In 2006 a record number of unhappy shareholders fought in Delaware courts to enforce their demands to inspect corporations' books and records. What caused this dramatic increase? Delaware courts frequently chastised shareholders for failing to use this powerful fact-gathering tool before bringing derivative suits. Many states, including Washington and Delaware, also recently expanded shareholders' statutory inspection rights.

In this Update we highlight two recent Delaware cases, Polygon and Shamrock, that identify important defenses available to corporations responding to inspection demands, and provide practical advice.

The Polygon and Shamrock Cases

Inspection demands often foreshadow important events. Unhappy shareholders often make requests to inspect corporations' books and records as a prelude to taking significant action, such as:

• Instituting derivative litigation;
• Seeking an audience with the board to discuss proposed reform;
• Preparing a stockholder resolution for the next annual meeting;
• Mounting a proxy fight to elect new directors; and/or
• Selling their shares.

In Polygon,a hedge fund bought shares shortly after the West Corporation announced that the company would go private in a squeeze-out merger transaction. Polygon bought West Corporation stock because it believed that the squeeze-out merger provided inadequate cash to the minority shareholders. Polygon brought a court action after West refused to grant its request to inspect West's books and records.

In Shamrock, a different hedge fund shareholder brought an action after iPass Inc. refused the shareholder's request to inspect iPass's books and records. Shamrock claimed that its disappointment with the results of a recent merger prompted its inspection demand in order to investigate potential mismanagement and misrepresentations.

Two Proper Purposes:  Share Valuation and Wrongdoing or Mismanagement

In Delaware, and generally in Washington (and other states), shareholders' requests to inspect a corporation's records require a "proper purpose."

Share Valuation.  In Polygon the Delaware Court of Chancery, consistent with prior law, clarified that a shareholder seeking information regarding share valuation in connection with a determination to seek appraisal satisfies the share valuation requirement.

• Requires Inadequate Public Information. Importantly, however, the court held that a shareholder must also demonstrate that the corporation provided inadequate public information. In Polygon the publicly traded corporation had produced "a wealth" of publicly available information pursuant to SEC rules governing "going private" transactions. The court therefore denied the shareholder's inspection request because the hedge fund had all the necessary, essential and sufficient information to determine whether to seek appraisal.

Polygon provides a key defense for corporations facing shareholder inspection requests for the alleged purpose of valuing shares – the requirement that a shareholder must demonstrate insufficient public information. A shareholder inspection request that does not do so provides a proper basis for the corporation to deny the shareholder's demand. Although the court did not make this a "per se" rule, shareholders will face an uphill battle in situations where the company complied with its disclosure obligations in going private transactions, or where fulsome public records are available.

Wrongdoing or Mismanagement.  Polygon asserted a second purpose for its records inspection request – it also claimed that it wanted to investigate possible mismanagement. Consistent with prior law, the Polygon court concluded that investigating wrongdoing or mismanagement satisfies the proper purpose requirement.

• Requires Credible Evidence.  A shareholder must do more than simply assert wrongdoing or mismanagement:  the shareholder must also establish some credible evidence sufficient to warrant continued investigation. In Polygon, the court denied the shareholder's request, in part because Polygon failed to provide credible evidence of wrongdoing. In contrast, the court in Shamrock refused to dismiss the shareholder's inspection request because the shareholder both alleged mismanagement after the merger and provided credible evidence (the board's failure to adopt an integration plan in a timely and comprehensive fashion).

As these two cases illustrate, shareholders requesting records inspection to investigate wrongdoing or mismanagement face a significant hurdle. Delaware corporations should keep this defense in mind as a potential basis for denying a shareholder's inspection demand. For corporations organized in other states that look to Delaware for guidance, these cases and the cases cited within the opinions provide potentially helpful guidance for responding to records inspection requests.

Additional Information

You can find the full text of the Delaware Court of Chancery's decision in Polygon Global Opportunities Master Fund v. West Corp., C.A. No. 2313-N (Oct. 12, 2006) at http://courts.delaware.gov/opinions/(333fpvjfaqfvqd45skq0b12d)/download.aspx?ID=83230. You can find the full text of the Delaware Court of Chancery's decision in Shamrock Activist Value Fund, L.P. v. iPass Inc., C.A. No. 2462-N (Dec. 15, 2006) at http://courts.delaware.gov/opinions/(333fpvjfaqfvqd45skq0b12d)/download.aspx?ID=85720. You can find discussion of other recent cases, laws, regulations and rules of interest to public companies on our website.