Books and Records: Court Explains a Failure to Clear the Sometimes Deceptively Challenging Credible Basis Hurdle
In Southeastern Pennsylvania Transportation Authority and Boston Retirement System v. Facebook, Inc., C.A. No. 2019-0228-JRS (Del. Ch. Oct. 29, 2019), the Delaware Court of Chancery reaffirmed its requirement that stockholders seeking records to investigate possible wrongdoing must have some credible basis from which the court can infer waste or mismanagement occurred. Here, following trial, the court granted judgment in favor of Facebook because the Plaintiffs (defined below) failed to make a credible showing, through documents, logic, testimony or otherwise, that there are or may be legitimate issues of wrongdoing which would warrant further investigation of the matter through grant of the books and records request.
Southeastern Pennsylvania Transportation Authority and Boston Retirement System (together, the “Plaintiffs”) are stockholders of Facebook, Inc. (“Facebook”). In 2016, Facebook discovered it had materially miscalculated the amount of exposure its video advertisements were receiving on its platform (the “Metric Miscalculation”). Two years later, on July 26, 2018, one day after the announcement on an investor call that Facebook expected its future revenue growth rates to decline, Facebook suffered the biggest-ever one day loss in market value for a U.S.-listed company, dropping 19% and losing approximately $119.1 billion in market value (the “Stock Drop”). Following the Stock Drop, Plaintiffs demanded to inspect Facebook books and records (the “Request”) pursuant to Section 220 and stated four purposes: (1) to determine “how to vote with respect to the 2019 Say On Pay Vote,” a stockholder advisory vote on executive compensation; (2) to determine “whether to pursue contact with Facebook’s directors and/or minority stockholders concerning Facebook’s decelerating revenue growth and executive compensation determinations,” (3) to “investigate possible fiduciary wrongdoing, mismanagement or unjust enrichment by Facebook directors or officers in connection with advertising sales and compensation awards decisions” and (4) to “investigate the independence of the Board of Directors to consider and act on a stockholder demand to initiate claims for fiduciary mismanagement, wrongdoing or unjust enrichment.” Facebook claimed it produced all responsive documents related to discussion of the Metric Miscalculation because there were no discussions of the Metric Miscalculation by Facebook’s committee responsible for executive compensation. Plaintiffs brought suit to compel additional document production, because, they reasoned, it didn’t seem possible that the Metric Miscalculation was not discussed in relation to executive compensation.
A stockholders’ right to inspect the books and records of companies in which they are invested is broad but not unlimited. In practice, the initial inquiry when determining the validity of a books and records request is whether the purpose is reasonably related to the stockholders’ interest as a stockholder. To meet this burden, a stockholder must prove by a preponderance of the evidence that the primary (or actual) purpose as to each category of documents demanded is proper. Here, the court determined that the four stated purposes all turned on the same underlying threshold question, “whether the Board considered the Metric Miscalculation and the trajectory of advertising revenue growth in the executive compensation process.” Additionally, at trial, it became clear that the Plaintiffs’ primary purpose for the Request was to investigate whether any wrongdoing occurred with respect to the setting of executive compensation. Investigation of wrongdoing by directors is a proper purpose.
Having stated a proper purpose for the Request, Plaintiffs must merely present some credible basis—some evidence, through documents, logic, testimony or otherwise—from which the court could infer that waste or mismanagement occurred. Importantly, Facebook’s organizational documents exculpate directors from liability to the maximum extent permitted under Delaware law. The relevant exculpatory provisions essentially eliminated the fiduciary duty of care, leaving only the duty of loyalty. Given, thus, the focus on the duty of loyalty, Plaintiffs were forced to argue that the Board’s decision to “overcompensate” executives, notwithstanding the Metric Miscalculation and declining revenue growth, could only be explained by bad faith.
According to the court, Plaintiffs’ bad faith theory failed for three separate reasons. First, Plaintiffs failed to present any credible evidence that Facebook overcompensated its executives. Second, Plaintiffs presented no credible evidence to support an inference that the Stock Drop was related to the Metric Miscalculation, which had been reported two years earlier. In contrast to the Plaintiffs’ argument, the court concluded the record indicated the apparent reason for the Stock Drop was the declining revenue growth statement made the preceding day. Thirdly, even if there were some evidence that the Metric Miscalculation and the Stock Drop were related, there still was no credible evidence that the Board’s compensation decisions were motivated by bad faith. The Request, based on a violation of the duty of loyalty, must overcome the protections afforded by the business judgment rule, which presumes corporate fiduciaries reasonably inform themselves and make decisions in the best interests of the corporation—in this case in connection with Facebook’sexecutive compensation awards. At trial, Plaintiffs conceded that there was no evidence of discussions of the Metric Miscalculation by the executive compensation committee. While this may seem negligent on the part of the committee, this fact alone was not found to be evidence of corporate wrongdoing—especially when the directors are exculpated from violations of the duty of care.
In considering the stated purposes not related to wrongdoing on the part of directors, the court dismissed them both as improper. Delaware law is clear, the stated purpose for inspection must be the stockholder’s actual purpose, and “[t]his court may consider a plaintiff’s actual purpose, and discount any secondary or ulterior purposes.” The court determined, based on Plaintiffs’ arguments at trial, that the actual purpose for the Request was investigation of wrongdoing and mismanagement by directors. In addition, the Say on Pay vote request was no longer timely, as the vote had occurred before the case was decided.
When Plaintiffs are making a books and records request that requires the court make an inference, Delaware law requires a stockholder to demonstrate a credible basis to infer some wrongdoing. While the credible basis burden is low, it is not meaningless, especially when directors are exculpated from the duty of care.