RECALIBRATING SECTION 220.

• Author: Hunt, Alyssa

INTRODUCTION 1196 I. THE INCREASINGLY PROMINENT ROLE OF SECTION 220 IN SHAREHOLDER DERIVATIVE LITIGATION 1199 A. Information Rights in Shareholder Derivative Litigation 1200 B. Section 220's Rise to Prominence 1202 1. Stringent Pleading Requirements: Fulfilling the Need for Information 1203 2. Liberalization of Section 220: Proper Purpose and Scope 1206 3. Delaware's Encouragement to Utilize the "Tools at Hand" 1208 C. The Benefits of Section 220's Role in Shareholder Litigation 1209 II. PERVERSE INCENTIVES IN SECTION 220 1210 A. Multijurisdictional Litigation and the Preclusion Problem 1211 1. California State Teacher's Retirement System v. Alvarez 1211 2. Alvarez's Implications: Undermining Section 220 with Perverse Incentives 1214 B. Increasing Intensity and Misuse of Section 220 in Delaware 1217 III. LEGISLATIVE REFORM TO RECALIBRATE SECTION 220: LIMITED FEE-SHIFTING AND STREAMLINING SECTION 220 1220 A. Limitations of Private Ordering 1220 1. Forum Selection Bylaws 1221 2. Fee-Shifting Bylaws 1223 3. Standardization and Efficiency in Private Ordering 1226 4. Necessity of Legislative Reform 1226 B. Proposals for Fee-Shifting and Streamlining 1227 1. Limited Fee-Shifting for Unreasonable Failure to Investigate 1227 2. Streamlining the Scope of Section 220 1230 CONCLUSION 1234 INTRODUCTION

In a recent speech, Chancellor Kathaleen McCormick of the Delaware Court of Chancery raised her concern that shareholder demands for corporate books and records under Delaware's Section 220 have been "'larding up' the court's docket with 'glorified discovery disputes.'" (1) Chancellor McCormick's observation is consistent with significant growth in the use of Section 220--from 2004 to 2018, there was a thirteen-fold increase compared to previous decades in the number of books and records requests filed in the Delaware Court of Chancery. (2) While the use of Section 220 has generated some notable benefits for the effectiveness and efficiency of shareholder derivative litigation, its use is also subject to perverse incentives deriving from the use of prefiling investigations in multijurisdictional litigation and aggressive offensive and defensive tactics that increase the intensity and potential misuse of litigation.

Delaware General Corporation Law's Section 220 allows plaintiffs to seek the books and records of corporate defendants, thereby empowering shareholders with information in the exercise of their primary rights to vote, sell, or sue. (3) The use of Section 220 has grown as a result of doctrinal developments that have raised pleading requirements to demand more information from plaintiffs, (4) as well as a broad interpretation of the statute. (5) Significantly, the growth of Section 220 has also come at the insistence of the Delaware courts. (6) Plaintiffs' access to corporate information with the aid of Section 220 has proven to be critical in sorting out meritorious claims from frivolous ones. (7) But perverse incentives threaten the utility of the doctrine.

While the evidence suggests that Section 220 is a desirable tool to encourage meritorious derivative claims that will hold managers accountable, (8) the incentives at play are misbalanced. The looming threat of preclusion in shareholder litigation proceeding in multiple jurisdictions creates perverse incentives. Some plaintiffs may forego careful investigation in favor of rushing to the courthouse, thereby predictably resulting in a dismissal at the demand futility stage and precluding more careful plaintiffs who sought books and records from bringing a claim on the same underlying facts in Delaware. (9) But even if the case remains in Delaware and does not face the threat of preclusion from parallel proceedings in other jurisdictions, perverse incentives still remain. Plaintiffs and defendants can both misuse Section 220 and transform what was once intended to be summary proceedings into surrogate litigation on the underlying merits. Defendants can employ overly aggressive tactics to thwart plaintiffs' access to corporate records, (10) and plaintiffs can push the boundaries of the scope of documents they are entitled to, seeking a sort of prefiling discovery that unfairly burdens defendants and the courts. (11)

Recalibration is needed to ensure that Section 220 remains a useful tool for screening shareholder litigation without becoming overly burdensome on the courts and on litigants. Recent scholarship has explored the increasing role that information rights play in shareholder litigation. (12) This Comment highlights the perverse incentives that follow from the expanding use of inspection rights in multijurisdictional litigation and the increasing intensity and potential misuse of Section 220 litigation generally. Ultimately, this Comment offers two legislative solutions to work towards recalibrating Section 220.

