The right of a shareholder to inspect corporate books and records pursuant to 8 Del. C. § 220 is not new. Delaware courts have long advised shareholders to utilize the "tools at hand," meaning the right to inspect corporate books and records, to investigate possible wrongdoing before filing an action for breach of fiduciary duty or other wrongs. However, in a series of recent decisions, the inspection of books and records has taken on a new-found importance because of the Court of Chancery's adoption of the "fast-filer presumption," which comes close to converting the right to inspect into an obligation to inspect before bringing a particular species of derivative claims. In cases where plaintiffs allege breach of fiduciary duties against the board of directors for either (1) knowingly violating positive law, or (2) failing to establish a proper reporting mechanism for conducting oversight (otherwise known as Caremark claims), the Court of Chancery normally expects plaintiffs to inspect books and records before filing. Because a Caremark claim must link the board of directors to the wrongdoing, it is often impossible to plead demand futility without internal corporate documents. If a plaintiff's Caremark claim cannot survive a motion to dismiss because the complaint fails to plead demand futility with particularity and the plaintiff opted not to inspect books and records before filing, the Court of Chancery will apply a rebuttable presumption that the fast-filing plaintiff failed to adequately represent the corporation, which may lead the court to dismiss a shareholder's claim with prejudice as to that plaintiff.
Suggested Solutions to Failure to Investigate
The roots of the Court of Chancery's recently applied presumption against fast-filing derivative plaintiffs dates back to a dispute over whether a shareholder who has already filed a derivative claim may thereafter bring an action seeking the inspection of books and records. In King v. VeriFone Holdings, Inc., 994 A.2d 354 (Del. Ch. 2010), a stockholder brought a demand to inspect the books and records of a corporation after already filing a derivative action asserting a Caremark claim in California. The stockholder purported to seek books and records to investigate mismanagement so as to amend the derivative complaint. Finding the timing of such a request improper, the Court of Chancery held:
[S]tockholders who seek books and records in order to determine whether to bring a derivative suit should do so before filing the derivative suit. Once a plaintiff has chosen to file a derivative suit, it has chosen its course and may not reverse course and burden the corporation (and its other stockholders) with yet another lawsuit to obtain information it cannot get in discovery in the derivative suit.
In reaching this conclusion, the court discussed the problem of fast-filing plaintiffs racing to the courthouse after the announcement of a corporate trauma in an effort to obtain lead-plaintiff status by winning the "filing Olympics." According to the court, "[t]he only reason King rushed to file his complaint in the derivative action and has since sought supplementary discovery through the § 220 process is so that he and his counsel could win the race to become lead plaintiff and lead counsel." Further explaining that allowing plaintiffs to file a derivative action and then investigate rewards behavior that costs the corporation and the judicial system resources, the court stated: "The derivative suit's central purpose is compromised when counsel prematurely file thinly-substantiated complaints that cannot meet the heightened Rule 23.1 particularized pleading standard only in order to beat their competitors in the plaintiffs' bar, and then attempt to compensate for those inadequate pleadings through an after-the-fact process that needlessly saps corporate funds through drawn-out dismissal motion practice and simultaneous lawsuits in separate forums." .
Rejecting the Court of Chancery's bright-line test barring a books and records inspection after filing a derivative action, the Delaware Supreme Court reversed and reaffirmed the "long-standing Delaware precedent which recognizes that it is a proper purpose under Section 220 to inspect books and records that would aid the plaintiff in pleading demand futility in a to-be-amended complaint in a plenary derivative action, where the earlier-filed plenary complaint was dismissed on demand futility-related grounds without prejudice and with leave to amend." King v. VeriFone Holdings, Inc., 12 A.3d 1140, 1150 (Del. 2011).
Although it reversed, the Delaware Supreme Court further instructed that the reversal should not be read as an endorsement of the file first and investigate later character of the plaintiff's actions. The court suggested three non-exclusive solutions to the problem of derivative actions filed without proper investigation. First, the court hearing the derivative action could deny the plaintiff "lead plaintiff" status. Second, the court could dismiss the derivative complaint both with prejudice and without leave to amend as to the named plaintiff. Third, the court could allow the plaintiff leave to amend once so long as the plaintiff paid the attorneys' fees incurred by the defendants on the first motion to dismiss.
Presumption Punishes Plaintiffs Who Fail to Inspect
Following the Supreme Court's suggestions in King to find other remedies to the fast-filer problem, the Court of Chancery applied what it termed the "fast-filer presumption" in two recent cases. In Louisiana Municipal Police Employees' Retirement System v. Pyott ("Allergan"), 46 A.3d 313 (Del. Ch. 2012) (appeal pending), a Delaware corporation specializing in pharmaceuticals, entered into a settlement agreement with the U.S. government following a three-year investigation into its off-label marketing of Botox. As part of the settlement, Allergan agreed to pay $375 million in criminal fines for misbranding and $225 million in civil fines to resolve False Claims Act actions that also dealt with off-label marketing. Following the public announcement of the settlement, various shareholder plaintiffs filed derivative actions in both California and Delaware. One of the shareholder plaintiffs in one of the Delaware actions sought to inspect books and records pursuant to Section 220. The rest did not.
After the California court dismissed the consolidated cases before it, the defendant directors moved to dismiss the Delaware action based on collateral estoppel. Rejecting the defendants' request in part because the California plaintiffs did not properly investigate the claims, the court stated:
[A] court in a plenary derivative action such as this one has discretion to address a rush to the courthouse by determining that the plaintiff in the original derivative action did not provide adequate representation for the corporation and declining on that basis to give preclusive effect to a Rule 23.1 dismissal of the fast-filer's complaint. In this case, to give preclusive effect to the California Judgment would favor the lawyers who filed hastily, penalize the diligent counsel who used Section 220, and confer a case-dispositive advantage on the defendants at the potential expense of the corporation.
