02.08.2011

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Updates

Section 220 of the Delaware corporation law provides that stockholders may inspect a corporation’s books and records for a “proper purpose.”  Normally, plaintiffs file Section 220 actions as an investigatory tool before commencing litigation—the sequence long-favored under Delaware law.  Frustrated by abuses occasioned by the opposite approach, in May 2010, Vice Chancellor Leo Strine of the Delaware Chancery Court ruled that “once a plaintiff files a derivative suit, he has made his election,” and cannot thereafter seek books and records in Delaware.  On January 28, 2011, the Delaware Supreme Court reversed.

 

 

Background

In November 2006, VeriFone Systems, Inc., acquired Lipman Electronic Engineering.  In December 2007, VeriFone announced that it would have to restate its financial results due to accounting errors relating to the integration of Lipman’s inventory systems.  Following this announcement, VeriFone’s stock price fell by almost 50%.  The next day, VeriFone shareholders filed a class action in the U.S. District Court for the Northern District of California, asserting federal securities fraud claims against VeriFone and its officers.

Eleven days after the announcement, Charles King, the owner of between 500 and 3,000 VeriFone shares since December 2006, filed a stockholder derivative action against VeriFone’s officers and directors alleging breaches of fiduciary duty and corporate waste, and seeking indemnification on behalf of the company for costs incurred in resolving the securities suits.  Three additional derivative actions followed.  The four cases were consolidated, and the California Federal Court appointed King as lead plaintiff.

Federal Rule of Civil Procedure 23.1 requires a plaintiff to allege particular facts demonstrating that the plaintiff either made, or was not required to make, appropriate demand on the board. The Federal Court dismissed the complaint without prejudice because King had not adequately pled that demand was not required.  However, the Federal Court invited King to amend the complaint—and suggested that King might be able to obtain the facts he needed by filing a Section 220 action to inspect VeriFone’s books and records in Delaware. King then filed a Section 220 complaint in Delaware, which VeriFone moved to dismiss.

Delaware Court of Chancery Opinion - King v. VeriFone Holdings, Inc., 994 A.2d 354 (Del. Ch. 2010)

 

Vice Chancellor Strine was not pleased with King’s counsel's rush to Federal Court “to win the filing Olympics.”  Racing hastily to Court provided no benefit to the VeriFone investors—particularly given that their alleged damages hinged on disposition of the securities law suits—but there was tremendous benefit to the self-interested “lawyers jockeying for position as lead counsel.” 

 

The Federal Court had other options to address King's failure to adequately plead demand, including dismissal with prejudice as to King.  Instead, “the court left the gold medal-winning, but dismissal motion-losing, plaintiff in its lead sinecure and encouraged him to file yet another lawsuit” in Delaware.  The Federal Court failed to consider the public policy implications of encouraging a litigant to open a second front of litigation, seeking discovery that the plaintiff had not requested and likely would not have been able to obtain under the Federal Rules of Civil Procedure.  The result was “a costly, inefficient end-run around the discovery rules applicable in the derivative action.” 

 

In the Vice Chancellor’s judgment, there was ample Delaware precedent supporting his view of good public policy.  The Delaware Supreme Court had, for years, made clear that derivative plaintiffs should seek books and records (or otherwise conduct an adequate investigation) “before rushing off to file a derivative complaint,” and a prior Chancery Court case, Beiser v. PMC-Sierra, Inc., had dismissed a books and records action under nearly identical circumstances.  The Vice Chancellor made short work of the authority cited by King, finding that it was distinguishable and offered too late. 

 

Vice Chancellor Strine concluded that King’s behavior was against public policy, and he did not have a proper purpose under Section 220.  A plaintiff that files a derivative suit “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.”

 

Delaware Supreme Court Opinion - King v. VeriFone Holdings, Inc., 2011 WL 284966 (Del. Jan. 28, 2011)

 

The Delaware Supreme Court reversed the Chancery Court’s opinion.  In the Court’s view, the Chancery Court opinion was “a preclusive judge-made rule that finds no support either in the language or its underlying policy of Section 220, or in Delaware case law.”  Section 220 defines a proper purpose as “a purpose reasonably related to such person’s interest as a stockholder,” and Delaware law is clear that investigating corporate mismanagement—the purpose identified by King—is a proper reason to invoke Section 220.  While “Delaware courts have strongly encouraged stockholder-plaintiffs to utilize Section 220 before filing a derivative action” to satisfy Chancery Court Rule 23.1, failing “to proceed in that specific sequence . . . has not heretofore been regarded as fatal.”

 

The Supreme Court identified three Delaware opinions that illustrated that what King did “was fully consistent with Delaware case precedent.” The Supreme Court also distinguished two additional cases in which the Chancery Court had dismissed the later-filed Section 220 actions for lack of proper purpose.  Importantly, neither dismissal “was grounded upon the bright-line rule announced by the Court of Chancery” in VeriFone.

 

Despite its ruling, the Supreme Court made clear that it was not endorsing the way King had proceeded, which “may well prove imprudent and cost-ineffective.”  However, the Chancery Court’s “prophylactic cure” could not be decreed by common law, but instead needed to be taken up by lawmakers.  If the “rush to the courthouse” is indeed a problem, the Supreme Court noted that it is up to the plenary court to craft solutions, which might include selection of other lead counsel, dismissal as to the named plaintiff, or awarding attorneys fees for the initial motion to dismiss.

Implications of VeriFone

Following VeriFone, derivative-action plaintiffs have available a potential avenue of discovery—and thus a lifeline to salvage an otherwise defective complaint—that would have been foreclosed by the Chancery Court’s decision. If the Chancery Court overreached by imposing a bright-line prohibition, the Supreme Court might be questioned for affirmatively holding—albeit with cautionary language—that it is a proper purpose under Section 220 to examine books and records, so long as the earlier-filed complaint was dismissed on demand futility grounds without prejudice and with leave to amend.

Still, counsel perceived as forum shopping, or otherwise “[y]oking” the Chancery Court “as an adjunct to another court” will continue to meet a frosty reception in Delaware.  Although the Supreme Court rejected the Vice Chancellor’s hard-line approach, both opinions provide a roadmap to legal and policy arguments that may prove useful in opposing wasteful litigation occasioned by self-interested races to the courtroom.

© 2011 Perkins Coie LLP