In re Fitbit, Inc. Stockholder Derivative Litigation

IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE
IN RE FITBIT, INC. STOCKHOLDER : CONSOLIDATED
DERIVATIVE LITIGATION : C.A. No. 2017-0402-JRS
MEMORANDUM OPINION
Date Submitted: September 6, 2018
Date Decided: December 14, 2018
Peter B. Andrews, Esquire, Craig J. Springer, Esquire and David M. Sborz, Esquire
of Andrews & Springer LLC, Wilmington, Delaware; Jessica Zeldin, Esquire of
Rosenthal, Monhait & Goddess, P.A., Wilmington, Delaware; Melinda A.
Nicholson, Esquire and Michael R. Robinson, Esquire of Kahn Swick & Foti, LLC,
Madisonville, Louisiana; Robert C. Schubert, Esquire of Schubert Jonckheer &
Kolbe LLP, San Francisco, California; and Edward F. Haber, Esquire of Shapiro
Haber & Urmy LLP, Boston, Massachusetts, Attorneys for Plaintiffs.
Elena C. Norman, Esquire of Young Conaway Stargatt & Taylor, LLP, Wilmington,
Delaware and Jordan Eth, Esquire, Anna Erickson White, Esquire and Ryan M.
Keats, Esquire of Morrison & Foerster LLP, San Francisco, California, Attorneys
for Defendants James Park, Eric N. Friedman, Jonathan D. Callaghan, Steven
Murray, Christopher Paisley, William R. Zerella, and Nominal Defendant Fitbit, Inc.
SLIGHTS, Vice Chancellor
In this derivative action, stockholders of Fitbit, Inc. (or the “Company”) allege
that certain members of the Company’s Board of Directors (the “Board”) and the
chief financial officer breached their fiduciary duties by using insider knowledge of
a faulty product to profit personally from the Company’s stock issuances. Plaintiffs
seek to recover on behalf of the Company the profits realized by the fiduciaries as a
result of their breaches.
The alleged insider knowledge concerns the accuracy of Fitbit’s
“PurePulse™” technology. PurePulse™ was designed to allow Fitbit devices to
calculate and record a user’s real-time heart rate with superior accuracy. Fitbit hailed
the technology as best in class. Indeed, PurePulse™ was meant to differentiate Fitbit
from its competitors and soon accounted for almost 80% of the Company’s revenue.
According to Plaintiffs, however, PurePulse™ was not what it was cracked up to be.
As Fitbit touted the promise of its new technology, behind the scenes, PurePulse™
consistently failed accuracy tests and caused “paranoia” among Fitbit management.
Amidst this paranoia, it is alleged that members of the Board manipulated
Fitbit’s June 18, 2015 initial public offering (the “IPO”) and its November 13, 2015
secondary offering (the “Secondary Offering”) (together with the IPO, the
“Offerings”) to prop up active trading notwithstanding PurePulse’s failures. The
Board first structured the IPO to permit insiders to sell an unusually large percentage
of the stock being offered to the market. Then, just a few months later, in advance
1
of the Secondary Offering, the Board voted to waive “lock-up” agreements that were
intended to prevent insiders from selling more shares for a period after the IPO.
Without the waivers, insiders would have been restricted from transferring shares
until March 2016, when the stock traded at a significantly lower price compared to
the prevailing price at the time of the Secondary Offering.
Plaintiffs allege that six Fitbit fiduciaries breached their duty of loyalty by
structuring the Offerings to favor insiders, and that five of the fiduciaries violated
Delaware law by profiting directly from the Offerings based on insider knowledge.
Defendants have moved to dismiss under Court of Chancery Rule 23.1 for failure,
without excuse, to make a pre-suit demand upon the Board, and Court of Chancery
Rule 12(b)(6) for failure to state a claim upon which relief may be granted.
In this Memorandum Opinion, I conclude that Plaintiffs have pled
particularized facts that raise a reasonable doubt that a majority of the Board could
impartially consider Plaintiffs’ insider trading and breach of fiduciary duty claims
and that Plaintiffs have stated viable claims.1 Accordingly, the Motion to Dismiss
must be denied.2
1
Given these findings, I deny as moot Plaintiffs’ Motion to Strike (D.I. 31) the 25 self-
selected exhibits spanning over 650 pages that were appended to the Motion to Dismiss.
2
To be clear, and this must be emphasized given the serious nature of these claims, I have
found that Plaintiffs have alleged facts that are adequate to survive dismissal given the
liberal pleading stage inferences to which they are entitled. Whether they can prove these
facts very much remains to be seen.
2
I. BACKGROUND
I draw the facts from the allegations in the Verified Second Amended
Consolidated Stockholder Derivative Complaint (the “SAC”), documents
incorporated by reference or integral to that pleading and judicially noticeable facts.3
In resolving the Motion to Dismiss, I have accepted as true the SAC’s well-pled
factual allegations and have drawn all reasonable inferences in Plaintiffs’ favor.
A. The Parties and Relevant Non-Parties
Plaintiffs, Anne Bernstein, Michael Hackett and Bright Agyapong, are current
holders of Fitbit common stock. Bernstein and Agyapong have owned Fitbit shares
continuously since before the closing of the IPO and Hackett has owned shares
continuously since before the Secondary Offering.4
3
See Wal-Mart Stores, Inc. v. AIG Life Ins. Co., 860 A.2d 312, 320 (Del. 2004) (holding
that on a motion to dismiss, the Court may consider documents that are “incorporated by
reference” or “integral” to the complaint (quoting In re Santa Fe Pac. Corp. S’holder Litig.,
669 A.2d 59, 69 (Del. 1995)); D.R.E. 201–02 (codifying Delaware’s judicial notice
doctrine). See also Amalgamated Bank v. Yahoo! Inc., 132 A.3d 752, 797 (Del. Ch. 2016)
(holding that where, as here, the nominal defendant has produced documents in response
to a demand for books and records under 8 Del. C. § 220 on the condition that such
documents be deemed incorporated by reference in any complaint that might later be filed,
it is appropriate for the Court to consider the documents in their entirety as opposed to only
the portions “cherry-picked” by the plaintiff).
4
Defendants argue that, contrary to the pled facts, none of the Plaintiffs have been
stockholders “since prior to the closing of the IPO” (SAC ¶ 22) and, therefore, none of
them have standing to prosecute these derivative claims. I decline to address this argument
at the pleading stage as it implicates a fact-intensive inquiry that extends beyond the
allegations in the SAC or properly considered evidence. With that said, standing is a
predicate to the Court’s exercise of subject matter jurisdiction and must be addressed as a
“threshold issue.” El Paso Pipeline GP Co. LLC v. Brinckerhoff, 152 A.3d 1248, 1256
3
Nominal defendant, Fitbit, is a Delaware corporation founded in 2007 that
produces wearable devices that monitor health and wellness for consumers.5 The
most well-known of these devices, and the ones relevant here, are Fitbit’s fitness
wrist bands.
The “Director Defendants,” as described below, are those Board members
who Plaintiffs allege structured the Offerings to benefit Fitbit insiders and voted to
waive the lock-up agreements that permitted Fitbit insiders prematurely to sell stock
in the Secondary Offering. The “Selling Defendants” are those Director Defendants
and the Company’s chief financial officer who Plaintiffs allege personally profited
from their inside knowledge of PurePulse’s flaws by participating in the Offerings
when the market was unaware of this information.
1. Director Defendants
Defendant, James Park, is a co-founder of Fitbit and has been its CEO and
President since September 2007.6 Park has served as a member of the Board since
(Del. 2016). Accordingly, before the parties commence merits discovery, they shall first
engage in limited “standing discovery” to address the discrepancies in Plaintiffs’ stock
ownership. Upon completion of that discovery, the Court will revisit the standing issue
and adjudicate it as “a question of law.” Id. See also Stratton v. American Ind. Ins. Co.,
2010 WL 37006617, at *8 (Del. Super. Ct. Sept. 16, 2010) (ordering “limited discovery”
on the standing issue when the facts as pled in plaintiff’s complaint to establish standing
were denied by the defendants).
5
SAC ¶¶ 23, 32.
6
SAC ¶ 24.
4
March 2007 and as its Chairman since May 2015.7 Between the IPO and Secondary
Offering, Park sold more than 3.3 million shares of Fitbit stock for more than
$83 million.8 He is, therefore, a Selling Defendant.
Defendant, Eric Friedman, is a co-founder of Fitbit.9 He has been an executive
officer of the Company since September 2007 and is currently its Chief Technology
Officer.10 He has also been a member of the Board since March 2007.11 Between
the IPO and Secondary Offering, Friedman sold over 2.2 million shares of Fitbit
stock for more than $51 million.12 He is, therefore, a Selling Defendant.
Defendant, Jonathan Callaghan, has served as a member of the Board since
September 2008.13 Callaghan is also a founder and managing member of True
Ventures, a venture capital firm that was an early Fitbit investor and has controlled
as much as one third of Fitbit’s total voting power.14 Between June and August
7
Id.
