Dropping Knowledge: Demanding Corporate Documents

February 10, 2011

Under Delaware law, a shareholder can demand documents from a corporation if the stockholder complies with 8 Del. C. 220, and “[t]he inspection such stockholder seeks is for a proper purpose.”  There are a bunch of technical aspects of a 220 demand, but those are formulaic, and easy followed.  The real question is whether the stockholder can show a “proper purpose.”    This is often the first step in filing a derivative case against a company’s officers and directors. 

As the Delaware Corporate and Commercial Litigation Blog notes here, the phrase “proper purpose” is open to interpretation, but investigating corporate mismanagement constitutes a “proper purpose.”

The Delaware courts consistently point out to unsuccessful litigants that they should have used the 220 device, because it is an excellent investigative tool for stockholders to determine whether to file a lawsuit against a company and/or its officers and directors.  Without documents from the 220 demand, pleading a demand futility (that a board could not independently consider a demand for action against itself or others) in a derivative case can be much tougher.

Recently, the Delaware Supreme Court addressed one such case.  Basically, stockholder plaintiffs filed a derivative action in the Northern District of California.   The California court dismissed the case holding that the plaintiffs did not establish that demand was futile on the company’ s board.  After the dismissal, the Plaintiffs made a 220 demand (which the company rejected), and then filed suit in the Delaware Court of Chancery to compel documents from the company under section 220.  The Delaware court dismissed the 220 case, stating that:

[S]tockholders who seek books and records in order  to determine whether to bring a derivative suit should do so before filing the derivative suit.  Once a plaintiff has chosen to file a derivative suit, it has chosen its course and may not reverse course and burden the corporation (and its other stockholders) with yet another lawsuit to obtain information it cannot get in discovery in the derivative suit.

The Delaware Supreme Court Reversed, stating that:

. . . long-standing Delaware precedent . . . recognizes that it is a proper purpose under Section 220 to inspect books and records that would aid the plaintiff in pleading demand futility in a to-be-amended complaint in a plenary derivative action, where the earlier-filed plenary complaint was dismissed on demand futility-related grounds without prejudice and with leave to amend.

So what does this mean?  A longer life to derivative cases, and possibly, an amendment to 8 Del. C. 220.  Now, derivative plaintiffs can file suit, lose, and then look for some documents to support an amended complaint.

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