Search "section 220"

Louisiana Municipal Police Employees’ Retirement Systems v. Pyott, C.A. 5795-VCL (Del. Ch. June 11, 2012).

Issues Addressed

Whether collateral estoppel, Rule 23.1 or Rule 12(b)(6) apply to require the dismissal of a Delaware derivative suit based on the dismissal in California of a related derivative suit in which a federal court granted a Rule 23.1 motion to dismiss for failure to make a pre-suit demand.

Short Answer

The Court of Chancery reasoned that collateral estoppel would not apply, and motions to dismiss based on Rule 23.1 and Rule 12(b)(6) were both denied. But see: Delaware Supreme Court’s reversal of this Chancery decision by opinion dated April 4, 2013.

Post-Decision Procedural History

The Delaware Supreme Court reversed this Chancery decision by opinion dated April 4, 2013. Highlights of that decision are available on these pages at this link.

See transcript of bench ruling on July 6, 2012 granting a motion for interlocutory appeal of this opinion and rebutting the online criticism of the decision. Alison Frankel of Thomson Reuters provides an insightful article about the oral argument on the motion. The Delaware Supreme Court next makes an independent decision whether or not to accept the interlocutory appeal.

Editor’s Comment

This decision by the Court of Chancery is an iconic statement of the law relating to Delaware corporate litigation on several different levels.  Much has already been written about this decision that was issued earlier this month and much more will be written, but in these brief comments I focus on two aspects of the decision that may help to place it in context.  First, this opinion can be read as part of a continuing effort by the Delaware Court of Chancery to raise the bar and to establish and enforce the highest standards for derivative litigation and class action suits by shareholders against officers and directors.  In that vein, this decision is part of an evolutionary process which was preceded by other decisions that heralded its coming.  See, e.g., prior decision by the author of this Chancery decision highlighted here.

Another of the many noteworthy aspects of this decision is the principled manner in which the Court of Chancery has asserted its right to decide important issues of Delaware corporate law without deferring to the decisions of non-Delaware courts who either “get it wrong” or cannot be expected to address the issues with the same care and concern as the experts of the Delaware bench can bring to bear.  [This should be contrasted with very recent decisions where the Delaware Court of Chancery has deferred to a first-filed lawsuit in another jurisdiction even when Delaware law applied (see, e.g., recent decision highlighted here), and a recent Chancery decision that deferred to a federal court on an issue of federal law.  (See recent case highlighted here.)]

I make an additional preliminary comment with the respectful caution of someone who makes his living by, at least in part, practicing before the Court that issued this opinion.  This decision extols the virtues of using § 220 of the Delaware General Corporation Law in order to obtain books and records of a corporation before filing a plenary lawsuit.  I have written often about the less than simple and less than completely predictable aspects of § 220.  For example, a recent decision by the Delaware Supreme Court rejected a § 220 request after more than a year of litigation. (See recent case highlighted here).  In addition, a recent law review article I co-authored observed that there is no directly controlling authority in Delaware that requires a corporation to provide, in response to a Section 220 demand, electronically stored information, which comprises the majority of business data which is never printed in hard copy.  See article here.  So, even though on an epistemological level, it makes eminent sense to advance the position that one should use Section 220 to obtain as much information as possible before preparing and filing a plenary complaint, on a practical level “from the trenches,” my experience and my close reading of § 220 cases, persuades me that § 220 can often be an expensive and lengthy process that does not always bear fruit or does not bear sufficient fruit to fulfill the promise of § 220 – – or make it worth the effort.

Aside: Some of the issues addressed in this case are at least tangentially related to the school of thought which argues that plaintiffs are increasingly choosing a forum outside of Delaware, even when Delaware law applies, in order to “try their luck” with judges who are less likely to apply the same degree of specialized close scrutiny that members of the Delaware Court of Chancery apply to the pleadings and lawyers before them. See, e.g., a recent essay on the topic published on the Foley & Lardner website. Sometimes referred to as “ABC” (anywhere but Chancery), a termed coined by Ted Mirvis, the highly-regarded Wachtell Lipton lawyer who is frequently involved in many high profile Chancery cases, we have written often on these pages about that phenomenon. E.g., here and here.

Finally, a review of the details of the decision follows:

Background of Pyott case:

In September 2010, Allergan, Inc. entered into a settlement with the United States Department of Justice and pled guilty to criminal misdemeanor misbranding and paid a total of $600 million in civil and criminal fees. Allergan, Inc., a Delaware corporation which develops and commercializes specialty pharmaceuticals, biologics, and medical devices, specifically Botox Therapeutic, entered into the settlement after admitting that they illegally promoted off-label uses of their popular drug.

The public announcement of this settlement prompted Louisiana Municipal Police Employees’ Retirement System (‘LAMPERS’) to file this action. Similar claims were filed in Federal Court in California which dismissed with prejudice that suit for failure to plead demand futility. The defendants supplemented their motion to dismiss in this action to invoke collateral estoppel.

Analysis:

The Court rejected the 3 arguments of defendants why this Delaware derivative suit should be dismissed in light of the dismissal of a very similar derivative suit in California: collateral estoppel, Rule 23.1, and Rule 12(b)(6). The Court of Chancery disagreed with many of the California Federal Court’s holdings, and held that the plaintiffs were not collaterally estopped from asserting demand futility in the Delaware derivative action. The Court focused on privity, not on whether the prior Rule 23.1 dismissal was on the merits.

Choice of Law

The Court emphasized that whether or not successive stockholders in a subsequent suit are in privity with the corporation and each other is a matter of Delaware law under the internal affairs doctrine and, thus, state law will govern. The Court reasoned that “whether a stockholder can sue derivatively after another stockholder attempted to plead demand futility is equally a matter involving the managerial prerogatives within a corporation,” and should not be governed by potentially different rules across the federal circuits, states, and territories. The ability of a stockholder in a Delaware corporation to bring such a suit should be governed uniformly by Delaware law.

The Same Party or a Party in Privity

Under Delaware precedent, the Court explained that until a derivative action passes the Rule 23.1 motion to dismiss stage, the stockholder is asking the Court for authority to sue in the name of the corporation. Where a Rule 23.1 motion is granted, the lack of authority to sue in the name of the corporation should be clear. Without authority to assert a corporation’s claim, the shareholder in the first case was asserting their own claim to obtain equitable authority to sue. The Court of Chancery previously has ”squarely” held that the adjudication of one stockholder’s individual claim does not have preclusive effect on a second stockholder’s ability to assert the claim.

When a stockholder representative pursues claims in a derivative action, authority for that action can be determined in the following ways: (1) the board of directors or an empowered committee can approve the litigation expressly or by failing to oppose it; (2) a court can determine that the stockholder plaintiff has the authority to proceed by denying a Rule 23.1 motion because the complaint adequately pleads either that demand should be excused as futile or that demand was made and wrongfully refused.

Moreover, when the same stockholder responds to a Rule 23.1 dismissal by filing a second complaint alleging demand futility, that same party may be confronted with the preclusive effect of a Rule 23.1 dismissal. However, when a different stockholder attempts to plead demand excusal, an earlier Rule 23.1 dismissal should not be preclusive; because the previous plaintiff lacked the authority to sue on behalf of the corporation and was not in privity with the corporation or stockholders.

Inadequate Representation

The Court of Chancery found that the California plaintiffs did not adequately represent the stockholders of Allegan or Allergan itself (if they were eventually given approval to represent Allergan). The decisions that offer a preclusive effect to a Rule 23.1 dismissal “universally recognize that another stockholder still can sue if the first plaintiff provided inadequate representation.” This inadequate representation was an independent basis to reject the argument that the California dismissal had a preclusive effect on the Delaware action.

Exception to First-Filed Rule

Many jurisdictions follow a “first-filed” rule which defers to the forum where the first action is filed, and entices fast filing to gain litigation control. Under this rule, the Court explained that plaintiffs’ lawyers cannot act appropriately as stockholders would want them to because by carefully and deliberately proceeding with the claim, the law firm risks losing control over the case to another who would file more immediately.

