Show Me the Books! – Recent Developments in Stockholder Inspection Rights Under Delaware Law
Corporate & Finance Alert
November 3, 2009
Section 220 of the Delaware General Corporation Law
Under Section 220 of the Delaware General Corporation Law (the “DGCL”), stockholders of a corporation organized under the laws of the State of Delaware have a statutory right (during usual business hours) to inspect their corporation’s stock ledger, a list of its stockholders and its other books and records, and to make copies and extracts thereof. This right is not absolute – instead it requires that the requesting stockholder comply with certain procedural formalities and have a proper purpose. Specifically, the inspection demand must be under oath and state its purpose, and must be made upon the corporation at its registered office in Delaware or its principal place of business. In addition, if the stockholder is not a record holder of stock (or member of a nonstock corporation), the demand also must state the stockholder’s status as a stockholder, be accompanied by documentary evidence of beneficial ownership of the stock and state that the provided documentary evidence is a true and correct copy of what it purports to be.
When a stockholder merely seeks to inspect the corporation’s stock ledger or a list of its stockholders, the stockholder need only establish that he or she is a stockholder and has complied with the demand form and manner requirements set forth in Section 220. If these hurdles are met, the burden of proof will be on the corporation to establish that the inspection is for an improper purpose. In contrast, where the stockholder seeks to inspect the corporation’s books and records, the stockholder first must also establish that the stockholder is a stockholder and has complied with the demand form and manner requirements of Section 220, but then must also demonstrate that the inspection is for a proper purpose. According to Section 220, a “proper purpose” is any purpose reasonably related to the demanding stockholder’s interest as a stockholder of the corporation.
If the corporation refuses to permit an inspection sought by a stockholder or does not reply within five (5) business days of an inspection demand, the stockholder may apply to the Court of Chancery of Delaware (the “Chancery Court”) for an order to compel the inspection. The Chancery Court is vested with exclusive power to determine whether or not a stockholder is entitled to the desired inspection. Recently, the Chancery Court has issued certain unpublished opinions that affect stockholder inspection demands under Section 220. Below is a discussion of three (3) such cases decided during 2009 that directly address, and potentially limit, stockholder inspection rights.
Smith v. Horizon Lines, Inc.
In Smith v. Horizon Lines, Inc., C.A. No. 4573-CC, 2009 WL 2913887 (Del. Ch. Aug. 31, 2009), the Chancery Court analyzed the degree of proof of stock ownership that is required when a beneficial owner of stock demands inspection rights pursuant to Section 220 of the DGCL. Specifically, in Horizon the plaintiff filed a complaint in the Chancery Court to enforce a demand to inspect the books and records of Horizon, which demand previously had been served on Horizon. Horizon responded to this complaint by alleging that the plaintiff’s demand was procedurally defective because, as required by Section 220, it was not “accompanied by documentary evidence of ownership of Horizon stock.”
The Plaintiff’s demand to inspect the books of Horizon was not completely void of documentary evidence of ownership of Horizon stock. With the demand, the plaintiff provided an account statement that purported to show his beneficial ownership of Horizon stock, which the plaintiff claimed was sufficient to meet the Section 220 requirements. The Chancery Court did not agree with the plaintiff, noting that “the demand letter was accompanied by a heavily redacted account statement that merely showed that ‘Smith’ owned some type of Horizon security at some unknown time,” which the Chancery Court determined had failed to comply with the statutory mandates of Section 220. Moreover, the court went on to add that it was “unable to conclude that any ‘documentary evidence’ is sufficient to show ownership simply because the demanding shareholder has sworn the document is ‘true and correct.’”
Beiser v. PMC-Sierra, Inc.
In Beiser v. PMC-Sierra, Inc., C.A. No. 3893-VCL, 2009 WL 483321 (Del. Ch. Feb. 26, 2009, the Chancery Court analyzed what constitutes a “proper purpose” under Section 220 of the DGCL. Of relevance in Beiser is the fact that, at the time of the plaintiff’s Section 220 investigation request, the plaintiff also was the lead plaintiff in a related federal lawsuit (the “Federal Lawsuit”) in which discovery had been stayed pursuant to the Private Securities Litigation Reform Act (the “PSLRA”).
