Above Board: Inspection Demands

MoFo Perspectives Podcast

15 Jan 2021

In this episode of the Above Board podcast, San Francisco-based securities litigation partner Mark R.S. Foster describes an issue that more and more boards are facing: how to best manage inspection demands from shareholders. Which shareholders can make these demands, which are expensive and risky for the recipient company? Can shareholders make the demand for any reason? What are the best practices for responding to an inspection demand?


Speaker: Welcome to MoFo Perspectives, a podcast by Morrison & Foerster, where we share the perspectives of our clients, colleagues, subject matter experts, and lawyers.

David Lynn: Hello, I’m Dave Lynn, and I’m a partner at Morrison & Foerster based in the Washington D.C., office, and I’m very pleased to be joined today by my colleague, Mark Foster, who’s a partner based in San Francisco. Mark is a co-chair of Morrison & Foerster’s Securities Litigation Enforcement and White Collar Defense group. Mark, thanks very much for joining me today.

Mark Foster: Thanks Dave, for having me.

David Lynn: Today, I’m going to talk to Mark about a topic that companies and boards are addressing, it seems more often these days, and that’s the situation where a company receives an inspection demand from its shareholders. Mark, could you explain to us what is an inspection demand and why should companies care about receiving these?

Mark Foster: Yeah. Happy to address that, Dave. As you said, inspection demands are definitely on the rise. Inspection demands are made by stockholders to review corporate books and records. Shareholders have a right to make inspections under many corporate codes and sometimes under the common law, depending on the state. We typically focus on books and records demands made under Delaware law and sometimes California law, too. Exercising this right, stockholders can review sensitive and high-level corporate books and records. The ultimate purpose animating the right is to enable shareholders to do some level of corporate oversight. That’s at least the goal in theory, but in reality, many would call inspection rights a license to snoop. If you’re a public company, you care about inspection demands because they certainly create an expense, but they also create a risk.

David Lynn: Is an inspection demand a precursor to some sort of litigation?

Mark Foster: You know, Dave, it often is, not always, but that’s the risk component that I was mentioning. It’s fair to say that the receipt of an inspection demand is a strong indicator that litigation is on the horizon, if it had hasn’t come already. It’s almost guaranteed that you’ll have an inspection demand after litigation is filed, but very often you’ll have an inspection demand made before litigation. The whole idea animating inspection demands is really generated from a lot of Delaware Supreme Court cases that have encouraged shareholders to use their inspection rights to see if there’s been any mismanagement or wrongdoing at the corporate level. You’ll often see inspection demands coming in the wake of bad news. For instance, if there’s a product recall, a government investigation, any type of regulatory issues, and sometimes significant HR issues will even do that. So, certainly if there’s bad news, that’s, at some level, material to the company that gets attention in the press, there’s a strong likelihood that you’ll get an inspection demand coming. Do you know Dave, how the inspection demands usually come?

David Lynn: How is that?

Mark Foster: In the mail!

Mark Foster: Snail mail. And that’s often a problem, because most companies have modernized and things are digital, and not everyone’s checking their mail every day. And often, these inspection demands get lost in the mail. I’ll talk about that a little bit later, but that’s just a hook in terms of why companies need to pay attention to their mail because that’s usually where these inspection demands come, addressed to the board of directors.

David Lynn: You mentioned that shareholders have a right to demand an inspection. Can any shareholder make that demand?

Mark Foster: Yeah. Under most states’ laws, almost any shareholder can do that. And under Delaware, where most companies are incorporated, it really is any shareholder. So if a shareholder just has one share of stock, they can impose this burden and an expense on companies. There are some states that have slightly different requirements. For instance, in California, you have to be a record holder of shares. That’s really a formality that any diligent shareholder can become a record holder. There are a few states that have thresholds in terms of a percentage of shares that you have to own before you can make an inspection demand, but by and large, most states say that any stockholder can do this. It’s certainly an opportunity for legislative reform because the idea that a shareholder with a very small number of shares can impose significant burden and expense on a company doesn’t really make sense if you look at it from just a good corporate governance perspective, especially when you see the abuses that inspection demands typically cause. Certainly an opportunity for legislative reform, and I’d say Dave, maybe even an opportunity for us to collaborate, because I think there’s an opportunity for potential changes at the bylaw or  charter level, similar to what we’ve seen companies do with form selection clauses, for instance.

David Lynn: And can shareholders seek inspection for any reason at all?

