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Send Them to Delaware to Inspect Corporate Books

Wednesday, June 15, 2011

Reprinted with permission from the June 15, 2011 issue of the Delaware Business Court Insider © 2011 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

As discussed in the first part of this two-part series, VeriFone Holdings Inc. shareholder Charles King won the proverbial "race to the courthouse" when he filed the first derivative shareholder complaint against VeriFone's officers and directors on Dec. 14, 2007? 11 days after the first of several putative securities class actions was filed against the company in the same court, the U.S. District Court for the Northern District of California. On March 26, 2010, the court dismissed the derivative action for failure to allege particularized facts that would excuse a pre-suit demand. The court granted King leave to amend the complaint and recommended that he and his lawyer file a books-and-records action in Delaware, get the facts, and bring them back to California. The case is captioned In re VeriFone Holdings Inc. Shareholder Derivative Litigation.

Under Delaware law, any holder of one or more shares of stock in a Delaware corporation may demand inspection of the corporation's books and records. If the corporation fails within five days to permit the inspection, the shareholder is entitled to petition the Court of Chancery, upon showing of a "proper purpose," for an order compelling the corporation to allow the inspection. Where derivative actions have been dismissed for failure to plead demand futility, courts and litigants are aware that Delaware's books-and-records statute is a powerful tool for obtaining information that may not ordinarily be made available to the public.

King made the required demand to inspect VeriFone's books and records. VeriFone cooperated, but drew the line at an audit committee report, prepared by counsel. King filed a books-and-records action in the Chancery Court, and VeriFone, as the corporate respondent, moved to dismiss the action on the ground that King's purpose, to gather information to re-plead demand futility in California, did not constitute a "proper purpose" for inspection under Delaware law. Vice Chancellor Leo E. Strine Jr., in an opinion dated May 12, 2010, agreed with VeriFone and dismissed King's books-and-records action.

Criticizing the Race to the Courthouse

By dismissing King's books-and-records action, the Chancery Court denied the use of the Delaware statute to early filers who have been turned away by federal district courts for failing to meet the pleading requirements for derivative actions.

The Court of Chancery was openly critical of the court in the California derivative action for not "pondering the multiple policy implications" of allowing King to re-plead and recommending that he initiate additional litigation in Delaware. First, King had "made an election" to bring his action in federal court subject to that court's rules. King's attorney told the Chancery Court that she had not sought discovery in California of the information she now sought in Delaware because the request would have been denied under that court's rules. King's books-and-records action was a "costly, inefficient end-run" around the federal court's discovery rules.

Second, the court in the California derivative action "rewarded" King for wasting corporate and judicial resources in litigation over a prematurely filed complaint by allowing him to keep his case alive and to continue as lead plaintiff. Recommending that King open a second, ancillary litigation 3,000 miles away in Delaware only added to the unnecessary burden on the company and the courts.

"Yoking this court as an adjunct to another court thousands of miles away wastes scarce judicial resources through repetitive litigation, and exposes the corporation and its shareholders to unnecessary additional defense costs." King's lawyer told the Chancery Court that the judge in the California Derivative Action told her, after she filed a still-deficient second amended complaint, that she could use information from the Delaware books-and-records action to "gild the lily" or "plug it up."

Finally, the court's action in the California derivative action encouraged the race to the courthouse. Allowing the use of the Delaware books-and-records statute to rehabilitate "thinly substantiated" complaints "exacerbates the perverse incentives motivating too many representative plaintiffs' unseemly and inefficient race to the courthouse." Such forbearance also discourages other, more diligent plaintiffs who might make the extra effort to investigate and litigate in a way that would be more beneficial to the corporation and its stockholders.

Other than the "self-interest of the lawyers jockeying for position as lead counsel," the Chancery Court found no reason for King's haste? damages could not be assessed in the derivative suits before they were determined in the securities class-action suits. King and his lawyer had raced to the courthouse, purportedly acting on behalf of VeriFone, when there was no benefit to VeriFone or its stockholders from an early filing.

King's attorney, by her own admission, was merely seeking to gain advantage in the "lead plaintiff fight." The better course would have been to first conduct an investigation, using the Delaware books-and-records statute if necessary, and to gather the facts for a well pled derivative complaint.

