Statutory Inspection Rights in Delaware: An Examination of the “Proper Purpose” Requirement

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  1. Statutory Inspection Rights

Alongside the rights to vote and sell shares, the ability to inspect corporate books and records is an important stockholder right. This type of action is frequently used to allow stockholders to investigate corporate mismanagement, prepare for a proxy fight, or possibly serve as a precursor to derivative litigation.[1] To mitigate against potential stockholder abuse of this right, statutes and courts require a “proper purpose” for the inspection.[2]  Many courts, including ones in Delaware, require that stockholders present “some evidence” to suggest a “credible basis” for corporate mismanagement or a breach of fiduciary duty to constitute a proper purpose.[3]  While this standard is very low,[4] courts have not been hesitant to reject inspection demands that have improper purposes.[5] Delaware inspection rights are codified in Delaware General Corporation Law (“DGCL”) Section 220 which defines proper purpose to mean “a purpose reasonably related to such person’s interest as a stockholder.”[6]

 

  1. Hoeller v. Tempur Sealy Int’l Inc. Reiterates the Governing Standard

In Hoeller v. Tempur Sealy Int’l Inc., the Delaware Chancery Court considered an inspection right action in the context of Tempur Sealy International, who supplied mattresses, furniture, and related products to Mattress Firm Holding Company (“Mattress Firm”), which was one of its largest retail customers.[7] After Mattress Firm was acquired by another company that had its own product line in August 2016, the Tempur Sealy CEO stated that Tempur Sealy will be affected but he was optimistic about the long-term relationship between the companies.[8]  Risks pertaining to this acquisition that could impact Tempur Sealy were also discussed in numerous filings with the Securities and Exchange Commission (“SEC”).[9]  In January 2017, however, Mattress Firm told Tempur Sealy it wanted to modify its contract otherwise it would terminate.[10]  While the parties appeared to agree to a wind-down contract, this plan was short-lived as breach of contract litigation soon commenced in various state and federal courts.[11]  A Tempur Sealy stockholder sent a Section 220 demand to the company, seeking documents to evaluate a possible breach of fiduciary duty claim because of the loss of a major customer and the public statements made by the CEO regarding the company’s financial well-being.[12]  Tempur Sealy rejected the demand but produced four documents to the stockholder asserting that those documents show that the company assumed it would continue its business relations with Mattress Firm.[13]  The stockholder proceeded with the Section 220 action.[14]  The Delaware Chancery Court rejected the stockholder’s claim, noting that there was no evidence of bad faith or a conflicted transaction.[15]  It also stated that the company had sufficiently disclosed the business risks from losing its biggest customer in its SEC filings.[16]  On a larger level, the Court was also concerned about the credible basis standard being undermined by allowing these types of broad allegations without even any evidence, which would render Section 220 effectively useless.[17]

 

  1. Implications and Takeaways

Delaware courts have recently granted inspection rights for newer types of documents and communications such as text messages and personal email accounts, recognizing that companies today are more frequently using these forms of communication to conduct formal business.[18]  Thus, while Section 220 may be construed somewhat more broadly when the types of corporate records themselves are changing, Hoeller reinforces the importance of properly satisfying the fundamental credible basis standard – one that is low but not a “mere speed bump.”[19]  In light of the constant back-and-forth in the granting or rejecting of Section 220 claims based on the “proper purpose” element,[20] this requirement is vitally important for the ability to exercise inspection rights. The Court in Hoeller also reconfirmed the deferential standard granted towards corporations in making their business decisions as a desire to avoid an ex post‘ second-guessing’ of an unsuccessful, good faith business act and open up the company to unbounded Section 220 actions.[21]  Disagreement with a business decision or a desire for a ‘better deal,’ solely by itself, is not going to be a successful basis to access a company’s corporate books and records.[22]


 

[1] See Saito v. McKesson HBOC, Inc., 806 A.2d 113, 117 (Del. 2002).

[2] See, e.g., Del. Code Ann. Tit.8, § 220(b) (2019); N.J. Rev. Stat.§ 14A:5-28(3) (2013); Wash. Rev. Code § 23B.16.020 (2019)

[3] See Seinfeld v. Verizon Commc’ns, 909 A.2d 117, 118 (Del. 2006) (noting that this standard “achieves an appropriate balance between providing stockholders who can offer some evidence of possible wrongdoing with access to corporate records and safeguarding the right of the corporation to deny requests for inspections that are based only upon suspicion or curiosity”). New York courts also reject speculative allegations of corporate mismanagement. See e.g., Lapsley v. Sorfin Int’l Ltd., 43 A.D.3d 1113, 1114 (2d Dep’t 2007) (refusing to grant inspection rights where shareholder’s claim of corporate waste was unsupported and conclusory).

[4] See Seinfeld, 909 A.2d at 123.

[5] See Skouras v. Admiralty Enters., Inc., 386 A.2d 674, 679 (Del. Ch. 1978) to harass corporate defendant is improper); Tatko v. Tatko Bros. Slate Co., Inc., 173 A.D.2d 917, 918 (3d Dep’t 1991) (listing some improper purposes including pursuing a personal social or political agenda, instituting strike suits, and promoting personal business).

[6] Del. Code Ann. Tit.8, § 220(b) (2019).

[7] Hoeller v. Tempur Sealy Int’l, Inc., C.A. No. 2018-0336-JRS, 2019 WL 551318, at *1 (Del. Ch. Feb. 12, 2019).

[8] Id. at *4.

[9] Id. at *3.

[10] Id. at *4.

[11] Id. at *5.

[12] Id. at *6.

[13] Id. at *7.

[14] Id. at *6.

[15] Id. at *9.

[16] Id. at *13.

[17] Id. at *12.

[18] See KT4 Partners LLC v. Palantir Techs. Inc., No. 281, 2018, 2019 WL 347934, at *2 (Del. Jan 29, 2019) (noting that if a company conducts its formal corporate business “largely through informal electronic communications, it cannot use its own choice of medium to keep shareholders in the dark” about their inspection rights under Section 220); Schnatter v. Papa John’s Int’l, Inc., C.A. No. 2018-0542-AGB, 2019 WL 194634, at *16 (Del. Ch. Jan. 15, 2019) (stating that “the utility of Section 220 as a means of investigating mismanagement would be undermined if the court categorically were to rule out the need to produce communications in these formats”).

[19] Hoeller, 2019 WL 551318, at *1.

[20] See, e.g., Caspian Select Credit Master Fund Ltd. V. Key Plastics Corp., C.A. No. 8625-VCN, 2014 WL 686308 (Del. Ch. Feb. 24, 2014) (granting the Section 220 inspection); La. Mun. Police Emps.’ Ret. Sys. v. Lenner Corp., 2012 WL 4760881 (Del. Ch. Oct. 5, 2012) (rejecting the Section 220 inspection).

[21] Hoeller, 2019 WL 551318, at *10.

[22] Id.

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Fordham Journal of Corporate & Financial Law