April 15, 2011
Corporate Governance Group
Client Alert
B eijing F rankfurt
H ong K ong L ondon L os A ngeles M unich
N ew Y ork S ão P aulo S ingapore T okyo W ashington , DC
DELAWARE COURTS PERMIT
STOCKHOLDERS TO PURSUE BOOKS
AND RECORDS INSPECTIONS IN
FURTHERANCE OF DERIVATIVE CLAIMS
Neither filing derivative action nor making pre-suit litigation demand forecloses
subsequent corporate books and records inspection
A stockholder of a Delaware corporation who seeks to recover damages caused
to the corporation by director and/or officer misconduct is required by the Delaware
General Corporation Law (“DGCL”) to sue derivatively on behalf and for the benefit of
the corporation. Before initiating derivative litigation, any such stockholder must first
make a demand on the corporation’s board of directors to pursue the claim, unless the
stockholder can properly allege “demand futility” by demonstrating that
“‘reasonable doubt’ exists as to whether the board is capable of making an
independent decision to assert the claim if demand were made … [or] (1) a
majority of the board has a material financial or familial interest; (2) a majority
of the board is incapable of acting independently for some other reason such as
domination or control; or (3) the underlying transaction is not the product of a
valid exercise of business judgment.”1
Delaware courts have “strongly encouraged” potential plaintiffs, before filing a
derivative action without a pre-suit demand, to make use of a DGCL §220 books and
records inspection “to uncover particularized facts that would establish demand excusal
in a subsequent derivative suit.”2 A stockholder seeking to pursue a DGCL §220
inspection must, however, establish a “proper purpose” as a pre-condition to gaining
access to a corporation’s books and records. It should be no surprise, given the highlycharged nature of derivative litigation, that related DGCL §220 books and records
proceedings have themselves generated significant litigation over the years.
In two recent cases, Delaware courts have upheld the rights of stockholders to
conduct corporate books and records inspections under DGCL §220 in furtherance of
potential derivative claims against directors and officers. First, in King v. VeriFone
1
2
King v. VeriFone Holdings, Inc., 12 A.3d 1140 (Del. 2011) en banc.
Id.
For further information
about this Client Alert,
please contact:
Roland Hlawaty
Partner
212-530-5735
[email protected]
David Schwartz
Of Counsel
212-530-5260
[email protected]
Roxana Azizi
Associate
212-530-5276
[email protected]
You may also contact
any member of Milbank’s
Corporate Governance Group.
Contact information can be
found at the end of this Client
Alert. In addition, if you
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This Client Alert is a source of
general information for clients
and friends of Milbank,
Tweed, Hadley &
McCloyLLP. Its content should
not be construed as legal advice,
and readers should not act
upon the information in this
Client Alert without consulting
counsel. © 2011 Milbank,
Tweed, Hadley & McCloy LLP.
All rights reserved. Attorney
Advertising. Prior results do not
guarantee a similar outcome.
Editor: Bob Reder
www.milbank.com
Corporate Governance Group
Holdings, Inc.,3 the Delaware Supreme Court reversed a Court of Chancery ruling that denied a stockholder
access to a corporation’s books and records because the stockholder filed a derivative suit in federal court
(which was dismissed for lack of a pre-suit demand on the board) before seeking to conduct a books and
records inspection. Because the derivative suit was dismissed without prejudice and with leave to amend, the
Supreme Court allowed the stockholder to proceed with a DGCL §220 inspection to facilitate establishing
demand futility in an amended complaint. Then, in Louisiana Municipal Police Employees Retirement System
v. Morgan Stanley & Co., Inc.,4 the Court of Chancery allowed a stockholder to inspect corporate books and
records relating to a board’s refusal of its demand to initiate a derivative lawsuit against directors and officers
for alleged wrongdoing. In effect, the Court of Chancery imposed an “accountability mechanism” on corporate
boards by declaring that a stockholder does not concede a board’s independence and disinterestedness by
making a pre-suit litigation demand.5
King v. VeriFone
Background
VeriFone Holdings, Inc., which “designs, markets, and services electronic payment transaction systems,”
acquired Lipman Electronic Engineering Ltd. in 2006, making VeriFone “the world’s largest provider of
electronic payment solutions and services.” On December 3, 2007, VeriFone publicly announced that due to
“accounting and valuation errors” made during integration of Lipman’s inventory systems, reported earnings
and net income for the prior three fiscal quarters had been “materially overstated.” In response, VeriFone’s
stock price dropped over 45% and several stockholders, as well as the Securities and Exchange Commission,
initiated federal lawsuits.
