Rare Instance of Fee Shifting in Section 220 Case

Among the multitude of court decisions on DGCL Section 220 highlighted on these pages, a rare bird is the shifting of fees by the court based on the bad-faith exception to the American Rule. In a rare instance that should not be considered anything other than unusual, the Court of Chancery recently granted, in a transcript ruling, fee shifting in a books and records action in which the court found that there was no justification for the refusal to provide LLC managers with requested books and records, and that the defendant LLC acted in bad faith by withholding those company records. See Crestview-Oxbow Acquisition, LLC, et al. v. Oxbow Carbon, LLC, C.A. No. 2018-0654-JTL, transcript (Del. Ch. Jan. 15, 2019; filed Jan. 31, 2019).

 

Director Not Entitled to Privileged Communications with Board Special Committee

A recent short Order of the Court of Chancery reiterated one of the limitations on the right of a director to receive corporate information. In the latest installment of the internecine imbroglio in the litigation captioned Schnatter v. Papa John’s International, Inc., C.A. No. 2018-0542-AGB, Order, (Del. Ch. Feb. 25, 2019), the Court explained that DGCL Section 141(c) allows a board to act “openly with the knowledge of the excluded director to appoint a special committee, in which case communications with the counsel would be properly protected, at least to the extent necessary for the committee’s ongoing work”. (internal quotes modified)(citing Kalisman v. Friedman, 2013 WL 1668205, at *4 (Del. Ch. Apr. 17, 2013)). The Kalisman case was highlighted on these pages.

A prior Chancery decision in the Papa John’s case, that also addressed the right of directors to corporate documents, was highlighted on these pages.

The Court in its Order reasoned that there was no evidence presented in the context of the motion to compel that Schnatter ever regarded the law firm for the Special Committee as the Company’s counsel or the Board’s counsel. Nor was there a reasonable basis for Schnatter to regard that law firm as representing his interests, including his interests as a director.

Schnatter was barred from obtaining privileged communications for a very narrow period of time in anticipation of the contemplated formation of a Special Committee pursuant to DGCL Section 141(c). Schnatter was excluded in order for the Special Committee to investigate certain matters concerning him.

 

Chancery Denies Section 220 Demand for Corporate Books and Records

A recent post-trial decision from the Delaware Court of Chancery denied a claim for corporate books and records based on DGCL § 220 after finding that there was no credible basis for wrongdoing to support the stated investigative purpose for the demand. Hoeller v. Tempur Sealy International, Inc., C.A. No. 2018-0336-JRS (Del. Ch. Feb. 12, 2019).  Section 220 cases are among the most common forms of Delaware corporate litigation. (In terms of the number of recent Delaware cases highlighted on this blog, it might only be outnumbered by forum selection clause cases.)

Commentary:

About 100 or more Delaware court decisions on Section 220 have been highlighted on these pages over the last 14 years. Regular readers will recall many commentaries about Section 220 that include this lawyer’s respectful skepticism, or lack of enthusiasm, for Section 220 as a tool to obtain information as part of one’s preparation for a plenary complaint.  To the extent that Section 220 is a tool, the decision highlighted in this post supports the view that in some cases Section 220 may be more akin to a sledgehammer than a scalpel, to the extent that Section 220 can often be expensive and time consuming and unsatisfying as a means of obtaining information from a corporation by a stockholder.

For busy readers, the most noteworthy aspects of this 39-page decision can be explained through the use of bullet points to highlight the court’s comprehensive and well-reasoned review of the facts and law involved in an unsuccessful Section 220 claim.

Brief Background:

This case involved a demand for corporate books and records in connection with the termination of a long-term corporate customer relationship which accounted for over 20% of the sales of the defendant company. This important relationship was the subject of alleged misrepresentations that were allegedly more optimistic about the future of the relationship than was warranted.  Although some documents were produced in response to a pre-suit Section 220 demand, the complaint in this case was filed when additional documents demanded were not provided.

Procedural History:

Although internal Chancery guidelines suggest a trial within about 90 days of a complaint, the trial in this case was held within a still comparatively prompt 6-months after the complaint was filed, in November 2018. This February 2019 post-trial decision provides for a relatively quick determination, however unsatisfying to the plaintiff, although prior Section 220 cases highlighted on these pages indicate that when Section 220 cases are appealed, and in some cases remanded, litigation involving Section 220 conceivably could last for several years.

