Last year I wrote about the uncertainty surrounding the rights of members of New York LLCs to gain access to company books and records primarily due to the paucity of court decisions construing the inspection statute, LLC Law Section 1102 (read here).  At the time I knew of only two, significant New York cases on the subject, Matter of Hay and Matter of O’Neill, which took markedly different approaches to the problem.

It’s been over a year since, and those apparently remain the only two cases of significance.  However, in the last few months there have been several, interesting decisions by the Delaware Chancery Court resolving disputes over access to LLC books and records.  (HT: Delaware Corporate and Commercial Litigation Blog)  The decisions address important issues concerning standing to seek inspection; the meaning of the phrase “books and records” as commonly used in inspection provisions in operating agreements; whether the right of access includes the right to photocopy records; and, perhaps most importantly, the degree to which a court will scrutinize the “proper purpose” basis for the member’s inspection demand.  Given the similarities between the Delaware and New York statutes, these decisions could be persuasive in resolving books and records actions in the New York courts.  Here’s a summary:

Court may consider evidence outside the operating agreement to determine if party is a member entitled to demand access to books and records.

Section 18-305(a)(1) of Delaware’s LLC Act gives each LLC “member” defined rights to obtain LLC records, as does its New York counterpart.  In a letter ruling in Mickman v. American International Processing, LLC, Del. Ch. C.A. No. 3869-VCP (Apr. 1, 2009), Vice Chancellor Parsons denied the defendant LLC’s motion for summary judgment seeking to dismiss a books and records action on the ground that the plaintiff was not listed as a member in the operating agreement and therefore lacked standing under the statute.  The plaintiff, who was divorced from one of the two members identified in the operating agreement, submitted an LLC tax return identifying her and her ex-husband as co-owners of a membership interest.  She also submitted her ex-husband’s Offer in Compromise to the IRS in which he stated under oath that his “only assets are his house . . . and stock in a number of closely held companies owned jointly by Taxpayer and his wife.”

The LLC argued that these representations were “mistakes” and that, in any event, the court should look only to the operating agreement to determine membership.  The LLC analogized to inspection rights for corporations under which only stockholders listed in the stock ledger are recognized as holders of record for purposes of a request for books and records.  The court rejected the analogy and accordingly denied defendant’s motion to dismiss, writing that because of

the flexible and less formal nature of LLCs, it is reasonable to consider evidence beyond the four corners of the operating agreement, where, as here, the plaintiff has presented admissible evidence that, notwithstanding the language of the operating agreement, suggests that the parties to that agreement intended to make, and believed they had made, the plaintiff a member of the LLC.

This blog has featured many cases involving contested shareholder or LLC member status in the context of dissolution proceedings.  I would expect courts to take the same, fact-specific approach in resolving standing disputes in books and records actions, as the court did in Mickman.

“Access to all books and records” as provided in operating agreement permits photocopying of LLC’s general ledger.

Tax returns and financial statements of a company provide a wealth of information, but if you really want to find out in detail what’s going on financially, you need to see the company’s general ledger which is not among the records to which access is specifically granted by the Delaware and New York statutes.  There are two avenues to obtain the general ledger (and all other non-enumerated records): (1) under the statutes’ catch-all provisions for “other information regarding the affairs of the [LLC] as is just and reasonable”, or (2) pursuant to rights of access given in the operating agreement.

Operating agreements frequently use the phrase “access to all books and records” or similar language in provisions granting members access to company information.  In a subsequent decision in the Mickman case dated July 28, 2009, Vice Chancellor Parsons ruled that “access to all books and records” as used in the subject LLC’s operating agreement (1) included the general ledger and (2) gave plaintiff the right to obtain photocopies of the general ledger, i.e., not merely the right to inspect.  The court pointed to decisions granting rights of access to the general ledger under the Delaware corporate books and records statute.  It also noted that the “parties to the LLC agreements undoubtedly knew how to use more limiting language, but did not.”  The court also looked to the Delaware corporate books and records statute to conclude that the right of access “includes a right to copies of those books and records,” adding:

In fact, courts have interpreted a more restrictive access right, “reasonable access,” to include the right to make copies.  Because the [LLCs’] operating agreements place no restrictions on members’ access rights and contain a broad access provision . . ., I construe “access” as having its ordinary meaning, which includes the right to make photocopies.

Having resolved the issue based on the plaintiff’s contractual right of access under the operating agreement, the court did not reach the plaintiff’s additional arguments for inspection rights under Section 18-305 of the Delaware LLC Act.

The decision is hardly surprising.  Anyone who’s ever seen a typically voluminous print-out of a company’s general ledger containing thousands of line-item transactions understands that the right to inspect without the right to obtain copies is tantamount to no access.

3.  A member seeking to enforce statutory inspection rights must demonstrate a proper purpose reasonably related to the specific interest of that member, not just “proper in the abstract.”  

The most frequently litigated issue in books and record cases, when the demanding member seeks information beyond the statutorily enumerated records such as tax returns, financial statements and organizational documents, is whether the demanding member satisfies the proper-purpose requirement.  The Hays and O’Neill cases mentioned at the top of this post reached opposite results on this very issue.

In JAKKS Pacific, Inc. v. THQ/JAKKS Pacific, LLC, Del. Ch. No. 4295-VCL (May 6, 2009), Vice Chancellor Lamb (who recently retired from the Chancery Court) dismissed a books and records action after trial, on the ground that the plaintiff member of the subject LLC failed to establish a proper purpose in support of its demand.  The decision includes a lengthy, detailed recitation of the complex facts leading up to the action, which I won’t even try to summarize here.  Suffice it to say that the LLC had a videogame license from World Wrestling Entertainment (“WWE”); that the plaintiff was the inactive member of the LLC whose sole financial interest consisted of a preferred return from the WWE license revenues; and that the other, managing member retained all other equity interests in the LLC.  In 2008, amidst a prior arbitration proceeding to determine the rate of preferred return, the plaintiff demanded and received over 110,000 pages of information.  In December 2008, the plaintiff made a new demand for information, characterized by the court as “an even more extensive list of items than had been demanded or produced as part of the arbitration.”  The managing member rejected the demand on the grounds it was overbroad and unreasonably burdensome, and failed to state a proper purpose.

In the plaintiff’s subsequent books and records action brought pursuant to Section 18-305, the plaintiff offered three purposes for its demand: (1) to aid in negotiating the preferred return for the next distribution period, which would occur only if the WWE renewed the license; (2) to value its interest in the LLC; and (3) to investigate alleged mismanagement and wrongdoing by the managing member.  Vice Chancellor Lamb set forth the plaintiff’s burden as follows:

[T]his court has held, “the plaintiff must first establish by a preponderance of the evidence the existence of a ‘proper purpose’ for inspection.”  Such a purpose cannot simply be proper in the abstract, but must be reasonably related to the specific interest of the member making the demand.

The court found plaintiff’s first two proffered purposes “meaningless or highly speculative” because of the uncertainty surrounding WWE’s renewal of the license and because the plaintiff, who had the right only to preferred return, had no residual interest in the LLC to value.  “[A] demand in order to satisfy a purpose so disconnected from the likely course of events,” wrote Vice Chancellor Lamb, “is not ‘reasonably related’ to [the plaintiff’s] interest in the LLC.”  The court also discounted the third proffered purpose, finding that the plaintiff’s two trial witnesses failed to offer any credible evidence of wrongdoing by the managing member.