One such stockholder, Charles R. King., filed a derivative action against certain VeriFone directors
and officers in California Federal Court on behalf of VeriFone, claiming that defendants “committed breaches
of fiduciary duty and corporate waste” in connection with the accounting errors. VeriFone sought to dismiss
King’s complaint on the ground that he failed to make a pre-suit demand on the board to bring the lawsuit on its
own. The Court granted VeriFone’s motion, holding that King’s complaint “failed to allege particularized facts
that would excuse a pre-suit demand.” However, the Court’s dismissal was “without prejudice” and with “leave
to amend the complaint,” and included the suggestion that King first “’engage in further investigation’ … by
filing a Section 220 action in Delaware.”
Accordingly, King made a written demand on VeriFone to inspect certain documents. When VeriFone
fulfilled all of King’s requests except for one – the Audit Committee Report containing “the results of an
internal investigation of VeriFone’s accounting and financial controls” – King filed a DGCL §220 action in
the Court of Chancery to “inspect the Audit Report and any documents relied upon in its preparation.” King
claimed the Audit Report was “essential to enable him to plead demand futility in the California federal action.”
VeriFone moved to dismiss, claiming King had commenced his “litigation backwards” by first filing
a derivative suit in federal court, which allegedly “violated the long-standing public policy-based rule that
derivative plaintiffs should utilize the Section 220 inspection process before commencing a derivative action.”
The Court of Chancery agreed with VeriFone, holding that King lacked a “’proper purpose’ for inspection”
because he had “elected” to file a derivative action in federal court “before conducting a pre-suit investigation.”
In so ruling, the Court of Chancery created a “bright-line rule” that “[o]nce a plaintiff has chosen to file a
Id.
C.A. No. 5682-VCL (Del. Ch. Mar. 4, 2011).
5
It is interesting to note that although these two recent decisions discussed similar subjects, the Court of Chancery’s decision in Morgan Stanley does
not cite the Supreme Court’s ruling in VeriFone.
3
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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.”
Allowing such a reversed process would, in the Court of Chancery’s view, “offend public policy and encourage
an ‘inefficient race to the courthouse.’” King appealed this ruling to the Delaware Supreme Court.
The Supreme Court’s Analysis
The Supreme Court reversed, agreeing with King that the bright-line rule “does not comport with
existing Delaware law or with sound policy.” The Supreme Court based its holding on three main grounds:
first, DGCL §220 is a “tool to aid demand excusal” that can be used “to develop facts sufficient to replead
demand futility” when the preceding derivative action is dismissed without prejudice and with leave to amend;
second, based on Delaware precedent, King had a “proper purpose” in seeking “to inspect books and records
that would aid … in pleading demand futility in a to-be-amended complaint”; and third, the bright-line rule
adopted by the Court of Chancery is “inconsistent with Section 220’s underlying policy.”
The Supreme Court explained that DGCL §220 is a tool that should be used to help “uncover
particularized facts” to substantiate demand futility and thus “establish demand excusal in a subsequent
derivative suit.” The Supreme Court further explained that while it may be “ill-advised” to not proceed in that
particular sequence, it is not “fatal” to do so. In support of this position, the Supreme Court pointed to three
previous decisions in which stockholders who “initiated a derivative suit without first prosecuting a Section 220
books and records action” were permitted to take advantage of DGCL §220 “to gather new information and
replead their derivative complaints” after the initial derivative suit was dismissed – but without prejudice – for
“failure to plead demand futility adequately.”
On the other hand, the Supreme Court did agree with the Court of Chancery that it would be a waste of
“the court’s and litigants’ resources to have a regime that could require a corporation to litigate repeatedly the
issue of demand futility.” To address this concern, the Supreme Court suggested “narrower remedies” in lieu
of the Court of Chancery’s proposed bright-line rule.6 For instance, courts could deny the coveted position of
“lead plaintiff” to a plaintiff who engages in “premature filing” of its derivative action without first investigating
facts “that would excuse a pre-suit demand.” The Supreme Court also suggested – while recognizing that it
would be a “more drastic” remedy – that a court could simply “dismiss the derivative complaint with prejudice
and without leave to amend.”7 Finally, the Supreme Court suggested that a court could “grant leave to amend
one time,” conditioned on plaintiff paying defendants’ attorneys’ fees in connection with the initial motion to
dismiss.
LAMPERS v. Morgan Stanley
Background
In August 2008, the New York Attorney General (“NYAG”) announced a settlement of claims brought
against Morgan Stanley arising from its participation in the auction rate securities market. Less than two weeks
later, a Morgan Stanley stockholder, Louisiana Municipal Police Employees Retirement System (“LAMPERS”),
filed a derivative action in the Southern District of New York seeking “to hold Morgan Stanley’s officers and
directors liable for the harm the corporation suffered as a result of the conduct that was the subject of the NYAG
investigation and settlement.” Rather than making a litigation demand on Morgan Stanley’s board of directors
In fact, the Supreme Court explained that any such bright-line rule “should be imposed expressly by the General Assembly, not decreed by judicial
common-law decision-making.”
