The Delaware Supreme Court decision in Sandys v. Pincus, 2016 WL 7094027, at *1 (Del. Dec. 5, 2016) (Zynga) has raised questions regarding well-established legal precedent and business practices that are recognized as common in the venture capital and entrepreneurial communities. Although Zynga and other decisions regarding director independence reveal the Delaware judiciary’s focus on certain issues, including close friendships and repeat-player networks, those cases do not suggest a sea change in Delaware law. Zynga does, however, raise the question of whether Delaware courts have identified an ecosystem of entrepreneurialism in which these issues bear unique significance. Some clues might lie in the recent director independence analyses in Rux v. Meyer, C.A. No. 11577-CB (Del. Ch. Nov. 18, 2016) (Sirius XM), Greater Pa. Carpenters’ Pension Fund v. Giancarlo, 135 A.3d 77 (Del. 2016) (Imperva), aff’g C.A. No. 9833-VCP (Del. Ch. Sept. 2, 2015) (Imperva Chancery Decision), and Del. Cty. Empls. Ret. Fund v. Sanchez, 124 A.3d 1017 (Del. 2015) (Sanchez Energy).
The Zynga Litigation
Zynga is a social-gaming technology company that was founded and controlled by Mark Pincus. The Zynga litigation began with a decision by the Zynga board of directors (the Zynga Board) to grant certain directors, including Pincus, exceptions from stock transfer restrictions immediately before releasing negative earnings data that resulted in a sharp drop in the company’s stock price. A Zynga stockholder brought suit in the Delaware Court of Chancery asserting that the Zynga directors had breached their fiduciary duties, and the Zynga Board moved to dismiss for his failure to make a litigation demand under Court of Chancery Rule 23.1. The plaintiff asserted that he should be excused from making demand on the Zynga Board and permitted to institute derivative litigation because a majority of the directors were not independent of Pincus. The litigation was assigned to Chancellor Andre Bouchard as Sandys v. Pincus, 2016 WL 769999 (Del. Ch. Feb. 29, 2016), who found that a majority of the Zynga directors were disinterested and independent of Pincus and, accordingly, held that demand was not excused. The Zynga stockholder appealed the chancellor’s decision to the Delaware Supreme Court.
On appeal, the Delaware Supreme Court reviewed Chancellor Bouchard’s decision de novo and reached a split decision with a four-justice majority reversing the chancellor’s decision, and Justice Valihura issuing a dissent in favor of affirming the chancellor’s decision. The court’s decision and the dissent repeatedly noted the factual specificity of the litigation stating, “This is a close call.” This repeated word of caution, as well as the court’s repeated admonition of plaintiff-appellant’s counsel for failing to develop the record through investigative tools, might suggest that Zynga is expected to have limited import going forward.
However, the court also explained that its holding—i.e., that the Zynga directors could not consider the litigation demand independently of Pincus’s influence—was based on a “reality” of the court’s findings. The court stated, “But, our courts cannot blind themselves to that reality when considering whether a director on a controlled company board has other ties to the controller beyond her relationship at the controlled company.” (Emphasis added). That “reality include[d] that: Gordon and Doerr are partners at Kleiner Perkins, which controls 9.2% of Zynga’s equity; Kleiner Perkins is also invested in One Kings Lane, a company co-founded by Pincus’s wife; and, Hoffman and Kleiner Perkins are both invested in Shopkick, and Hoffman serves on its board with another Kleiner Perkins partner.” The court concluded, “But, the reality is that firms like Kleiner Perkins compete with others to finance talented entrepreneurs like Pincus, and networks arise of repeat players who cut each other into beneficial roles in various situations.” (Emphasis added).
