Delaware Supreme Court Announces Key Changes to Standing Doctrines in Derivative Shareholder Litigation

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Last week, the Delaware Supreme Court handed down two important decisions clarifying key doctrines relating to derivative shareholder litigation. The first, Brookfield Asset Management, Inc. v. Rosson, No. 406, 2020 (Del. Sept. 20, 2021), overruled Gentile v. Rossette, 906 A.2d 91 (Del. 2006), and eliminated Gentile’s carve-out exception to the test for direct versus derivative claims under Tooley v. Donaldson, Lufkin & Jennette, Inc., 845 A.2d 1031 (Del. 2004). The second, United Food and Commercial Workers Union v. Zuckerberg, No. 404, 2020 (Del. Sept. 23, 2021), adopted a new universal futility test for the derivative claim demand requirement.

By way of introduction, there is a critical and often outcome-determinative distinction between “direct” and “derivative” shareholder claims under Delaware corporate law. Direct claims are those shareholders bring on their own behalves to redress harms to themselves as shareholders (as opposed to the enterprise at large)—akin to breach of contract claims. In contrast, derivative claims are those shareholders bring on behalf of the corporation (or alternative entity, as the case may be) to redress harms to the entity.

Derivative claims run counter to a “cardinal precept” of Delaware law that the directors, not the shareholders, manage the business affairs of the corporation. Normally then, directors decide whether the corporation pursues litigation. But under certain circumstances, Delaware law permits shareholders to wield that power “to prevent a complete failure of justice on behalf of the corporation.”

To safeguard directors’ managerial prerogative, Delaware law imposes several threshold requirements on derivative plaintiffs, including contemporary and continuous stock ownership and a demonstration that a demand to pursue the claim first was directed to and rejected by the corporation’s directors—or else that such a demand would be futile due to debilitating conflicts.

For a variety of reasons, a shareholder may not make such a demand upon the directors, meaning, to pursue derivative claims, it must establish demand futility—now under the new Zuckerberg test. If, however, the shareholder seeks to pursue direct claims, futility and other derivative requirements do not come into play. Whether a claim is direct or derivative must be assessed under the Tooley test, which now under Brookfield no longer has a carve-out exception for certain claims.

Both demand futility and the direct/derivative distinction relate to the larger question of whether a plaintiff has standing to bring its claim. As such, both issues commonly are litigated, and their resolutions can mean the difference between a favorable judgment and claims being dismissed. Thus, the doctrinal clarifications announced last week in Brookfield and Zuckerberg are important developments that will shape the contours of Delaware corporate litigation moving forward.

Brookfield Asset Management, Inc. v. Rosson, No. 406, 2020 (Del. Sept. 20, 2021)

Brookfield presented an opportunity for the Delaware Supreme Court to clarify the test for direct versus derivative claims, which it described as a “difficult and important area of our law.” In doing so, it took the unusual step of expressly overruling one of its prior decisions.

The general test to establish a direct claim was set forth in Tooley v. Donaldson, Lufkin & Jennette, Inc., 845 A.2d 1031 (Del. 2004): the stockholder must demonstrate that a duty owed to it was breached and that it can prevail without showing an injury to the corporation. Thus, the test turns solely on who suffered the alleged harm and who would receive the benefit of any remedy. But just two years later, the waters were muddied by Gentile v. Rossette, 906 A.2d 91 (Del. 2006), which found a “dual-natured claim” (i.e., a claim that was both direct and derivative) where a corporation overpaid its controller with equity to forgive a debt, resulting in “independent aspects” of the claim stemming from the loss of value and voting power suffered by the minority shareholders.

Gentile created a carve-out to the Tooley test for which subsequent Delaware courts struggled to define the boundaries and some expanded to non-controller transactions. A decade later, that expansion was curtailed in El Paso Pipeline GP Co. v. Brinckerhoff, 152 A.3d 1248, 1256 (Del. 2016), where then-Chief Justice Strine’s concurrence questioned Gentile’s continued viability.

