Delaware Supreme Court Allows Books and Records Action After Derivative Lawsuit

On January 28, 2011, the Delaware Supreme Court clarified in King v. VeriFone Holdings, Inc., Del. Supr., No. 330, 2010, that plaintiffs may in some circumstances inspect a corporation’s books and records to bolster a derivative action complaint even after they have filed a lawsuit.

Section 220 of Delaware’s General Corporation Law provides shareholders with a limited right to inspect the books and records of Delaware companies in which they own stock. That right is subject to several conditions, including the condition that shareholders have a “proper purpose” for seeking inspection. [1] Investigating corporate mismanagement, for example, is a proper purpose. [2] Indeed, Delaware courts have repeatedly urged shareholders to use Section 220 to conduct such investigations before filing a derivative action. By using the “tools at hand,” those courts have explained, shareholders can become better equipped to plead allegations that are sufficient to meet the stringent pleading requirements that apply to derivative complaints, particularly in cases in which the plaintiffs did not serve a pre-suit demand and thus must plead “demand futility” (i.e., that serving a demand would be useless because the board of directors is biased against the claims or dominated by others who are). [3] Litigants have frequently clashed over whether the purpose of obtaining information to fortify a derivative complaint is “proper” when the complaint has already been filed.

The Delaware Supreme Court squarely confronted that issue in VeriFone. Reversing a decision of Vice Chancellor Strine, the court held that “it is a proper purpose under Section 220 to inspect books and records that would aid the plaintiff in pleading demand futility in a to-be-amended complaint,” when his or her earlier complaint was dismissed with leave to amend. Although the court recognized that the interests of judicial economy counsel against allowing the re-litigation of insufficient and premature complaints, it reasoned that trial courts have sufficient means to curb slapdash pleadings. For example, they may deny lead plaintiff status to plaintiffs who file defective complaints or dismiss such complaints with prejudice.

Significantly, the court strongly implied that the investigation of claims is an improper purpose under Section 220 when a derivative complaint is pending and the plaintiff does not have leave to amend, or when the complaint has been dismissed with prejudice. Moreover, the decision arguably is limited to situations in which a complaint has been dismissed due to failure to plead demand futility. Furthermore, VeriFone does not disturb the long line of precedent that forbids plaintiffs from using civil discovery in a pending derivative lawsuit to investigate demand futility or otherwise supplement their allegations. [4] Despite plaintiffs’ frequent efforts to exploit the more liberal discovery rules of other jurisdictions, Section 220 remains the exclusive vehicle for investigating demand futility under Delaware law.

What lasting effect the decision will have on litigation before Delaware’s Court of Chancery is uncertain. The opinion omits any discussion of Rule 15(aaa) of the Court of Chancery Rules, which provides that the Court of Chancery must generally dismiss a complaint with prejudice if the complaint fails to state a claim or insufficiently pleads demand futility. [5] Since the Court of Chancery will rarely grant leave to amend, it should be the exceptional case in which plaintiffs are permitted to seek records under Section 220 after their complaint is dismissed in Delaware.

As a matter of sound risk management, corporations should bear in mind the following in responding to records requests or complaints under Section 220:

• A Section 220 request is often a signal that a derivative or class action lawsuit will follow. Such requests thus raise immediate and important strategic considerations regarding imminent litigation, and should be taken seriously.
• Despite the burden on shareholders to demonstrate standing and a proper purpose, it is difficult for corporations to obtain dismissal of a Section 220 complaint at the pleadings stage. The Court of Chancery has observed that “books and records actions are summary proceedings” that “are to be promptly tried.” “Rarely is dispositive motion practice efficient,” the court added, “when the case can be tried within two months of filing.” [6]
• Given the risk that certain corporate books and records can be subject to review by prospective plaintiffs, corporations should observe best practices when documenting board decisions or corporate transactions that are potentially susceptible to controversy.
• Not every situation requires the production of books and records in response to a Section 220 demand, despite the ruling in VeriFone. Although VeriFone repeatedly emphasized that a Section 220 action is not barred “solely” because the plaintiff previously filed a derivative lawsuit, corporations may have other grounds for defeating a demand for their books and records, including lack of standing by the requesting party, insufficient evidence to suggest a credible basis for inferring corporate wrongdoing, or overbreadth of the demand.

Endnotes

[1] Seinfeld v. Verizon Commc’ns, Inc., 909 A.2d 117, 121 (Del. 1997).
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[2] Sec. First Corp. v. U.S. Die Casting & Dev. Co, 687 A.2d 563, 567 (Del. 1997).
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[3] Scattered Corp. v. Chi. Stock Exch., 701 A.2d 70, 78 (Del. 1997), overruled in part on other grounds by Brehm v. Eisner, 746 A.2d 244 (Del. 2000).
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[4] See, e.g., Beam v. Stewart, 845 A.2d 1040, 1056 (Del. 2004) (“In general, derivative plaintiffs are not entitled to discovery in order to demonstrate demand futility.”); In re Merck & Co., Inc. Sec., Deriv. & ERISA Litig., 493 F.3d 393, 400 (3d Cir. 2007) (“[D]iscovery generally may not be used to supplement allegations of demand futility.”); In re Openwave Sys. Inc. S’holder Deriv. Litig., 503 F. Supp. 2d 1341, 1351 (N.D. Cal. 2007) (“It appears undisputed that under Delaware law, derivative plaintiffs are not entitled to discovery in order to demonstrate demand futility.”) (citation and marks omitted); cf. Levine v. Smith, 591 A.2d 194, 208 (Del. 1991) (holding that plaintiffs are not entitled to discovery prior to responding to a motion to dismiss in a demand-refused case).
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[5] See, e.g., In re Dow Chem. Co. Derivative Litig., C.A. No. 4349-CC, 2010 WL 66769, at *1 & n.2 (Del. Ch. Jan. 11, 2010). The court may grant leave to amend only if the plaintiff shows good cause and the court determines that dismissal with prejudice would be unjust under the circumstances. Del. Ch. R. 15(aaa).
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[6] Lavi v. Wideawake Deathrow Entm’t, LLC, C.A. No. No. 5779-VCS, 2011 WL 284986, *1 (Del. Ch. Jan. 18, 2011) (analyzing an analogous books and records statute that applies to limited liability companies).
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