Shareholder Inspection Rights: from Credible Basis to Rational Belief

• Publication year: 2023

Shareholder Inspection Rights: From Credible Basis to Rational Belief

Lynn Bai

SHAREHOLDER INSPECTION RIGHTS: FROM CREDIBLE BASIS TO RATIONAL BELIEF

Lynn Bai^*

Abstract

Jurisdictions are split on the standard of proof for shareholder inspection lawsuits when inspections are for the purpose of investigating managerial misconduct. Delaware and its followers apply a credible basis standard that calls for extrinsic evidence, beyond mere suspicion, curiosity, or disagreement with management, to permit an inference of misconduct. A minority of jurisdictions require shareholders to show merely a rational belief that mismanagement likely happened. Rational belief can be satisfied by sound logic without referencing extrinsic evidence. The Delaware Supreme Court rejected rational belief for fear that a permissive standard would lead to a cascade of frivolous inspections, although numerous factors suggest otherwise. This paper offers the first empirical verification of the court's assumption. The Delaware Supreme Court also dismissed shareholders' argument that credible basis was an insurmountable obstacle to their exercise of statutory inspection rights, reasoning that the standard had only barred inspections in a couple of cases out of a "myriad" of inspection lawsuits. This paper is the first to offer empirical evidence that the court grossly underestimated the deterrence effect of credible basis. The paper shows that both the evil of frivolous lawsuits under rational belief and the evil of over-deterrence under credible basis exist, but the latter overshadows the former in magnitude. The paper suggests that the court adopts rational belief for inspection lawsuits against private companies where credible basis poses the biggest problem, and simultaneously implements cost-shifting for inspection items that impose an onerous burden on the target corporation.

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Table of Contents

Introduction.......................................................................................... 195

I. How Credible Basis and Rational Belief Affect Shareholder Information Rights............................................ 199

A. Credible Basis and Its Insistence on Extrinsic Evidence .......... 199
B. Rational (or Good Faith) Belief.............................................. 202

II. Credible Basis and Shareholders' Predicaments..................204

A. Difficulty in Meeting Pleading Requirements .......................... 206

1. Pleading for Rebutting Management's Refusal to Sue or Demand Futility ..................................................... 206
2. Pleading Fiduciary Breaches ............................................ 207
3. Pleading Federal Securities Fraud.................................... 209
4. Pleading Corwin and MFW............................................... 210

B. The Downside of Delays in Inspection Lawsuits ...................... 211

1. A Higher Risk that a Plenary Action Is Barred by Collateral Estoppel........................................................... 212
2. A Higher Risk of Losing Standing Due to the Defendant's Tactical Merger............................................. 213
3. A Higher Risk of Losing Lead Plaintiff Status.................... 215

III. The Merits and Concerns of Rational Belief........................215

A. Rational Belief Promotes Governance..................................... 215
B. A Uniform Standard of Proof Avoids a Difficult Conflict of Laws Issue ..............................................................................217
C. Delaware Supreme Court's Basis for Rejecting Rational Belief...................................................................................... 221

1. Seinfeld and Its Assumption About Frivolous Inspection Lawsuits........................................................... 221
2. Factors Casting Doubt on the Delaware Supreme Court's Assumption of Frivolous Lawsuits ........................ 222
3. The Delaware Supreme Court's Underestimation of Credible Basis's Deterrence Effect.................................... 224

IV. Credible Basis or Rational Belief: Empirical Evidence.......225

A. Experimental Design............................................................... 225
B. Summary Statistics.................................................................. 227
C. Logit Regression..................................................................... 232

V. How to Mitigate Against the Costs of Frivolous Inspections Under Rational Belief..........................................234

A. Existing Preventative Measures: "Necessary and Essential" with "Rifled Precision," the Tiered Approach, and the Condition of Confidentiality.................................................... 234

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B. A Proposal for Cost-Shifting to Deter Frivolous Inspections ...236

Conclusion.............................................................................................240

