subsidiary

Two decisions do not a trend make, but I can’t shake the feeling that the Appellate Division, First Department, is telling trial judges to take a broader view of shareholder statutory and common-law rights to inspect corporation books and records.

The first decision, two years ago, was the McGraw-Hill case which I reported on here. In that case, the First Department reversed a lower court’s ruling denying a shareholder’s inspection petition under Section 624 of the Business Corporation Law and common law. The petitioner sought records concerning the McGraw-Hill Board of Directors’ oversight of purported wrongdoing by its wholly-owned subsidiary, the Standard & Poor’s credit rating agency. The appellate ruling focused on the proper-purpose standard, holding that the petitioner’s stated purpose to investigate alleged misconduct by McGraw-Hill’s management and obtaining information that may aid in litigation are proper purposes “even if the inspection ultimately establishes that the board had engaged in no wrongdoing.” Essentially, the ruling eliminated the Catch-22 of requiring outside shareholders to tender proof of management wrongdoing to gain access to company records enabling them — or not — to show wrongdoing.

The petition in McGraw-Hill sought records of the parent company in which the petitioners held shares, not the subsidiary. Last week, in Matter of Pokoik v 575 Realties, Inc., 2016 NY Slip Op 06648 [1st Dept Oct. 11, 2016], in a decision of apparent first impression, the First Department again reversed a lower court ruling denying inspection rights and held that the petitioner was entitled under the common law to inspect records of the corporation’s wholly-owned subsidiary.

Pokoik involves an inspection petition by a family limited partnership with an 8% interest in a corporation called 575 Realties, Inc. (“575”) which holds an interest in a midtown Manhattan office building managed by 575’s wholly-owned subsidiary called Steinberg & Pokoik Management Corp. (“SPMC”). The controlling and non-controlling direct and beneficial owners of the two companies and its affiliates are related members of an extended family real estate business reaching back several generations.

The petition (read here) includes a copy of the petitioner’s initial demand to inspect records both of 575 and SPMC concerning salaries and other compensation paid by either company, stating as its purpose “to ensure that corporate assets are not dissipated and to ensure that the salaries paid are proper.” The response from the companies’ counsel, also attached to the petition, advised that 575 had no responsive records but refused any inspection of SPMC records on the ground petitioner is not a shareholder of SPMC.

The lower court, in an oral bench ruling (read transcript here), granted the inspection petition as to 575 but denied it as to SPMC without stating the basis for denial, although the judge suggested, depending on what the records produced by 575 show, that the petitioner may have the ability to seek further judicial recourse as to SPMC’s records.

575 subsequently advised petitioner that it did not possess any documents responsive to petitioner’s requests, at which point the petitioner took up the judge’s suggestion and filed a motion for reconsideration of the court’s prior ruling concerning SPMC’s records. The judge denied the motion by handwritten order (read here) stating simply that the petitioner failed to demonstrate grounds for reconsideration.

On appeal, the First Department reversed the order denying reconsideration and ordered SPMC’s compliance with the demand for inspection, finding that “petitioners have made a sufficient showing to establish their common-law right to inspect the books and records of SPMC, 575’s wholly owned subsidiary, relating to salary and compensation.” The court did not articulate a categorical rule governing when a shareholder of the corporation is or is not entitled to inspect books and records of its wholly-owned subsidiary, but in the following excerpt it implied a facts-and-circumstances approach focused on the degree of management overlap and control (domination) exercised by the parent, as well as the availability of the sought-after information from the parent and the burdensomeness of the request:

Petitioners’ concerns about board mismanagement and excessive expenditures and wasteful dissipation of corporate assets are, on their face, a proper purpose, “even if the inspection ultimately establishes that the board had engaged in no wrongdoing” (Id.). While respondents maintain that petitioners did not tender any evidence to suggest that corporate formalities were not followed between 575 and SPMC, they do not refute petitioners’ assertions that SPMC is the wholly owned subsidiary of 575, in which petitioner Leon Pokoik Family Partners, LP holds shares, and that 575 and SPMC share office space and management and are dominated by certain family members who control the affairs of multiple family businesses. Significantly, 575’s counsel advised petitioners’ counsel that “575 . . . has no employees; has no payroll; pays no salaries; pays no workers’ compensation insurance; and, issues no W-2 forms . . . [and] has no books or records reflecting salaries paid by 575 . . . to any individual or entity” — which leaves petitioners with no source other than SPMC for the information they seek. Furthermore, petitioners’ requests are narrowly related to salaries and compensation and there has been no showing that requiring SPMC to produce the records would impose any undue burden.

The decision cites only two New York cases in support of its holding: the McGraw-Hill case which, as noted above, involved the underlying activities of a subsidiary but did not involve a request to inspect the subsidiary’s records, and a cryptic 1960 Second Department ruling (Bluhdorn v Greenwald Industries, Inc., 12 AD2d 662) affirming without opinion an unpublished lower court ruling directing an inspection. Perhaps recognizing the thinness of these authorities, the Pokoik decision also cites two cases from Ohio and Missouri in which the courts explicitly upheld inspections of the records of subsidiaries.

I’m a little surprised the court did not cite the more influential Delaware case law which has long upheld the right of shareholders to demand inspection of the books and records of a wholly-owned subsidiary that is under the full control of the parent and where the value of the subsidiary accrues to the parent or, stated otherwise, where the corporation and its subsidiary are not really separate entities. (For more on inspection rights under Delaware law, click here, here, and here.)

The Pokoik decision closes with some practical reasons for rejecting the companies’ argument against inspection of the subsidiary’s records:

Respondents’ argument that the right to inspect extends only to the shareholders of the corporation whose books and records they seek to inspect would allow respondents to shield their alleged misdeeds from scrutiny, as the books and records of SPMC would never be discoverable by anyone other than 575’s board of directors. It also fails to give due consideration to the relationship between a parent and its wholly owned subsidiary. For example, where the parent controls the subsidiary, a shareholder may bring a “double” derivative action “not only for wrongs inflicted directly on the corporation in which he holds stock, but for wrongs done to that corporation’s subsidiaries which make indirect, but nonetheless real, impact upon the parent corporation and its stockholders.” [Citations omitted.]

When used properly — whether to gather evidence for subsequent litigation claims or to assist in settlement negotiations — the books-and-records proceeding can be a powerful and expeditious tool for achieving management accountability. Pokoik adds a little more fire power to the litigator’s arsenal.

My thanks to attorney Leland Solon, who represented the petitioner in Pokoik, for providing copies of the lower court decisions.