February 7, 2011
On January 28, 2011, the Delaware Supreme Court clarified in King v. VeriFone Holdings, Inc., Del. Supr., No. 330, 2010, that plaintiffs may in some circumstances inspect a corporation’s books and records to bolster a derivative action complaint even after they have filed a lawsuit.
Section 220 of Delaware’s General Corporation Law provides shareholders with a limited right to inspect the books and records of Delaware companies in which they own stock. That right is subject to several conditions, including the condition that shareholders have a "proper purpose" for seeking inspection. Investigating corporate mismanagement, for example, is a proper purpose. Indeed, Delaware courts have repeatedly urged shareholders to use Section 220 to conduct such investigations before filing a derivative action. By using the "tools at hand," those courts have explained, shareholders can become better equipped to plead allegations that are sufficient to meet the stringent pleading requirements that apply to derivative complaints, particularly in cases in which the plaintiffs did not serve a pre-suit demand and thus must plead "demand futility" (i.e., that serving a demand would be useless because the board of directors is biased against the claims or dominated by others who are). Litigants have frequently clashed over whether the purpose of obtaining information to fortify a derivative complaint is "proper" when the complaint has already been filed.
The Delaware Supreme Court squarely confronted that issue in VeriFone. Reversing a decision of Vice Chancellor Strine, the court held 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," when his or her earlier complaint was dismissed with leave to amend. Although the court recognized that the interests of judicial economy counsel against allowing the re-litigation of insufficient and premature complaints, it reasoned that trial courts have sufficient means to curb slapdash pleadings. For example, they may deny lead plaintiff status to plaintiffs who file defective complaints or dismiss such complaints with prejudice.
Significantly, the court strongly implied that the investigation of claims is an improper purpose under Section 220 when a derivative complaint is pending and the plaintiff does not have leave to amend, or when the complaint has been dismissed with prejudice. Moreover, the decision arguably is limited to situations in which a complaint has been dismissed due to failure to plead demand futility. Furthermore, VeriFone does not disturb the long line of precedent that forbids plaintiffs from using civil discovery in a pending derivative lawsuit to investigate demand futility or otherwise supplement their allegations. Despite plaintiffs’ frequent efforts to exploit the more liberal discovery rules of other jurisdictions, Section 220 remains the exclusive vehicle for investigating demand futility under Delaware law.
What lasting effect the decision will have on litigation before Delaware’s Court of Chancery is uncertain. The opinion omits any discussion of Rule 15(aaa) of the Court of Chancery Rules, which provides that the Court of Chancery must generally dismiss a complaint with prejudice if the complaint fails to state a claim or insufficiently pleads demand futility. Since the Court of Chancery will rarely grant leave to amend, it should be the exceptional case in which plaintiffs are permitted to seek records under Section 220 after their complaint is dismissed in Delaware.
As a matter of sound risk management, corporations should bear in mind the following in responding to records requests or complaints under Section 220:
 See, e.g., Beam v. Stewart, 845 A.2d 1040, 1056 (Del. 2004) ("In general, derivative plaintiffs are not entitled to discovery in order to demonstrate demand futility."); In re Merck & Co., Inc. Sec., Deriv. & ERISA Litig., 493 F.3d 393, 400 (3d Cir. 2007) ("[D]iscovery generally may not be used to supplement allegations of demand futility."); In re Openwave Sys. Inc. S’holder Deriv. Litig., 503 F. Supp. 2d 1341, 1351 (N.D. Cal. 2007) ("It appears undisputed that under Delaware law, derivative plaintiffs are not entitled to discovery in order to demonstrate demand futility.") (citation and marks omitted); cf. Levine v. Smith, 591 A.2d 194, 208 (Del. 1991) (holding that plaintiffs are not entitled to discovery prior to responding to a motion to dismiss in a demand-refused case).
 See, e.g., In re Dow Chem. Co. Derivative Litig., C.A. No. 4349-CC, 2010 WL 66769, at *1 & n.2 (Del. Ch. Jan. 11, 2010). The court may grant leave to amend only if the plaintiff shows good cause and the court determines that dismissal with prejudice would be unjust under the circumstances. Del. Ch. R. 15(aaa).
 Lavi v. Wideawake Deathrow Entm’t, LLC, C.A. No. No. 5779-VCS, 2011 WL 284986, *1 (Del. Ch. Jan. 18, 2011) (analyzing an analogous books and records statute that applies to limited liability companies).
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you work or any of the following members of the Securities Litigation Practice Group Steering Committee:
Securities Litigation Group:
Jonathan C. Dickey – Practice Co-Chair, New York (212-351-2399, email@example.com)
Robert F. Serio – Practice Co-Chair, New York (212-351-3917, firstname.lastname@example.org)
Wayne W. Smith – Practice Co-Chair, Orange County (949-451-4108, email@example.com)
Paul J. Collins – Palo Alto (650-849-5309, firstname.lastname@example.org)
George B. Curtis – Denver (303-298-5743, email@example.com)
Ethan Dettmer – San Francisco (415-393-8292, firstname.lastname@example.org)
Gareth T. Evans – Los Angeles (213-229-7734, email@example.com)
Joel A. Feuer – Los Angeles (310-551-8808, firstname.lastname@example.org)
Daniel S. Floyd – Los Angeles (213-229-7148, email@example.com)
Barry R. Goldsmith – New York (212-351-2440, firstname.lastname@example.org)
Mark A. Kirsch – New York (212-351-2662, email@example.com)
John C. Millian – Washington, D.C. (202-955-8213, firstname.lastname@example.org)
John H. Sturc – Washington, D.C. (202-955-8243, email@example.com)
Andrew S. Tulumello – Washington, D.C. (202-955-8657, firstname.lastname@example.org)
M. Byron Wilder – Dallas (214-698-3231, email@example.com)
Meryl L. Young – Orange County (949-451-4229, firstname.lastname@example.org)
Please also feel free to contact any of the Securities Litigation Partners for further information about the topics covered in this alert.
© 2011 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.