Decision continues recent trend of resolving corporate books and records disputes in favor of requesting stockholders

In several decisions handed down over the last two years, the Delaware Court of Chancery has demonstrated its willingness to resolve disputes over demands for access to corporate books and records in favor of the requesting stockholder.1 A decision recently issued in Paul v. China MediaExpress Holdings, Inc.2 continues this trend. The decision is notable not only because it provides useful rules of the road for stockholders desiring to inspect books and records in anticipation of bringing potential derivative claims against a corporation's directors, but also because it demonstrates the Court's resolve to preserve, as much as possible, the right of stockholders to inspect books and records despite the pendency of federal litigation premised on the same alleged directorial wrongdoing.

Background

In January 2011, a financial analyst firm issued a report alleging that China MediaExpress Holdings Inc. ("CME"), a Delaware corporation who operates its business of selling "television advertising on intercity and airport express buses in China," was engaged "in fraudulent accounting practices and that most of CME's business could be a fraud." On February 7, 2011, following the issuance of reports by two shortsellers "making similar allegations," CME's Chairman responded by "denying any fraud" and accusing the shortsellers of "promot[ing] their own objective of driving down the Company's stock price."

The following month, CME's independent auditor Deloitte Touche Tohmatsu resigned, publicly announcing that "it was 'no longer able to rely on the representations of management,' that certain issues raised in the audit should be addressed through an independent investigation, and that the issues may have adverse implications for prior periods' financial reports." On the heels of Deloitte's resignation, CME requested that the NASDAQ Stock Market temporarily suspend trading in its stock. Next, two CME directors resigned, citing concerns over management's response to the situation. Thereafter, the NASDAQ Stock Market delisted CME's shares.

As these events unfolded, Starr Investment Cayman II, Inc., a CME stockholder, sued CME and certain of its directors in the United States District Court for the District of Delaware, alleging various violations of state law and federal securities laws. As required by the Private Securities Litigation Reform Act (the "PSLRA"), discovery in this action was automatically stayed pending resolution of a motion to dismiss brought by the defendants.

While the federal action was pending, Mark Paul, another CME stockholder, served CME with a voluminous demand for inspection of its books and records, claiming that "a series of reports and events, including the resignation of the company's independent auditor, raised suspicions that the company had engaged in fraud and falsified its financial statements." Paul offered two purposes to justify his demand: "(1) to investigate 'possible mismanagement and breaches of fiduciary duties by the directors and officers of the Company, including ... in connection with the Company's lack of oversight and possible participation in fraudulent conduct ...'; and (2) to 'determin[e] whether the Company's directors are independent and have acted, and are capable of acting, in good faith with respect to the Company's potential misconduct.'" Paul acknowledged that this second purpose was "in anticipation of alleging demand futility if he later decides to bring a derivative action on behalf of the Company." When CME failed to respond to this request, Paul brought an action in the Court of Chancery under Section 220 of the Delaware General Corporation Law ("DGCL §220") seeking to enforce his inspection rights.

The Court of Chancery's Analysis

CME attacked Paul's inspection request on two separate grounds. First, CME claimed that Paul had not stated a proper purpose under DGCL §220. Second, CME argued that Paul's action should be stayed pending resolution of the motion to dismiss pending in the federal action.

Proper Purpose

Under DGCL §220, "[a]ny stockholder ... shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose ... [t]he corporation's stock ledger, a list of its stockholders, and its other books and records ...." The Court explained that to take advantage of DGCL §220, "a stockholder must prove that he (1) is a stockholder of the company, (2) has made a written demand on the company, and (3) has a proper purpose for making the demand." The Court also noted that a 'proper purpose" is one that is "reasonably related to such person's interest as a stockholder." Further, although "[t]here is no shortage proper purposes under Delaware law, ... the purpose asserted by the stockholder should be intended to further[] the interest of all stockholders and should increase stockholder return."

Accordingly, the Court turned to an examination of each of Paul's professed purposes for gaining access to CME's books and records.

Investigating Waste and Management

The Court began this portion of its analysis by stating that it is "well-established that a stockholder's investigation of wrongdoing or mismanagement at a company is a 'proper purpose' for a §220 action." However, a stockholder seeking to inspect corporate books and records "must make more than mere conclusory statements that waste and mismanagement have occurred or are occurring." Rather, "the stockholder must present some credible basis through documents, logic, testimony or otherwise from which the Court can infer wrongdoing," even if such evidence "may ultimately fall well short of demonstrating that anything wrong occurred."

