King v. VeriFone Holdings, Inc.: Derivative Plaintiffs May Inspect Books and Records After Filing Derivative Action

February 1, 2011

Publication| Corporate Transactions| Corporate & Chancery Litigation

In King v. VeriFone Holdings, Inc., No. 330, 2010 (Del. Jan. 28, 2011), the Delaware Supreme Court reversed the Court of Chancery’s decision that established a bright-line rule barring stockholder-plaintiffs from seeking books and records pursuant to 8 Del. C. § 220 (“Section 220”) solely because they filed a derivative action first. The Supreme Court reaffirmed “long-standing Delaware precedent which recognizes that it is a proper purpose under Section 220 to inspect books and records that would aid the plaintiff in pleading demand futility in a to-be-amended complaint in a plenary derivative action, where the earlier-filed plenary complaint was dismissed on demand futility-related grounds without prejudice and with leave to amend.”

On December 3, 2007, VeriFone Holdings, Inc. (“VeriFone”) restated its reported earnings and net income for the prior three fiscal quarters. In response, plaintiff filed a derivative action in federal court alleging, among other things, that the directors and officers of VeriFone breached their fiduciary duties and committed corporate waste. The federal court dismissed the plaintiff’s complaint for failure to allege particularized facts that would excuse pre-suit demand. In granting leave to amend the complaint, the federal court suggested that plaintiff utilize Section 220 to obtain facts that might aid in pleading demand futility. In 2009, plaintiff submitted to VeriFone a written demand pursuant to Section 220, and VeriFone produced documents responsive to all but one of plaintiff’s requests. VeriFone declined to produce an audit committee report, which contained the results of an internal investigation of VeriFone’s accounting and financial controls that had been conducted after the 2007 restatement. Thereafter, plaintiff filed a complaint under Section 220 seeking an order permitting him to inspect the audit committee report. The Court of Chancery dismissed plaintiff’s complaint for failure to state a proper purpose as required by Section 220. In doing so, the Court of Chancery held that plaintiff lacked a proper purpose under Section 220 because he elected to prosecute the derivative action before conducting a pre-suit investigation, including use of the Section 220 process. The Court of Chancery stated: “[S]tockholders who seek books and records in order to determine whether to bring a derivative suit should do so before filing the derivative suit. Once a plaintiff has chosen to file a 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.”

On appeal, the Supreme Court concluded that the Court of Chancery’s bright-line rule “does not comport with existing Delaware law or with sound policy.” The Supreme Court noted that Delaware courts have strongly encouraged stockholder-plaintiffs to utilize Section 220 to obtain facts sufficient to plead demand futility before filing a derivative action. The decision to file a derivative complaint before using the Section 220 inspection process, the Supreme Court noted, is “ill-advised” but not “fatal” to a stockholder-plaintiff’s right to seek books and records pursuant to Section 220. The Supreme Court relied on earlier decisions, such as In re Walt Disney Co. Derivative Litigation, Ash v. McCall and Melzer v. CNET Networks, Inc., as examples of situations in which Delaware courts have dismissed derivative complaints, but recommended that stockholder-plaintiffs utilize Section 220 as a tool to obtain facts sufficient to replead demand futility in an amended derivative complaint. In each case noted above, the plenary court dismissed the stockholder-plaintiff’s derivative complaint without prejudice and with leave to amend. These factors distinguished the cases relied upon by VeriFone, cases which held that stockholder-plaintiffs lack a proper purpose because their earlier-filed derivative action was dismissed with prejudice or without leave to amend. Thus, the Supreme Court held that a stockholder-plaintiff seeking books and records under Section 220 does not lack a proper purpose simply because the stockholder-plaintiff filed a derivative action first, which was dismissed for failure to plead demand futility adequately.

Lastly, the Supreme Court concluded that the bright-line rule adopted by the Court of Chancery was “overbroad and unsupported by the text of, and the policy underlying, Section 220.” The Supreme Court, however, cautioned that “filing a plenary derivative action without having first resorted to the inspection process afforded by [Section 220] may well prove imprudent and cost-ineffective. But, absent some other, sufficient ground for dismissal, that sequence is not fatal to the prosecution of a Section 220 action.” Expressing its sensitivity to the policy concerns raised by the Court of Chancery, the Supreme Court recognized that the plenary court may fashion remedies to deter a race to the courthouse and the premature filing of derivative actions. For example, the Supreme Court noted that the plenary court may deny lead plaintiff status, grant a motion to dismiss with prejudice and without leave to amend as to the named plaintiff or require the plaintiff to pay the defendants’ attorneys’ fees incurred on the initial motion to dismiss. Automatically foreclosing a stockholder-plaintiff’s ability to utilize the Section 220 inspection process after filing a derivative complaint, however, is not warranted under Delaware law.

  • sign up for our newsletter

    To keep our clients and friends updated on the latest legal news, Richards Layton distributes practice area e-alerts and newsletters. If you are interested in receiving these publications, please subscribe below.