Corporations and LLC's Flashcards
Summary
The shareholder had a “proper purpose” when she sought to inspect board minutes and accounting records relevant to alleged foreign bribes to determine whether to bring a lawsuit concerning possible illegal corporate conduct. Therefore, the shareholder is entitled to inspect the requested minutes and accounting records.
Because the MEGA board did not conduct a reasonable inquiry before concluding that it was not in the corporation’s best interest to investigate and remediate alleged illegal activities, the court is not required to dismiss the shareholder’s suit, and her claim can proceed.
The MEGA directors have a fiduciary duty to act in “good faith,” which encompasses an obligation not to condone illegal corporate conduct and to investigate credible evidence of such illegality. The business judgment rule does not protect decisions of directors to condone or disregard illegal corporate conduct, even if such conduct may be profitable for the corporation.
Does the shareholder have a “proper purpose” in seeking to inspect Mega’s board minutes and accounting records to determine whether to bring (and maintain) a suit concerning the alleged foreign bribes?
The shareholder has a right to inspect board minutes and accounting records if she has a “proper purpose.” Gathering information to decide whether to bring a lawsuit alleging a breach of fiduciary duties arising from illegal corporate behavior is a proper purpose.
Rule
A shareholder, whether of record or who beneficially owns her shares, has a right to inspect minutes of board meetings and “accounting records” for a proper purpose. Model Business Corp. Act (MBCA) § 16.02(b), (c), (f ). See also Del. Gen. Corp. L. § 220(b) (inspection right encompasses “corporate books and records”). A proper purpose is a purpose reasonably related to a person’s interest as a shareholder, “such as a desire . . . to determine whether improper transactions have occurred.” Official Comment, MBCA § 16.02(d) (2011). See also Del. Gen. Corp. L. § 220(b).
Application
Here, the shareholder has an interest in determining whether the directors permitted the corporation to engage in illegal conduct that could result in the corporation paying civil and criminal penalties. An inspection request must be granted whenever the shareholder articulates a purpose to address “economic risks” to the corporation. See Conservative Caucus v. Chevron Corp., 525 A.2d 569 (Del. Ch. 1987) (permitting inspection of shareholders’ list by shareholder seeking to propose that corporation stop doing business in communist Angola, based on alleged economic risks to corporation).
Rule 2
A shareholder seeking inspection of corporate documents must offer credible evidence that there was mismanagement or other improper conduct. See Security First Corp. v. U.S. Die Casting and Dev. Co., 687 A.2d 563 (Del. 1997) (shareholder has burden to show credible evidence of possible mismanagement to obtain inspection of books and records).
Application
Here, the news story in a leading financial newspaper, coupled with the board’s failure to investigate or to deny the truth of the allegations in the news story, appears to constitute a credible basis for concluding that MEGA may have engaged in illegal conduct. Moreover, although MEGA’s response to the shareholder indicated that the news story about the illegal foreign bribes was “unsubstantiated,” there is no indication in the facts, nor did MEGA make the assertion, that the news story was untrue.
Rule 3 and Application 3
Under the MBCA, the shareholder’s right to inspect corporate documents relevant to the alleged bribery is subject to certain limitations. The MBCA allows a shareholder to inspect “only relevant excerpts of [board] minutes . . . directly connected with the shareholder’s purpose.” Official Comment to MBCA § 16.02(c) (2011). The MBCA also allows inspection of “accounting records,” although this category is not as broad as the “books and records” category found in other corporate statutes. According to the Official Comment, accounting records are “records that permit financial statements to be prepared which fairly present the financial position and transactions of the corporation.” Official Comment to MBCA § 16.01(b). Many documents related to the payment of foreign bribes could be seen to be “accounting records,” to the extent that they relate to how such transactions would be presented in the corporation’s financial statements. Under the MBCA, the corporation could refuse to allow inspection of non-financial documents related to the alleged foreign bribery.
In sum, the shareholder has a right to inspect MEGA’s board minutes and accounting records related to the alleged bribery of Country X officials because her purpose is connected to bringing a lawsuit to protect her economic interest in MEGA.
[NOTE: Under the MBCA, a “proper purpose” need not be shown for the inspection of minutes of shareholders’ meetings. See MBCA §§ 16.01(e), 16.02(a). But here the shareholder asked for board minutes, for which a “proper purpose” must be shown. See MBCA § 16.02(d)(1).
Under the MBCA, the shareholder’s inspection rights were not terminated when she filed her derivative claim against the MEGA directors. The MBCA instead specifies that shareholders who have been denied inspection may apply for a court order permitting inspection, which the court is to decide “on an expedited basis.” MBCA § 16.04(b). Courts have encouraged shareholders to first seek inspection of corporate documents before bringing suits alleging improper corporate transactions and breaches of fiduciary duty. See Brehm v. Eisner, 746 A.2d 244 (Del. 2000). But the right to inspection has been recognized even while a lawsuit is proceeding. See King v. VeriFone Holdings, Inc., 12 A.3d 1140, 1145–46 (Del. 2011).]
May the board obtain dismissal of the shareholder’s derivative claim if the board concludes that it is not in the corporation’s best interest to continue the lawsuit, even though the board has not investigated the allegations of illegal foreign bribes?
The board may not obtain dismissal of the shareholder’s derivative claim, even if the board concludes that it is not in the corporation’s best interest to continue the lawsuit, because the board’s conclusion was not based on a reasonable investigation into the shareholder’s allegations.
