Delaware Supreme Court Finds That Stockholders May Be Able To Inspect Company Emails And Other Electronic Information In § 220 Demands Where The Company Fails To Maintain Non-Electronic Information Responsive To The Deman
On January 29, 2019, the Delaware Supreme Court, in KT4 Partners LLC v. Palantir Techs. Inc., ruled that the petitioner, KT4, was entitled to inspect respondent Palantir’s emails in order to satisfy KT4’s demand to inspect Palantir’s books and records under § 220 of the Delaware General Corporation Law. KT4 is a stockholder of Palantir, a privately held technology company based in Palo Alto, California. KT4 sought to investigate suspected wrongdoing by Palantir, including allegations that Palantir made improper amendments to its stockholder agreement. To do so, KT4 served a § 220 demand on Palantir to inspect Palantir’s books and records. The Court of Chancery found that KT4 was entitled to inspect certain Palantir documents under § 220, but denied KT4’s request to inspect emails related to the allegedly improper amendments to Palantir’s stockholder agreement. On appeal, the Delaware Supreme Court overturned that portion of the Court of Chancery’s opinion, ruling instead that KT4 was entitled to inspect certain Palantir emails because they were “necessary” to investigate potential wrongdoing.
In so ruling, the Delaware Supreme Court did not alter the longstanding rule that a § 220 inspection be limited to those documents that are “essential and sufficient to the stockholder’s stated purpose.” Nor did the Delaware Supreme Court alter the notion that a corporation need not produce electronic documents where it has “traditional, non-electronic documents sufficient to satisfy the petitioner’s needs.” But the Delaware Supreme Court did find that an email inspection could indeed be required in situations where the company’s non-email books and records are insufficient to respond to the demand.
Addressing the specific facts of the case, the Delaware Supreme Court found that KT4 was entitled to inspect Palantir emails because Palantir conducted its corporate business informally over email and other electronic media, instead of through more traditional means, and could not offer any non-email documents that would have been essential to KT4’s request. The Delaware Supreme Court concluded that “[i]f a respondent in a § 220 action conducts formal corporate business without documenting its actions in minutes and board resolutions or other formal means, but maintains its records of the key communications only in emails, the respondent has no one to blame but itself for making the production of those emails necessary.”
The Court of Chancery had also imposed a broad jurisdictional use restriction on the use of the materials that KT4 was entitled to inspect, such that KT4 was not allowed to use them in any litigation outside the Court of Chancery (other than another Delaware court should the Court of Chancery decline jurisdiction). The Delaware Supreme Court ruled that the Court of Chancery abused its discretion by refusing KT4’s requests to alter such jurisdictional use restriction and allow it to bring suit based on the materials in either the Superior Court, where litigation was already pending, or in a court outside of Delaware for any non-derivative action. Given that the Court of Chancery found that KT4 had a credible basis to investigate potential wrongdoing related to the violation of contracts with strong ties to California, it lacked reasonable grounds for denying the modifications that KT4 requested, which would allow a potential suit to be brought in another jurisdiction, such as California. The Delaware Supreme Court explained that the Court of Chancery must be “cautious” in limiting the jurisdictions in which a petitioner can use the books and records it receives and that such restrictions be justified by “case-specific factors,” such as where a corporation’s bylaws limits the permissible jurisdictions in which to bring suit, or where there are other “pertinent circumstances” weighing toward restricting use outside of Delaware. The Delaware Supreme Court ruled that given the strong ties of both petitioner and respondent to California, no such circumstances existed.
This decision is an important reminder of the significance of maintaining corporate formalities. The holding could motivate potential petitioners to more aggressively push for the inspection of electronic information, such as emails and text messages, in § 220 demands. Significant corporate decisions—particularly board-level decisions that are prompted by contentious issues with stockholders—should be formally documented in meeting minutes or other forms if one wishes to avoid a more burdensome, time consuming, expensive electronic document production. Defendants in § 220 actions should also take note of the jurisdictional ruling and, when faced with an allowed § 220 demand, highlight to the Court of Chancery case-specific reasons why limiting future litigation to the Court of Chancery is justified.
