Characterizing the decision to bring a books and records inspection action after filing a plenary or substantive action as “[i]nherently contradictory,” the Delaware Court of Chancery recently dismissed a Section 220 action brought by a group of investors.  The decision signals that the Court of Chancery remains alert to the use of books and records inspection actions for improper purposes, including to subvert the ordinary conduct of civil discovery.

The dispute at issue arose over a $25 million investment made by CHC Investments, LLC (“CHC”), to Strategic Growth Bancorp, Inc. (“SG Bancorp”) in March 2014.  At the time, SG Bancorp was raising funds to support its national mortgage platform and real estate investment trust business units.

Though it claimed to be developing its mortgage platform business, SG Bancorp announced that it was spinning off the business unit only a few months after CHC’s investment.  In early 2015, SG Bancorp released financial statements, which CHC alleged contained information that had previously been concealed from SG Bancorp shareholders.  CHC alleged that in December 2014, it learned for the first time of securities fraud and Federal Housing Finance Agency suits involving high-level SG Bancorp employees that resulted in “nine- and ten-figure settlements.” SG Bancorp merged into FirstSun Capital Bancorp, the named defendant, in 2017.

CHC filed its first suit, the “Plenary Action,” in 2018, bringing claims for, among other things, breach of fiduciary duty, fraud, inadequate disclosure, alleging that SG Bancorp’s disclosures in connection with the investment contained material misrepresentations or omissions about its mortgage business.

After filing the Plenary Action, SG Bancorp served FirstSun with a demand to inspect FirstSun’s books and records.  Section 220 of the Delaware Chancery code permits a stockholder to inspect certain books and records of a corporation for “any proper purpose” (8 Del. C. § 220(b)) and to bring suit in the Court of Chancery to compel inspection if inspection is refused or the demand is ignored (8 Del. C. § 220(c)).  In this case, CHC’s stated purpose for inspection was to “investigate the facts behind . . . [SG Bancorp’s] incomplete disclosures, corporate mismanagement in association with the split-off of its operation into [a] separate Delaware limited liability company . . . , and improprieties” associated with the terms of the spin-off of its mortgage platform business.  CHC denied inspection in view of the earlier-filed Plenary Action, causing CHC to file a Section 220 Action, which SG Bancorp moved to dismiss.

Newly-appointed Vice Chancellor Kathaleen S. McCormick dismissed the Section 220 Action, characterizing CHC’s tactics in the related suits as a “problematic,” “sue first, ask questions later” approach.  Forming the basis of the decision was the Court’s determination that bringing a Section 220 Action after a Plenary Action, absent “special circumstances,” is inherently contradictory.  The mere filing of a Plenary Action with substantive claims, the Court opined, is a representation that the plaintiff has sufficient information to support its claims, pursuant to Rule 11.  In contrast, where the stated purpose of the Plenary Action plaintiff’s Section 220 demand is to investigate the same subject matter as its Plenary Action claims, the same plaintiff is representing that the information it seeks to learn in its Section 220 Action is necessary for its Plenary Action. Thattension was laid bare in the instant case, where CHC admitted that its 21 record inspection demands were “all designed to give Plaintiff the information necessary to investigate the claims” asserted in the Plenary Action.

In granting the Motion to Dismiss, the Court acknowledged, but distinguished, two exceptions (or “special circumstances”) to the general principle that a Section 220 Action cannot follow a Plenary Action in the ordinary course.  First, CHC relied on the Court of Chancery’s decision in Khanna v. Covad Communications Group, Inc., 2004 WL 187274 (Del. Ch. Jan. 23, 2004), to argue that the two actions may proceed simultaneously where “time pressures” necessitate.  The Court noted that, in Khanna and its progeny, the time pressures were either the fault of the defendant, or at least not caused by the plaintiff, but here, any time pressure or delay to bringing suit was caused by CHC itself.

Second, CHC also contended that, under the reasoning of King v. VeriFone, 12 A.3d 1140 (Del. 2011), it could proceed via Section 220 so long as it retained the opportunity to amend its Complaint.  The Court disagreed, distinguishing King and cases like it on the ground that there was “prior judicial action” in those cases, wherein the court analyzing the Plenary Action, e.g., dismissed the case without prejudice, which may invite a records request by the plaintiff to obtain more information and re-plead.  The Court also noted that both Khanna and King were derivative suits, which invited “some measure of leniency” in view of the heightened pleading requirements in those cases.

Without an applicable “special circumstance” to save CHC, the Court dismissed the Section 220 Action.  The result appears consistent with a textual reading of the Court of Chancery’s Rules and is a cautionary tale for plaintiffs.  Where a plaintiff determines that it has sufficient information to bring substantive claims, that plaintiff should expect to proceed via ordinary civil discovery, rather than by invoking the books and records inspection rule.  In contrast, and in the absence of special circumstances, a plaintiff that requires additional information should sequence its Section 220 activities early, to investigate and develop the basis for any substantive claims prior to filing. And in all cases, a party should be careful to define a proper purpose for its Section 220 books and records inspection, including in view of any pending or contemplated litigation.

The case is CHC Investments, LLC v. FirstSun Capital Bancorp, C.A. No. 2018-0610-KSJM in the Court of Chancery of the State of Delaware.