The Delaware Court of Chancery recently issued an opinion making a narrow but key distinction in appraisal proceedings: the petitioners’ underlying intent in filing a Section 262 action matters. The court held that petitioners should not be allowed to obtain full discovery where the sole purpose in bringing the appraisal proceeding is to investigate potential wrongdoing. In this case, such intent was determined from Petitioners’ de minimis financial stake in the company.
Key Factual Background
Two investors of Zoox, Inc., an autonomous ride-hailing venture, petitioned the Delaware Chancery Court for an appraisal of their shares pursuant to Section 262 of the Delaware Code. The Petitioners had previously served inspection demands pursuant to Section 220, but the merger in question closed prior to the completion of the five-day waiting period imposed under the statute, at which time Petitioners lost their standing to demand access to books and records. After the merger, Petitioners filed—but later withdrew—a complaint to enforce their Section 220 inspection rights prior to filing the underlying appraisal action. In voluntarily dismissing their Section 220 Action, the Petitioners noted their belief that, through the appraisal action, they “would be entitled, at a minimum, to discovery of the same material” previously sought in their books and records demand.
In response, Respondents primarily argued that the discovery requests violated the proportionality requirement of the Court of Chancery Rule 26 because the cost of discovery would significantly exceed the amount in controversy. The court rejected this argument, following a long line of cases that hold that the size of an appraisal petitioner’s holdings does not determine the scope of discovery. The Court of Chancery further declined to adopt a new approach in light of the 2019 amendments to Rule 26, concluding that the amendments did not dramatically alter Delaware law. Respondents further argued that the Petitioners’ sole purpose in the appraisal action was to investigate potential wrongdoing and that policy considerations weigh against using an appraisal action for such purpose. This argument is the crux of the court’s decision.
Before getting further into the details of the opinion, below is a brief overview of Section 220 and Section 262:
Section 220 is an exception to the general rule that a plaintiff may not file a lawsuit for the sole purpose of investigating future claims through discovery. However, Section 220 has some limitations that make it a challenging tool in the M&A context. First, a stockholder must wait five days after serving a demand for inspection before filing an enforcement action. Second, the statute requires that a stockholder own stock at the time of any enforcement proceeding, and thus such action must be filed prior to the transaction’s close. This is a problem when it comes to private companies because nothing prohibits the companies from closing in less than five days, which in effect may block investors from enforcing inspection demands because the investors lose ownership of their stock prior to the time they can file an action. Finally, Section 220 limits plaintiff’s discovery rights to those documents necessary to satisfy the stockholder’s stated purpose.
Section 262, which governs appraisal proceedings, does not have the same limitations. Additionally, discovery is substantially broader under Section 262 because it is to be liberally construed under Rule 26.
The Court of Chancery applied the principles in Cede against the backdrop of the evolving availability of Section 220 pre-suit investigations. In Cede, the Delaware Supreme Court recognized the value of Section 262 appraisal proceedings in uncovering fiduciary misconduct, and thus refused to foreclose shareholders who elect appraisal rights from later bringing fraud actions based on evidence uncovered in the appraisal proceeding. In doing so, the Delaware Supreme Court relied on two main policy considerations: (1) that appraisal proceedings were the exclusive means of pre-suit investigation and (2) that it would be inequitable to bar those seeking appraisal rights from later pursuing fraud claims because doing so would in effect immunize a controlling shareholder from such claims.
In addressing the question before them, the Court of Chancery recognized that the first policy concern stated in Cede is generally no longer applicable due to recent case law strengthening Section 220 as a means of pre-suit investigation. However, the court recognized that the policy concern is still a reality when dealing with private companies who can agree to close in fewer than five days. Importantly, the Court of Chancery reasoned that, to allow what Petitioners were seeking—i.e., full discovery where Petitioners’ sole purpose was to investigate wrongdoing—would “stretch Cede beyond its facts.” The opinion thus suggests full discovery in appraisal actions should only be allowed where there exists at least some valid purpose—beyond pre-suit discovery—for bringing the appraisal action.
- Generally, a court should limit discovery in Section 262 appraisal proceedings where the sole purpose of the suit is to investigate wrongdoing. A court may consider a petitioner’s de minimis financial stake when determining intent.
- If the company in question is private, an appraisal may be an appropriate tool for the sole purpose of investigating future claims. But even in such instances, discovery will be limited to that which could be attained in a Section 220 books and records demand.
Ultimately, policy concerns weigh against allowing Section 262 to be used to expand upon the discovery that is available under Section 220. As a result, appraisal respondents should evaluate whether a petitioner’s interest is de minimis, or whether there is any other indicia of intent to justify limiting discovery.