However, previously the Court of Chancery has clearly held that when a stockholder plaintiff sues in a representative capacity, the first-filed rule does not control which plaintiff has the substantive right to proceed. This case seems to exemplify this race to file. Within 48 hours of Allergan announcing their settlement, LAMPERS filed a complaint, without using Section 220, without conducting an investigation, and without any real allegations which could potentially defeat a demand-futility motion. In California, the plaintiffs’ firms failed to fulfill their duties, motivated by the desire to gain control of the case, and in turn failed to provide adequate representation. Since the plaintiffs in the California action provided inadequate representation for Allergan, the Court concluded that the dismissal of the Delaware case is not required.

Rule 23.1 Inferences Permissible

A reasonable inference can be made from the allegations of the Delaware complaint and the documents presented, that the board knowingly approved and oversaw the business plan which endorsed illegal off-label marketing of Botox.  They held presentations, seminars, funded facilities, and incentivized physicians who would use Botox in these off-label capacities. The complaint only needs to make a “threshold showing, through the allegation of particularized facts, that their claim had some merit.” While the California Federal Court felt the complaint fell short because it lacked evidence of a decision by board members to promote any off-label marketing, this Court believes that at the pleadings stage, a court can draw inferences which are supported by particularized allegations of fact.  While at later stages of the case the plaintiffs will not be entitled to these presumptions and will need to prove their claims, at the pleadings stage, particularized allegations which support reasonable inferences suffice. Because this standard is met here, the Rule 23.1 motion to dismiss was denied.

One of many observations about this case is that Delaware Courts are not often persuaded by the rulings of non-Delaware courts on the finer points of Delaware law.

Rule 12(b)(6)

Because a complaint that “pleads a substantial threat of liability” for purposes of Rule 23.1 “will also survive a 12(b)(6) motion to dismiss,” this motion was also denied.

Additional highlights of the Court’s legal analysis follow the conclusion below.

Conclusion

Collateral estoppel, under Delaware precedent, does not mandate dismissal of this case. (1) The California plaintiffs acted in a self-serving way which ultimately meant inadequate representation. The California dismissal based on Rule 23.1 was not persuasive because it adopted a defendant-friendly inference, but the particularized allegations supported reasonable inferences of the board’s knowledge. The motion to dismiss pursuant to Rule 12(b)(6) was also denied for the same reasons.

(1) [This is my own footnote, not from the Court of Chancery’s opinion]. See generally, Smith v. Bayer Corp., 131 S. Ct. 2368 (2011)(collateral estoppel does not bar unnamed members of a putative class action from refiling a second class action if class certification in the first action is denied).

Highlights of Substantive Law that Make this Decision Iconic

The Preclusive Effect of a Dismissal Based on Rule 23.1

The Court of Chancery acknowledged substantial case law both in other jurisdictions and in prior decisions in Chancery that give preclusive effect to dismissals of derivative complaints pursuant to Rule 23.1.  See cases cited in footnotes 1 and 11.  The Court carefully distinguished those cases based on several principles.  For example, citing decisions of the U.S. Supreme Court and the Delaware Supreme Court, the Court invoked the internal affairs doctrine.  The Court described the internal affairs doctrine as a choice of law concept which applies the law of the state where a corporation was formed to matters related to the relationships among the corporation and its officers, directors and shareholders.

Collateral Estoppel

The Court spent a substantial part of the opinion describing collateral estoppel and the privity element of collateral estoppel.  The opinion is must reading on this nuance of Delaware law.  The Court only needed to address the privity requirement because that requirement for the application of collateral estoppel was not satisfied and, therefore, it was unnecessary to address the other two elements which involve whether a final judgment was on the merits, and whether the issue decided in the prior proceeding was identical.  Because the defendants only invoked collateral estoppel (i.e., issue preclusion), the Court did not consider the more expansive doctrine of res judicata (i.e., claim preclusion).  See footnote 6.

Nature of Derivative Action

The Court regarded the issue of pre-suit demand to be a matter of substantive law governed by the internal affairs doctrine, based on decisions of the U.S. Supreme Court and the Delaware Supreme Court.

The Court cited to a number of federal cases that “missed the point” as a matter of Delaware law, on representative litigation.  Namely, the Court instructed that:  “A stockholder whose litigation efforts are opposed by the corporation does not have authority to sue on behalf of the corporation until there has been a finding of demand excusal or wrongful refusal.” (citing Rales v. Blasband, 634 A.2d 927, 932 (Del. 1993)).  That is, the derivative plaintiff lacks authority to sue on behalf of the corporation until the denial of a Rule 23.1 motion to dismiss.  This is because of the two-fold nature of a derivative action which is as follows.  First, “it is the equivalent of a suit by the shareholders to compel the corporation to sue.”  Second, “it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it.”  See Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984).  See footnote 8 and accompanying text in the Pyott opinion.

The Court emphasized that simply because the underlying claim in a derivative action belongs to the corporation and ultimately will be asserted in the name of the corporation if the stockholder receives permission to sue, it does not support the proposition the stockholders are in privity for purposes of the preclusive effect of an order granting a Rule 23.1 motion to dismiss.  The Court observed that:  “At that phase of the case, the competing stockholders are asserting only their individual claim to obtain equitable authority to sue.”

Judicial Estoppel

The Court at footnote 10 provides extensive authority on the concept of judicial estoppel which prevents a party from asserting in a legal proceeding, a position inconsistent with a position previously taken by him in the same or in an earlier proceeding.  As applied to this case, the defendants previously argued in California that the plaintiff lacked authority to assert claims derivatively on behalf of the corporation based on Rule 23.1; and after having prevailed on that point, the same defendants now argue that the stockholder in that case did have authority to assert the claims on behalf of the corporation sufficient to bind all the other stockholders.  The Court applied judicial estoppel to prevent this reversal of position from being argued.

Why Prior Rule 23.1 California Dismissal did not have Preclusive Effect in Delaware

The Court relied on black letter law regarding the preclusive effect of a Rule 23.1 dismissal only when the plaintiff has the authority to assert the claims of the corporation, which would be true in three circumstances:  (1) When the corporation has brought the case or taken it over via a special litigation committee process; (2) The derivative plaintiff survived a Rule 23.1 motion to dismiss, thereby gaining authority to sue and then obtained a decision on summary judgment or at trial; or (3) A court has approved a derivative action settlement and made the determinations required by Rule 23.1.

However, the preclusive effect does not apply when the stockholder plaintiff lacks the authority to sue on behalf of the corporation, and it “particularly does not hold true for a decision determining that the stockholder plaintiff lacks authority to sue.”  The Court cited prior Chancery decisions that squarely held that the decision on one stockholder’s individual claim does not have preclusive effect on a second stockholder’s ability to assert the claim.  Kohls v. Kenetech Corp., 791 A.2d 763 (Del. Ch. 2000) aff’d 794 A.2d 1160 (Del. 2002).  Compare Beiser v. PMC-Sierra, Inc., 2009 WL 483321, at *3 (Del. Ch. Feb. 26, 2009) (one stockholder’s efforts to use Section 220 was limited by a different stockholder’s filing of a federal securities action that triggered the automatic stay under the Private Securities Litigation Reform Act).

The Court specifically disagreed with the prior Chancery decision in Career Education, specifically the part of the decision that followed federal cases holding that Rule 23.1 dismissal has a preclusive effect.  See 2007 WL 2875203, at *10.

Declining to follow the Chancery decision in Career Education, the Court explained that an earlier Rule 23.1 dismissal “does not have a preclusive effect on a subsequent derivative action brought by a different plaintiff because, as the earlier Rule 23.1 decision itself established, the prior plaintiff lacked authority to sue on behalf of the corporation and therefore was not in privity with the corporation or other stockholders.”  Following the decision in the Kohls case, however, the Court recognized that an earlier decision may by persuasive authority and could have an impact based on stare decisis.

The Fast-Filing Problem

The extensive citations in this opinion to scholarly articles and commentary by practitioners and academics on the role that derivative actions play in the “big picture” of corporate governance and in the enforcement of fiduciary obligations, demonstrates that the Court has thought long and hard about these issues, and this opinion demonstrates the care and attention with which the Court is addressing the larger issues raised in, and the societal consequences of, representative corporate litigation.  See footnotes 17 through 19 and accompanying text.  After discussing the “big picture” and the problems with derivative suits that are filed quickly without adequate investigation in order to give the plaintiffs’ firm the control that historically has come with filing the first complaint, the Court described a more ideal approach which it referred to as the “idealized derivative action.”

