Archive: March 15, 2016

CHANCERY COURT DISMISSES STOCKHOLDER DERIVATIVE SUIT ON BEHALF OF ZYNGA, INC. ON GROUNDS OF FAILURE TO DEMONSTRATE DEMAND FUTILITY APPLYING THE RALES TEST

By: Shoshannah D. Katz and Alexa M. Ekman

In Sandys v. Pincus et al., C.A. No. 9512-CB (Del. Ch. Feb. 29, 2016), the Delaware Court of Chancery systematically dismissed claims brought in a stockholder derivative suit on behalf of Zynga, Inc. (“Zynga”), regarding alleged breaches of fiduciary duties in connection with Zynga’s secondary offering of its common stock, due to the plaintiff’s failure to demonstrate that the procedurally required demand upon Zynga’s board of directors to initiate such litigation would have been futile. The court applied the Rales test to assess demand futility, which required the plaintiff to prove reasonable doubt that the board at the time the litigation commenced was able to properly exercise its independent and disinterested business judgement in responding to a demand to file suit, and in doing so extended the scenarios in which to apply the Rales test.

Following the initial public offering (“IPO”) of its Class A common stock at $10 per share in December 2011, Zynga launched a secondary offering in April 2012 for $12 per share, in which various executives of Zynga and four members of Zynga’s board of directors (the “Participating Board Members”) were selling stockholders. To allow such participation in the offering by the various executives and the Participating Board Members, the underwriters agreed to the early release of certain lock-up agreements entered into by such executives and directors in conjunction with the IPO, and the audit committee of Zynga’s board of directors approved exceptions to the trading window restrictions set forth in Zynga’s 10b5-1 trading plan that otherwise would prohibit such sales by these individuals at the time of the secondary offering.

The secondary offering, including the selling stockholder participation, was approved by Zynga’s board of directors; however, of the eight members at such time, only seven were present to vote. The four Participating Board Members voted for the secondary offering, constituting the majority vote required to proceed. At the time the complaint was filed, Zynga’s board had increased to nine members, comprised of six members who served on Zynga’s board at the time of the secondary offering (of which only two were Participating Board Members) and three additional members who had since been added to Zynga’s board.

On April 4, 2014, the plaintiff, a stockholder of Zynga at all relevant times, filed suit and asserted three claims: (1) against the Participating Board Members, alleging breach of fiduciary duties by misusing Zynga’s confidential information when they sold shares in the secondary offering while in possession of materially adverse, non-public information, (2) against Zynga’s board of directors at the time of the secondary offering, alleging breach of the fiduciary duty of loyalty for approving the secondary offering and exempting the Participating Board Members from the trading window restrictions set forth in Zynga’s 10b5-1 trading plan, and (3) against Zynga’s board of directors and various Zynga executives at the time of the secondary offering alleging breach of fiduciary duties by failing to put controls in place to ensure adequate public disclosures and to avoid material omissions in its public statements.

The plaintiff brought each of the claims derivatively on behalf of Zynga, invoking Court of Chancery Rule 23.1, which requires the plaintiff of a derivative stockholder suit to make a demand upon the board of directors to initiate such litigation or demonstrate that such a demand would be futile. As the plaintiff in Sandys v. Pincus did not make a demand on Zynga’s board to initiate litigation, to over come the defendants’ motion to dismiss, the plaintiff needed to instead demonstrate such demand would be futile. To prove demand futility, Delaware courts apply one of two tests. The first, articulated in Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984), requires the plaintiff to plead facts that create a reasonable doubt either that the directors are disinterested and independent, or that the challenged transaction was otherwise the product of a valid business judgment (the “Aronson test”). The Aronson test does not apply when the board that would be considering the demand did not make a business decision which is being challenged in the derivative suit. The second test, articulated in Rales v. Blasband, 634 A.2d 927, 933-34 (Del. 1993), requires the plaintiff to create reasonable doubt that the board could have properly exercised its independent and disinterested business judgment in responding to the demand at the time the complaint was filed (the “Rales test”).

