Nonetheless, the petitioners filed a Section 220 action to enforce their inspection rights on August 13, 2020. On October 9, 2020, the petitioners withdrew their appraisal demands with respect to more than 95 percent of their collective shares. As a result, the petitioners only left 2,000 of their collective shares subject to appraisal. These 2,000 shares were worth less than $2,000 at the merger price, and the court found that even if it accepted the petitioners’ allegations as true, it would be unlikely that the shares would be worth more than $20,000 (which would represent over ten times the merger consideration).

The petitioners filed the Section 262 action on December 7, 2020, and voluntarily dismissed their Section 220 action. In the notice of voluntary dismissal, the petitioners stated that they believed the Section 262 action would entitle them “at a minimum to discovery of the same material sought” in the Section 220 action.

The petitioners served document requests in the Section 262 action on January 15, 2021. These requests sought 53 categories of documents, which included the 23 categories of documents sought in the petitioners’ Section 220 demands. In response, the respondent produced board-level materials, which included “all board-level materials concerning the company’s valuation and financial performance, the Amazon deal, alternative transactions, all non-disclosure agreements entered into with any potential counterparties to an alternative transaction, and a waterfall analysis of the liquidation preferences of the various classes of Zoox stockholders, updated as of July 31, 2019.” The respondent subsequently provided an updated (as of closing) waterfall analysis as well.

The respondent objected to producing emails or other electronically stored information (ESI). The petitioners proposed protocols to narrow their discovery demands. Even with the narrowed perimeters, the respondent estimated that the process would generate vendor costs ranging from approximately $50,000 to $130,000. The respondent moved for a protective order.

Analysis

The respondent advanced two arguments in favor of a protective order. First, the respondent’s “lead argument” was that the discovery requested (and the cost to produce the discovery) was “massively disproportionate” to the value of the litigation based on the shares at issue. Even if petitioners were entirely successful, their stock would appraise for no more than $20,000. But discovery costs would likely exceed $50,000. The respondent argued that the discovery would run afoul of the proportionality requirement of Chancery Rule 26.

The court rejected this argument. The court held that under well-established precedent, the proportionality requirement alone should not limit the scope of discovery in an appraisal action based on the size of the petitioner’s stake. The court also rejected the argument that the 2019 amendment to Chancery Rule 26 changed the rule in substance, finding that the added language was simply a “clarification” that “is not intended to change the scope of available discovery under the Delaware rules.”

It was the second argument that won the day. The respondent argued that given the relatively small financial benefit the petitioners stood to gain, the only reasonable inference was that they were pursuing appraisal merely to obtain the discovery that they had failed to get through the Section 220 process with the ultimate aim of bringing breach of fiduciary duty claims. The respondent argued that this ulterior motive violates the well-established principle of Delaware law that a litigant is not entitled to conduct discovery for the purpose of developing new causes of action. The petitioners did not deny that information gathering was among their aims but maintained that it was not their sole purpose.

The court exercised its broad discretion to limit the discovery to the materials that the petitioners would have received in a Section 220 action. The court held that “public policy militates against granting appraisal petitioners full discovery where the proceeding is an obvious replacement for an unavailable Section 220 action.” Delaware courts have encouraged would-be plaintiffs to use Section 220 as their mechanism for pre-suit investigation. The scope of discovery under Section 220 is markedly narrower than the scope under Section 262. If the court were to bless Section 262 as an alternative path for pre-suit investigation, would-be plaintiffs would likely start using Section 262 instead to avail themselves of its broader discovery. This result would run contrary to Delaware lawmakers’ efforts to limit appraisal litigation and would undermine the Court of Chancery’s efforts in refining Section 220 law.

The court found that the appraisal action in this case was “an obvious replacement” for Section 220, taking into account the timing of the action and the fact that the appraisal proceeding would be “an economically irrational investment” given that the value of the shares in question would be unlikely to exceed $20,000.

Nonetheless, the court did not rule that the petitioners should leave empty handed. The court held that the petitioners should be permitted to obtain the documents that they would have received through the Section 220 process given that they were “foreclosed from pursuing a Section 220 action through no fault of their own.” The Court acknowledged that “Section 220(c)’s stockholder-standing requirement and five-day rule render Section 220 an imperfect tool for investigating M&A transactions in the private company context” where investors lack the protections of federal disclosure laws and other regulations applicable to public companies. Thus, there may be circumstances where relevant information of bad acts would only come to light through an appraisal action. The court noted that it would be a matter for further submissions whether the board-level materials that the respondent had already produced in this case were sufficient to satisfy the Section 220 standard.

Takeaways

• Discovery in a Section 262 appraisal action is broad, and there is no requirement that the costs of this discovery be “proportionate” to the value of the shares in dispute. The 2019 revisions to Chancery Rule 26 did not alter the scope of discovery available.
• The Court of Chancery is amenable to allowing would-be plaintiffs to seek discovery in a Section 262 appraisal action as a “substitute” for Section 220.
• However, where it is clear that the purpose of the appraisal action is just to function as a substitute for Section 220, the court will limit discovery to the narrower discovery that the petitioner would have received through a Section 220 action.

Client Alert 2022-073