Like Delaware, the Third Circuit Will Now Apply De Novo Review to Demand-Futility Decisions

At a Glance

• With In re Cognizant Technology Solutions Corp. Derivative Litig., the Third Circuit adopted de novo review for district courts’ demand-futility rulings.
• Although the applicable standard of review in federal court is an issue of federal law, the Third Circuit found it important to be cognizant (no pun intended) of Delaware law (where most public companies are incorporated) so as to minimize any anomalies resulting from separate federal and state demand requirements.
• After reviewing the plaintiffs’ allegations de novo, the Third Circuit affirmed the district court’s finding that the plaintiffs failed to establish demand futility because the majority of the director defendants did not: (1) receive a material personal benefit from the alleged misconduct; (2) face a substantial likelihood of liability on any of the claims at issue; or (3) lack independence from someone who received a material personal benefit from or face substantial likelihood of liability on the alleged misconduct.

Twenty-four years ago, the Delaware Supreme Court clarified that de novo review was the appropriate standard of review for the Court of Chancery’s dismissal of a derivative case for failure to plead demand futility. Brehm v. Eisner, 746 A.2d 244, 253 (Del. 2000). For much of that same period, the Third Circuit, where Delaware sits, has applied abuse-of-discretion review to demand-futility decisions. That changed recently with In re Cognizant Technology Solutions Corp. Derivative Litig., 2024 WL 1947955 (3d Cir. May 3, 2024), where the Third Circuit adopted de novo review for district courts’ demand-futility rulings.

In that case, the plaintiffs, stockholders of nominal defendant Cognizant Technology Solutions Corporation (“Cognizant” or the “Company”), filed derivative claims in the U.S. District Court for the District of New Jersey, alleging that Cognizant’s directors and officers breached their fiduciary duties and engaged in corporate waste. According to the plaintiffs, from 2010 to 2015, Cognizant employees violated the Foreign Corrupt Practices Act of 1977 (FCPA) by paying $6 million in bribes to government officials in India. Meanwhile, Cognizant’s board received updates revealing that Cognizant’s anticorruption controls needed some improvement. For instance, at a November 2015 meeting, Cognizant’s directors learned that the company was working to implement a program that would “ensure that disciplinary actions in India come into closer conformance” with Cognizant’s approach in other countries. In 2015 and 2016, Cognizant published board-approved “Sustainability Reports,” which described its efforts to improve compliance and stated that no incidents of corruption or bribery had been reported in 2014 or 2015. It is unclear when Cognizant’s leadership discovered the India bribery scheme, but in late 2016 and early 2017, Cognizant disclosed the India bribery allegations and notified the DOJ and SEC. While the DOJ opted not to prosecute, the SEC launched an investigation into Cognizant’s compliance with SEC rules and regulations, resulting in a $25 million fine and $60 million in investigative costs.

The plaintiffs alleged that since 2014, Cognizant’s management had been aware of “red flags” in the company’s FCPA compliance program, but ignored those issues and hid them from stockholders. The defendants responded to the operative complaint by moving to dismiss for failure to plead demand futility, and the plaintiffs argued that demand would have been futile because most of the director defendants faced a substantial likelihood of personal liability or lacked independence from other directors, who faced a substantial likelihood of liability.

After finding that the plaintiffs’ complaint lacked the allegations necessary to demonstrate that demand would have been futile, the District of New Jersey granted the defendants’ motion to dismiss. The plaintiffs appealed, and the Third Circuit, sua sponte, requested that the parties brief the applicable standard of review for demand-futility decisions. Ultimately, the Third Circuit adopted de novo review and affirmed the District of New Jersey’s dismissal of the plaintiff’s claims.

Adoption of De Novo Review Explained

The Third Circuit’s first step towards abandoning abuse-of-discretion in favor of de novo review was to acknowledge the clear trend toward de novo review in other courts. After rejecting the notion that any of its decisions are based on the views of other jurisdictions, the Third Circuit conceded that where, as here, other courts largely disapprove of its reasoning, those contrary views will trigger some introspection. In this case, the Third Circuit reconsidered the appropriate standard of review because in the time since it adopted the abuse-of-discretion standard (see Blasband v. Rales, 971 F.2d 1034 (3d Cir. 1992)), the First, Second, Sixth, Seventh, Eighth and Tenth Circuits all have adopted de novo review of demand-futility decisions. Moreover, two of the out-of-circuit decisions that the Third Circuit relied upon in Blasband are no longer good law, and the Ninth and D.C. Circuits have expressed concerns about abuse-of-discretion review. The Third Circuit further noted that just eight years after the Blasband decision, the Delaware Supreme Court abandoned abuse-of-discretion in favor of de novo review. And although the applicable standard of review in federal court is an issue of federal law, the Third Circuit found it important to be cognizant (no pun intended) of Delaware law (where most public companies are incorporated) so as to minimize any anomalies resulting from separate federal and state demand requirements.

Having explained the basis for reconsidering the abuse-of-discretion standard, the Third Circuit turned to the factors established by the U.S. Supreme Court when deciding whether abuse-of-discretion or de novo review is appropriate. See Pierce v. Underwood, 487 U.S. 552, 559, 563 (1988). Those factors include: (1) whether, “as a matter of the sound administration of justice, one judicial actor is better positioned than another to decide the issue in question”; (2) “[t]he non-amenability of the problem to rule, because of the diffuseness of circumstances, novelty, vagueness, or similar reasons that argue for allowing experience to develop”; (3) “the language and structure of the governing statute” or rule; and (4) whether the decision under review “ordinarily has such substantial consequences” that “one might expect it to be reviewed more intensively.” Id.

