Jennifer Barnes v. Sprouts Farmers Market, Inc.

Citation: Not availableDocket: CA 2017-0735-MTZ

Court: Court of Chancery of Delaware; July 18, 2018; Delaware; State Appellate Court

Original Court Document: View Document

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Jennifer Barnes, a stockholder of Sprouts Farmers Market, Inc. (Sprouts), has filed a demand to inspect the company's books and records, alleging that the grocery chain failed to disclose significant produce deflation during its stock offering. The plaintiff seeks this inspection to investigate potential breaches of duty, corporate mismanagement, wrongdoing, and unjust enrichment by the company's fiduciaries. The defendant contends that the plaintiff has not demonstrated a credible basis for inferring any wrongdoing or mismanagement.

In a post-trial final report, the Master concludes that the plaintiff has indeed established a credible basis for the court to infer that potential wrongdoing or mismanagement may have occurred. Sprouts, a Delaware corporation founded in 2002, focuses on offering fresh, natural, and organic food, with produce sales accounting for approximately 25% of its revenue. As of November 1, 2017, it operated 285 stores across fifteen states.

Prior to its initial public offering (IPO) on August 1, 2013, Apollo Global Management held over 50% of Sprouts’ stock and retained a 44.5% stake post-IPO. Apollo sold a majority of its shares in several registered secondary offerings between late 2013 and March 2015, including a final offering that closed on March 10, 2015. Notably, the offering documents filed on March 4, 2015, did not mention the produce deflation that began in mid-February 2015, despite the fact that the documents were signed by key figures, including Andrew S. Jhawar, who served as both chairman of Sprouts’ board and a vice president at Apollo.

The Secondary Offering’s registration statement included Sprouts' 2014 Annual Report on Form 10-K, which highlighted the critical role of produce in the company's business and addressed the implications of price volatility on sales and profitability. The report noted that inflation could diminish sales growth and earnings, while deflation could impact gross profit margins. Sprouts experienced produce price deflation in the first half of fiscal 2012, resulting in higher gross margins, but indicated that the effects of price changes are contingent upon competitive market conditions and their pricing strategies. Despite fluctuations in sales and profitability due to changing prices, Sprouts did not foresee any substantial long-term impacts on its business strategy.

In the first quarter of 2015, Sprouts reported lower gross profit margins and sales growth, attributed to produce supply issues caused by adverse weather and West Coast port strikes. CEO Douglas Sanders identified these factors as the primary reasons for the lower growth, along with an increase in produce deflation starting in mid-February through March. CFO Amin N. Maredia elaborated that the deflation was unusual and intensified due to port challenges, leading to an influx of product that exacerbated price declines.

On August 6, 2015, during the second quarter results announcement, Sanders acknowledged that significant deflation, nearly 10%, impacted the growth achieved in that quarter. He emphasized that produce deflation notably affects Sprouts due to its high produce sales volume. Maredia added that deflation adversely impacted comparable sales by nearly 200 basis points during May and June, contradicting previous expectations of a decrease in deflation.

On March 24, 2016, a class action lawsuit was initiated against Sprouts Farmers Market, Inc. and several of its officers, including Sanders, Maredia, and Jhawar, in Arizona state court, alleging violations of Section 11 of the Securities Act of 1933. The lawsuit, referred to as the Arizona Action, claims that Sprouts failed to disclose a known trend of produce deflation during a Secondary Offering, which was required under Item 303 of SEC Regulation S-K. The complaint cites several statements made by Sprouts' executives regarding deflation after the Secondary Offering, suggesting that these statements indicate the company's awareness of the deflation trend.

Sprouts moved to dismiss the complaint, but on August 25, 2017, the Arizona court denied this motion, applying ordinary notice pleading standards. The court highlighted that the alleged deflation trend began shortly before the offering and determined that the issue of whether this constituted a known trend or a mere fluctuation could not be resolved at the dismissal stage. The court found that the statements made by Sprouts’ officers could imply knowledge of a significant deflation trend at the time of the offering, thus supporting the plaintiff's claims.

Separately, on March 1, 2017, the plaintiff sent a demand for books and records to Sprouts to investigate potential breaches of duty and corporate mismanagement. Sprouts rejected this demand, asserting that the plaintiff lacked a proper purpose. Consequently, on October 17, 2017, the plaintiff filed a verified complaint under Delaware law (8 Del. C. 220), with Sprouts’ stock trading at approximately $18.60 per share at that time. The parties agreed to bifurcate the proceedings into two stages: the first focused on whether the plaintiff demonstrated a proper purpose, which was tried on February 28, 2018, followed by additional briefings. A draft report was issued on May 2, 2018, which Sprouts contested, leading to further briefings on the exceptions raised. This document marks the final report on the matter.

