The past year has led to two cutting-edge developments in Delaware law that boards should factor into their deliberations going forward: first, a streamlined test for demand futility that will impact all derivative cases against Delaware companies, and second, decisions concerning material adverse effect (MAE) clauses and ordinary course covenants in light of the COVID-19 pandemic that reaffirmed the Delaware Courts’ reluctance to permit parties to terminate deals based on unfavorable post-signing events.
Delaware Supreme Court establishes a streamlined demand futility test in derivative cases
For years, the Delaware Courts used two different tests to analyze demand futility. The first, set forth in Aronson v. Lewis, excused pre-suit demand if there was a reasonable doubt that the directors were disinterested and independent or that the challenged action was the product of a valid business judgment. The second, set forth in Rales v. Blasband, was limited to Aronson‘s first prong and only required a showing that the board could not have properly exercised its independent and disinterested business judgment in responding to a demand. The differences between the Aronson and Rales tests are significant, and in some cases potentially outcome-determinative, although when to apply each test was often unclear.
In United Food and Commercial Workers Union v. Zuckerberg, the Delaware Supreme Court jettisoned the Aronson and Rales dichotomy and instead imposed a universal, three-part test for assessing demand futility. Under this new test, judges should ask three questions on a director-by-director basis to determine whether demand should be excused as futile:
Whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;
Whether the director faces a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand; and
Whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that would be 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 these questions is “yes” for a majority of the board members who would evaluate the demand (or at least half for an even-numbered board), then demand is excused as futile and the stockholder may proceed to litigate on the company’s behalf. The refined test, the Court explained, “refocuses the inquiry on the decision regarding the litigation demand, rather than the decision being challenged.”
The Zuckerberg decision is a welcome development, bringing much-needed clarity to a complex area of law and minimizing litigation over whether Aronson or Rales should apply. It also reinforces the high pleading burden stockholder plaintiffs must meet where the company has adopted an exculpatory provision protecting directors from liability for breaches of the duty of care. In those circumstances, absent allegations of breaches of the duty of loyalty, there can be no “substantial likelihood of liability” sufficient to excuse demand, even where, for example, a challenged transaction is subject to entire fairness review. Because the test for futility emphasizes nonexculpated risk of liability, key action items for boards following Zuckerberg include:
Conducting an assessment of strategic risk areas;
Updating that assessment with new areas of risk over time;
Ensuring that management is elevating more detail to the board, especially for mission-critical risks;
Creating specialized board committees devoted to key risk areas;
Reacting quickly to corporate trauma; and
Monitoring for potential conflicts that could defeat director independence.
COVID-19 MAE litigation
The Delaware Courts have been historically reluctant to allow buyers to invoke MAE clauses to escape from M&A deals, granting relief to a buyer under an MAE clause in only one pre-pandemic case. With the worldwide spread of COVID-19, multiple buyers invoked the pandemic as a reason to terminate deals and turned to the Delaware Courts for relief. Analyzed together, the recently decided cases on this issue make clear that the heavy burden on buyers imposed by Delaware law remains unchanged and that the pandemic, while a unique event with profound economic effects, provides an insufficient basis standing alone to terminate.
In AB Stable VIII LLC v. Maps Hotels and Resorts One LLC, for example, the Court held that the pandemic fell within the “natural disasters and calamities” exception to the definition of an MAE under the parties’ agreement, emphasizing that the provision was “seller-friendly” given its omission of a common exclusion to the exception for events that have a “disproportionate effect” on the target. The Court, however, did hold that the target’s responses to the pandemic, including closing two of its hotels and substantially reducing operations and staffing at others, breached the agreement’s ordinary course covenant, thus permitting the buyer to terminate the deal.
In Snow Phipps Group, LLC v. KCAKE Acquisition, Inc., the Chancery Court held that a decline in sales of the target cake decoration supplier due to the pandemic was insufficient under the parties’ MAE clause to allow the buyer to terminate the $550m purchase agreement because the sales decline was unlikely to be durationally significant and indeed was already rebounding. In addition, the decline fell within the MAE clause’s exception for effects arising from changes in laws, and thus was not materially disproportionate to the target’s peers. Similarly, the Court held that the ordinary course covenant was not violated because, among other reasons, the target’s $15m draw on a $25m revolver was not inconsistent with its past practice, was the result of a policy applied by the target’s private equity parent to all portfolio companies, and was ultimately never spent.
Similarly, in Bardy Diagnostics, Inc. v. Hill-Rom, Inc., which involved post-signing regulatory developments, the Court required the buyer to close on its merger with medical device startup Bardy, even after regulators reduced the reimbursement rate for Bardy’s flagship heart monitor by more than 50 percent a few weeks after signing. According to the Court, the buyer did not prove durational significance, given that the rate was likely to be revisited due to its considerable impact on a socially valuable product category, and in any event, the buyer had forecasted that the target, as a startup, would not be immediately profitable. The Court also held that the rate reduction was a “change in healthcare law,” which fell within the MAE carve-out and that the catch-all “disproportionate impact” clause did not apply because the impact on the target’s revenue and profitability differed from its principal competitor by only a few percentage points.
 Aronson v. Lewis, 473 A.2d 805 (Del. 1984).
 Rales v. Blasband, 634 A.2d 927 (Del. 1993).
United Food and Commercial Workers Union v. Zuckerberg, et al., — A.3d —, 2021 WL 4344361 (Del. Sup. Ct. Sept. 23, 2021).
AB Stable VIII LLC v. Maps Hotels and Resorts One LLC, 2020 WL 7024929 (Del. Ch. Nov. 30, 2020).
Snow Phipps Group, LLC v. KCAKE Acquisition, Inc., 2021 WL 1714202 (Del. Ch. Apr. 30, 2021).
Bardy Diagnostics, Inc. v. Hill-Rom, Inc., 2021 WL 2886188 (Del. Ch. July 9, 2021).
Key takeaways for boards
In light of these decisions, key action items for boards include:
Ensuring an agreement’s MAE clause, including any carve-outs and “disproportionate impact” provision, is adequately clarified;
Remaining mindful of the types of actions that might breach an ordinary course covenant;
Ensuring that agreements contain a sufficiently specific remedies provision; and
Remaining mindful of the reluctance of Delaware Courts to permit termination on the basis of an MAE.