Chancery Grants Records Under Section 220 Despite Pending Federal Securities Suit
Paul v. China MediaExpress Holding, Inc., C.A. No. 6570-VCP (Del. Ch. Jan. 5, 2012), read opinion here.
(1) Whether a Section 220 case should be stayed pending the outcome of a related federal securities suit; and (2) Whether the shareholder in this case established a proper purpose to inspect books and records under DGCL Section 220.
(1) Based on a three-part test as applied to the facts of this case, the Court refused to stay this action in favor of a pending related federal securities suit, even though a motion to stay was also pending in the federal court. (2) In this post-trial opinion, the Court determined that the shareholder established a proper purpose and was entitled to the documents necessary to investigate that proper purpose.
This is another installment in what can be referred to as the Court of Chancery’s “China Series,” to the extent that it deals with corporate governance complaints involving Delaware entities that are based in or conduct most of their operations in Hong Kong and/or mainland China. The defendant company in this case was engaged in the business of television advertising on buses in China. Until recently it was listed on the NASDAQ, which listing it obtained via a merger with a public company in 2009. The shareholder in this case sought books and records after a report was released indicating that the defendant company (“CME”) was engaging in fraudulent practices. Shortly after those reports, the independent auditor of the company, Deloitte Touche Tohmatsu (“DTT”) resigned, stating in its resignation letter that it was “no longer able to rely on the representations of management”. That same day, the company requested that NASDAQ temporarily suspend trading in its stock. Following the resignation of DTT, the CFO of the company as well as another CME director also resigned. Shortly thereafter, NASDAQ notified the company that it was suspending trading in the company’s stock and then NASDAQ delisted shares of CME.
Meanwhile, another investor filed a complaint in the U.S. District Court for the District of Delaware alleging violations of state and federal securities laws and breach of fiduciary duty. Discovery in that matter was stayed pending the resolution of a motion to dismiss pursuant to the Private Securities Litigation Reform Act (“PSLR”).
In May 2011, while the federal action was proceeding, the shareholder in the instant matter served a written demand on CME for books and records pursuant to DGCL Section 220. No response was forthcoming by CME and as a result a complaint was filed in this action on June 16. A trial date was set for October 11, 2011.
On September 27, 2011, CME moved in the Federal Action for a stay of discovery in this Section 220 action pursuant to the Securities Litigation Uniform Standards Act (“SLUSA”). Then, less than a week before the scheduled trial in this action, CME requested a continuance of the trial date in this case until after the District Court decided the Motion to Stay. The Court of Chancery denied the request and the trial in this matter proceeded on schedule in October.
This decision provides a helpful overview of the prerequisites that must be satisfied in order for a shareholder to successful pursue a demand for books and records under Section 220. For example, the Court discusses the prerequisites under DGCL Section 220 such as proper purpose and a credible basis to allege wrongdoing.
A shareholder who seeks books and records (other than the stock ledger or list of stockholders) has the burden of proof to demonstrate a proper purpose for inspection by a preponderance of the evidence. There are many proper purposes that have been well established, including investigation of waste and mismanagement, for which there must be a credible basis “through documents, logic testimonial or otherwise”, from which the Court can infer wrongdoing, although actual proof of wrongdoing is not necessary.
The Court explained that a credible basis is the lowest possible level of proof and does not require a preponderance. It must be a showing from which the Court can infer that there are reasonable grounds to suspect mismanagement that would warrant further investigation. This showing may ultimately fall well short of demonstrating that anything wrong occurred.” See footnotes 31-32.
In this case, Court found a credible basis for suspicion of waste and mismanagement based on numerous third-party media reports alleging fraudulent conduct, the halting of trading by NASDAQ, as well as delisting of CME shares; the resignation of the company’s independent auditors, the noisy resignations of three board members and the CFO, as well as the initiation of CME’s own internal investigation. The Court noted that that next lowest standard other than credible basis would be to eliminate the requirement that the stockholders show any evidence of possible wrongdoing. The Court also noted that for purposes of establishing a credible basis, the Court may rely on hearsay evidence. See footnote 34-35.
The Court emphasized that the defendant misunderstood the relevant law about whether or not the proper purpose could be defeated by a showing that the plaintiff could not prove that he would qualify as a representative plaintiff in a later class derivative action. Instead, the Court explained that the purpose stated in this case is to investigate the independence of directors in anticipation of alleging demand futility, and if later a class or derivative suit is brought, it is sufficient if the shareholder would have standing to bring either a direct or derivative claim against the company following the requested inspection– regardless of whether the shareholder would qualify as a representative plaintiff in a later class or derivative action. See footnote 40.
Scope of Demand
The Court emphasized that even after a proper purpose is established, that the scope of inspection for the books and records demand must be “circumscribed with precision and limited to those documents that are necessary, essential and sufficient to the stockholder’s purpose”. See footnotes 42-45.
This opinion recites each and every document requested and examines which of them satisfy the “scope of demand” related to the proper purpose established, and then the Court describes which specific books and records will be ordered for production.
This post-trial opinion is indicative of how expensive and unpredictable Section 220 cases can be. After the substantial cost of a trial, the only thing that the shareholder won, after prevailing in this Section 220 case, is the right to receive a limited scope of documents. After spending what was a considerable sum on discovery and trial preparation on an expedited basis, one can still predict skirmishes between counsel over what specific documents the company will claim that it has – - compared to documents that are actually sought.