Mark Zuckerberg wants Facebook to create a Class C of stock (a third class class in the capitalization structure) with non-voting rights so that he can sell billions of dollars worth of FB stock in the coming years so that he can maintain the 60% voting power in Facebook that will effectively allow him to personally keep control of Facebook even while gradually draining his equity investment in the social media corporation.
Facebook shareholders Eric McGinty and Eric Levy separately launched class action lawsuits two days after the April 27th Class C stock announcement alleging that Zuckerberg and the Facebook Board of Directors violated their fiduciary duty of loyalty to the shareholders by engaging in a conflict of interest transaction that gives Zuckerberg the benefit of entrenchment without giving the adversely affected voting rights of the remaining shareholders the benefit of a bargain. The reason why it is a class action lawsuit instead of a derivative claim is because derivative claims apply to injuries against the corporation and class actions apply when it is a minority of shareholders within the corporation that are adversely affected.
Anytime there is an interested fiduciary like Zuckerberg engaging in a controlling shareholder type of transaction, we have to ask ourselves the question: What’s the standard of review going to be? This is important to figure out because it often pre-ordains the outcome.
We have three options:
If Zuckerberg and the Board approve the Class C issuance, and then they include themselves in the vote to approve it, the class C issuance is evaluated in the Delaware courts according to the “entire fairness” test in which Zuckerberg and the Board must prove that this deal is fair for other shareholders. This would be a hard lawsuit for Zuckerberg and the Board to win since there is no indication of hard negotiation before the creation of this Class C stock.
If Zuckerberg create a special committee to approve the Class C stock issuance in the first instance but fail to implement a “majority of the minority” shareholder vote, then there is still an “entire fairness” test except the plaintiffs suing Zuckerberg and the Facebook board will have the burden to show that the transaction wasn’t fair. There is no clear case law in Delaware on this, and it will be a toss-up case of first impression.
If Zuckerberg agreed in writing upfront (before the discussions of Class C stock issuance began) that he would not pursue Class C stock creation unless the disinterested board members voted to approve it and he removed himself from the shareholder vote as well, then the business judgment rule applies. This is highly deferential towards management because you’d have to show a waste of corporate assets to succeed which is nearly impossible, and Zuckerberg and Facebook would prevail in this class action.
So which option did Zuckerberg and the Board choose? They went for door number two. They could have put themselves in a position for this Class C stock to blow up in their face by not creating a special committee of disinterested board members to approve the transaction, but they did that. On the other hand, they could have nearly guaranteed its success by getting Zuckerberg to agree upfront that he would abide by whatever decision a disinterested board vote and an independent shareholder vote reached. He didn’t do the latter.
This means that the class action litigants against Zuckerberg and the Facebook Board will have to show that the Class C stock creation does not pass the entire fairness test, and the case law on this has nothing on point. It’s almost always the Board failing to sanitize the transaction in any way, and then having to prove fair dealing and fair price. But Facebook did a halfway sanitization that shifts the burden, but doesn’t get business judgment rule protection. Here, the Facebook class action litigants have to show that there wasn’t fair dealing and fair price, and there is no clear case law showing how to do that. Hopefully, they won’t settle with the Facebook Board and Zuckerberg, as this has the makings of being one of the top five corporation lawsuits of the past thirty years. Or, the shareholders could follow Nancy Reagan’s advice and “just say no” at the June 20th vote, and this issue would become moot.