Pity the poor books-and-records proceeding. Misunderstood. Neglected. Widely viewed among New York practitioners as an ineffective use of time and resources. Jealous cousin to its wildly popular Delaware counterpart.

That perception could start to change thanks to a decision last week by a Manhattan appellate panel in a shareholder books-and-records proceeding. Although the court’s ruling involves a public company, its liberalizing influence is bound to effect books-and-records proceedings involving closely-held business entities as well.

There are two sources of a shareholder’s right to gain access to corporate information: statute and common law. The New York statute, Business Corporation Law § 624, is nothing if not miserly. Under § 624 (b) and (e), a shareholder has the right upon written demand to examine minutes of shareholder meetings, the shareholder list, and the most recent annual and interim financial statements. That’s it. Not very useful if the shareholder wants detailed knowledge of the corporation’s decision-making, communications and financial transactions.

Then there’s the common-law right to inspect a corporation’s books and records, which is broader than the statutory right and can extend to all of the relevant corporation books and records. While it can be argued that the burden of pleading and proof differs depending upon whether the right to inspect is sought under the statute or common law, in either event, if the shareholder presents in good faith and shows a “proper purpose” for seeking the corporate records, the corporation resisting inspection must show the shareholder’s purpose is improper or is otherwise proceeding in bad faith.

One of the recognized, proper purposes for a common-law inspection demand is to investigate potential wrongdoing and mismanagement by corporate officers and directors. In the past, this has presented something of a dilemma for courts trying to balance the shareholder’s right to know versus protecting the corporation from a “fishing expedition” based on nothing more than a hope and a prayer that useful material for shareholder derivative claims will be netted. This balancing act gives added importance to the burden-of-proof question, and also invites the resisting corporation to defend on the ground that the shareholder is attempting to get “free” pre-litigation discovery without having to satisfy the disclosure standards of relevance, materiality, and burdensomeness that apply in litigation.

The McGraw-Hill Case

Which brings us to last week’s decision by the Manhattan-based Appellate Division, First Department, in Retirement Plan for General Employees v. McGraw-Hill Companies, Inc., 2014 NY Slip Op 06154 [1st Dept Sept. 11, 2014], in which the court unanimously reversed the lower court’s dismissal of a shareholder’s books-and-records petition and ordered a hearing to determine the proper scope of inspection.

The case stems from efforts by a Florida pension fund and its counsel to gather information for a potential shareholder’s derivative suit against the management of McGraw-Hill, the parent company of the credit-rating agency Standard & Poor’s. Over the years there have been numerous lawsuits and investigations by various state and federal agencies relating to S&P’s ratings of mortgage-backed securities and collateralized debt obligations that contributed to the 2008 financial meltdown. The pension fund contends that McGraw-Hill, under the direction of its chairman and CEO, directed S&P to provide optimistic credit ratings for toxic mortgage-backed securities in an effort to attract more business from the issuers and gain more revenue from those issuers’ complex securities.

In late 2011, the pension fund made a written demand upon McGraw-Hill — among the relatively few major public companies incorporated in New York — under BCL § 624 and New York common law seeking to inspect 15 categories of books and records of McGraw-Hill’s board of directors relating to its oversight and management of S&P, and also relating to the board’s independence. The demand stated numerous “proper purposes” for the demand, first among them being “to investigate potential wrongdoing, mismanagement, and breaches of fiduciary duty” by McGraw-Hill’s board and senior management.

McGraw-Hill steadfastly resisted the demand, other than producing the bare minimum required by BCL § 624. After an extended period of negotiations during which the pension fund scaled back its inspection demands, in January 2013 the pension fund filed a petition to enforce its rights to inspect books and records (read here). Its supporting memorandum of law (read here) focused on inspection rights under New York common law but also relied heavily on Delaware Chancery Court precedents strongly urging stockholder-plaintiffs to utilize books-and-records demands before filing derivative lawsuits in order to satisfy demand futility pleading requirements and to avoid strike suits based on claims of fiduciary breach lacking the requisite factual basis to establish the underlying misconduct.

McGraw-Hill’s legal brief fired back, arguing primarily that the pension fund’s failure to identify any specific misconduct by McGraw-Hill’s board negated the pension fund’s claimed showing of proper purpose. “Put simply,” McGraw-Hill wrote, “there can be no ‘proper purpose’ to investigate wrongdoing by the Board where there is nothing to suggest that any such wrongdoing occurred.”

