Chancery Approves Incorporation of Reference Condition in Section 220 Litigation

The Court of Chancery has broad powers to impose “conditions as the court deems appropriate” on the inspection rights of shareholders. In United Technologies v. Treppel, Delaware's Supreme Court held that the Court of Chancery has the power to restrict the use of a corporation's books and records in any legal action to a Delaware court. And recently, the Court of Chancery approved an incorporation-by-reference condition in Elow v. Express Scripts Holding. The condition permits a corporation to respond to “cherry picked documents” that are taken “out of context” with the entirety of the produced records at its disposal.

This condition resembles the court's approach to ruling on motions to dismiss after plaintiffs have taken expedited discovery in support of an application for preliminary injunction. It also provides a backstop against selective inclusion and out of context quoting of corporate records. “In explaining its current judicial pharmacology, this court has noted the efficacy of an incorporation requirement; it provides the court an alternative to relying solely on the 'strong medicine' of Rule 11 where a plaintiff 'takes a document out of context' and 'insists on an unreasonable inference that the court could not draw if it considered related documents.'”

The Ruling

The plaintiff's argument against the incorporation condition was that it allows corporations to manipulate the universe of documents produced to frustrate the prosecution of meritorious claims. Despite acknowledging the potential for this conduct, the court determined that the benefits of being able to eliminate complaints involving misleading citations to a limited subset of records outweighed the potential for malfeasance by a corporation. The court noted that the plaintiff's argument was not frivolous; however, the court held that the interests of judicial and litigants' economy outweighed the potential detriment faced by the plaintiff.

Analysis

The fallout, if any, from the incorporation-by-reference condition decisions remains unknown. Essentially, plaintiff's counsel now needs to weigh whether the risk of not utilizing a books and records demand prior to filing litigation is less pervasive than the risk that a corporation selectively produces records that, if litigation is commenced, makes the potential for dismissal stronger. Also, shareholders may start bringing Section 220 actions in alternative jurisdictions with hopes of avoiding being saddled with forum and incorporation restrictions. Of course, the pendulum could swing back at corporations should the court find, likely in a case that survives a motion to dismiss, that a corporation failed to produce documents responsive to a Section 220 and sanction such conduct.

While such a ruling hardly seems controversial, it could dissuade corporations from trying to take advantage of a landscape that arguably is tipping in favor of the corporate defendants. In any event, the evolution of books and records litigation continues. Practitioners must be mindful that proposed confidentiality stipulations represent the first figurative battle in a fight to determine where litigation can be brought and what the presiding court may consider.

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Brett M. McCartney ([email protected]) is a partner at Morris James in Wilmington, and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Court of Chancery and Delaware Superior Court. This article also appeared in the Delaware Business Court Insider, an ALM sibling publication of this newsletter.

Books and records actions are heralded as the “tools at hand” for litigators pursuing shareholder claims against a corporation. In fact, the Delaware Court of Chancery has been critical of litigants who failed to take advantage of a shareholder's right to request the books and records of a corporation prior to commencing litigation against the corporation. See, e.g., Thermopylae Capital Partners v. Simbol, 2016 WL 368170, at *17 (Del. Ch. Jan. 29, 2016). And while many shareholders have utilized Section 220's summary proceeding to get a corporation's books and records, Delaware courts have approved certain conditions on the use of those records. As discussed below, the Court of Chancery recently approved a company's proposed incorporation condition, assuring the company that all the documents it produces pursuant to a books and records demand will be incorporated, even if not explicitly referenced, in any subsequent litigation where the plaintiff relies on any of the records produced by the company.

Background

In The City of Cambridge Retirement System v. Universal Health Services, the shareholder plaintiff demanded certain books and records of Universal Health Services, Inc. (UHS) to investigate corporate wrongdoing for purposes of a potential derivative action. While UHS contested the scope of the demand, it offered to produce certain documents subject to a confidentiality agreement. UHS's proposed confidentiality agreement included an incorporation-by-reference provision, which stated, “the stockholder agrees that the complaint in any derivative lawsuit that it files relating to, involving or in connection with the Inspection demand or any confidential inspection material, shall be deemed to incorporate by reference the entirety of the brooks and records of which inspection is permitted.” The shareholder plaintiff refused, and filed an action seeking to compel the inspection of UHS's books and records.

The Court of Chancery has broad powers to impose “conditions as the court deems appropriate” on the inspection rights of shareholders. In United Technologies v. Treppel, Delaware's Supreme Court held that the Court of Chancery has the power to restrict the use of a corporation's books and records in any legal action to a Delaware court. And recently, the Court of Chancery approved an incorporation-by-reference condition in Elow v. Express Scripts Holding. The condition permits a corporation to respond to “cherry picked documents” that are taken “out of context” with the entirety of the produced records at its disposal.

This condition resembles the court's approach to ruling on motions to dismiss after plaintiffs have taken expedited discovery in support of an application for preliminary injunction. It also provides a backstop against selective inclusion and out of context quoting of corporate records. “In explaining its current judicial pharmacology, this court has noted the efficacy of an incorporation requirement; it provides the court an alternative to relying solely on the 'strong medicine' of Rule 11 where a plaintiff 'takes a document out of context' and 'insists on an unreasonable inference that the court could not draw if it considered related documents.'”

The Ruling

The plaintiff's argument against the incorporation condition was that it allows corporations to manipulate the universe of documents produced to frustrate the prosecution of meritorious claims. Despite acknowledging the potential for this conduct, the court determined that the benefits of being able to eliminate complaints involving misleading citations to a limited subset of records outweighed the potential for malfeasance by a corporation. The court noted that the plaintiff's argument was not frivolous; however, the court held that the interests of judicial and litigants' economy outweighed the potential detriment faced by the plaintiff.

Analysis

The fallout, if any, from the incorporation-by-reference condition decisions remains unknown. Essentially, plaintiff's counsel now needs to weigh whether the risk of not utilizing a books and records demand prior to filing litigation is less pervasive than the risk that a corporation selectively produces records that, if litigation is commenced, makes the potential for dismissal stronger. Also, shareholders may start bringing Section 220 actions in alternative jurisdictions with hopes of avoiding being saddled with forum and incorporation restrictions. Of course, the pendulum could swing back at corporations should the court find, likely in a case that survives a motion to dismiss, that a corporation failed to produce documents responsive to a Section 220 and sanction such conduct.

While such a ruling hardly seems controversial, it could dissuade corporations from trying to take advantage of a landscape that arguably is tipping in favor of the corporate defendants. In any event, the evolution of books and records litigation continues. Practitioners must be mindful that proposed confidentiality stipulations represent the first figurative battle in a fight to determine where litigation can be brought and what the presiding court may consider.

*****
Brett M. McCartney ([email protected]) is a partner at Morris James in Wilmington, and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Court of Chancery and Delaware Superior Court. This article also appeared in the Delaware Business Court Insider, an ALM sibling publication of this newsletter.