8
Id.
9
SAC ¶ 26.
10
Id.
11
Id.
12
Id.
13
SAC ¶ 27.
14
Id. True Ventures II, L.P., an entity affiliated with True Ventures, is the corporate entity
that holds Fitbit stock and voting power. Id. n.13. True Ventures and its affiliated entities
are collectively referred to as “True Ventures.”
5
2013, True Ventures paid $999,999 for 677,904 shares of Fitbit’s Series D
Convertible Preferred Stock.15 These shares were automatically converted to
Class B shares of the Company in the IPO.16 During the IPO and Secondary
Offering, True Ventures sold over 7.9 million shares of Fitbit stock for more than
$195 million.17 For reasons explained below, Callaghan is a Selling Defendant.
Defendant, Steven Murray, has served as a member of the Board since June
2013.18 He is a partner at SoftBank Capital, a venture capital firm, where he has
worked since 1996.19 Between June and August 2013, SoftBank paid $15 million
for 10,168,572 shares of Fitbit’s Series D Convertible Preferred Stock.20 These
shares were automatically converted to Class B shares of the Company in the IPO.21
During the IPO and Secondary Offering, SoftBank sold over 2 million shares of
15
SAC ¶ 27.
16
Id.
17
Id.
18
SAC ¶ 28.
19
Id. SoftBank PrinceVille Investments, L.P., an entity affiliated with SoftBank Capital,
is the corporate entity that holds Fitbit stock and voting power. Id. n.14. SoftBank Capital
and its affiliated entities are collectively referred to as “SoftBank.”
20
SAC ¶ 28.
21
Id.
6
Fitbit stock for more than $49 million.22 For reasons explained below, Murray is a
Selling Defendant.
Defendant, Christopher Paisley, has served as a member of the Board since
January 2015.23 He did not sell Fitbit stock during the Offerings and is not, therefore,
a Selling Defendant.24
2. The CFO
Defendant, William Zerella, has served as Fitbit’s CFO since June 2014.25 In
connection with the Secondary Offering, Zerella sold 216,000 shares of the
Company’s stock for more than $6 million.26 He is, therefore, a Selling Defendant.
3. Individual Non-Defendant Directors
Brad Feld was a member of the Board from August 2010 until May 2015.27
Although he had left the Board at the time of the IPO, Plaintiffs allege that Feld
participated in Board discussions regarding the IPO in advance of the offering and
continued to attend Board meetings after he left the Board.28 Feld is a managing
22
Id.
23
SAC ¶ 29.
24
Id.
25
SAC ¶ 25.
26
Id.
27
SAC ¶ 30.
28
Id.
7
member of the Foundry Group Funds.29 At the time of the Offerings, the Foundry
Group Funds held between 26% and 27% of Fitbit’s voting power.30 Neither Feld
nor the Foundry Group Funds are named as defendants.
Laura Alber and Glenda Flanagan joined the Board after the Offerings.31
While not named as defendants, they were members of the Board at the time this
action was filed and are relevant, therefore, to the demand futility analysis.32
B. Fitbit’s PurePulse™ Technology
In September 2012, Fitbit released the Fitbit One™ and Fitbit Zip™ as its first
activity trackers that synched wirelessly to smartphones.33 The Fitbit Flex™—
Fitbit’s first wrist-based device—launched in May 2013 and incorporated an LED
display of specific user data.34 Although these second-generation products tracked
more health and wellness data categories than the original “Fitbit™” devices, none
measured heart rate activity.35 In October 2013, the Company launched the Fitbit
29
Id.
30
Id.
31
SAC ¶ 31.
32
Id.
33
SAC ¶ 36.
34
SAC ¶ 37.
35
Pls.’ Corrected Answering Br. in Opp’n to Defs.’ Mots. to Dismiss (“PAB”) 6 (D.I. 33).
8
Force®, which added new features to the Flex™.36 The Force® was a “lemon,”
however, that ultimately prompted lawsuits and a product recall after widespread
complaints of skin irritation.37 In the wake of the Force® fiasco, Fitbit was left with
an inventory of dated and unmarketable products.38 It was in need of an innovative
device that would drive sales and continue growth.39
In October 2014, Fitbit announced its development of PurePulse™, a wrist-
based heart rate monitoring technology.40 A launch of two devices featuring the
technology, the Charge HR™ and the Surge™, followed soon after.41 The
incorporation of heart rate data allowed Fitbit to market important health metrics and
to raise the price of the products containing PurePulse™ technology.42 Indeed, the
price of the Charge HR™ was half again the price of essentially the same device
without PurePulse™.43
36
SAC ¶ 39.
37
Id.
38
Id.
39
Id.
40
SAC ¶ 40.
41
SAC ¶ 41.
42
SAC ¶¶ 43, 45.
43
SAC ¶ 45.
9
Fitbit implemented an aggressive marketing campaign featuring its heart rate
tracking technology leading up to the IPO.44 For instance, a Fitbit press release
issued on October 27, 2014, claimed that PurePulse™ “‘provides continuous and
automatic wrist-based heart rate tracking, without an uncomfortable chest strap . . .
and applies Fitbit’s finely tuned algorithms to deliver heart rate tracking 24/7.’”45
Fitbit’s advertising campaign in late 2014–2015 also proclaimed the efficacy—and
significance—of PurePulse™ technology with slogans like: “The Difference
Between Good and Great . . . Is Heart”; “For Better Fitness, Start with Heart”; “Get
More Benefits with Every Beat—Without an Uncomfortable Chest Strap”; “Every
Beat Counts”; and “Know Your Heart.”46 On February 12, 2015, Fitbit’s website
featured a blog post from an ultra-marathoner who wrote
[A] heart rate monitor is an invaluable tool for maximizing your
training . . . .
When I’m training, I monitor my heart rate to stay within certain
parameters during certain stages of the run . . . during interval training
I push toward the upper ranges for set intervals of time during speed
bursts.
To make the most out of your ChargeHR or Surge, wear it 24/7 to get
used to watching fluctuations in your heartbeat and correlating those
44
SAC ¶ 47.
45
Id.
46
SAC ¶ 49.
10
with the way you feel. This will give you a more innate understanding
of how your body works . . . .47
What Fitbit did not tout, or even reveal, is that PurePulse™ only worked at low or
resting heart rates.48
C. The Real PurePulse™ Story
The truth, as Plaintiffs allege it, is that PurePulse™ was “wildly inaccurate”;
and only people within Fitbit, including the Selling Defendants, knew it.49 Internal
PurePulse™ testing results for the fifteen months preceding the Secondary Offering
consistently showed that PurePulse™ had accuracy problems that were never
sufficiently addressed.50 As early as September 2014—the month before the
technology was announced—heart rate measuring errors reached as high as 53% in
testing.51 A month later, errors still remained near 35%.52
Fitbit tracked PurePulse’s developing problems and its executives were
updated monthly on these issues through summary presentations.53 An internal
47
SAC ¶ 52.
48
SAC ¶ 50.
49
SAC ¶ 88.
50
SAC ¶ 103.
51
Id.
52
Id.
53
SAC ¶¶ 104–05.
11
presentation, dated January 22, 2015, which was emailed to Friedman, identified
“Heart Rate Sensor Failing” as the most common problem reported by users for
returned devices.54 The presentation also notes, “Sensor testing—[heart rate monitor
(‘HRM’)] continuing investigation possible noise/crosstalk issue,” suggesting that
Fitbit had begun to investigate its heart rate monitoring devices before the end of
January 2015.55 On February 19, 2015, Park and Friedman received an “Executive
Update” dated “January & February 2015.”56 This presentation included charts
summarizing analyses of returned Charge HR™ and Surge™ units.57 For Charge
HR™ devices, “HRM not working” was the most common “symptom/defect.”58
“Data accuracy” was also noted as a common “symptom/defect.”59 For Surge™
devices, “Heart Rate Sensor Failing” was the prevailing defect.60 These same
concerns were reiterated in subsequent presentations emailed to Friedman.61
54
SAC ¶ 105.
55
SAC ¶ 106.
56
SAC ¶ 107.
57
SAC ¶¶ 107–08.
58
SAC ¶ 107.
59
Id.
60
SAC ¶ 108.
61
SAC ¶ 109.
12
Fitbit attempted to develop various technological repairs or enhancements to
address the PurePulse™ flaws.62 In May 2015, Friedman received a presentation
informing him and other Fitbit executives of the Company’s efforts to correct the
heart rate technology.63 Specifically, Fitbit had begun developing a software
algorithm codenamed “Hydra” that could be incorporated into future products to
reduce the misreporting of heart rate data.64 The May 2015 presentation noted that
the “Hydra team” had “previously” presented a laboratory analysis showing
improvements for workout and running modes.65 The presentation also included
charts documenting the results of comparisons between a chest strap monitor and the
version of the Surge™ without Hydra (i.e., the version available for purchase on the
market).66 During running or similarly stressful activities, the Surge™ substantially
underreported heart rates by roughly 10–40 beats per minute.67 During biking, the
Surge™ underreported heart rates by as much as 50 beats per minute.68 During
62
SAC ¶ 110.
