"Trust, But Verify": The SJC addresses shareholder inspection rights.

The Supreme Judicial Court clarified the burden a shareholder must meet to obtain corporate records under chapter 156D, section 16.02(b) last week in Chitwood v. Vertex Pharmaceuticals, Inc. Using a Russian proverb, an analog to a well-known Biblical verse, and a biting observation about the underlying litigation, the Court added some color to the somewhat mundane topic of statutory shareholder inspection rights.

Ultimately, the Court held that (1) the trial court, which had applied a standard derived from Delaware law to the inspection request and dismissed the shareholder's complaint for court-ordered inspection after a one day bench trial, imposed too stringent of a burden on a shareholder who sought records to "investigate his allegations" in his previously-rejected derivative demand that the board of directors had committed a breach of its fiduciary duty of oversight with respect to the company's financial reporting and insider stock sales and (2) the shareholder's request for inspection far exceeded the scope of permissible inspection under the statute.

Defendant Vertex Pharmaceuticals, Inc. develops and manufactures drugs for treatment of serious diseases.

Plaintiff is a shareholder in Vertex.

In the Spring of 2012, Vertex issued a press release announcing the interim results of a "phase two" study regarding the effectiveness of two of its drugs to treat cystic fibrosis. The announcement suggested a medical breakthrough. The company's stock price rose.

3 weeks later, Vertex issued a new press release, which suggested the phase two study did not reflect a medical breakthrough. The company's stock price declined.

In between the first and second press releases, Vertex officers and directors sold $37 million in corporate stock.

The Derivative Demand.

In November 2012, plaintiff wrote to the Board of Directors detailing alleged "false and misleading statements" in the first press release and identifying officers and directors he contended had wrongfully engaged in insider trading before the second announcement. He demanded that the Board initiate litigation against the responsible parties.

The Board established a special committee of independent directors to investigate the plaintiff's allegations and retained outside counsel to assist in the investigation. Ultimately, the Board informed plaintiff that the committee had completed its investigation and reported findings to the Board and that a majority of independent directors had determined there was no wrongdoing that that a lawsuit as not in the company's best interests.

The Inspection Request.

The shareholder then made a written inspection request seeking access to the seven categories of corporate records "to investigate potential wrongdoing, mismanagement, and breaches of fiduciary duties" by the Board or others.

He sought records and minutes of all Board and special committee meetings, the special committee's report and all drafts, all documents distributed to the Board or special committee, all documents regarding he phase two study results, copies of all policy and procedure manuals and documents describing internal control practices for selection and oversight of contractors to perform trials and studies, and calendars to show number and duration of Board and special committee meetings

The Board rejected the request, stating that (1) it was not made for a proper purpose because it sought records to investigate wrongdoing, but "failed to present a credible basis to infer there were legitimate issues" warranting further review; (2) there was no proper purpose for the request because it sought discovery in support of the derivative demand allegations when such discovery would be unavailable even if the shareholder had commenced a derivative lawsuit since the company would be entitled to dismissal; (3) the request was overbroad and beyond the statutory scope; and (4) the Board made a good faith determination that disclosure would adversely affect the corporation and its business.

The records lawsuit

The shareholder sued.

After more than two years and after a one day bench trial the trial court dismissed the lawsuit with prejudice.

Although recognizing that the shareholder's right to inspection would be limited to 16.02 records, the trial court "concluded that the plaintiff was not entitled to inspect even this narrow swath of records because he had failed to meet his burden of showing a proper purpose."

The judge concluded that where a shareholder seeks to inspect corporate records under section 16.02(b) to investigate allegations of corporate wrongdoing, the shareholder "must present some evidence of wrongdoing." Since there was no evidence calling into question the independence or diligence of the special committee, the shareholder failed to meet this standard.

The trial judge also reasoned that if the plaintiff had filed a derivative lawsuit, it would be subject to dismissal and all discovery would be stayed pending dismissal, so the shareholder would not be entitled to the same materials in discovery.

The SJC's Decision.

The SJC opened its explanation of its decision with the following observation: "Viewed from the perspective of the appellate bench this was an expensive litigation war of attrition that was fought over nearly nothing."

The Court nevertheless vacated the dismissal and remanded for further proceedings consistent with its opinion.

First, the Court ruled that the 7 categories of records demanded "far exceeded" the scope of records within the right of inspection under section 16.02(2).

The Court concluded that the only records within those categories that may be subject to inspection were "excerpts of minutes or comparable records that reflected the actions taken at meetings of the board of directors or meetings of the special committee." As the Court explained, the drafters made clear that inspection rights extend to votes or actions on relevant matters, not to reports, discussion or decisions not to act.

Second, the Court ruled that the trial court erred in using the Delaware standard to determine if the shareholder had a proper purpose because Delaware's statute allows for inspection of "books and records" generally and, therefore, of a greater scope of records than the Massachusetts statute.

The Court explained that "[t]he inverse of the Biblical adage that to whom much is given, much is expected is that to whom less is given, less is expected."

The Court went on, "Where a shareholder seeks corporate books and records under [section] 16.02(b) and claims a proper purpose of investigating corporate wrongdoing or mismanagement, the shareholder demonstrates a proper purpose where he or she identifies particular facts and circumstances that permit a reasonable inference that the requested books and records would possibly reveal information that would tend to indicate the existence of corporate wrongdoing or mismanagement.

Where a shareholder has made a derivative demand, based on allegations of inider trading after an inaccurate press release, the shareholder had a proper purpose in asking to inspect the excerpts of the original minutes of the Board meetings and special committee meetings that reflect the actions taken at those meetings regarding the requested derivative action.

As the Court noted, the shareholder's is entitled to "trust, but verify", as the proverb goes. The shareholder's desire to verify actions by the special committee and the Board in response to his allegations is a purpose that is "reasonably relevant to the demanding shareholder's interest as a shareholder."

The Court also rejected any connection between the right to inspect and the availability of discovery in a derivative lawsuit, noting that the statute makes the right to inspection independent of any other right to obtain records. It also did not address the scope of any remaining common law right to inspection since that issue was not before it.

<<Read our article about Massachusetts Shareholders Rights>>

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