Third Circuit Rejects Automatic Denial of Tolling of Statute of Limitations During Pendency of Section 220 Books and Records Action
In an opinion issued on June 13, 2017, the United States Court of Appeals for the Third Circuit (the Court) held that courts may not categorically decline to toll the statute of limitations with respect to underlying claims for corporate misconduct during the pendency of an action under § 220 of the Delaware General Corporation Law (DGCL) seeking access to books and records simply because the stockholder knew or had reason to know of facts relating to the potential wrongdoing prior to initiating such action. In Norman v. Elkin, if the statute of limitations was not tolled, the underlying claims would have been barred from being brought by the time the § 220 action had concluded. The Court emphasized that automatic denial of tolling in this context would be incompatible with Delaware’s intent to encourage § 220 actions. The Court recognized the importance of § 220 actions in uncovering information that may be necessary for a stockholder to actually pursue an action for misconduct or deceitful activity. Further, the Court encouraged other courts within the Third Circuit to have due regard for the positive function of § 220 actions in determining whether to allow tolling of the statute of limitations in future stockholder suits and recognize that tolling may be appropriate absent a countervailing consideration such as evidence of bad faith.
In the early 1990s, Jeffrey Norman and David Elkin founded US MobilComm Inc. (USM), a company that acquired, developed and sold rights to 220 megahertz radio frequencies (Frequencies). Norman owned 25% of the outstanding equity of the company, while Elkin owned 75%. The Frequencies had previously been available only for non-commercial use, but the FCC had recently announced a plan to grant licenses for commercial use (Licenses). The FCC granted the first wave of Licenses by lottery in 1991-92. At that time, Norman’s primary responsibility was to acquire, aggregate and manage the Licenses held by the initial holders across the country. By 1996, USM had successfully acquired several dozen Licenses and entered into agreements to manage over 150 more Licenses. By that point, Norman’s involvement in the day-to-day affairs of USM had ceased as Elkin continued to actively manage the company.
In 1998, the FCC began a second phase of issuing Licenses through an auction process. After Elkin registered the company for the auction, USM won several Licenses, which Elkin registered in the name of The Elkin Group (TEG), a separate company that he owned. Elkin claimed that TEG’s involvement was necessary to provide USM with the funds to partake in the auction and bid on Licenses and that this arrangement would ensure that a friendly corporation acquired any Licenses that overlapped with those already owned by USM. Meanwhile, Norman closely monitored the auction. Subsequently, he emailed Elkin requesting more information about the auction results and contacted the FCC seeking a status of Licenses acquired by USM at the auction. Although several FCC notices stated that USM was the winning bidder, other public documents referred to TEG as the Licenses’ owner.
At the time USM was formed, Norman and Elkin had entered into an oral agreement (the Oral Contract) to invest a proportional share of capital in USM to satisfy a $1 million capital requirement – with Norman to invest $250,000 and Elkin to invest $750,000. Disputes arose, however, as both parties allegedly failed to fulfill these obligations. Additionally, Elkin and the Assistant Secretary of USM alleged that Norman had taken USM funds for personal use. At Elkin’s direction, USM reduced Norman’s capital contribution due to these alleged personal expenditures. Elkin claimed that he was only required to maintain a capital contribution proportional to that of Norman, and, accordingly, reduced his own target to $420,000 pursuant to a Shareholder Loan Agreement. Under that agreement, USM would treat any amount Elkin contributed over $420,000 as a loan. Elkin contributed additional amounts to the company, as evidenced in a Shareholder Loan Schedule showing loans by Elkin to USM of over $690,000. In 2000-01, USM sold its initial Licenses and repaid $615,026 to Elkin but did not make any distributions to Norman.
