This post is based on an article by Francis Pileggi and Bernard Conaway that appeared in The Delaware Law Weekly.
Section 220 of the Delaware General Corporation Law gives a shareholder the right to inspect certain books and records of a corporation, but that right is not without limitations. The right to those books and records oftentimes seems shallow because enforcing that right, if contested, requires a substantial amount of time and money to file a lawsuit under Section 220, engage in limited discovery, and endure a trial that, only if successful, will merely establish your right to certain books and records with limitations imposed for such matters such as confidentiality of the information. A recent decision by the Delaware Chancery Court clarifies the overlap of such a special statutory summary proceeding with the discovery rights which might otherwise be available in a related lawsuit. Khanna v. Covad Communications Group, Inc., 2004 WL 187274 (Del. Ch.). The scope of discovery in a “conventional” lawsuit is much broader than that available in a Section 220 case. Documents obtainable by means of a simple discovery request in a conventional action contrasts with a Section 220 lawsuit; that only if successful after trial, would entitle one to the limited scope of documents available under Section 220.
This is true despite recent amendments to Section 220 of the Delaware General Corporation Law that shifted the burden to the corporation to show why a shareholder should not be entitled to a list of other shareholders. The Delaware Supreme Court has often encouraged attorneys to use Section 220 to obtain more detailed information from a company prior to filing a claim, in order to make certain that there is a sound factual basis to assert a cause of action. The Delaware Supreme Court has referred to Section 220 as one of “the tools at hand” that should be used by an attorney before filing a conventional lawsuit. See Brehm v. Eisner, 746 A.2d 244, 266-267; n.57 and n.74 (Del. 2000).
Specifically, Section 220 of Title 8 of the Delaware Code gives shareholders the right to inspect certain records of a corporation when that request is made for a proper purpose. What amounts to a proper purpose in any given case, however, is often peculiar to the facts of that case. The Khanna case is noteworthy because the Court thoroughly addressed many Section 220 issues that a practitioner in the area will confront.
Of course, litigation under Section 220 is only necessary if the pre-suit inspection is not granted to the satisfaction of the requesting shareholder. The facts of the Khanna case are unremarkable aside from the fact that the case actually went to trial. Khanna was the general counsel and the largest individual shareholder of Covad. Eventually he was dismissed as general counsel. Khanna believed that his dismissal was, at least in part, based upon racial motivations. At some point after his dismissal, in his capacity as a shareholder and relying upon 8 Del. C. ¨Ŗ 220, Khanna served a request to inspect the Covad corporate books and records. In support of his demand Khanna asserted that he needed the records to: (1) enable him to investigate fiduciary breaches by Covad directors; (2) to investigate allegations of self-dealing; and (3) to evaluate the viability of derivative claims. The document request, set out in the opinion, identified 14 categories of documents.
Covad denied Khanna’s request for several reasons including the assertion that: (1) the request was improperly tied to Khanna’s potential claims for wrongful termination; (2) Khanna could not meet his alleged burden that corporate wrongdoing had occurred; (3) the request was vague and overly broad; (4) Khanna lacked standing to assert a derivative claim because he could not qualify as a class representative; (5) the request was not reasonably related to his reasons for seeking review; and (6) many of the documents were subject to privilege claims. After Covad denied the request Khanna filed a Section 220 suit in the Delaware Chancery Court. Fearing a potential statute of limitation problem and within two months of filing the Section 220 action, Khanna filed a derivative action asserting breaches of fiduciary duties of loyalty. In that separate suit he alleged that the directors approved 4 transactions in which some members of the board had a personal interest.
Covad argued that by filing the derivative action Khanna demonstrated that he no longer needed to inspect the corporation books and records “because his counsel must have been confident with the information available to them” otherwise they would run afoul of Rule 11. Thus, Covad argued, the Section 220 action was unnecessary. Additionally, because Covad’s motion to dismiss the derivative claim was pending at the time the 220 trial began, they argued that Khanna was impermissibly using the 220 action as a discovery tool to support the derivative claim. Covad also argued out that derivative plaintiffs are not entitled to discovery to assist their compliance with Chancery Court Rule 23.1. Vice Chancellor Noble rejected both arguments. He pointed out that Khanna’s predicament was, in large part, the result of Covad’s failure to timely comply with Khanna’s 220 request. This failure, the Vice Chancellor pointed out, was at the root of the overlap between the 220 action and the derivative action.
