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October 03, 2017

Is the Delaware Section 220 Tango Worth the Wait?

Frank R. Schirripa and Daniel B. Rehns – October 3, 2017

This article provides a brief examination of whether plaintiff shareholders who initiate a demand to inspect books and records under Delaware General Corporation Law (DGCL) section 220, as opposed to opting to instead file a derivative suit in a jurisdiction outside Delaware, are placed at a procedural disadvantage.

Section 220: Background and Requirements
The common-law right to inspection dates back over 100 years and was codified in DGCL section 220 in 1967. The codification of this public policy—namely, the right of a shareholder to inspect books and records to monitor its fiduciaries’ discharge of management duties—was premised on the shareholder having a “proper purpose” for its inspection, and it has been a cornerstone of Delaware fiduciary law since.

Delaware courts encourage shareholders to make use of this “tool at hand,” section 220 demands, before racing to the courthouse and filing a derivative action—mainly to aid plaintiffs in meeting the heightened pleading requirements of Rule 23.1 under Delaware law. Indeed, Delaware courts will often dismiss complaints containing vague allegations of fiduciary breaches, especially in cases in which a plaintiff shareholder did not exercise its inspection rights before filing suit. Section 220 demands are especially relevant when shareholders in a company assert what are now commonly referred to as “Caremark claims”—allegations that inadequate board oversight led to serious problems at the company—against a board of directors.

Demand Futility and Caremark Claims
A derivative complaint must allege, with particularity, a shareholder’s efforts to demand action from the company, as well as the reasons for its failure to obtain the action sought from the company. A demand is futile if a plaintiff’s allegations create either a reasonable doubt that the directors are disinterested and independent or, alternatively, a reasonable doubt that the challenged transaction or conduct was otherwise the product of a valid exercise of business judgment.

Following the 1996 Delaware Chancery Court decision in In re Caremark International Inc. Derivative Litigation (698 A.2d 959 (Del. Ch. 1996)), the fiduciary duty of corporate directors has been understood to embrace the implementation and maintenance of corporate compliance programs designed to identify corporate wrongdoing and to bring evidence of that wrongdoing to the attention of the board of directors and corporate management. Further, within the context of a “Caremark claim,” there now exists a presumption that when a shareholder rushes to file suit without first seeking a section 220 demand for books and records in order to obtain documents that may demonstrate a connection (or no connection) between the corporate damage and director action or inaction, the shareholder’s suit inadequately represents the best interests of the corporation.

To sustain a Caremark claim in Delaware, the Chancery Court requires a shareholder to link the particular directors’ knowledge or awareness of the wrongdoing to the resultant corporate trauma. In the absence of specific allegations of such knowledge or “red flags” as well as the subsequent response, Delaware courts are disinclined to infer Caremark liability. Traditionally, a shareholder would use the “tools at hand”—a DGCL section 220 books and records demand—to gain insight into the directors’ and officers’ knowledge or awareness of the wrongdoing. This hurdle has become increasingly more difficult and time consuming for plaintiffs to overcome—driving plaintiffs into fora outside Delaware to seek redress for fiduciary breaches.

In April 2013, the Delaware Supreme Court overturned a Chancery Court ruling that attempted to address the problem of fast-filing plaintiffs—those plaintiffs who file suit without first using the “tools at hand” available to them. There, the Delaware Supreme Court rejected the Chancery Court’s irrebuttable presumption of inadequacy that attached to the claims of fast-filing plaintiffs, ruling that the claims of plaintiffs who fail to initiate a section 220 demand action are not necessarily inadequate. See Pyott v. La. Mun. Police Emps’ Ret. Sys., 2013 WL 1364695 (Del. Ch. Apr. 4, 2013). This ruling helped set the stage for subsequent shareholder plaintiffs to look outside Delaware for redress without filing a section 220 demand.

In Louisiana Municipal Police Employees’ Retirement System v. Hershey Co., C.A. No. 7996-ML, 2013 BL 311584 (Del. Ch. Nov. 8, 2013), the Court of Chancery dismissed an investor group’s legal claim that the Hershey Co. had engaged in “wrongdoing” by relying on West African farms that use illegal child labor to harvest cocoa beans. Despite the concession that child labor in the chocolate industry is a serious problem, the court ultimately concluded that the plaintiff had not made any effort to allege any breaches of fiduciary duty outside the alleged violations of child labor law. Further, having failed to set forth any evidence from which the court could infer that Hershey had violated the law, the plaintiff’s bid to investigate corporate mismanagement or breaches of fiduciary duty related to those violations failed.