As demand futility is assessed claim by claim, the court addressed each of the three claims separately, first determining whether to apply the Aronson or Rales test. The court applied the Rales test for each claim. In doing so, the court analyzed whether the plaintiff created reasonable doubt that at least five of the nine directors of Zynga’s board at the time the complaint was filed were able to properly exercise his or her independent and disinterested business judgement in responding to a demand to file suit. According to the court, a director lacks independence when he or she is sufficiently beholden to someone interested in the litigation that he or she may be unable to consider the demand impartially. An interested director is one who receives from a corporate transaction a personal benefit not equally shared by the stockholders, such that he or she could face liability if the transaction were subjected to entire fairness scrutiny.

With respect to the first claim, the court applied the Rales test because the claim did not challenge a business decision of the board, but rather the Participating Board Members’ individual decisions to sell in the secondary offering. Applying the Rales test, the court concluded that of the members of Zynga’s board at the time the complaint was filed, only the two remaining directors that had sold shares and received a benefit, faced liability under the alleged claim. Thus, the remaining seven members were not interested directors. The court reviewed certain facts pled to ascertain whether the seven disinterested board members were beholden to the two remaining Participating Board Members, and found that facts such as friendship or co-ownership of an asset, each absent a bias nature, are insufficient to raise reasonable doubt as to independence. The court dismissed plaintiff’s first claim for failure to allege demand futility under the Rales test.

For the second claim, the court applied the Rales test because Zynga’s board composition had changed since the secondary offering, marking an expansion of the scenarios in which such test applies. In assessing whether Zynga’s board at the time the complaint was filed could impartially decide whether to pursue plaintiff’s second claim, the court stated that the mere fact that two board members are both partners in the same firm does not support the plaintiff’s theory that they would not want to initiate litigation against the other, as the plaintiff presented no evidence that they are beholden to one another or have a relationship aside from their partnership that would suggest otherwise. In addition, in response to plaintiff’s argument that non-selling directors of Zynga’s board at the time of the secondary offering are interested directors because of the litigation risk they would face in an entire fairness review applicable to such claim, the court stated that a plaintiff seeking monetary damages as a result of this claim must plead non-exculpated facts against a director who is protected by Section 102(b)(7) of the Delaware General Corporation Law. Since Zynga’s charter contains such exculpatory provision, plaintiff needed to demonstrate breaches of duty of loyalty, bad faith, or a conscious disregard for directorial duties. As the plaintiff failed to demonstrate such facts and thus to cast the required reasonable doubt, the court dismissed the claim.

Lastly, the court applied the Rales test to plaintiff’s third claim because the claim did not address a business decision of the board, but rather a violation of the board’s oversight duties. The court held that in the context of an alleged oversight violation, there is no transaction in which the directors may be interested. For directors to have a disabling interest, they must face a meaningful litigation risk with a substantial likelihood of personal liability for the violations. Due to the exculpatory provision in Zynga’s charter, its directors would not face likelihood of personal liability unless plaintiff pled exculpated facts. As no such exculpated facts were pled, the court dismissed this claim for failure to allege demand futility under the Rales test.

In sum, the court dismissed each of plaintiff’s claims due to plaintiff’s failure to demonstrate that a demand upon Zynga’s board to initiate litigation would have been futile, applying the Rales test for demand futility. Under the Rales test, plaintiff failed to prove reasonable doubt that Zynga’s board was able to properly exercise its independent and disinterested business judgement in responding to plaintiff’s demand to file suit.

Sandys v. Pincus et al.

CHANCERY COURT GRANTS SUMMARY JUDGMENT FOR ADVANCEMENTS OF FEES AND EXPENSES

By Eric Feldman and Michael Bill

On a motion for summary judgment in Marino v. Patriot Rail, the Delaware Court of Chancery confirmed, under Section 145 of the Delaware General Corporation Law (the “DGCL), that the advancement rights of officers and directors of a Delaware corporation, acting in their capacity as such, (i) continue after they leave office with respect to actions taken while in office, (ii) cannot be amended or eliminated retroactively unless the source of such rights provides otherwise, and (iii) do not apply to actions taken after an officer or director leaves office.

