Delaware Supreme Court Announces New Demand Futility Test

William SavittRyan A. McLeod, and Anitha Reddy are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell memorandum, and is part of the Delaware law series; links to other posts in the series are available here.

In what promises to be a landmark decision, the Delaware Supreme Court last week reframed the rules governing derivative litigation. United Food & Commercial Workers Union v. Zuckerberg, No. 404, 2020 (Del. Sept. 23, 2021).

A Facebook stockholder sued current and former directors to recover costs the company had incurred in connection with a proposed stock reclassification. The Court of Chancery dismissed the suit, finding that the plaintiff had failed to establish that at least half of the current directors were incapable of independently evaluating whether to pursue the suit.

The Delaware Supreme Court affirmed. Writing for the unanimous Court, Justice Montgomery-Reeves adopted a new test to determine when a stockholder will be permitted to press corporate claims over the board’s opposition. The Court emphasized that “the demand-futility analysis provides an important doctrinal check that ensures the board is not improperly deprived of its decision-making authority.” The essential inquiry is thus whether “there is reason to doubt that the directors would be able to bring their impartial business judgment to bear on a litigation demand” by a stockholder. When a corporation’s charter exculpates directors from liability for breach of care claims, such claims “no longer pose a threat that neutralizes director discretion.” Accordingly, the Court held that directors are not disabled from impartially considering a demand simply because the proposed complaint alleges that they breached their duty of care.

The Court went on to adopt the trial court’s proposed three-part test for demand futility, replacing the 30-year old framework supplied by the Aronson and Rales cases. To excuse demand under the new test, a complaint must allege with particularity that at least half of the members of the current board (1) received a material personal benefit from the misconduct alleged in the complaint; (2) face a substantial likelihood of liability on any of the claims in the complaint; or (3) lack independence from someone who received a material personal benefit from the misconduct alleged in the complaint or who would face a substantial likelihood of liability for any of the claims in the complaint. The Court took care to note, however, that because its new test was conceptually consistent with Aronson and Rales, earlier precedents properly applying those rulings remain good law.

The decision reaffirms that directors are presumed to exercise their business judgment in the best interests of the corporation—even when they are named as defendants. The law will therefore supplant board authority over corporate litigation only if a stockholder makes a detailed showing that at least half of the directors face a substantial threat of actual liability.

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