Rule
Under the MBCA, the board can seek dismissal of the shareholder’s derivative action if a majority of the board’s “qualified directors”—those directors who do not have a material interest in the derivative action, see MBCA § 1.43(a)(1)—determine in good faith, after conducting a reasonable inquiry upon which its conclusions are based, that continuance would be contrary to the corporation’s best interests. MBCA § 7.44(a) & (b). Although the Official Comment to MBCA § 7.44 suggests that a full-blown board investigation is not necessary, the board’s request for dismissal must have “some support in the findings of the inquiry.” Failure to investigate credible allegations of corporate illegality constitutes lack of “good faith.” Stone v. Ritter, 911 A.2d 362, 364–65 (Del. 2006) (stating that directors breach duty of good faith if they “knew or should have known” of violations of law and failed to act).
Application
Here, given the apparent lack of any inquiry or corrective action by the board, as evidenced by the letter of June 1 to the shareholder, the court should not grant the motion to dismiss the derivative action or accept the board’s conclusion that proceeding with the lawsuit would be contrary to the corporation’s best interests.
[NOTE: Directors breach their fiduciary duties by failing to act upon “red flags” of corporate illegality. See Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del. 1963) (directors breach their duties by ignoring “obvious danger signs” of illegal corporate conduct). Here, the MEGA board’s failure to investigate the shareholder’s allegations based on a report in a leading financial newspaper, which the board did not deny, suggests bad faith on the part of the directors, thus excusing demand. See In re Abbott Laboratories Derivative Shareholders Litig., 325 F.3d 795, 806 (7th Cir. 2003) (excusing demand when shareholders alleged that directors had known of illegal activity and allowed it to continue).]
Is the decision of the MEGA directors not to investigate or take action on the shareholder’s allegations of illegal corporate behavior a breach of the directors ’duty to act in good faith, and is that decision protected by the business judgment rule?
The MEGA directors’ disregard of the legality of the corporation’s conduct is a failure to act in good faith and is not protected by the business judgment rule, even if the directors believed the conduct to be in the corporation’s best interests.
Rule
A director is liable to the corporation for the director’s decisions or failures to take action that were “not in good faith.” MBCA § 8.31(a)(2)(i). The Official Comment to this section states:
Conduct involving knowingly illegal conduct that exposes the corporation to harm will constitute action not in good faith, and belief that decisions made (in connection with such conduct) were in the best interests of the corporation will be subject to challenge as well.
Courts applying the duty of good faith have made clear that corporate directors cannot consciously violate—or permit the corporation to violate—legal norms, even when such violations may be profitable to the corporation. The Official Comment to MBCA § 8.31 states that “a lack of good faith is presented . . . where a transaction . . . is known to constitute a violation of applicable positive law.” See Gagliardi v. TriFoods Int’l Inc., 683 A.2d 1049, 1051 (Del. Ch. 1996); Hillary A. Sale, “Monitoring Caremark’s Good Faith,” 32 Del. J. Corp. L. 719 (2007) (collecting and summarizing cases where directors were alleged to have failed to monitor illegal corporate conduct).
In addition, the duty to act in good faith requires corporate directors to establish procedures to ensure the corporation’s compliance with legal norms. See Stone v. Ritter, supra, at 369–70. Thus, courts have required corporate directors to establish “[corporate] information and reporting systems” that provide “timely, accurate information . . . concerning both the corporation’s compliance with law and its business performance.” In re Caremark Int’l, Inc. Derivative Litig., 698 A.2d 959, 970 (Del. Ch. 1996); see also Official Comment to MBCA § 8.30 (citing Caremark for proposition that board of directors must ensure that the corporation “has information and reporting systems in place to provide directors with appropriate information . . . to permit them to discharge their responsibilities”).
The “good faith” standard requires that directors, among other things, not approve (or condone) wrongful or illegal activity. See In re Walt Disney Co. Derivative Litig., 825 A.2d 275, 289 (Del. Ch. 2003) (holding that attitude of “we don’t care about risks” breaches duty of good faith). In particular, directors violate their fiduciary duties by approving bribery of foreign government officials, even when the practice is widespread. See Gall v. Exxon Corp., 418 F. Supp. 508 (S.D.N.Y. 1976).
Application and Rule
Even when disregard of legal norms might result in a net financial benefit to the corporation, directors are required to comply with the law. See In re Caremark Int’l, Inc., supra (requiring internal controls even with no net financial benefit to corporation); see also Guttman v. Huang, 823 A.2d 492, 506 (Del. Ch. 2003) (fiduciary cannot manage entity in illegal fashion, even if fiduciary believes illegal activity will result in profits for the entity). Here, the failure of MEGA’s directors to investigate or take corrective action regarding alleged illegal foreign bribes exposes the corporation to significant penalties and constitutes action not in good faith.
The business judgment rule does not protect decisions by directors not acting in good faith. As the Official Comment to MBCA § 8.31 summarizing the business judgment rule states:
In basic principle, a board of directors enjoys a presumption of sound business judgment . . . that, in making a business decision, directors act in good faith, on an informed basis, and in the honest belief that the action taken is in the best interests of the corporation. See Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1983).
Specifically, the business judgment rule, while normally protecting the honest business judgment of directors, does not apply upon a showing of “illegality.” See Shlensky v. Wrigley, 237 N.E.2d 776, 778 (Ill. App. Ct. 1968) (business judgment rule applies “unless there is a showing of fraud, illegality, or conflict of interest”).
Directors breach their fiduciary duties—and the business judgment rule provides no protection— when they approve illegal business operations (or refuse to investigate alleged illegal business activities), even though the illegal business may be profitable to the corporation. See Roth v. Robertson, 118 N.Y.S. 351 (Sup. Ct. 1909) (bribery of state officials to protect an amusement park’s illegal Sunday operations); Miller v. AT&T, 507 F.2d 759, 761 (3d Cir. 1974) (corporation’s failure to collect loan to political party, in violation of campaign finance laws).
Thus, the MEGA directors would not be protected by the business judgment rule.
