Delaware Chancery Court Declines to Dismiss Fiduciary Duty Claims Against Board for Post-IPO Waiver of Lock-Up Restrictions But Dismisses Aiding and Abetting Claims Against Underwriters for Consenting to the Waiver
In an opinion1 issued on November 14, 2014, the Delaware Court of Chancery (C Bouchard) declined to dismiss breach of fiduciary duty claims against the directors of Zynga Inc. (“Zynga”) for waiving post-IPO lock-up restrictions in a manner that permitted certain stockholders, including half the members of the board, to sell some of their stock in a secondary offering two months before the lock-ups agreed at the time of the IPO would have expired, while extending the lock-up period applicable to other shares they owned. Other stockholders remained subject to the original lock-up timing. The lock-up waiver had the effect of allowing certain Zynga stockholders, including four Zynga directors, to sell a portion of their shares at a price that turned out to be twice the price of the Zynga stock at the expiration of the original lock-up period. The Court held, in the context of a motion to dismiss, that it was reasonably conceivable, as of the time the decision was made to restructure the lock-ups, that the opportunity to sell earlier provided the directors an unfair benefit. However, the Court dismissed the plaintiff’s aiding and abetting claims against Zynga’s underwriters, whose consent was necessary to waive the lock-ups, finding on the facts pled that there was no reasonable inference that the underwriters knowingly participated in a breach of fiduciary duty by the directors.
In rejecting the aiding and abetting claim, the Court came to a different conclusion about “knowing participation” than it (VC Laster) did in the recently decided Pontiac General Employees Retirement System v. Healthways, Inc.,2 in which it declined to dismiss aiding and abetting claims against a lender for including a dead hand “proxy put” in a credit agreement. The difference in result appears to be attributable to the fact that the Healthways Court viewed the negotiating lenders as on notice that there was a potential entrenching element to the conflict-ridden negotiation of the dead hand “proxy put” and as potentially inducing the breach by negotiating for the provision, while in Lee v. Pincus the Court found there were insufficient facts to show that the underwriters knew the directors were treating stockholders unfairly or sought the result. These cases, together with In re Rural/Metro Stockholders Litigation,3 make clear not only that aiding and abetting allegations are increasingly commonplace, but also that actions by directors that may be found to be breaches of fiduciary duties could create liability for advisors, particularly in circumstances where advisors are seen as inducing the breach.
In December 2011, Zynga completed its IPO in which Morgan Stanley & Co. LLC (“Morgan Stanley”) and Goldman, Sachs & Co. (“Goldman”) served as the lead underwriters. Zynga’s officers and employees, along with most other pre-IPO investors (688 million shares) were subject to a 165-day lock-up of their shares.
In March 2012, Zynga’s eight directors decided to restructure the lock-up restrictions to stagger the number of shares that could be sold into the marketplace. In the first instance, they waived the lock-up for approximately 49 million shares held by select investors, including four of Zynga’s eight directors, as well as Zynga’s blackout policy that would have prevented the selling directors from participating in a secondary offering on April 3, 2012. At the same time, they extended the lock-up on those select investors’ remaining shares so that 50 million shares could be sold two months after the expiration of the original lock-up and another 150 million a month after that. The Zynga board also waived the lock-up but not Zynga’s blackout policy for approximately 114 million shares held by non-executive employees; as a result, the first date those shares could be sold was May 1, 2012, a month before the expiration of the original lock-up but after the secondary offering. For approximately 325 million shares held by former employees and institutional investors, the lock-ups were not modified, and expired at the end of May 2012.
On April 3, 2012, the secondary offering closed at a price of $12.00. Mark Pincus, Zynga’s founder and a director, netted approximately $192 million in proceeds; the other three selling Zynga directors sold several million dollars each in the secondary offering. Zynga’s stock declined significantly following the secondary offering to a closing price of $6.09 on the date that the original lock-up restrictions ended, and a closing price of $5.36 and $3.00 per share, respectively, on the two extended lock-up periods applicable to the selling Zynga directors.
