On Jan. 31, Chancellor Kathaleen McCormick of Delaware’s Court of Chancery issued her opinion in the matter of Wei v. Zoox, C.A. No. 2020-1036-KSJM, where the court addressed the intersection of legal principles at play in the realms of 8 Del. C. Section 220 (permitting a stockholder of a Delaware corporation to inspect certain books and records of the entity) (Sec. 220); certain timing and informational realities in play in private company M&A transactions that might limit a stockholder’s use of Sec. 220; and the scope of discovery in a statutory appraisal proceeding prosecuted by a former stockholder of a Delaware corporation pursuant to 8 Del C. Section 262 (Sec. 262). As framed by the court: “No Delaware court has yet confronted the precise issue presented by respondent’s motion—whether an appraisal petitioner may obtain full discovery in an appraisal proceeding where the proceeding was commenced for the purpose of pre-suit investigation.” Put another way, the particular question before the court was whether a former stockholder, who could not use Sec. 220 as a tool to investigate potential wrongdoing by fiduciaries in a merger transaction, may nevertheless file a statutory appraisal action and use the rather broad discovery rules of Rule 26 of the Court of Chancery Rules solely—or perhaps primarily—for the purpose of such an investigation to aid a potential direct, class action against fiduciaries for alleged misconduct in the merger.
On the facts of this case, the chancellor answered in the negative. The court did, however, grant the stockholder access to discovery in the appraisal litigation that would essentially mirror the more limited inspection rights attendant to Sec. 220.
On June 24, 2020, Zoox, Inc. (the company) entered into a merger agreement to be acquired, and on June 25, 2020, the merger was approved by the holders of the company’s voting equity via written consent. On July 6, 2020, the company’s stockholders received an information statement notifying them of the estimated merger consideration (between $0.69 and $0.76 per share).
On July 23, 2020, two common stockholders of the company, James Wei and Yanzin Zhang (together, petitioners) demanded appraisal of their shares—13,000 shares and 29,166 shares, respectively—pursuant to Sec. 262. The petitioners later served the company with demands to inspect the books and records of the company for the purpose of investigating potential wrongdoing in connection with the merger, pursuant to Sec. 220. Sec. 220 grants a responding corporation five business days to respond to a Sec. 220 demand before a stockholder may file an action in the Court of Chancery to enforce the statutorily sanctioned inspection rights. Here, the merger closed before the expiration of that five day period, which has the consequence of divesting the stockholders of standing to pursue a Sec. 220 inspection. Nevertheless, several days later the petitioners filed an action pursuant to Sec. 220 seeking to enforce their inspection rights.
In October 2020, the petitioners withdrew their demand for appraisal for more than 95% of their shares, leaving a combined 2,000 shares subject to the appraisal proceeding, which had the practical effect of the petitioners accepting the merger consideration for the vast majority of their shares, and the shares now subject to appraisal having a value of less than $2,000 at the merger price. The court noted that even if the petitioners were correct in their belief that the shares were worth substantially more than the merger price, it was unlikely to exceed even $20,000—10 times the merger price. After filing their appraisal action, three days later the petitioners dismissed their prior-filed Sec. 220 litigation via a notice of voluntary dismissal, stating their belief that in the appraisal action they “would be entitled, at a minimum, to discovery of the same material sought” in the Sec. 220 litigation.
In discovery in the appraisal litigation, the petitioners sought discovery materials that essentially doubled the number of categories of documents originally demanded in the Sec. 220 proceeding (from 23 to 53 categories). While the company initially produced the types of documents that have come to be known as “Formal Board Materials,” in the Sec. 220 context that related to the consideration and approval of the merger, it objected to producing in discovery other types of documents and information, such as emails or other electronically stored information. The company estimated that the costs to gather, review and produce the latter types of discovery materials would range “from approximately $50,000 to $130,000.”
The company moved for a protective order, making two primary arguments. First, the company argued that the discovery being sought in the appraisal action was disproportionate to the needs of the case in violation of Rule 26 when the costs of that discovery were compared to the amounts at issue in the litigation. Second, the company argued that “policy considerations militate against granting an appraisal petitioner full discovery where the petitioner’s clear purpose is to investigate a follow-on claim for breach of fiduciary duty.” The court rejected the first argument but adopted the second.
In rejecting the company’s Rule 26 argument regarding proportionality, the court recognized that, in general, the “court construes the scope of discovery permitted under Rule 26 liberally in favor of the free exchange of information, even in statutory appraisal proceedings.” While Rule 26 had been amended in 2019 to specifically add the proportionality clause, the chancellor found there was no intent in doing so to overturn precedent that made clear that Sec. 262’s “statutory mandate applies regardless of the size of the petitioner’s stake.” Thus, because the “General Assembly has mandated that the court perform an appraisal function regardless of the size of the petitioner’s stake,” the chancellor rejected the company’s arguments that the proportionality aspects of Rule 26 should limit the scope of discovery in this Sec. 262 appraisal proceeding.
The court found merit in the company’s policy-based argument. In her ruling, the chancellor first discussed the law and policy that give life to Sec. 220. Critical to the court’s analysis was the chancellor’s recognition that:
The stockholder-standing requirement and the five-day rule make Section 220 an imperfect tool for investigating acquisitions of private companies. While federal securities laws ensure that stockholders of public companies have a window of time after notice of impending M&A transactions to pursue a books and records action, nothing prohibits private companies from agreeing to close on a shorter timeline.
The court further recognized that the scope of an inspection pursuant to Sec. 220 is “relatively limited.” The chancellor contrasted this limitation of Sec. 220 to the reality that “aspects of appraisal proceedings pursuant to Sec. 262 render them particularly effective information-gathering tools” because “discovery in an appraisal proceeding is almost guaranteed” given the limited procedural mechanisms available for early dismissal or resolution of such actions short of trial. While the court discusses the historical basis for which stockholders might use information obtained in discovery in appraisal proceedings to file ancillary actions for breaches of fiduciary duty, it focused here on its finding that these petitioners were seeking “full discovery in an appraisal proceeding that had been commenced for the purpose of conducting a pre-suit investigation” and not for purposes of actually seeking a statutory valuation of their stake in the company. In those circumstances, the court held that appraisal petitioners would not be entitled to full discovery in that action, but rather, “are entitled to nor more information through discovery than what they would be entitled to through a Section 220 proceeding.”
The court closed its opinion with a word of caution to legal counsel to corporate defendants that find themselves involved in Sec. 262 appraisal proceedings:
The risk of this holding is that it will inspire defense attorneys to engage in wasteful discovery and motion practice targeting appraisal petitioners’ purposes. This should not be the takeaway. The facts of this case are unusual. The findings concerning the Petitioners’ purpose are based on clear, objectively reasonable facts. It would be a mistake to conclude from this decision that it is open season on an appraisal petitioner’s purposes.
Given the court’s ruling in Zoox, stockholders of Delaware corporations that are facing the decision of whether to seek appraisal of their stock following a qualifying transaction will still need to consider carefully all of the economics that surround such a decision, but the fact that such litigation might lead to discovery of other—potentially more lucrative—claims for breach of fiduciary duty will likely be a less prominent factor.
Reprinted with permission from Delaware Business Court Insider, © ALM Media Properties LLC. All rights reserved.