Mark Foster: Technically, no. Technically, shareholders have to have a proper purpose for inspection and that the proper purposes that courts have identified include valuing your shares, communicating with other shareholders, and investigating potential mismanagement or wrongdoing. Now, what we see most of the time is that shareholders are seeking to investigate potential wrongdoing, and they’re seeking to see if directors or officers engaged in malfeasance. They’re typically looking to see if they can ferret out a claim for a breach of duty of loyalty, either arising out of self-dealing transactions, or more often the case, a failure of corporate oversight over some area in the company, whatever it is. For a shareholder to go that route and pursue investigation of potential wrongdoing, they actually have to show a credible basis to suspect it. They can’t just contrive reasons out of the sky, but the test of what meets the credible basis standard is considered the lowest burden under Delaware law.

Mark Foster: So it’s certainly relatively easy for shareholders to start inspecting books and records by sending a letter that articulates a few things that they suspect is wrong. Oftentimes, courts will look at pieces of evidence, bad news article, evidence of a product recall, customer complaints, anything where there’s already some hint out there in the public about wrongdoing is often enough reason for shareholders to launch these inspection demands. Certainly, shareholders can’t go on a phishing expedition. Delaware courts for instance, have strenuously said that shareholders can’t suspect management and then go look at every piece of evidence in a company’s files. But at the end of the day, in practice, shareholders who make inspection demands get to do a lot of probing.

David Lynn: And once you receive an inspection demand, how can a company respond to it?

Mark Foster: I’d say quickly, thoughtfully, and strategically. I’d say quickly because, at least under Delaware law, companies have five days to respond to the inspection demand. And as I mentioned earlier, if that demand is lost in the mail room, oftentimes that five day window is lost. We’ve seen instances where companies don’t find these inspection demands for months. Now, the five-day window that I mentioned is really just kind of a gating item. Under Delaware law, shareholders can’t sue to enforce their inspection rights until five days have passed, so missing the five-day deadline is not, in any way, perceived like some kind of default or a or failure, but it certainly sets a company behind. That’s why minding the mail and what’s sent to the board of directors in the general counsel’s office is really important. The first way to really respond once somebody’s opened that envelope and seen the demand is to usually acknowledge receipt. That usually buys some time and allows the company an opportunity to do a little bit of meaningful groundwork to see what’s going on.

Mark Foster: Usually an acknowledgement letter goes out saying, “We’ve received this. We’re gonna forward it to the board of directors for further consideration.” It’s also an opportunity for the company to ask for proof of stock ownership, because only stockholders can make these demands. And it’s—there are some certain technical requirements that shareholders have to make when they make these demands, and one of those is providing proof of stock ownership, so if that does not accompany an inspection at demand, that’s really the first thing to ask for. And we’ve certainly seen plaintiffs go away. When I say plaintiffs, I mean shareholders who make demands sometimes go away when you ask for that proof of ownership. And I think the reason is that we often see that the relationship of plaintiffs’ lawyers and their shareholder clients is often tenuous and sometimes it takes months to get proof of ownership and sometimes it never materializes.

Mark Foster: And as is often the case in shareholder litigation, sometimes these shareholders don’t really exist and sometimes they don’t even own stock, so asking for that threshold information is really important. The second step I’d recommend after acknowledging receipt is to really do an assessment. And the first question to ask is, does this look like litigation is coming or is it related to existing litigation? And if the answer is yes or probably yes, I think it’s certainly time to loop in some litigators to at least start thinking about what does this look like on a litigation front? And that leads to step three, which is really developing a strategy. You have to think through the litigation potentials if there is litigation on the horizon. There are two types of litigation to keep in mind, Dave. One type is just litigation to enforce the inspection demand.

Mark Foster: If the company chooses not to respond or to give what is requested in full or in part. And the second type of litigation is actually litigation on the merits, the merits of the subjects being addressed in the litigation demand. I think it’s really imperative to think about the litigation strategy for both of those fronts at the same time. If you think an inspection demand is frivolous, a company can stand on principle and just say no, we’re not giving you the documents. A shareholder can then turn around and file a lawsuit to compel production of documents. Sometimes they do that, and sometimes they walk away because they realize it’s not worth the fight or expense. Companies have to make that decision upfront about whether it’s worth fighting or not. And it often depends on the bigger picture and the stakes at issue.

David Lynn: What kind of documents can shareholders get access to through an inspection demand?