In April 2013, the plaintiff stockholder, who was a former employee, filed suit on behalf of a putative class of Zynga stockholders, claiming that Zynga’s directors breached their duty of loyalty by waiving the lock- up restrictions and Zynga’s blackout policy to favor the directors at the expense of other pre-IPO stockholders, and that Morgan Stanley and Goldman aided and abetted those breaches. The defendants filed motions to dismiss.
THE COURT’S DECISION
A. DIRECTORS MAY HAVE BREACHED DUTY OF LOYALTY; PLAINTIFF REBUTS BUSINESS JUDGMENT PRESUMPTION
The Court concluded at the motion to dismiss stage that it was reasonably conceivable that the Zynga directors’ decision to afford certain directors the opportunity to benefit from the lock-up restructuring made them self-interested. Since the lock-up restructuring was not approved by a majority of disinterested and independent directors, the Court held that the plaintiff had pled sufficient facts to rebut the business judgment presumption and to require the Zynga directors to show that the transaction was entirely fair. The Court went on to conclude that on the facts pled it was reasonably conceivable that the benefit the directors received in the lock-up restructuring was not entirely fair, although the Court noted that the fully developed record may well show that the defendant directors did not receive a net benefit from the lock- up restructuring. In so holding, the Court rejected the defendants’ argument that no director actually received a benefit because (1) the four selling directors only received a lock-up waiver of a portion of their shares and that in receiving the waiver they agreed to subject a greater portion of their holdings (80%) to an extended lock-up period, and (2) the average market price at which those four directors could first sell their shares was less than the market price at which those subject to unmodified lock-ups could first sell their shares. The Court noted that at the time the decision was made, the opportunity to sell earlier reasonably conceivably afforded the directors a benefit that outweighed any detriment from the lock-up extensions. The Court stated that the arguments based on average market prices at which the various stockholders could sell their shares were inapposite because they were “entirely hypothetical” and based on ex post determinations, not on conditions present when the relevant decisions were made. The Court also rejected the defendants’ argument that the lock-up waivers were not a material benefit, stating that where a director allegedly engages in self-dealing, he or she is interested by virtue of receiving the benefit in the transaction, however material it is.
The Court also rejected the defendants’ argument that the directors’ obligations to the putative class of stockholders was limited to the contractual terms of the lock-ups and that they did not owe fiduciary duties with respect to the modification of the lock-up agreements. Noting that under Delaware law a right must be solely a creature of contract for fiduciary relationships between directors and stockholders to be preempted, the Court found that the plaintiff’s claim sought to enforce the directors’ obligations not to receive personal benefits inconsistent with the directors’ fiduciary duties, and, therefore, the claim was “quintessentially a fiduciary duty claim,”4 not a contract claim.
B. UNDERWRITER PARTICIPATION IN WAIVER OF LOCK-UPS DID NOT AMOUNT TO AIDING AND ABETTING
The Court went on to hold that the plaintiff had failed to plead any facts from which it was reasonably inferable that the underwriters, Morgan Stanley and Goldman, knew when they provided their consent to modify the lock-ups that doing so would facilitate a breach of fiduciary duty by the directors. The Court stated that the mere fact that the banks’ consent was necessary for the directors to waive the lock-up restrictions was not sufficient to demonstrate that the banks knew that the directors were treating stockholders unfairly. In dismissing the aiding and abetting claim, the Court stated that there were no facts alleged that the underwriters extracted “unreasonable” compensation or an “improper side deal” in order to consent to the waivers. As a result, the Court stated, it was not reasonable to infer that by receiving customary fees for acting as underwriters in the secondary offering, Morgan Stanley and Goldman “participated in the [Zynga] board’s decisions, conspired with [the] board, or otherwise caused the board to make the decisions at issue.”5