Delaware Chancery Court Rejects Stockholder's Section 220 Books and Records Demand Based Upon Failure to Demonstrate "Credible Basis" for Inspection

by Sheppard Mullin Richter & Hampton LLP

In Louisiana Municipal Police Employees’ Retirement System v. Lennar Corp., C.A. No. 7314-VCG, 2012 WL 4760881 (Del. Ch. Oct. 5, 2012), the Delaware Court of Chancery, on a motion for summary judgment, rejected a stockholder’s demand under Section 220 of the Delaware General Corporation Law (“Section 220”).  Section 220 provides that a stockholder in a Delaware corporation may, under certain conditions, request and cause the corporation to make available for inspection certain books and records, provided the demand has a proper purpose and some credible basis exists for suspecting mismanagement, waste, or wrongdoing.  In this instance, although the court found the purpose of the demand — investigation of the corporation’s compliance with labor law — to be proper, it held that the evidence presented did not amount to a credible showing that legitimate issues of mismanagement existed to warrant an investigation.

The facts in the case were not in dispute. In September 2011, a news article reported that the U.S. Department of Labor was investigating several of the nation’s largest home builders, including Lennar Corp. (“Lennar”), to enforce compliance with the Fair Labor Standards Act (“FLSA”). Nine days later, a follow-up article reported that state-level agencies and the IRS had joined the investigation. Shortly thereafter, plaintiff Louisiana Municipal Police Employees’ Retirement System sent a Section 220 demand letter to Lennar seeking board minutes and other documents related to Lennar’s compliance with state and federal labor laws, tax and immigration laws, citing the recent news articles. Lennar rejected the demand, claiming that plaintiff had no credible basis for believing there had been wrongdoing by Lennar.

In response to the rejection, plaintiff filed an action to obtain the requested books and records. In its lawsuit, plaintiff relied on the news articles it had cited in its demand letter and on a series of eight settled lawsuits brought by Lennar employees against Lennar between 2007 and early 2009 alleging FLSA violations. Lennar moved for summary judgment, contending that plaintiff’s evidence was insufficient as a matter of law to support a Section 220 demand.

The Chancery Court first considered whether plaintiff’s stated purpose for the demand was proper. The court noted that Delaware law recognizes that an investigation of corporate mismanagement, waste or wrongdoing is a proper purpose provided the issues investigated affect the stockholder’s interest as a stockholder, and thereby permit the stockholder to seek a remedy. Based upon this standard, plaintiff agreed that it lacked standing to investigate any past wrongdoing that gave rise to the 2007-2009 FLSA suits, and that it sought to investigate only ongoing mismanagement relating to labor law compliance. The court determined that plaintiff stated a proper purpose.

The court next considered whether a credible basis existed to believe mismanagement was in fact occurring to warrant a Section 220 inspection. The court remarked that absent some required showing, Section 220 inspections would occur upon mere suspicion, indiscriminately exposing corporations to constant fishing expeditions and draining corporate resources. At the same time, under a “credible basis” standard, a stockholder need not prove actual wrongdoing occurred, but must only show legitimate mismanagement issues exist. The court noted that this standard is so low that to lower it more would remove the requirement of coming forward with evidence altogether.

Nevertheless, the court concluded that the evidence plaintiff presented failed to clear even this low hurdle. It found that the past FLSA lawsuits as proof of present wrongdoing required an improper, speculative inference, and thus lacked probative value. Specifically, the last of the lawsuits was brought in early 2009, more than two years earlier. All of the lawsuits settled without an admission of wrongdoing. Furthermore, plaintiff offered no proof that the number of FLSA lawsuits — eight — represented a disproportionally high or unusual number for a company of Lennar’s size. Plaintiff itself did not rely on the suits in its demand letter.

The court also discounted the evidentiary value of the newspaper articles. While a newspaper article reporting on possible wrongdoing could meet the “credible basis” test (at least where there is some corroborating evidence), the articles here did not identify any actual mismanagement. The articles mentioned only the existence of the investigation and named Lennar as one of the companies being investigated. As the court put it, the articles provided “no reportorial suggestion, based on investigation, that Lennar is engaged in wrongdoing.”

Lastly, the court considered whether the past lawsuits and the newspaper articles taken together supplied a credible basis of misconduct justifying a Section 220 inspection. It concluded that, because the probative value of each item was so negligible, combining them could make no difference, and granted summary judgment.

This case confirms that the Delaware Court of Chancery, while continuing to endorse the use of Section 220 to investigate claims before stockholders file suit on behalf of the corporation, will nevertheless insist that stockholders meet the low evidentiary showing required to justify imposing Section 220’s books and records inspection burden on the corporation.

For further information, please contact John Stigi at (310) 228-3717 or John Landry at (213) 617-5561.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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