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Facebook: New Name, New Rules

By Camila Laval, J.D. on December 04, 2021 2:54 AM

Not only does Facebook have a new name, but the company can also take credit for helping establish a new test for demand futility for derivative lawsuits under Delaware law. The new test, adopted by the Supreme Court of Delaware in United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, establishes a director-by-director analysis to address demand futility.

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Costly Philanthropy

In 2018, Facebook stockholder United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund (¨Tri-State¨) filed a derivative suit in Delaware against both the company and Mark Zuckerberg, who acts as the controller, chairman, and CEO.

Tri-State sought compensation for funds Facebook spent defending itself in a class action filed by a group of stockholders after the board approved a stock reclassification to allow Zuckerberg to sell the lion's share of his stock while retaining voting control.

Zuckerberg intended to sell most of his shares to fulfill promises he made when taking the Giving Pledge—a campaign encouraging business leaders to donate most of their wealth, led by fellow billionaires Bill Gates and Warren Buffet.

Before trial, Zuckerberg requested that the board withdraw the reclassification, rendering the class action moot. However, Facebook had already spent $20 million defending itself against the class action and more than $68 million in attorney fees paid to plaintiffs' counsel.

Tri-State did not make a litigation demand to the board before filing the lawsuit. Instead, they argued that demand would have been futile because the board was accountable to Zuckerberg, and the board's approval of the reclassification was not a valid exercise of its business judgment.

The trial court dismissed the complaint on the basis that it failed to plead demand futility with particularity. Tri-State appealed.

A New Test for Demand Futility

To evaluate demand futility, Delaware courts have historically used the tests outlined in Aronson v. Lewis and Rales v. Blasband.

Under Aronson, a litigation demand is futile when the facts either raise reasonable doubts that the directors are disinterested and independent or that the challenged transaction was the product of a valid business judgment.

Under Rales, a litigation demand is futile when the facts create a reasonable doubt that a majority of the board could have exercised its independent and disinterest business judgment to respond to the demand.

On appeal, the Supreme Court of Delaware adopted a new director-by-director analysis. The new test asks whether each director:

  • Received a material personal benefit from the alleged misconduct that is the subject of the litigation demand
  • Would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand
  • Lacks independence from someone who received a material personal benefit from the alleged misconduct that is the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand

If the answer to any of the questions is "yes" for at least half of the board members, then demand is excused as futile.

Do Aronson and Rales Survive?

The court noted that changes in the law after Aronson, such as the ability of corporations to adopt charter provisions insulating directors from liability for breaching their duty of care, rendered the tests challenging to apply. By providing a universal way to address demand futility, it is no longer necessary to decide whether the Aronson or Rales test applies. However, the court noted that the new test is consistent with those cases and, therefore, does not overrule them.

Tri-State got the Supreme Court of Delaware to adopt a new test. However, it did not get it to overturn the dismissal of the complaint. Under the new test, the Supreme Court held that Tri-State failed to allege with particularity that most directors lacked independence for Zuckerberg.

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