Delaware Supreme Court Revives Zynga Suit, Provides Guidance On Director Independence
The Delaware Supreme Court recently revived a lawsuit against the controlling shareholder of Zynga Inc. and other board members for allegedly breaching their duties to the online gaming company and allowing leaders to dump stock in a 2012 offering. The decision is Sandys v. Pincus deals with a fundamental issue in corporation law: director independence. The court’s holding should be given careful consideration by boards of directors of companies facing stockholder derivative lawsuits.
The 2014 lawsuit was brought by a Zynga shareholder who alleged that certain top officers and directors at Zynga, creator of the popular Farmville and Words With Friends games, were exempted from a rule restricting stock sales until three days after an earnings announcement. The shareholder said the insiders, including controlling shareholder and former CEO Mark Pincus, sold their stock in an April 2012 secondary offering, when they knew of problems with the company’s performance.
The lawsuit alleged the insiders breached their fiduciary duties by misusing confidential information. It also asserted a duty of loyalty claim against members of the Zynga board of directors who approved exceptions to certain trading restrictions, thereby allowing the sale.
The Delaware Chancery Court dismissed the lawsuit in February 2016. Under state law, before a stockholder can assert claims on behalf of the corporation, they must either make a pre-suit demand on the board or show why it would be futile to do so. The shareholder in this case made no pre-suit demand, so the decision turned on whether the demand would have been futile.
The Chancery Court held that two directors who participated in the selling of shares - Pincus and Reid Hoffman - were interested in the transaction and could not impartially consider a demand. Still, the court said the plaintiff failed to allege facts that would create reasonable doubt as to the ability of the majority of the nine-member board to act independently of Pincus and Hoffman and exercise business judgment when responding to the demand.
In a 4-1 decision on Dec. 5, the Delaware Supreme Court ruled the lower court should have found five members of Zynga’s board could not impartially consider a demand, not just two. As such, the justices said the plaintiff had adequately pled that the demand was futile.
Writing for the court, Chief Justice Leo E. Strine pointed to the “powerful and unusual fact” that one director, Ellen Siminoff, was married to a man who co-owned an airplane with Pincus. The justice said this suggested an “extremely intimate personal friendship between their families.” Justice Strine also emphasized that other two directors, William Gordon and John Doerr, are partners at venture capital firm Kleiner Perkins Caufield & Byers. In addition to controlling 9.2 percent of Zynga’s equity, Kleiner Perkins was invested in One Kings Lane, a company co-founded by Pincus’ wife, and another company where Hoffman was a director.
“[T]hese relationships can give rise to human motivations compromising the participants‘ ability to act impartially toward each other on a matter of material importance,” wrote Justice Strine, who also noted that Zynga itself did not consider Gordon and Doerr independent under the NASDAQ listing standards.
In a dissent, Justice Karen L. Valihura acknowledged this was a “close case,” but wrote that she would have affirmed the Chancery Court’s decision to dismiss the lawsuit. With respect to Gordon and Doerr, the justice said that “the relationships among these venture capitalists and entrepreneurs, as alleged, are not sufficient to raise a reasonable doubt as to [their] independence.” Similarly, the justice she did not think co-ownership of the plane “rises to the level of creating a reasonable doubt as to Siminoff‘s ability to carry out her fiduciary duties, to properly consider a demand, and to put at risk her reputation by disregarding her duties.”
There are a couple of important takeaways from the majority’s opinion in Sandys that boards of directors should consider. The first is that a close personal or business relationship between directors may be considered by a court to affect the board’s ability to maintain control of derivative suits.
Delaware courts have long held that in order to render a director unable to consider a demand, a relationship must “be of a bias-producing nature.” The Sandys majority held that standard “does not require a plaintiff to plead a detailed calendar of social interaction to prove that directors have a very substantial personal relationship rendering them unable to act independently of each other.” Here, the network of venture capital investments among directors was enough for the court to raise a reasonable doubt that two directors would not be able to impartially consider suing Pincus.
Similarly, and somewhat surprisingly, the court found reasonable doubt as to a director’s impartiality on the basis of co-owning an airplane. Explaining its reasoning, the majority said that owning an airplane together “is suggestive of the type of very close personal relationship that, like family ties, one would expect to heavily influence a human‘s ability to exercise impartial judgment.”
Another key takeaway is that a company’s decision about whether a certain director is independent under stock exchange rules can affect whether that director is considered independent for the purposes of Delaware law. The majority acknowledged that the Delaware independence standard is context specific and doesn’t perfectly match the stock exchange standards in all cases. “But, to 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 cognitive dissonance that our jurisprudence should not ignore,” the court wrote.
Boards of directors of companies, in particular those for companies that have a controlling shareholder, should review the court’s decision and review their current situation. Ultimately, the Sandys opinion indicates that each case can only be determined on the specific facts.