, in In re Carvana Co., No. 2020-0415-KSJM (Del. Ch. June 30, 2022), applied the recently adopted Zuckerberg test for demand futility and denied the defendants’ motion to dismiss. The court found that the stockholders in this derivative action pled demand futility by alleging facts showing that two of the six directors had deep personal and professional ties to a third director, defendant Ernest Garcia III (who received a material personal financial benefit in the transaction at issue), such that they could not objectively consider a demand to pursue litigation against Garcia III. The court then found that the plaintiffs stated a viable breach of fiduciary duty claim, and that the transaction at issue, a US$600 million stock offering to Garcia, his father, and a few other select investors during a March 2020 pandemic-related dip in stock prices, would be subject to entire fairness review because it was not approved by a majority of disinterested directors.
Carvana Co. (Carvana) is an e-commerce platform for buying and selling used cars founded by defendant Ernest Garcia II (Garcia II) and his son Ernest Garcia III (Garcia III), who is the CEO, President, and Chairman of Carvana. Together, the Garcias control 92 percent of the voting power in Carvana.
According to the complaint, after the stock market declined in February 2020 due to the onset of the COVID-19 pandemic, Carvana and its management reviewed the business to assess whether it needed an influx of capital. The plaintiffs alleged that Garcia III and his team determined that Carvana did not need more capital to survive the pandemic because it could cut costs and streamline operations, and had reached a significant new financing agreement with a major lender.
Nevertheless, while Carvana’s stock was trading down from US$110 on February 21 to less than US$30 on March 20, the plaintiffs allege that Garcia III began to orchestrate a capital raise through a non-public direct offering. According to the complaint, Garcia III handpicked investors to participate in the offering, and led a rushed negotiation and board approval process (though he abstained from the final board vote). The direct offering closed on March 30 at US$45 per share, with each of the Garcias purchasing US$25 million worth of Carvana stock. The plaintiffs allege that, as soon as the short-swing trading period expired, Carvana’s stock price had soared, and Garcia II sold Carvana shares for a total of US$478.4 million. Section 220 demands and stockholder suits followed, with the court consolidating the cases in January 2021.
The defendants moved to dismiss the consolidated complaint for failure to allege demand futility and failure to state a claim.
Focusing on the third prong of the demand futility test recently adopted by the Delaware Supreme Court in Zuckerberg, the court considered whether the allegedly conflicted directors lacked independence from a defendant who received a material personal financial benefit from the alleged misconduct that would be the subject of the litigation. The court concluded that two of Carvana’s directors lacked independence from the Garcias, who had received material financial benefits in the direct offering at issue.
The court found that the first potentially conflicted director, Gregory Sullivan, lacked independence from Garcia II, because Garcia II gave Sullivan a job at DriveTime (another used-car business owned by the Garcia family) after Sullivan was censured by the New York Stock Exchange for actions he took on behalf of Garcia II. Sullivan rose through the ranks at that job to eventually become the CEO; and then, when Sullivan left DriveTime to invest his savings into a new business, Garcia II made a significant investment into that venture. The court concluded that it was reasonably conceivable that Sullivan could not objectively consider a demand to bring litigation against Garcia II, “the man who allegedly saved [Sullivan’s] career, helped generate [Sullivan’s] personal wealth, and financially shores [Sullivan’s] current livelihood.”
With regard to the second director, Ira Platt, the court found that the plaintiffs adequately pled facts showing that Platt was conflicted because he gave Garcia III his first job after college, Garcia III later gave Platt’s son an internship at Carvana, Garcia II appointed Platt to numerous lucrative director positions, and the Garcias caused Carvana to gift Platt nearly US$30 million worth of Carvana equity when no other directors received similar grants.
Given that Carvana had a six-member board, and that there was no dispute that the Garcias had received personal financial benefits in the direct offering, these allegations were sufficient to show demand futility.
The court wrapped up its decision by rejecting Garcia III’s arguments that (a) he could not be liable for breaching his fiduciary duties in approving the transaction because he abstained from the final board vote, and (b) that the transaction should be subject to the business judgment rule. On the first argument, the court noted that abstaining from a final vote is a fact-intensive argument that “does not provide a get out of jail free card” at the motion to dismiss stage, particularly where the plaintiffs alleged facts showing that Garcia III played a significant role in negotiating, structuring, and approving the direct offering. On the second argument, the court determined that the plaintiffs had already established, at least at the pleading stage, that half of the board was conflicted in approving the direct offering, and therefore that the entire fairness test applied and not the business judgment rule.