The “reality” in Zynga comprised both factual findings that certain directors shared an airplane and coinvested in other businesses, and the observation that the Zynga directors operated in, and had substantial interests inextricably linked to, their own ecosystem of close friendships and repeat-players of serial entrepreneurs and sources of private financing. The court explained that this “reality” of personal relationships was “crucial to commerce and most human relations. But, precisely because of the importance of a mutually beneficial ongoing business relationship, it is reasonable to expect that sort of relationship might have a material effect on the parties’ ability to act adversely toward each other.”
The court’s characterization of this “reality” suggests that the pleaded facts were viewed within a broader context. Three other decisions issued in Delaware around the time of Zynga touch on similar issues in the context of director independence, including close personal friendships and repeat-player networks. An examination of the recent director independence analyses in Sirius XM, Imperva, and Sanchez Energy could supply some guidance regarding whether the court has identified a particular community of co-dependent actors and the rules of such an entrepreneurial ecosystem.
Close, Personal Friendships
In Zynga, Pincus and another director co-owned an airplane. The court held that the appropriate inference from such a unique connection was that they shared a “close, personal friendship.” The court observed that, “owning an airplane together is not a common thing”; therefore, the court drew inferences of an “extremely close, personal bond,” a “most important and intimate friends[hip],” a “partnership in a personal asset,” an “expensive co-investment,” “close cooperation,” and “detailed planning indicative of a continuing, close personal friendship.” In fact, it is suggestive of the type of close, personal relationship that, like family ties, one would expect to heavily influence a human’s ability to exercise impartial judgment.
The Delaware Supreme Court also addressed close, personal friendships in Sanchez Energy. In that case, the court reversed Vice Chancellor Glasscock’s decision that a majority of the Sanchez Energy board of directors was independent in its determination to reject a stockholder’s litigation demand. Among its holdings, reached on de novo review, the court concluded that a director was not independent of the Sanchez Energy chairman, who was also the largest stockholder at the company, where the director and the director’s brother earned a substantial proportion of their income. The court found that a buttress to this economic relationship was a “deeper human friendship . . . that would have the effect of compromising a director’s independence.” The court found the director to have been “close friends with an interested party for a half century.” The court explained, “Close friendships of that duration are likely considered precious by many people, and are rare. People drift apart for many reasons, and when a close relationship endures for that long, a pleading stage inference arises that it is important to the parties.”
The court in Sanchez Energy suggested that close, personal friendships could support an allegation that a director is not independent for excusal of a litigation demand. This holding was limited by the additional economic relationship and the unusually long duration of the friendship. In Sirius XM, however, Chancellor Bouchard encountered a relationship of shorter duration and a primarily economic basis.
In Sirius XM, Chancellor Bouchard addressed a similar fact in the context of the Sirius XM board’s approval of the company’s repurchase of outstanding shares not owned by its majority stockholder Liberty Media (which was, in turn, controlled by 47-percent stockholder John Malone), and found that a director was not independent for demand excusal due to the duration of his relationship with Malone. The chancellor examined the implications of a two-decade relationship “interwoven with John Malone’s various interests” and held that it raised a reasonable doubt as to director Vogel’s independence from Malone. In similar phrasing as the Supreme Court’s in Zynga, the chancellor stated, “Significant to my finding is the reality that in almost all of the professional dealings between Vogel and John Malone, Vogel was subordinate to and, it is reasonable to infer, dependent on maintaining John Malone’s good graces.” (Emphasis added.) The “reality” in this case was “exemplified by the fact that John Malone held significant stakes in many of the companies where Vogel served as a senior executive or a director and, it is alleged, appointed Vogel to the position of CEO or to the board of several companies.”
Relationships lasting multiple decades could undermine the “presumptive independence” of a director in a demand analysis. The court in Sanchez Energy may have been presented with a truly extraordinary friendship of 50 years, but the chancellor in Sirius XM came to a similar holding on the basis of a relationship lasting less than half that duration and on much less personal terms.
