The Chancery Court Strictly Adheres to the Proper Purpose Requirement in 220 Actions in Two Recent Decisions

Katelyn Tuoni

Section 220 of the Delaware General Corporation Law provides a process for stockholders to request access to a corporation’s books and records for inspection.  Section 220 requires that stockholders comply with certain procedural and substantive requirements for making books and records demands. Pursuant to Section 220, stockholders must state a “proper purpose” for their demands. The two main purposes for which inspections are sought are to value a stockholder’s shares and to investigate mismanagement or wrongdoing by the board of directors.  Delaware courts have determined that a proper purpose to investigate mismanagement is established when stockholders articulate a “credible basis” that their investigation is reasonably related to furthering their interests as stockholders.  Section 220’s requirement of a credible basis is a lower burden than a preponderance of the evidence, and is designed to strike a balance between stockholders’ rights and corporations’ interests in avoiding frivolous claims.

If a corporation denies an inspection request, Section 220 empowers stockholders to apply to the Court of Chancery for an order to compel inspection.  Except where the materials requested for inspection are the stock ledger or list of stockholders, if the stockholder does not meet the burden of proving proper purpose, the inspection must be denied. Even where a proper purpose is established, the court has discretion to impose limitations on the scope or use of records to be inspected.

The Court of Chancery has repeatedly suggested and encouraged the use of Section 220 in order to plead demand futility.  Although no longer an absolute requirement, the court had even held that if pursuing inspection of corporate records under Section 220 is a prerequisite to filing a derivative complaint.  In all events, the Delaware Supreme Court has strongly encouraged the use of inspection rights under Section 220 prior to bringing a derivative action. 

Section 220 access to books and records provides a valuable investigative tool, because derivative plaintiffs are not entitled to discovery. Section 220 is a means of gathering information that will allow stockholders to develop and plead more thorough claims.

On August 30 and 31, 2016, Judge LeGrow, sitting as a Vice Chancellor by designation, decided two Section 220 actions. In both cases, defendants challenged plaintiffs’ compliance with the substantive requirements of Section 220. The court’s decisions indicate its continued focus on the substantive sufficiency of books and records demands in regard to Section 220’s proper purpose requirement.

In the first case, Bizzari v. Suburban Waste Services Inc. (“Bizzari”), plaintiff and his wife were the sole owners of Suburban Waste Services (“Suburban Waste”). Over time, the company faced financial and managerial difficulties.  In an effort to rehabilitate the business, plaintiff and his wife brought on a third owner.

Plaintiff was described as being volatile, and regularly made damaging remarks about Suburban Waste. Due to his behavior, plaintiff took a leave of absence to avoid harming Suburban Waste. Over time, it became clear to plaintiff that he was not welcome at the company and that his wife and the third owner were involved in an extramarital affair.  Plaintiff began working for a competitor owned by his father.

Plaintiff, a director and stockholder of Suburban Waste, demanded to review Suburban Waste’s books and records pursuant to Section 220. He asserted three purposes for seeking inspection: (1) to value his interest in Suburban Waste; (2) to investigate possible mismanagement or wrongdoing by Suburban Waste’s two other stockholders; and (3) to fulfill his fiduciary duties as a director of Suburban Waste.  After Suburban Waste denied plaintiff’s demand, plaintiff filed an action in the Court of Chancery claiming that he was entitled to inspect the books and records in his capacity both as a stockholder and as a director of Suburban Waste.

The court granted in part and denied in part plaintiff’s request. The court permitted plaintiff to inspect high-level financial information, bound by a confidentiality order, to value his shares. The court denied plaintiff’s demand with respect to investigation of mismanagement or wrongdoing, holding that such investigation was not a proper purpose because plaintiff failed to establish a credible basis for his claimFirst, he did not provide evidence to suggest or allow the court to infer that possible mismanagement or wrongdoing occurred.  Second, plaintiff conceded that the documents he sought to inspect were not essential to his interest in investigating wrongdoing or mismanagement.  After trial, but before the court resolved plaintiff’s demand, plaintiff filed a separate claim for breach of fiduciary duty against the other stockholders, alleging that they removed him as director and attempted to sell corporate assets without his consent. By filing the claim plaintiff conceded that he already had sufficient information to bring a claim of wrongdoing and mismanagement and, therefore, did not require access to or investigation of Suburban Waste’s books and records. The potential for discovery in the separate action negated plaintiff’s need to investigate mismanagement and wrongdoing through an inspection.  Therefore, the court held that plaintiff did not articulate a “credible basis” for his demand.