In 2000 and 2001, Norman had received K-1 tax forms from USM, which stated that USM had realized a capital gain, but the forms did not list what was sold or report any shareholder loans or distributions. Nevertheless, in a deposition, Norman had admitted that a capital gain would have necessarily resulted from the sale of a License. In a 2002 telephone call, Elkin told Norman that several Licenses had been sold and that he had taken a distribution. Norman requested additional information from Elkin, which Elkin refused to provide. Subsequently, Norman’s attorney sent a letter requesting information pursuant to § 220 of the DGCL.
Approximately two months later, Norman received a letter from Elkin stating that USM had sold Licenses “it owned.” Included with the letter were purchase and sale agreements demonstrating that TEG had sold some of the Licenses that had been acquired at the auction, as well as an itemization of the uses of the proceeds, which included the repayment of so called “shareholder loans.” However, the payment to Elkin was significantly underreported. The Shareholder Loan Agreement was included in a later letter sent by USM to Norman’s counsel in response to a request for further information.
The parties then began what the Court described as a “long and tortuous litigation trail,” commencing with Norman filing suit in the Chancery Court in November 2004. Norman brought suit under § 220 to compel Elkin to allow inspection of USM’s books and records. Elkin opposed that proceeding, but in October 2005, the Chancery Court compelled USM’s disclosure of the requested documents.
Several months later, Norman filed a complaint in the Chancery Court, which was subsequently removed to District Court, asserting various claims against Elkin, USM and TEG (Defendants), including breach of contract, usurpation of corporate opportunities, conversion, fraud, breach of fiduciary duties and unjust enrichment. In response, Defendants moved for summary judgment, arguing that all of Norman’s claims were time-barred by the statute of limitations. The District Court denied their motion, ruling that pursuant to Delaware’s borrowing statute, Pennsylvania’s two-year statute of limitations applied to all but the breach of contract claim—to which the District Court applied Delaware’s three-year limitations period. The District Court agreed with Norman that Elkin’s alleged concealment of facts tolled the statute of limitations. Accordingly, the District Court explained that the limitations period began to run at the time Norman knew or should have known of the facts constituting Elkin’s alleged wrongdoing. Thus, the District Court determined that the claims could not be ruled untimely at the summary judgment stage.
The parties’ dispute went to trial in the District Court twice, with both juries returning verdicts for Norman. However, these verdicts were overturned post-trial as the District Court held most of Norman’s claims to be untimely and rejected others due to insufficient evidence. Norman appealed the District Court’s decision to the Third Circuit, challenging several of the court’s statute of limitations rulings and seeking to restore the jury verdicts. Specifically, he argued that the District Court had applied the wrong statute of limitations and that tolling was appropriate under the circumstances. Elkin cross-appealed seeking to affirm the rulings rejecting Norman’s claims.
The Court held that the District Court had applied the correct limitations period but had erred by applying the wrong standard when determining whether to toll the limitations period after Norman filed his § 220 action. In light of this finding, the Court remanded to allow the District Court to reconsider whether the limitations period should have been tolled and whether Norman’s claims were time-barred.
The District Court had concluded that a § 220 action would not operate to toll the limitations period in a situation such as this, where the plaintiff-stockholder knew or had reason to know of the facts constituting the alleged wrongdoing underlying his claim (Inquiry Notice) prior to initiating the § 220 action. The Court rejected the District Court’s “categorical denial” of tolling where a stockholder has Inquiry Notice. First, the Court looked to precedent in Delaware and noted that “Delaware case law does not support such a categorical rule forbidding tolling” in this context. In fact, the primary case relied on by the District Court suggested that a § 220 action may operate to toll a limitations period where there is Inquiry Notice.
Next, the Court emphasized that the District Court’s categorical rule was incompatible with Delaware’s apparent aim to encourage § 220 actions as a means to allow stockholders to resolve disputes with the aid of a streamlined books and records proceeding. The Court cited several Delaware opinions demonstrating this intent to encourage stockholders to avail themselves of § 220 proceedings and noted that a rule automatically forbidding tolling once a party had Inquiry Notice would effectively penalize the use of such “important tools.” The Court also explained that “if a shareholder has enough suspicion of wrongdoing to file a successful § 220 action, then there is some probability that the shareholder also has inquiry notice.” Further, the Court stated that such a rule would “swallow the general principle that tolling may apply after the filing of a § 220 action.”
