IN A PREVIOUS ISSUE of this newsletter, we explored in detail some of the potentially powerful, but still somewhat infrequently used, rights of stockholders pursuant to Section 220 of the Delaware General Corporation Law (“Section 220”) to access many types of corporate records beyond the typical obtainment of a stockholder list or request for materials in connection with a derivative suit.1 That article concluded by noting that “Section 220 will undoubtedly continue to develop as the most recent trend of investor activism exploits the boundaries of Section 220 and as the Delaware judiciary mediates the ensuing disputes.” That prediction has come true, and this article, in addition to summarizing some of the basics of Section 220 as a brief refresher, explores some of the more recent developments that have continued to define those boundaries.
Background on Section 220
Section 220 provides stockholders, under certain conditions, with the statutory right to inspect a “corporation’s stock ledger, a list of its stockholders, and its other books and records.” This right includes the right to make copies of demanded documents and can include the right to inspect the “books and records” of any subsidiary of the corporation. This statutory right “is an expansion of the common law right of [stockholders] to protect themselves by keeping abreast of how their agents [are] conducting corporate affairs.”2 If all requirements are met, Section 220 can serve as a powerful tool for the activist investor.
To demand documents through Section 220, a stockholder must satisfy two general conditions set forth in the statute. The first requirement is that the stockholder actually be a stockholder during the relevant time period. The second requirement, which often is the subject of disputes, is that the stockholder must establish a “proper purpose.” Under the statute, if the corporation refuses to provide the demanded documents (or fails to reply to the demand within five business days from the date the demand was made), and the stockholder has satisfied all requirements, the stockholder may apply to the Chancery Court for an order compelling disclosure.
Establishing a proper purpose is “[t]he paramount factor in determining whether a stockholder is entitled to inspection of corporate books and records.”3 Section 220(b)(2)(b)(2) defines a “proper purpose” as “a purpose reasonably related to such person’s interest as a stockholder.” A stockholder seeking to utilize Section 220 to access documents carries the burden of demonstrating a proper purpose by a preponderance of evidence.4 Examples of proper purposes, as recognized by the Delaware Courts, are: clarifying an unexplained discrepancy in the corporation’s financial statements regarding assets,5 ascertaining the value of one’s stock6 and investigating the possibility of an improper transfer of assets out of the corporation. 7 Central to these purposes is the goal of investigating possible mismanagement by the corporation’s board of directors and executives. However, Delaware courts have been careful to balance the right of stockholders to investigate possible corporate mismanagement under Section 220 against Delaware’s general policy of deferring to the board of director’s business judgment.8 Therefore, stockholders must show “some evidence of possible mismanagement as would warrant further investigation” in order to demand documents under Section 220.9
A stockholder must demonstrate “that the information [he or she] seeks is necessary and essential to satisfy its stated purpose.”10 This places a key limitation on what information a stockholder may access. Each document sought must be specifically identified and necessary to satisfy the purpose. Delaware Courts have repeatedly stated their policy against allowing Section 220 demands to become “fishing expeditions.”11 If the Chancery Court finds that alternative and publicly available information would satisfy the purpose, it may refuse to order the corporation to allow stockholders to access the information.12 Therefore, it is of paramount importance that the stockholder precisely define the purpose of his or her Section 220 document demand. It should be broad enough to justify access to the appropriate documents, but not so broad that it risks the Chancery Court characterizing the demand as a fishing expedition.
I. Ownership Time Period Requirement
Recently, in connection with the requirement to be a stockholder in the relevant time period, Delaware Courts have grappled with the issue of whether a stockholder that purchases stock after alleged mismanagement can seek documents related to the alleged mismanagement. In Polygon Global Opportunities Master Fund v. West Corp., the Delaware Chancery Court denied a stockholder’s request for an order compelling disclosure of documents pursuant to Section 220 because the stockholder had purchased stock after the alleged mismanagement was made public.13 In this case, the stockholder alleged that West Corporation’s directors breached their fiduciary duty in approving a squeeze-out merger. The court reasoned that because the stockholder had purchased the stock after the merger was announced, the stockholder’s purpose in seeking documents under Section 220 was “not reasonably related to [the investor’s] interest as a stockholder as it would not have standing to pursue a derivative action based on any potential breaches” and thus denied the application for an order compelling disclosure.
Were Polygon interpreted as a complete bar to obtaining information regarding events occurring prior to the demanding party becoming a stockholder, the implications of the holding would be very significant. However, in Melzer v. CNET Networks, Inc., the Chancery Court signaled at least a partial retreat from Polygon’s strong stance on timing. In Melzer, CNET attempted to rely on the court’s rationale in Polygon in refusing to provide documents to a stockholder who was seeking to demonstrate demand futility with respect to various securities and state law claims related to CNET’s admitted back-dating of stock options. Despite the fact that the stockholder had purchased stock after the back-dating had occurred, the court refused to rule that Polygon foreclosed the stockholder’s access to documents. The court found that the stockholder was seeking the documents “to show that there was a ‘sustained or systematic failure of the board to exercise oversight’—a violation of the board’s duty of loyalty by way of bad faith,” which would have potentially permitted the plaintiffs to establish a derivative action they would have had standing to assert.14 In order to show such a “‘sustained or systematic oversight’ the [stockholders] might reasonably need to consult documents that predate their ownership” of the corporation’s stock. Accordingly, the court granted the stockholder’s request to order the corporation to allow it access to the documents.
