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Standard to Allege Mismanagement in Motion to Dismiss Section 220 Complaint

June 4, 2014
Albert H. Manwaring, IV
Delaware Business Court Insider

Section 220 of the Delaware General Corporation Law permits a stockholder to inspect the books and records of a corporation, provided that the demand for inspection meets certain form and manner requirements, and the inspection is sought for a proper purpose—e.g., one reasonably related to the interests of stockholders. It is well established that the investigation of corporate mismanagement or wrongdoing is a proper purpose under DGCL Section 220. But, to state a proper purpose to investigate mismanagement or wrongdoing of a corporation, a stockholder must allege a "credible basis" to infer "possible" mismanagement or wrongdoing. The Court of Chancery has noted that the "credible basis" standard has, however, the lowest possible burden of proof under Delaware law.

A Section 220 action for books and records is a summary proceeding. In commenting on whether a defendant should move to dismiss a books-and-records action under Court of Chancery Rule 12(b)(6), the court has counseled against filing a motion to dismiss a Section 220 complaint. The court has explained that the plaintiff-friendly standard in a motion to dismiss combined with the lenient "credible basis" standard results in a "doubly" high burden to succeed in a motion to dismiss a Section 220 complaint, which results in inefficiency. The motion to dismiss will delay the summary Section 220 action that would otherwise have proceeded expeditiously to trial. At the trial of a Section 220 action, where it is unconstrained by the procedural posture of a motion to dismiss, the court may make determinations about the sufficiency of evidence and weigh competing inferences to strike the balance required under the "credible basis" standard between granting stockholders proper access to a corporation's records and protecting them from wasteful fishing expeditions based on the mere suspicion or curiosity of a stockholder. A recent transcript decision of the Court of Chancery reaffirms these principles, and clarifies the "credible basis" standard to state a proper purpose to investigate mismanagement or wrongdoing in the context of a Rule 12(b)(6) motion to dismiss a Section 220 complaint.

Under the unusual set of facts presented in Louisiana Municipal Police Employees' Retirement System v. The Hershey Co., (Del. Ch. November 8, 2013) (Legrow, M.), the master in chancery recommended dismissal of a complaint in a books-and-records action on the grounds that the plaintiff stockholder failed to state a "credible basis" for corporate mismanagement under Rule 12(b)(6). In a March 18 decision, Vice Chancellor J. Travis Laster declined, however, to follow the dismissal recommendation of the master, ruling instead that the stockholder's complaint stated a proper purpose to inspect books and records in the context of a Rule 12(b)(6) motion. In Louisiana Municipal Police Employees' Retirement System v. The Hershey Co., Civil Action No. 7996-ML (Del. Ch. March 18, 2014) (Laster, V.C.), the court held that drawing all competing inferences in favor of the plaintiff stockholder as required in a Rule 12(b)(6) motion, the stockholder had sustained its minimal burden to state a "credible basis" to infer "possible" mismanagement or wrongdoing of defendant The Hershey Co. to support a proper purpose to inspect Hershey's books and records under Section 220 of the DGCL.

Background

The plaintiff stockholder brought an action to obtain books and records from Hershey in connection with its alleged mismanagement and wrongdoing in purchasing cocoa from farms in West Africa, farms that utilize child labor, to make Hershey's iconic chocolate candy. The plaintiff alleged statistics that Hershey controls 42 percent of the chocolate market in the United States and is a major player in the chocolate industry worldwide. Approximately 70 percent of the world's supply of cocoa, and the largest percentage of Hershey's supply of cocoa, comes from West African nations, including Ghana and the Ivory Coast. A 2011 report from the Payson Center for International Development at Tulane University found that child labor on cocoa farms and human trafficking continue to be extremely serious problems in West Africa, with children being forced to work in labor camps under horrific conditions. Issues of human trafficking, child labor and abuse in the West African cocoa industry are pervasive, well-known internationally, and undeniable. Hershey is a signatory to a 2001 protocol that sought industry-wide standards of public certification by 2005 that cocoa beans and derivative products, such as chocolate, have been grown or made without the worst forms of child labor. Hershey failed to meet the goal of the protocol to verify by 2005 that its supply chain of cocoa was not relying on child labor, and set a new goal of 2020 to make such public certification. Despite deep involvement and control over its cocoa supply chain, and concerns of stockholders and customers that Hershey's supply chain for cocoa possibly relies on child labor, Hershey has nevertheless declined to provide details about its sources of cocoa or to disclose its suppliers.

