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By Mitchell A. Lowenthal and Ari D. MacKinnon, Cleary Gottlieb Steen & Hamilton LLP
The right of shareholders to inspect corporate books and records occupies an important—though sometimes overlooked—place in corporate democracy and in shareholder litigation.
The basic premise underlying inspection rights is that shareholders—as owners of the corporate enterprise—have a legally cognizable interest in accessing certain information relevant to their financial investment in the corporation.1 Nonetheless, the separation of share ownership from management control is one of the foundational principles of corporate law and, thus, a shareholder's inspection rights necessarily must be limited in deference to the basic principle that a corporation's board of directors, not its shareholders, is charged with managing the affairs of the corporation.2
Shareholder inspection rights have come to the forefront in several recent Delaware derivative lawsuits, in which the Delaware Court of Chancery has strongly encouraged shareholders of Delaware companies to avail themselves of shareholder inspection rights before bringing derivative actions, including so-called Caremark3claims for failure to adequately oversee and monitor alleged corporate wrongdoing.4
Although the Delaware Supreme Court recently rejected the most far-reaching implications of these Chancery Court decisions, holding that there is no “irrebuttable presumption” that shareholders who bring Caremark claims without first exercising their inspection rights will provide inadequate representation to shareholders generally, the court also acknowledged the “fast filer” problem, directed that remedies for that problem be aimed at counsel, and cited cases in which it had previously emphasized the importance of issuing pre-suit inspection demands.5
Delaware courts encourage shareholder plaintiffs to exercise their inspection rights before filing plenary suits in order to (a) dissuade the filing of derivative actions that cannot satisfy applicable demand futility or wrongful refusal of demand standards or fail to state a claim, and (b) improve the quality of any plenary litigation that is brought (including by enabling the plaintiff to plead demand futility or wrongful refusal with the required particularity and to plead the necessary factual link between any corporate “trauma” that is the basis of the claim and the fiduciaries who are the subject of the suit).6
Reinforcing these objectives, Delaware courts generally preclude the filing of books and records actions after a derivative complainant has filed a plenary action, requiring the complainant to defend his pleading based upon the allegations contained therein, without further enhancement through a post-suit inspection demand.7
New York law, too, grants inspection rights to shareholders under the common law and by statute.8 New York courts have grappled with inspection rights in the past and likely will continue to confront them in future litigation, especially if the trend in Delaware to encourage shareholders to employ their inspection rights carries over to New York, as it should.
Given the important position that shareholder inspection rights occupy in safeguarding shareholders' financial interests and informing shareholder legal action, and the at least equally important policy that gives primacy to the board of directors in deciding whether a corporation should pursue causes of action (and if so, how), shareholders and corporate management alike should be aware of these rights.
Accordingly, this article seeks to shed light on the scope of New York shareholder inspection rights, as well as the procedures for exercising and enforcing them.
In order to exercise the common-law or statutory right of inspection, a shareholder of a New York corporation must make a demand upon the board of directors seeking specific books and records.9
Neither the common law nor the BCL specifies the necessary content of such an inspection demand. Nonetheless, a corporation may condition a shareholder's exercise of his statutory right of inspection upon the submission of an affidavit attesting that “inspection is not desired for a purpose which is in the interest of a business or object other than the business of the corporation and that he has not within five years sold or offered for sale any list of shareholders of any corporation of any type or kind.”10
Although the case law does not expressly hold that the common-law right may be conditioned upon the submission of such an affidavit, a New York court might so rule, as the common-law and statutory rights often are analyzed apiece.11
Once an inspection demand has been made upon a corporation, the corporation generally must endeavor to respond to that demand within a reasonable period of time.12 Further, in the event that the corporation denies a shareholder's inspection demand, the shareholder may seek judicial relief, usually in the form of a petition for a writ of mandamus pursuant to Article 78 of the Civil Practice Law and Rules.13
New York courts have not explicitly confronted arguments regarding whether shareholder inspection rights may be enforced contemporaneously with the filing of derivative claims.14 The Delaware courts, however, have explicitly held that inspection rights may not be enforced at the same time that a shareholder is prosecuting a derivative claim.
Substantial policy and practical concerns support this result. First, a derivative complainant affirms that he has sufficient information to bring a lawsuit by filing that suit, and a request to inspect corporate books and records contradicts that affirmation.15
Second, shareholders elect the board to manage the corporation's affairs, including whether to bring litigation, and that responsibility should not be displaced unless a shareholder complainant has in hand a factual basis for seeking to do so.16 The corporation (and all of its shareholders) should not be put to the expense of addressing derivative action litigation if the complainant requires access to books and records in order to determine whether it can satisfy the threshold requirements with respect to demand futility or wrongful refusal.17
Third, once a shareholder complainant commences a derivative action, any discovery available in that action should be governed by the applicable rules of civil procedure, such as the CPLR, rather than the BCL.18
Further, requiring potential complainants to seek access to books and records before commencing plenary actions may both weed out cases that should not be filed, and improve those that should be.19
There are two principal substantive prerequisites to the enforcement of common-law and statutory shareholder inspection rights in New York: (1) shareholder status at the time of the inspection request; and (2) good faith and a proper purpose in making the inspection request.