The Supreme Court described the tight web of relationships, which might be characterized as an entrepreneurial ecosystem, in Zynga. In Zynga, the Supreme Court found that “Gordon and Doerr are partners at Kleiner Perkins, which controls 9.2% of Zynga’s equity; Kleiner Perkins is also invested in One Kings Lane, a company co-founded by Pincus’s wife; and, Hoffman and Kleiner Perkins are both invested in Shopkick, and Hoffman serves on its board with another Kleiner Perkins partner.” The Supreme Court explained the importance of relationships in this start-up ecosystem: “Of course, the defendants now argue that the relationships among these directors flowed all in one direction and that it is Pincus who is likely beholden to Gordon, Doerr, and Kleiner Perkins for financing. But, the reality is that firms like Kleiner Perkins compete with others to finance talented entrepreneurs like Pincus, and networks arise of repeat players who cut each other into beneficial roles in various situations.” The court further explained, “There is, of course, nothing at all wrong with that. In fact, it is crucial to commerce and most human relations. But, precisely because of the importance of a mutually beneficial ongoing business relationship, it is reasonable to expect that sort of relationship might have a material effect on the parties’ ability to act adversely toward each other.”
The court stated that, although the Zynga directors were sophisticated businesspeople, the “reality” inferred by the court from the entire situation was that their judgment could be clouded by the effects of a decision on their close relationships and future economic prospects. The court stated, “Causing a lawsuit to be brought against another person is no small matter, and is the sort of thing that might plausibly endanger a relationship.”
Zynga has injected the entrepreneurial ecosystem into considerations of director independence, but the concept arose earlier in 2016. In Imperva, the court affirmed Vice Chancellor Parsons’s dismissal of the stockholder’s complaint and did so by an order on the basis of the vice chancellor’s bench ruling. During colloquy at oral argument with plaintiff-appellant’s counsel, however, Chief Justice Strine expressed skepticism regarding a theory of “incest” in the entrepreneurial ecosystem. Greater Pa. Carpenters’ Pension Fund v. Giancarlo, No. 531, 2015 (Del. Mar. 9, 2016) (oral argument) (Imperva Oral Argument) (electronic video recording available at https://livestream.com/DelawareSupremeCourt/events/4944419/videos/114930292). Although comments during oral argument would not carry precedential weight, the fact that they were made by current members of the court and were aligned with the court’s holding to affirm might provide guidance for understanding the current state of Delaware law. The court’s treatment and framing of the issues could also provide some insight into the evolution of the issue. When compared to the court’s decision in Zynga, this shows the narrow margin and factual specificity in the independence analysis.
In Imperva, Shlomo Kramer was described as a “serial entrepreneur and investor who has had unparalleled success founding and backing data security startups.” The other directors (mostly affiliated with venture capital firms) were alleged to be nonindependent with respect to a decision on whether to permit Kramer to take an alleged corporate opportunity that Kramer wanted for himself because of their repeated investments with Kramer. The chief justice and plaintiff-appellant’s counsel then considered the ramifications of a director’s decision to act adversely toward Kramer.
CHIEF JUSTICE STRINE: I understand. . . . You now have incest. Here’s news; business happens because of relationships. That’s not a good or bad thing. It’s actually a good thing. Human beings form networks. It’s good. Silicon Valley is big. By the way, you know how many former CEOs and former entrepreneurs there are in Silicon Valley? How many cases are there in Silicon Valley where someone had an idea for a company and found themselves on the outs and the so-called angel investors have picked a new CEO? . . . So people in the incestuous family, some people get kicked out of the party, right?
MR. WEINBERGER: Right, but for various reasons. So if the question here is whether any of these individuals experience it. But the question; and I believe this comes from this court’s opinion in Beam. Would these individuals experience a detriment, a detriment by acting adversely to Mr. Kramer, and the answer has to be “yes.”
This colloquy is instructive for its further examination of the issues that were later central to the court’s decision in Zynga, including the allegedly “incestuous” relationships and motivations involved in the entrepreneurial ecosystem.
