Documentary Evidence of Beneficial Ownership is a Strict Prerequisite for a Stockholder Demand for Inspection of Books and Records

In Central Laborers Pension Fund v. News Corp., No. 682, 2011 (Del. May 29, 2012), the Delaware Supreme Court upheld the Court of Chancery’s dismissal of a complaint to enforce a demand for inspection of books and records under Section 220 of the Delaware General Corporation Law (“Section 220”). The Supreme Court’s decision was based solely on plaintiff’s failure to attach documentary evidence of its beneficial stock ownership in the defendant Delaware corporation.

Section 220 entitles stockholders to inspect a Delaware corporation’s books and records for any “proper purpose.” One requirement for the right of inspection is that a beneficial stockholder (as opposed to a stockholder of record) must submit “documentary evidence” of its stock ownership. The right to inspection is often used by plaintiffs when bringing stockholders’ derivative actions (i.e. actions by stockholders on behalf of a corporation).

Stockholders can bring derivative actions only if they have first unsuccessfully demanded that the corporation’s directors pursue a corporate claim. Alternatively, stockholders can assert that such a demand would be futile (for instance because the directors have a conflict of interest with respect to the claim in question), and then proceed directly with the derivative action. However, to assert futility, the underlying facts need to be alleged with particularity. Plaintiffs and their counsel are well advised to go through the investigative proceedings under Section 220 before filing a derivative action. Accordingly, Section 220 is an important stepping stone in bringing stockholder litigation.

In Central Laborers Pension Fund, plaintiff sent a demand letter under Section 220 to defendant to investigate the records related to a pending corporate acquisition and a possible breach of fiduciary duties by the directors.

A few days later, plaintiff filed a derivative action in the Court of Chancery challenging the acquisition and asserting claims for breach of fiduciary duty by defendant’s board. The complaint alleged that a demand on the defendant’s board would have been futile because the directors had previously shown an unwillingness or inability to challenge Rupert Murdoch’s purported control over defendant (Rupert Murdoch’s daughter was the founder of the target company of the corporate acquisition in question).

One hour after the filing of the derivative action, plaintiff filed another complaint in the Court of Chancery seeking to enforce the Section 220 demand.

Defendant moved to dismiss the complaint under Section 220 on three grounds:

1. The demand letter was not accompanied by evidence of plaintiff’s beneficial stock ownership;
2. The simultaneous filing of the derivative action and the Section 220 complaint refuted any proper purpose for the inspection request; and
3. The scope of the inspection sought was overbroad.

The Court of Chancery granted the motion to dismiss on the second ground. Plaintiff’s derivative action showed that it had sufficient grounds for alleging demand futility without having to conduct an inspection of books and records under Section 220. Therefore, plaintiff could not have a proper purpose for pursuing such an inspection.

The Supreme Court affirmed the judgment based solely on the alternative ground that plaintiff had not complied with the “form and manner” requirements of Section 220 by not including evidence of its beneficial ownership with the demand letter. The Supreme Court emphasized the importance of strict compliance with the formal statutory requirements of Section 220. By omitting evidence of beneficial ownership, plaintiff had not properly invoked its inspection rights. The Supreme Court rejected plaintiff’s argument that it had cured the defect when it later submitted evidence of beneficial ownership in the court proceeding. For an inspection demand to be effective, under the statute, it needed to “be accompanied by” the necessary evidence of beneficial ownership. The Supreme Court found it unnecessary and inappropriate to decide whether an inspection demand could have an appropriate purpose once a derivative action was filed.

This Alert was written by Peter Flägel, a director in the Firm’s Corporate Group. For more information on this topic, please also contact Frank Cannone, Brian DiBenedetto, Terry Myers or Steven Sholk.