Pursuant to Section 220 of the General Corporation Law of Delaware, stockholders of Delaware corporations have a qualified right to access certain nonpublic information under the control of the company. (A parallel right exists for Delaware limited liability company members pursuant to 6 Del. C. § 18-305.) Nonpublic information may be relevant to the decisions stockholders must make in order to protect their economic interests, including decisions about whether to sell their shares, prepare a stockholder resolution, wage a proxy fight, seek legal action (direct or derivative), or how to vote their shares. A stockholder, however, may not access that nonpublic information without a proper purpose, defined by statute as “a purpose reasonably related to such person’s interest as a stockholder.” When asserted with a proper purpose, a Section 220 inspection is an important investigative tool for a stockholder. In fact, Delaware courts routinely encourage stockholders to utilize this tool before pursuing litigation. The Delaware Court of Chancery in Mizel v. Connelly, 1999 WL 550369, *5 n.5 (Del. Ch. Aug. 2, 1999), has explained that “[a]fter the repeated admonitions of the Supreme Court to use the ‘tools at hand’ . . . lawyers who fail to use those tools to craft their pleadings do so at some peril.” This article will address two recent cases from the Court of Chancery, Southeastern Pennsylvania Transportation Authority v. AbbVie, Inc., 2015 WL 1753033 (Del. Ch. Apr. 15, 2015) and Oklahoma Firefighters Pension & Retirement System v. Citigroup, Inc., 2015 WL 1884453 (Del. Ch. Apr. 24, 2015), which address what constitutes a “proper purpose” for a Section 220 inspection. In particular, both of these cases offer valuable guidance to stockholders and their counsel regarding the proper purposes for asserting Section 220 inspection rights.
The AbbVie Case
The AbbVie case involved separate actions by plaintiffs Southeastern Pennsylvania Transportation Authority (SEPTA) and James Rizzolo to obtain records from AbbVie, Inc. (the “Company”) for the stated purpose of investigating potential corporate wrongdoing by the Company’s directors in connection with a failed merger attempt. While the cases were not consolidated, as the stated purposes of each plaintiff were not identical, the court conducted a coordinated one-day trial on the papers in both actions.
Sometime in 2013, the Company’s senior management proposed that the Company pursue a corporate inversion (i.e., change its country of residence), in part to take advantage of favorable tax treatment under then-current interpretation of U.S. tax law as enforced by the Treasury Department. Due to certain regulatory restrictions, any corporate inversion would require a series of transactions with a foreign entity. Thus, in 2014, the Company began discussions on a merger with Shire PLC, an entity registered in the island of Jersey, with its principal place of business in Dublin, Ireland. The merger involved substantial risk, which the Company’s directors considered throughout the process. The risk was that the tax law, or its interpretation by the Treasury, would change before sufficient tax advantages could be realized to offset the costs to stockholders of the transaction. As part of the transaction, the parties negotiated a $1.635 billion breakup fee (representing approximately 3 percent of the total value of the deal). Ultimately, the Treasury later changed its interpretation of the applicable tax law such that it eliminated the tax advantages of the merger before its consummation. The Company’s directors then concluded that it would be better to withdraw from the merger – and pay a substantial breakup fee – than to proceed as planned. The Company eventually paid the breakup fee.
Both SEPTA and Rizzolo sought inspection of certain books and records of the Company for the purpose of gathering information to potentially pursue a derivative action on behalf of Company against the directors in connection with a failed merger attempt. In addition, SEPTA sought to investigate demand futility, and Rizzolo sought to investigate the Company’s financial advisor, J.P. Morgan, for possibly aiding and abetting breaches of fiduciary duty by the Company’s directors. The Company denied their inspection demand.
Section 220 is Limited to Investigating Non-exculpated Corporate Wrongdoing
The court began its analysis by noting that “[i]t is well established that investigation of potential corporate wrongdoing is a proper purpose for a Section 220 books and records inspection.” (Citing Thomas & Betts Corp. v. Leviton Mfg. Co., 681 A.2d 1026, 1031 (Del. 1996).) The court then examined the effect of the provision contained in the Company’s certificate of incorporation which exculpated its directors from monetary liability for a breach of the duty of care pursuant to 8 Del. C. § 102(b)(7). In light of the exculpatory provision, the court held that while not having “squarely addressed the issue of whether, when a stockholder seeks to investigate corporate wrongdoing solely for the purpose of evaluating whether to bring a derivative action, the ‘proper purpose’ requirement under Section 220 is limited to investigating non-exculpated corporate wrongdoing.” (Emphasis in original.)
