The proposed amendments to Delaware corporate law have sparked intense debate among corporate legal scholars and practitioners. A flurry of commentary has focused thus far on the proposed changes to Section 144, which governs transactions with controlling shareholders. This post, by contrast, focuses on the proposed changes to Section 220, which governs shareholders’ inspection rights. While the issue of what “books and records” shareholders can inspect before filing a lawsuit may seem incidental, it is key to how corporate law works.

The proposed changes restrict the scope of documents that shareholders can inspect, in ways that hinder the market’s ability to discipline corporate insiders. To understand why, consider the evolution of inspection rights. Shareholders have always enjoyed a qualified right to inspect their company’s books and records. However, the exact scope of this right has never been defined by statute but rather developed in court rulings. Over the past decade, courts have acknowledged that key company communications increasingly occur through electronic channels: Directors email advisers, text one another, and use informal messaging platforms. To enable outside shareholders to learn what insiders are doing and potentially hold them accountable, courts have increasingly allowed shareholders to inspect these electronic communications.

The proposed amendment reverses this trend. It limits the kinds of documents that shareholders can obtain to core materials, such as the certificate of incorporation, minutes of shareholder and board meetings, and financial statements. While the proposed amendment leaves courts some discretion to order other documents turned over, that discretion is limited to circumstances where a company does not have formal documents such as proper board minutes.

The impact of limiting shareholders’ inspection rights to formal materials cannot be overstated. Access to electronic communications has often been essential in corporate litigation over the past decade, as illustrated by two examples.

First, in Morrison v. Berry, Ray Berry – the founder of The Fresh Market – joined forces with a private equity firm to bid for the company. A shareholder used Section 220 to unearth internal emails revealing that Berry had committed to a specific bidder. That bidder had offered Berry private benefits he probably could not have obtained from other bidders, such as a $25 million payout and an employment package. Berry did not share the full details with the board in a timely manner, and the company’s proxy statement excluded these details. Uncovering this email helped shareholders ensure that their lawsuit survived a motion to dismiss.

Second, in Calgon Carbon, a stockholder asserted that a target company’s board was not receptive to alternative bids. By obtaining emails, the stockholder was able to challenge the deal pre-closing by showing that the officers and directors were so focused on their own retention and compensation that it could be inferred they were beholden to a single bidder.

The ability to inspect informal materials has been instrumental not only in deal litigation, but also for oversight claims, such as in the Boeing case. The reasoning is straightforward: Formal documents such as board minutes are usually drafted after the fact, by paper-trail-generating lawyers. Informal electronic communications are created in real time and tend to be more candid. Allowing shareholders to inspect informal communications thus increases the chance that they will expose shenanigans or a lack of effort.

To be sure, allowing inspection of informal communications has clear downsides. Senator Bryan Townsend, who introduced the proposed amendment, noted for example that disputes over what documents to provide have become increasingly protracted.

Whether the benefits from robust pre-lawsuit investigations outweigh the costs depends on the case, which is why it is better to leave these decisions up to Delaware’s expert judges rather than to resolve them through legislation. Followers of Delaware case law know that the courts do not order provision of electronic communications automatically. Instead, the courts closely manage the categories of information that companies must provide, striking down some categories as overboard while allowing others. In doing so, Delaware courts carefully weigh the incremental contribution of each set of documents against the costs of expanding discovery.

That leads to a broader point about the goal of the new legislation. Its proponents have invoked the concept of shareholder primacy and the need to let the market work its magic, arguing that litigation is a tax on companies that benefits only lawyers. We do not need judges to intervene with the benefit of hindsight, the argument goes, when market forces (notably, institutional investors) can themselves discipline corporate misbehavior. Perhaps that logic can justify the proposed amendments to Section 144, but it makes little sense when applied to the proposed Section 220 amendment, which makes it harder to rely on shareholder voting.

A shareholder vote cannot discipline behavior unless it is informed, and the only way to ensure an informed vote is with the threat of exposing discrepancies between what insiders knew and what they told the outside world. In many cases, the only way to ensure a credible threat is to allow shareholders to inspect informal communications rather than just a few documents selected and prepared for the purpose. In other words, assuring votes are informed requires a one-two punch: a requirement to disclose all material information about a planned transaction and a potent enforcement mechanism. The MFW decision itself nudged shareholders to use their inspection rights to ensure that the market-based process (a shareholder vote and an independent committee) functions effectively.

The proposed amendment may also lower the quality of future board minutes. Under the current system, boards have incentives to create meaningful minutes, because producing detailed minutes effectively eliminates the risk that a court will order the provision of additional documents. The proposed amendment requires minutes, not necessarily meaningful minutes. As a result, boards may have incentives to revert to the once-prevalent short-form, agenda-style mode of minutes that do not provide meaningful information.

The proposed amendment to Section 220 will not eliminate litigation but make it less effective and socially useful. Since the 1993 Rales decision, Delaware courts have implored plaintiffs to use their inspection rights to create more detailed complaints so courts can quickly screen out ones that are without merit. Prefiling discovery is not necessarily bad for corporate defendants. A more informed complaint can help a court dismiss it early if the information pertains to business mistakes rather than breaches of fiduciary duties. To revisit the example of a failure-of-oversight claim, Stone v. Ritter started as a Section 220 case. There, the documents that the plaintiff extracted convinced the courts to dismiss the complaint. Using information from Section 220 to reveal quickly that there is no actionable claim is not necessarily bad for plaintiffs, either; it can help them cut their losses early instead of continuing to invest in a weak case.

The expansion of shareholder inspection rights has raised difficult issues, but it is better than the alternatives. To strike the right balance between, on the one hand, deferring to business judgments and screening frivolous litigation and, on the other hand, facilitating the monitoring of corporate misbehavior, case-specific methods such as “fee shifting” are preferable: If plaintiffs risk paying defendants’ legal costs for meritless claims, and if defendants risk covering plaintiffs’ costs for unjustified refusals to produce materials, Section 220 disputes will be less frequent and quicker to resolve. Cases such as Gilead have already moved in that direction, showing that Delaware judges are up to the task.

This post comes to us from Roy Shapira, a professor of law at Reichman University and a research member at ECGI.