After disposing of Covad’s threshold procedural objections, Vice Chancellor Noble evaluated Khanna’s purpose in making the 220 request. He noted that a 220 request is proper “so long as it is reasonably related to [a person’s] interest as a stockholder.” That purpose, however, may be subject to additional review when, as is Khanna’s case, the individual making the request has individual claims against the corporation. Khanna, however, defused that argument by committing not to use documents procured through the 220 action in his discrimination claim. Nonetheless, Vice Chancellor Noble noted parenthetically that Khanna’s intent to use the 220 action to develop adequate information to support a derivative claim is an appropriate purpose under Delaware law.
The Court’s analysis next focused on Khanna’s breach of fiduciary duty allegation against the directors. To sustain his 220 request on this basis Khanna was required to “demonstrate by a preponderance of the evidence some credible basis from which the court can infer that waste or mismanagement may have occurred.” This burden, however, did not require Khanna to prove that such waste or mismanagement actually occurred. Vice Chancellor Noble then evaluated each of four transactions that Khanna alleged to have supported his claims of director wrongdoing. That evaluation, he noted, was not for the purpose of evaluating the merits of the fiduciary claims but rather to ascertain whether “there are legitimate issues of wrongdoing.” Based upon the evidence presented at trial the Court concluded that Khanna met his burden.
The court summarily rejected Covad’s argument that Khanna was an improper class representative given his past position as general counsel. The court pointed out that Covad’s argument might be appropriate in the derivative action but it was patently inappropriate in the context of the 220 action.
Finally, the court evaluated Covad’s claim that compliance with the 220 request would require production of documents that were otherwise protected by the attorney-client privilege or work-product doctrine against non-disclosure. Discovery of non-opinion work-product may be discovered in a 220 action upon a showing similar to that embodied in Chancery Court Rule 26(c). Namely, a party must show substantial need for the material and that it cannot acquire the substantial equivalent without undue hardship. Conversely, access to opinion work-product may be obtained only if the requesting party shows that the information is directed to a pivotal issue in the case and the need for the information is compelling. Lastly, the court noted “the attorney-client privilege can be avoided by a Section 220 plaintiff who can demonstrate ‘good cause’ why the privilege should not attach.”
Despite the privilege claim Covad never developed a privilege log. In the absence of this log and Khanna’s failure to offer evidence to rebut the Covad’s privilege claims, the Court set the issue aside. In doing so the court avoided the need to weigh other privilege issues.
Ultimately the court concluded the Khanna asserted a proper purpose to support his 220 claim. Having reached this conclusion, the court next evaluated the 14 classes of documents that Khanna requested. Two well-recognized principles guided this evaluation. First, notwithstanding a proper purpose, a party to a 220 action was not then entitled to a fishing expedition through the corporation’s books and records. Second, “only those records that are essential and sufficient to the shareholder purpose will be included in a court-ordered inspection.” Khanna bore the burden of establishing that his 14 requests meet this standard.
Most Section 220 caselaw turns on factually determinative issues. Although rare, there is precedent among Delaware Chancery Court cases for the filing of a Motion for Summary Judgment prior to the trial of a Section 220 case to establish proper purpose under Section 220. See Freund v. Lucent Technologies, Inc., Del. Ch., C.A. No. 18893 (Jan. 9, 2003), 28 Del.J.Corp.L. 808 (2003). (Motion for summary judgment granted to entitle plaintiff to documents under Section 220 prior to trial.)
By comparison, there are also decisions involving a party spending considerable time and money to go through a trial in a Section 220 case, but the court ruling that no right to books and records was established.
Among the Section 220 cases that are litigated, disputes often arise regarding the limited scope of discovery that is available in a Section 220 action prior to trial, as well as what restrictions should be imposed on documents that are produced. The terms of Section 220 do not entitle the company producing the documents to establish conditions to production such as confidentiality, but as a practical matter the courts often enforce such conditions for truly confidential information. See e.g., Hoschett v. TSI International, 1996 WL 4223440 (Del. Ch.). In sum, Section 220 is a useful tool, but other tools are often needed.