The court held that if a plaintiff’s sole purpose for seeking a Section 220 inspection is to evaluate whether to bring derivative litigation to recover for alleged corporate wrongdoing, a proper purpose exists only to the extent the plaintiff has demonstrated a credible basis from which the court can infer non-exculpated wrongdoing. In reaching its decision, the court relied upon several analogous decisions finding that a plaintiff, who lacks standing to bring a derivative suit and has sought inspection solely to investigate bringing litigation, lacks a proper purpose under Section 220. Similarly, in light of the “necessity of proper balance of the benefits and burden of production under Section 220,” if a plaintiff seeks inspection for the sole purpose of investigating whether to bring derivative litigation, the corporate wrongdoing must be justiciable. In other words, “if the stockholder would not have standing to seek a remedy, then that stockholder has not stated a proper purpose.” (Quoting La. Mun. Police Emps.’ Ret. Sys. v. Lennar Corp., 2012 WL 4760881, at *2 (Del. Ch. Oct. 5, 2012).)
While the court’s decision regarding the exculpatory provision was not necessarily unexpected, it remains to be seen how subsequent courts will treat the decision – either broadly or narrowly. The court, on several occasions, specifically noted that the plaintiffs in AbbVie sought inspection solely to investigate whether to bring derivative litigation, and that in order to state a proper purpose the claims must be non-exculpated. An exculpatory provision, such as a Section 102(b)(7) provision, however, does not bar all derivative litigation, and, accordingly, even in the face of an exculpatory provision, under certain circumstances investigating potential derivative litigation may still be a proper purpose. In particular, it is well established that an exculpatory provision under Section 102(b)(7) does not apply to corporate wrongdoing by officers of a corporation. Gantler v. Stephens, 965 A.2d 695, 708-09 (Del. Ch. 2009). Thus, the decision is inapposite under those circumstances. Moreover, the court’s decision does not prevent plaintiffs from seeking inspection if they can show a credible basis that the company’s directors have, in some manner acted disloyally (i.e., were interested in a transaction or were acting in bad faith) thereby offering a basis for non-exculpated claims.
Finally, investigating corporate wrongdoing is only one proper purpose for seeking to inspect books and records. The court’s decision does not prevent stockholders from seeking Section 220 inspections for other proper reasons such as to inform the company electorate of corporate wrongdoing (or to mount a proxy fight), seek an audience with the board, or to prepare a stockholder resolution for a company’s next annual meeting. Despite the effectiveness of a Section 220 investigation, it is also not the sole remedy for a stockholder seeking to hold fiduciaries accountable. Nothing in this decision prevents a stockholder or stockholders from exercising their voting rights in response to potential corporate wrongdoing.
The Citigroup Case
In Citigroup, issued just nine days after the AbbVie decision, the Court of Chancery found that the plaintiff had established a proper purpose to inspect the books and records of defendant Citigroup, Inc. Plaintiff’s stated purpose was to investigate possible mismanagement and breaches of fiduciary duty by Citigroup’s directors and officers in connection with recently-disclosed adverse events involving two of Citigroup’s subsidiaries: Bancop Nacional de Mexico, S.A. (“Banamex”) and Banamex USA.
On February 28, 2014, Citigroup disclosed that a recent fraud had been discovered at Banamex stemming from a $585 million extension of short-term credit to Oceanografia A.A. de C.V. (OSA), a Mexican oil services company, through an account receivables financing program. Banamex also had approximately $33 million in outstanding loans and credit to OSA. On February 11, 2014, Citigroup discovered that OSA had been suspended from being awarded new Mexican government contracts, causing Citigroup to investigate its credit exposure to OSA and the accounts receivable financing program. The investigation revealed that a significant portion of the accounts receivables recorded were fraudulent. As a result of this fraud, Citigroup adjusted downward its financial results by $235 million after tax and its net income fell from $13.9 billion to $13.7 billion.
