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Del. Court OKs Suit Against Zynga Directors for Alleged Self-Dealing

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By Mark Wilson, Esq. on November 19, 2014 10:54 AM

When you're the CEO of a new company, when is the time to sell your shares and make some actual cash? The answer is probably "not very soon" -- at least not so soon that it looks like there's some impropriety.

Case in point: Mark Pincus, CEO of Zynga, the company that makes those Facebook games where you grow pumpkins or mine diamonds, or something. Thanks to some questionable conduct, some of Zynga's directors are in Delaware Chancery Court.

Self-Dealing

The plaintiff in this case, Wendy Lee, was a Zynga employee from 2009 to 2011. She exercised a stock option agreement and purchased 30,000 shares of Zynga stock in August 2011.

A few months after Zynga's IPO in December 2011, Zynga's board of directors waived -- only for Pincus and three other board members -- restrictions on selling stock ("lockups") that prevented most other pre-IPO investors (including Lee) from selling their stock until May 2012.

Waiving the lockups was part of an overall plan to make a secondary offering of stock to the public in April 2012. During this secondary offering, the four directors sold their stock, receiving quite a bit of money. Pincus made out with $192 million. Zynga as a company, though, didn't sell any shares during the second offering.

The stock price dropped quickly, reaching a price of $6.09 per share May 29, when the lockup restrictions were originally supposed to expire. (When Pincus and the other directors sold their shares during the secondary offering, they got $12 per share.)

The Business Judgment Rule

Ah, the board of directors' old friend. After the court dispensed with Zynga's claim that this is really a derivative suit (it's not; Lee was directly harmed) and that it's really a contract suit and Zynga didn't owe any fiduciary duties to pre-IPO investors (it doesn't), it got to the business judgment rule, which allows directors to do whatever they want as long as they're acting reasonably.

But the BJR is never a defense to self-dealing. And the BJR can be quickly rebutted on a showing that at least half the directors were interested in the transaction -- which is basically what's going on here. While it's true, the court acknowledged, that it had to take the whole transaction into account, on balance, it personally benefited the directors who stood to benefit. They knew that, after the lockup period expires, the stock price generally goes down. So it was advantageous that they waived the lockup for themselves so they could get a higher price than they would have gotten otherwise.

So far, the only issue is whether Lee's case should be dismissed; the court here said it shouldn't, which is a pretty big deal in itself. It's hard to successfully sue a board of directors.

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