June 30, 2012

DELAWARE INSIDER: Sue First, Ask Questions Later: Can a Derivative Plaintiff Seek to Inspect Books and Records After Filing Its Derivative Claims?

Bruce E. Jameson

Recently, the Delaware Supreme Court was presented with the question whether a stockholder who files a derivative action is necessarily precluded from pursuing its statutory inspection rights under 8 Del.C. § 220 where the purpose of the inspection is to investigate acts of corporate mismanagement that form the basis of the stockholder's derivative claims. In Central Laborers Pension Fund v. News Corp., No. 682, 2011, 2012 WL 1925724 (Del. May 29, 2012), the Delaware Supreme Court affirmed the Court of Chancery's dismissal of the section 220 action, but declined to address the interplay of that action to the prior filed derivative action. Although the Delaware Supreme Court has previously expressed reservations about the advisability of a stockholder filing derivative claims prior to utilizing the "tools at hand" afforded by section 220 to gather information, Delaware law continues to recognize that there may be limited circumstances where stockholder inspection rights remain valid notwithstanding the prior filing of derivative claims.

Derivative Suit Not a Bar to Inspection Rights

Last year, the Delaware Supreme Court considered that issue in King v. VeriFone Holdings, Inc., 12 A.3d 1140 (Del. 2011). The court reversed the Delaware Court of Chancery's dismissal of a books and records action holding that the plaintiff's prior-filed derivative action in California did not bar the plaintiffs' inspection rights. The derivative action had been dismissed by the federal district court in California but the dismissal was without prejudice to plaintiff's right to re-plead based on information the plaintiff might obtain if it chose to exercise its statutory inspection rights under section 220. In dismissing the section 220 suit, the Court of Chancery in King v. Verifone Holdings, Inc., 994 A.2d 354, 356-57 (Del.Ch. 2010), reasoned that "stockholders who seek books and records to determine whether to bring a derivative suit should do so before filing the derivative suit," and that once a stockholder files a derivative suit it ". . . has chosen its course and may not reverse course and burden the corporation (and its stockholders) with yet another lawsuit to obtain information it cannot get in discovery in the derivative suit."

The Delaware Supreme Court reversed. It acknowledged the well settled principle that a "proper purpose" for a stockholder's exercise of its inspection right is the investigation of corporate mismanagement noting that "Delaware courts have strongly encouraged stockholder-plaintiffs to utilize Section 220 before filing a derivative action, in order to satisfy the heightened demand futility pleading requirements of Court of Chancery Rule 23.1." (Emphasis added). While filing a derivative action before pursuit of inspection rights under section 220 may be "ill-advised," the Delaware Supreme Court identified and discussed several prior Delaware opinions where it had not been "fatal." In each of the cases cited by the Delaware Supreme Court, the plaintiffs' original derivative complaints had been dismissed with leave to re-plead. Furthermore, in all instances the dismissing courts had affirmatively suggested that the plaintiffs make use of section 220 to develop facts prior to re-pleading. On the other hand, the Delaware Supreme Court identified two cases where the Delaware Court of Chancery had dismissed with prejudice section 220 actions because of the existence of earlier-filed derivative actions. In both cases, the plaintiff had been denied leave to re-plead its derivative claims. Because the plaintiff in King had been specifically granted leave to amend his derivative complaint by the federal district court in California, the Delaware Supreme Court held that King had stated a proper purpose under section 220 and his action seeking to inspect books and records could proceed. Notwithstanding its recognition that in certain circumstances an action to inspect corporate records may be pursued after the initiation of a derivative action, the Delaware Supreme Court cautioned that its holding "should not be read as an endorsement . . . of proceeding in that way."

The Next Step Not Taken

In Central Laborers, the Delaware Supreme Court again faced the question whether and when a stockholder plaintiff can pursue its section 220 inspection rights to investigate mismanagement after having first filed a derivative suit. Central Laborers Pension Fund commenced a derivative action against the directors of News Corporation (News Corp.) challenging the fairness of News Corp.'s acquisition of the Shine Group, an entity formed by Elisabeth Murdoch, the daughter of News Corp. CEO, Rupert Murdoch. On the same day that it filed the derivative suit, Central Laborers also filed an action to compel inspection of News Corp.'s books and records for the purpose of investigating potential breaches of fiduciary duty in connection with the acquisition of Shine Group. News Corp. moved to dismiss the section 220 action on various grounds including that the filing of the derivative action refuted any claim of a proper purpose for inspection under section 220.

The Court of Chancery dismissed the section 220 proceeding holding that "once the derivative action is filed, and until the judicial processing of the dismissal motion reached the point where a recasting of the allegations has been authorized, the stockholder may not, as a general matter, demonstrate a proper purpose for invoking Section 220." Central Laborers Pension Fund v. News Corp., 2011 WL 6224538 at *2 (Del.Ch. Nov. 30, 2011). The Court of Chancery acknowledged that "there may be special circumstances that would warrant the pursuit of books and records action at the same time as the related derivative action" but found that such circumstances did not exist there. The court did not discuss the nature of when such special circumstances might exist other than to cite Khana v. Covad Commc'ns Group, Inc., 2004 WL 187274, at *4 (Del.Ch. Jan. 23, 2004). In Khana, the Court of Chancery found a section 220 action could proceed despite the plaintiff's prior filing of a derivative action because of plaintiff's concern that the derivative claims could become time barred if further time passed. Concerns that the limitations period applicable to the derivative claims may expire during the pendency of a section 220 action may now be of limited validity because the Delaware Court of Chancery ruled in 2010 that filing of a section 220 action tolls the statute of limitations as to claims regarding the mismanagement that is being investigated. Sutherland v. Sutherland, 2009 WL 857468, at *5 (Del.Ch.).