First, because plaintiffs engaged in multijurisdictional litigation are incentivized to file quickly and forego prefiling investigations due to the threat of preclusion, a limited fee-shifting provision in Section 220 enacted by legislative amendment would more narrowly target the causes of frivolous litigation without overly deterring all litigation. While some have suggested that Delaware should rely on private ordering to address the preclusion problem, private ordering is ultimately unlikely to solve the issue because plaintiffs may still initiate inspections. Moreover, private ordering would not provide the standardized and efficient solution that Section 220 requires. Second, with respect to the increasing intensity and misuse of Section 220, Delaware courts should streamline Section 220 proceedings to mitigate their increasingly surrogate nature. Specifically, Delaware courts should provide streamlined access to formal board-level materials to plaintiffs that state a proper purpose to ultimately reduce the burden of Section 220 litigation on litigants and the courts.

This Comment proceeds as follows. Part I considers the role of information rights in shareholder derivative litigation and explores why Section 220 has become a mainstay in derivative litigation over the past decade, concluding with research detailing the screening benefits of Section 220. After reviewing its desirable features, Part II examines the incentive problems plaguing Section 220. Part II first discusses the ways in which multijurisdictional shareholder derivative litigation creates a preclusion problem that encourages the quick filing of scantly researched complaints. It goes on to explain how perverse incentive problems remain, even when a case remains only in Delaware, due to both plaintiffs' and defendants' tendency to employ overly aggressive offensive and defense tactics, resulting in the increasing intensity and misuse of Section 220 litigation.

In Part III, after explaining why private ordering solutions are insufficient, this Comment advocates for two legislative proposals to address these perverse incentive problems. First, to address the preclusion problem, this Comment proposes an amendment to Section 220 allowing for a court to implement limited fee-shifting for parties that bring a claim but unreasonably fail to incorporate information from a prefiling investigation. Next, to address the perverse incentives presented by the increasing intensity and misuse of Section 220, this Comment proposes simplifying the scope of inquiry by providing presumptive access to formal board-level materials to plaintiffs that state a proper purpose. Together, these proposals can mitigate the burden of Section 220 litigation on litigants and the courts, while still maintaining its critical--yet discrete--role in shareholder litigation.

1. THE INCREASINGLY PROMINENT ROLE OF SECTION 220 IN SHAREHOLDER DERIVATIVE LITIGATION

   Section 220 plays an important role for shareholders by providing information to support the exercise of their three primary rights to vote, sell, or sue. In derivative litigation, information rights are particularly important to overcome the gatekeeping mechanisms--the demand requirement and special litigation committees--that boards can use to wrest control over litigation. (13) Section 220 has risen to prominence in part because Delaware courts often insist that plaintiffs exercise their inspection rights before filing suit. (14) While some criticize Section 220 for turning books and records litigation into a surrogate proceeding to litigate the merits of the suit, recent research has supported the benefits of Section 220 to address the age-old problem in shareholder derivative litigation: sorting out meritorious cases from frivolous ones and ultimately generating more successful claims to hold managers accountable. (15)

   1. Information Rights in Shareholder Derivative Litigation

      Shareholders have three primary rights--the right to vote, sell, or sue (16)--and they have information rights so that they can effectively exercise those rights. (17) Because "[e]ffective corporate governance cannot occur in an information vacuum," shareholders need access to corporate information to know "when something rotten might have occurred in the boardroom." (18) Shareholder inspection rights can be thought of as a tool for driving down the agency costs that result from the separation of ownership and control in a corporation. (19) In Delaware, Section 220 provides for shareholder inspection rights. (20) The statute provides a right for "[a]ny stockholder... upon written demand under oath stating the purpose" to inspect "[t]he corporation's stock ledger, a list of its stockholders, and its other books and records." (21)

      Information rights are particularly important in derivative litigation because of the fight over control of the litigation. The corporate board is the traditional gatekeeper of shareholder derivative litigation. (22) This is because shareholder derivative claims ultimately belong to the corporation, and the board is charged with managing the...