| The following article appeared in the current issue of the recently debuted publication called the Delaware Business Court Insider.
Courts Clarifying Shareholders’ Rights to Information |
Two recent decisions help clarify the type of information a shareholder may obtain from a corporation under Section 220 of the Delaware General Corporation Law (DGCL), and the timing of when a Section 220 suit may be brought.
In Louisiana Municipal Police Employees Retirement System v. Morgan Stanley & Co., the Court of Chancery on March 4 allowed a shareholder, Louisiana Municipal Police Employees Retirement System (Lampers), to obtain information regarding the investigation by a board committee and the report of its counsel. This follows the recent decision of King v. VeriFone by the Supreme Court, which refused to dismiss a Section 220 suit simply because it was filed after a derivative suit for which the shareholder was seeking additional details to amend the derivative complaint.
The Lampers Case
In Lampers, the plaintiff sought information to “investigate whether the board of directors of Morgan Stanley & Co. wrongfully refused an earlier demand by the shareholder that Morgan Stanley must initiate litigation against certain officers and directors for alleged wrongs arising out of the involvement by the company with auction rate securities.”
The court granted the motion to dismiss to the extent that some information was not reasonably required to investigate whether the litigation demand was wrongfully refused, but denied the motion to dismiss to the extent that the request lacked a “proper purpose.”
Notably, Lampers had previously filed a stockholder derivative action against Morgan Stanley without first using Section 220 to obtain books and records, but nonetheless asserted in the derivative action that presuit demand was futile.
Lampers had originally filed a separate derivative action in federal court in New York but that complaint was provisionally dismissed for failure to comply with Rule 23.1. The federal court, however, retained jurisdiction and set a schedule to allow for: (i) the plaintiff[s] to make a demand on the board; (ii) the board to respond; and (iii) the plaintiffs to seek any further relief necessitated by the board’s response. The federal court thereafter stayed the derivative case pending a decision by the Delaware Court of Chancery in the Section 220 proceeding.
Eight months after the litigation demand, the board hired the law firm of Simpson Thacher & Bartlett to investigate the litigation demand and eight months later the board received a report. Based upon that report, the board refused to take any action. In addition, in its reply to Lampers’ litigation demand, the board merely described the process followed by Simpson Thacher in rendering a report and recommendation. However, the board’s explanatory letter did not provide any “substantive insight” into the reasoning behind the decision to refuse to take action in response to the demand. Thereafter, Lampers submitted a demand seeking certain books and records pursuant to Section 220.
In addition to information relating to the investigation and report by Simpson Thacher, Lampers also sought a report prepared by Skadden Arps Slate Meagher & Flom in connection with the separate investigation it did in 2007 and 2008 into Morgan Stanley’s involvement with auction rate securities.
The court recited the well-established truism that “books and records actions” pursuant to Section 220 are summary proceedings that “are to be promptly tried.” The court in this instance entertained the motion to dismiss because it appeared that the underlying facts were largely undisputed, although dispositive motion practice may otherwise be inefficient in a summary proceeding, which often can be tried within approximately two months of filing.
Proper Purpose
The court observed that under Section 220(b), a shareholder must have a “proper purpose” for requesting the information the shareholder is seeking and that has has been defined as “a purpose reasonably related to such person’s interest as a stockholder.” Referring to prior decisions of both the Delaware Supreme Court and the Delaware Court of Chancery, the court explained that the stockholder plaintiff did not, by making a pre-suit demand, waive the right to claim that demand has been wrongfully refused. In that explanation, the court cited the 1996 Delaware Supreme Court decision in Grimes v. Donald (Grimes I). In addition, in its 1998 decision Grimes v. DSC Communicatons Corp. (Grimes II), the Court of Chancery decided that a request for books and records to determine whether a special committee complied with Delaware law in their analysis and rejection of a pre-suit demand — was a proper purpose,
The court also relied on Delaware Supreme Court precedent — Grimes I — for the position that a pre-suit demand does not concede the independence or the disinterestedness of the board for purposes of demand refusal analysis (as opposed to demand futility).
The court also provided a long list of exemplary “proper purposes” under Section 220 (quoting from a leading treatise on Delaware corporate law), which included:
(1) Seeking to investigate allegedly improper transactions or mismanagement.
(2) To clarify an unexplained discrepancy in the corporation’s financial statements.
(3) To investigate the possibility of an improper transfer of assets out of the corporation.
(4) To ascertain the value of stocks.
(5) To aid litigation and to contact other stockholders regarding litigation and to invite their association with the case.
(6) To inform fellow shareholders of one’s view concerning the wisdom or fairness, from the point of view of the shareholders, or a proposed recapitalization and to encourage shareholders to seek appraisal.
(7) To discuss corporate finances and inadequacies of management, and then depending on the response, to determine stockholder sentiment for either a change in management or a sale.
(8) To inquire into the independence, good faith and due care of a special committee formed to consider a demand to institute derivative litigation.
(9) To communicate with other stockholders regarding a tender offer.
(10) To communicate with other stockholders in order to effectuate changes in management policies.
(11) To investigate stockholders’ possible entitlement to oversubscription privileges.
(12) To determine an individual’s suitability to serve as a director.
(13) To obtain names and addressed of stockholders for contemplated proxy solicitation.
(14) To obtain particularized facts needed to adequately allege demand futility after the corporation has admitted engaging in backdating stock options.
The court also referred to the 2010 Delaware Supreme Court decision in City of Westland Police and Fire Retirement Systems v. Axcelis Tech Inc. for the position of Delaware law that books and records may be demanded under Section 220 for the purpose of “evaluating the suitability of directors to serve.” It was further explained that whether or not the board acted wrongfully in denying and refusing to pursue the claim was not currently at issue. Rather the issue was whether Lampers’ purpose for inspection was proper and the court found that it was. This may be compared with the March 25 Chancery Court transcript ruling in Espinoza v. Hewlett-Packard Co., which denied a Section 220 request for a report from counsel of board committee, based on attorney-client privilege and the attorney work product doctrine.