63
Id.
64
Id.
65
SAC ¶ 111.
66
SAC ¶ 112.
67
SAC ¶¶ 112–13.
68
SAC ¶ 114.
13
spinning (i.e., stationary bicycling), the Surge™ reported “heart rates . . . almost
unintelligible for the test subject, swinging wildly back and forth from as much as
160 beats per minute to below 100 beats per minute.”69 It is alleged that Friedman
received this presentation just as Fitbit coincidentally was accelerating its efforts to
commence the IPO.70
Despite reports of PurePulse’s inaccuracy, Fitbit and its executives continued
to hold out the technology as the differentiator in the wellness tracker industry. The
Company’s IPO Prospectus, issued on June 18, 2015, repeated positive claims about
the devices’ “highly accurate measurements.”71 Among other things, the Prospectus
lauded that Fitbit is a leader in the industry because its “health and fitness devices
leverage industry-standard technologies . . . as well as proprietary technologies, such
as [its] PurePulse continuous heart rate tracking and [its] algorithms that more
accurately measure and analyze user health and fitness metrics.”72
69
SAC ¶ 115.
70
SAC ¶ 110.
71
SAC ¶¶ 5 n.3, 91.
72
SAC ¶ 66.
14
D. The Fitbit IPO and Lock-up Agreements
Fitbit’s public statements with respect to PurePulse™-equipped devices led to
investor enthusiasm and a strong reception for the IPO.73 It is alleged that, in the
midst of this artificially positive response, Fitbit insiders took advantage of their
confidential knowledge about PurePulse™ to structure the IPO in their favor.74
1. The IPO Structure
The Board structured Fitbit’s IPO to permit Park, Friedman, Callaghan,
Murray and the Foundry Group Funds to provide more than 39% of the
approximately 36.6 million IPO shares.75 And Fitbit fiduciaries, not the Company,
contributed the overallotment of roughly 5.5 million shares.76 Since the
overallotment was fully exercised, the fiduciaries’ shares ultimately came to 47% of
all shares sold in the IPO.77
The Selling Defendants’ plan to unload unusually large blocks of Fitbit stock
began as early as February 27, 2015, when the Board and Zerella held a meeting to
73
SAC ¶ 5.
74
SAC ¶ 2.
75
SAC ¶ 55.
76
Id.
77
Id.
15
discuss the IPO.78 On May 1, 2015, the IPO Pricing Committee (consisting of
Callaghan, Murray and Paisley) determined the number of shares that Park,
Friedman, Callaghan and Murray could sell.79 That same day, the Board designated
Callaghan as its lead independent director.80 Murray and Callaghan’s respective
firms proceeded to collect nearly $75 million through the IPO, with Callaghan’s
True Venture’s share accounting for nearly $60 million.81
As often occurs in an initial public offering process, Fitbit insiders entered
lock-up agreements with Fitbit IPO underwriters that prohibited insiders from selling
Fitbit stock until December 14, 2015—180 days after the IPO.82 Because
December 14, 2015 fell during a “blackout period,” Selling Defendants would have
been prohibited from selling additional Fitbit shares until March 1, 2016, had the
lock-up agreements remained in place.83
78
SAC ¶¶ 54–57.
79
SAC ¶¶ 61, 63.
80
SAC ¶ 62. Plaintiffs allege that this designation is problematic because, on February 17,
2015, Callaghan had resigned from his service on the Audit Committee “due to lack of
independence.” Id.
81
SAC ¶ 63.
82
SAC ¶¶ 70–71.
83
SAC ¶ 143. The “blackout period” prohibits insiders from selling stock during a
designated time around the release of the Company’s quarterly earnings. Id.
16
2. The IPO Sales
On June 17, 2015, the SEC declared effective Fitbit’s IPO Registration
Statement, which incorporated by reference the IPO Prospectus and related IPO
filings.84 As noted, the IPO Prospectus advertised Fitbit’s role as a leader in health
and fitness because of its PurePulse™ technology and “highly accurate” devices.85
The SEC filings also underscored the importance of PurePulse™ devices to Fitbit’s
bottom line, stating that “the Fitbit Charge™, Fitbit Charge HR™, and Fitbit
Surge™ . . . were the primary drivers of our revenue growth in the first quarter of
2015.”86 Notably, concerns regarding the accuracy of the PurePulse™ technology
and Company efforts to correct the problems were nowhere to be found in the IPO
disclosures.87
Fitbit conducted its IPO on June 18, 2015, and sold over 22 million shares at
$20 per share, raising approximately $416 million in proceeds.88 Park, Friedman,
Callaghan and Murray sold about 6.2 million shares for over $115 million.89 The
84
SAC ¶ 65.
85
See SAC ¶¶ 66, 91.
86
SAC ¶ 96.
87
SAC ¶ 68.
88
SAC ¶ 67.
89
SAC ¶ 6.
17
proceeds, as broken down by Selling Defendant, are depicted in the following
chart90:
E. The Fitbit Secondary Offering, Lock-up Waivers and Additional Insider
Stock Sales
In the months that followed the IPO, Fitbit’s now-publicly traded common
stock traded above the $20 IPO price, reaching a high of $51.64 on August 5, 2015.91
The Company continued to herald PurePulse™ technology and to introduce
purported advancements.92 According to Fitbit, the software updates “improve[d]
upon an already positive heart rate tracking offering.”93 Around this time, Park
90
PAB 12. Within the chart, True Ventures-owned Fitbit stock is attributed to Callaghan,
and Softbank-owned Fitbit stock is attributed to Murray. SAC ¶¶ 27–28.
91
SAC ¶ 69.
92
SAC ¶ 86.
93
Id.
18
professed on an earnings call that he had “never been more confident in Fitbit’s
future.”94 Behind the scenes, however, a different story was playing out. On
June 23, 2015, five days after Fitbit’s IPO, Fitbit management circulated an internal
memorandum that included an analysis of ways to improve PurePulse’s accuracy
and noted thousands of customer complaints about heart-rate monitoring.95 The next
month, Friedman received a presentation concerning updates on the status of testing
the Hydra algorithm.96 The presentation described additional challenges in the
research process to improve the PurePulse™ technology, including that “Hydra
workout algorithms are ill-suited to walking and can result in HR [heart rate]
overestimation.”97
At this point, Hydra remained a work in progress and was not ready to be
implemented in new devices.98 A July 20, 2015 executive presentation specifically
highlighted testing results and the poor performance of the PurePulse™ technology
and confirmed that the development of the Hydra algorithm was “ongoing.”99
94
SAC ¶ 89 (citing James Park, Nov. 2, 2015, Fitbit Earnings Call).
95
SAC ¶ 116. Park received the memorandum by email on July 17, 2015. Id.
96
SAC ¶ 117.
97
Id.
98
Id.
99
SAC ¶¶ 12, 118. Plaintiffs allege Friedman and Park reviewed the presentation and
Friedman received the presentation by email on July 19, 2015. SAC ¶ 118.
19
Notably, the communication circulating this presentation expressed pervasive
concern regarding public disclosure of PurePulse’s flaws:
[Friedman] & [Park] instructed us that these slides not be distributed in
any form as a leave behind, whether it be printed, emailed, Dropbox’ed
etc. at the end of the session.
Frankly, I think they’d like you to destroy the slides once the
presentation is over, but I’ve cc’ed [Friedman] so that he can correct
the appropriate level of paranoia if I got it wrong .100
Defendants began planning for the Secondary Offering during a Board
meeting on July 30, 2015, or just over a week after this email was circulated
internally within Fitbit.101 At the meeting, the Board reviewed a presentation from
an advisor in which it was observed that, since 2011, only a “small subgroup” of
companies that had conducted an IPO in Fitbit’s range of success had quickly
thereafter conducted a secondary offering.102
Another presentation emailed to Friedman on October 20, 2015, a few weeks
before the Secondary Offering issued, listed “Improve heart rate accuracy during
exercise” as Fitbit’s first objective for the third quarter.103 The presentation also
detailed continued improvement efforts behind Hydra as well as “Project Tiwi,”
100
SAC ¶ 12 (emphasis omitted) (smiley emoji in original).
101
SAC ¶¶ 73–74.
102
SAC ¶ 73.
103
SAC ¶ 119.
20
which was described as a “hardware” solution to the problem of “heart rate
accuracy.”104
On October 28, 2015, with Morgan Stanley representing the Fitbit IPO
underwriters in attendance, the Board approved the Secondary Offering and a waiver
of the lock-up agreements.105 Fitbit publicly announced the waivers in a Form 8-K
on November 2, 2015,106 and contemporaneously filed a Form S-1 announcing the
Secondary Offering.107 The Form S-1 stated that the Secondary Offering would
include 21 million shares, with the Company offering seven million shares and the
Selling Defendants (along with the Foundry Group Funds) offering the remaining
14 million shares.108 The Selling Defendants also offered the underwriters an option
for an overallotment of 3.15 million shares.109 If the underwriters exercised the
104
Id.
