Securities Regulation Daily Despite reviving complaint, court has words with Zynga shareholder over diligence failure
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Wednesday, December 7, 2016

Despite reviving complaint, court has words with Zynga shareholder over diligence failure

By Anne Sherry, J.D.

The Delaware Supreme Court revived a Zynga stockholder’s derivative suit by reversing the chancery court, which had determined that presuit demand was not excused. The plaintiff’s failure to conduct a presuit investigation into the board’s independence made it a closer call, but the high court ultimately concluded that the complaint raised a reasonable doubt as to several directors’ independence. Justice Valihura, dissenting, would have concluded that six of the nine directors were independent (Sandys v. Pincus, December 5, 2016, Strine, L.).

Complaint and dismissal. The plaintiff’s breach-of-duty claims centered on allegations that certain Zynga insiders sold stock shortly before the company issued negative earnings announcements. The suit also raises a duty of loyalty claim against the directors who approved the sales despite a standing rule at the gaming company barring insiders from selling shares until three days after an earnings announcement.

Dismissing the complaint, the chancery court determined that demand was not excused because there were no allegations challenging the independence of any of the directors. Allegations of common membership on another company’s board were insufficient to raise a reasonable doubt about independence. The court also was not persuaded by allegations of business or personal friendships among board members in the absence of a "bias-producing" relationship.

Complaint raised a reasonable doubt—barely. Calling it a close case, the supreme court took a different approach to the friendship question. One of the directors co-owned an airplane with Zynga’s former CEO and controlling stockholder, suggesting "an extremely intimate personal friendship between their families." The plaintiff also pleaded that two other directors were partners at a venture capital firm that controls 9 percent of Zynga’s equity, among other interlocking relationships with the controller. There is nothing wrong with these ongoing business relationships, but it is reasonable to expect that they may have a material effect on one party’s decision to authorize suit against the other. Furthermore, the Zynga board itself determined that these two directors did not qualify as independent under the NASDAQ rules, the court observed.

Adding these three directors to the two whom the chancery court properly determined were interested in the transaction, along with the CEO, meant that six of the nine board members lacked independence at the pleading stage.

The importance of a presuit investigation. The chancery court, along with both the majority and dissenting justices, all admonished the plaintiff for insufficient presuit diligence. The plaintiff did seek books and records to plead the complaint, but neglected to ask for any books and records bearing on the independence of the board. "Furthermore," the majority wrote, "although purporting to be a fitting representative for investors in a technology company, the plaintiff appears to have forgotten that one of the most obvious tools at hand is the rich body of information that now can be obtained by conducting an internet search." A Google search alone would have dug up more information about the relationship between the aircraft co-owners, for example. And a targeted books-and-records request would have shed more light on why the Zynga board determined that two of its members were not independent. Not only did the plaintiff’s failure make the chancery court’s task more difficult than necessary, it hazarded an adverse result for those represented by the complaint.

Dissent. In dissent, Justice Valihura said that she would have affirmed the chancery court on the basis that six of the directors were independent. Because the plaintiff failed to plead any facts going to the materiality of the relationships among the venture capitalists and entrepreneurs on the board, those relationships were not sufficient to raise a reasonable doubt as to the directors’ independence. The plaintiff also failed to allege why the directors lack independence under NASDAQ rules, and that lack of independence, while relevant to the court’s analysis, is not dispositive. "It is not difficult to come up with a scenario where a director might be deemed ‘not independent’ under the NASDAQ rules, or NYSE rules, yet deemed independent for demand futility purposes," the justice observed.

Justice Valihura also disagreed with the majority that the most likely inference to draw from co-ownership of a small plane is that there was a personal relationship between the co-owners. The plaintiff chose to plead only a business relationship and failed to allege more, let alone facts suggesting familial loyalty and intimate friendship. The Delaware Supreme Court has previously reaffirmed that a reasonable inference cannot be made that a particular friendship raises a reasonable doubt without specific factual allegations to support such a conclusion.

The case is No. 157, 2016.

Attorneys: Norman M. Monhait (Rosenthal, Monhait & Goddess, P.A.) for Thomas Sandys. Anna Erickson White (Morrison & Foerster LLP) for Mark J. Pincus.

Companies: Zynga Inc.

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