How to Prevent Pretextual Books and Records Demands

Delaware General Corporation Law § 220 permits shareholders to inspect a corporation’s books and records for a proper purpose, such as investigating managerial misconduct, valuing shares, or communicating with other shareholders. The Delaware case law interpreting this statute has created a troublesome loophole: Shareholders who are affiliated with the corporation’s competitors can make a “mere incantation of an accepted ‘valuation’ purpose” to gain access to the corporation’s sensitive business information unless the corporation proves the shareholders’ inspection demand is a pretense. Private corporations are especially vulnerable to pretextual inspections because shareholders can easily cite the lack of public information available about the corporation to justify their need for a valuation.

In a new paper, we discuss this loophole and propose solutions that would put the burden on competitor-affiliated shareholders to show that they genuinely need to value their shares and want to use § 220 to further that purpose.

Delaware courts have long held that a shareholder’s affiliation with competitors of the target corporation is insufficient grounds to deny an inspection. In 2020, the Delaware Court of Chancery took its pro-shareholder stance to a new level in Woods v. Sahara Enterprises, Inc. by holding that a shareholder is not required to provide a reason behind a stated need for a valuation to assert the inspection right. Instead, the court placed the initial burden on the target corporation to show that the shareholder’s valuation purpose was pretextual. Although the court stated that Delaware law does not require shareholders to establish both a proper purpose and “an end to which the fruits of the inspection will be put,” case law prior to Woods had required the inspecting shareholder to explain the need or reason behind the prospective valuation as a way to demonstrate the requisite bona fides. Woods’ shifting of the initial burden is inconsistent with how the law allocates the burden of proof in other contexts in which an actor’s motive is in dispute: A legal actor (here, the shareholder demanding the inspection) typically has the burden to show the purpose behind the action, not the other way around. This shift is consequential because the initial burden is, as the Woods court acknowledged, “fact intensive and difficult to establish.”

Even if the target corporation satisfies its initial burden of proof, a shareholder can easily counter an allegation that the inspection is pretextual by giving some superficial reason for the valuation. The shareholder need not support it with any concrete action, such as by taking steps to market the shares or search for potential buyers. Currently, a Delaware court will presumably deem the stated intention to sell the shares “when the market is right” credible even if a market does not exist in any practical sense.

To illustrate how Delaware law has made corporations vulnerable to pretextual § 220 inspections, let us imagine that a senior researcher worked for five years at Startup A, a Delaware corporation, where he accumulated 0.5 percent ownership of Startup A’s stock by exercising stock options he gained there as employment income. Startup B, a competitor, hires away this senior researcher from Startup A by offering him a higher salary. Startup A suspects that Startup B intends to expand into its niche field of business, which would present business challenges for Startup A. However, Startup A has no conclusive evidence of this. So long as the senior researcher still has that small holding of Startup A stock, he can file a § 220 inspection demand to access Startup A’s confidential information by merely stating that he needs to value his shares for a possible future sale.

A Delaware corporation can try to protect its confidential information from competitor-affiliated shareholders through confidentiality agreements or private ordering, but these methods are generally ineffectual. Delaware courts sometimes impose confidentiality restrictions on shareholder inspections, but the target corporation must show the court that the restriction is necessary. Courts are skeptical of indefinite durations and liquidated damages provisions in these agreements. A corporation could insert a meticulously drafted protective provision in its charter or bylaws, but Delaware courts have often refused to enforce these provisions. Likewise, they have invalidated protective provisions in shareholder agreements between corporations and their shareholders for technical errors, regardless of the parties’ apparent intentions in forming the agreement. Ultimately, the legal avenues available for a Delaware corporation to protect its confidential information from competitors are currently unreliable.

Despite Delaware courts’ admirable intention to protect shareholders and their rights, this heightened vulnerability for Delaware corporations is inequitable, and the law should evolve to better protect Delaware corporations from competitors who would use § 220 to gain an unfair business advantage. Instead, competitor-affiliated shareholders should be required to show that they actually need to value their shares and are taking steps toward their planned actions with the shares in order to use § 220 for the purpose of valuation. This would help deter shareholders from using the inspection right to fish for confidential business information and sharing it with a competitor. Furthermore, Delaware courts should consider a target corporation’s vulnerability to these pretextual inspection demands when they interpret contractual waivers of inspection rights, upholding waivers that are limited to the duration of a shareholder’s affiliation with a competitor. Through this evolution in the common law, Delaware courts can balance shareholders’ statutory inspection rights with protection for Delaware corporations from pretextual inspections.

This post comes to us from Lynn Bai and Sean Meyer at the University of Cincinnati College of Law. It is based on their recent paper, “No Peeking: Addressing Pretextual Inspection Demands by Competitor-Affiliated Shareholders,” available here.