Key Takeaways:

Some of the key legal principles that can be found in this post-trial opinion include the following well-known prerequisites for a Section 220 claim, and important nuances of those requirements, many of which are not expressly stated in the statute:

  • The prerequisite of a “proper purpose” for inspection is defined as one that is reasonably related to the interest to the plaintiff as a stockholder.
  • Although the desire to investigate mismanagement or wrongdoing is a recognized proper purpose, a stockholder must prove by a preponderance of the evidence that it has presented a “credible basis” from which the court can infer that the alleged wrongdoing occurred. Credible basis requires merely “some evidence” of wrongdoing–and not that wrongdoing actually occurred.
  • A stockholder must also state the reasons why he seeks to inspect books and records. That is, what the plaintiff will do with the information or the goal of the investigation. The court applies this requirement to avoid fishing expeditions. In the absence of evidence of a fiduciary duty breach, where a decision falls within the business judgment rule’s protection, the proper purpose requirement fails as there is no claim for a stockholder to pursue in that situation. (Also, for example, though valuation is a well-established Section 220 proper purpose, some cases have required an explanation about the reason a valuation is sought.)
  • Where the purpose of a stockholder is based on the possible breach of the duty of oversight, such as in a Caremark claim, a stockholder must provide “some evidence” from which the court may infer that the board “utterly failed to implement a recording system or ignored red flags.” Moreover, in that context, there must be evidence of non-exculpated corporate wrongdoing in order to survive a defense (in the event that a corporation has a Section 102(b)(7) provision).
  • In this case, there was an allegation that there were misrepresentations about the future of important customer relationships, but the court found that there was insufficient evidence to satisfy the “credible basis” requirement.
  • In addition, the court referred to prior cases in which the plaintiff could not explain the basis for the wrongdoing that was being investigated or the need for the documents that were requested. In those prior cases, the court found that it was the attorneys who were the driving force behind the litigation and not the plaintiff that was requesting the documents. Although the court suspected that to be applicable in this matter, the court did not deny the claim on that basis, but rather reasoned that: “the plaintiff has failed to proffer even a scintilla of evidence to support a credible basis that a claim may exist” under Caremark.
  • The court also reasoned that the fact that active negotiations failed to lead to a deal with a key customer does not support a Caremark claim, especially based on evidence that the board was apprised of, and at times involved in, the negotiations.
  • An important aspect of the court’s decision is the following rationale: “Disagreement with a business decision, in the absence of evidence from which the court may infer a possible breach of fiduciary duty, does not create a credible basis from which the court can infer mismanagement.” See Slip op. 26-27, n. 90.

Second Amendment Legal Advocacy Award

News from the Department of Self-Promotion: Recently I was awarded the 2019 Chief Justice William Killen Award for Second Amendment Legal Advocacy in connection with my most recent successful legal challenge of certain state regulations. The award was presented on behalf of the Delaware State Sportsmen’s Association, which is an affiliate of the National Rifle Association, before a group of about 600 people in Dover. In a recent Delaware court opinion highlighted on these pages, my colleague Jamie Inferrera and I prevailed in our arguments that certain regulations at state parks were in violation of a Delaware Supreme Court decision that found prior regulations invalid based on the Second Amendment to the U.S. Constitution and the counterpart in the Delaware State Constitution at Article I, Section 20. The award is named after the first Chief Justice and first Chancellor of the State of Delaware. Although this is not an annual award, several years ago I received this award for other appellate victories.

There are many people–lawyers and non-lawyers alike–as well as several organizations too numerous to mention in this short post who made it possible to prevail in three major court decisions, available at the above hyperlinks, that now form a foundation for a body of law in Delaware that is based on the natural right to self defense, which every human is born with, and that the United States Supreme Court has ruled to be at the core of the right to bear arms.

Company Required to Produce Emails Among Management to Stockholders

The Delaware Supreme Court recently issued an opinion that clarifies the duty of a company to produce emails among its management in a Section 220 case. In KT4 Partners LLC v. Palantir Technologies, Inc., Del. Supr., No. 281, 2018 (Jan. 29, 2019), Delaware’s High Court addressed a demand under Delaware General Corporation Law (DGCL) Section 220 by a stockholder for corporate books and records, including emails among management, to allow the stockholder to investigate possible wrongdoing, such as the reasons behind amendments to an Investors’ Rights Agreement that severely reduced the original rights granted under that agreement.

Notably, the court in its opinion quoted from a law review article that yours truly co-authored on the topic, which explained why demands under DGCL Section 220 should often include electronically-stored information (ESI) such as emails. See footnote 76.