Tenth Circuit Holds That Dodd-Frank Reaches Foreign Securities Fraudsters Where Fraudulent Conduct Satisfies The “Conduct-And-Effects” Test
On January 24, 2019, the U.S. Court of Appeals for the Tenth Circuit, in Securities and Exchange Commission v. Scoville et al, affirmed the District of Utah’s ruling that the SEC can bring extraterritorial securities fraud claims against foreign defendants under the Dodd-Frank Act where the alleged violation involves either conduct that occurred within the United States or conduct that occurred outside the United States that had a foreseeable and substantial effect within the States (an analysis referred to as the “conduct-and-effects” test). In so holding, the majority found that the Dodd-Frank Act effectively abrogated, in part, a 2010 Supreme Court ruling in Morrison v. National Australia Bank Ltd., which limited the application of federal antifraud actions to fraudulent conduct “in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States” (and which was decided less than a month before Dodd-Frank was enacted into law).
The case centers on Defendant Charles Scoville, who operated an internet traffic exchange business, Traffic Monsoon, LLC. Among other advertising-based services, Traffic Monsoon was in the business of selling “visits” or “clicks” to a purchaser’s website in order to make that website look more popular than it was (referred to as “Adpacks”). Adpack purchasers also qualified, under certain circumstances, to share in Traffic Monsoon’s revenue. The SEC brought a civil enforcement action against Scoville and Traffic Monsoon, alleging that the operation was a Ponzi scheme in violation of Exchange Act Section 10(b), Rule 10b-5, and Securities Act Section 17(a). Relying on Morrison, Defendants argued that the antifraud provisions of federal securities laws did not reach Traffic Monsoon’s sale of Adpacks to people living outside the United States. The Tenth Circuit disagreed. The Tenth Circuit explained that the Morrison court, in holding that the federal securities laws did not have extraterritorial reach, relied on the presumption that “[w]hen a statute gives no clear indication of an extraterritorial application, it has none.” The Tenth Circuit noted that just days after Morrison was decided, Congress passed the Dodd-Frank Act, which “affirmatively and unmistakably” directed that those provisions apply extraterritorially where the alleged antifraud violation involves “(1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.” Thus, the Tenth Circuit ruled that the passage of the Dodd-Frank Act abrogated Morrison’s restrictions on the extraterritorial application of the federal securities law. After deciding that federal securities laws could potentially apply to overseas conduct, the court applied the “conduct-and-effects” test to the specific facts in Scoville and found that the federal antifraud provisions could reach Defendants’ sale of Adpacks to people living outside the country. The Tenth Circuit agreed with the district court that Defendants’ conduct within the United States “constitute[d] significant steps in furtherance of the violation’ of Rule 10b-5 and Section 17(a).” Specifically, the Tenth Circuit noted that Scoville conceived and created Traffic Monsoon in the United States, Scoville created and promoted the Adpack investments over the internet while residing in Utah, and the servers housing the Traffic Monsoon website were physically located within U.S. borders. The decision significantly bolsters the SEC’s reach, and signals that the SEC and DOJ could more aggressively bring enforcement actions against foreign transactions that arguably fall within the conduct-and-effects test, increasing the risk for companies that offer securities world-wide.