105
SAC ¶¶ 76–77. “[I]n connection with the Public Offering, Morgan Stanley, on behalf
of the Underwriters, has agreed to release certain of the Company’s employees and
contractors (the “Eligible Service Providers”) . . . from the IPO Lock-Up Agreements with
respect to 10% of the aggregate number of shares of Class A Common Stock . . . .”
SAC ¶ 77 (citing Oct. 28, 2015 meeting minutes, Ex. A).
106
SAC ¶ 78.
107
SAC ¶ 79.
108
Id.
109
Id.
21
overallotment option, the Selling Defendants’ shares would account for 71% of the
Secondary Offering.110 The Company did not offer an overallotment option.111
On November 12, 2015, the Board revised the terms of the Secondary
Offering to remove four million shares from what Fitbit intended to sell, thereby
increasing the likelihood that the underwriters would exercise the Selling
Defendants’ overallotment option.112 After these changes, the Selling Defendants
were set to offer roughly 85% of the Secondary Offering shares.113
Fitbit’s Secondary Offering Registration Statement and Prospectus contained
the same descriptions as the IPO filings with respect to Fitbit’s devices and
competitive strengths.114 Nevertheless, as with the Company’s IPO, Defendants
continued to appreciate at the time of the Secondary Offering that Fitbit’s
PurePulse™ technology was flawed.115 In spite of this knowledge, the Board
proceeded with the Secondary Offering on November 18, 2015, and the Selling
Defendants sold 9.62 million shares of Fitbit stock at $28.13 per share for proceeds
110
SAC ¶ 82.
111
SAC ¶ 79.
112
SAC ¶¶ 82–84.
113
SAC ¶ 84.
114
SAC ¶¶ 91–92.
115
SAC ¶ 127.
22
exceeding $270 million.116 The proceeds, as broken down by Selling Defendant, are
depicted in the chart below117:
F. The PurePulse™ Problems Are Revealed
Fitbit’s devices with PurePulse™ technology continued to fail tests, with
results varying by user activity, age, gender and skin color, as late as December
2015.118 On January 5, 2016, the cat was let out of the bag when a consumer class
action was filed, captioned McLellan, et al. v. Fitbit, Inc., 3:16-cv-00036-JD
116
SAC ¶¶ 139–40, 144. The Selling Defendants collected $386 million between the IPO
and the Secondary Offering. SAC ¶ 140.
117
PAB 25. Here again, within the chart, True Ventures-owned Fitbit stock is attributed
to Callaghan, and Softbank-owned Fitbit stock is attributed to Murray. SAC ¶¶ 27–28.
118
SAC ¶ 104.
23
(N.D. Cal. Jan. 5, 2016) (the “Consumer Action”).119 The plaintiffs in that lawsuit
alleged:
Expert analysis has further corroborated the inability of the
PurePulse™ Trackers to perform as promised and warranted. A board-
certified cardiologist tested the PurePulse™ Trackers against an
electrocardiogram (“ECG”), the gold standard of heart rate monitoring,
on a number of subjects at various exercising intensities . . . .
The results were as expected: the PurePulse™ Trackers consistently
misrecorded the heart rates by a significant degree. At intensities over
110 bpm [beats per minute], the Heart Rate Trackers often failed to
record any heart rate at all. And even when they did record heart rates,
the Heart Rate trackers were inaccurate by an average of 24.34 bpm,
with some readings off by as much as 75 bpm. With those margins of
error, the Heart Rate Trackers are effectively worthless as heart rate
monitoring devices.120
On the day the Consumer Action was filed, the intraday high for Fitbit stock was
$30.96.121 Just two days later, the stock hit a low of $20.25—a drop of more than
33%.122 As alleged, the stock devaluation was caused by the unanticipated release
of the truth about PurePulse™: the technology did not work and Fitbit could not fix
it.123
119
SAC ¶¶ 15 n.9, 145.
120
SAC ¶ 145.
121
SAC ¶ 146.
122
Id.
123
SAC ¶ 15.
24
On March 1, 2016, the earliest date the Selling Defendants would have been
able to sell their shares had the lock-up agreements remained in place, Fitbit stock
traded at $12.35 per share.124 At the time the SAC was filed, Fitbit stock traded at
$5.00 per share.125
G. Procedural History
This past summer, Judge James Donato of the Unites States District Court for
the Northern District of California denied Fitbit’s motion to dismiss the Consumer
Action.126 In January 2016, a federal securities class action, captioned Robb v. Fitbit
Inc., et al., 3:16-cv-00151-SI (N.D. Cal. Jan. 11, 2016) (the “Securities Action”),
was also filed, which alleged securities fraud under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934 and Rule 10b-5, and violations of Sections 11 and
15 of the Securities Act of 1933, for issuing materially false or misleading statements
related to IPO sales.127 All Defendants—Park, Friedman, Zerella, Callaghan,
124
SAC ¶¶ 143–44.
125
SAC ¶ 154.
126
Compendium of Unreported Authorities Cited in PAB (“Pls.’ Compendium”) Tab 3
(McLellan v. Fitbit, Inc., Case No. 3:16-cv-00036-JD (N.D. Cal. June 5, 2018) (ORDER)).
The order stated, “Given the magnitude of the aberrant heart rate readings and multiple
allegations that the devices under-report heart rate, [plaintiff] has plausibly alleged an
‘unreasonable safety hazard’ that may arise when users rely on Fitbit heart rate readings
during exercise.” Id. at 4.
127
SAC ¶¶ 15, 17.
25
Murray and Paisley—were named as individual defendants in the Securities
Action.128 On October 26, 2016, Judge Susan Illston denied the defendants’ motion
to dismiss the Securities Action and thereafter denied the defendants’ motion for
partial reconsideration.129 The Securities Action was settled on April 23, 2018,
nearly a year after this action commenced.130
This stockholder derivative action is the result of a Court-ordered
consolidation of three complaints, the first of which was filed on May 26, 2017.131
The operative complaint was amended on June 30, 2017, and again on March 20,
2018 in response to the consolidations.132 On April 4, 2018, Defendants moved to
dismiss the SAC under Court of Chancery Rules 23.1 and 12(b)(6).133
128
Pls.’ Compendium Tab 2 (Robb v. Fitbit, Inc., Case No. 16-cv-00151-SI, at 3 n.3
(N.D. Cal. Oct. 26, 2016) (ORDER) (denying motion to dismiss)).
129
Id. at 3; Pls.’ Compendium Tab 1 (Robb v. Fitbit, Inc., Case No. 16-cv-00151-SI, at 3
(N.D. Cal. Jan. 19, 2017) (ORDER) (denying motion for partial reconsideration)).
130
Opening Br. in Supp. of Defs.’ Mot. to Dismiss (“DOB”) 14 (D.I. 21); Transmittal Aff.
of Nicholas Rohrer in Supp. of DOB (“Rohrer Aff.”), Ex. 18 (D.I. 22).
131
Bernstein initiated a derivative action on May 26, 2017, captioned Bernstein v. James
Park, et al., C.A. No. 2017-0402-JRS (D.I. 1). Hackett initiated an action on June 9, 2017,
captioned Hackett v. James Park, et al., C.A. No. 2017-0444-JRS. On June 21, 2017, the
Court consolidated these actions into the present Action (D.I. 6). Agyapong initiated his
derivative action on August 8, 2017, captioned Agyapong v. Park, et al., C.A. No. 2017-
0562-JRS. The Court consolidated that action with this one on September 8, 2017
(D.I. 11).
132
D.I. 7, D.I. 18.
133
D.I. 20.
26
II. ANALYSIS
The SAC states two causes of action: Count I is a derivative claim for breach
of fiduciary duty (i) against all Defendants for allowing the Selling Defendants to
sell stock in the Offerings based on insider information and (ii) against the Director
Defendants for waiving the lock-up agreements134; Count II is a derivative claim for
breach of fiduciary duty against the Selling Defendants under Brophy v. Cities
Service Co.,135 which permits a corporation to recover from its fiduciaries for harm
caused by insider trading.136
I start my analysis with an assessment of Plaintiffs’ showcase claim
(the Brophy claim), as stated in Count II, and conclude that Plaintiffs have pled
particularized facts that “create a reasonable doubt that, as of the time the complaint
[was] filed, the board of directors could have properly exercised its independent and
disinterested business judgment in responding to a demand.”137 I next consider
whether Plaintiffs have pled demand futility with respect to the Board’s decision to
waive the lock-up agreements, as alleged in Count I. Again, I find that they have.
134
SAC ¶¶ 199–204.