Central Laborers appealed the Court of Chancery's dismissal of its section 220 claims. The Delaware Supreme Court affirmed the Court of Chancery's dismissal of the section 220 action on grounds not considered by the Court of Chancery, and ruled that Central Laborers had failed to comply with the procedural requirements of section 220 by not supplying proof of beneficial ownership with its original demand. Although Central Laborers submitted proof of beneficial ownership in response to defendant's motion to dismiss, the Delaware Supreme Court considered that submission inadequate holding that "strict adherence to the section 220 procedural requirements" was required to protect "the right of the corporation to receive and consider a demand in proper form before litigation is initiated." Because it found the form of the demand deficient, the Delaware Supreme Court did not review the Court of Chancery's determination that the plaintiff's filing of the derivative suit precluded the existence of a proper purpose necessary to support plaintiff's inspection rights.

The Potential Impact of Chancery Rule 15(aaa)

Because of a procedural rule unique to the Delaware Court of Chancery, the circumstances when a stockholder may simultaneously prosecute a derivative action and section 220 action may vary based on the forum in which the derivative action is brought. In all the cases cited by the Delaware Supreme Court in King as examples of plaintiffs being permitted to prosecute their section 220 claims after having filed derivative actions, the dismissal of the plaintiff's derivative complaint was subject to a right to amend. Such a scenario is unlikely today if the derivative action is filed in the Delaware Court of Chancery because of the adoption of Court of Chancery Rule 15(aaa) which became effective June 1, 2001. Rule 15(aaa) requires a plaintiff that desires to amend its complaint in response to a motion to dismiss to file an amended complaint or motion to amend before the time that its answering brief in response to the motion to dismiss is due. If the plaintiff fails to amend its complaint and the court grants the motion to dismiss, the dismissal is with prejudice unless the court, for good cause shown, finds that dismissal with prejudice would not be just under the circumstances. Unlike cases decided under Federal Rule of Civil Procedure 15, which states that the right to amend shall be freely given, the Court of Chancery Rules make it much less likely that a section 220 action can be prosecuted once a derivative suit is filed in Delaware.

The two cases cited by the King v. Verifone court as examples of instances where section 220 suits were permitted to go forward after derivative suits had been filed and dismissed in Delaware (In re: Wald Disney Co. Derivative Litig. and Ash v. McCall) both pre-date the adoption of Rule 15(aaa). The third case cited by the King court, Melzer v. CNET Networks, Inc., and King v. Verifone itself, both involve instances where the derivative suit had been filed in federal court. In Central Laborers, plaintiff filed its derivative suit in the Delaware Court of Chancery but there was no discussion by the Court of Chancery regarding the potential impact of Court of Chancery Rule 15(aaa). The Court of Chancery did note that the derivative action had not been dismissed and that no judicial action had occurred requiring further pleading. Had a motion to dismiss the derivative action been filed and ruled on by the Court of Chancery, any dismissal likely would have been with prejudice pursuant to Chancery Court Rule 15(aaa) unless the court found good cause to permit plaintiffs to re-plead.

Whether the existence of Court of Chancery Rule 15(aaa) will result in different outcomes for plaintiffs who file derivative suits in the Delaware Court of Chancery compared to those who file derivative suits in the federal courts, and then subsequently seek to pursue statutory inspection rights, remains to be seen. Similarly, it remains an open question whether a stockholder may ever state a proper purpose for assertion of corporate inspection rights where the stockholder's derivative suit has not yet been the subject of a motion to dismiss and no obligation or right to re-plead has yet arisen.

The Delaware Supreme Court in King strongly cautioned against filing derivative claims first and section 220 claims later. Nevertheless, the Delaware Supreme Court's acknowledgement in King that the sequence of filing claims by a stockholder cannot by itself be fatal to a stockholder's statutory inspection rights, and the suggestion by the Delaware Court of Chancery in Central Laborers that "special circumstances" may at times warrant the simultaneous prosecution of a books and records action and derivative action leaves open the door, if only just a crack, to the possibility that simultaneous assertion of those claims in the future may occur. Court of Chancery Rule 15 (aaa), however, limits the likelihood that such circumstances are likely to occur where the derivative claims are filed in the Delaware Court of Chancery.

Bruce E. Jameson

Director, Prickett Jones & Elliott, P.A.

Bruce E. Jameson is a director of Prickett Jones & Elliott, P.A. in Wilmington, Delaware, where his practice focuses on corporate litigation. The views expressed are solely those of the author and do not necessarily represent the views of the firm or its clients.