16 December 2021

The Refined Demand Futility Standard Takes Shape

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Over the past several months, a number of decisions released by the Delaware courts have begun to grapple with the new Zuckerberg three-part demand futility standard announced by the Delaware Supreme Court in September. Many cases spotlight the need to assess demand futility on a director-by-director basis. But at least one recent decision has highlighted another aspect of the test, and instead turns on the need to assess demand futility on a transaction-by-transaction basis. In In re Vaxart, Inc. Stockholder Litigation, Vice Chancellor Fioravanti dismissed several claims from a shareholder derivative suit purportedly filed on behalf of Vaxart, Inc. because the plaintiffs failed to allege that a majority of the directors received a material personal benefit or faced a substantial likelihood of liability from the specific transaction that would have been the subject of the pre-suit demand.

Background

In the early months of the pandemic, biotech company Vaxart began developing a vaccine for COVID-19. In late June 2020, Vaxart announced that it had been selected to participate in a primate study sponsored by Operation Warp Speed, the federal government program intended to accelerate development of a vaccine, and that it had entered a manufacturing deal to produce its oral vaccine. The price of Vaxart stock skyrocketed on that news.

This suit arises from the decision of Vaxart’s board of directors earlier in June 2020 to approve amendments to two 2019 warrant agreements between Vaxart and Armistice Capital LLC (a former majority shareholder). The warrant amendments approved by the board permitted Armistice to beneficially own a greater number of Vaxart shares upon exercise of the warrants, and to dispose of those warrant shares more quickly, than under the previous agreements. Separately, at a series of meetings during spring 2020, the board also voted to issue options to several of the directors as compensation for their service, and stockholders subsequently approved an amendment to the equity incentive plan that allowed for those option grants. Within days of the public announcement that Vaxart had been selected to participate in the Operation Warp Speed study, Armistice began exercising its warrants and selling most of the underlying shares. In the following weeks, several board members exercised their stock options as well.

The plaintiff stockholders asserted claims against both Armistice and Vaxart’s board of directors, alleging that the board members knew of Vaxart’s selection for the study by late May before approving the warrant amendment and options grants, which they exercised to their benefit after the positive news was released. Several of the claims — including breach of fiduciary duty claims and unjust enrichment claims against the directors and Armistice — were asserted derivatively on behalf of Vaxart. The plaintiffs did not first make a pre-suit demand on Vaxart’s board.

Dismissal for Failure to Make a Demand

Applying the “refined” demand futility test adopted by the Delaware Supreme Court earlier this year in Zuckerberg, the Court of Chancery concluded that the derivative claims relating to the warrant amendments must be dismissed for failure to make a pre-suit demand. The Court first rejected the argument that demand on the board (which included two Armistice-designated directors) would have been futile because Armistice was a “controlling” shareholder. As an initial matter, the Court noted that Armistice was no longer a “controlling” shareholder at the time that the warrant amendments were approved because it owned less than 10% of outstanding shares. In addition, even if Armistice were a “controlling” shareholder, that alone would not excuse demand because the plaintiffs failed to allege that at least half of the members of the demand board were incapable of fairly considering a demand as to the warrant amendments.

The Court first rejected arguments that two of the directors lacked independence from or were beholden to the two Armistice-designated directors under the third prong of the Zuckerberg test merely because the Armistice-designated directors supported stock option grants to the other directors and the appointment of the other directors to positions as officers and directors.

The Court next analyzed whether any directors either received a personal benefit from or faced the potential for liability from the transaction that would have been the subject of the demand — the approval of the warrant amendments. The plaintiffs argued that five of the directors were “interested” in the warrant amendments because they shared a common goal with the two Armistice-employed directors of keeping the Operation Warp Speed study secret so that they could grant themselves beneficial stock options at a low exercise price. But the Court rejected this argument because the stock option grants, which were awarded to individual directors over the span of four months, were “wholly distinct transactions” from the amendments to Armistice’s warrants approved at a separate meeting. Thus, any alleged “material benefit” the directors received from the stock options did not derive from the alleged misconduct in approving the warrant amendments that underlies the pre-suit demand.

Moreover, a majority of directors did not face a substantial likelihood of liability arising from the approval of the warrant amendments because Vaxart’s Section 102(b)(7) exculpatory provision shielded directors from liability. The Court rejected the plaintiffs’ argument that an “entire fairness” review should be triggered. There was no controlling stockholder at the time of the warrant amendment approval and, because the stock option grants were a distinct transaction from the warrant amendments, a majority of the board was not conflicted. And the plaintiffs’ allegations that the board had acted in bad faith by “gifting” the warrant amendments for no consideration amounted to no more than second-guessing of the board’s business judgment.

Based on this analysis, the Court concluded that demand was not excused as to any claim relating to the warrant amendments and dismissed both the breach of fiduciary duty claims and the unjust enrichment claims.

Conclusion

The practical repercussions of the Delaware Supreme Court’s refinement of the demand-futility standard in the Zuckerberg decision will continue to unfold in the coming months. However, it has become clear that the test does not tolerate mismatch between the alleged misconduct that would be the subject of the pre-suit demand and the alleged wrongdoing that purportedly exposes directors to liability or brings them a material benefit. Before pre-suit demand will be excused, plaintiffs must establish futility claim by claim, director by director, and transaction by transaction.