Based on the record before it, the Court concluded that Paul had in fact established "a credible basis to warrant suspicion of waste and mismanagement at CME," citing "numerous third-party media reports alleging fraudulent conduct" at CME, the resignation of Deloitte as CME's auditor, the "noisy resignations" of two CME directors and the actions taken by the NASDAQ Stock Market in response. While "[e]ach of these items arguably provides [the requisite] credible basis," in the Court's view, taken together they "convince me that Paul has presented a credible basis for suspecting wrongdoing" on the part of CME's directors "in breach of their fiduciary duties." In this connection, the Court explained that, at least for purposes of a DGCL §220 action, so-called "hearsay statements" that are nonetheless "sufficiently reliable, 'may be considered in determining whether a credible basis exists to conclude that waste and mismanagement may have occurred ....'"

Determining Director Independence

With respect to Paul's second stated purpose, CME argued that Paul's desire to investigate director independence and the ability of the directors to act in good faith, in anticipation of bringing a derivative claim against CME's directors, was negated by the fact that "he continued to buy shares of CME stock after the release of negative third-party reports." The Court rejected this line of argument, stating that "Paul need not prove that he would qualify as a representative plaintiff in a later class or derivative action to show a proper purpose under §220. Instead, what matters in proving a proper purpose under §220 is that he would have standing to bring either direct or derivative claims against CME following the requested inspection." Because Paul had been a CME stockholder during the relevant period, the Court concluded that he "presumably will have standing to bring either direct or derivative claims against CME and had, therefore, "demonstrated the existence of a proper purpose to investigate demand futility."

Scope of the Investigation

On this basis, the Court granted Paul's request for inspection, subject to Paul signing a confidentiality agreement. The Court did, however, limit the scope of Paul's inspection to books and records of CME that were "necessary, essential and sufficient" to Paul's stated purposes.

Of particular note in this regard is the Court's outright rejection of Paul's demand "for all ... emails [and] notes ... created by, distributed to, or reviewed by or on behalf of CME's Board ... or any committee thereof, concerning [well over two dozen subjects]." In the Court's view, this aspect of Paul's demand "reads much more like a sweeping discovery request than a narrowly focused §220 demand."

Deference to the Federal Proceeding

While recognizing "that the district court may have authority to stay this action if it determines that [Paul's books and records] inspection would interfere with the automatic stay in the Federal Action," the Court nevertheless refused to stay the books and records action of its own accord. The Court explained that federal courts are granted discretion by the PSLRA to stay discovery in concurrent state law proceedings (i) where "there is a risk that the federal plaintiffs will obtain the state plaintiff's discovery," (ii) if the "underlying facts and legal claims in the state and federal actions overlap" and (iii) in light of "the burden that the state court discovery proceedings will impose on the federal defendants."

In fact, the Court took pains to explain why it believed that the District Court should not stay the Delaware books and records proceeding. Among the factors cited by the Court for this view are:

  • Paul neither is the plaintiff in the federal action nor has any relationship with the actual plaintiff in that action.
  • Paul's signing of a confidentiality agreement with respect to any information learned as a result of his DGCL §220 inspection will make it "unlikely that further proceedings in this case will result in some form of discovery inadvertently reaching the federal plaintiffs."
  • The respective claims made in the books and records litigation and in the federal litigation "involve entirely different legal claims," "the actual judgments entered in §220 cases are much more limited in scope" and, from a timing point of view, "it still is unlikely that any judgment will issue from ... a future derivative action [in Delaware court] before the district court has an opportunity to decide the motion to dismiss."
  • "I do not expect complying with the production ordered in this action to be overly burdensome for CME."

Conclusion

The Court of Chancery's decision in Paul v. China MediaExpress Holdings demonstrates the Court's continued desire to protect the fundamental right of stockholders under DGCL §220 to inspect a corporation's books and records. This decision is noteworthy in two regards. First, the decision provides a clear and helpful explanation of how a stockholder who may be contemplating derivative litigation against directors alleged to have engaged in wrongdoing or to lack independence may demonstrate the proper purpose required to gain access to corporate books and records under DGCL §220. Second, it gives the Court an opportunity to "plead its case" to the federal courts as to why the automatic stay of discovery in federal securities law litigation triggered by a motion to dismiss should not necessarily interfere with a stockholder's right to inspect books and records under DGCL §220 in anticipation of bringing state law fiduciary duty claims.

Footnotes

1 Please see our prior Client Alerts entitled "Delaware Courts Permit Stockholders to Pursue Books and Records Inspections in Furtherance of Derivative Claims" (dated April 15, 2011), and "Delaware Supreme Court Clarifies Standard for Analyzing Books and Records Claims in the context of 'Plurality Plus' Governance Policies" (dated September 7, 2010).

2 No. 6570-VCP, 2012 WL 28818 (Del. Ch. Jan. 5, 2012).

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