This opinion is noteworthy because it clarifies Delaware law and authoritatively describes those circumstances when a demand for books and records under DGCL Section 220 will require the company to produce ESI, such as emails among management, to the extent necessary for the proper purpose established in a Section 220 case.

Brief Overview:

The stockholder demand in this case stated as its purpose the investigation of mismanagement, including depriving investors of their right of first refusal under an investors’ agreement that was amended without the consent of all investors, as well as interfering with the sale of stock by a large stockholder. The Court of Chancery, in a decision highlighted on these pages, determined that although some books and records had to be produced, emails need not be. The Supreme Court disagreed with that ruling and affirmed in part, reversed in part, and remanded.

Importantly, the facts of this case include an acknowledgment by the company that it often did not follow corporate formalities such as preparing board resolutions and keeping minutes of board meetings, but rather often communicated by email and took action by email–including on matters that were the subject of the investigative purpose of the Section 220 demand.

Highlights of Key Aspects of the Court’s Ruling:

For busy readers, I provide bullet points of key aspects of this crucial decision, but those who need to be familiar with the nuances of this aspect of Delaware corporate litigation should read the entire 49-page opinion linked above.

Procedural Background:

  • The court discussed what appeared to be an issue of first impression about the standard of review regarding a dispute over the interpretation of the stated purpose in a Section 220 demand. The court explained that the standard of review for the scope of relief is abuse of discretion, but de novo review applies to questions of law such as whether the stated purpose under Section 220 is proper. Although contract interpretation is also subject to de novo review as a question of law, fact-intensive and judgment-based determinations are reviewed for abuse of discretion, and factual determinations that underlie the trial court’s interpretation of an ambiguous written document deserve the deference given to factual findings.
  • The Delaware Supreme Court found that the demand in this case did include an explicit reference to a request for electronic documents.
  • The core issue identified by the High Court was whether the Court of Chancery abused its discretion in ruling that emails and other ESI were not necessary to satisfy the purpose of investigating the wrongdoing alleged in this Section 220 case.

Basic Principles:

  • The court reviewed the basic principles and policy undergirding the qualified common law and statutory right to inspect corporate books and records. See Slip op. at 22 to 24.
  • The court observed that the scope of documents to which a stockholder is entitled under Section 220 is limited to those that are necessary to accomplish the proper purpose as stated in the demand. See Slip op. at 24 to 25.

Emails/ESI Production:

  • In explaining why ESI should be included in appropriate Section 220 cases, the Delaware Supreme Court quoted from a law review article on this topic co-authored by your truly. See footnote 76 (quoting Francis G.X. Pileggi, et al., Inspecting Corporate “Books and Records” in a Digital World: The Role of Electronically Stored Information, 37 Del. J. Corp. L. 163, 165 (2012)).
  • The court reviewed Delaware cases that previously addressed whether ESI such as emails should be included in a Section 220 request. See footnotes 71 to 74. See also Amalgamated Bank v. Yahoo!, Inc., a Chancery opinion highlighted on these pages that also cited the same law review article on this topic co-authored by yours truly that was quoted by the Supreme Court in the instant case. See, e.g., footnote 72 (citing a Court of Chancery Order allowing for imaging of a Blackberry in a Section 220 case.)
  • The court also explained, based on the facts and circumstances of this case, why emails and ESI had to be produced and were needed to accomplish the stated purpose. See Slip op. at 31. For example, the court explained that the company involved did not comply with required corporate formalities such as minutes of board meetings and that it often conducted corporate business informally, including over email, regarding the issues subject to the Section 220 demand. See footnote 77 and accompanying text. The ESI at issue included, for example,  an allegedly incriminating message sent via LinkedIn.
  • The court also emphasized that there may be some Section 220 cases where ESI may not be required to be produced by the company, such as those situations where the corporation has traditional, non-electronic documents that are sufficient to satisfy the needs of the Section 220 petitioner.
  • In this case, the company admitted that there were no hardcopy documents that addressed all of the requests, and that there were emails and other ESI that were responsive to the requests.
  • The court also provided practice tips for future litigants: there should be a cooperative effort to focus on the substantive data that should be produced–or in other words, focus on the information that is needed and that is available whether it be in hardcopy or in ESI format.

The court also addressed an unrelated issue. It rejected the argument that the company made that as a condition of production it could require the stockholder to file any suits based on the data received in the Delaware Court of Chancery. Although there have been cases that have imposed similar jurisdictional conditions, the court explained why such a condition should be the exception and not the norm.

