Inspection Rights Under Delaware Law

Today we have two student posts, by Trevor Crow and Frank Tsu, that address shareholder inspection rights under Delaware law.  Inspection rights are the state law method for shareholders to acquire information.  Rather than requiring companies to make affirmative disclosure (a failure that resulted in part in the adoption of the Exchange Act and the imposition of the periodic reporting system), states put the onus on shareholders to seek information under their right of inspection. 

Forget that the process is inefficient, may require travel (to get to the location of the documents), and is time consuming.  The existence of a "proper purpose" requirement allows judicial machination designed to impede the ability of shareholders to exercise this authority.  In fact, a proper purpose is really not enough.  Instead, shareholders must present enough evidence to show a "credible basis" that corporate misconduct has occurred.  In the case of alleged backdating (the Countrywide case) or excessive executive compensation (the Seinfeld case), how do shareholders meet this burden from public sources?

In other words, in what Delaware courts do so well, they have grafted on an evidentiary burden that is often difficult or impossible to meet at the pleading stage.  Thus, in Seinfeld, the court denied a request to inspect books and records to determine whether the payment of $200 million in compensation over three years was proper.  Plaintiffs needed some evidence of impropriety; the amount and surrounding circumstances weren't enough. 

In Countrywide, the court allowed the inspection to go forward but only because the plaintiff marshalled statistical evidence of backdating, something the court characterized "barely sufficient to carry the minimal burden imposed by Seinfeld."  This "barely sufficient" ground required the discovery of an LA Times article that discussed statistical data suggesting backdating, the hiring of outside counsel, the hiring of an expert (characterized as "well credentialed") to examine the statistical data, and the costs of litigation in which the company presented its own expert.  In other words, courts turned Section 220 hearings into full blown evidentiary hearings.  Indeed. Countrywise asserted "in its post-trial brief that this Court has encouraged defendants to introduce evidence in Section 220 proceedings," something the court conceded "may be true."  But wait, it's not over.  Thereafter, "the plaintiff bears the burden of proving that each category fo books and records sought is essential to the stated purpose of its inspection."

If access were easier, would, as the opinion stated, shareholders engage in "[i]ndiscriminate 'fishing expeditions?"  No.  The court has plenty of authority to restrict the scope of the search depending upon the nature of the allegations. 

All of this illustrates that courts deliberately discourage the use of inspection rights by shareholders, using not language in the statute but excessive pleading standards.  It is little different than the excessively high standard imposed on shareholders attempting to show, again without the benefit of discovery, the lack of independence of directors.  One might say that this is another area ripe for preemption except that it already has been to a large degree.  Nonetheless, as courts deny shareholders access to materials through their inspection rights, pressure will simply build on the Commission to require additional public disclosure, largely rendering inspection rights irrelevant.