The plaintiff in Beiser claimed that he sought PMC-Sierra’s books and records for the following purposes: “(i) investigating possible mismanagement and breaches of fiduciary duties; (ii) investigating violations of law by the officers and directors of [PMC-Sierra] in connection with [PMC-Sierra’s] stock option granting practices and procedures and internal controls; and (iii) determining whether [PMC-Sierra’s] officers and directors are independent and/or disinterested and whether they have acted in good faith.” The Chancery Court initially recognized that “Delaware courts have often held that investigating possible wrongdoing by a company’s officers and directors is a “proper purpose” under Section 220.” However, the Chancery Court went on to note that at the pleading stage, a plaintiff must do more than merely state a generally accepted purpose as a conclusion. Instead, the plaintiff must state what it will do with the information or the result that may be achieved by the investigation. According to the Chancery Court, the plaintiff did not plead any proper end to his purposes, and the Chancery Court was unable to infer any proper purpose from his pleadings.
The Chancery Court went on to note that “the Delaware courts have consistently encouraged plaintiffs to utilize Section 220 before filing a derivative action.” However, in Beiser the plaintiff waited over 20 months to make the Section 220 request, causing PMC-Sierra to incur considerable expenses in defense of the Federal Lawsuit during this period. Based on this fact, the Chancery Court noted that the timing makes it more difficult for the plaintiff to plead a proper purpose because the most obvious purpose (to aid in filing a subsequent action) is no longer available.
Notwithstanding the foregoing, the Chancery Court went on to state that Delaware courts have permitted Section 220 actions to proceed concurrently with a PSLRA mandated discovery stay, “but only where (1) the plaintiff was not currently involved in the federal action, (2) the plaintiff’s counsel was not currently involved in the federal action, and (3) the plaintiff agreed to enter a confidentiality agreement preventing him from sharing the information obtained with the plaintiff or counsel in the federal action.” In Beiser, the Court found that none of these safeguards were present.
According to the Chancery Court, where no proper end is evident, a plaintiff must clearly plead how he might use the books and records to satisfy the “proper purpose” requirement of Section 220. In Beiser, the Chancery Court found that the only reasonable end use of the books and records would be to aid the plaintiff in the Federal Lawsuit through discovery that has been stayed by the PSLRA. Therefore, the Chancery Court held that the plaintiff’s purpose was not a proper purpose under Section 220.
Norfolk County Retirement System v. Jos. A. Bank Clothiers, Inc.
In Norfolk County Retirement System v. Jos. A. Bank Clothiers, Inc., C.A. No. 3443-VCP, 2009 WL 353746 (Del. Ch. Feb. 12, 2009), the Chancery Court again was asked to review a DGCL § 220 investigation demand made subsequent to the filing of related federal lawsuits. In Norfolk, the Chancery Court first recognized that the pursuit of a derivative action based on perceived wrongdoing by a corporation’s officers or directors is a proper purpose under Section 220. Thereafter, the Chancery Court was faced with the question of whether the plaintiff had demonstrated a proper purpose and, if so, whether the documents provided by Jos. A. Bank were sufficient, necessary and essential for the plaintiff’s purpose.
According to the Chancery Court, a stockholder must present “some evidence to suggest a credible basis from which a court can infer that mismanagement, waste or wrongdoing may have occurred;” however, this benchmark does not require that a stockholder prove actual mismanagement. Instead, a stockholder must provide a “credible showing, through documents, logic, testimony or otherwise, that there are legitimate issues of wrongdoing.” Nonetheless, even if a credible basis is established, the stockholder still is not entitled to inspect all documents believed to be relevant, or likely to lead to information relevant, to the purpose.
In Norfolk, the plaintiff sought documents relating to allegedly false and misleading statements at issue in a securities class action and a derivative action. In response to this request, Jos. A. Bank provided the plaintiff with a copy of a report of its Special Litigation Committee (“SLC”), including the exhibits thereto, the meeting minutes of the SLC and the minutes of the Jos. A. Bank’s Board approving the creation and functions of the SLC. Thereafter, the plaintiff did not articulate a reasonable need for additional documents. Thus, the Chancery Court concluded that Jos. A. Bank had produced all of the documents required under § 220 for the plaintiff’s stated purposes.
In sum, the cases sited above indicate that the Chancery Court may be taking a more pro-company position with regard to stockholder inspection demands pursuant to Section 220 of the DGCL. Only time will tell if future decisions of the Chancery Court continue down this path. Accordingly, when faced with a Section 220 inspection demand, companies should not only consider the text of Section 220, but also should review the then available case law (including the above cited cases) to establish whether the demand is adequate and to aid in determining the scope of what, if any, information must be disclosed. Stockholders contemplating a Section 220 demand also should consider the then available case law prior to making the demand to assist them in making the demand at the appropriate time and in the required manner.
This client alert was prepared by Brian DiBenedetto, an associate in the Firm’s corporate department in our New York office.