Delaware Court Of Chancery Imposes Incorporation-By-Reference Condition On Section 220 Production, Consistent With Other Recent Decisions
On October 12, 2017, Vice Chancellor Sam Glasscock III of the Delaware Court of Chancery agreed to impose an “incorporation-by-reference” condition on any production by Universal Health Services, Inc. (“UHS”) in response to a books-and-records demand under Delaware General Corporation Law Section 220. City of Cambridge Ret. Sys. v. Universal Health Serv., Inc., C.A. No. 2017-0322-SG (Del. Ch. Oct. 12, 2017). In so disposing of the action to compel production brought by the UHS stockholder who made the Section 220 demand (The City of Cambridge Retirement System (“City of Cambridge”)), the Court explained that the interests of judicial and litigants’ economy outweighed whatever concern might exist that a company would manipulate “the universe of documents produced” to attempt to frustrate a later-filed derivative action.
Following a December 2016 online report, which claimed that UHS misdiagnosed and misled patients in order to maximize insurance payments, the stockholder sought to investigate the alleged wrongdoing for purposes of potential derivative litigation. On March 9, 2017, the City of Cambridge sent UHS a Section 220 demand and proposed confidentiality agreement. UHS objected to the demand as overbroad and offered to produce certain documents if the stockholder would agree to a confidentiality agreement that included an incorporation-by-reference provision, which had been accepted by two other UHS stockholders who made Section 220 demands. The provision would have incorporated by reference into any follow-on complaint that relied upon any produced corporate record (or information gleaned from such a record) all documents produced by UHS in response to the Section 220 demand. The stockholder refused and filed an action pursuant to Section 220 to compel inspection.
In opposing UHS’s request for imposing the incorporation-by-reference condition, the stockholder argued that conditioning a Section 220 production on incorporation-by-reference frustrates the prosecution of meritorious cases because the condition allows a company to “produce a self-selected subset of documents of their choosing, without any punishment for failing to produce harmful documents.” City of Cambridge further argued that incorporation-by-reference conditions disadvantage a stockholder, who cannot test the sufficiency of Section 220 production in the same way as a litigant receiving discovery. While Vice Chancellor Glasscock acknowledged these concerns, he explained that incorporation by reference allowed a company to respond to allegations in a complaint that are based on “cherry-picked documents [ ] taken out of context,” which better enables the Court to assess the merits of a claim than would the traditional Rule 11 limits restricting the Court’s analysis to the four corners of the complaint. The Court also noted that comparable conditions were imposed recently in several other actions to compel Section 220 productions, and because nothing in the record suggested a heightened risk of malfeasance by the company in this particular case, the Court found no reason to deviate from that precedent.