February 8, 2011

Delaware Supreme Court Reverses Precluding Books & Records Inspections After Commencement of Derivative Litigation

– by Tom Bayliss, Abrams & Bayliss LLP

On January 28th, the Delaware Supreme Court issued a decision in King v. VeriFone Holdings, Inc., No. 330, 2010. The twenty-four page opinion reverses a Court of Chancery decision dismissing a books and records suit under 8 Del. C. § 220 because the stockholder plaintiff had previously initiated a derivative action in California. The Supreme Court’s opinion is important because it rejects a bright-line rule that would require stockholders seeking books and records to demand them first, before filing corresponding derivative litigation.

Take Aways:

1. In the opinion, Vice Chancellor Strine articulated several policy reasons for imposing a rule requiring the submission of a books and records demand before the initiation of derivative litigation. Writing for the Court en banc, Justice Jacobs acknowledged the legitimacy of these policy concerns but determined that a bright-line rule was inconsistent with the results reached in Disney, McKesson HBOC and CNET — three cases which allowed § 220 inspections despite the plaintiff’s prior initiation of derivative litigation. Ironically, practitioners have generally viewed Disney, McKesson, HBOC and CNET and their tortured histories (including failed attempts to plead demand futility) as examples of what not to do as a plaintiff when pursuing derivative claims against a Delaware corporation.

2. Read broadly, the result in VeriFone suggests that stockholders of Delaware corporations may simultaneously pursue corporate books and records under § 220 and derivative claims against the corporation’s directors and officers. This timing issue is critical, because under prior law (at least as it was understood by the Court of Chancery), derivative plaintiffs had to elect whether to (a) seek books and records and then follow with a detailed, fact laden derivative complaint or (b) file suit quickly without seeking books and records to maximize the chance of winning the race to the courthouse (and capturing lead plaintiff status).

3. Anecdotal evidence suggests that under the prior rule, most derivative plaintiffs chose to forego § 220 inspections, win the race to the courthouse and then fight dismissal on typically weak pleadings drafted without the benefit of access to the corporation’s books and records. VeriFone appears to allow stockholders who win the race to the courthouse to avail themselves of the benefit of § 220 after having captured lead plaintiff status (once they know whether the investment in time and resources is likely to pay off). This may lead to more § 220 inspections and better derivative pleadings in the long run, but it undercuts the incentive to conduct pre-suit § 220 inspections, something the Delaware Supreme Court and the Court of Chancery have long encouraged.

4. The result in VeriFone seems to cut against the result contemplated by Court of Chancery Rule 23.1 and analogous rules in other jurisdictions (including Federal Rule 23.1) which have been interpreted to bar discovery until a derivative plaintiff satisfies its substantial pleading burdens. VeriFone appears to envision a regime in which a stockholder can seek indirectly — through a books and records inspection — precisely the type of information that the stockholder cannot seek directly in the pending derivative action before surviving a motion to dismiss. If VeriFone allows this end run around federal pleading requirements, it could reinvigorate pre-emption arguments that, at least until now, have made little headway in § 220 cases.

5. Future litigants will dispute whether VeriFone should be limited to its facts. The stockholder in VeriFone had brought derivative litigation in the United States District Court for the Northern District of California. The federal court had dismissed the stockholder’s suit without prejudice and suggested that the stockholder “engage in further investigation to assert additional particularized facts” by filing a Section 220 action in Delaware. It is unclear whether the federal court’s instruction played a critical role in the Supreme Court’s decision-making process.

6. Future litigants may also dispute whether some form of dismissal is required before the holding in VeriFone becomes applicable. However, it is not entirely clear why the opinion should be limited in that way. The plaintiff in VeriFone filed an amended derivative complaint in federal court during the pendency of the § 220 proceeding. Thus, the Supreme Court’s decision appears to validate the use of a § 220 proceeding to support a pending derivative action regardless of a prior dismissal order.

7. In the opinion, the Supreme Court emphasizes that filing a derivative suit first and then seeking books and records is “ill-advised” and “may well prove imprudent and cost-ineffective.” However, the powerful incentives that drive the race to the courthouse will likely overwhelm these warnings, particularly if a books and records inspection is available after the commencement of a derivative suit. Because of this dynamic, VeriFone may reduce the number of pre-suit § 220 demands (and increase the number of post-suit § 220 demands) served on Delaware corporations.

8. The result in VeriFone may increase the likelihood that corporate defendants will face two suits filed by the same plaintiff in different jurisdictions – one seeking books and records and another seeking damages and other relief against the corporation’s officers and directors. A representative plaintiff may be better off filing its books and records suit and its derivative suit in different jurisdictions to avoid arguments that the books and records demand constitutes impermissible backdoor discovery prohibited by Court of Chancery Rule 23.1 or the analogous rule in the applicable forum. However, VeriFone could be interpreted to allow this backdoor discovery as matter of right.

9. The result in VeriFone may widen a chink in the armor of corporate defendants that are otherwise protected by the automatic discovery stay in the Private Securities Litigation Reform Act. Derivative actions have always represented a potential vulnerability to these defendants, but the high pleading burdens associated with those derivative actions have typically served as a formidable barrier. VeriFone may presage a new breed of derivative litigation that involves complaints armed with details from post-suit books and records inspections.

10. The Supreme Court emphasizes that “[i]f relief under Section 220 is to be restricted in the manner adjudicated by the Court of Chancery, any such restriction should be imposed by the General Assembly, not decreed by judicial common law decision-making.” It is unclear whether the General Assembly will respond to this invitation.

11. The VeriFone decision may not have any effect on the parties to that action. In a footnote, the Supreme Court acknowledges that the federal district court had dismissed the stockholder plaintiff’s derivative suit with prejudice during the pendency of the appeal. The Supreme Court refused to find that this development mooted the dispute because the Court of Chancery’s decision announced a principle of Delaware law “that could have significant impact in future cases… and should be subject to appellate review before it becomes operational prospectively.”