7
The Supreme Court noted that if the California Federal Court had dismissed King’s complaint “with prejudice and without leave to amend,”
King would not have had a proper purpose under DGCL §220 and, therefore, would have justifiably been denied inspection rights by the Court of
Chancery.
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before filing its derivative suit, LAMPERS asserted that “demand was excused as futile because the board
of directors was ‘dominated and controlled by wrongdoers who continue to obscure their own misconduct.’”
The District Court granted Morgan Stanley’s motion to dismiss, apparently with prejudice, holding that “the
complaint had not adequately pled demand futility.”
Accordingly, in August 2009, LAMPERS formally demanded that the Morgan Stanley board “take
action to remedy breaches of fiduciary duties and other misconduct” pertaining to the Company’s auction
rate securities market activities. In response, on April 26, 2010, the board, acting on the recommendations
of its audit committee following an investigation led by outside counsel, issued a letter refusing to act on
LAMPERS’s litigation demand. The board’s letter apparently did not provide “substantive insight” into the
committee’s work or explain its rationale for refusing to commence litigation.
Undeterred, LAMPERS delivered a books and records demand to Morgan Stanley under DGCL §220,
seeking to inspect various documents in order “to enable [it] … to evaluate the Board’s refusal of the Demand”
and to ascertain whether the refusal “constituted a reasonable and good-faith exercise of the Board’s business
judgment.” Morgan Stanley rejected this demand on the ground that “LAMPERS failed to state a proper
purpose for conducting an inspection.”8
In the face of this rejection, LAMPERS asked the Court of Chancery to permit it to inspect the requested
Morgan Stanley books and records for the purpose of determining whether the board “wrongfully refused”
LAMPERS’s earlier litigation demand. Morgan Stanley moved to dismiss.
The Court of Chancery’s Analysis
Morgan Stanley sought to “recast[] LAMPERS’s purpose as seeking to investigate corporate
wrongdoing” and, on that basis, presented two arguments in support of its motion to dismiss. First, Morgan
Stanley claimed that the description of “the process used to evaluate the Litigation Demand” in its demand
refusal letter precluded the need for further investigation. Second, Morgan Stanley argued that “a stockholder
who makes a demand has ‘conceded the independence and disinterestedness of the Board by making a
demand,’” leaving LAMPERS with “no credible basis for questioning the decision to refuse the demand.”
The Court summarily rejected Morgan Stanley’s first argument, stating that a board of directors “cannot
defeat the use of Section 220 … by sending a self-serving letter describing process sans content.” If that were
the case, a stockholder’s “right to use Section 220 to investigate demand refusal” would be rendered “nugatory.”
With respect to Morgan Stanley’s second argument, the Court recognized that Delaware precedent
demonstrates that “a stockholder who makes a [litigation] demand does not concede the independence or
disinterestedness of the board for purposes of demand refusal.” Rather, a stockholder “is entitled to use Section
220 to determine whether ‘an otherwise independent-appearing board or committee’ failed ‘to carry out its
fiduciary duties in good faith or conduct a reasonable investigation.’”
Moreover, the Court explained, Delaware precedent makes it clear that “[e]xploring whether a litigation
demand was wrongfully refused is a proper purpose for using Section 220.” Consistent with last year’s
Delaware Supreme Court decision in City of Westfield Police & Fire Ret. Sys. v. Axcelis Techs., Inc.,9 the Court
At the same time, the District Court denied LAMPERS’s request for a case management conference, ruling that DGCL §220(c) provides the
Delaware Court of Chancery “with exclusive jurisdiction to determine whether or not the person seeking inspection is entitled to the inspection
sought.”
9
1 A.3d 281 (Del. 2010). In Axcelis, the Court pointed out that “investigating a board’s decision ‘to override an exercised shareholder voting right
without prior shareholder approval’ constituted a proper purpose under Section 220 even though the stockholder had not established a credible basis
to suspect corporate wrongdoing.” For a further discussion of the Axcelis decision, see our Client Alert entitled “Delaware Supreme Court Clarifies
Standard for Analyzing Books and Records Claims in the Context of ‘Plurality Plus’ Governance Policies” (September 7, 2010).
