Norfolk County Retirement System v. Jos. A. Bank Clothiers, Inc., (Del. Ch., Feb. 12, 2009), read opinion here. This Delaware Chancery Court decision denied a demand for books and records under Section 220 of the Delaware General Corporation Law. There have been many decisions on Section 220 summarized on this blog. This decision is an example of why Section 220 claims are not always simple or predictable.
Kevin Brady, a highly respected Wilmington lawyer, has prepared the following detailed review of the case:
The Chancery Court granted the defendant’s motion for summary judgment finding that the plaintiff had failed to demonstrate that it had a right under 8 Del. C. § 220 to inspect certain books and records of defendant Jos. A. Bank Clothiers (the “Company”). While the events in question in this dispute occurred during the period from December 2005 through June 2006, it was not until eighteen months and two law suits later, that plaintiff Norfolk County Retirement System (“Norfolk”) sent a demand letter to the Company seeking to inspect certain books and records related to the circumstances surrounding allegedly false and misleading statements regarding defendant’s financial affairs and in particular, the levels of inventory of the Company’s Fall/Winter 2005 clothing lines. Apparently, those inventory levels led the Company to steeply discount inventory, which increased sales but decreased profit margins.
The triggering event occurred on June 7, 2006, when the Company reported a drop in year-over-year first quarter earnings. By the close of trading on June 8, 2006, the Company’s stock price had fallen 29%. In response to the stock price drop, stockholders filed securities class action complaints in the United States District Court for the District of Maryland alleging violations of Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. While a derivative action alleging breaches of fiduciary duty also was filed in the same court, the plaintiff in the Maryland derivative action did not request any books or records before filing or during the course of the law suit. Instead, that plaintiff argued that demand was futile because the directors were not independent. That claim was denied and the derivative action was dismissed. The Maryland derivative plaintiff then sent a letter to the Board demanding that the Board set up a special litigation committee (“SLC”) to investigate the alleged wrongdoing. The Board established a SLC and after an investigation, the SLC determined that there was no wrongdoing and that the derivative action and the securities class action were without merit. Subsequent to the SLC’s findings, on January 3, 2008, Norfolk filed an action in the Delaware Court of Chancery seeking to compel inspection pursuant to 8 Del. C. §220. On September 19, 2008 the parties cross- moved for summary judgment.
There were two issues before Vice Chancellor Parsons: (i) to what extent had Norfolk demonstrated a “proper purpose” under Section 220; and (ii) if Norfolk has articulated a proper purpose, had the Company produced the documents “necessary, essential and sufficient” for that purpose? In its demand letter, Norfolk had identified three reasons: (i) to evaluate potential “wrongdoing, mismanagement, and breaches of fiduciary duties” regarding certain financial disclosures in June 2006, which could lead to the filing of a derivative suit; (ii) to investigate the possibility of filing a derivative suit; and (iii) “to take appropriate action in the event the members of the Company’s Board of Directors did not properly discharge their fiduciary duties.”
Burden of Proof –“Credible Evidence” Standard
In discussing the standard by which the Court would measure the actions of Norfolk at the summary judgment stage of the litigation, the Court noted:
In a case like this one, summary judgment may be granted for a corporate defendant if the stockholder seeks inspection to investigate potential corporate wrongdoing and yet fails to present ‘some evidence to suggest a credible basis from which a court can infer that mismanagement, waste or wrongdoing may have occurred.’ The “credible basis” standard has been described as the ‘lowest possible burden of proof’ in Delaware jurisprudence. Under Delaware law, a stockholder making a Section 220 demand does not have to prove mismanagement actually occurred, but must make a ‘credible showing, through documents, logic, testimony or otherwise, that there are legitimate issues of wrongdoing.’ The scope of the documents available to a stockholder under § 220, however, is limited. Even if a plaintiff demonstrates a proper purpose, that plaintiff is not entitled to inspect all the documents that he or she believes are relevant or even likely to lead to information relevant to that purpose. Delaware courts repeatedly have held that ‘[t]he scope of inspection should be circumscribed with precision and limited to those documents that are necessary, essential and sufficient to the stockholder’s purpose.’
Norfolk was seeking documents related to the circumstances surrounding the allegedly false and misleading statements at issue in the Securities Class Action, which also formed the basis for the Maryland derivative action. After the Company received the November 2007 demand letter, it provided Norfolk with a copy of the SLC Report, the exhibits thereto, the minutes of the meetings of the SLC and the minutes of the meetings of the Company’s Board approving the creation and function of the SLC. However, Norfolk wanted much more including, among other things, financial data, financial procedures and controls, compliance and auditing materials.
Vice Chancellor Parsons found that while Norfolk had not demonstrated a reasonable basis for believing that the Company was not adequately represented by the prior derivative plaintiff or the SLC, it had received documents that “should suffice for the purposes of establishing or raising reasonable grounds for suspicions about a special committee’s independence, good faith and due care.” The Court went on to state that “[u]nder the low burden imposed by Delaware courts in § 220 actions, such a showing could entitle Norfolk to inspect additional documents beyond what the Company voluntarily provided.” Norfolk argued that it should be able to rely on the complaint filed in the Securities Class Action case and the fact that it had survived a motion to dismiss and a motion for judgment on the pleadings (although the Court did not examine the SLC Report at the pleading stage because it was not incorporated by reference in the complaint or a public record). Vice Chancellor Parsons, however, disagreed stating that “Norfolk has made no meaningful attempt to question the adequacy of the SLC’s process or the reasonableness of its investigation and conclusions.”
While the Court found that Norfolk had received documents that were sufficient for the purpose of investigating the possibility of bringing a derivative suit, it had to articulate a reasonable need for whatever additional documents it sought and it failed to do that. The Court noted that Norfolk’s arguments might have been more persuasive if Norfolk had pursued its demand for books and records promptly. Because it did not, Norfolk had to make at least a threshold showing that it had a reasonable prospect of overcoming the additional and contrary evidence presented by the SLC related documents. The Court found that Norfolk had failed to meet that burden and could not rely on what happened in the Securities Class Action because those decisions dealt with motions made under Rule 12 of the Federal Rules of Civil Procedure and as a result, the Court specifically did not consider the SLC Report or its exhibits. Thus, the Court found that those decisions are not dispositive on the issue of “proper purpose.” As a result, the plaintiff’s complaint was dismissed with prejudice.
For those interested in a negative perspective on the case, and criticism of Delaware corporate law in general, commentary can be found on the blog called The Race to the Bottom by Professor J. Robert Brown here.