Delaware

By David P. Hamm, Jr.

In Sandys v. Pincus, the Delaware Supreme Court reversed a “thoughtful forty-two page opinion” by Chancellor Bouchard that dismissed a derivative action based upon the stockholder’s failure to make pre-suit demand.[1] The court’s opinion can be found here.  The underlying Court of Chancery opinion can be found here.

Expansion of the Rales Test for Demand Futility

The authority of the board of directors to manage the business and affairs of a corporation under Section 141(a) of the Delaware General Corporation Law extends to the board’s authority to decide whether to initiate or refrain from initiating litigation. Thus, pursuant to Court of Chancery Rule 23.1, a plaintiff in a derivative action must “either make a demand upon the board to initiate the litigation or demonstrate that such demand would be futile.”[2]

Delaware courts apply either the Aronson test or the Rales test in determining whether a plaintiff’s demand upon the board would be futile. In general, the Aronson test requires the plaintiff to plead particularized facts that create a reasonable doubt that either “the directors are disinterested and independent” or that “the challenged transaction was otherwise the product of a valid exercise of business judgment.”[3] In general, the Rales test requires the plaintiff to plead particularized facts that create a reasonable doubt that, at the time the complaint was filed, “the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.”[4] The timing of the inquiry is a chief distinction between the two tests.

The Aronson test has been criticized over the years and exceptions to the application of the Aronson test have been created in several contexts. Three such exceptions were outlined in Rales as follows:

“A court should not apply the Aronson test for demand futility where the board that would be considering the demand did not make a business decision which is being challenged in the derivative suit. This situation would arise in three principal scenarios: (1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced; (2) where the subject of the derivative suit is not a business decision of the board; and (3) where . . . the decision being challenged was made by the board of a different corporation.”[5]

Chancellor Bouchard’s application of the Rales test to the plaintiff’s Brophy and Caremark claims do not result in the expansion of the test’s application. However, the Chancellor’s application of the Rales test in the context of the plaintiff’s claim that the board breached its fiduciary duties by approving the secondary offering in question (the “Secondary Offering Claim”) does constitute an expansion of the Rales test. The novelty of the test’s application is acknowledged by Chancellor Bouchard as follows:

“In identifying these three scenarios, the Court [in Rales] included a qualification that they were the ‘principal’ scenarios where Aronson would not apply, implying that there could be other scenarios. In my opinion, this case presents such a scenario.”[6]

The Chancellor set forth the following facts in support of his application of Rales to the Secondary Offering Claim:

  1. A majority of the board that approved the secondary offering “had a personal financial interest in the transaction such that they may have received an unfair benefit and the transaction may be subjected to entire fairness review.”[7]
  2. A majority of the board was not changed from the time the secondary offering was approved to the time the complaint was filed. Thus, the “principal scenario” set forth by the Court in Rales did not find application.
  3. The board composition changed from the time the secondary offering was approved to the time the complaint was filed to the extent that a majority of directors derived no personal financial benefit from the secondary offering.

These facts led Chancellor Bouchard to conclude that the demand futility inquiry should be focused solely upon the board that existed at the time the complaint was filed (as required by Rales) rather than the board that existed at the time the second offering was approved (as required by the second prong of Aronson).

The application of the Rales test was also supported by the Chancellor’s position that it “functionally covers the same ground as the Aronson test” and “investigates the same sources of potential partiality that Aronson would examine.”[8]  The Chancellor further reasoned that the Rales test “provides a cleaner, more straightforward formulation to probe the core issue in the demand futility analysis for each board member who would be considering plaintiff’s demand.”[9]

Although the Delaware Supreme Court did not expressly adopted Chancellor Bouchard’s expansion of the Rales test, it did implicitly do so by utilizing the test in its analysis: “On appeal, neither party contests the applicability of the Rales standard employed by the Court of Chancery. Therefore, we use it in our analysis to determine whether the Court of Chancery erred in finding that a majority of the board was independent for pleading stage purposes.”[10]

As a result, the Delaware Supreme Court has, at least implicitly, expanded the application of the Rales test in the demand futility context.

Particularized Facts Providing Grounds of Reversal

While the Delaware Supreme Court implicitly approved of Chancellor Bouchard’s utilization of the Rales test, it expressly reversed his application of same.  The reversal was based upon “particularized facts” that created a reasonable doubt as to the impartiality of three directors (Ellen Siminoff, William Gordon, and John Doerr).

The Delaware Supreme Court reversed Chancellor Bouchard’s independence determination as to Ellen Siminoff based upon the particularized fact that she and her husband co-own an airplane with Mark Pincus (the controller). Despite the fact that the plaintiff simply characterized the co-ownership of the airplane as a business relationship, the court saw more there and concluded that the co-ownership of the plane was “suggestive of an extremely intimate personal friendship” and created “a reasonable doubt that she [could] impartially consider a demand adverse to his [Pincus’] interests.”[11] While admittedly limited to the facts of this case, the Delaware Supreme Court’s analysis on this point arguably lowers the level of proof needed to show demand futility.

Of greater import, the Delaware Supreme Court reversed Chancellor Bouchard’s independence determination as to William Gordon and John Doerr based upon particularized facts that evidenced “a mutually beneficial network of ongoing business relations” between several of the directors.[12] Gordon and Doerr are both partners at Kleiner Perkins Caufield & Byers, a venture capital firm. Kleiner Perkins owns 9.2% of Zynga, Inc.’s stock, invested in a company co-founded by Pincus’ wife, and has an equity position in a company where another Zynga director, Reid Hoffman, is both a shareholder and director.

The court’s analysis on this point has potentially significant implications given the realities of the venture capital landscape. However, such implications can be qualified by the fact that William Gordon and John Doerr did not qualify as independent directors under the NASDAQ Listing Rules.[13] The import of this fact for the court is clearly seen by the following dicta: “[T]o have a derivative suit dismissed on demand excusal grounds because of the presumptive independence of directors whose own colleagues will not accord them the appellation of independence creates a cognitive dissonance that our jurisprudence should not ignore.”[14]

Conclusion

In sum, Sandys arguably expands the application of the Rales test and provides the representative plaintiff bar with a lower threshold for demonstrating demand futility. While limited to the facts of the case, the court’s analysis should be considered when making internal determinations as to the independence of directors.

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[1] Sandys v. Pincus, No. 157, 2016, 2016 WL 7094027 (Del. Dec. 5, 2016) (Valihura, J., dissenting).

[2] Sandys v. Pincus, No. CV 9512-CB, 2016 WL 769999, at *6 (Del. Ch. Feb. 29, 2016), rev’d, No. 157, 2016, 2016 WL 7094027 (Del. Dec. 5, 2016).

[3] Id. (quoting Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984).

[4] Id. (quoting Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993).5. Rales v. Blasband, 634 A.2d 927, 933–34 (Del. 1993) (emphasis added).

[6] Id. at *12.

[7] Id.

[8] Id.

[9] Id. at *13.

[10] Sandys, 2016 WL 7094027, at *3.

[11] Id. at *1.

[12] Id. at *5.

[13] See NASDAQ Marketplace Rule 5605(a)(2).

[14] Sandys, 2016 WL 7094027, at *5.