The chief justice and counsel then continued their colloquy by outlining issues that featured prominently in the Zynga opinion and may be expected to factor into Delaware courts’ independence analyses:
MR. WEINBERGER: Krausz is probably the best example. He is the exemplar. He explains precisely how this works. He’s the partner at U.S. Venture Partners, and he explains in his own words. In 2013, Fortune Magazine asked him about an investment he made alongside Kramer in a company started or founded or co-founded by one of Kramer’s co-founders in Imperva, Mr. Boodaei. And the journalist asked him: How did you hear about this investment in Trusteer? This is a company sold in 2013 to IBM for over $700 million dollars. And Krausz explains it. He says, well, we were investors in Check Point; that’s Kramer’s first startup. He says we invested in Imperva, next Kramer startup. And then he says and I’m quoting, “I’m still on the board of Imperva with Shlomo Kramer. And another Imperva co-founder is Mickey Boodaei who co-founded Trusteer, so I knew both of them.” And then skipping ahead one line to his next quote, “So Shlomo invested in Trusteer’s Series A, and we came in on the Series B as the company’s only BC investor.” So, in other words, because Krausz knows Kramer, has invested in his company, sits on the Imperva board with him, has a strong professional relationship with him, is in this inner ring, he was able to get in on yet another successful investment related to the serial entrepreneur and angel investor, Shlomo Kramer. And that’s the value of the relationship with Kramer, rather. That is why a venture capitalist or a Venture Capital Firm that makes many, many investments, many, if not most, of which will be written off and seeks these outside returns cannot make an objective business decision with respect to Mr. Kramer.
CHIEF JUSTICE STRINE: I get it. So it tends on—you’re saying that periodically their sense is they pay off Kramer by doing unfair things. And that they realize that, overall, they’ve got to just sort of take one for the team and that’s why they’re different than other investors? Because the other thing would be, they invest with Kramer because they think he was a good fiduciary and he runs good businesses. They want to get money out of their investments. They would stop investing with Kramer if he was, you know, not treating them or other investors well. They have a lot of money at stake. What you’re now turning it into is if somebody—if a business person establishes credibility in raising companies then the people who give their equity capital to those ventures, even without any other connection, the fact that they’ve done it more than once renders them, instead of good monitors, because they have a deep equity investment, non-independent?
MR. WEINBERGER: But it’s not just once or twice.
CHIEF JUSTICE STRINE: I understand. . . . You now have incest. Here’s news; business happens because of relationships. That’s not a good or bad thing. It’s actually a good thing. Human beings form networks. It’s good. Silicon Valley is big. By the way, you know how many former CEOs and former entrepreneurs there are in Silicon Valley? . . .
MR. WEINBERGER: . . . Krausz can’t call up his broker and say, “I really like the management of this team, this management team at the company, buy me in on the Series B.” These are private investments. There are very limited opportunities. This is a specific space within this incestuous Silicon Valley and venture capital community, and I don’t mean to keep using the word incestuous, but it’s critical, and context is critical, Your Honor. . . . But just to get back to the thickness of the relationship with Mr. Kramer because these relationships, they absolutely have to be substantial. Just making one or two investments, that doesn’t destroy the director’s impartiality. So we look at the individual circumstances of these people. The people who are venture capitalists, work for venture capital firms, the nature of their business. What is the nature of their business? They’re making the highest-risk investments in pursuit of the highest returns. And these opportunities are very limited. These are private companies. And we allege in the complaint that the opportunities are even fewer now since there’s so much capital. And then you look at Mr. Kramer. What does he provide to these people? He is in this inner ring. He has the access to the best investment. He provides the access, as Mr. Krausz explains. He explains what the value of, as Mr. Kramer says about Ms. Gouw, being his collaborator is. His go-to investor for security is. A member of his team is. And he has the Midas touch. I mean they’re investing in companies, startups, unproven, unknowns. Kramer is the known. So are those facts alone—do those facts alone establish materiality? No. But you look at the repeated pattern of these investors or their firms again and again and again investing in or alongside Mr. Kramer. And we have well-pleaded allegations that these firms have made money in the past with them, at the pleading stage. And we allege stockholdings with Imperva. We allege prices at which these firms would have sold their shares in the company, but at the pleading stage. If you get on the ground floor of a startup investment that ends up hitting it big, becoming a public company, the reasonable inference is that the firm did very well.