Under Section 220 of the Delaware General Corporation Law, stockholders are entitled to inspect a corporation's books and records for any proper purpose, which includes investigating potential wrongdoing or mismanagement. The burden of proof lies with the stockholder to demonstrate this proper purpose by a preponderance of the evidence, although only a “credible basis” for the inquiry needs to be established, which is the lowest standard of proof. The stockholder can satisfy this standard through various forms of evidence including documents and testimony.

In this case, the plaintiff seeks access to Sprouts' records to investigate possible breaches of fiduciary duty by its directors and officers, specifically regarding the alleged failure to disclose the impact of produce price deflation during the time of the Secondary Offering. The plaintiff argues that statements made by Sprouts' management in early 2015 suggest that the company was aware of the negative financial implications of produce deflation at the time of the offering.

Sprouts contends that the management's statements are merely retrospective and do not imply knowledge of the deflation during the offering period. Furthermore, Sprouts argues that the use of "we" in communications does not specifically implicate individual directors or officers and that the two-week deflation period cannot constitute a “trend” under Item 303 of the Securities Act of 1933. Sprouts asserts that the plaintiff has not met the burden of proof necessary to suggest that any wrongdoing occurred, as the presence of Apollo on the board does not inherently indicate impropriety among unaffiliated directors and officers.

Before addressing Sprouts' defenses, the court must determine if these arguments are premature and based on merits, or if they directly challenge the credibility of the evidence presented by the plaintiff for inferring potential wrongdoing.

A Section 220 proceeding is not intended for a trial on the merits of underlying claims, as affirmed by the Delaware Supreme Court. The purpose of this process is to encourage stockholders to gather necessary information before initiating a derivative action that must meet heightened pleading standards. Delaware courts typically refrain from assessing the likelihood of a stockholder's success in a subsequent plenary action. In a books and records action, only those arguments that assess the credibility of the plaintiff's evidence to infer potential wrongdoing are considered.

In the Countrywide case, the court differentiated between arguments that could inform the assessment of a credible basis for inferring wrongdoing and those that pertained to whether wrongdoing actually occurred. The plaintiff's expert provided statistical evidence suggesting potential option manipulation, while the defendant's expert critiqued this methodology and presented evidence countering the possibility of springloading. The court accepted the critique but maintained that the plaintiff's expert did not present fundamentally flawed analysis. Conversely, the evidence regarding springloading was dismissed as it related to the existence of actual wrongdoing.

In the current case involving Sprouts, the court will evaluate an argument regarding the interpretation of managers' statements related to their knowledge of deflation at the time of the Secondary Offering. Sprouts contends that these statements do not imply that the managers had contemporaneous knowledge. While Sprouts’ interpretation is not definitively established, it is sufficient at this stage for the plaintiff's allegations to suggest possible wrongdoing. The court finds that the statements could be construed as the plaintiff suggests, allowing for an inference of wrongdoing.

Sprouts’ additional arguments, which include evidence of government pricing data and assertions that managers could not have anticipated deflation's impact, are deemed merits defenses. These arguments address whether wrongdoing occurred rather than the credibility of the plaintiff's claims. If the managers lacked knowledge of deflation, they could not be guilty of failing to disclose it.

Sprouts contends that the Plaintiff has not sufficiently demonstrated that its managers were aware of the deflation and its implications, nor that they intended to mislead. This argument parallels the merits-based argument rejected in Citigroup, which requires stockholders to present specific evidence of wrongdoing by management before allowing a Section 220 inspection. Sprouts attempts to frame these arguments within the context of a duty of disclosure claim as established in Malone v. Brincat. The relevant inquiry is not whether the Plaintiff has established a credible basis for all elements of a specific claim, but rather whether there is evidence of general wrongdoing. The Court finds Sprouts' claims regarding the managers' knowledge and actions to be premature merits-based challenges. Even accepting Sprouts’ arguments as critiques of the Plaintiff’s evidence, the Plaintiff's minimal burden of proof necessitates a favorable outcome for the Plaintiff. The managers’ statements, viewed in light of significant deflation affecting Sprouts’ business and Apollo’s board presence, support an inference of potential wrongdoing. While additional evidence could strengthen the Plaintiff’s case, the existing evidence is adequate. Furthermore, the Plaintiff's reference to the Arizona court's denial of a motion to dismiss does not impact this decision, as precedent from In re UnitedHealth Group, Inc. Section 220 Litigation indicates that such a denial does not influence the Court's assessment of the evidence presented. Consequently, the Court finds that the Plaintiff has established a legitimate purpose for requesting Sprouts’ books and records. This report is submitted in accordance with Court of Chancery Rule 144.