Accordingly, the court denied the motion to dismiss based on the presumption that the fast-filing California plaintiffs had not adequately represented the company because they failed to seek books and records before filing. However, the Allergan court did not explain what test governed the fast-filer presumption or how it could be rebutted.
Test for Fast-Filer Presumption
In South v. Baker, 2012 WL 4372538 (Del. Ch. Sept. 25, 2012), the Court of Chancery expanded on the Allergan decision to articulate the test governing the fast-filer presumption. Following the public announcement of lower silver production projections by Hecla Mining Company and the announcement of numerous safety violations by the U.S. Mine Safety and Health Administration after several accidents in Hecla's mines, plaintiffs filed two actions alleging securities law violations in Idaho. The securities cases alleged that Hecla's disclosures relating to its safety procedures had been materially misleading. In Delaware, shareholders of Hecla brought a derivative action alleging Caremark claims against the directors of the company for the damages the company had and would suffer as a result of the securities lawsuits.
The plaintiffs in the Delaware action failed to inspect Hecla's books and records before bringing their action, and the directors moved to dismiss. As is often the case with Caremark claims that are not investigated before filing, the court found the plaintiffs were unable to allege particularized facts supporting demand futility by showing that a majority of the board faced a substantial risk of liability. Explaining the disloyalty to the company normally evidenced by fast-filing of a Caremark claim, the court stated:
When a stockholder rushes to file a Caremark claim without first conducting an adequate investigation to determine whether or not there is a connection between the corporate trauma and director action or conscious inaction, the stockholder acts contrary to the interests of the corporation but consistent with the interests of the plaintiffs' firm that files the suit. This recurring scenario supports a presumption that the plaintiff has acted disloyally and is not an adequate fiduciary for the corporation.
The court further explained that the fast-filing plaintiff is normally serving the interests of the law firm filing the action so that the firm may win the race to the courthouse to increase the chance that the law firm will represent the lead plaintiff. Because the plaintiffs in South filed shortly after the public announcements and the filing of the securities actions and failed to conduct a books and records inspection pursuant to Section 220, their actions triggered the fast-filer presumption.
However, the court also concluded that the presumption that the fast-filing plaintiff acted disloyally and was not an adequate representative of the corporation could be rebutted. Delaware Rule of Evidence 301 provides that "a presumption imposes on the party against whom it is directed the burden of proving that the nonexistence of the presumed fact is more probable than its existence." Pursuant to DRE 301, the court found that the party opposing the presumption could rebut it in two ways. First, the party could prove that despite the fast-filer's failure to inspect books and records under Section 220, the shareholder had "conducted a meaningful and thorough investigation." Second, the person attempting to rebut the presumption could prove that the act of filing quickly benefitted the company, and not just the law firm.
The plaintiffs in South were unable to rebut the fast-filer presumption. Plaintiffs' counsel admitted to spending only "several hours" investigating the claims. Furthermore, the plaintiffs were unable to offer any reason why they could not have utilized Section 220 to investigate and then bring their Caremark claims if the inspection of books and records generated sufficient evidence. Finally, plaintiffs' counsel admitted that he filed the action quickly due to the fear that other plaintiffs might move faster and gain control of the action against the directors. Accordingly, consistent with the Supreme Court's suggestion in King, the court dismissed the plaintiffs' claims with prejudice as to the named plaintiffs.
Litigating Under the Fast-Filer Presumption
Although the fast-filer presumption remains in its infancy, a number of lessons can be drawn for both plaintiff and defense counsel. Perhaps most obviously, a plaintiff shareholder who wishes to bring a Caremark claim should almost always seek to inspect books and records to investigate the board's knowledge of the wrongdoing or failure to establish proper oversight to prevent the wrongdoing. If the plaintiff fails to investigate, defense counsel bringing a motion to dismiss should highlight the failure by the plaintiff to investigate as well as the timing of the filing vis-à-vis the announcement of the corporate trauma prompting the filing. The fast-filer presumption also creates situations in which both plaintiff and defense counsel will have to be prepared to rebut the presumption, depending on the procedural posture of the case. If the case is being brought by a fast-filer plaintiff and the fast-filer presumption is triggered, the plaintiff will need to prove that this is one of the rare situations in which a meaningful pre-suit investigation was possible without a books and records inspection or that somehow the speed of the filing benefitted the company. If on the other hand the case is being brought by a second derivative plaintiff after the fast-filer's action has already been dismissed, and if the Delaware Supreme Court finds on the Allergan appeal that a second derivative plaintiff is in privity with the first and should ordinarily be collaterally estopped from litigating after a first derivative action is dismissed, counsel for the directors in the second derivative action will have to rebut the presumption that the original fast-filing plaintiffs inadequately represented the company in order to preclude the second derivative action. In other words, the directors who obtained the dismissal of the first derivative action will be in the somewhat awkward situation of defending the efforts and investigation of the fast-filing original derivative plaintiff in order to rebut the fast-filer presumption in the subsequent derivative action. Although the standard announced in South v. Baker only requires the party opposing the presumption to prove "that the nonexistence of the presumed fact is more probable than its existence," given the difficulty of alleging demand futility on a Caremark claim without access to corporate documents, in practice this presumption will likely prove to be difficult to rebut.