Delaware Court of Chancery Allows Stockholder to Inspect Books and Records Over Defendant Corporation’s Objections

By Scott Waxman and Serena Hamann

In Senetas Corporation, Ltd. v. DeepRadiology Corporation, C.A. No. 2019-0170-PWG (Del. Ch. July 30, 2019), the Delaware Court of Chancery allowed a stockholder’s books and records inspection despite objections raised by the defendant corporation because the stockholder established a proper purpose for the inspection by proving a credible basis from which the Court could infer mismanagement or wrongdoing may have occurred and because the defendant failed to prove the plaintiff’s stated purpose was offered under false pretenses.

The plaintiff,Senetas Corporation, Ltd. (“Senetas”), sent a written demand to inspect the books and records of the defendant, DeepRadiology Corporation (“DeepRadiology”). As a major stockholder in DeepRadiology, Senetas desired to investigate DeepRadiology books and records for potential corporate mismanagement and wrongdoing. Specifically, Senetas argued DeepRadiology failed to comply with basic rules of corporate governance and made critical business decisions without consulting its Board or stockholders. Senetas also claimed DeepRadiology failed to act with proper due diligence when considering an initial coin offering and deciding to discontinue efforts to pursue FDA approval for its product. Additionally, Senetas argued DeepRadiology management failed to keep proper financial records, failed to keep its Board reasonably informed about operations, misappropriated the company’s intellectual property, and provided misleading information to stockholders.

DeepRadiology did not respond to Senetas’ demand and resisted inspection claiming Senetas lacked a credible basis to infer wrongdoing or mismanagement and had a competitor’s ulterior motive for an overbroad inspection. DeepRadiology claimed Senetas’ demand was wholly or primarily driven by its desire to gain competitive access to DeepRadiology’s technology and human resources to further its own business and other investments. When DeepRadiology failed to respond to the demand, Senetas filed a complaint in the Delaware Court of Chancery.

Under Section 220 of the Delaware General Corporation Law, a stockholder must (1) be a stockholder of record; (2) comply with the form and manner requirements when making the demand; and (3) state a proper purpose for the requested inspection. A “proper purpose” is one reasonably related to the party’s interest as a stockholder. Investigation of mismanagement, waste, and wrongdoing is well-recognized as a proper purpose. A stockholder need only show, by a preponderance of evidence, a credible basis from which the Court of Chancery can infer there is possible mismanagement warranting further investigation. A stockholder need not prove actual wrongdoing but must do more than simply state a generally accepted purpose. The stockholder’s burden may be met by a credible showing, through documents, logic, testimony or otherwise, that there are legitimate issues of wrongdoing. Once a proper purpose has been established, a defendant may not rebut this purpose by showing an alternative or ulterior motive on the part of the plaintiff. Instead, the defendant must demonstrate that the plaintiff’s stated purpose was offered under false pretenses. The fact that the plaintiff is business competitor or is hostile to the defendant’s management is insufficient to defeat the plaintiff’s legal entitlement to inspect for a proper purpose.

Here, the Court found that Senetas stated a proper purpose: to determine the “true value of [DeepRadiology’s] assets, and whether its assets and opportunities are being managed and pursued in a way that maximizes shareholder value.” The Court examined the governing documents and activities of DeepRadiology and the Stock Purchase Agreement, under which Senetas became a major investor. The Court recounted the details of DeepRadiology’s mismanagement in finding Senetas met its low burden of showing sufficient evidence for the Court to infer possible mismanagement and wrongdoing at DeepRadiology. The Court also addressed DeepRadiology’s allegations as to Senetas’ actual motives for inspection by concluding Senetas is not DeepRadiology’s competitor as Senetas operates in the cybersecurity market and DeepRadiology in the healthcare market. DeepRadiology offered no evidence either that Senetas was trying to enter the same market or that DeepRadiology’s technology was transferable to Senetas’ cybersecurity business.

The Court concluded its analysis by noting DeepRadiology’s legitimate interest in protecting its confidential information from competitors would be adequately protected by the execution of a confidentiality agreement between the two parties prior to the production of any documents. The parties were asked to submit such an agreement to the Court for approval and to confer regarding specific documents or categories of books and records in light of the Court’s articulation of Senetas’ proper purpose.