The Chancery Court suggested that the court in the California derivative action, rather than rewarding King for his premature filing, should have dismissed the action with prejudice as to King only, re-opening the contest for lead-plaintiff status as one over "quality, not speed." Going further, the Chancery Court stated "[p]erhaps it is time for the reversal of the traditional presumption in favor of first filers in the derivative suit context." The plaintiff who files without investigation and "deep reflection" on the facts and law should be presumed to be unfit to serve as "the lead fiduciary for the corporation and its stockholders" in a derivative action.

Considering the sound public policy upon which the pre-suit demand rule is based, the Chancery Court was unwilling to hold that King had a proper purpose for inspection of VeriFone's books and records. In enforcing the Delaware books-and-records statute, the court thus concluded that it should apply the public policies the court in the California derivative action failed to consider. It found, accordingly, that King's purpose was not a proper one.

Another, similar case followed King in the Delaware Court of Chancery. In an opinion dated June 3, 2010, Vice Chancellor J. Travis Laster turned away a derivative plaintiff in similar circumstances, in Baca v. Insight Enterprises Inc . The court added to the policy discussion, referring to three "levels of analysis," two of which followed Strine's concerns in King.

"Analyzed doctrinally," it would be contrary to the policy behind the pre-suit demand pleading rule to find that re-pleading demand futility is a proper purpose for inspecting corporate books and records. "Analyzed systemically," allowing inspection "rewards entrepreneurial plaintiffs' lawyers who file quickly to gain control of a derivative case without conducting a meaningful pre-suit investigation," and imposes unnecessary litigation costs on the corporation and its stockholders.

Laster also pointed out that, "at the level of the individual plaintiff," a stockholder who files a derivative action makes a certification under Rule 11 that he has sufficient facts to pursue the action in good faith and in accordance with applicable pleading standards. A subsequent demand for inspection of corporate books and records for the purpose of determining demand futility contradicts that certification, and exposes the plaintiff, his attorneys, and their law firms to sanctions.

In its Jan. 28 opinion, the Delaware Supreme Court rejected Strine's policy-based application of the statute in King, re-opening the door for plaintiffs to gather the facts they need to return to federal court and re-plead their derivative actions. But the policy concerns still stand, and plaintiffs' firms, as well as federal district courts, should be familiar with them. The Supreme Court agreed with Strine that that King's approach was "wasteful," saying, "Undoubtedly, the preclusive rule adopted by the Court of Chancery was intended as a needed prophylactic cure."

The Supreme Court held, however, that the rule propounded by the Chancery Court was overly broad. Narrower remedies that might serve as a "cure" for the ill effects of the race to the courthouse might include, as the Chancery Court suggested, denial of lead-plaintiff status or dismissal with prejudice as to the named plaintiff. In addition, the Supreme Court suggested that a court might grant leave to amend a derivative complaint only once, while requiring the plaintiff to pay the defendants' attorney fees incurred in seeking dismissal of the original complaint.

Rule 11 of both the Federal Rules of Civil Procedure and the Delaware Chancery Court Rules allows courts to award attorney fees as a sanction "if imposed on motion and warranted for effective deterrence." In addition, attorneys who are found to have made false certifications under Rule 11 may be subject to other sanctions under applicable rules of professional conduct.

Although it suggested possible remedies for the filing of premature derivative complaints, the Supreme Court made clear that any such remedies should be fashioned and imposed by the court in the derivative action. The Delaware Supreme Court concluded that the Chancery Court should not attempt to remediate another court's failure to consider the policy implications of its rulings by establishing and enforcing its own "preclusive judge-made rule" in a subsequent books-and-records action.

Robert L. Hickok, Gay Parks Rainville and James G. McMillan

Written by

Robert L. Hickok
Phone: 215.981.4583
Fax: 215.981.4750
hickokr@pepperlaw.com

Gay Parks Rainville
Phone: 215.981.4952
Fax: 215.981.4750
rainvilleg@pepperlaw.com

James G. McMillan
Phone: 302.777.6556
Fax: 302.421.8390
mcmillanj@pepperlaw.com


The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.


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