New Developments

Delaware Court of Chancery on inspecting books and records before share ownership

The Delaware Court of Chancery has held that a shareholder may inspect books and records related to acts occurring before the shareholder owned shares where the purpose is to assemble facts showing demand futility rather than to investigate misdeeds the stockholder would have no standing to assert. In Melzer v. CNET Networks, Inc., plaintiff filed a derivative complaint in federal court. The District Court dismissed without prejudice for failure to plead demand futility and stayed the proceedings to allow a books and records request under DGCL § 220. Mr. Melzer filed an action in the Court of Chancery when CNET resisted his demand as to documents related to facts that pre-date Mr. Meltzer’s share ownership. CNET’s primary argument against inspection is that plaintiff would not have standing to assert any claims uncovered by documents predating his share ownership.

Chancellor Chandler permitted inspection. He premised his decision on the idea that, “A stockholder must be given sufficient access to books and records to effectively address the problem of backdating through derivative litigation.” Under Stone v. Ritter, one way to show demand futility is to allege a Caremark claim. The standard of review for such a claim is a sustained or systematic failure to exercise oversight. To allow plaintiff to effectively address that claim, he is entitled to inspect documents that pre-date his stock ownership.

This opinion is noteworthy because it’s a nice synopsis of the Delaware Court of Chancery’s approach to books and records requests. It’s a good applied example of the Supreme Court’s recent Seinfeld decision, which was primarily theoretical. It also suggests that Caremark claims may be more useful that one might think at first blush. In Caremark and Stone, and perhaps other opinions, the Delaware courts have observed that a failure to monitor claim is extraordinarily difficult to maintain, in large part because the standard of review is so high. The board is liable only if it intentionally engaged in a sustained or systematic failure to monitor. However, this opinion suggests that plaintiff might be able to use a colorable Caremark claim to inspect books and records beyond those the plaintiff might ordinarily inspect because those broader records are germane to whether the board exhibited a sustained or systematic failure to monitor. Obviously the real effect of this opinion will depend on how the Court of Chancery bench shape their orders permitting inspection. I suspect this will be a subject of warm contention for a while until an aesthetic of inspection for Caremark claims emerges.

The Chancellor was clearly annoyed with CNET’s resistance. He began the opinion by observing, “This should have been a very easy case.” With wonderful symmetry, he ends with another pithy statement: “It is about time defendant … gets ‘going, going / back,

back / to Cali, Cali,’ ” citing, of course, to The Notorious B.I.G.

This case could be taught in Chapter 15 along with Seinfeld. Francis Pileggi was kind enough to send me this case and, as ever, had a good post here.

Supreme Court of Missouri on cancelled shares

The Supreme Court of Missouri has erroneously held that put options may be exercised even after the underlying shares have been cancelled. In Weinstein v. KLT Telecom, Inc., Weinstein obtained an option in December 2000 to put shares of DTI Holdings, Inc. to KLT Telecom, Inc. at $15 million. The option was exercisable beginning September 1, 2003. Weinstein gave the share certificates to an escrow agent to hold. DTI entered bankruptcy in 2001 and in June 2003 the bankruptcy court cancelled all DTI equity securities. On September 2, 2003 (September 1 was Labor Day), Weinstein sought to exercise the option. KLT refused and Weinstein filed suit. KLT’s primary defense was failure of consideration because the shares had ceased to exist at the time of exercise.

Judge Limbaugh held that the consideration should be measured when the option contract was entered into and thus the option was supported by consideration, even though the shares later became worthless. To the extent KLT was arguing failure of performance by Weinstein, Judge Limbaugh held that

The shares, though worthless, do in fact exist, and they were tendered to [KLT] through the escrow agent.

Judge White, in dissent, pointed out the distinction between worthless shares and nonexistent shares. If the value of the DTI shares had simply been zero, the option could be exercised. However, the shares were cancelled; they ceased to exist. Thus there was a failure of consideration.

Judge White must be correct in this interpretation. Missouri’s corporations statute does not contain a cognate to MBCA § 6.03(a): “Shares that are issued are outstanding shares until they are reacquired, redeemed, converted, or cancelled.” Nonetheless, the common law concept of cancelling shares is that the shares cease to exist. Obviously the certificates for cancelled shares simply represent nothing. This case could be taught in Chapter 6 at page 197 in connection with the concept of “outstanding”.