135
70 A.2d 5 (Del. Ch. 1949).
136
SAC ¶¶ 205–11.
137
Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993). The parties agree that both of
Plaintiffs’ claims are derivative. See DOB 18–19, PAB 29.
27
I therefore deny the Motion to Dismiss under Rule 23.1. Because I find in the
demand futility analysis that the SAC states viable claims, I deny the motion to
dismiss under Rule 12(b)(6) as well.
A. Legal Standard
“A cardinal precept of the General Corporation Law of the State of Delaware
is that directors, rather than shareholders, manage the business and affairs of the
corporation.”138 Accordingly, where a plaintiff seeks to file a derivative suit—which
“[b]y its very nature . . . impinges on the managerial freedom of directors”—the
plaintiff must cross a threshold framed by Rule 23.1.139 To meet the requirements,
the plaintiff must demand that the board pursue the claim or, alternatively, must
demonstrate that demand on the board would be futile such that the demand
requirement should be excused.140
Plaintiffs acknowledge they made no pre-suit demand upon the Board.141
Thus, they also acknowledge they must plead demand futility by meeting
Rule 23.1’s “stringent requirements of factual particularity that differ substantially
138
Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984), overruled on other grounds by Brehm
v. Eisner, 746 A.2d 244 (Del. 2000) (citing 8 Del. C. § 141(a)).
139
Aronson, 473 A.2d at 811.
140
See Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, 845 A.2d 1040,
1044 (Del. 2004).
141
SAC ¶ 180.
28
from the permissive notice pleadings” embodied in Chancery Rule 8 and facilitated
by Rule 12(b)(6)’s reasonable conceivability standard.142
A plaintiff can satisfy Rule 23.1 only by setting forth “particularized factual
statements that are essential to the claim.”143 In that sense, as noted, conclusory
statements or mere notice pleading are insufficient to satisfy Rule 23.1.144 “The
pleader is not required to plead evidence,”145 however, and “all reasonable inferences
from the pled facts must . . . be drawn in favor of the plaintiff in determining whether
the plaintiff has met its burden under Aronson.”146
B. The “Demand Board”
The goal of a demand futility analysis is to determine “whether the board that
would be addressing the demand can impartially consider its merits without being
influenced by improper considerations.”147 With this in mind, Plaintiffs maintain
that demand futility must be assessed in reference to the seven-member Board as
comprised at the time the first complaint in this consolidated action was filed on
142
Brehm, 746 A.2d at 254.
143
Id.
144
Id.
145
Id.
146
Del. Cty. Empls. Ret. Fund v. Sanchez, 124 A.3d 1017, 1020 (Del. 2015).
147
Rales, 634 A.2d at 934.
29
May 26, 2017. Defendants see it differently and argue that demand futility should
be evaluated against Fitbit’s board as it existed—with nine members—when the
SAC was filed.148 I agree with Plaintiffs.
Under Braddock v. Zimmerman,149 a plaintiff is excused from making a (new)
demand on the board in place at the time an amended (as opposed to original)
complaint is filed when three elements are present: “first, the original complaint was
well pleaded as a derivative action; second, the original complaint satisfied the legal
test for demand excusal; and third, the act or transaction complained of in the
amendment is essentially the same as the act or transaction challenged in the original
complaint.”150 Of these factors, Defendants challenge only whether the original
complaint satisfied the legal test for demand excusal. As explained below, because
I find that demand was excused in connection with the original complaint, I am
satisfied under Braddock that there would have been no need to make a new demand
at the time the SAC was filed. Accordingly, I evaluate demand futility with respect
to the Board that existed at the time the original complaint was filed (the “Demand
Board”).
148
Reply Br. in Further Supp. of Defs.’ Mot. to Dismiss (“DRB”) 28 (D.I. 39).
149
906 A.2d 776 (Del. 2006).
150
Id. at 786.
30
C. Count II – The Brophy Claim
The parties agree that the test set forth in Rales v. Blasband governs demand
futility with respect to Count II.151 As noted, under Rales, demand is excused only
if the plaintiff’s particularized factual allegations “create a reasonable doubt that, as
of the time the complaint is filed, the board of directors could have properly
exercised its independent and disinterested business judgment in responding to a
demand.”152 A board will be deemed interested in a transaction and unable to make
an impartial decision in response to a demand if a majority of the members face
“a ‘substantial likelihood’ of personal liability.”153
In this case, the demand futility question as to Count II turns on whether a
majority of the Demand Board faces a substantial likelihood of liability on the
Brophy claim. As to that claim, Plaintiffs are required to well-plead that Fitbit
insiders: “1) . . . possessed material, nonpublic company information; and 2) . . .
used that information improperly by making trades because [they were] motivated,
in whole or in part, by the substance of that information.” 154 I address these elements
in turn.
151
See DOB 22, PAB 29.
152
Rales, 634 A.2d at 934.
153
Guttman v. Huang, 823 A.2d 492, 501 (Del. Ch. 2003) (quoting Rales, 634 A.2d at 936).
154
In re Oracle Corp., 867 A.2d 904, 934 (Del. Ch. 2004). See also Guttman, 823 A.2d at
502 (“The balanced approach that is more in keeping with the spirit of [Aronson and Rales]
31
1. The SAC Well-Pleads that Knowledge of PurePulse™’s Design Flaws
and the Company’s Attempts To Fix Them Were Material and
Nonpublic
Plaintiffs allege the Selling Defendants had reason to know that PurePulse™
devices had serious problems with accurately reporting heart rates and that Fitbit
was struggling to fix those problems. The Selling Defendants counter that these
issues were well known in the market and by no means the subject of inside
information. Relying mostly on negative online consumer reviews, the Selling
Defendants claim that “the market was flooded with information about the accuracy
of the heart-rate trackers.”155 The Selling Defendants also maintain that the internal
documents on which Plaintiffs rely do not conflict with Fitbit’s public statements.
According to the Selling Defendants, both acknowledge that “there were issues with
is to focus the impartiality analysis on whether the plaintiffs have pled particularized facts
regarding the directors that create a sufficient likelihood of personal liability because they
have engaged in material trading activity at a time when (one can infer from the
particularized facts that) they knew material, non-public information about the Company’s
financial condition.”).
155
DRB 17; see, e.g., Rohrer Aff., Ex. 28 at ¶ 156 (“However, as early as January 2015,
product reviews on Amazon.com reported that the Charge HR was ‘absolutely horrible for
tracking heart rate during exercise,’ ‘completely inaccurate if you’re doing anything
besides steady state cardio like a jog,’ ‘horribly inaccurate when doing any . . . high
intensity interval training,’ ‘fairly useless as a HR monitor during any exercise other than
jogging,’ and prone to under-reporting users’ heart rates by up to 50%.”).
32
the accuracy of the heart-rate tracking devices under certain circumstances, with
certain users, for some exercises.”156
The Selling Defendants misconstrue the information Plaintiffs allege was
nonpublic. The challenged information is not that some consumers experienced
some issues with PurePulse™-equipped devices. Rather, it is the alleged internal
discussions regarding the scope and severity of PurePulse’s technology problems,
and the Company’s persistent inability to fix them, that Plaintiffs allege was known
by the insider traders but not by the public. In this regard, Plaintiffs point to internal
documents showing that PurePulse’s flaws were so significant that the Company
could not resolve them even after developing a curative algorithm (Project Hydra)
and hardware solution (Project Tiwi).157 Moreover, Plaintiffs have alleged with
particularity that at least Park and Friedman made an effort to keep these failures
confidential by directing employees to destroy documents in which management was
recounting the problems and the failed efforts to solve them.158 All the while, Fitbit
issued public statements claiming that PurePulse™ devices could track heart rates
156
DRB 20–21.
157
SAC ¶¶ 104–19.
158
SAC ¶ 12. See also Pls.’ Compendium Tab 4 (Diep v. Sather, et. al., C.A. No. 12760-
VCL (Del. Ch. Mar. 17, 2017) (TRANSCRIPT) (“The fact that they had been locked up
for awhile and that this was the first time they could sell . . . heightens the likelihood that
there was incentive to keep this information quiet until people could at least unload
something.”)).
33
with a high degree of accuracy. Contrary to Defendants’ argument, a statement in
the IPO Prospectus that Fitbit “must continually . . . improve and enhance our
existing products” does not sufficiently temper the Company’s endorsement of
PurePulse™ or its bullish forecast of the Company’s future, fueled by sales of
products with PurePulse™ technology.159
Judge Illston determined on a motion to dismiss the Securities Action that the
precipitous and continuous decline in the Fitbit stock price following the filing of
the Consumer Action plausibly suggested the market did not know about the severity
of PurePulse’s flaws.160 The Selling Defendants respond to that finding with several
reasons why the stock price declined the way it did.161 Those reasons may well prove
true on a developed record. For now, however, just as the federal court found it
plausible that the market’s discovery of the PurePulse™ issues prompted the decline
in stock price, I find that the causal connection is pled with particularity and is
reasonably conceivable. Plaintiffs have adequately pled that the information at issue
was material and nonpublic.