Unfortunately, it is not yet clear whether the strict Polygon standard or the more flexible Melzer application of Polygon will ultimately control in a situation in which a stockholder seeks documents through Section 220 that predate his or her ownership of stock in a context where derivative litigation is not the purpose of the demand.
II. Limitations on Receipt of Confidential Information
Section 220(c)(3) gives the Chancery Court the power, “in its discretion, [to] prescribe any limitations or conditions with reference to the inspection, or award such other or further relief as the Chancery Court may deem just and proper.” Of primary importance is the court’s concern that potential harms from disclosing confidential business materials not outweigh any potential benefits of disclosure.15 The court will normally condition an order compelling disclosure of confidential documents on a “reasonable confidentiality order.”16 In determining whether a document is confidential, the court will examine factors such as whether the documents discuss “non-public business and personnel matters,”17 whether they relate to “private communications among or deliberations of the Company’s board of directors,”18 and whether the documents’ appearance signals the company’s intention of keeping the documents confidential.19
However, the court has recognized situations in which a stockholder may avoid the restraints of such a confidentiality order. “Chief among these, of course, is the use of the information to bring a derivative suit in the case of corporate waste or mismanagement, or to bring a suit attacking some aspect of a company’s public disclosures.”20 A stockholder may also be justified in releasing confidential information obtained through Section 220 if the stockholder can demonstrate that the confidentiality of the documents has been compromised.21 The court will also “entertain an application for relief from a Section 220 confidentiality agreement in the context of an active proxy solicitation.”22 Disclosure may also be allowed under other “exigent circumstances (e.g., an active election contest) in which time constraints will not allow a stockholder to draft and file a complaint and then deal with issue of confidentiality in the ordinary course.”23
In the recent decision, Pershing Square, L.P. v. Ceridian Corp., the Chancery Court identified some limitations on these exceptions, particularly indicating that Section 220 cannot be used solely to “find a legal mechanism by which [a stockholder] can publicly broadcast otherwise improperly obtained and confidential information.” In that case, Pershing Square learned of the existence and contents of certain letters to Ceridian’s board of directors, but it only learned of the letters as a result of a breach of fiduciary duty by a self-dealing executive officer. The court in Pershing Square also indicated that the determination of the ability to avoid confidentiality obligations and allow inspection and publishing of material would be subject to a balancing of the desire to permit open, candid communications among executives and directors without fear of disclosure versus the benefits of disclosure in the particular circumstances.24 More helpful to stockholders, however, the court did clearly indicate that a “desire to investigate the ‘suitability of a director’” is a proper purpose for a Section 220 demand.25
III. Risk of Counter-Document Requests Through Discovery
In any action seeking an order to compel the disclosure of records under Section 220, the stockholder runs the risk that the Chancery Court will rule that the corporation has the right to discover documents in the possession of the stockholder if those documents are “reasonably calculated to lead to evidence” that would undermine the existence of a proper purpose. In Meltzer v. CNET Networks, Inc.,26 the Chancery Court ordered the stockholders to provide to the corporation a letter in the stockholders’ possession because the letter was reasonably calculated to lead to evidence that undermined the stockholders’ claimed proper purpose under Section 220.27 The corporation was also permitted to question the stockholders about their stated purpose.28
Because the right to access documents in the hands of stockholders is based on discovery rules, this right is not triggered until application is made to the Chancery Court seeking an order compelling discovery. A corporation may have an incentive to force a stockholder seeking documents under Section 220 to seek an order if the corporation’s board believes that the stockholder possesses documents that would disprove a proper purpose.
In Meltzer, the corporation specifically identified a document in the possession of the stockholders. Delaware courts will not give corporations a blank check to discover any documents related to a proper purpose.29 Doing so would be inconsistent with the Chancery Court’s refusal to allow Section 220 to become a “fishing expedition.” An activist investor seeking to utilize Section 220 runs the risk, after seeking an order compelling disclosure, that the corporation will demand records from the investor. However, the scope of what can be discovered from the stockholder should be limited; the corporation may need to know about a specific document that is “reasonably calculated to lead to evidence” of an invalid purpose.
Conflicts between stockholders and corporations over the past few years have given the Delaware judiciary multiple opportunities to further delineate the requirements of Section 220 demands. However, uncertainties still remain and the statutory landscape of Section 220 will undoubtedly continue to develop as “books and records” demands become more frequently used and the judiciary is presented with new structures and situations arising as a result of significant changes in the corporate world.