An individual is entitled to exercise common-law and statutory inspection rights only if he is a shareholder at the time of his inspection request. Accordingly, although there is no express requirement that shareholder status be proved through any particular means, a corporation nevertheless may require reasonable proof of shareholder status before granting access to corporate books and records.21
Under the common law of New York and by statute, a shareholder is entitled to exercise his inspection rights only if he acts in good faith and with a proper purpose.22 Thus, a corporation may deny a shareholder's inspection demand if it determines that the shareholder is not acting in good faith or otherwise does not have a proper purpose. Further, if a shareholder subsequently brings suit to enforce his common-law or statutory inspection rights, a court may order that inspection be granted only if it determines that the shareholder is acting in good faith and has a proper purpose.23
Significantly, when a shareholder brings suit to enforce the common-law right of access, he has the burden of “plead[ing] and prov[ing] that inspection is desired for a proper purpose,”24 whereas when the shareholder asserts the statutory right of access, the corporation bears the burden of “showing an improper purpose or bad faith.”25 In either event, if there is a question of fact as to whether the shareholder seeks to exercise his inspection rights in good faith and has a proper purpose, the court must hold a hearing to adjudicate that issue.26
There is scant case law on the meaning of good faith in the context of shareholder inspection rights,27 as most of the jurisprudence focuses upon the “proper purpose” requirement. In this respect, common-law and statutory inspection rights exist principally to permit shareholders reasonably to “protect their financial interests in a corporation by inspecting its books and records.”28 Thus, whether an individual shareholder has a “proper purpose” in seeking inspection turns on a fact-specific inquiry into whether he is reasonably seeking to safeguard his investment.
Although the “proper purpose” inquiry necessarily is fact intensive, the case law provides some guidance on shareholder purposes that may be deemed sufficiently connected to safeguarding shareholder financial interests as to ground an inspection demand.
Generally, proper shareholder purposes may “include, among others, efforts to ascertain the financial condition of the corporation, to learn the propriety of dividend distribution, to calculate the value of stock, to investigate management's conduct, and to obtain information in aid of legitimate litigation.”29
On the other hand, improper purposes embrace “those which are inimical to the corporation, for example, to discover business secrets to aid a competitor of the corporation, to secure prospects for personal business, to find technical defects in corporate transactions to institute ‘strike suits,' and to locate information to pursue one's own social or political goals.”30
In line with this general guidance, New York courts regularly permit inspection for purposes of valuing shareholdings, especially in the context of closely held corporations.31 There also is support for the use of shareholder inspection rights to obtain a shareholder list for purposes of preparing a tender offer or proxy filing.32
The investigation of possible corporate mismanagement and the preparation of shareholder litigation also may constitute proper inspection purposes under certain circumstances, although the case law is more limited and more nuanced on this point.
New York courts do not require conclusive proof of wrongdoing before allowing a shareholder to inspect books and records in order to investigate management conduct or prepare for litigation.33 Nonetheless, New York courts have made clear that they will not permit shareholder inspection rights to be used as fishing expeditions.34
Further, conclusory allegations of corporate mismanagement or wrongdoing fail to provide a sufficient foundation for the exercise of shareholder inspection rights.35 Therefore, it seems reasonable to conclude that New York courts, like their Delaware counterparts, generally will require a showing of some concrete reasonable basis to infer that wrongdoing has occurred before allowing a shareholder inspection predicated solely on allegations of mismanagement or wrongdoing.36
In addition, a shareholder possesses a proper purpose for conducting an inspection only if the inspection is reasonably calculated to advance that proper purpose.37 In other words, a shareholder is not entitled to inspect books and records merely because he states a purpose that, in the abstract, may be proper where, for example, that purpose cannot be advanced through inspection.38
The statutory and common-law rights of inspection provide access to distinct, though partly overlapping, corporate books and records.
Beginning with the statutory right, BCL § 624 narrowly delineates the books and records available to shareholders. In particular, subsection (b) permits a shareholder to examine the “minutes of the proceedings of [the corporation's] shareholders and record of shareholders and to make extracts therefrom for any purpose reasonably related to such person's interest as a shareholder.”39 Subsection (e) allows a shareholder to obtain “an annual balance sheet and profit and loss statement for the [corporation's] preceding fiscal year, and, if any interim balance sheet or profit and loss statement has been distributed to its shareholders or otherwise made available to the public, the most recent such interim balance sheet or profit and loss statement.”40
Other records may be obtained (if at all) only through reliance on the common-law right of access.
In delimiting the scope of the common-law right of inspection, courts generally hold that a shareholder is entitled to access only those books and records that are “relevant and necessary” to his “proper purpose.”41Accordingly, the shareholder's purpose in seeking access is the primary guidepost in determining the books and records that the shareholder is entitled to review. Therefore, the scope of materials available through the exercise of common-law inspection rights generally is much narrower than the scope of materials available through disclosure in the context of litigation.42
Finally, a corporation is entitled to withhold documents based on the attorney-client and work-product privileges.43 Moreover, where the documents to be inspected include potentially sensitive materials, a corporation may be entitled to a protective order restricting the dissemination or use of such materials.44
Shareholder inspection rights provide an important tool for shareholders to obtain information regarding their financial stake in the corporation and to exercise their share ownership rights on a more informed basis. Given the separation of ownership and management embodied by the New York corporate form, such inspection rights are of course not without their reasonable limitations.
It behooves shareholders and corporations alike to be fully aware of the scope and content of shareholder inspection rights. Such awareness may permit shareholders to enhance their ability to make reasonably informed investment decisions, while also allowing corporations to process inspection demands efficiently.
Mitchell A. Lowenthal is a partner of Cleary Gottlieb Steen & Hamilton LLP, resident in the firm's New York office. Mr. Lowenthal's practice focuses on the prosecution and defense of disputes arising out of significant capital markets events and M&A transactions.
Ari D. MacKinnon is an associate of Cleary Gottlieb Steen & Hamilton LLP, resident in the firm's New York office. Mr. MacKinnon's practice focuses on litigation.
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