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Corporate Governance Group
observed that “exploring corporate wrongdoing is not the only proper purpose that will support a Section 220
investigation.” Thus, the Court rejected Morgan Stanley’s attempt to recast LAMPERS’s purpose, as well as its
arguments as to why LAMPERS had not established a “credible basis” for suspecting wrongdoing as required
by DGCL §220.10 The Court noted, in fact, that the “highly deferential” nature of the business judgment rule –
the standard of judicial review for a board refusal to bring a derivative claim where prior demand is not excused
– requires some form of an “accountability mechanism” that provides stockholders with “a limited right to
information under Section 220.”
Finally, the Court inquired into the proper scope of LAMPERS’s inspection. The right to inspection is
not absolute, the Court explained, but rather “is limited to those books and records necessary to accomplish the
stated purpose.” While the Court granted LAMPERS access to “documents and other records upon which the
board relied” in reaching its decision, it denied access to other requested documents. As to these, LAMPERS
was required to “articulat[e] in more specific and convincing fashion why the incremental information is
reasonably required to evaluate the Board’s demand-refusal decision.”
Conclusion
Delaware courts are generally inclined to defer to a board of directors acting under the broad reservation
of powers provided by DGCL §141(a), primarily through application of the business judgment rule. However,
the VeriFone and Morgan Stanley decisions illustrate that in those limited situations where stockholders are
allocated specific rights by the DGCL – such as the right to inspect books and records granted by DGCL §220
– Delaware courts often will find a way for stockholders to exercise those rights. VeriFone establishes that a
stockholder’s DGCL §220 action to help it establish demand futility will not be dismissed solely due to having
first filed a derivative action that is dismissed for failure to make a pre-suit demand, so long as the dismissal is
without prejudice and with leave to amend. And, in light of LAMPERS, a stockholder who is required (in the
absence of demand futility) to make a demand on a board of directors to initiate derivative litigation will not be
foreclosed, by virtue of that very demand, from also pursuing a DGCL §220 books and records investigation
into the propriety of the board’s rejection of the stockholder’s litigation demand.
The Court also spent some time discussing the different standards of judicial review applicable to a board decision (i) to seek dismissal of a
derivative lawsuit as to which prior demand is excused as futile versus (ii) to refuse a demand to bring litigation in a case (as with Morgan Stanley) as
to which prior demand is not excused. In the former case, Delaware courts apply a more intrusive “enhanced scrutiny” review, while in the latter, the
more deferential “business judgment rule” is applicable.
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Corporate Governance Group
Please feel free to discuss any aspect of this Client Alert with your regular Milbank contacts or with any of the
members of our Corporate Governance Group, whose names and contact information are provided below.
Beijing
Units 05-06, 15th Floor, Tower 2
China Central Place, 79 Jianguo Road, Chaoyang District
Beijing 100025, China
Anthony Root
+86-10-5969-2777
Edward Sun
+86-10-5969-2772
[email protected]
[email protected]
Frankfurt
Taunusanlage 15
60325 Frankfurt am Main, Germany
Norbert Rieger
[email protected]
+49-89-25559-3620
Hong Kong
3007 Alexandra House, 18 Chater Road
Central, Hong Kong
Anthony Root
+852-2971-4842
Joshua Zimmerman +852-2971-4811
London
10 Gresham Street
London EC2V 7JD, England
Stuart Harray
+44-20-7615-3083
[email protected]
[email protected]
[email protected]
Los Angeles
601 South Figueroa Street, 30th Floor
Los Angeles, CA 90017
Ken Baronsky
+1-213-892-4333
Neil Wertlieb
+1-213-892-4410
[email protected]
[email protected]
Munich
Maximilianstrasse 15 (Maximilianhöfe)
80539 Munich, Germany
Peter Nussbaum
+49-89-25559-3430
[email protected]
New York
One Chase Manhattan Plaza
New York, NY 10005
Scott Edelman
Roland Hlawaty
Thomas Janson
Joel Krasnow
Alan Stone
Douglas Tanner
Paul Wessel
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
+1-212-530-5149
+1-212-530-5735
+1-212-530-5921
+1-212-530-5681
+1-212-530-5285
+1-212-530-5505
+1-212-530-5077
São Paulo
Rua Colombia, 325
Jardim América
São Paulo, SP
01438-000
Andrew Janszky
+55-11-3927 7701
Singapore
30 Raffles Place, #14-00 Chevron House
Singapore 048622
David Zemans
+65-6428-2555 Naomi Ishikawa
+65-6428-2525 Tokyo
21F Midtown Tower, 9-7-1 Akasaka, Minato-ku
Tokyo 107-6221 Japan
Gary Wigmore
+813-5410-2840
Washington, DC
International Square Building, 1850 K Street, NW
Suite 1100
Washington, DC 20006
Glenn Gerstell
+1-202-835-7585
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
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