The case involves an underlying action that took place in a California court between Patriot Rail Company LLC (the “Company”) and Sierra Railroad Company (“Sierra”) which ended in favor of Sierra. Sierra moved to amend the judgment to add, among others, Gary Marino, the former Chairman, President and CEO of the Company, as a judgment debtor (the “Post-Judgment Motion”).  The Company existed as a Delaware corporation until May 1, 2013, when it converted to a Delaware limited liability company.  Prior to the time of such conversion, on June 18, 2012, the Company, which was partially owned indirectly by Marino, had been sold to a third party and Marino resigned from all of his positions with the Company.  Marino asked the Company to advance the fees and expenses that he would incur to oppose Sierra’s Post-Judgment Motion, but the Company denied the request. Marino subsequently commenced this action seeking the advancements of attorneys’ fees and expenses; the Company answered, and the parties cross-moved for summary judgment.  As the Company was a Delaware corporation during the time that Marino was an officer and director of it, and the conversion did not affect the obligations or liabilities of the Company arising prior to its conversion, the organizational documents of the Company during the time in which it was a Delaware corporation and the DGCL were relevant to the advancement issues.

The Company’s certificate of incorporation stated: “This Corporation shall indemnify and shall advance expenses on behalf of its officers and directors to the fullest extent permitted by law in existence either now or hereafter.” Marino and the Company disagreed as to whether this language continued to cover Marino after he ceased being an officer or director of the Company against claims arising during his service.  Marino contended, and the Court agreed, that Marino remained covered for claims challenging the propriety of his actions taken while he was serving as an officer and director of the Company.  The Court looked at Section 145 of the DGCL—Delaware’s indemnification and advancement statute—because the Company’s certificate of incorporation contemplated advancement “to the fullest extent permitted by law.”  The Court paid particular attention to (i) Section 145(e), which authorizes advancements, (ii) Section 145(j), which addresses the extent to which a covered person’s indemnification and advancement rights continue after the person leaves their position, and (iii) Section 145(f), which restricts a corporation’s ability to alter the rights after a person has served in reliance upon them.

After looking at the statutory history of Section 145 and prior precedent, the Court determined that Section 145 allows a corporation to grant mandatory advancement rights to directors and officers that provide coverage conditioned solely on an undertaking (Section 145(e)). The granted rights continue to provide coverage for actions taken by individuals during their service, even after the individuals have ceased to serve, unless the governing provision clearly states otherwise (Section 145(j)).  And, unless the governing provision provides otherwise, the granted rights cannot be altered or eliminated retroactively with respect to prior actions, after a director or officer has already exposed themselves to potential suit by acting on the corporation’s behalf (Section 145(f)).  The Court noted that this structure is set up to “encourage capable men [and women] to serve as corporate directors” as they will be “secure in the knowledge that expenses incurred by them in upholding their honesty and integrity as directors will be borne by the corporation they serve.”

Thus, when Marino agreed to serve in a covered capacity, Marino became “entitled to receive mandatory indemnification and advancements to the fullest extent of Delaware law” as part of the consideration offered to him by the Company and was entitled to advancement for covered claims. The Court therefore found that Marino was entitled to receive advancement in the Sierra Post-Judgment Motion for actions taken by Marino during his service and in his capacity as a director or officer of the Company.

However, certain of the claims made by Sierra in the Post-Judgment Motion related to actions taken by Marino after he ceased serving as a director and officer of the Company and taken on behalf of himself or other entities which he directly or indirectly controlled. The Court found that Marino was not entitled to advancement with respect to any such claims.

Marino v. Patriot Rail, C.A. No. 11605-VCL (Del. Ch. February 29, 2015)

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