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Hearsay OK, gamesmanship not, in books-and-records trials: Dela. justices

The seal of The Delaware Supreme Court is seen in Dover, Delaware, US REUTERS/Andrew Kelly

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  • Nvidia Corporation v. City of Westland Police and Fire Retirement System Opinion

  • Thomas & Betts Corporation v. Leviton Manufacturing Co Opinion

(Reuters) – The Delaware Supreme Court refused this week to restrict shareholders’ use of hearsay evidence to justify their demands for access to corporate books and records – but warned plaintiffs not to abuse that leeway by refusing to give defendants fair notice about their trial plans .

The state justices held in Nvidia Corporation v. City of Westland Police and Fire Retirement System that Chancellor Kathaleen McCormick of Delaware Chancery Court did not err when she allowed shareholders to rely on hearsay evidence — statements contained in their original demand for Nvidia books and plaintiffs’ responses to Nvidia’s interrogatories, rather than live testimony – to establish their proper purpose in seeking corporate records.

Shareholders asserted in their demand that they needed the internal records to investigate corporate potential wrongdoing in Nvidia’s handling of a sudden spike and subsequent decline in demand for graphic processing units, which are used by video gamers and cryptocurrency miners.

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Nvidia’s lawyers at Cooley and Richards, Layton & Finger had argued that no Chancery Court judge has allowed shareholders to rely on hearsay evidence to establish a proper purpose for books and records demands under Section 220 of Delaware’s corporate code without assent from the defendants. Here, Nvidia argued, it did not agree that the hearsay evidence was sufficient. In fact, the company said, it repeatedly told shareholders before trial on their 220 demand that Nvidia wanted an opportunity to contest the legitimacy of their intentions, either by cross-examining a live witness or challenging plaintiffs’ affidavits with deposition testimony.

The Delaware justices, in an opinion written by Justice Tamika Montgomery-Reeves, said the Supreme Court implicitly endorsed the use of reliable hearsay evidence to establish proper purpose back in 1996, in Thomas & Betts Corporation v. Leviton Manufacturing Co. Montgomery-Reeves, who has been nominated for a spot on the 3rd US Circuit Court of Appeals, said numerous subsequent Chancery Court decisions have relied on the evidentiary loophole established in that ruling.

“It appears to us,” the justice wrote, “that Thomas & Betts has provided an answer to the hearsay issue: Hearsay is admissible in a Section 220 proceeding when that hearsay is sufficiently reliable.”

As the decision noted, the holding on hearsay evidence is a boon to plaintiffs’ lawyers. Books and records demands have become a fertile arena for litigation in recent years, with shareholders now routinely exercising their right to examine internal corporate documents in order to obtain evidence for derivative breach-of-duty claims. The court’s explicit endorsement of the hearsay evidence gives shareholders one less concern in Section 220 trials.

But the Supreme Court added an important corollary in the Nvidia ruling: The loophole “should not be abused,” wrote Montgomery-Reeves. “Plaintiffs in a Section 220 proceeding must be upfront about their plans regarding witnesses. Such transparency ensures that companies can choose whether to depose the stockholders during discovery or call the stockholders as witnesses at trial.”

Shareholder lawyers in the Nvidia case, the Supreme Court said, fell short on that score. Nvidia, according to the Delaware justices, asked plaintiffs before trial to disclose whether they planned to call witnesses to establish the purpose of their Section 220 demand. Shareholder lawyers said they were considering affidavits instead.

Nvidia, which had opted not to depose any plaintiffs, said it needed to see the affidavit in advance to determine whether it needed to conduct a deposition. Shareholders did not respond until after the deadline for identifying trial witnesses, when they informed Nvidia that they were willing to discuss a deposition. Ultimately, plaintiffs chose not to submit an affidavit but to rely on previous court filings.

Those tactics, wrote Montgomery-Reeves, deprived Nvidia of its right to challenge shareholders’ purported purpose. “This type of behavior creates the potential for gamesmanship, which should be discouraged,” the Supreme Court said. “If stockholders are going to introduce sufficiently reliable hearsay to establish a proper purpose, they must communicatedly and early with companies regarding their intent so as to allow companies to decide to depose the stockholders or to identify their own witnesses for trial.”

McCormick had ruled that Nvidia was required to turn over emails and other communications related to shareholders’ allegation that top Nvidia executives profited from stock sales based on insider information about supply and demand for the graphic processing units. Because the justices found that Nvidia shareholders were not sufficiently transparent about the evidence they relied upon, the Supreme Court vacated that ruling and remanded the 220 action to McCormick to allow Nvidia to test the legitimacy of shareholders’ demand for the records.

The Supreme Court rejected several other arguments by Nvidia, including its contention that the Chancery Court judge was confused by shareholders’ ever-shifting demands and ordered the company to produce documents that do not exist. “The Court of Chancery was far from confused,” the justices said, noting that McCormick’s discovery order was based on claims that emerged in parallel securities action after shareholders’ original Section 220 demand for books and records.

The justices also said that, in their view, shareholders’ claims met the lenient standard for establishing a proper purpose for a Section 220 demand. “While this evidence likely would fall far short of that necessary to support an actual claim, we cannot say that it is insufficient to meet the lowest possible burden of proof — a credible basis from which the Court of Chancery can infer there is possible mismanagement that would warrant further investigation,” the court wrote.

Nvidia counsel from Cooley and Richards Layton did not respond to my query. Nvidia has argued that shareholders’ insider trading claims are entirely meritless, as demonstrated by the dismissal of the shareholder class action where the claims emerged. Nvidia also asserts that the supply chain issues were a brief setback from which the company – and its share price — quickly recovered.

Shareholder lawyer Seth Rigrodsky of Rigrodsky Law, who argued the case before the Delaware justices, did not respond to my email. Shareholders are also represented by Hach Rose Schirripa & Cheverie, Levi & Korsinsky, Robbins Geller Rudman & Dowd, Monteverde & Associates and Gainey McKenna & Egleston.

Read more:

Chancery’s harsh new message to defendants: ‘Egregious’ Section 220 fights will cost you big

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