SUPPLEMENT: Law360 published an article about this case in which they quoted my comments about the importance of the High Court’s opinion. (Subscription required)

Chancery Enjoins Shares Issued to Director Without Stockholder Approval

A recent Court of Chancery decision is notable for its analysis of an issuance of shares approved by a sole director–but without stockholder approval. In the matter of Applied Energetics, Inc. v. Farley, C.A. No. 2018-0489-TMR (Del. Ch. Jan. 24, 2019), the court considered a somewhat unusual set of facts that included a shell corporation, at the time of the issuance of stock being contested, that only had one director–although the bylaws required a minimum of three directors.  A stockholder challenged the issuance of a large number of shares to the sole director at a price that was allegedly less than fair market value.

The most notable aspects of this opinion include the following bullet points:

  • When discretionary director compensation–including issuance of stock by directors to themselves–is done without stockholder approval, the directors have the burden of establishing the entire fairness of the transaction to the corporation and stockholders. See footnotes 99 to 103 and accompanying text.
  • In the context of this case, the stockholders sought a preliminary injunction to prevent the director from selling or transferring the shares that he authorized to be issued to himself. In the context of a motion for preliminary injunction, despite the normal burden under the entire fairness standard, the moving party must carry the burden to show a reasonable probability of ultimate success on the merits in order to obtain injunctive relief prior to trial.
  • The entire fairness standard includes a requirement for both fair price and fair dealing. In the circumstances of this case, the court determined that those two criteria were so overlapping that it focused on the fair price that the sole director determined on his own.
  • The court found that there was an insufficient basis for the director to determine the low price that he set for himself for the large number of shares that he purported to authorize to be issued to himself.
  • See DGCL § 141 requiring board approval by written consent to be unanimous. Only one director was serving at the time, but the bylaws provided for a minimum of three directors.
  • The court reviewed the prerequisites of injunctive relief: (1) a likelihood of success on the merits; (2) irreparable harm, and (3) a balance of the equities, to support its reasoning for granting a preliminary injunction.
  • The court also considered a claim for fraudulent transfer based on some of the shares being transferred to an LLC controlled by the family of the director–after it became likely the issuance of shares would be challenged. See Slip op. at 28 to 32 and accompanying text.
  • The court also discussed how it determined the amount of the bond that would be required in order for injunctive relief to be granted. See Slip op. at 38 to 40 and accompanying text.

Supreme Court Explains the Implied Covenant of Good Faith and Fair Dealing

A recent Delaware Supreme Court decision is must-reading for those who need to know the latest iteration of Delaware law on the implied covenant of good faith and fair dealing. In Oxbow Carbon & Minerals Holdings, Inc. v. Crestview-Oxbow Acquisition, LLC, Del. Supr. No. 536, 2018 (Jan. 17, 2019), Delaware’s High Court provided the latest articulation of Delaware law on the multi-faceted doctrine of the implied covenant of good faith and fairing dealing. In connection with affirming in part and reversing in part a 176-page trial court opinion, which was highlighted on these pages, the Supreme Court agreed with the analysis of the trial court’s correct reading of the plain meaning of the LLC agreement at issue, but disagreed with the application by the trial court of the implied covenant.

Highlights of the most recent authoritative explanation of the implied covenant under Delaware law are noted in the following bullet points:

  • When a board is given contractual discretion to make a choice, that is not a “gap” to be filled. Although “the vesting of a board with discretion does not relieve the board of its obligation to use that discretion consistently with the implied covenant of good faith and fair dealing,” the argument was not made in this case that the board exercised this contractual discretion in bad faith. See footnotes 92 and 93 and accompanying text.
  • The court explained the two common situations where the implied covenant often applies. The first, at issue in this case, is when it is argued that a situation has arisen that was unforeseen by the parties and where the agreement’s express terms do not cover what should happen. See footnote 93.
  • The next situation is when a party to the contract is given discretion to act as to a certain subject and it is argued that the discretion has been used in a way that is impliedly proscribed by the contract’s express terms. Id.
  • “When a contract confers discretion on one party, the implied covenant requires that the discretion be used reasonably and in good faith.” Id.
  • Delaware’s High Court explained that the “implied duty of good faith and fair dealing is not an equitable remedy for rebalancing economic interests after events that could have been anticipated, but were not, later adversely affected one party to a contract.” See footnote 109 and accompanying text.
  • Rather, “the covenant is a limited and extraordinary legal remedy.” See footnote 110.
  • The Supreme Court added that the implied covenant “does not apply when the contract addresses the conduct at issue, but only when the contract is truly silent concerning the matter at hand. Even where the contract is silent, an interpreting court cannot use an implied covenant to re-write the agreement between the parties, and should be most chary about implying a contractual protection when the contract could easily have been drafted to expressly provide for it.” See footnotes 110 to 113 and accompanying text.