In this regard, Delaware courts have declined to establish such a bright-line rule. Rather, “the pendency of such an action, and the relationship between it and the claims eventually filed, may in some circumstances operate to toll the limitations period” (emphasis added). Factors that weigh in favor of tolling include the existence of bad faith, deceitful conduct and evidence that a suit could not have been brought without the information gathered during the § 220 action. However, these factors are not prerequisites for tolling, and none of the parties pointed to any case where the court refused to toll after a successful § 220 action. “It seems, instead, that Delaware law preserves a court’s discretion to toll or not toll the limitations periods on claims that may be informed by the results of a § 220 action. The decision to toll is not dependent on inquiry notice” (emphasis added).
The Court then advised that courts within the Third Circuit should “proceed with due regard for the positive role that § 220 actions are meant to play under Delaware law,” particularly when the court has properly exercised its judgment and found that a § 220 action has merit. Under such circumstances, tolling is “likely appropriate absent a countermanding consideration, such as evidence that a shareholder pursued the § 220 action in bad faith or in order to stall.” In this case, Norman successfully sought relief under § 220, and there was no evidence of bad faith. In fact, Norman obtained valuable information through the action. In light of the foregoing considerations, the Court remanded to allow the District Court to determine whether tolling should apply to the period of Norman’s books and records action. Additionally, the District Court should undertake the highly fact-intensive inquiry of evaluating when Norman had Inquiry Notice in order to determine whether he should “benefit from tolling as a result of filing the § 220 action and if so, whether his claims are timely even if tolling is appropriate.”
The Norman v. Elkin decision offers useful guidance for addressing tolling of claims that may be informed by the results of a § 220 action under the DGCL. Importantly, a court’s review of such matters is not dependent on any rigid rule such as whether the plaintiff was on Inquiry Notice of the misconduct. The opinion is important because it preserves the value of §220 actions with respect to information gathering to determine whether there is just cause for bringing a lawsuit as to corporate misconduct or other similar matters. If the court had held that tolling was not permissible, then stockholders would be in the unenviable position of being required to commence lawsuits based on speculation and suspicions in order to avoid any ultimate suit being time-barred by the applicable statute of limitations.
We will continue to monitor any future developments on books and records requirements and considerations pursuant to § 220 of the DGCL. If you have questions or would like additional information, please contact Marc Casarino (firstname.lastname@example.org; 302.467.4520), Lori Smith (email@example.com; 212.714.3075), Bridget Henwood (firstname.lastname@example.org; 212.631.4421) or Michael Psathas (email@example.com; 212.868.4833).
 Specifically, the letter requested information relating to “the sale or other disposition of any assets or stock of [USM] over the past three (3) years, and the distribution or use of any proceeds or any such sales or dispositions.”
 In connection with his contract claim, Norman advanced three theories of Elkin’s breach of the Oral Contract: (1) Elkin failed to pay him his pro rata share of all proceeds, (2) Elkin refused to maintain his full capital contribution and (3) Elkin improperly caused USM to enter into the Shareholder Loan Agreement.
 The District Court explained that the conduct underlying those claims arose in Pennsylvania, citing several connections between the dispute and that state (e.g. Elkin was a resident of the state, TEG was incorporated there, and USM’s principal place of business was located there).
 According to the Court, in Technicorp International II, Inc. v. Johnston, the shareholder “almost certainly had inquiry notice due to a report from a forensic accounting firm.” The Chancery had held that it was “settled Delaware Law” that the applicable limitations period was “tolled during the pendency of . . . [the] § 220 . . . action.” Moreover, the Chancery Court emphasized that pursuit of § 220 action was “regarded as strong evidence that plaintiff was aggressively asserting its claims at that time.”