A recent Appellate Division decision has focused attention on a powerful statury tool: Shareholders in both public and closely held corporations have a qualified right of inspection of the corporate books and records.
Litigation provides the benefits of the discovery process and the subpoena power, which give a party access to information that another would prefer not to disclose. In the business world, N.J.S.A. 14A:5-28 directors and shareholders have a right to inspect corporate books and records without pending litigation. The recent decision in Cain v. Merck & Co., Inc., 415 N.J. Super. 319 (App. Div. 2010), has clarified this powerful discovery tool.
With regard to small corporations, the statute affords minority shareholders additional power to their right to claim oppression. Whereas claiming minority oppression risks provoking a motion to be bought out, exercising one's right of inspection can avoid that threat. Thus shareholders in closely held corporations should be wary of issuing shares to reward loyal long term "non-family" employees. Rather then issuing shares which would make the employee a shareholder, it is more advisable for the award to be in the form of money or stock rights (phantom stock). Once the "outsider" becomes a shareholder, he or she has the right to inspect the corporation's books of account and learn facts which the other shareholders probably prefer to keep within the family.
As to publicly held corporations, courts have suggested that before shareholders file a derivative action without first having made a demand on the board of directors, they should exercise their right of inspection to obtain the factual basis to support the argument that they are excused from demanding action by the board.
Because inspection rights have common law and statutory roots, shareholder inspection rights differ depending on what one desires to review. As noted by the Cain court, prior to the adoption of the New Jersey Business Corporation Act (BCA) effective January 1, 1969, shareholders' statutory right of inspection was limited to transfer books and stock books, but New Jersey also recognized a common-law right of inspection that was more expansive. Compare Drake v. Newton Amusement Corp., 123 N.J.L. 560 (Sup. Ct. 1939), and Rosenbaum v. Holthausen, 9 N.J. Super. 484 (Ch. Div. 1950). It has been held that the Maryland statutory right of inspection extinguished common law rights in that state. Without regard to whether that rule would apply in New Jersey, it would appear that the Corporate Law Revision Commission, in crafting the BCA, adopted from the Model Act as it then existed and melded into the statute both pre-existing statutory and common law rights.
Section 1 of the current statute requires the corporation to keep specified books and records. Under Section 2 any shareholder may request and receive the corporation's year end balance sheet and income statement. Section 3, deals with shareholder minutes and the list of shareholders, and places reasonable restrictions on which shareholders may exercise the right to examine them. Section 4, the focus in Cain, is much broader. It empowers a court, upon proof of proper purpose, to permit a shareholder to examine books and records of account, "minutes," and record of shareholders subject to such limitations and conditions as the court may prescribe. If it were ever in doubt, Cain makes it clear that the term "minutes" in Section 4 extends not only to the shareholder minutes referred to in Section 3, but also to the minutes of the board of directors and executive committee required to be maintained by Section 1.
The other issue addressed in Cain is the proper purpose requirement. While a corporate director has a virtual absolute and unqualified right to inspect the corporation's books and records, a shareholder must have a "proper purpose" to do so.
When a shareholder seeks to examine only shareholder minutes and the record of shareholders under Section 3, the corporation bears the burden of showing that the shareholder has an improper purpose. Under Section 4, however, to gain access to the wider scope of documents including books and records of account, the burden of proof of proper purpose is on the shareholder.
Inspection rights under the statute are narrower than litigation discovery afforded under the Rules of Court. The inspection must be germane to the claimant's status as a shareholder and must be exercised in good faith. Curiosity is not enough; curiosity enhanced by suspicion is still insufficient. In determining what is a proper purpose, the court must weigh against the desire (concern) of minority shareholders to "know what is going on" the fact that inspection of a corporation's books may adversely affect other shareholders and the corporation. The shareholder cannot simply cry "mismanagement." He or she must produce some evidence, not to prove mismanagement, but to establish a credible basis to support a claim that further investigation is warranted. An August, 2010 decision of the Supreme Court of Delaware denying inspection rights appears to take that concept to the limit.
Among purposes which have been determined to be proper are to facilitate communication with other shareholders concerning a pending tender offer; to determine the value of one's shares; to determine the corporation's financial condition, correctness of a dividend, or facts involving management conduct; to determine the corporation's ability to pay dividends; and to become informed about a transaction which requires a shareholder vote. If it is likely that the interests of all shareholders will be served by the investigation, it is more likely that the right to inspect will be granted. In addition to a proper purpose, the shareholder's demand must be reasonable. A Louisiana court, although granting access to ledgers, record books, and tax returns, found the demand to review the original of every cancelled check, deposit slip, and invoice to be unreasonable. In Cain, the court limited the scope of inspection to documents generated within a certain time period pertinent to the main claim in the federal action.
Improper purposes have been found to be seeking to discover secrets for a competitor; gaining knowledge for one's own personal business, politics, or social programs; and harassment.
An issue not reached in Cain is whether seeking facts to support a previously filed derivative action is a proper purpose. There are benefits to being lead plaintiff and lead counsel in a derivative action. This causes some corporate shareholders (or their counsel) to race to be the first to file. As a result the derivative claim, which belongs to the corporation, is filed without demand first having been made on the corporation's board of directors to bring the action, and without a sufficient showing to excuse the demand requirement. Discovery is generally not permitted to support allegations of demand futility. Thus, after a motion to dismiss for failure to make demand is filed, the plaintiff seeks to exercise the shareholder's right of inspection to obtain facts to support the allegation that demand should be excused. The question presented is whether the "horse" of inspection should follow the "cart" of filing or, stated differently, whether the winner of the race to the courthouse has stated a "proper purpose."
In May, 2010, Vice Chancellor Strine, in the Delaware Court of Chancery, concluded in no uncertain terms that a stockholder lacks a proper purpose when he seeks to inspect corporate records to obtain material to excuse his failure, in his previously filed derivative action, to make demand on the corporation's board of directors. Citing public policy reasons, the respected Vice Chancellor refused access to the corporate records, finding that the right to inspect should not be used "to rescue [the derivative plaintiff] from his own self-interested premature rush to file."
The Cain court was advised of the Delaware decision after it had heard oral argument. It did not address the issue because it had not been briefed. It will be interesting to see whether the Delaware decision will remain the rule in Delaware, and whether it will be followed in New Jersey.
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