A thorough discussion of the concept of derivative actions and the Court’s description of the most ideal way for a derivative action to be prepared and investigated in a careful, methodical way, is juxtaposed with the approach of being the first to file a complaint without having the time for a proper investigation.  The Court describes its preferences for how a derivative action should be prepared and investigated prior to filing.  This case must be read by anyone planning to file a derivative action in Delaware.

Caremark Claim

The Court provides a “how-to manual” that explains how to properly file a Caremark claim, and also provides an exemplary exegesis of Caremark jurisprudence.  A Caremark claim is a breach of fiduciary duty claim that seeks to hold directors accountable for the consequences of a corporate trauma that results from an environment that the directors set in motion or “allowed a situation to develop and continue which exposed the corporation to enormous legal liability, and that in doing so they violated a duty to be active monitors of corporate performance.”  See In Re Caremark Int’l, Inc. Deriv. Litig., 698 A.2d 959, 967 (Del. Ch. 1996).  The Court discussed the extensive case law interpreting the Caremark decision and provided tips and suggestions for properly pleading a Caremark claim.

This opinion should be required reading for any lawyer who plans to file a Caremark complaint in Delaware.  The Court observed that the standard for Caremark liability is a high one that “parallels the standard for imposing damages when a corporation has an exculpatory provision adopted pursuant to 8 Del. C. § 102(b)(7).”  That is:  “Such a provision can exculpate directors from monetary liability for a breach of the duty of care, but not for conduct that is not in good faith or a breach of the duty of loyalty.”  (See Stone, 911 A.2d at 367, in connection with the explanation of the Court about the lack of good faith conduct that is a necessary condition for director oversight liability).  A citation in the text of the opinion (not a mere footnote) referred to “friend of this blog” Professor Stephen M. Bainbridge’s article entitled A Convergence of Good Faith and Oversight, 55 UCLA L. Rev. 559 (2008) (discussing the re-interpretation of Caremark as a good faith case and the potential liability risks to directors that result.)  See Slip op. at 50. Professor Bainbridge is often cited in Delaware corporate decisions.

DGCL Section 220

In connection with explaining how a successful Caremark claim can be plead, the Court spent a considerable amount of time exhorting the use of DGCL § 220.  As I have indicated elsewhere, on a conceptual level, it is hard to disagree with the wisdom of using § 220 in the hope of obtaining as much information as possible about the details and the factual basis for a Caremark claim.  My reservation is based on my experience and my knowledge of many of the Delaware decisions on § 220 which have (on occasion, at least), resulted in a denial of any right to books and records under § 220 after expensive trials and lengthy and expensive appeals, or the judicial determination that parties are entitled to documents under § 220 but being confronted with the reality that as of this writing there is no controlling Delaware authority to require the production of electronically stored information, which represents the vast majority of business data created today.

Inspecting Corporate Books and Records in a Digital World: The Role of Electronically Stored Information is the title of the latest law review article that I co-authored with Kevin Brady. A former associate also joined us as a co-author. The article will appear in The Delaware Journal of Corporate Law in the issue distributed this month in hard copy, which is designated as Vol. 37, No. 1, cited as 37 Del. J. Corp. L. 163 (2012), also is now available online and is also now available on SSRN.

The synopsis below describes the cutting edge issues we address regarding the deficiencies in the current state of the law regarding statutory demands by a shareholder for books and records of a corporation purusant to DGCL section 220.

This Article examines Section 220 of Delaware General Corporation Law (“DGCL”) which generally provides limited rights to shareholders seeking “books and records” of a corporation.  The Article presents an argument that encourages Delaware’s Legislature and courts to address the archaic nature of the phrase “books and records” by modernizing and making more meaningful the statute and case law which do not reflect the current world of electronically stored information (“ESI”) and the fact that nearly all information in today’s digital world is created and maintained exclusively in electronic form and is not reduced to “hard copy.”  While certain judicial decisions have reflected a reluctance to consider ESI in this context, no Delaware court has directly and authoritatively addressed the issue of whether ESI must be produced in connection with a proper Section 220 demand.  This Article provides persuasive reasoning why the Delaware Legislature and the Delaware courts should require the production of appropriate ESI in response to a proper Section 220 demand in order for Section 220 to maintain any practical usefulness.   

The following key Delaware corporate and commercial decisions from the first four months of 2012 are a follow-up to our summary of the key decisions that we featured from 2011. We highlight on these pages all the corporate and commercial opinions from Delaware’s Supreme Court and Court of Chancery, and we have chosen the following 2012 rulings as being especially noteworthy, as the month of April comes to a close. Comments are welcome if readers think we missed a decision that should be included in this list.Photo of the Supreme Court Courthouse in Dover
Supreme Court Decisions

EMAK Worldwide, Inc. v. Kurz, No. 512, 2011 (Del. Supr., April 17, 2012).  Issue Addressed: Whether the Court of Chancery properly granted an interim fee award in a shareholders’ suit which did not produce an immediate monetary benefit. Short Answer: Yes. Summary available here.  (The Supreme Court’s stately building in Dover is featured at right.)

Cambium Ltd. v. Trilantic Capital Partners, No. 363, 2011 (Del. Supr., Jan. 20, 2012. This Order of the Delaware Supreme Court applied the recent decision of Delaware’s High Court in the Central Mortgage case in which it clarified that Delaware has not adopted the federal standard for motions to dismiss under Rule of Civil Procedure 12(b)(6) as described in the U.S. Supreme Court’s Twombly and Iqbal decisions, despite the truism that the Delaware Rules of Civil Procedure are generally based on the Federal Rules of Civil Procedure. A fuller overview is available here. The recent Delaware Supreme Court decision in Central Mortgage taking this position was highlighted here.

Court of Chancery Rulings

Shocking Technologies, Inc. v. Michael, C. A. No. 7164-VCN (Del. Ch. April 10, 2012). Issue Addressed: Whether the Court of Chancery has the inherent authority to remove a director for breach of fiduciary duty, other than via DGCL Section 225? Short answer:  The issue was not directly decided, but based on the facts of this case, the Court was not inclined to exercise such an inherent power, if such a power exists, prior to the expedited trial. Summary available here.

In Re K-Sea Transportation Partners LP Unitholders Litigation, C.A. No. 6301-VCP (Del. Ch. April 4, 2012). The prior Chancery decision in this case was highlighted on these pages here. Issues Addressed: The issues addressed by the Court of Chancery in this matter were whether the fiduciary duty claims and the contractual claims were barred by the provisions in the limited partnership agreement, including whether a provision in the agreement that established a presumption of good faith barred claims for breach of the implied covenant of good faith and fair dealing. Summary available here.

Manning v. Vellardita, C.A. No. 6812-VCG (Del. Ch. March 28, 2012), is an important decision of the Delaware Court of Chancery on legal ethics as applied to non-Delaware attorneys who appear before the Court pro hac vice. Issues Addressed: Whether lack of complete candor to the Court in a Motion for Admission Pro Hac Vice is a basis to either: (i) disqualify counsel, and/or (ii) revoke the admission pro hac vice. The Court also addressed standards (articulated in this context for the first time), of candor and full disclosure, regarding potential conflicts, that those seeking admission pro hac vice must now follow. Summary available here.

Badii v. Metropolitan Hospice Inc., C.A. No. 6192-VCP (March 12, 2012), involves a post-trial decision on an action under 8 Del. C. § 291 for the appointment of a receiver for an insolvent, closely held corporation, Metropolitan Hospice, Inc. (“MHI”) which owed, among other things, approximately $2 million to the IRS for back taxes, penalties, and interest. Summary available here.

In re Delphi Financial Group Shareholder Litigation, Cons. C.A. No. 7144 -VCG (Del. Ch. Mar. 6, 2012). This is the third Delaware Court of Chancery decision in as many weeks that denied injunctive relief, in an expedited opinion, in response to a challenged transaction–despite criticism in two of the cases, of the process and the players, but ultimately leaving it up to the shareholders to decide whether to accept offers of a substantial premium to sell their shares. Summary available here. See In Re El Paso, summarized here, and In Re Micromet, summarized here.