159
DRB 22 (citing Rohrer Aff., Ex. 1 at 16).
160
Pls.’ Compendium Tab 2 at 18–19.
161
See, e.g., DOB 33 (arguing that on the same day as the filing of the Consumer Action,
the Company launched a new product, the Fitbit Blaze™, which analysts panned); id. 33–
34 (arguing that the Indianapolis local news report concerning the results of the Ball State
Study on the accuracy of Fitbit devices aired on the same day that Fitbit announced its first
financial guidance for Q1 and FY 2016, which fell below analysts’ expectations).
34
2. The SAC Well Pleads that the Selling Defendants Acted With Scienter
When They Sold Their Fitbit Shares
The second Brophy element requires a plaintiff to well-plead (and ultimately
prove) that the corporate fiduciary used material inside information he possessed to
make trades based, at least in part, on the substance of that information.162 In other
words, Plaintiffs must show that the Selling Defendants acted with scienter.163
In seeking dismissal, Defendants call the predicate question of whether
Plaintiffs have adequately pled that all of the Selling Defendants actually sold stock
in the Offerings. In doing so, Defendants implicitly question whether Plaintiffs have
well-pled that a majority of the Demand Board faces a substantial likelihood of
liability on the Brophy claim. It is undisputed that Park and Friedman sold their
Fitbit shares during the IPO and the Secondary Offering.164 The parties disagree,
however, as to whether True Ventures’s and SoftBank’s sales during the Offerings
can be attributed to Callaghan and Murray, respectively. Defendants argue that
Plaintiffs have failed to allege facts showing that Callaghan and Murray benefited
162
Silverberg ex rel. Dendreon Corp. v. Gold, 2013 WL 6859282, at *14 (Del. Ch. Dec. 31,
2013).
163
Guttman, 823 A.2d at 505.
164
DRB 1 (“[O]nly two Directors of Fitbit’s seven-member demand board—Park and
Friedman—personally sold stock.”).
35
financially from their funds’ sales.165 They also claim that Callaghan and Murray
could only be disabled from considering a pre-suit demand as a consequence of these
sales if Plaintiffs had named True Ventures and Softbank as defendants, which they
did not do.166 Neither argument is persuasive.
The parties have not provided (and the Court has not found) any instance
where a Delaware court has considered whether a fiduciary may be held liable on a
Brophy claim for trades that an entity or fund associated with that fiduciary executed
in its name. While I see no basis or reason to state a hard and fast rule, I am satisfied
that finding ipso jure that the True Ventures and Softbank trades cannot be attributed
to Callaghan and Murray would frustrate the policy that animates Brophy.
Chancellor Harrington’s Brophy decision is a descendant of Chief Justice Layton’s
seminal Guth v. Loft, Inc. decision, in which our Supreme Court elucidated the scope
of the fiduciary duty of loyalty and the range of remedies available to address a
fiduciary’s usurpation of a corporate opportunity167:
[T]he law charges the interest so acquired with a trust for the benefit of
the corporation . . . while it denies to the betrayer all benefit and profit.
The rule, inveterate and uncompromising in its rigidity, . . . rest[s] . . .
upon a broader foundation of a wise public policy that, for the purpose
165
DRB 8.
166
DRB 9; Oral Arg. on Defs.’ Mot. to Dismiss Tr. 46:1–12 (Sept. 6, 2018) (D.I. 50).
167
5 A.2d 503 (Del. 1939).
36
of removing all temptation, extinguishes all possibility of profit flowing
from a breach of the confidence imposed by the fiduciary relation.168
Brophy applied this policy to insider trading, recognizing that “[p]ublic policy will
not permit an employee occupying a position of trust and confidence toward his
employer to abuse that relation to his own profit, regardless of whether his employer
suffers a loss.”169
Here, the Selling Defendants seek a ruling that would permit a director to trade
on inside material information without consequence just because the director did not
trade personally but rather passed the information to an entity with which he is
affiliated (and over which he exercised control) to do the trading. That is not and
cannot be our law. Indeed, to allow these directors, through their controlled funds,
to profit from inside information without recourse would be inconsistent with the
policy of “extinguish[ing] all possibility of profit flowing from a breach of the
confidence imposed by the fiduciary relation” that undergirds Delaware’s insider
trading law.170
168
Id. at 510 (emphasis supplied).
169
Brophy, 70 A.2d at 8. See also Kahn v. Kolberg Kravis Roberts & Co., L.P., 23 A.3d
831, 840 (Del. 2011) (citing Guth in its refusal to restrict disgorgement in Brophy cases
and explaining that “Brophy focused on the public policy of preventing unjust enrichment
based on the misuse of confidential corporate information”).
170
I also note that Brophy liability in this context is akin to tipper liability under federal
law. Under Dirks v. Sec. & Exch. Comm’n, 463 U.S. 646 (1983), a tipper of inside
information can be liable only if the tipper personally benefited from the disclosure of
inside information. In Salman v. United States, 137 S. Ct. 420 (2016), the Supreme Court
37
Although no Delaware court has had occasion to consider whether Brophy
liability should be imposed under these circumstances, our courts have not
foreclosed the possibility of personal liability for trades executed by a controlled
fund either. In Kahn v. Kolberg Kravis Roberts & Co., L.P., for example, our
Supreme Court addressed a case in which plaintiffs alleged that designated directors
supplied nonpublic information to the directors’ sponsoring fund, which then traded
on the information. Although the court upheld the special committee’s
recommendation not to pursue the Brophy claims, that ruling did not rest on a
holding that the directors could not, as a matter of law, be held liable for the improper
trades of their funds. Rather, the Court determined that the insider information was
immaterial, the claims were time-barred and the sponsor did not intend to profit
(and in fact did not profit) from the trades.171
Callaghan and Murray are not simply board designees for their funds.172
Plaintiffs allege that Callaghan is a co-founder and managing member of True
Ventures, which held 37,731,585 Fitbit shares and received approximately
unanimously held that the requirement of personal benefit could be satisfied by a tipper’s
gift of inside information to a trading friend or relative.
171
See Kahn, 23 A.3d at 841.
172
Thus, Defendants’ reliance on In re Rouse Props., Inc. Fiduciary Litig., 2018
WL 1226015 (Del. Ch. Mar. 9, 2018) and Gilbert v. El Paso Co., 575 A.2d 1131
(Del. 1990) is misplaced.
38
$136.7 million in proceeds from the Offerings.173 As for Murray, Plaintiffs allege
he is a partner of Softbank, which held 9,343,572 Fitbit shares and received
$33.8 million in proceeds from the Offerings.174 Both directors share voting and
dispositive power over the Fitbit stock owned by their respective funds.175 Plaintiffs’
particularized allegations are sufficient at the pleading stage to allow a reasonable
inference that Callaghan and Murray personally and materially profited from the
challenged stock sales through their ownership and control of their affiliated
funds.176
Having determined that Plaintiffs have pled particularized facts supporting a
reasonable inference that four of the seven Demand Board members sold stock
during the Offerings, I turn next to the sufficiency of Plaintiffs’ allegations that these
four Board members acted with scienter.177 The Selling Defendants argue that
173
Rohrer Aff., Ex. 9 at 116 n.10.
174
Id. at 116 n.11.
175
Id. at 116 n.10, n.11.
176
I note that information regarding whether Callaghan and Murray personally profited
from the trades in question would not likely be found in a Section 220 books and records
production. In this regard, I am reminded of Justice Hartnett’s admonition in his
concurring opinion in Brehm v. Eisner: “Plaintiffs must not be held to a too-high standard
of pleading because they face an almost impossible burden when they must plead facts
with particularity and the facts are not public knowledge.” Brehm, 746 A.2d at 268
(Hartnett, J., concurring).
177
Although this section explicitly addresses the inference of scienter as to Park, Friedman,
Callaghan and Murray for purposes of assessing demand futility, the analysis applies
equally to the question of whether Plaintiffs have well-pled that Zerella, as CFO, acted
39
Plaintiffs have failed to point to any evidence that a majority of the Selling
Defendants received the material, nonpublic information that is at the heart of
Plaintiffs’ Brophy claim. Indeed, the evidence mentioned in the SAC expressly
identifies only Park and Friedman as having received the internal documents that
recount the problems Fitbit was experiencing with the PurePulse™ technology.
Plaintiffs counter that they are not required to uncover and plead the “smoking
scienter gun” in order to state a Brophy claim. Rather, at this stage, it is enough that
they plead a series of particularized facts that would support a reasonable inference
of knowledge, and resulting scienter, on the part of the insider traders. I agree and
find they have done just that here.178
Plaintiffs have alleged that the products featuring the PurePulse™ technology
accounted for 80% of Fitbit’s revenue,179 that Fitbit experienced serious problems
with scienter when trading in the Secondary Offering. As for Paisley, who was a member
of the Demand Board but did not trade in the Offerings, the analysis is relevant to his state
of knowledge as a member of the Board when the Court later considers whether he is
disabled from impartially considering a demand that the Company prosecute Count I.