Scope of Inspection
While the language of Section 220 refers to “books and records” as the scope of inspection is limited to information that is “necessary to accomplish the stated purpose.”
In this case, the court concluded that Lampers stated a proper purpose and was entitled to obtain the information it requested, including:
(1) The minutes of any meeting of the board or the Audit Committee where the litigation demand was discussed or evaluated.
(2) Simpson Thacher’s written report and presentation to the Audit Committee in connection with the firm’s recommendation to refuse the litigation demand.
(3) The Audit Committee’s report and presentation to the board.
(4) Any documents and other records upon which the board relied.
Moreover, the court found that Lampers stated a proper purpose to obtain the engagement letter of Simpson Thacher in order to evaluate the scope of the firm’s engagement and its economic incentives. In addition, the court concluded that Lampers had a right to obtain the report prepared by Skadden Arps and those parts of the investigation by Skadden Arps that were considered by Simpson Thacher.
Lastly, the court granted leave for Lampers to pursue a future Section 220 demand in which it would be permitted to make arguments based on the materials it obtained.
A Prelude to Lampers
In a prelude of sorts to the Chancery decision in the Lampers case, the Supreme Court in King v.VeriFone Holdings Inc., a Jan. 28 opinion, also provided added clarity to practitioners regarding the “proper purpose” and related prerequisites that a shareholder must satisfy in order to successfully seek books and records under DGCL Section 220. This ruling reversed a Court of Chancery decision that found a lack of proper purpose in part because the Section 220 action was filed after a derivative suit was filed. Delaware’s high court explained that it remains preferable to file Section 220 suits to obtain books and records prior to filing a derivative suit, but following that chronology is not, per se, a fatal flaw in a Section 220 action.
In VeriFone, a shareholder filed a derivative complaint in California based on VeriFone’s restatement of financial statements. Notably, however, VeriFone provided most of the requested “categories of documents” that were sought before suit except one: “The Audit Committee Report with the results of an internal investigation regarding the issues surrounding the restatement of VeriFone’s financial statements.” The purpose of this demand, which was pursuant to the specific direction of the federal court in which the derivative suit was pending, was to use information gathered through the DGCL § 220 suit to amend the complaint, in order to assist King in pleading demand futility in the California suit.
The Supreme Court’s Analysis
Delaware’s high court recognized “investigation of corporate mismanagement” as a “proper purpose” for seeking books and records pursuant to DGCL § 220. Other cases were cited for the Delaware court’s frequent exhortations to practitioners to use DGCL § 220 to obtain detailed information prior to a plenary lawsuit, in order to obtain the detailed facts needed to successfully plead “demand futility” for purposes of satisfying Court of Chancery Rule 23.1 in derivative suits.
Delaware’s high court recognized that it may be ill-advised to file a § 220 suit after a derivative case is filed, but the court explained that such a sequence “has not heretofore been regarded as fatal.”
Three Delaware decisions were discussed at length to support the court’s reasoning that: “both this court and the Court of Chancery [have] permitted stockholder-plaintiffs to utilize the Section 220 inspection process to gather new information and replead their derivative complaints.” Two other Delaware cases that reached a different result were distinguished.
The court emphasized that it was reaffirming “long-standing Delaware precedent” recognizing that a proper purpose under Section 220 includes seeking books and records to aid in pleading demand futility in a “to-be-amended” complaint in an existing plenary derivative action.
Moreover, while rejecting the Court of Chancery’s holding that a prerequisite of a § 220 action is to file a § 220 suit prior to a derivative suit; the Delaware Supreme Court did not endorse that particular sequence as a best practice in connection with filing a § 220 suit. Although the court was sensitive to the policy issues involved with its rejection of a bright-line test for the timing of a § 220 suit, it explained that the Delaware General Assembly would need to amend the statute to impose a sequential prerequisite, and it would not be appropriate for the judiciary to do so.
Contentious, Complex and Costly
The Lampers and the VeriFone decisions highlight how Section 220 actions can be contentious, complex and costly. The tortuous procedural background particularly in VeriFone, indicates that so-called summary proceedings can be hard fought and often are. While it is rare for the members of the Delaware Supreme Court and Court of Chancery to disagree on the interpretation of basic provisions of the DGCL as in the VeriFone case, there are many decisions denying Section 220 requests. Also, these matters can be costly because as the VeriFone case illustrates, these cases are frequently appealed to the Delaware Supreme Court. And it is important to remember that after all that effort, if the plaintiffs “wins” they merely get information.
In sum, these two cases taken together clarify for practitioners that seeking data about a board committee’s investigation of alleged wrongdoing by a company’s officers and directors, as well as the report of the committee’s counsel, may be a proper purpose for a Section 220 action, and that a Section 220 case may not be dismissed for the sole reason that it was filed after a derivative case by the same plaintiff. We will have to wait and see if the Delaware General Assembly responds to the Supreme Court’s comment in VeriFone that in order for a sequential prerequisite to be part of Section 220 (e.g., requiring that it be filed prior to a derivative action), the statute must be amended to expressly provide as much.
Kevin F. Brady is a partner with Connolly Bove Lodge & Hutz in Wilmington. He is the chair of the firm’s business law group as well as chair of the information security, electronic discovery and records management group.
Francis G.X. Pileggi is the founding partner of Fox Rothschild’s Wilmington office. He practices primarily corporate and commercial litigation, with an emphasis on representing public and privately held corporations, directors, stockholders and members or managers of limited liability companies and other alternative entities.