Litigation threat in sheep's clothing

Most public company general counsels can safely assume that their company is eventually going to be targeted by a shareholder lawsuit. Thankfully, given the heightened pleading requirements for securities class actions and derivative lawsuits, general counsels can also assume that absent some actual wrongdoing, plaintiffs will have a very difficult time in maintaining their case past the pleading stage. In short, the threat of shareholder litigation is real, but so too are the myriad protections companies enjoy.

Recently, however, activist shareholders and plaintiff firms have taken up an unexpected strategy of attack, one that is not only sanctioned by the courts, but can catch many general counsels off guard. The new strategy? Issuing a books and records request for confidential company documents. With confidential company records in hand, a creative plaintiff can often craft a complaint sufficiently detailed to survive a motion dismiss - even where no actual wrongdoing occurred.

Such requests are not in themselves new - shareholders have long had the legal right to request corporate books and records. See 8 Del. Code Section 220; Cal. Corp. Code Section 1600. As Delaware courts have repeatedly recognized, few shareholders have taken advantage of this right, as most shareholder plaintiffs rush to file their complaints before launching any investigation. But that trend is changing - not just because plaintiffs have begun to realize the relative ease by which they can gain a litigation advantage by demanding company records, but because Delaware courts are now all but requiring plaintiffs to investigate their claims before they file. Where plaintiffs seek documents and the companies fail to properly respond, the potential downside risks are also increasingly serious.

The Rules

Many states, like Delaware, afford shareholders a near-universal right to inspect mundane company records like a shareholder list. Where shareholders seek more sensitive company documents, like board minutes or deal materials, Delaware law requires them to show a "proper purpose," typically defined to be any purpose "reasonably related to a person's interest as a shareholder." Courts have held that initiating shareholder litigation constitutes a "proper purpose," though to the extent the shareholders are seeking to investigate mismanagement, they must be able to offer some "credible basis" to show that mismanagement occurred. A critical press article or analyst comment is often enough to make this showing and establish a "credible basis" for investigating mismanagement.

Once the shareholder plaintiffs establishes their "proper purpose," the company must then produce documents "essential" to the evaluation of that purpose. Shareholders are not entitled to "every document, letter, and email" in the company's possession, as they would be in discovery, and are not entitled to conduct a fishing expedition. What, then, constitutes the "essential" materials necessary to satisfy a request? The responding general counsel must answer that question while balancing competing interests. One the one hand, she has an obligation to produce materials to the requesting shareholder; on the other hand, she has a fiduciary obligation to protect shareholder interests as a whole, and not allow needless strike suits to proliferate where they could have been avoided.

Recent Developments

These concerns are amplified by recent Delaware case law. As noted above, Delaware courts are increasingly insistent that shareholders seek corporate records before filing suit. In fact, the Delaware Court of Chancery recently went so far as to hold that if a shareholder fails to seek books and records before filing a derivative complaint, the court can assume that shareholder cannot "provide adequate representation for the corporation." La. Mun. Police Empls'. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012). That decision was later overturned by the Delaware Supreme Court, but by acknowledging "the trial court's concerns," the Supreme Court yet again reiterated its expectation that shareholders should request company records as a matter of first course. Pyott v. La. Mun. Police Emples.' Ret. Sys., 2013 Del. LEXIS 179 (Del., Apr. 4, 2013).

By the same token, Delaware courts have now firmly established that a shareholder can request books and records in almost any circumstance, including:

- Before a litigation demand is made;

- To determine why a litigation demand was refused (see La. Mun. Police Emp. Ret. Sys. v. Morgan Stanley & Co., Inc., 2011 Del. Ch. LEXIS 42 (Del. Ch. Mar. 4, 2011));

Before the filing of a complaint;

- During the pendency of another shareholder action pursuing the identical claims; and, significantly,

- After a complaint is dismissed, in order to successfully replead (see King v. Verifone Holdings, Inc., 12 A.3d 1140 (Del. 2011)).

Companies experiencing a stock drop or bad press can find themselves facing multiple books and records requests while simultaneously having to deal with multiple shareholder litigation demands and lawsuits. Mapping out the proper response through such a thicket of competing concerns can present very difficult challenges for any fiduciary. That is particularly true given the potential downsides for failing to respond properly. Recently, the Delaware Court of Chancery held that where a company fails to produce certain documents in response to a books and records action, the court can draw negative conclusions from their absence. In re China Agritech, Inc., 2013 Del. Ch. LEXIS 132 (Del. Ch. May 21, 2013). In other words, while many companies worry about producing too many documents for fear they will be used against them in litigation, producing too few documents - or not producing specific documents the court feels should have been produced - might now be used against them in litigation.

As with any body of law, the rules governing books and records demand will continue to evolve, particularly as more shareholder actions are funneled into Delaware. Before responding, companies and their directors and officers should take note of the current state of the law and move cautiously when faced with a books and records demand to be sure that both shareholder and company concerns are considered before any production occurs.

Key Points:

- Shareholder records requests are more common than ever, and are often the first step toward litigation

- In responding, general counsels must balance their production obligation against the risk of a potentially damaging strike suit

- Courts increasingly expect shareholders to seek records before filing suit

- Courts are also now drawing adverse inferences where companies fail to produce