178
See Sanchez, 124 A.3d at 1020 (holding that plaintiff is entitled to reasonable inferences
when resisting a motion to dismiss under Rule 23.1).
179
Defendants argue that the core operations doctrine has no place under Rule 23.1’s
heightened pleading standard (DRB 11-12). The cases Defendants cite, however, suggest
the doctrine is not sufficient on its own in the context of generally pled allegations to
establish scienter. See, e.g., Sandys v. Pincus, 2016 WL 769999, at *17 (Del. Ch. Feb. 29,
2016), rev’d on other grounds by Sandys v. Pincus, 152 A.3d 124 (Del. 2016) (rejecting
the core operations doctrine where plaintiffs’ allegations were “pled generally” and noting
that plaintiffs in Pfeiffer v. Toll had put forth additional allegations that outside directors
sold substantial amounts of stock during the period in question); In re Yahoo! Inc. S’holder
40
with the technology early on, that Fitbit attempted to design fixes to the problems
and those fixes were not working, that management was keeping the Board apprised
of the problems and the efforts to address them, and that, all the while, Fitbit was
touting the promise and success of PurePulse™ to the market.180 These well-pled
facts, combined with the nature, timing and size of the Offerings, adequately support
a reasonable inference that the Selling Defendants sought to make trades based on
nonpublic information.181
Plaintiffs have also adequately pled that the Board designed the Secondary
Offering to accommodate the Selling Defendants’ interests. Aside from initiating a
rather unusual Secondary Offering after a successful IPO, the Board adjusted the
terms of the offering at the eleventh hour to remove four million shares from what
Deriv. Litig., 153 F. Supp. 3d 1107, 1123 n.10 (N.D. Cal. 2015) (“‘[A] plaintiff must allege
more than that directors should have known or must have known about matters relating to
the corporation’s ‘core business’”) (citing In re Accuray, Inc. S’holder Deriv. Litig.,
757 F. Supp. 2d 919, 928 (N.D. Cal. 2010)); In re Rocket Fuel Inc. Deriv. Litig., 2016
WL 4492582, at *6 (N.D. Cal. Aug. 26, 2016) (“It is hardly clear from the [complaint] that
combatting ad fraud is the ‘core’ of Rocket Fuel’s business . . . . Without more, the court
cannot infer that the outside directors should or would have had detailed knowledge . . . .”).
The totality of the facts Plaintiffs have pled with particularity allow a reasonable pleading
stage inference that, because the problems with PurePulse™ were profound and
PurePulse™ drove the Company’s bottom line, both Fitbit management, including Zerella,
and the Board knew of the alleged material, nonpublic information.
180
SAC ¶¶ 105–23.
181
See Pfeiffer v. Toll, 989 A.2d 683, 693 (Del. Ch. 2010), abrogated on other grounds by
Kahn, 23 A.3d 831 (recognizing that allowing directors to claim ignorance of obvious
information affecting the company would “afford ostrich-like immunity to directors”).
41
Fitbit intended to sell, increasing the likelihood that the underwriters would exercise
the Selling Defendants’ overallotment option.182 In addition to this adjustment, the
Board, without apparent explanation, waived the lock-up agreements for designated
insiders. With these waivers in hand, the Selling Defendants were able to execute
their Secondary Offering trades at $28.13 per share. Had the lock-up agreements
not been waived, the Selling Defendants would have realized only $12.50 per share
on the earliest day they would have been allowed to trade.
Defendants’ exposure in the federal Securities Action is also a relevant factor
in the Rales analysis. As noted, all Defendants were also named as defendants in
the Securities Action. This court addressed a similar situation in Pfeiffer v. Toll,
where individual defendants in a Delaware action alleging a Brophy claim were also
named defendants in a companion federal securities action.183 In addressing the
defendants’ motion to dismiss, the court took notice of the federal court’s holding
that “the complaint sufficiently alleged that the defendants ‘made material
misrepresentations and omissions of material fact,’ [and] that the insider trading of
the individual defendants . . . raised a ‘powerful and cogent inference of scienter,’
182
SAC ¶¶ 82–84. Cf. Silverberg, 2013 WL 6859282, at *14 (considering circumstantial
evidence, such as timing and scope, to find defendants acted with scienter).
183
Pfeiffer, 989 A.2d at 690.
42
and was ‘unusual in scope and timing.’”184 Given the board members’ exposure in
the federal companion litigation, Vice Chancellor Laster concluded that the plaintiff
had pled a reason to doubt whether the derivative defendants could consider a
demand impartially.185
In the Securities Action, Park, Friedman and Zerella were alleged to have
violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and
Rule 10b-5 and all Defendants were alleged to have violated Sections 11 and 15 of
the Securities Act of 1933 for issuing materially false or misleading statements
related to the IPO.186 The plaintiffs in the Securities Action twice survived a motion
to dismiss under the rigorous standards for pleading securities fraud.187 Judge Illston
found that the plaintiffs’ allegations were “sufficient to establish scienter” as to Park,
Friedman and Zerella regarding their knowledge of PurePulse™’s inaccuracy.188
In denying the motion to dismiss, the court also determined that,
Taken together, the allegations in this case are at least as cogent or
compelling as a plausible alternative inference, namely that Fitbit
executives were simply unaware of the high degree of inaccuracy in
184
Id. (quoting City of Hialeah Empls.’ Ret. Sys. and Laborers Pension Trust Funds v. Toll
Bros., Inc., 2008 WL 4058690, at *2, *5 (E.D. Pa. Aug.29, 2008)).
185
Pfeiffer, 989 A.2d at 690.
186
SAC ¶¶ 17–18.
187
Pls.’ Compendium Tab 2 at 3 (denying motion to dismiss); Pls.’ Compendium Tab 1
at 3 (denying motion for partial reconsideration).
188
Pls.’ Compendium Tab 2 at 17–18.
43
PurePulse™ devices alleged. Particularly given the contributions these
devices made to Fitbit’s revenue stream in 2015 . . . the Court finds that
a holistic review of the allegations suffices to establish scienter.189
I take judicial notice that another court reviewing similarly pled facts found
that those facts supported an inference of knowledge not only for Park, Friedman
and Zerella but also for all Defendants under a “holistic review” of the pleading.
And although the Securities Action has since settled, the settlement was not
approved until a year after Plaintiffs filed their original complaint. If the Company
had elected to move forward with Plaintiffs’ action against the Selling Defendants,
then the Company’s efforts almost certainly would have “undercut or even
compromise[d] the defense” of all defendants in the Securities Action.190
Having considered the foregoing, I am satisfied that Plaintiffs have pled
particularized facts that support a reasonable inference that Park, Friedman,
Callaghan and Murray—four of seven demand Board directors—possessed material,
nonpublic information and relied on that information when making trades in the
Offerings. Accordingly, Plaintiffs have met their burden to plead that these directors
189
Id. at 18.
190
Pfeiffer, 989 A.2d at 690. For these same reasons, Paisley, who is also a defendant in
the Securities Action, would be disabled from impartially considering a demand to
prosecute the Brophy claims on behalf of the Company since positions the Company would
take in prosecuting those claims would likely compromise his defenses in the Securities
Action.
44
face a substantial likelihood of personal liability on the Brophy claims, and demand
is excused as futile as to Count II.191
D. Count I – The Breach of Fiduciary Duty Claim
Plaintiffs’ breach of fiduciary duty claim as stated in Count I has two
components: (i) that all Defendants permitted the Selling Defendants to trade in the
Offerings based on insider information; and (ii) that the Director Defendants waived
the lock-up agreements that would have otherwise prevented the Selling Defendants
from making their trades.192 Defendants point out that Plaintiffs abandoned any
claim based on the theory that the directors failed to prevent insider trades.193
Indeed, Plaintiffs’ brief suggests that only the Director Defendants’ actions to
facilitate the Selling Defendants’ trades are relevant.194 Accordingly, I focus my
demand futility analysis on the second component of Count I and find that Plaintiffs
have waived the first component.195
191
Rales, 634 A.2d at 936.
192
SAC ¶ 201.
193
DRB 24 (citing PAB 58–59 n.235).
194
PAB 58–59 n.235 (focusing only on the Board’s approval of the lock-up waivers and
stating “Defendants’ argument concerning the Board’s ‘inaction’ and cases where directors
failed to detect accounting regularities . . . is irrelevant. Plaintiffs here allege much more
than inaction and instead assert affirmative steps the Board took to facilitate the Selling
Defendants’ trades upon inside information”).
195
See Emerald P’rs LP v. Berlin, 726 A.2d 1215, 1224 (Del. 1999) (“Issues not briefed
are deemed waived.”).