On March 3, 2014, Citigroup also disclosed in its annual report on Form 10-K that it and its subsidiary, Banamex USA, had received grand jury subpoenas relating to compliance with BSA and AML requirements in connection with the U.S. Attorney’s Office’s investigation into “whether [Banamex USA] . . . failed to alert the government to suspicious banking transactions along the U.S.–Mexico border that in some cases involved suspected drug-cartel members.” Citigroup had previously entered into a series of consent orders (the “Consent Orders”) with various regulators in 2012 and 2013 relating to a number of the regulators’ findings that Citigroup and two of its subsidiaries, including Banamex USA, had deficient BSA/AML programs. As a result of the Consent Orders, Citigroup’s board agreed to “enhance its risk management program with regard to BSA/AML compliance.”
In light of these disclosures, the stockholders made a Section 220 demand. The stated purpose for inspecting the books and records of Citigroup was “to investigate mismanagement and possible breaches of fiduciary duty by Citigroup’s directors and officers in connection with the Banamex fraud and Banamex USA’s BSA/AML compliance” as well as “in contemplation of derivative ligation, [to investigate] the disinterest of the Board to determine whether presuit demand would be excused.” The company denied their inspection demand prompting the stockholders to initiate this Section 220 action.
Investigating a Parent for Failure to Monitor Subsidiary is a Proper Purpose
The case was originally tried on a paper record before a Master in Chancery. The court approved and adopted the Master’s final report that held that plaintiff had established a proper purpose. In connection with the Banamex fraud, the court noted that plaintiff’s intent is “to test whether it has viable Caremark claims against Citigroup’s fiduciaries for failing to fulfill their oversight responsibilities.” (A Caremark claim is a claim that directors failed to establish or oversee a monitoring system for a corporation's compliance with the law. See In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996).) The court explained that Caremark cases “are among the hardest to plead successfully” and that the court “has analogized the practice of immediately filing a complaint asserting such claims after a negative corporate event to purchasing a lottery ticket.” For this reason, the court “encourages stockholders to pursue a Section 220 demand instead of bringing a premature complaint.”
The court explained that the record would not support a motion to dismiss but emphasized that the relevant question was whether it established a credible basis, the “lowest burden of proof,” that plaintiff’s demand is based on more than mere suspicions and conjecture. Based on that framework, the court held that the fact that wrongdoing occurred did not mean that mismanagement occurred. However, the court noted that there were red flags that could have alerted Citigroup’s board to problems occurring at the subsidiary and that this fact and the “nature and magnitude of the Banamex fraud” created “at least a credible basis to infer deficiencies at Citigroup.” Whether plaintiff had a proper purpose for investigating the Banamex USA BSA/AML compliance was “a closer case.” The court noted that the existence of the Consent Orders in isolation would not satisfy the credible basis standard but held that based on the government’s targeted investigation against Citigroup and Banamex USA, the plaintiff “has cobbled together sufficient evidence, taken as a whole, to satisfy the threshold credible evidence standard” because it was reasonable to infer that Citibank either did not carry out the Consent Orders correctly or failed to carry out the orders. The court did not allow the plaintiff to investigate what led to the Consent Orders but allowed plaintiff to investigate Citigroup’s implementation of the “controls and compliance programs that it agreed to under the Consent Orders.”
Interestingly, in a footnote, the court distinguished this case from AbbVie. The court explained that in AbbVie, “the record did not establish a credible basis to doubt that directors had acted loyally in connection with approving and subsequently terminating a merger. The record reflected that the board was informed of the merger-related risks and had factored the risks into its decision to approve the deal.” The court explained that unlike AbbVie, the “Plaintiff is not asserting that Citigroup’s board improvidently made a business decision that imposed a substantial risk on the Company. Instead, the Plaintiff has established a minimum credible basis from which one can infer a failure of oversight at the Company.”
This distinction between AbbVie and Citigroup makes sense because Caremark claims arise from a lack of good faith, which is a subset of the duty of loyalty. The Citigroup decision is an example of the court’s willingness to find that a plaintiff established a proper purpose to inspect books and records when the allegations rise to the level of non-exculpated corporate wrongdoing, i.e., facts that would demonstrate a breach of the duty of loyalty.
Delaware law continues to evolve in response to a changing worldwide marketplace. The AbbVie and Citigroup decisions join a complex and fulsome body of Section 220 jurisprudence. Together, these decisions provide further guidance to stockholders and their counsel regarding the scope of what constitutes a “proper purpose” for Section 220 demands. By carefully stating an appropriate proper purpose, a stockholder can use this important investigative tool to materially aid its understanding of corporate activity, leaving it in a better position to act in an informed manner when confronted with the often difficult decisions facing stockholders today.