By Jay McMillan
In drafting a complaint, an attorney might rely on a document “in isolation, not in bad faith but perhaps over-zealously in the belief that the document reveals more than it does.” Amalgamated Bank v. Yahoo! Inc., 132 A.3d 752, 799 (Del. Ch. 2016). Ordinarily, a defendant responding to such a complaint in a Delaware state court could be frustrated by the rule that blocks the defendant from introducing other documents in the same context unless they are specifically incorporated by reference in the complaint. But that rule does not always apply.
In several recent cases involving stockholder demands for inspection of corporate books and records, the Delaware Court of Chancery has approved an “incorporation condition” providing that all documents produced by the corporation in response to such a demand are incorporated into any subsequent derivative complaint filed by the stockholder against the corporation’s directors on behalf of the corporation. Ordinarily, a defendant may only move to dismiss a complaint based on the insufficiency of the complaint itself and the documents incorporated by reference in the complaint. In other words, at the pleading stage a defendant may not refute the plaintiff’s documents with other documents of its own. However, where an incorporation condition applies, the defendant may use any of the documents it produced to the stockholder plaintiff in response to a books-and-records demand. A recent case, City of Cambridge Retirement System v. Universal Health Services, Inc., C.A. No. 2017-0322-SG (Oct. 12, 2017), solidifies the use of incorporation conditions in books-and-records cases.
In that case, the corporation, UHS, agreed to produce documents in response to a stockholder demand only if the stockholder entered into a confidentiality agreement with an incorporation condition. The stockholder refused and brought a books-and-records action in the Court of Chancery under Section 220 of the Delaware General Corporation Law, seeking production of the documents free of the incorporation condition.
Although the allegations against UHS were sensational, Vice Chancellor Sam Glasscock III found in UHS’s favor on the narrow issue of the incorporation provision. The plaintiff alleged that UHS illegally committed patients to behavioral health facilities by luring them in with “advertisements for free wellness examinations … [and] trick[ing] patients into implying they harbored suicidal thoughts,” keeping them in the facilities “until their insurance benefits ran out.” The Court in a footnote pointed out that UHS “stoutly denied” the allegations, but “If true, in addition to being morally despicable behavior by the individuals responsible, this would represent the worst abuse of a Delaware corporate franchise of which I am aware.”
The plaintiff argued that incorporation provisions are “pernicious” because they allow companies to “manipulate” their document productions “without any punishment for failing to produce [harmful] documents.” Although the Court pointed out that the same argument could be made about a corporation’s ability to manipulate the record available to a plaintiff through discovery on a motion for summary judgment, the plaintiff argued that a stockholder making a Section 220 demand “has substantially less ability to test the sufficiency of production, compared with a litigant receiving discovery.” The Court rejected that argument, concluding that “the benefits of allowing the court to eliminate complaints involving misleading citations to a limited subset of records” outweighed “the risk of potential malfeasance” by producing defendants.
The Court stressed that the standard on a motion to dismiss in Delaware “remains plaintiff-friendly” – a complaint survives unless the plaintiff could not prevail based on any “reasonably conceivable” set of facts inferable from the complaint. The Court expressed confidence in its ability, “through proper application of that standard [to] eliminate much of the risk of gamesmanship and improper dismissal.”
The Court found that the plaintiff in UHS had failed to distinguish the previous cases in which the Court had approved incorporation conditions. Those cases, along with UHS, make incorporation conditions virtually the norm in books and records cases. After UHS, Stockholders making books-and-records demands and corporations confronted with them should both anticipate that any production will be subject to a confidentiality agreement that includes an incorporation condition.
James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information about the firm, visit hfk.law.