CHIEF JUSTICE STRINE: And then the reasonable inference later on, the default position is, because somebody you invested with was a good fiduciary and business person, that when you invest your money substantially in the future and you take on the position as a fiduciary yourself, you will sell out your trust and your own equity position in order to periodically make unfair payments to him so you can take the good with the bad? . . . You get to a specific transaction. Shlomo Kramer wants to do something. He’s been a good guy in the past, made us a lot of money as equity investors. We now have to take it. . . . We got to give Shlomo what he wants now because in the future he’ll be good to us again. This is the periodic bribe for the price of being on the Shlomo team. That’s your theory, right?
The court’s decision to affirm on the basis of Vice Chancellor Parsons’s decision without its own commentary suggests that the court did not agree with plaintiff-appellant’s “theory.” It is also worth placing this finding in the context of the court’s decision: even if the court had held that director Krauz was not independent, the vice chancellor’s decision would not necessarily be reversed because a majority of the Imperva board of directors was independent.
In Imperva, the stockholder-plaintiff also pointed at a specific form of evidence that allegedly demonstrated one director’s entanglement in the entrepreneurial ecosystem. The plaintiff asserted that the website of a director’s new business, showing her with Kramer, was evidence of a repeat-player network that undermined her independence for demand excusal. That director’s website included an endorsement from Kramer which read, “The instant we . . . partnered with [Gouw] as one of our first investors, I knew I had a collaborator I wanted on my team long term. She has a very deep understanding of data security. She gets how mobile and cloud are transforming our business and offers incisive, measured advice to help us make smart moves. We . . . are thrilled she continues to be on our board after our IPO. She is our go to investor for security.” Imperva Chancery Decision at 30. Plaintiff’s counsel argued to the Supreme Court:
MR. WEINBERGER: Look at someone like Gouw who runs a brand-new firm—a brand-new firm that she started in 2014. The very first investment she is on, the very first Series A her firm Aspect Ventures makes, is with Kramer. And Kramer is on her website saying this person is my collaborator. She is my go-to investor for security. She’s a member of my team long term. You know, Kramer is an obscure figure. I’m sure, to us. Certainly is to me. I don’t invest in data security. But if you’re—so let’s take an analogy, but keeping with Venture Capital. Someone like Ms. Gouw, say she’s not operating a data security. She is operating in social media. And Mark Zuckerberg is quoted on her website saying, this person is my collaborator. She’s my go-to investor. She’s a member of my team long term. What more valuable endorsement could a person in that space have? That is communicating to investors the next Facebook. This firm’s in on it. My new firm, we have access to that. We have access to this resource. If you’re an entrepreneur, invest with me. Mark Zuckerberg is going to be part of the network. And that’s what this endorsement from Kramer communicates to potential investors and Aspect Ventures of this new firm, entrepreneurs who are potentially looking to invest with Ms. Gouw and her venture capital firm. Can she make an objective business decision to act contrary to his interest in the specific context? And the answer, we would submit, is “no.”
Imperva Oral Argument at 17:46 (emphasis added).
This argument arose at the end of the plaintiff-appellant’s colloquy with the court and did not receive a direct response from the court. The chief justice’s earlier skepticism and the court’s order affirming on the basis of the vice chancellor’s decision suggest, however, that the court did not view this director’s advertisement of herself as a “member of [Kramer’s] team long term” as evidence of her lack of independence.