Southern District Of Texas Dismisses ERISA Lawsuit Against Exxon, Highlighting Heightened Pleading Standard
On February 4, 2019, the U.S. District Court for the Southern District of Texas, in Fentress, et al v. Exxon Mobil Corp., dismissed an Employee Retirement Income Security Act (“ERISA”) class action brought by employee participants in the company’s employee stock ownership plan. In doing so, the court found that Exxon’s corporate officers did not breach their fiduciary duties under ERISA by keeping the employees’ retirement savings in Exxon stock despite having inside knowledge that forthcoming disclosures related to the effect of climate change on Exxon’s oil reserves could negatively impact the price of the stock. Plaintiffs alleged that Exxon’s corporate officers breached their fiduciary duty of prudence under ERISA by continuing to invest in the company’s stock despite allegedly knowing that its stock price was “artificially inflated” and would fall due to the effect of global warming and declining oil prices on its reserves. ERISA requires a fiduciary of a pension plan to manage plan assets “with the care, skill, prudence, and diligence . . . that a prudent man acting in a like capacity and familiar with such matters” would use under the same circumstances. Under U.S. Supreme Court precedent set forth in Fifth Third Bancorp v. Dudenhoeffer, a plaintiff alleging a violation of the duty of prudence based on non-public information must also plausibly allege an “alternative action” that the defendant could have taken “that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.” Notably, the Fifth Circuit employs a heightened pleading standard that requires an ERISA plaintiff to show that the “alternative action” is “so clearly beneficial that a prudent fiduciary could not conclude that it would be more likely to harm the fund than to help it.” The District Court, in applying the “alternative action” analysis, rejected Plaintiffs’ argument that defendants could have taken the “alternative action” of persuading Exxon executives to refrain from making the alleged misrepresentations regarding the value of Exxon’s stock, explaining that such an action could have easily caused more harm than good to the stock price. The District Court also contrasted the circumstances with those in the Second Circuit’s recent decision in Jander v. Retirement Plans Comm. of IBM, which concerned supplemental notices. In Jander, the plaintiffs alleged that the defendants violated the duty of prudence by failing to issue a corrective disclosure when they knew the company was overvalued. The Second Circuit found that “a prudent fiduciary in the Plan defendants’ position could not have concluded that corrective disclosure would do more harm than good” because, among other things, the defendants allegedly knew that the stock was artificially inflated through accounting violations, defendants had the power to make corrective disclosures to correct the price, general economic principles suggested that the reputational damage to a company increases the longer a fraud continues, and the eventual disclosure was inevitable because the business was being sold. The Fentress court distinguished Jander and found that “the two arguments the Second Circuit appeared to find the most persuasive—that the fraud became more damaging over time and that the eventual disclosure was inevitable—do not apply” because the Fifth Circuit, in a separate case, had previously rejected an argument that reputational damage to the company would increase the longer the fraud went on. Further, the court found that “the inevitability of the disclosure in Jander also differentiates the instant case, because there was no major triggering event that made Exxon’s eventual disclosure inevitable.” The holding reaffirms the high burden necessary to allege such prudence claims under ERISA.
Jury In Central District Of California Awards Damages To Investors Of Puma Biotechnology In Rare Securities Class Action To Proceed To Verdict
On February 4, 2019, a Central District of California jury, in HsingChing Hsu v. Puma Biotechnology, Inc. et al, found that Puma Biotechnology Inc. executives knowingly made materially false or misleading statements about the results of a phase III clinical trial involving a breast cancer treatment. In just the 15th securities class action to reach a jury verdict since the passage of the Private Securities Litigation Reform Act, the jury found that Puma falsely stated that the disease-free survival rate of a breast cancer treatment was 91% compared to 86% for those who were treated with a placebo. The stock price later dropped by approximately 18% when the market discovered that the true statistical difference between the drug and the placebo was roughly half that previously disclosed. The jury found that the difference in disease-free survival rates between those treated and those who were given a placebo—a 2.3% swing as compared to the 5% that Puma had represented—was material and played a substantial role in causing Puma’s stock to decline and awarded damages of $4.50 per share. Jurors found for Puma on three other alleged misrepresentations, finding that Puma did not misrepresent statements regarding a grade 3+ diarrhea rate, Kaplan-meier curves, or discontinuation rate due to adverse events. For life sciences companies reporting clinical trial results, the verdict underscores that there is no wiggle room for truthful and full reporting of data results, as even a relatively small difference between disclosed and actual results can significantly impact stock price and expose the company to potential liability under securities laws.