In Re El Paso Corporation Shareholder Litigation, Consol. C. A. No. 6949-CS (Del. Ch. Feb. 29, 2012). Chancellor Strine denied the stockholder plaintiffs request for a preliminary injunction to enjoin a merger between El Paso Corporation and Kinder Morgan, Inc. While the Court in a 33-page opinion, severely criticized the actions of a number of the players, in the end the Chancellor decided to give the shareholders of El Paso the opportunity to decide for themselves if they liked the price being offered to them. Summary available here. The Court’s opinion in this matter marks the second time in the span of only a few months that the Delaware Court of Chancery has strongly criticized Goldman Sachs for conflict of interest issues in multi-billion dollar transactions. The most recent high-profile criticism was in the Court of Chancery’s 100-plus page decision in the Southern Peru Copper case highlighted on these pages here. Our LexisNexis videocast on this opinion is available here.

Danenberg v. Fitracks, C.A. No. 6454-VCL (Del. Ch. Mar. 5, 2012), addressed important issues of advancement and indemnification and established a protocol for resolving the amount of fees payable pursuant to the grant of advancement rights. Summary available here.

Matthew v. Laudamiel, C.A. No. 5957-VCN (Del. Ch. Feb. 21, 2012). Apparently no prior Delaware law directly addressed the issue of whether the dissolution and cancellation of an LLC transformed derivative claims into direct claims held proportionately by the members of the LLC. The Court concluded that, after the filing of the certificate of cancellation, such claims must be brought in the name of the LLC by a trustee or a receiver appointed under 6 Del. C. Section 18-805, or directly by the LLC, or derivatively by its members after reviving the LLC by obtaining a revocation of its certificate of cancellation. Summary available here.

Hermelin v. K-V Pharmaceutical Company, C.A. No. 6936-VCG (Del. Ch., Feb. 7, 2012). Issues Addressed: The Court of Chancery addressed an issue of first impression in Delaware regarding: “what evidence is relevant to an inquiry into whether an indemnitee acted in good faith for the purposes of permissive indemnification” under DGCL §§145(a) and (b). The Court also addressed: (1) Whether the former CEO is entitled to mandatory indemnification as a matter of law; (2) Whether additional discovery is required to determine whether the former CEO acted in good faith (in which case he would be entitled to statutorily permissive indemnification pursuant to his rights under an indemnification agreement.) Summary available here.

Auriga Capital Corp. v. Gatz Properties LLC, C.A. No. 4390-CS (Del. Ch., Jan. 27, 2012). What this Case is About and Why it is Important: This case establishes a high-water mark in terms of providing the most comprehensive explanation, based on legislative history and a review of Delaware cases, to explain why the default standard in the LLC context is that fiduciary duty principles will apply to managers of an LLC unless those duties are expressly and clearly limited or eliminated in an LLC agreement. Summary available here.

Dweck v. Nasser, C. A. No. 1353-VCL (Del. Ch. Jan. 18, 2012), found that Dweck, the former CEO, a director and 30% stockholder in Kids International Corporation (“Kids”), and Kevin Taxin, Kids’ President, breached their fiduciary duties of loyalty to Kids by establishing competing companies that usurped Kids’ corporate opportunities and converted Kids’ resources. The Court also imposed liability on an officer of the company for approving the reimbursement with company funds of the personal expenses of his superior. Summary available here.

Steinhardt v. Howard-Anderson, C.A. No. 5878-VCL (Del. Ch. Jan. 6, 2012). Issue Addressed: This opinion addressed the issue of whether representative plaintiffs in a putative class action should be in sanctioned for trading on the basis of confidential information obtained in the litigation. The motion was granted. Summary available here.

Gerber v. Enterprise Products Holdings, LLC, et al., C.A. No. 5989-VCN (Del. Ch., Jan. 6, 2012). Issue Addressed: This decision speaks to the limitations imposed by 6 Del. C. § 17-1101 on Delaware courts to address sanctionable conduct by partners and members of alternate entities that have contracted away their fiduciary duties. Summary available here.

Paul v. China MediaExpress Holding, Inc., C.A. No. 6570-VCP (Del. Ch. Jan. 5, 2012). Issues Addressed: (1) Whether a Section 220 case should be stayed pending the outcome of a related federal securities suit; and (2) Whether the shareholder in this case established a proper purpose to inspect books and records under DGCL Section 220. Short Answer: (1) Based on a three-part test as applied to the facts of this case, the Court refused to stay this action in favor of a pending related federal securities suit, even though a motion to stay was also pending in the federal court. (2) In this post-trial opinion, the Court determined that the shareholder established a proper purpose and was entitled to the documents necessary to investigate that proper purpose. Summary available here.

Bonus

An important development during the first 4 months of 2012 was the promulgation by the Court of Chancery of its inaugural Practice Guidelines, highlighted here.

Supplement

The Delaware State Bar Association’s annual seminar on Developments in Corporate and Alternative Entity Law will be presented in Wilmington on May 22 as described in more detail on these pages here.

Postscript: Professor Bainbridge kindly linked to this post on his blog.

Buerger v. Apfel, C.A. No. 6539-VCL (Del. Ch. March 15, 2012).

Issue Presented

Whether equitable tolling could save claims that would otherwise be barred by the applicable statute of limitations or latches, which defendants argued should block any challenge to certain stock options and other related-party transactions.

Background

The disputed transactions involve a company that sells fragrances and related products over the internet.  The company is controlled by Dennis Apfel and his two sons who collectively own 68% of the outstanding stock and comprise the entire board of directors.  Plaintiffs invested $100,000 in the start-up and received a 30% equity stake.  Those two plaintiffs now own 19%.  The company raised $500,000 through a reverse merger with a publicly listed company and its stock was traded on the NASDAQ from 1999 until 2005 when it effected a reverse split and delisted.  At that time it also stopped sending financial statements and other information to its stockholders.  The common stock of the company continues to trade in the over-the-counter market.

The complaint challenges a series of transactions involving affiliated companies and the Apfel family.

Legal Analysis

The procedural posture of this case was presented on a motion for judgment on the pleadings pursuant to Court of Chancery Rule 12(c).  The Court noted cases finding that the Rule 12(c) standard has been described as almost identical to the Rule 12(b)(6) standard and favors the plaintiffs to the extent that the Court must draw all reasonable inferences from undisputed facts in a light most favorable to the non-moving party.  The Court disregarded affidavits and a host of documents that the defendants attempted to use to support their Rule 12(c) motion.

The parties agreed that the “presumptive limitations” for latches in this case is 3 years, based on Section 8106 of Title 10 of the Delaware Code.  The parties did not argue that the limitations should be extended to account for the efforts they made to obtain books and records pursuant to DGCL Section 220.

However, the Court noted at footnote 1 several cases that it cited for the proposition that the applicable statute of limitations was tolled during the pendency of a Section 220 action.

The complaint alleged breach of fiduciary duties in connection with the adoption by the 3 members of the Apfel family of employment agreements that they each adopted and which provided for allegedly excessive compensation. (The agreements were adopted in round robin fashion with 2 of the 3 family members voting at a time for the agreement of the one who abstained.)

In connection with the approval by the 3-member “all Apfel” board of the compensation agreements at issue, the Court observed the following principle: “When fiduciaries have the power to terminate or modify an agreement, the decision to leave the agreement in place and continue to receive self-dealing benefits can be challenged as a breach of duty.”

Employment Agreements–Terminable Upon 30 Days’ Notice

Although the original adoption of the employment agreement was time-barred, the Court observed that the company could terminate the employment agreement on 30 days notice and each of the Apfels had the power to amend the employment agreement at their convenience.  Therefore, the Court determined that the plaintiffs may challenge the fairness of the failure to terminate or modify the employment agreement during the period from March 18, 2008 through the present.  See Teachers’ Ret. Sys. of LA. v. Aidinoff, 900 A.2d 654, 666 (Del. Ch. 2006)).

Office Lease

In addition to serving as a part-time CEO of the company, one of the Apfels, Dennis, also serves as a named partner in a law firm that specializes in divorce work and family law.  Since 2006, the company provided Dennis’ firm with office space in its headquarters.  There was no written lease and the firm does not pay rent.  Rather the parties have an informal “rent-for-services arrangement.”  The Court observed that:  “It is reasonably conceivable at the pleadings stage that the company would not have much need for divorce work.”  Based on the reasoning in the Aidinoff case, cited above, the Court reasoned that the plaintiffs could challenge the sublease from March 18, 2008 onward because the company had the ability to terminate the informal arrangement at any time.  However, challenges to the sublease for the period prior to March 18, 2008 were barred by latches.

