The Delaware Supreme Court has affirmed a new “universal” three-part demand futility test in the case captioned United Food and Commercial Workers v. Zuckerberg et al. No. 404, 2020, 2021 WL 4344361 (Del. Sept. 23, 2021). The new standard, initially espoused by the Court of Chancery, blends the so-called Aronson and Rales tests into a modern three-part test that accounts for recent developments in Delaware corporation law.

The Zuckerberg ruling stemmed from the aftermath of an anticipated reclassification of Facebook stock designed to allow the company’s founder, Mark Zuckerberg, to fulfill a promise to donate the vast majority of his stock to charitable causes without giving up his voting control over the company. The Facebook board of directors approved the reclassification; however, the reclassification triggered class action claims on which Facebook spent more than $21 million in defense costs. The board eventually abandoned the reclassification, thereby mooting the class action claims but subjecting the company to more than $68 million in additional fees to the plaintiffs’ attorneys under the corporate benefit doctrine.

The Zuckerberg plaintiff filed a derivative complaint on behalf of Facebook for recovery of the millions spent in connection with the abandoned reclassification from the individual board members. The defendants moved to dismiss on the basis that the plaintiff had failed to properly establish demand futility under Court of Chancery Rule 23.1.

Under Court of Chancery Rule 23.1, a stockholder seeking to assert derivative claims on behalf of a corporation must plead particularized facts showing either that (1) the stockholder had made a demand on the board of directors to pursue the litigation and the board wrongfully refused the demand or (2) making a demand would have been futile because a majority of the board could not impartially make a decision regarding the litigation. Until the Delaware Supreme Court’s opinion in Zuckerberg, there were two tests under Delaware law used to determine whether a stockholder had adequately pled demand futility:

  • The two-prong Aronson test, which historically applied in the context of a challenge to a board decision. Aronson v. Lewis, 473 A.2d 805 (Del. 1984), overruled on other grounds, 746 A.2d 244 (Del. 2000). The Aronson test considered whether “(1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” Id.
  • The Rales test, which applied in all other contexts. Rales v. Blasband, 634 A.2d 927 (Del. 1993). The Rales test asked on a director-by-director basis whether “as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” Id. Under Rales, a director is disqualified for demand futility purposes where a plaintiff alleges particularized facts showing the director faces a “substantial likelihood” of personal liability from the corporation’s potential claims. Id.

On October 26, 2020, the Court of Chancery dismissed the derivative plaintiff’s complaint for failure to plead demand futility. See 250 A.3d 862 (Del. Ch. 2020). In so doing, the court considered whether it should apply the Aronson test or the Rales test for demand futility. The court acknowledged that the Aronson test would typically apply because the challenged decision was an affirmative board action, but lamented that “its analytical framework [was] not up to the task” given turnover on Facebook’s board and the abstention of certain directors from the vote on the reclassification. In an effort to minimize the potential for doctrinal confusion flowing from the two separate tests, the Court of Chancery determined that a three-part test that combined the relevant considerations of Rales and Aronson should apply. Specifically, the court decided to consider all the following criteria on a director-by-director basis:

  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.
  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.

Because the plaintiff failed to allege facts supporting the argument that a majority of the board were disqualified under this standard, the Court of Chancery granted the defendants’ motions to dismiss under Rule 23.1.

In creating the new three-part test, the court further noted that Aronson was decided before the adoption of Section 102(b)(7) of the Delaware General Corporation Law, which now allows corporations to exculpate directors for duty of care violations. In that pre-102(b)(7) era, it made sense to find demand futile under the second prong of the Aronson test for duty of care violations that would preclude application of the business judgment rule, because those violations could lead to personal monetary liability for directors. Now, most corporations employ Section 102(b)(7) provisions; therefore, directors generally no longer face a risk of personal liability for duty of care claims. Accordingly, it no longer makes sense to evaluate demand futility based on the applicable standard of review.

On appeal, the Supreme Court affirmed the Court of Chancery’s decision and adopted the three-part test. The Supreme Court agreed with the Court of Chancery that Aronson was a creature of the pre-102(b)(7) context in which it was decided:

At that time, if the business judgment rule did not apply, allowing the derivative litigation to go forward would expose the directors to a substantial likelihood of liability for breach-of-care claims supported by well-pleaded factual allegations. It is reasonable to doubt that a director would be willing to take that personal risk.

In light of Section 102(b)(7), the Supreme Court confirmed in In re Cornerstone Therapeutics, Inc. S’holder Litig. that exculpated directors may be dismissed at the pleadings stage, even in cases where heightened scrutiny applies. 115 A.3d 1173, 1186–87 (Del. 2015). Thus, the court noted in Zuckerberg that “Cornerstone eliminated ‘any continuing vitality from Aronson’s use of the standard of review for the challenged transaction as a proxy for whether directors face a substantial likelihood of liability sufficient to render demand futile.’” In adopting the modernized three-part test, however, the Supreme Court noted that the new test was “consistent with and enhances Aronson, Rales, and their progeny”; thus, “cases properly construing Aronson, Rales, and their progeny remain good law.”

The Zuckerberg ruling is significant for derivative litigants. As a general matter, stockholder derivative suits constitute an intrusion on the managerial authority and discretion of a company’s board of directors. Absent a disqualifying conflict, a board of directors holds the right to manage the corporation’s business and affairs, including considering whether the corporation should pursue potential litigation. The new three-part test adopted in Zuckerberg acknowledges the fact that, just because a director is named as a defendant, the director may still be able to exercise proper business judgment. The decision abandons the second prong of the Aronson test and confirms that a director who is only alleged to have engaged in conduct that would be exculpated pursuant to a Section 102(b)(7) provision should not be disqualified from considering a demand. In addition to accounting for the evolution of Delaware law, the adoption of the new test will also simplify the analysis of whether pre-suit demand on the board should be excused as futile. Litigants will no longer need to question the application of one test instead of another.