45
The parties agree that when a plaintiff challenges a decision of the board to
take affirmative action, like waiving the lock-up agreements, demand futility must
be assessed under the two-pronged test stated in Aronson v. Lewis.196 Thus, Plaintiff
is obliged to plead particularized facts creating a “reasonable doubt” that either
“(1) [a majority of] the directors [is] disinterested and independent or (2) the
challenged transaction was otherwise the product of a valid exercise of business
judgment.”197
A director is interested in the underlying transaction if he “appears ‘on both
sides of a transaction’ or expects ‘to derive any personal financial benefit from it in
the sense of self-dealing, as opposed to a benefit which devolves upon the
corporation or the stockholders generally.’” 198 Plaintiffs have alleged with
particularity that the Director Defendants voted to approve the waivers of the lock-
up agreements. And, as of the date Plaintiffs filed their complaint, four of seven
Director Defendants—Park, Friedman, Murray, and Callaghan—were beneficiaries
of the waivers when they sold shares in the Secondary Offering for significant
196
See DOB 48–49, PAB 56.
197
Aronson, 473 A.2d at 814.
Chester Cty. Empls.’ Ret. Fund v. New Residential Inv. Corp., 2017 WL 4461131, at *6
198
(Del. Ch. Oct. 6, 2017) (quoting Aronson, 473 A.2d at 812).
46
personal profit.199 If these pled facts are proven, entire fairness would be the
standard of review.200
The Defendants argue that the waiver provided no unique benefits to the
Selling Defendants because it applied equally to “other employees, consultants, and
early investors” who were also subject to the lock-up agreements.201 This argument
misses the mark for the simple reason that Plaintiffs have well pled that, unlike other
constituencies who may have benefited from the waiver, the Selling Defendants
were armed with nonpublic information not available to others who might be
considering whether to participate in the Offerings.
Defendants’ argument that Plaintiffs have failed to well-plead that the trades
were material to the Selling Defendants is also unpersuasive.202 While the
percentages of stock that Park, Friedman, Callaghan and Murray sold may have been
small in relation to their holdings, their profits were sizable to say the least.
199
Cf. In re Tyson Foods, Inc. Consol. S’holder Litig., 919 A.2d 563, 592–93 (Del. Ch.
2007) (noting that spring-loaded and bullet-dodging options (options timed to enable
insiders to avoid losses from future harmful disclosures) “clearly involve[] a deception”
and implicate a “duty of loyalty”).
200
See Lee v. Pincus, 2014 WL 6066108, at *12-13 (Del. Ch. Nov. 24, 2014) (holding that
entire fairness standard of review would apply to plaintiff’s claim that board members
breached their fiduciary duty by agreeing to waive contractual restrictions that had
prevented most pre-IPO investors from selling their stock for a designated period because
the directors personally were beneficiaries of the waiver).
201
DOB 50.
202
Id.
47
Friedman and Murray are alleged to have made over $30 million from the Secondary
Offering and Park is alleged to have made more than twice that much. As pled, the
trades were material.203
Plaintiffs have adequately pled facts that raise a reasonable doubt as to
whether the Demand Board was disinterested with respect to the waiver of the lock-
up agreements for designated employees and consultants. Accordingly, they have
well-pled demand futility under the first prong of Aronson as to Count I of the SAC.
Under Delaware law, each director facing liability as a result of an action by
the board has a right to be considered individually “because the nature of their breach
of duty (if any), and whether they are exculpated from liability for that breach, can
vary by director.”204 Here, Plaintiffs allege that Paisley voted to waive the lock-up
agreements but did not subsequently sell shares in the Secondary Offering. As such,
he is situated differently from the remaining Director Defendants discussed above
who personally benefited from their votes to waive the lock-up agreements.
Although not expressly separating Paisley in their opposition papers,
Plaintiffs have made clear their position that he is disabled from impartially
203
See Chen v. Howard-Anderson, 87 A.3d 648, 670 (Del. Ch. 2014) (noting that a
director’s interest was material when he received more than $840,500 in benefits not shared
with other stockholders).
204
In re Emerging Commc’ns Inc. S’holders Litig., 2004 WL 1305745, at *38 (Del. Ch.
June 4, 2004).
48
considering a demand with respect to Count I for two reasons. First, as previously
noted, Paisley was a defendant in the Securities Action and faced the same likelihood
of liability as the remaining Defendants in that action. An election to move forward
with Plaintiffs’ demand in this action would undercut the defense in the Securities
Action for Paisley as well as for the other Director Defendants.
Moreover, Plaintiffs cast doubt as to whether Paisley exercised his business
judgment when he voted to waive the lock-up agreements. In In re Emerging
Commc’ns, then-Vice Chancellor Jacobs found that a board member who voted to
approve a transaction—but did not directly benefit from it—nonetheless
“‘consciously and intentionally disregarded’ his responsibility to safeguard the
minority stockholders from the risk, of which he had unique knowledge, that the
transaction was unfair.”205 Because this director had a unique understanding of the
company’s intrinsic value, the court found that his vote of approval exposed him to
liability for breach of his fiduciary duty of loyalty. Here, Plaintiffs have alleged that
Paisley faces a similar likelihood of liability because he knowingly facilitated the
Selling Defendants’ insider trading when he voted to waive the lock-up
agreements.206 Thus, Plaintiffs have adequately pled that director Paisley is also
In re Emerging Commc’ns, 2004 WL 1305745, at *40 (citing In re Walt Disney Co.
205
Derivative Litig., 825 A.2d 275, 289 (Del. Ch. 2003)).
206
See also In re Tyson Foods, 919 A.2d at 592–93 (“A director who intentionally uses
inside knowledge not available to shareholders in order to enrich employees while avoiding
49
disabled from considering a demand as to Count I under the second prong of
Aronson.
E. Plaintiffs State Reasonably Conceivable Claims
Under Court of Chancery Rule 12(b)(6), a complaint must be dismissed if the
plaintiff would be unable to recover under “any reasonably conceivable set of
circumstances susceptible of proof” based on the facts pled in the complaint.207
In considering a motion to dismiss, the Court must accept as true all well-pled
allegations in the complaint and draw all reasonable inferences from those facts in
plaintiff’s favor.208 The Court need not accept conclusory allegations that lack
factual support, however, or “accept every strained interpretation of the allegations
proposed by the plaintiff.”209 “In the context of a motion to dismiss for failure to
state a claim, the pleading standard does not reach so high a bar as Rule 23.1.”210
shareholder-imposed requirements cannot, in my opinion, be said to be acting loyally and
in good faith as a fiduciary.”).
In re Gen. Motors (Hughes) S’holder Litig., 897 A.2d 162, 168 (citing Savor, Inc. v.
207
FMR Corp., 812 A.2d 894, 896–97 (Del. 2002)).
208
In re Gen. Motors, 897 A.2d at 168.
209
Id.
210
Ryan v. Gifford, 918 A.2d 341, 357 (Del. Ch. 2007).
50
Thus, if a complaint survives a motion under Rule 23.1, it will likely survive a
motion under Rule 12(b)(6).211
Beyond renewing the same arguments they raised to attack the sufficiency of
Plaintiffs’ Brophy and fiduciary duty claims in the context of their Rule 23.1
dismissal motion, Defendants’ remaining argument in support of Rule 12(b)(6)
dismissal is that Plaintiffs’ claims are subject to exculpation under Section 102(b)(7)
of the DGCL and the exculpatory provision in Fitbit’s certificate of incorporation.212
At this pleading stage, I cannot agree. The exculpatory provision does not, and
cannot, provide director exculpation “for any transaction from which the director
derived an improper personal benefit,” implicating their duty of loyalty. 213 For
reasons discussed above, Plaintiffs have stated a viable Brophy claim against the
Selling Defendants and viable breach of the duty of loyalty claims against the
Director Defendants relating to the waiver of the lock-ups. As pled, these claims are
not subject to Section 102(b)(7) exculpation.
211
McPadden v. Sidhu, 964 A.2d 1262, 1270 (Del. Ch. 2008).
212
DOB 53–54, 58–60 (citing 8 Del. C. § 102(b)(7)).
213
8 Del. C. §102(b)(7)(iv). See also In re Emerging Commc’ns, 2004 WL 1305745, at
*40 (holding that a director who facilitated a breach of the duty of loyalty by a fellow
director was not entitled to exculpation). I also note that although corporate officers and
directors owe identical fiduciary duties, Section 102(b)(7) does not exculpate officers from
monetary liability. See Gantler v. Stephens, 965 A.2d 695, 708, 709 n.37 (Del. 2009).
Accordingly, Zerella is not entitled to exculpation as a matter of law.
51
III. CONCLUSION
Based on the foregoing, I am satisfied Plaintiffs have adequately pled demand
futility and stated viable claims under Brophy and for breach of the fiduciary duty
of loyalty in connection with the Company’s PurePulse™ technology, IPO, lock-up
waivers and subsequent Secondary Offering. The Motion to Dismiss, therefore,
must be DENIED.
IT IS SO ORDERED.
52