The Third Circuit held that each of the factors weighs in favor of a de novo standard of review. First, because demand futility is a pleading issue and the plaintiff’s allegations must be accepted as true, district courts are no better positioned than appellate courts to decide whether demand should be excused as futile. In fact, just like district courts, when appellate courts confront the dismissal of an action, the court reads the facts alleged in the complaint, assumes the truth of those facts, and decides whether those facts state a claim under the applicable legal standard.

Second, the Third Circuit found that demand futility is amenable to general rules that cover a wide range of circumstances, which makes de novo review appropriate. Third, neither Rule 23.1 nor analogous state law indicates a preference for the trial court’s decision or assessments on this issue such that an abuse-of-discretion review would be necessary. Last, demand futility has “substantial consequences” for shareholder cases, both because it is an issue that could end the litigation and it arises frequently. As a result, parties might expect demand futility to be reviewed more intensively than an abuse-of-discretion standard might allow.

The District of New Jersey’s Dismissal of the Plaintiffs’ Lawsuit Is Affirmed

With the opportunity to consider the plaintiffs’ allegations anew, the Third Circuit held that the District of New Jersey was correct to dismiss the relevant lawsuit for failure to establish demand futility.

Delaware, Cognizant’s state of incorporation, applies a three-part test for analyzing demand futility. See United Food & Commercial Workers Union & Participating Food Indus. Employers Tri-State Pension Fund v. Zuckerberg, 262 A.3d 1034, 1059 (Del. 2021). Under that test, demand is futile when the majority of directors who would have considered the demand: (i) received a material personal benefit from the alleged misconduct; (ii) faces a substantial likelihood of liability on any of the claims at issue; or (iii) lacks independence from someone who received a material personal benefit from the alleged misconduct.

First, the plaintiffs do not assert that any director or officer received a material benefit from the bribery scheme or the board’s purported failure to disclose it. As to the second prong of the Zuckerberg test, Cognizant’s certificate of incorporation waives duty of care claims against directors, and the duty of disclosure is not an independent duty; therefore, the plaintiffs could not establish a substantial likelihood of liability unless the director defendants breached their duty of loyalty or engaged in corporate waste. In an effort to satisfy that requirement, the plaintiffs assert that the director defendants breached their fiduciary duty of loyalty by informing stockholders that Cognizant did not have any incidents of corruption in 2014 or 2015 — all the while certain of the Company’s employees actively engaged in a bribery scheme. Those allegations were insufficient to establish that the majority of the demand board had a substantial likelihood of liability because the allegedly false and misleading assurances were part of routine securities filings and were not associated with a request for stockholder action; and because of that, the plaintiffs could not establish a claim for breach of the duty of loyalty without demonstrating that the director defendants knowingly disclosed false information to stockholders. The operative pleading lacks any such allegations.

The plaintiffs, however, argue that the complaint’s allegations satisfied the knowledge requirement because when the director defendants made assurances to stockholders, they knew of deficiencies in Cognizant’s compliance program. The Third Circuit disagreed, finding that awareness of compliance failures is not the same as knowing that Cognizant’s officers and employees paid bribes to foreign government officials. And none of the complaint’s allegations demonstrate that the director defendants knew about, sought to avoid knowledge about, or otherwise should have known about the bribery scheme. As a result, there is no basis to conclude that the director defendants faced substantial likelihood of liability for breach of the duty of loyalty.

The plaintiffs also failed to demonstrate that the director defendants face a substantial likelihood of liability on the corporate waste claim. A claim of corporate waste requires particularized facts that an exchange was “so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.” In re Qualcomm Inc. FCPA Stockholder Derivative Litig., 2017 WL 2608723, at *5 (Del. Ch. June 16, 2017). Establishing such a claim is an onerous burden that cannot be met without factual allegations sufficient to establish that a corporation’s directors irrationally squander or give away corporate assets.

In this case, the plaintiffs asserted that the director defendants paid themselves and the officer defendants millions of dollars in fees, compensation and benefits while they were violating their fiduciary duties. Missing, however, are facts sufficient to conclude that the defendants performed no work and added zero benefit to Cognizant during the relevant period. Without such allegations, the plaintiffs have not plausibly alleged that the director defendants squandered corporate assets in a manner sufficient to expose them to substantial likelihood of liability for engaging in corporate waste.

Having failed to satisfy the first two prongs of the Zuckerberg test, the Third Circuit noted that the plaintiffs’ only hope for establishing demand futility is to show that six directors on Cognizant’s eleven-member board exercised insufficient independence from other directors who faced a substantial risk of liability on the asserted claims. Here, too, the plaintiffs fall short because they allege that only three directors lack independence. Even if the appeals court were to accept the plaintiffs’ assertion that three directors lack independence, the plaintiffs still fall well short of the six they need to demonstrate that the majority of the board lacks independence.

After reviewing the plaintiffs’ allegations de novo, the Third Circuit affirmed the district court’s finding that the plaintiffs failed to establish demand futility because the majority of the director defendants did not: (1) receive a material personal benefit from the alleged misconduct; (2) face a substantial likelihood of liability on any of the claims at issue; or (3) lack independence from someone who received a material personal benefit from or face substantial likelihood of liability on the alleged misconduct. On that basis, the district court was correct to dismiss the plaintiffs’ complaint.