Personal Loan to Jason Apfel

The issue arose about whether the claim based on the terms of a loan dispersed in June of 2007 were time barred.  The Court determined that the plaintiffs did not meet the pleading requirement for equitable tolling because they failed to identify the date when they learned of the loan.  Without this information, the Court explained that the doctrine of equitable tolling could not be applied.  However, the Court reasoned that,

“Fairness requires that the plaintiffs be granted leave to amend their complaint to cure its isolated omission.  Because the defendants have filed the operative motion under Rule 12(c), Rule 15(aaa) does not limit the plaintiffs’ ability to plead.”

Ct. Ch. R. 15(aaa) requirement that presents a binary choice to either respond to a motion to dismiss or amend one’s complaint, does not apply to Rule 12(c) motions.

Other Amendments Allowed

The Court allowed 60 days for an amended complaint to be filed to clarify for purposes of determining the applicability of equitable tolling, the exact date when the plaintiffs learned of the challenged transactions, including a challenge to a loan made to a company wholly-owned by the Apfel family, as well as the decision to form and fund an entity wholly-owned by the Apfel family.

Commentary

This delightfully short 11-page opinion may have been animated by the awareness by the Court that the applicable fiduciary duties were not being strictly observed, and the Court’s determination that fairness required giving the plaintiffs another opportunity to plead their claims so that all the allegedly egregious breaches of fiduciary duty would not be time-barred.

Noteworthy 2011 Corporate and Commercial Decisions from Delaware’s Supreme Court and Court of Chancery.

By:  Francis G.X. Pileggi and Kevin F. Brady.

Introduction

This is the seventh year that we are providing an annual review of key Delaware corporate and commercial decisions. During 2011, we reviewed and summarized approximately 200 decisions from Delaware’s Supreme Court and Court of Chancery on corporate and commercial issues.  Among the decisions with the most far-reaching application and importance during 2011 include those that we are highlighting in this short overview.  We are providing links to the more complete blog summaries, and the actual court rulings, for each of the cases that we highlight below. Prior annual summaries are linked in the right margin of this blog.

Top Five Cases from 2011

We begin with the Top Five Cases on corporate and commercial law from Delaware for 2011 and we are glad to see that at least four of them have some support from the bench as these were the cases that four Vice Chancellors highlighted as important decisions in a recent panel presentation that they offered in New York City in early November 2011.  Those cases were the following:  In Re: OPENLANE Shareholders Litigation; In Re: Smurfit Stone Container Corp. Shareholder Litigation; In Re: Southern Peru Copper Corp. Shareholder Litigation and Air Products and Chemicals, Inc. v. Airgas Inc., and Kahn v. Kolberg Kravis Roberts & Co., L.P.

In Re: OPENLANE Shareholders Litigation. In what many commentators referred to as a “sign and consent” transaction, in which the majority shareholders and the board of directors had sufficient control to provide the statutorily required consent, the Court of Chancery determined that the Revlon standard was satisfied and fiduciary duties were not breached notwithstanding the Omnicare case and even without customary safeguards such as a fairness opinion. See fuller summary here.

 In Re: Smurfit Stone Container Corp. Shareholder Litigation. The Court of Chancery denied a motion for preliminary injunction and determined that the Revlon standard applied to a merger for which the consideration was split roughly evenly between cash and stock. See fuller summary here.

In Re: Southern Peru Copper Corp. Shareholder Litigation. In what may be the largest award granted in the Court of Chancery’s venerable history, a judgment was entered for $1.2 billion (later amended to $1.3 billion) for breach of fiduciary duties in connection with an interested transaction. With interest, the total is expected to be $2 billion.  The Court later awarded attorneys’ fees of 15% which amounts to $300 million, in this derivative action. See fuller summary here.

Air Products and Chemicals, Inc. v. Airgas Inc. This magnum opus of over 150-pages in length will be the focus of scholarly analysis for many years to come. For purposes of this short blurb, it ended a year-long takeover battle between two determined companies, with the Court of Chancery ruling, among other things, that the target company was not required to pull its poison pill when the board determined that the offer for the company was too low. See fuller summary here.

Kahn v. Kolberg Kravis Roberts & Co., L.P.  This Delaware Supreme Court decision reversed and remanded an opinion by the Court of Chancery interpreting “a Brophy claim as explained in Pfeiffer.”  The issue before the Court was whether a stockholder had to show that the company had suffered actual harm before  bringing  a breach of loyalty claim that a fiduciary improperly used the company’s material, non-public information (a Brophy claim).  The Supreme Court rejected that part of the Chancery’s decision in Pfeiffer v. Toll which requires a showing of actual harm to the company.  See fuller summary here.

We also selected the following additional noteworthy cases:

Shareholder Litigation

In Re: John Q. Hammons Hotels, Inc. Shareholder Litigation.  Despite the application of the entire fairness standard, the Court concluded that the merger price was entirely fair, the process leading to the transaction was fair, that there was no breach of fiduciary duty, and therefore no claims for aiding and abetting fiduciary duty.  See fuller summary here.

Reis v. Hazelett Strip-Casting Corp.  The Court applied an entire fairness analysis and held that the attempt to cash out minority shareholders via a reverse split was neither the result of a fair process nor did it involve a fair price.  See fuller summary here.

In re: Del Monte Foods Co. Shareholders Litigation. This first of three rulings enjoined a shareholder vote on a premium LBO transaction and the buyers’ deal protection devices.  The Court also held that the advice that the target board received from a financial advisor (who also did work on the deal for the bidder) was so conflicted as to give rise to a likelihood of a breach of fiduciary duty and the Court indicated that the financial advisory firm could face monetary damages due to aiding and abetting the potential breach.  See fuller summary here.

In re: Massey Energy Company Derivative and Class Action Litigation.  The Court declined to enjoin a proposed merger.  The Court noted that the derivative claims that the plaintiffs argued were not being fairly valued as part of the merger, would become assets of the surviving corporation.  The Court reasoned in part that the shareholders should decide for themselves whether to exchange their status as Massey stockholders for a chance to receive value from a third party in an arms-length merger.  See fuller summary here.

Frank v. Elgamal.  This decision exemplifies the different approach taken by different members of the Court in connection with an application for interim fees in a class action.  (Compare the different approach in the Del Monte case.)  See fuller summary here.

Krieger v. Wesco Financial Corp.  This decision determined that holders of common stock were not entitled to appraisal rights under Section 262 when they had the option of electing to receive consideration in the form of publicly traded shares of the acquiring company.  See fuller summary here.

In re: The Goldman Sachs Group, Inc. Shareholder Litigation.  In this first corporate opinion by Vice Chancellor Glasscock, the Court dismissed a derivative action brought against Goldman’s current and former directors based on a failure to make a pre-suit demand.  At issue was Goldman’s allegedly excessive compensation structure.  See fuller summary here.

Contested Director Elections

Genger v. TR Investors, LLC.  In this opinion, the Delaware Supreme Court addresses electronic discovery issues and contested elections for directors involving DGCL Section 225. See fuller summary here.

Johnston v. Pedersen.  This opinion determined that directors breached their fiduciary duties when issuing additional stock and as a result were not entitled to vote in connection with the removal of the incumbent board and the election of the new directors.  See fuller summary here.

Section 220 Cases

King v. VeriFone Holdings, Inc. This Delaware Supreme Court ruling reversed a Chancery decision that found a lack of proper purpose in a suit by a shareholder seeking books and records pursuant to Section 220.  Delaware’s High Court explained that it remains preferable to file Section 220 suits for books and records prior to filing a derivative suit, but holding that such a chronology is not, per se, a fatal flaw in a Section 220 action.  See fuller summary here.

Espinoza v. Hewlett Packard Co. This affirmance of Chancery’s denial of a §220 claim was based on the requested report to the board being protected by the attorney/client privilege.  (This is one of several decisions in this matter.) See fuller summary here.

Graulich v. Dell., Inc.  This is a Section 220 case in which Chancery denied a request for books and records due to the underlying claims being barred by a previous release and due to the shareholder not owning the shares during the period of time for which he was requesting documents.  See fuller summary here.

Alternative Entity Cases

CML V, LLC v. Bax.  This Delaware Supreme Court decision determined that creditors of an insolvent LLC are not given standing by the Delaware LLC Act to pursue derivative claims unlike the analogous situation in the corporate context.  See fuller summary here.

