Inspection Of Corporate Books: A Powerful Tool For Discovery

Stuart L. Pachman of Brach Eichler L.L.C.


A decision, Cain v. Merck & Co., Inc., 415 N.J. Super. 319 (App. Div. 2010), has focused attention on N.J.S. 14A:5-28 (the "Statute"), as a tool for discovery available to shareholders and directors in both public and closely held corporations. A pending action, through which litigation discovery rights and the subpoena power may be exercised, is not a prerequisite to the ability of directors and shareholders to inspect corporate books and records and gain access to information that the corporation may prefer not to disclose.

In the small corporation, the Statute affords minority shareholders a sword supplemental to their right to claim oppression. Whereas invoking minority oppressionrisks a motion to be bought out, exercising one's right of inspection may avoid that threat. Thus shareholders in closely held corporations should be wary of issuing shares to reward loyal long term "non-family" employees. Rather then issuing shares which would make the employee a shareholder, it is more advisable for the award to be in the form of money or stock rights (phantom stock). Once the "outsider" becomes a shareholder, he or she has the right to inspect the corporation's books of account and learn facts which the other shareholders probably prefer to keep within the family.

As to publicly held corporations, courts have suggested that before shareholders file a derivative action without first having made a demand on the board of directors, they should exercise their right of inspection to obtain the factual basis to support the argument that they are excused from demanding action by the board.

Because inspection rights have both common law and statutory roots, shareholder inspection rights differ depending on what one desires to review. As noted by the Cain court, the shareholders' statutory right of inspection prior to the adoption of the New Jersey Business Corporation Act (BCA) effective January 1, 1969, was limited to transfer books and stock books, but New Jersey had also recognized a common law right of inspection that was more expansive. Compare Drake v. Newton Amusement Corp., 123 N.J.L. 560 (Sup. Ct. 1939), and Rosenbaum v. Holthausen, 9 N.J. Super. 484 (Ch. Div. 1950). It has been held that the Maryland statutory right of inspection extinguished common law rights in that state. Without regard to whether that rule would apply in New Jersey, it would appear that the Corporate Law Revision Commission, in crafting the BCA, adopted from the Model Act as it then existed and melded into the Statute both pre-existing statutory and common law rights.

Section 1 of the current Statute requires the corporation to keep specified books and records. Under Section 2 any shareholder may request and receive the corporation's year end balance sheet and income statement. Section 3, which deals with shareholder minutes and the list of shareholders,places reasonable restrictions on which shareholders may exercise the right to examine them.

Section 4, the focus in Cain, is much broader. It empowers a court, upon proof of proper purpose, to permit a shareholder to examine books and records of account, "minutes," and record of shareholders subject to such limitations and conditions as the court may prescribe. If it were ever in doubt, Cain makes it clear that the term "minutes" in Section 4 extends not only to the shareholder minutes referred to in Section 3, but also to the minutes of the board of directors and executive committee required to be maintained by Section 1.

The other issue addressed in Cain is the proper purpose requirement. While a corporate director has a virtual absolute and unqualified right to inspect the corporation's books and records, a shareholder must have a "proper purpose" to do so.

When a shareholder seeks to examine only shareholder minutes and the record of shareholders under Section 3, the corporation bears the burden of showing that the shareholder has an improper purpose. Under Section 4, however, to gain access to the wider scope of documents including books and records of account, the burden of proof of proper purpose is on the shareholder.

Inspection rights under the Statute are narrower than litigation discovery afforded under the Rules of Court. The inspection must be germane to the claimant's status as a shareholder and must be exercised in good faith. Curiosity is not enough; curiosity enhanced by suspicion is still insufficient. In determining what is a proper purpose, the court must weigh against the desire (concern) of minority shareholders to "know what is going on" the fact that inspection of a corporation's books may adversely affect other shareholders and the corporation. The shareholder cannot simply cry "mismanagement." He or she must produce some evidence, not to prove mismanagement, but to establish a credible basis to support a claim that further investigation is warranted. An August, 2010 decision of the Supreme Court of Delaware denying inspection rights appears to take that concept to the limit.

Among purposes which have been determined to be proper are to facilitate communication with other shareholders concerning a pending tender offer; to determine the value of one's shares; to determine the corporation's financial condition, correctness of a dividend, or facts involving management conduct; to determine the corporation's ability to pay dividends; and to become informed about a transaction which requires a shareholder vote. If it is likely that the interests of all shareholders will be served by the investigation, it is more likely that the right to inspect will be granted.

In addition to a proper purpose, the shareholder's demand must be reasonable. A Louisiana court, although granting access to ledgers, record books, and tax returns, found the demand to review the original of every cancelled check, deposit slip, and invoice to be unreasonable. In Cain, the court limited the scope of inspection to documents generated within a certain time period pertinent to the main claim in the federal action.

Seeking to learn secrets for a competitor; to gain knowledge for one's own personal business, politics, or social programs; and harassment are improper purposes.

An issue not reached in Cain is whether seeking facts to support a previously filed derivative action is a proper purpose. There are benefits to being lead plaintiff and lead counsel in a derivative action. This causes some corporate shareholders (or their counsel) to race to be the first to file. As a result the derivative claim, which belongs to the corporation, may be filed without demand first having been made on the corporation's board of directors to bring the action, and without a sufficient showing to excuse the demand requirement. Because discovery is generally not permitted to support allegations of demand futility, to obtain facts to support the allegation that demand should be excused, the plaintiff may try to exercise the shareholder's right of inspection after a motion is filed to dismiss for failure to make demand. The question presented is whether the "horse" of inspection should follow the "cart" of filing or, stated differently, whether the winner of the race to the courthouse has stated a "proper purpose."

The Delaware Court of Chancery, in a May, 2010 decision, ruled that it is not a proper purpose for the winner of the race to the courthouse to inspect corporate records in order to obtain facts that would excuse the failure to make demand in the derivative action. In January, 2011, the Delaware Supreme Court reversed that ruling saying that barring the right of inspection solely because the plaintiff had previously filed a derivative suit was "overbroad," but also saying that the reversal "should not be read as an endorsement" of a stockholder's invoking the inspection right after filing a derivation action.

Stuart Pachman, Member in Roseland,

Stuart Pachman is the author of Title 14A Corporations (Gann), which he updates regularly and is recognized as an authority on corporate law in New Jersey. The book and his law review articles have been cited by New Jersey and federal courts as well as courts in other jurisdictions. Stuart focuses on counseling businesses, non-profit corporations and their officers; drafting complex and unusual agreements that successfully memorialize the business deal reached by the parties; structuring transactions; guiding business formations and breakups; advising executives on day-to-day issues including those involving employees, borrowings, and litigation at both the trial and appellate level. He has also served as a court appointed officer in business disputes.

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances. For legal advice, please consult your personal lawyer or other appropriate professional. Reprinted with permission from Brach Eichler L.L.C.