But it was not until Brookfield that the opportunity arose to squarely address this legal tension with a factual paradigm “strikingly similar” to Gentile. Faced with a derivative claim under Tooley but dual-natured under Gentile, the Delaware Supreme Court made a “searching inquiry” into Gentile’s rationale and found Gentile’s “practical and doctrinal difficulties” “fundamentally unworkable” through “the added perspective of fifteen years of development in Delaware corporate law.”

In overruling Gentile, Brookfield found its carve-out to Tooley “superfluous” in light of the availability of direct claims under Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173, 182 (Del. 1986), and a shareholder’s right to directly challenge a merger. It further found that permitting “dual-natured” claims unnecessarily complicates fashioning remedies in such cases. The result is that formerly “dual-natured” claims are now exclusively derivative, and Tooley stands as the exceptionless test to determine whether a claim is direct or derivative.

United Food and Commercial Workers Union v. Zuckerberg, No. 404, 2020 (Del. Sept. 23, 2021)

In Zuckerberg, the Delaware Supreme Court reexamined the standard for pleading demand futility and announced a new universal test that blends and refines elements from its two prior tests.

Previously, Delaware courts applied the test of Aronson v. Lewis, 473 A.2d 805 (Del. 1984), where the complaint challenged a decision made by the same board that would have considered the litigation demand. In those cases, demand was deemed futile if the complaint raised a reasonable doubt that the directors were interested and independent, or if the challenged transaction was otherwise the product of a valid business judgment. In all other circumstances, the test of Rales v. Blasband, 634 A.2d 927 (Del. 1993), would apply, and demand was considered futile if the complaint created a reasonable doubt that a majority of the demand board could have property exercised its independent and disinterested business judgment in responding to the demand.

But in subsequent cases, shifting board composition made Aronson at times difficult to apply. More importantly, Aronson was decided before the Delaware General Assembly enacted Section 102(b)(7) of the General Corporation Law, which allows corporations to insulate directors from personal exposure for breaches of the duty of care.  Section 102(b)(7) weakened the connection between rebutting the business judgment rule and the risk directors’ judgment in considering the demand would be sterilized. These issues, coupled with other developments in corporate law, led the Court of Chancery in its Zuckerberg opinion to suggest that Aronson should be abandoned.

The Supreme Court declined that invitation, and instead adopted the Court of Chancery’s new test meant to blend the principles underlying both Aronson and Rales. Under the new Zuckerberg test, the court will ask three questions on a director-by-director basis:

(i) did the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;

(ii) does the director face a substantial likelihood of liability on any of the claims that are the subject of the demand; and

(iii) does the director lack independence from someone who received a material personal benefit from the alleged misconduct or who would face a substantial likelihood of liability on any of the claims that are the subject of the demand.

If the answer to any question is “yes” for at least half of the board, demand is excused as futile.  The Zuckerberg Court explained that the new test refocuses the inquiry on the demand itself rather than the decision being challenged but does not change the result of the preexisting demand-futility analysis. Properly construed, Aronson, Rales, and their progeny remain good law.

Takeaways

• Both Brookfield and Zuckerberg tackled head-on important aspects of Delaware corporate law that had created confusion and difficulty for shareholder litigants and courts. The immediate effect of Brookfield is that certain claims—particularly minority dilution claims—must proceed derivatively if at all. The new Zuckerberg test, while not a radical shift in futility analysis, refines and refocuses what allegations are required as to each director to plead demand futility. The net effect is an incremental tightening of the standard would-be representative shareholder plaintiffs must meet in certain cases to establish the standing needed for their claims to proceed to the merits.
• In both decisions, the Delaware Supreme Court expressed a willingness to critically reexamine its precedent in light of subsequent developments and judicial wisdom, and where manifestly necessary, overrule its prior decisions. However, the regard these decisions give to precedent strikes an impressive balance of rational innovation and conscious deference. Corporate law in Delaware, then, continues its dynamic but reasoned evolution.