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Delaware Supreme Court Addresses Scope of Relief in Section 220 Actions

December 14, 2011
Morris James LLP
Delaware Business Court Insider

Espinoza v. Hewlett-Packard Co. reflects the Delaware Supreme Court's latest guidance on the scope of relief available to a stockholder under 8 Del C. § 220. This decision arose from the departure of defendant Hewlett-Packard's former CEO and chairman, Mark Hurd.

Hurd left HP after an investigation into allegations that he had sexually harassed a former HP contractor. HP retained Covington & Burling to conduct the investigation and Covington & Burling prepared a report. One week after the HP board received the Covington Report, Hurd settled with the contractor and, shortly thereafter, HP announced Hurd was leaving the company. HP announced that the investigation revealed Hurd had violated HP's standards of business conduct, but not that Hurd had committed sexual harassment. HP did not terminate Hurd for cause. Instead, HP approved a separation agreement with approximate severance payments of $30 million to Hurd.

A number of stockholder derivative actions were filed after Hurd's resignation. Plaintiff Ernesto Espinoza, an HP stockholder, demanded books and records relating to Hurd's resignation under 8 Del. C. § 220. Although HP disputed Espinoza's entitlement to these books and records, it provided much of the documentation he sought. HP, however, refused to provide the Covington Report, claiming it was subject to attorney-client privilege and work-product protection.

Espinoza demanded the Covington Report and filed a Section 220 action after HP again refused to provide it. The Court of Chancery concluded that Espinoza had not demonstrated the required need for the Covington Report to overcome either the attorney-client privilege or work-product doctrine. Thus, HP did not have to produce the Covington Report. Because the Court of Chancery found that the Covington Report was protected by the attorney-client privilege and work-product doctrine, it did not consider it necessary to resolve whether Espinoza had established a right to inspect the Covington Report. Espinoza appealed the Court of Chancery's judgment in favor of HP.

The Delaware Supreme Court, sitting en banc, affirmed the Court of Chancery's judgment in favor of HP, but on alternative grounds. The Supreme Court recognized that Espinoza had stated a proper purpose under Section 220 - to investigate possible wrongdoing - and had shown there was a credible basis to infer possible mismanagement. Espinoza still had to show, however, that the books and records he demanded were essential to the stated purpose for inspection. A document is essential if it addresses the crux of the stockholder's purpose and if the essential information was not available from another source. This is a fact-specific inquiry.

According to Espinoza, the Covington Report was essential to his purpose of investigating why the HP board paid Hurd millions of dollars in severance rather than firing him for cause, because it contained a discussion of potential disciplinary options or was the basis for the board's discussion of disciplinary options.

The Supreme Court concluded Espinoza had failed to satisfy his burden of proving the Covington Report was essential to his purpose. First, HP represented to both the Court of Chancery and Supreme Court that the Covington Report did not discuss whether HP could terminate Hurd for cause. Based on that representation, the Court of Chancery found that the Covington Report did not discuss the "for cause" issue at all and Espinoza did not directly contest that finding on appeal. Interestingly, the Supreme Court noted that an in camera inspection by the trial court may be appropriate in a dispute over the contents of demanded materials.

Second, there was no evidence that the Covington Report played any role, let alone a central role, in the board's decision-making process regarding the "for cause" issue. Covington did not prepare the report so that the board could decide whether to terminate Hurd for cause. Additionally, the board held multiple meetings between receipt of the Covington Report and Hurd's departure, but Covington provided no further reports and it was unclear whether Covington even participated in later meetings.

Finally, HP had disclosed the essential aspects of the Covington Report to Espinoza. HP provided Espinoza with extensive documentation concerning Hurd's departure, including the allegations leading to the investigation, records documenting his misconduct and the key findings of the Covington Report.

The Supreme Court did not reach the issue of whether the Covington Report was protected from disclosure based upon the attorney-client privilege or work-product immunity. Once the court determined that the Covington Report fell outside the scope of relief Espinoza was entitled to under Section 220, it was not necessary to address the privilege issues.

As this case illustrates, a stockholder may not receive certain books and records even if he or she establishes a proper purpose. Stockholders making demands must be prepared to show that the books and records demanded are also essential to their purpose.

In responding to books and records demands, company counsel should keep the "essentiality" requirement in mind as it will narrow what a company must produce in response to a proper demand. This case also reflects the trust Delaware courts will place in counsel. In reaching its decision, the Court of Chancery relied on the representations of HP's counsel that the Covington Report did not discuss whether Hurd could be terminated for cause. That reliance was critical to the Supreme Court's holding that Espinoza had not established the Covington Report was essential to his demand purpose.

Although the Supreme Court noted that the Court of Chancery could have reviewed the Covington Report in camera, it did not hold that the Court of Chancery was required to do so. This case is a reminder that gaining the trust of Delaware courts is important for attorneys appearing in those courts.