Chancery Clarifies Director’s Right to Corporate Records

A recent Delaware Court of Chancery decision addressed the important issue of the right of directors to be given access to corporate records. In Schnatter v. Papa John’s International, Inc., C.A. No. 2018-0542-AGB (Del. Ch. Jan. 15, 2019), Delaware’s court of equity considered a claim under Section 220(d) of the Delaware General Corporation Law (DGCL) by the founder and largest stockholder of the Papa John’s pizza chain who was forced out as the CEO but retained his position as a director.  He sought to obtain books and records in his capacity as a director to support an investigation that the other directors breached their fiduciary duties by improperly ousting him for unjustified reasons.

 Key Bullet Points that Make this Case Noteworthy include the following:

  • The court required the Defendant-Directors to produce their text messages and their private emails, that they sent and received, that related to the specific issues in contention. Prior Chancery decisions have required the production of such personal communications that related to corporate business but such a ruling is still notable. For example, a few years ago, in Amalgamated Bank v. Yahoo!, Inc., highlighted on these pages, the Court of Chancery ordered a similar scope of production–and also cited to a law review article that yours truly published in which my co-authors and I explained why electronically stored information (ESI), including text messages and private emails, should often be included within the scope of a DGCL Section 220 demand. See law review article co-authored by yours truly which argued that the court should often include ESI as part of the obligation to produce records under Section 220. See 37 Del. J. Corp. L. 163, 165 (2012), highlighted on these pages here.
  • It is well-established that directors have nearly unfettered rights to access to books and records of a corporation in which they serve. Unlike a stockholder, when a director makes a demand for books and records under Section 220(d), the corporation has the burden to establish that the director’s demand for books and records is based an improper purpose.
  • Unlike the impact of a stockholder filing a plenary action before a Section 220 case is complete, when a director files a plenary action before a final ruling in a Section 220 case, that will not necessarily bar the continuation of Section 220 claims and it will not otherwise moot the Section 220 claims. See generally CHC Investments, Inc. v. FirstSun Bancorp, C.A. No. 2018-0610-KSJM (Del. Ch. Jan. 24, 2019)(Section 220 stockholder demand case dismissed due to parallel plenary action.)
  • The court observed that a director should not be required to sign a confidentiality agreement as a condition to obtaining records because a director already has a fiduciary duty to keep them confidential—as compared to stockholders who routinely are required to sign a confidentiality agreement as a condition to obtaining records pursuant to a Section 220 demand. See generally Murfey v. WHC Ventures, LLC, C.A. No. 2018-0652-MTZ (Del. Ch., Jan.23, 2019)(proposed confidentiality order rejected by Court as non-compliant with Chancery Rule 5.1 because it did not allow for filing confidential documents with the court–confidentially.)

United States Supreme Court Addresses Arbitrability

A recent decision of the United States Supreme Court addressed the frequently encountered issue of arbitrability—that is, whether a court or an arbitrator should decide whether or not a particular issue is subject to arbitration based on the arbitration clause in an agreement.

This decision is noteworthy because the issue often arises about how to handle an argument that a claim is subject to arbitration when that claim is frivolous (at least in one party’s view.) In Henry Schein, Inc. v. Archer & White Sales, Inc., U.S. Supr. Ct., No. 17-1272 (Jan. 8, 2019), a unanimous decision written by Justice Brett Kavanaugh, the court rejected a judicially-imposed exception to arbitrability under the Federal Arbitration Act.  The court determined that if an agreement containing an arbitration clause provides that arbitrators have the power to resolve arbitrability questions, then an arbitrator—not the court—should decide whether the arbitration provision applies to the issue involved, regardless of whether the arbitration demand is “groundless.”

The court rejected an argument followed by some lower courts that if an arbitration claim was “wholly groundless,” a court should decide arbitrability. The nation’s high court reasoned that because the statute did not impose a “wholly groundless” exception, the gateway question of arbitrability is a matter of contract law and, for example, when an agreement refers to the rules of the American Arbitration Association, those rules provide for the arbitrator to have the power to resolve arbitrability questions.

This decision should be compared to the long line of Delaware cases on arbitrability beginning with the Delaware Supreme Court decision in Willie Gary, highlighted on these pages here, that almost 13 years ago reached a similar result regarding questions of arbitrability. (Yours truly successfully argued that Willie Gary case.)

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