Motion to Dismiss

To support its claim of mismanagement or wrongdoing, the plaintiff alleged that Hershey's purchase of cocoa from suppliers linked to West Africa violated Ghana, Ivory Coast and federal law. The plaintiff asserted that Hershey violated laws of Ghana and the Ivory Coast that prohibit employing children below a certain age, Ghana's Human Trafficking Act, and the United States' Trafficking Victims Protection Reauthorization Act of 2008. Before the court was defendant Hershey's motion to dismiss the plaintiff stockholder's complaint based on the failure to state a proper purpose for the inspection of Hershey's books and records. As required by the Delaware Supreme Court's decision in DiGiacobbe v. Sestak, 743 A. 2d 180 (Del. 1999), Laster did not give the master's report any deference, and therefore reviewed the motion to dismiss de novo.

The court first set forth the reasonable-conceivability standard under Rule 12(b)(6) that asks whether there is a "possibility" that the allegations in the complaint, after drawing all inferences, including competing inferences, in plaintiff's favor, support a claim for relief. Next, the court set forth the credible-basis standard established by the Delaware Supreme Court in Seinfeld v. Verizon Communications, 909 A. 2d 117 (Del. 2006),to state a proper purpose to investigate mismanagement or wrongdoing of a corporation under Section 220 of the DGCL. The court explained that under Seinfeld, the credible-basis standard does not require a plaintiff to prove that "actual" mismanagement or wrongdoing is occurring, but rather, a plaintiff must show, by a preponderance of the evidence, that there is a "credible basis" to infer "possible" mismanagement or wrongdoing that would warrant further investigation—a showing that may ultimately fall well short of demonstrating that in fact anything wrong occurred. Therefore, the court concluded that to state a proper purpose to investigate mismanagement or wrongdoing in a Section 220 action under Rule 12(b)(6), the plaintiff stockholder only had to show that there was a "possibility" that the allegations in the complaint stated a "credible basis" to infer "possible" mismanagement or wrongdoing, creating at this procedural stage a "double" possibility standard, and a very high hurdle to overcome to succeed on a motion to dismiss a Section 220 action.

The court found that the plaintiff had pleaded sufficient allegations to state a credible basis to infer possible mismanagement or wrongdoing of Hershey in the context of a 12(b)(6) motion to dismiss. The court explained that in applying the credible-basis standard, the master's report and Hershey's brief repeatedly focused on whether actual violations of the law or wrongdoing had occurred, which is not the correct standard under Seinfeld. Rather, the proper standard is whether the allegations support an inference of possible violations of the law or wrongdoing. Turning to the credible basis (and applying the proper standard) for possible wrongdoing, the court reasoned that one possible reasonable inference from the allegations in the complaint was that Hershey's board knew that some of its cocoa is being sourced from farms that exploit child labor and use trafficked persons in violation of the laws of Ghana. The court also pointed out that one possible inference from Hershey's cocoa sustainability efforts, which put Hershey in contact with West African farmers, results in Hershey having knowledge of instances involving the use of trafficked children on cocoa farms in Ghana, which knowledge triggered a duty to inform under the law of Ghana. Lastly, one possible inference is because of its relationship and control of its cocoa suppliers, and its failure to nevertheless provide information about its suppliers, Hershey is aiding and abetting the use of child labor in violation of international law.

In sum, the court held that the plaintiff had sufficiently shown at the pleadings stage a "credible basis" to infer that Hershey had possibly violated the law. Accordingly, because the plaintiff had stated a proper purpose to investigate mismanagement or wrongdoing in connection with Hershey's alleged purchase of cocoa from West Africa under Rule 12(b)(6), the court denied Hershey's motion to dismiss, and set the case down for trial within 60 days.

Lessons Learned

Unless a complaint fails to show any possibility that the allegations would support a credible basis to infer possible mismanagement or wrongdoing, defendants must carefully evaluate whether a motion to dismiss is an efficient means to obtain dismissal of a Section 220 action. In light of the plaintiff-friendly standard in a motion to dismiss and the lenient credible-basis standard, which results in a "doubly" high burden to succeed in a Rule 12(b)(6) motion, a defendant's moving expeditiously to trial in a summary Section 220 action is likely a more efficient and expedient course of action to obtain dismissal than moving to dismiss a Section 220 complaint (with such motion's attendant delay and probability of failure) under Rule 12(b)(6).