On November 14, 2014, the Delaware Court of Chancery rejected a motion brought by the board of directors of Zynga Inc. to dismiss a claim alleging it had breached its fiduciary duties by permitting certain stockholders, including half the board, to sell their pre-IPO stock before other stockholders could (Lee v. Pincus, C.A. No. 8458-CB, (Del. Ch. Nov. 14, 2014)). The claim alleges that the board breached its duty of loyalty by waiving certain lock-up agreements and allowing four of the board's eight directors to sell their stock before their lock-ups' initial expiration date. The Court held that the claim was direct in nature, not derivative, and that it implicated the entire fairness standard of review. The Court concluded, for purposes of a motion to dismiss, that it was reasonably conceivable that when the board restructured the lock-up restrictions, half of the directors who approved that decision received an unfair benefit. At the same time, the Court granted a motion to dismiss brought by the underwriters of Zynga's IPO, finding that they had not aided and abetted the board's alleged breach.

Zynga, the maker of online games for social media platforms, completed its initial public offering on December 16, 2011. The IPO consisted of a sale of 100 million shares of Class A common stock at an offering price of $10 per share, for an offering size of exactly $1 billion. For a full summary of the terms of the offering, see What's Market, Zynga Inc. IPO.

As part of the IPO terms, most of Zynga's pre-IPO stockholders, as well as its directors, officers and employees who held Zynga stock, agreed to lock-up agreements that collectively restricted 688 million shares from being sold for 165 days, until after May 28, 2012. Any waiver or amendment of a lock-up was subject to the consent of Morgan Stanley & Co. LLC and Goldman, Sachs & Co., the lead underwriters of Zynga's IPO.

In March 2012, Zynga's directors decided to modify the lock-up restrictions to permit certain pre-IPO stockholders to sell some of their shares before the original lock-up expiration date while extending the lock-up on the rest of their shares past that date. In particular, the lock-up modification created staggered lock-up expiration dates along four lines:

The purpose of staggering the expiration dates was to make more stock available to the public gradually, rather than flood the market all at once with vastly more shares than had been previously available, which could sink the stock price. Morgan Stanley and Goldman Sachs consented to the lock-up modifications.

On April 3, 2012, the secondary offering of the first tranche of 49 million shares closed, at a price of $12 per share. The four directors whose lock-ups were modified each sold shares in the offering, with the company founder, director defendant Mark Pincus, selling 16.5 million shares for net proceeds of more than $192 million. Morgan Stanley and Goldman Sachs acted as lead underwriters in the offering, and each received more than $5.3 million in fees and commissions.

After the secondary offering, Zynga's stock price began to drop precipitously. By the time of the initial lock-up expiration date, which freed up 325 million shares for sale, the price had dropped to $6.09 per share. Had the four Zynga directors who sold stock in the secondary offering at $12.00 per share instead sold those shares on May 29 at $6.09 per share, they would have received approximately $100 million less in proceeds. The stock price continued to drop beyond that date, falling to $5.36 per share on July 6, 2012, and $3.00 per share on August 16, 2012.

The Court rejected the director defendants' motion to dismiss, finding that the claim was direct in nature, that it appropriately alleged a breach of fiduciary duty, and that the board's decisions were reviewable for entire fairness. The Court granted the underwriter defendants' motion to dismiss.

The particulars of the decision to allow the loyalty claim to proceed against the directors of Zynga do not, from a corporate law perspective, break much new ground. The holdings that the plaintiff's claim is direct, based on fiduciary duty principles and reviewable for entire fairness flow easily from the facts of the case. However, for practitioners who practice securities law more often than corporate law, the decision serves as a useful reminder that board decisions made in the context of securities offerings implicate state corporate law in addition to the federal securities laws. Issuer's counsel must have fiduciary-duty issues as a front-of-mind consideration and consider whether a decision that will benefit directors or a controlling stockholder without conferring the same benefit on the other stockholders will constitute a breach of the duty of loyalty.

The Zynga decision also serves as reminder that the presumptions of the business judgment rule are lost if half or more of the directors are interested in the underlying board action. Stated from the opposite angle, the board of Zynga could have won dismissal of the suit if only three of the board's eight directors had benefitted from the lock-up restructuring, rather than four. Although there may be room to question why a board should be considered free of the specter of conflict if a majority of its members are disinterested and independent even as the conflicted members take part in the board's decision-making, this principle is firmly rooted in Delaware common law.

The decision to dismiss the claim against the underwriters is also worthy of attention, as a juxtaposition to the Court's recent bench ruling in the Healthways case (see Legal Update, Pontiac GERS v. Ballantine: Chancery Court Declines to Dismiss Claims Against Board and Lenders Based on Loan Agreement Proxy Put). In that ruling, involving an agreement to a "proxy put" provision in a credit agreement, Vice Chancellor Laster declined to dismiss both the underlying claim of breach against the board and the aiding and abetting claim brought against the lender. Vice Chancellor Laster found that it was reasonably conceivable that the lender had knowingly participated in the board's breach by virtue of its negotiation of, and agreement to, the proxy put.

The reason why Healthways and Zynga should have come to opposite conclusions on this point is not readily apparent, and Chancellor Bouchard, the author of the Zynga decision, does not cite Healthways in his discussion of the knowing-participation element of aiding and abetting (even as he did cite a different aspect of Healthways in his decision in Allergan, as discussed in the Legal Update linked above). One possible explanation arises from the emphasis placed in Healthways on the idea that lenders had been put on notice after Amylin and SandRidge that proxy puts raise concerns about fiduciary duties. In Zynga, by contrast, the underwriters had not been similarly alerted to the perils of agreeing to lock-up waivers. This is not the most satisfying explanation, though, as it essentially turns "ignorance of the law" into an excuse for the underwriters.

A better explanation might be found by examining the differences between the provisions that the respective banks agreed to. As Vice Chancellor Laster explained at length in Healthways, the proxy put is problematic because it itself acts as a deterrent against stockholder action. Consequently, when the lender agrees to the proxy put, it directly brings about the deterrent effect. By contrast, a waiver of a lock-up is not necessarily wrongful in and of itself. Rather, the wrongfulness of a waiver depends on the particular circumstances of the offering and how other stockholders, who are subject to unmodified lock-ups, are being treated. These are factors that the board is expected to understand. They are not, however (Chancellor Bouchard appears to hold), within the purview of the underwriters to anticipate, absent facts that prove the underwriters were aware of the effect of their waiver in the particular situation.