Sanders v. Ohmite Holding, LLC.  This decision clarified the rights of a member of an LLC that demanded books and records of an LLC.  The Court determined that pursuant to Section 18-305 of the Delaware LLC Act a member may seek records for a period prior to becoming a member of the LLC.  See fuller summary here.

Achaian, Inc. v. Leemon Family LLC.  This opinion addressed the transferability of interests of a member of an LLC and specifically whether one member of a Delaware LLC may assign its entire membership interests, including voting rights, to another existing member, notwithstanding the provision in an agreement that requires the consent of all members upon the admission of a new member.  See fuller summary here.

Jurisdictional or Procedural Issues

Central Mortgage Co. v. Morgan Stanley Mortgage Capital Holdings LLC.  In this decision, a Delaware Supreme Court determined that Delaware would not follow the standards for a motion to dismiss under Rule 12(b)(6) announced by the U.S. Supreme Court in the Twombly or Iqbal opinions.  See fuller summary here.

Hamilton Partners, LP v. Englard.  This decision addressed the issue of personal jurisdiction over directors and interlocking entities, as well as demand futility in the context of a double derivative shareholders suit.  (Although this was decided at the end of 2010, it was important enough to include in this list as it was issued after our deadline for our compilation last year). See fuller summary here.

Encite LLC v. Soni.  This decision rejected a request for an extension of a deadline for submitting expert reports because the Court did not approve an amendment to the Scheduling Order.  See fuller summary here.

Whittington v. Dragon Group.  In this latest iteration of multiple decisions in this long-running saga, the Court examines the doctrine of claim preclusion, issue preclusion and judicial estoppel.  See fuller summary here.

In re: K-Sea Transportation Partners, L.P. Unitholders Litigation.  This decision provides a useful recitation of the standard used in Chancery for deciding whether to grant a motion to expedite proceedings, and it also reviews language in a limited partnership agreement which arguably was an effective waiver of traditional fiduciary duties as allowed by the LP statute.  See fuller summary here.

Sagarra Inversiones, S.L. v. Cemento Portland Valderrivas, S.A.  This ruling determined that the standard of “irreparable harm” granting injunctive relief was not satisfied based on the financial condition of the defendant which was “not poor enough” to convince the Court that a money judgment would not make the plaintiff whole.  (This is one of several decisions in this matter.) See fuller summary here.

ASDC Holdings LLC v. The Richard J. Malauf 2008 All Smiles Grantor Retained Annuity Trust.  This decision discussed the enforceability of forum selection clauses and in particular when those clauses will be enforced despite a related case being filed first in another forum.  See fuller summary here.

Gerber v. ECE Holdings LLC.  This decision discusses the difference between a motion to supplement and a motion to amend a complaint.  See fuller summary here.

Advancement

Fuhlendorf v. Isilon Systems, Inc.  This decision addresses the advancement of fees incurred by officers and directors sued in connection with their corporate roles.  The specific issue in this case was whether the corporation should pay for all of the costs of a Special Master appointed to review the interim application for fees.  The case also discusses the common procedure employed to review disputed monthly legal bills in advancement cases.  See fuller summary here.

Receiver or Dissolution

Pope Investments LLC v. Benda Pharmaceutical Inc.  This decision rejected the application for the appointment of a receiver on the grounds that while the plaintiff demonstrated that the defendant was insolvent, the plaintiff failed to show that “special circumstances existed which would warrant the appointment of a receiver.”  See fuller summary here.

Stephen Mizel Roth IRA v. Laurus U.S. Fund, L.P.  This decision rejected a request to dissolve a limited partnership and refused to appoint a receiver in the context of an investment fund that was in liquidation mode but was not dissolved, nor was it winding-up as that term is used in the statute.  See fuller summary here.

Legal Ethics

BAE Systems Information and Electronics Systems Integration, Inc. v. Lockheed Martin Corp.  This opinion addresses Delaware Lawyers’ Rule of Professional Conduct 3.4(b) and discusses those situations in which a fact witness may be compensated for the “lost time” away from his “day job” suffered while testifying.  See fuller summary here.

Judy v. Preferred Communications Systems, Inc.  This decision addresses the issue of legal ethics involved in determining whether an attorney may assert a retaining lien over the documents of a former or delinquent client.   See fuller summary here.

Common Law v. Statutory Claims

Overdrive, Inc. v. Baker & Taylor, Inc.  In this last formal decision  by Chancellor Chandler, the Court discussed how the Delaware Uniform Trade Secrets Act displaces conflicting tort and other common law claims that are grounded in the same facts which would support the statutory misappropriation of trade secret claims.  See fuller summary here.

Damages for Breach of Agreement to Negotiate in Good Faith

PharmAthene, Inc. v. SIGA Technologies, Inc. This Court of Chancery decision awarded damages for breach of a contractual obligation to negotiate in good faith and fashioned an equitable remedy that required the sharing of profits from the production of a product that the defendant failed to negotiate the license of in good faith. There are several decisions involving contract law by the Court of Chancery in this matter, the most recent ruling denying a motion for reargument. See fuller summary of the most recent decision here.

Postscript

On a final note, the last week of 2011 saw the sudden and sad passing of one of the nation’s foremost experts on alternative entities, Professor Larry Ribstein, who was often cited in opinions of the Delaware Courts. He coined the word “uncorporations” to refer to alternative entities and was the author of many treatises, law review articles and other publications on uncorporations, jurisdictional competition, the business of law firms and related topics involving the intersections of law and business. He was an iconic figure in the law, and the legal profession is better because of his many contributions.

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UPDATE: The Harvard Law School Corporate Governance Blog published this post here. The NACD’s Directorship.com site kindly published this article as a lead story on Jan. 5, 2012, available here. Professor Stephen Bainbridge graciously commented on this summary in his post available here. Professor Joshua Fershee on the Business Law Prof  Blog linked to this summary with kind references here.

Hurd v. Espinoza and Hewlett-Packard Company, No. 167, 2011 (Del. Supr., Dec. 28, 2011; corrected on Dec. 29, 2011), read Delaware Supreme Court opinion here. The Chancery decision appealed from was highlighted on these pages here. The New York Times online article about this  Supreme Court decision is available here. The separate Delaware Supreme Court decision last month addressing the underlying Section 220 issues in this case was summarized on this blog here.

Issue Addressed:  The issue addressed in this decision was whether a particular document filed with the Court should be kept under seal pursuant to Court of Chancery Rule 5(g). That document was a letter that included sundry allegations against the former CEO of Hewlett-Packard Co., which eventually led to his resignation.

Brief Overview and Background

Although the extensive media coverage regarding the document sought to be kept under seal in this matter focused on the aspects of the issue that are commonly found in tabloids, for purposes of corporate litigation, the Delaware Supreme Court appropriately focused on the issue of whether the prerequisites of Rule 5(g) were satisfied in order to maintain a document under seal (i.e., to keep it from public access).

The document sought to be kept under seal was a letter about the former CEO of Hewlett-Packard that was attached as an exhibit to the complaint filed in this case under DGCL Section 220 to obtain books and records of Hewlett-Packard Company.  At the time, Mark Hurd was the CEO of Hewlett-Packard (“HP”), until a lawyer for a former girlfriend of Hurd sent a letter alleging improper behavior which led to the resignation of Hurd as the CEO of HP.  That letter is the subject of this decision.  Although neither the shareholder who filed the §220 action nor HP regarded the letter as confidential, Hurd intervened in this case to argue that the letter was confidential and should be kept under seal and not revealed to the public (even though it was filed as part of the Section 220 lawsuit).  The Court of Chancery, in a 71-page opinion released in March, explained why the details of the letter, however embarrassing, should not remain under seal (for the most part), even based on California law, which is the primary basis on which Hurd sought to maintain its confidentiality.

Analysis

The Delaware Supreme Court did not rely on California law and instead affirmed the trial court based on an analysis of Court of Chancery Rule 5(g), which describes the prerequisites that must be satisfied in order to maintain a document under seal when it is filed with the Court.  In a pithy decision, Delaware’s High Court explained in a businesslike manner that in order to place a document under seal that has been made part of the public record, and in order to justify a denial of public access to that document, “good cause” must be established.  “Good cause” has been found to be a basis to seal documents when the documents contain trade secrets, non-public financial information, and third-party confidential material.  Information that is “mildly embarrassing” does not suffice to protect it from disclosure.  See In Re Yahoo!, Inc. S’holders Litig., 2008 WL 2268354 (Del. Ch.); Romero v. Dowdell, 2006 WL 1229090 (Del. Ch.); Khanna v. McMinn, 2006 WL 1388744 (Del. Ch.).