Appendix A. Shareholder Inspection Right Survey..........................243

Introduction

Corporations are owned by shareholders but managed by the board of directors. Shareholders typically have no voice in business decisions except on extraordinary matters (e.g., mergers or dissolutions) or matters for which the corporate charter mandates a shareholder vote. Instead, shareholders influence business decisions indirectly through electing directors and holding them accountable for mismanagement by bringing fiduciary breach lawsuits. Fiduciary breach claims must be pled with sufficient specificity to make it reasonably conceivable that mismanagement has occurred. Without inspecting records or receiving information from whistleblowers, shareholders who are precluded from managerial roles would find it difficult to meet this specificity requirement.

Shareholders' inspection rights are recognized as an important part of the corporate governance landscape and a "game changer in corporate litigation."¹ Inspection lawsuits increased thirteenfold from 1981-1994 to 2004-2018.² Inspection rights, which originated in common law to curtail the agency problem caused by the separation of ownership and managerial power, are now codified in states' corporate statutes.³

In Delaware, the domicile of the greatest number of publicly traded corporations, Delaware General Corporation Law ("DGCL") Section 220 governs.⁴ This section states that shareholders can inspect, with a written demand stating under oath any proper purpose, the corporation's stock ledger, a list of its stockholders, and its other books and records.⁵ The corporation has five business days to respond to the demand. If the corporation fails to provide the requested documents within the time limit, shareholders may bring a lawsuit to compel production.⁶

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In a similar spirit, but with varying details, Model Business Corporation Act ("MBCA") Section 16.02 grants shareholders the right to inspect corporate records by giving the corporation a timely notice.⁷ The MBCA allows shareholders to inspect—without showing a proper purpose—basic documents, such as the articles of incorporation, bylaws, written communications to shareholders generally, names and business addresses of the company's current directors and officers, and the most recent annual report.⁸ Shareholders must show proper purpose to inspect more sensitive items, such as the financial records, minutes for board or committee meetings, records of any action taken without a meeting, or shareholder records.⁹

Consistent with case law, the DGCL and MBCA define "proper purpose" to mean a purpose reasonably related to the interest of the person who demands inspection as a shareholder.¹⁰ Proper purposes include, for example, a desire to determine the corporation's present and past ability to pay dividends, learn more about a transaction to be voted on in an upcoming shareholder meeting, communicate with other shareholders, value the requestor's interest in the corporation, or investigate mismanagement.¹¹ Improper purposes, by contrast, include using inspection to harass and avenge the management, advance the requestor's own political or social goals not directly related to his economic interests in the company, ferret proprietary information out of the company to compete with it, or simply satisfy the requestor's idle curiosity.¹² An inspection can have multiple purposes. If the primary purpose is proper, secondary motives that are otherwise improper do not prevent shareholders from accessing records.¹³ Recent empirical evidence shows that valuation and investigation of mismanagement are the most common reasons for inspection.¹⁴

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Jurisdictions are split on who bears the burden to prove "proper purpose." Delaware law imposes the burden on shareholders, except for inspections of the stock ledger or shareholder list, for which the burden is on the corporation to prove improper purpose.¹⁵ Some jurisdictions impose the burden on corporations in all inspection cases.¹⁶ When the purpose of an inspection is investigating mismanagement, Delaware courts and followers in other jurisdictions require shareholders to show a "credible basis" from which to infer misconduct.¹⁷ The credible basis standard calls for extrinsic evidence, beyond a mere suspicion, curiosity, or disagreement with the management, that permits an inference of corporate misconduct.

The circular requirements to plead specificity and credible basis for inspecting records often put shareholders in an impossible position. Credible basis is particularly onerous for shareholders of private companies. Those companies are not obligated to file periodic reports with regulatory authorities, and they attract little attention from the media. Often, the lack of public information about private companies hinders shareholders from monitoring management's conduct and verifying information that management chooses to disseminate.

Credible basis is not unanimously applied across jurisdictions. A small number...