Additionally, the court denied plaintiff’s demand to inspect Suburban Waste’s books and records in his capacity as a director of Suburban Waste. Although it is a general principle that directors should have unfettered access to corporations’ books and records, the unusual circumstances of this case elicited an uncommon judicial response. The court permitted plaintiff to inspect only those records essential to valuing his shares, and required that he do so under a confidentiality order. The court believed that plaintiff had an ulterior motive and that further inspection would likely constitute a breach of his fiduciary duty, not, as he claimed, a fulfillment of his entitlement to do so.  Suburban Waste had the burden to prove that plaintiff’s motives were improper.  The court held that Suburban Waste met its burden by demonstrating that plaintiff’s actions during the last year were not consistent with Suburban Waste’s interest.  Suburban Waste presented evidence that plaintiff damaged Suburban Waste’s reputation with employees and banks by claiming the corporation had financial difficulties, plaintiff worked directly with a competitor, and plaintiff allowed his emotional distress concerning the other two owners “cloud his judgment.”  Plaintiff failed to rebut Suburban Waste’s evidence therefore, the court held that plaintiff’s purpose for inspection as a director was improper. 

In the second case decided by Judge LeGrow, Beatrice Corwin Living Irrevocable Trust v. Pfizer, Inc. (“Corwin”), the trustees of the Beatrice Corwin Living Irrevocable Trust (the “Corwin Trustees”) sought to inspect Pfizer, Inc.’s (“Pfizer”) books and records in order to value the trust’s interest in Pfizer and investigate alleged mismanagement or wrongdoing.  One of the Corwin Trustees read a New York Times article indicating that certain large public companies, including Pfizer, were not calculating repatriation tax for investments overseas because the calculation was “not practicable.”  The Corwin Trustees then sent a Section 220 demand to Pfizer seeking to review books and records stating that the failure to calculate the tax was mismanagement and possible breach of fiduciary duty.  Pfizer denied their demand. Upon such denial, the Corwin Trustees applied to the Court of Chancery to compel access to Pfizer’s books and records.

The court determined that the Corwin Trustees’ demand was substantively deficient in that it failed to demonstrate a proper purpose and establish a credible basis for investigating mismanagement. The sole purpose of the Corwin Trustees’ demand was to evaluate potential litigation.

Without reaching the parties’ arguments as to whether the tax calculation was practicable, the court stated that the Corwin Trustees failed to present evidence to support their allegations of wrongdoing. The court explained that, without more, statements of “mere suspicion” or “subjective belief” are insufficient to establish a proper purpose under Section 220.

Additionally, based on one of the Corwin Trustees’ own testimony, the documents sought to value the trust’s interest in Pfizer were not essential to such valuation because he admitted that he would not likely understand such documents without the assistance of an expert.  He conceded that he typically used publicly available records to value his shares and that such records had been sufficient.  Additionally, the only evidence presented regarding the effect of the deferred tax liability and the company’s value was a news article about G.E.’s plan to repatriate foreign earnings and incur a repatriation tax.  The difference between G.E. and Pfizer is that G.E. repatriated earnings and incurred tax while Pfizer did not repatriate earnings or owe tax.  The court held that the evidence presented was “vague” and there was a “gap” between information cited and the case at bar, therefore plaintiffs failed to show that an accurate valuation depended on inspection of the books and records sought. 

In conclusion, the court’s opinions in Bizzari and Corwin make clear that it will not grant Section 220 demands that fail to sufficiently articulate proper purposes for inspection of corporate books and records.

Katelyn is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law

Suggested Citation: Katelyn Tuoni, The Chancery Court Strictly Adheres to the Proper Purpose Requirement in 220 Actions in Two Recent Decisions, Del. J. Corp. L (Nov 14, 2016), www.djcl.org/blog. 

This entry was posted in djcl. Bookmark the permalink.