The Court explained that the letter at issue did not contain any trade secrets, non-public financial information or other proprietary information.  Therefore, the limited issue before the Court was whether the letter contained any third-party confidential information.  The Court reasoned that even if the letter contains some embarrassing detail about the behavior of Hurd, it does not describe any intimate conversations or conduct, and was sent to Hurd in his capacity as the CEO of HP at the company’s address, and involved claims against both HP and Hurd.

In affirming the decision of the Court of Chancery (in a decision that was only 10% as long), the Court also observed that most of the claims made in the letter were already widely reported in “virtually every media.”

In Espinoza v. Hewlett-Packard Co., read opinion here, the Delaware Supreme Court yesterday affirmed the Court of Chancery’s denial of a request under DGCL Section 220 for a report regarding the investigation relating to the ouster of former Hewlett Packard CEO Mark Hurd. Highlights of prior Chancery decisions in this matter are available here. Professor Larry Hamermesh of the Widener University School of Law provides an overview of the case here.

Supplement
This Delaware Supreme Court Opinion provides a pithy overview of the prerequisites for successfully seeking books and records under DGCL Section 220. Although the decision of the Court of Chancery was affirmed, it was affirmed for different reasons. The Court of Chancery determined that Espinoza was not entitled to the investigative report prepared for the board by outside counsel (“the Report”). The Court of Chancery decided that the report was protected by both the attorney/client privilege and the work/product immunity doctrine. However the Delaware Supreme Court determined that Espinoza was not entitled to the Report because it was not “essential to his stated purpose,” and that it was not necessary to address the privilege issue.

This case demonstrates why Section 220 cases can be less than predictable. In this case, it was uncontested that as the Court described it: “as a matter of law, Espinoza has stated a proper shareholder purpose under Section 220 – – to investigate possible wrongdoing. Nor is it contested that he made the required factual showing of a credible basis to infer possible mismanagement.” See footnote 14. Although the entitlement to inspection relief was not an issue, the issue that remained was the specific “scope of relief to which Espinoza is entitled – – ‘specifically, whether he has established the right to inspect the Report.’”

That is, the remaining prerequisite that was necessary for Espinoza to satisfy in order to prevail in this Section 220 case was the burden to “show that the specific books and records he seeks to inspect are ‘essential to the accomplishment of the stockholder’s articulated purpose for the inspection.’” See footnote 15.

The Court explained that a document is “essential” for Section 220 purposes if, “at a minimum, it addresses the crux of the shareholder’s purpose, and if the essential information the document contains is unavailable from any other source.” See footnotes 16 and 17. The Court further explained that: “whether or not a particular document is essential to a given inspection purpose is fact specific and will necessarily depend on the context in which the shareholder’s inspection demand arises. In making that scope of relief determination, our Courts must circumscribe orders granting inspection with rifled precision.’” (emphasis in original). See footnote 18.

The Court explained that the “essentiality” requirement was not met in this case based in large measure on the representations that the Court accepted from Hewlett Packard that the Report did not contain any details on which the board relied to determine that the CEO should be discharged. That is, the Court relied on the representation of Hewlett Packard that the Report did not address the issue of whether the CEO could be dismissed “for cause.” Due to those representations, the Court did not find that an in camera review was necessary. See footnote 20.

The Court explained at footnote 23 why the “essentiality” inquiry should precede the analysis of the applicability of the attorney/client privilege or work product protections because the issue of essentiality will determine the scope of inspection of relief to which a plaintiff is entitled under Section 220, and “if the documents are not essential, both attorney/client privilege and work product issues become academic.”

Postscript
For commentary on the challenges that shareholders face in Section 220 cases, we refer the reader to a postscript to a summary of a relatively recent Section 220 case available here.

DFG Wine Company, LLC v. Eight Estates Wine Holdings, LLC, C.A. No. 6110-VCN (Del. Ch. Aug. 31, 2011).  This decision was initially sealed and not available to the public until recently.

Issue Addressed

This is a books and records action involving an LLC, based on Section 18-305 of the Delaware LLC Act.  In this post-trial 31-page opinion, the Court granted in part the request for  documents.

Background

DFG sent a written demand in late 2010 for 16 categories of documents.  The stated purposes for seeking the records were two-fold:  (1) To determine the value of its investment in Eight Estates; and (2) To determine whether it should appoint a representative to sit on the board of managers.  The 16 categories of requested records were itemized on pages 4 through 6 of the letter opinion.  After an exchange of letters in which Eight Estates maintained that neither the LLC Agreement nor 6 Del. C. Section 18-305 required the production of the requested records, and after making a final request on Dec. 7, 2010 for reconsideration, DFG filed this lawsuit on January 4, 2011.

On January 24, 2011 Eight Estates provided DFG with the documents described at page 7 of the slip opinion. The LLC Agreement defined the rights of members and managers to inspect the books and records of the company and itemized specific records including tax returns and financial statements to which members and managers were entitled.

Specific Issues

The issues for trial were whether Eight Estates completely satisfied the demands of documents requested in categories 1, 4 and 6.  Eight Estates satisfied categories 2, 3 and 5 after the complaint was filed but did not provide any documents responsive to categories 7 to 17.

Why this Decision is Useful

This ruling provides helpful explanations about the scope of documents that are required to be produced for those seeking to value a closely-held company.  The Court explained that because members of a closely-held LLC “do not have access to the same quantity of information available from the regulatory filings of publicly traded companies . . .,” they should “be given slightly broader access rights.”  See footnote 23.

Court’s Reasoning

The Court also explained that the right of limited liability company members to inspect books and records of a limited liability company’s subsidiaries is not made explicit by 6 Del. C. Section 18-305, but nonetheless, Delaware courts have recognized that the statute provides a right to inspect the records of such subsidiaries where “the facts at least suggested the absence, in reality, of separate entities.”  See footnotes 24 and 25 (relying on DGCL Section 220(b)(2) by analogy).

The Court also observed that Section 18-305(c) limits the inspection rights granted to members of an LLC to the extent that the LLC “has the opportunity to establish a good faith belief that disclosure of the desired information would not be in the best interest of the entity . . . .” (citing Arbor Place, L.P. v. Encore Opportunity Fund, LLC, 2002 WL 205681, at *5 (Del. Ch. Jan. 29, 2002)).  Moreover, unlike a Section 220 case, a limited liability company is a creature of contract and the LLC Agreement may grant inspection rights that are “in addition to and separate from” the statutory inspection right.

The Court, unsurprisingly, concluded that the purpose of valuation was a proper purpose.

The Court also determined that it was a proper purpose to seek books and records for the purpose of determining whether to appoint someone, and if so, who to appoint as a member of the board of managers of the LLC.  The Court compared Section 18-305(b), which gives managers the right to examine all the materials described in Section 18-305(e), with the provision of Section 18-305(c) which allows for a good faith defense to a books and records action involving members – – but not managers.

Importantly, the Court emphasized, by reliance on a Delaware Supreme Court decision (in footnote 36), that so long as a single proper purpose related to one’s role as a stockholder is established, all other purposes are irrelevant (relying on DGCL Section 220).

Records of Subsidiary of LLC

The Eight Estates LLC had no value apart from its subsidiary known as Ascentia.  The Court distinguished the Arbor Place case because unlike that case and subsidiaries of the LLC in that opinion, the facts in this case “suggest the absence, in reality, of separate entities.”  The Court reasoned that it would be unfair under these circumstances to require a member of Eight Estates to attempt to value its holdings without providing access to the records of the only asset of the LLC, which are the records of the subsidiary, in order to allow the member to value that asset.  See footnote 43 citing to a decision involving piercing the corporate veil, which relies on a combination of factors and an overall element of unfairness as opposed to a single factor.

Trade Secrets

Although the Court allowed the company to redact any information that would be in the nature of trade secrets, the Court was not persuaded by the defense that the member seeking the information would be using that information in order to “cherry pick” or otherwise damage the competitive position of the company.

See footnote 50, referring to Section 18-305(c) which provides that an objective standard is applied to the belief of a manager that certain information is in the nature of a trade secret–but a subjective standard is applied to a belief of a manager that certain disclosures would not be in the best interest of the company.