Mark Foster: More than you think, or at least more than most people think. And it certainly depends, but certainly in almost every case, it’s focused at the board-level documents, but not exclusively. Shareholders are virtually certain to get board minutes and board agendas and almost always likely to get board decks, too, but there are instances where shareholders can get even more. They can get internal reports, correspondence, and you’ll like this, believe it or not, they can sometimes get emails among top executives or directors. And that kind of more invasive searching for internal emails and internal electronic documents sounds like a litigation discovery and the kind of thing you don’t really have until you’re deep into litigation. That’s probably the most surprising thing about inspection demands is that there are instances where shareholders can start searching up your director’s emails based on some suspicion that they were engaged in wrongdoing. That’s certainly something that everybody needs to be mindful of.

David Lynn: Is there something that the board or the company can do to minimize the risk of getting an inspection demand?

Mark Foster: Certainly can’t minimize the risk of getting one, but you can minimize the risk of what happens when an inspection demand is made. I think that really comes down to having thoughtfully‑prepared board materials, making sure that the board minutes and board decks are well vetted, and they’re thoughtfully prepared, that they have just the right Goldilocks balance of the right type of information, not so much that it provides a potential roadmap to litigation, but not so little that there’s not a robust record of showing that a board of directors considered a matter thoroughly and thoughtfully. And so the key and the key takeaway of thinking about inspection demands is really an opportunity to make sure that corporate minutes and corporate presentations are really well vetted. I encourage making sure that board minutes show good process engagement. There’s discussion of the factors and the issues that boards consider on each subject that where their judgment is called upon to bear.

Mark Foster: And I think it’s really important that when it comes to substantive decisions, that the information and recommendations don’t only come for lawyers, because what you see in practices is when there’s an inspection demand made, you have to redact that information for privilege, and then the shareholders have no information. And then courts are more likely to say, yeah, well, then you’re going to be allowed to go looking at people’s emails. Another tip I have in terms of what companies can do to minimize their risk is to be really thoughtful about email usage. I think, oftentimes, companies don’t think about the email addresses that their directors are using. Sometimes directors use their personal addresses, their Gmail or otherwise, but sometimes they also use other companies email addresses. If one of your directors is a CFO or CEO of another public company and your board materials are going through that email server, that certainly creates a bunch of issues that sometimes companies don’t think about in terms of, is a privilege potentially waived by having this information go to another server, is there an expectation of privacy or confidentiality with that information on another company server. And I think it’s really important for companies to think about those issues from the get-go well before an inspection demand is made. It’s really a matter of good corporate hygiene, and inspection demands are good prism by which companies can really start to do that kind of introspection.

David Lynn: Is it expensive to respond to an inspection demand, and are these the kind of costs that insurance might cover?

Mark Foster: Yeah, I think everyone is usually surprised when they have an inspection demand about how expensive they can be because just the review of documents itself can be expensive, but often, because of the litigation posture, you’ll see that it requires a lot of strategizing too, and thinking through how documents and positions will play out in litigation that hasn’t even been filed yet. It’s an expense that kind of arises before the litigation even occurs. If a company chooses to fight and resist the inspection demand, that’s certainly an expense too, because you have to—companies will find themselves actually having to litigate those issues sometimes in court if a shareholder decides to sue to enforce the inspection, right? So that can certainly be expensive on the litigation front and the document review front. Some insurance companies will cover the costs of an inspection. Many do not. This is why it’s important when an inspection demand comes in the door, that companies pull out their DNO policies or contact their brokers to find out if there is coverage. Depending on whether there is coverage that may inform the strategy in terms of how a company will respond to an inspection demand.

David Lynn: What is the worst-case scenario when you find yourself receiving an inspection demand?

Mark Foster: The worst case scenario that I see is you have to collect, review, and produce a bunch of documents, either voluntarily or after a court order, and that the documents really present a bad record of decision-making. And those documents are used in litigation against your board of directors in a lawsuit that survives a motion to dismiss, that proceeds into full-fledged merits discovery, and potentially to trial, and ultimately a verdict. Litigation is certainly the most likely next step from an inspection demand, and if those records aren’t in top shape, the worst case scenario is more likely as a result.

David Lynn: And what about the best-case scenario when you receive an inspection demand?

Mark Foster: Best-case scenario is probably when you ask for shareholder ownership information and they walk away. But assuming that a shareholder who makes a demand actually has proof of stock ownership, I’d say that the best-case scenario is that you have great board materials, you turn them over and you convince them to walk away. And we have seen that happen and it sometimes happens, and it really depends on the quality and robustness of the board materials that are prepared.

David Lynn: Great. Well, thanks Mark for sharing all of those insights about responding to inspection demands.

Mark Foster: Thanks, Dave. Thanks for having me and happy to answer any other questions when they arise.

David Lynn: Great. Thank you.

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