At a hearing in May 2013, Manhattan Commercial Division Justice Jeffrey K. Oing agreed with McGraw-Hill and dismissed the petition (read transcript here), concluding that the pension fund’s “extreme” books-and-records demand was “beyond the proper purpose” recognized at common law and, effectively, sought “full-blown discovery” without affording McGraw-Hill the normal protections available in a plenary lawsuit against irrelevant, overbroad or otherwise abusive discovery demands. In Justice Oing’s view, the pension fund’s appropriate recourse was to make a demand upon McGraw-Hill’s board and, depending on the response, bring a derivative suit afterward.

The Appellate Ruling

The pension fund appealed, culminating in last week’s appellate ruling reversing Justice Oing’s dismissal of the petition. The appellate court squarely rejected McGraw-Hill’s Catch-22 argument, which would require a shareholder to specify board misconduct as a condition of gaining access to the very information that would allow it to determine whether the misconduct took place. Instead, bringing New York closer in line with the Delaware approach, the court held that the pension fund’s stated purpose, to investigate the board’s oversight of its S&P subsidiary, was a proper purpose “even if the inspection ultimately establishes that the board engaged in no wrongdoing.” Here’s what the court said:

Here, petitioners sufficiently showed that they were acting in good faith and for a proper purpose in seeking to enforce their common-law right to inspect respondent’s books and records. Specifically, the petition alleges that petitioners seek to investigate alleged mismanagement and breaches of fiduciary duty by respondent’s board of directors in failing to oversee purported wrongdoing by S & P; this alleged wrongdoing, petitioners assert, exposed respondent to substantial potential liability in multiple civil actions and investigations. These allegations form a proper basis for petitioners’ request.

Contrary to respondent’s contentions, investigating alleged misconduct by management and obtaining information that may aid legitimate litigation are, in fact, proper purposes for a BCL § 624 request, even if the inspection ultimately establishes that the board had engaged in no wrongdoing. Indeed, petitioners identified several reasons for making their demand, including assessment of policies that the board had implemented when issuing credit ratings and investigation of possible wrongdoing by the respondent’s board of directors. Each of these purposes adequately justifies petitioners’ access to certain board documents. Moreover, because the common-law right of inspection is broader than the statutory right, petitioners are entitled to inspect books and records beyond the specific materials delineated in BCL § 624(b) and (e). [Citations omitted.]

The court’s ruling does not end the matter. Stating that “[o]n this record, we cannot determine which records are relevant and necessary for petitioner’s purposes,” the court remanded the case for a hearing to determine the proper scope of inspection.

What Does McGraw-Hill Mean for Closely Held Corporations?

There are relatively few major, publicly-owned companies incorporated in New York. The impact of McGraw-Hill likely will be felt more keenly in the populous realm of closely held corporations, which are subject to the same statutory and common-law precepts applied in McGraw-Hill. In fact, most of the modest body of reported New York court decisions in books-and-records proceedings in the last 50-60 years involves closely held corporations.

Non-controlling, outside shareholders of closely held New York corporations who bring books-and-records proceedings typically rely on one or more of three “proper purposes”: to value their shares; to obtain information bearing on distributions; and to investigate financial and other abuses by the controlling owners-managers. Until McGraw-Hill, as evidenced by the lower court’s ruling in that case, the respondent corporation could successfully characterize inspection of records concerning suspected but unsubstantiated mismanagement as a prohibited effort to obtain pre-litigation discovery. After McGraw-Hill, the petitioning shareholder’s purpose to investigate mismanagement presumptively is proper, with the burden placed on the respondent corporation to justify denial of access. This should provide a significant boost to the heretofore unheralded books-and-records proceeding in New York.

The prospect of a successful books-and-records proceeding brought by a disgruntled minority shareholder, aiming to ferret out financial wrongdoing by the majority controllers may, in some instances, provide the minority shareholder with additional leverage to achieve a desired buy-out, thus giving the staid books-and-records proceeding a strategic as well as tactical character.

Finally, one cannot discuss the efficacy of a books-and-records proceeding in New York without mentioning what I’ll call the “Commercial Division effect.” From the date the McGraw-Hill petition was filed, it took Justice Oing, one of nine Manhattan Supreme Court Commercial Division judges whose caseload is confined to complex commercial and corporate litigation, less than four months to decide the case, which is a remarkably rapid disposition of a complex case involving a major public company. The speed with which the case was handled also is attributable to its permitted form under New York practice as a so-called summary proceeding initiated by petition brought on by order to show cause, rather than the less expeditious plenary action initiated by ordinary summons and complaint. Presently the New York Supreme Court has a Commercial Division in ten counties including three of five New York City boroughs, upstate cities, Westchester and Long Island. A practitioner representing a non-controlling shareholder contemplating an action against management, but who lacks potentially vital information for purposes of formulating a suit, should seriously consider the option of first bringing a books-and-records proceeding, especially if able to establish proper venue in a county with a Commercial Division.