Prior Production

The Court also rejected the defense that because a large number of hard copy documents were produced in a separate arbitration proceeding, which were designated as “for attorneys’ eyes only,” that the members seeking books and records would not be able to obtain those same documents in this case.

Scope of Relief and Specific Documents Required to be Produced

The Court determined that state tax returns of the subsidiary were not part of the enumerated documents that members were entitled to under the LLC Agreement, but such returns would be part of the “true and full information regarding the status of the business” to which it was entitled under Section 18-305(a)(1).

The Court also explained that the company did not establish a good faith belief that withholding the information would not be in the best interest of the company, and thus required state tax returns to be produced.  The Court also required the production of the “independent auditor’s report and financial statements” as well as the unaudited financial statements because those documents are reasonably related to the purpose of valuing the membership interests.

The Court also required the production of Employment Agreements with key employees which would be included within the category of “information regarding the affairs of the limited liability company” pursuant to Section 18-305(a)(6), and these documents also contribute to the valuation of the interest in the LLC, and there was no basis to establish the belief of a manager that withholding those records would be in the best interest of the company.

The production of a general ledger of the subsidiary was also required based on Section 18-305(a)(1).  The Court mandated the production of business plans and budgets including projections for future performance, and all documents related to such estimates or projections, subject only to redaction for trade secrets.

The Court also ordered the production of documents related to inventory and non-inventory assets that it determined would be necessary to value an interest in the LLC or its subsidiary.  Likewise, the Court ordered the production of documents related to the relationship of the company with its creditors such as any loan agreements, notes, mortgages and other debts or liabilities.  In addition, the Court required the production of information regarding grape contracts which apparently have great value in connection with valuing a winery.  The Court permitted the production of either the grape contracts themselves or a summary of the contracts that shows how many contracts it has and has had since 2008 and related information about the contracts.

Espinoza v. Hewlett-Packard Company, C. A. No. 6000-VCP (Del. Ch. Mar. 17, 2011), read 70-page Court of Chancery opinion here.

The background of this decision has been referenced in the popular press for many months. It involves the former CEO of Hewlett-Packard, Mark Hurd. In August 2010 he resigned as CEO amid allegations of improper conduct regarding a former HP contractor, Jodie Fisher. A letter to Hurd was sent by Fisher’s lawyer, Gloria Allred, alleging certain claims against Hurd and HP. A settlement was reached on August 5, 2010 and Hurd resigned the next day.

Court of Chancery Rule 5(g) regarding confidential filings, and the procedures and considerations relating to those filings, is discussed in great detail and this opinion is destined to be a useful reference for corporate litigators who need to be familiar with that rule. See, e.g., text accompanying footnotes 33 to 38 and 176 to 180.

This case started as a demand for books and records pursuant to DGCL Section 220 regarding the handling of Hurd’s resignation by HP. The Court of Chancery allowed Hurd to intervene in this case in order to allow him to argue why the Allred letter should be kept confidential. Hurd argued that California law applied. The Court concluded that Hurd did not  demonstrate good cause why the Allred letter should be kept under seal.  Hurd claimed that the public disclosure of the Letter would violate his "protectable legal interests" based on six different theories arising under various California laws and statues. After a choice of law analysis, the Court, in applying California substantive law found that Hurd failed to demonstrate that the letter qualified for protection under California law. As a result, the Court looked to Delaware procedural rules and in particular Chancery Rule 5(g). However, a small portion of the letter relating to Hurd’s family was kept under seal. See footnote 85.

Bloomberg reports here with more details and explains that Hurd will appeal the decision, but that HP "takes no position" on the matter.

Kevin F. Brady of Connolly Bove Lodge & Hutz LLP contributed to the highlight of this case.

Supplement:

Although only tangentially related, a noteworthy postscript to this ruling is a Brief filed in the Court of Chancery, available here, on behalf of the New York Attorney General, who intervened in a Chancery case involving Intel to argue that a Protective Order should be modified or clarified to confirm that it did not prohibit the New York Attorney General from accessing documents that may be covered by the Order but which were otherwise made available as part of the NY AG’s investigation of Intel. The Brief contains a useful collection of cases for a third-party who wants to argue that a Protective Order should not restrict its access to documents otherwise available.

Louisiana Municipal Police Employees Retirement System v. Morgan Stanley & Co., Inc., C.A. No. 5682-VCL (Del. Ch. Mar. 4, 2011), read opinion here. This is a decision by the Delaware Court of Chancery which granted in part and denied in part a motion to dismiss a complaint pursuant to DGCL Section 220 in which a shareholder sought books and records regarding the investigation of a board’s special committee and its counsel.

Short Overview

The stated purpose for seeking the inspection of books and records pursuant to Section 220 was to “investigate whether the board of directors of Morgan Stanley & Co. (the “Board”) 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 only to the extent that some books and records were not reasonably required to investigate whether the litigation demand was wrongfully refused, but the motion was denied to the extent that Morgan Stanley argued that the shareholder lacked a “proper purpose.”

Notably, the plaintiff shareholder in this case ("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. Cf. overview here of King v. VeriFone, a recent Delaware Supreme Court decision reversing an unrelated Court of Chancery decision and allowing Section 220 claims which were filed after a derivative action.

Brief Background

The plaintiff shareholder in this matter, LAMPERS, in a separate derivative action filed in federal court in New York had its complaint provisionally dismissed for failure to comply with Rule 23.1, but the federal court retained jurisdiction and set a schedule to allow for: (i) the plaintiffs to make a litigation demand on the Board; (ii) the Board to respond; (iii) the plaintiffs to seek any further relief necessitated by the response of the Board. The federal court  thereafter stayed the derivative case pending a decision by the Delaware Court of Chancery in the instant Section 220 proceeding.

Eight months after the litigation demand, the Board received a report from the law firm of Simpson Thacher and Bartlett LLP (“Simpson Thacher”) whom the Board had retained to investigate the litigation demand. Based on that report, the Board refused to take any action, and 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. Very soon after the letter refusing to take action, LAMPERS submitted a demand on May 12, 2010 seeking certain books and records pursuant to Section 220.

In addition to the documents sought relating to the investigation and report by Simpson Thacher, LAMPERS also sought a report prepared by the Skadden Arps firm in connection with the separate investigation it did in 2007 and 2008 into Morgan Stanley’s involvement with auction rate securities.

Short Synopsis of Court’s Legal Analysis

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 Section 220(b) requires a proper purpose when a shareholder seeks books and records. A proper purpose has been defined in this context 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 opinion explained that the stockholder plaintiff does not, by making a pre-suit demand, waive the right to claim that demand has been wrongfully refused (citing Grimes v. Donald (Grimes I), 673 A.2d 1207 (Del. 1996)). In addition, in a later iteration of the dispute between the same parties, the Court of Chancery decided that a request for books and records which are needed to determine whether a special committee complied with Delaware law in their analysis and rejection of a pre-suit demand–was a proper purpose (citing Grimes v. DSC Commc’ns Corp. (Grimes II), 724 A.2d 561, 566 (Del. Ch. 1998)).

The Court also relied on Delaware Supreme Court precedent 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) (citing Grimes I at 1219).

A long list of exemplary “proper purposes” under Section 220 was quoted from a leading treatise on Delaware corporate law. Those recognized proper purposes include the following:

(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. See slip op. at 10-11.

The Court also referred to the recent Delaware Supreme Court decision in City of Westland Police and Fire Retirement Systems v. Axclis Techs., Inc., 1 A.3d 281, 288 (Del. 2010), 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 is proper and the Court found that it was.

Scope of Inspection

The scope of inspection in a Section 220 case is limited to “those books and records that are necessary to accomplish the stated purpose.” The core inquiry is whether the requested documents are “reasonably required to satisfy the purpose of the demand” (citations omitted).

In this case, the Court reasoned that LAMPERS stated a valid claim to obtain the information, including the following: (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; and (4) Any documents and other records upon which the Board relied. Moreover, the Court found that LAMPERS stated a claim to obtain the engagement letter of Simpson Thacher so that they could 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 the Skadden Arps firm 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 was permitted to make arguments based on the materials it obtained through the instant action. Those subsequent demands would need to be considered “in due course.”

In conclusion, the Court determined that if the parties could not resolve the dispute based on this ruling, they were ordered to “negotiate a schedule that will bring this summary proceeding to a final hearing within 60 days.”