When Vice Chancellor Parsons considered this point in the Imperva Chancery Decision, it also failed to find traction regarding the director’s independence. The vice chancellor held (and the Supreme Court affirmed) that the allegation regarding the website endorsement was conclusory, describing the allegations that director (Gouw) lacked independence from Kramer “because aggressively pursuing plaintiff’s claims would jeopardize her chance to participate in what could be Kramer’s next multi-billion-dollar deal relating to a securities start-up. In other words, Gouw’s preferred position in Kramer’s inner circle is extremely valuable.” The vice chancellor held, “On its face, this endorsement of Gouw highlights her professional relationship with Imperva as an expert investor and director, rather than a close personal relationship between Gouw and Kramer, as evidenced by the repeated use of first-person plural pronouns ‘we’ and ‘our.’ In other words, Gouw’s use of the endorsement on her website is meant to communicate to other entrepreneurs her professional strength as an investor in and director of data security start-ups.” On this basis and the further finding “that other entities like Trulia and athenahealth have recognized Gouw’s business acumen and talent also counsels against giving too much importance to Kramer’s endorsement,” Vice Chancellor Parsons found that the plaintiff had not demonstrated Gouw to have lacked independence.
In Sirius XM, however, Chancellor Bouchard addressed a similar fact in the context of the Sirius XM board’s approval of the company’s repurchase of outstanding shares not owned by its majority stockholder Liberty Media (which was, in turn, controlled by 47-percent stockholder John Malone), and found that the director was not independent for demand excusal. The chancellor considered whether Mooney could not be independent from John Malone because Mooney “now runs a consulting business, the success of which is dependent upon his good relationships with his former business partners.” As in Imperva, director Mooney was alleged to have a website advertising “his demonstrated comprehensive winning corporate strategies for companies including Virgin Media and Sirius XM” and that the consulting company “is currently Mooney’s only employer (and therefore chief source of income).” Chancellor Bouchard held, “Being conscious of the significant influence John Malone wields in the media industry and drawing all reasonable inferences in plaintiff’s favor, I find that plaintiff has satisfied that standard as to Mooney’s independence based on the factual allegations I’ve discussed.”
Although it will be a close, fact-specific decision in each case, an Internet advertisement of repeat-players, such as Shlomo Kramer or John Malone, may be construed—at least under pleading-stage standards of review—as a sign of membership in a network that comes with line-cutting privileges for “beneficial roles in various situations.” Directors and counsel should be aware that these images are not merely a framed photograph intended to impress clients when they visit a private office space, but a public presentation, and that they are searchable and discoverable by clients as well as plaintiffs and their counsel.
Chancellor Bouchard’s comments regarding Sirius XM directors’ relationships with Malone and the Zynga court’s view on the entrepreneurial ecosystem show a similar focus on the “reality” of those relationships. That broadly contextual approach may suggest that the Delaware judiciary will view allegations as couched in relevant business norms and industry practices, which is shorthanded as “reality.” The uniqueness of this “reality” in the entrepreneurial ecosystem may also have driven the analysis of Zynga director independence. However, the overlap between Malone’s conglomerate businesses and the entrepreneurial ecosystem are not exact, and the similarities to more typical businesses that depend on networks and diversification could suggest a broader application of Zynga going forward. Because personal friendships and overlapping business relationships are relatively common themes, however, corporate practitioners should be cognizant of the Delaware judiciary’s focus on these connections and the fact-driven “reality” of directors’ independence outside of the entrepreneurial ecosystem.
On a more granular level, directors and their counsel should be cognizant of the tangible evidence of these connections that may be produced in litigation. As visible manifestations of a relationship, a shared airplane or web-based endorsement may carry outsized evidentiary weight comparable to meaningful intangibles, such as several decades of close friendship or a career’s worth of economic sustenance. In that regard, the Zynga court made clear that its decision—like most litigation involving analysis of director independence—was factually specific and a “close call.” When read along with Imperva, we can see that the law in this area is evolving slowly and has not disturbed the central tenet of Delaware law, which ensures deference to board decisions made by a clearly independent majority of directors.