The recent Chancery Court decision in In re Qualcomm Inc. FCPA Stockholder Derivative Litigation, C.A. No. 11152-VCMR (Del. Ch. June 16, 2017), serves as another reminder that Caremark claims are among the most difficult claims to successfully make against directors in Delaware. In Qualcomm, the plaintiff shareholders claimed breaches of fiduciary duties against Qualcomm’s directors and chief financial officer, stemming from the Securities and Exchange Commission’s determination that Qualcomm violated the Foreign Corrupt Practices Act (FCPA) from 2002 through 2012. The plaintiffs alleged that the Qualcomm board knew of several red flags concerning FCPA reporting problems in China and Korea and that these reporting problems amounted to a conscious disregard for the board’s duties. However, the Chancery Court was unconvinced, holding that the plaintiffs failed to prove the board acted in bad faith pursuant to a Caremark claim for a breach of fiduciary duties because the plaintiffs failed to adequately plead the board’s intentional dereliction of duty despite the presence of the red flags.

Recent trends in case law indicate that shareholders may not face such difficulties when filing outside the jurisdiction of the Chancery Court.

The growing frustration with making a DGCL 220 demand in Delaware was evident in the derivative actions arising from Wal-Mart’s bribery scandal. One action started as a 220 demand in Delaware, while a second action was filed in Arkansas federal court. Both actions were triggered by the Department of Justice’s investigation into potential misconduct by Wal-Mart employees in some overseas markets, including China, Brazil, India, and Mexico. While the section 220 plaintiffs proceeded in Delaware, the Arkansas case was dismissed for lack of demand futility. Once the Arkansas court issued its decision, the Delaware plaintiffs, who did exactly what Delaware asks of them, were collaterally estopped from asserting their claims against the Walmart directors. Notably, at the outset of the Delaware action, the then chancellor told the plaintiffs that their case would likely be dismissed if they did not take the time to pursue a section 220 demand of Wal-Mart’s books and records. One likely, and realistic, result of the Wal-Mart scenario is that the Delaware plaintiffs will be forced to abandon their 220 demands and intervene in pending cases filed outside Delaware to avoid being cut out at the knees by a plaintiff who rushes to file its lawsuit elsewhere.

Another problem for Delaware plaintiffs who choose the section 220 route is that courts outside Delaware apply a much lower standard of scrutiny to Caremark claims than that of the Chancery Court. These courts have sustained claims on nothing more than public information regarding potential director breaches of fiduciary duty.

For example, a shareholder of Intuitive Surgical, Inc., filed a derivative action arising from the harm caused to Intuitive by a series of materially false and misleading statements issued by the defendants concerning the company’s da Vinci surgical system, Intuitive’s flagship product and source of revenues, and the defendants’ concerted efforts to conceal da Vinci’s internally known defects and the injuries caused to patients, including death. Without the “benefit” of a DGCL 220 demand for books and records, a federal judge in California sustained the complaint finding that a “combination of widespread and enduring impropriety in Intuitive’s corporate activity supports an inference of Board knowledge and conscious inaction” excusing shareholders from demanding redress from the board before filing a lawsuit. See In re Intuitive Surgical, Inc. Derivative Litig., 146 F. Supp. 3d 1106 (N.D. Cal. 2015).

Most recently, a federal judge in California—unbound by Delaware’s 220 demand requirements—found demand in a lawsuit against the directors of Wells Fargo (Shaev v. Baker (In re Wells Fargo & Co. S’holder Derivative Litig.), No. 16-cv-05541-JST, 2017 U.S. Dist. LEXIS 68523 (May 4, 2017 N.D. Cal.)) to be futile, holding that the shareholders adequately alleged that the board ignored evidence of unauthorized account generation—part of Wells Fargo’s cross-selling strategy to increase the number of its retail products. Per the judge’s ruling, the shareholder plaintiffs had brought enough evidence that the board either was negligent in not being aware of reports of fake account generation by thousands of Wells Fargo employees or else willfully ignored those reports for the complaint to survive the motion to dismiss filed by the bank and its current and former board members. Further demonstrating the jurisdictional discrepancies in adjudicating the Caremark standard, one week later, just down the street at the state courthouse, identical allegations against the same Wells Fargo board for the same alleged misconduct were deemed to have not satisfied demand futility due to the plaintiffs’ failure to meet the Caremark standard. Meanwhile, the plaintiffs that pursued and filed a 220 action for documents in Delaware to overcome the high standards of Caremark must prosecute the 220 action and intervene in both California jurisdictions to prevent the Wal-Mart problem of being collaterally estopped, should demand be found futile.

In the current legal environment in Delaware, there is a strong likelihood of a long and protracted section 220 litigation, with no guarantee a shareholder will be successful in obtaining books and records from the company. This fact, coupled with the trend that the Delaware standard applied to Caremark claims may be applied more leniently outside Delaware, gives the shareholder an incentivize to bypass employing the Chancery Court’s “tools at hand” and opt instead to win the race to the courthouse.

Frank R. Schirripa and Daniel B. Rehns – October 3, 2017