Richards Layton & Finger

King v. VeriFone Holdings, Inc. and Baca v. Insight Enterprises, Inc. - Court of Chancery Dismisses Books and Records Actions Filed After Derivative Actions

August 3, 2010

In two recent decisions, the Court of Chancery dismissed books and records actions under 8 Del. C. § 220 (“Section 220”) that were filed after the plaintiffs had filed derivative actions. In King v. VeriFone Holdings, Inc., C.A. No. 5047-VCS (Del. Ch. May 12, 2010), the Court dismissed the plaintiff’s Section 220 action, holding that his demand, made in an attempt to avoid discovery restrictions in an earlier-filed derivative action, lacked a proper purpose. Similarly, in Baca v. Insight Enterprises, Inc., C.A. No. 5105-VCL (Del. Ch. June 3, 2010), the Court dismissed the plaintiff’s later-filed Section 220 action because the plaintiff lacked a proper purpose. The Court suggested in both cases that it may be time to re-examine the “first-to-file sweepstakes,” which rewards plaintiffs’ counsel who may file representative actions without adequate pre-suit investigation.

In VeriFone, the plaintiff filed a derivative action in federal court seeking to hold directors and officers of VeriFone Holdings, Inc. (“VeriFone”) liable for damages that might arise from pending securities litigation. The derivative complaint was dismissed without prejudice for failure to plead demand excusal, but the federal court suggested that the plaintiff pursue a Section 220 action in Delaware to obtain the facts needed to replead demand excusal. Following the federal court’s suggestion, the plaintiff sent a books and records demand to VeriFone, which in response produced 1,350 pages of documents. VeriFone would not, however, produce a report of its audit committee that was prepared by the committee’s counsel, and the plaintiff filed a Section 220 action. The plaintiff’s only stated purpose was to obtain books and records to plead demand excusal in the derivative action.

The Court of Chancery noted that the plaintiff filed his derivative complaint “hastily,” despite an absence of exigent circumstances, as he sought damages that rested on the outcome of pending lawsuits. According to the Court, that “rush to the courthouse” allowed the plaintiff’s attorney to win the lead-counsel battle, but did not leave time to conduct a proper pre-suit investigation. The Court concluded that “[o]nce a plaintiff files a derivative suit, he has made his election” and that “stockholders who seek books and records in order to determine whether to bring a derivative suit should do so before filing the derivative suit.” Specifically, the Court held that the plaintiff’s stated purpose was improper for a number of well-established public policy reasons. First, the plaintiff’s demand was a “costly, inefficient end-run around the discovery rules applicable in [a] derivative action,” which disallow discovery to establish demand futility. Second, the plaintiff chose the forum for the derivative action, and it was not in the best interests of VeriFone and its investors to litigate two suits over the same matter in separate jurisdictions. And third, allowing the plaintiff to pursue a Section 220 action after filing a plenary action would create “perverse” incentives for stockholders to file representative actions to establish themselves as lead plaintiffs without performing adequate pre-suit investigation. The plaintiff has appealed the Court’s decision to the Delaware Supreme Court.

In Insight, the plaintiff filed a derivative action in federal court seeking damages on behalf of Insight Enterprises, Inc. (“Insight”) that might arise from then-ongoing securities litigation regarding Insight’s announcement that it would restate its earnings. After Insight moved to dismiss the derivative action, the plaintiff made a books and records demand related to his derivative claims. Insight rejected the demand, pointing out that it is improper to seek inspection of books and records during the pendency of an earlier-filed plenary action. Thereafter, the federal court dismissed the derivative action, and the plaintiff filed a second amended complaint focused instead on alleged stock option backdating.

The Court of Chancery held that, given the plaintiff’s sequence of filings, the plaintiff lacked a proper purpose. The Court noted that by filing a derivative action, the plaintiff and his counsel certified that they had sufficient facts to pursue that action, and that the post-plenary-action Section 220 demand was inconsistent with that certification. The Court also questioned the “fire, ready, aim” approach of the plaintiff, who based his derivative action on potential losses from pending securities litigation in which a motion to dismiss had been filed. The Court opined that “a rational stockholder plaintiff, free of the compulsion to win a first-to-file sweepstakes, would wait until after a ruling on a motion to dismiss … before commencing a derivative suit.”

The Court acknowledged that the plaintiff amended his derivative complaint after filing the Section 220 action, shifting focus to a new set of claims. The Court, however, stated that such “post-filing procedural contortions” did not remedy the plaintiff’s failure to conduct a pre-suit investigation. The Court was unwilling to allow stockholders to file placeholder complaints to secure control of derivative actions and “then cleverly use the amendment process to open a window for a subsequent Section 220 investigation.” Although the Court recognized that there might be circumstances under which a Section 220 demand would not be foreclosed by a prior derivative action, such as “a desire to explore unrelated matters not put validly at issue in the pending derivative action,” it found none in Insight.