IN REJECTING DEFENDANTS’ MOTION FOR DISMISSAL, CHANCERY COURT FINDS THAT INDIVIDUAL FIDUCIARY MAY BE HELD LIABLE FOR TRADES THAT AN ASSOCIATED ENTITY OR FUND MAKES

By: Scott E. Waxman and Adrienne Wimberly

In the consolidated stockholder derivative litigation, In re Fitbit, Inc., CA No. 2017-0402-JRS (Del. Ch. Dec. 14, 2018), the Delaware Court of Chancery denied the Defendants’ motion to dismiss Plaintiffs’ insider trading and breach of fiduciary duty claims. The claims stem from alleged insider knowledge of members of Fitbit’s Board of Directors (the Board) and chief financial officer that Fitbit’s PurePulse™ technology was not as accurate as the company claimed. Plaintiffs alleged that members of the Board structured the company’s Initial Public Offering (IPO) and Secondary Offering (together, “the Offerings”) to benefit Fitbit insiders and voted to waive employee lock-up agreements, thereby allowing those insiders, to prematurely sell stock in the Secondary Offering. As a result of their sales, the alleged insiders sold about 6.2 million shares for over $115 million in the IPO and about 9.62 million shares for over $270 million in the Secondary Offering.

Plaintiffs brought claims against Director Defendants, who approved the deal structure. Director Defendants include: Fitbit co-founder and CEO, James Park, co-founder, Eric Friedman, founder and managing member of True Ventures, Jonathan Callaghan, partner of SoftBank Capital, Steven Murray, Fitbit Chief Financial Officer, William Zerella, and Chris Paisley. In addition, Plaintiffs brought claims against the subset of directors who sold stock, called the Selling Defendants. Selling Defendants include: Park, Friedman, Callaghan, Murray, and Zerella. Plaintiffs stated two causes of action: Count I- breach of fiduciary duty against all Defendants for allowing the Selling Defendants to sell stock in the Offerings based on insider information and against the Director Defendants for waiving the lock-up agreements and Count II- breach of fiduciary duty against the Selling Defendants for harm caused by insider trading. Non-defendant directors Brad Feld, Laura Alber, and Glenda Flanagan were included in the demand futility analysis.

Beginning with Count II, the Court analyzed demand futility, the Defendants’ alleged knowledge of material, nonpublic information, and whether Plaintiffs alleged the requisite scienter. Given that the Plaintiffs made no pre-suit demand upon the Board, the Court concluded that Plaintiffs pled particularized facts to create reasonable doubt that the Director Defendants could exercise their independent and disinterested business judgment in responding to a demand. The Court analyzed demand futility in reference to the seven-member Board as comprised at the time the first complaint in the consolidated action was filed. This Board, called the Demand Board, included Selling Defendants Park, Friedman, Callaghan, and Murray as well as non-defendant directors Feld, Alber, and Flanagan.

Citing precedent, the Court determined that Plaintiffs were required to well-plead that a majority of the Demand Board possessed material, nonpublic company information and used that information improperly by making trades motivated by that knowledge. First, the court determined that knowledge of the design flaws in the PurePulse™ technology was material and nonpublic. Despite Defendants’ claim that negative consumer reviews demonstrated the public’s knowledge of the faulty technology, the Court found that the public was unaware of the scope and severity of the defect as well as Fitbit’s inability to fix the problems.

The court also looked to previous litigation against Fitbit to support its finding. In January 2016, Fitbit faced a consumer class action (the “Consumer Action”) related to the failure of its pulse tracking technology to perform as warranted. Simultaneously, Fitbit faced a federal securities class action (the “Securities Action”) that alleged securities fraud related to issuing materially false or misleading statements related to IPO sales. In the instant case, the Court cited the Securities Action as support for the proposition that the “precipitous and continuous decline” in the Fitbit stock price after the filing of the Consumer Action suggested that the market was not aware of the severity of the PurePulse™ technology flaws.

Second, the Court found that Plaintiffs well-plead that the Selling Defendants acted with scienter. Defendants argued that Plaintiffs did not adequately plead that all the Selling Defendants actually sold stock in the Offerings. There is no question that individuals, Park and Friedman, sold stock. However, the Court faced an issue of first impression as to whether a fiduciary may be held liable for trades that an entity or fund associated with that fiduciary executed in its name. The Court found, for policy reasons, that the sales by True Ventures and Softbank could be attributed to Callaghan and Murray, respectively. To find otherwise, the Court said, would be inconsistent with the policy of preventing fiduciaries from profiting from a breach of confidence. The Court found that Callaghan and Murray personally and materially profited from the stock sales through their ownership and control of those entities.

Although Plaintiffs’ complaint only expressly identified Park and Friedman as having received internal documents, the Court found that, at this stage of the proceeding, this was enough to support a reasonable interference of knowledge and scienter. Further, the Court found given that the PurePulse™ technology accounted for 80% of Fitbit’s revenue, Fitbit tried and failed to fix the design flaws, and Fitbit boasted about the technology to the market despite these problems, combined with the nature, timing, and size of the Offerings, the Selling Defendants sought to make trades based on nonpublic information.

Additionally, the Court found that the Board designed the Secondary Offering to accommodate the Selling Defendants’ interests by incentivizing underwriters to exercise the Selling Defendants’ overallotment option and waiving lock-up agreement for certain insiders. By waiving the lockup agreements, Selling Defendants were able to trade at $28.13 per share, as compared to the price on the earliest day they would have otherwise been allowed to trade, $12.50 per share. Again citing the Securities Action, the Court took judicial notice that another court reviewing similarly pled facts found that those facts supported an inference of knowledge for all the Defendants.

As to Count I, the Court noted that four of seven Director Defendants were beneficiaries of the waiver of their lock-up agreement when they sold shares in the Secondary Offering and made a personal profit. Despite the small percentages of stock the four defendants sold, the Court found that the trades were material because the profits were “sizable to say the least.” This fact created enough reasonable doubt that the Demand Board was disinterested in the waiver of the lock-up agreements. Finally, the Court rejected Defendants’ argument that they were entitled to exculpation under § 102(b)(7) of the Delaware General Corporation Law and Fitbit’s certificate of incorporation. The Court noted that § 102(b)(7) did not apply when a director derived an improper personal benefit from a transaction. Thus, the Court denied the Defendants’ Motion to Dismiss for both counts.

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