Melzer v. CNET Networks, Inc.
2007 Del. Ch. LEXIS 163, 934 A.2d 912, 2007 WL 4146237 (2007)
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Rule of Law:
Under Delaware law, shareholders seeking to inspect corporate books and records to gather particularized facts for pleading demand futility in a derivative action are entitled to inspect documents that predate their stock ownership, provided those documents are necessary and essential to establish a 'sustained or systematic failure of the board to exercise oversight' (a Caremark claim) which can excuse demand.
Facts:
- A March 18, 2006 article in the Wall Street Journal suggested that many large corporations were engaging in an options-granting practice that contravened corporate charters.
- In May 2006, the Center for Financial Research and Accountability (CFRA) published an analysis specifically identifying CNET as a company whose pattern of granting options indicated backdating.
- On June 27, 2006, CNET disclosed that its option granting practices were under investigation by the U.S. Attorney for the Northern District of California and by the Securities and Exchange Commission.
- In July 2006, CNET announced that an internal investigation conducted by a special committee confirmed the CFRA report and concluded the company would need to restate its financial statements from 2003-2005.
- In mid-October 2006, CNET released further findings from its special committee, which concluded that backdating had been a problem for the company from the time of its IPO in 1996 through at least 2003.
Procedural Posture:
- On June 19, 2006, plaintiffs filed their initial complaint in the District Court for the Northern District of California alleging federal securities and state law claims against CNET and its directors related to backdated stock options.
- Plaintiffs later amended their derivative complaint following CNET’s public disclosures regarding backdating.
- Defendants moved to dismiss the amended complaint for failure to make a demand on the CNET board (arguing that plaintiffs had not shown it would be futile to ask the board to take action first).
- The district court granted the motion to dismiss, applying the Aronson test for demand futility, and found that plaintiffs failed to plead particularized facts demonstrating that a majority of the board received or engaged in backdated options.
- After dismissing the amended complaint, the district court granted plaintiffs further leave to amend their complaint.
- The district court issued a stay of the federal action, specifically requesting that CNET cooperate and expedite a books and records inspection in Delaware, and listed four categories of documents that would be helpful.
- On May 14, 2007, plaintiffs sent their demand to inspect books and records to CNET.
- CNET did not comply with the demand, leading plaintiffs to initiate the present action in the Delaware Court of Chancery on June 14, 2007, seeking to compel inspection.
- The parties engaged in discovery disputes, including a motion to compel and a motion for a protective order.
- On November 5, 2007, the parties submitted a stipulation cancelling the scheduled trial, but remained in dispute over the precise scope of documents plaintiffs were entitled to inspect under Section 220.
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Issue:
Are shareholders, seeking to plead demand futility in a derivative action, entitled to inspect corporate books and records relating to stock options granted before they owned stock in the corporation?
Opinions:
Majority - Chandler, Chancellor
Yes, shareholders seeking to plead demand futility in a derivative action are entitled to inspect corporate books and records relating to stock options granted before they owned shares, provided these documents are necessary to obtain particularized facts for that purpose. The court found that the plaintiffs’ purpose was not to investigate potential new causes of action for which they would lack standing, but rather to gather specific facts to adequately re-plead demand futility for claims they do have standing to bring. To plead demand futility under the second prong of Aronson v. Lewis, a shareholder must allege particularized facts creating a reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment. This can include showing a “sustained or systematic failure of the board to exercise oversight,” which is a breach of the duty of loyalty by way of bad faith under Caremark (as affirmed by Stone v. Ritter). To establish such a historical pattern of oversight failure, plaintiffs might reasonably need to consult documents that predate their ownership of CNET stock. Distinguishing this case from Polygon (where the shareholder sought to investigate new claims they had no standing for) and West Coast (where repleading demand futility was explicitly barred), the court emphasized that Saito v. McKesson HBOC, Inc. mandates giving a stockholder “enough information to effectively address the problem.” Since plaintiffs cannot effectively address the alleged problem through a derivative suit unless they can properly plead demand futility, and older documents may be essential for a Caremark claim, their request for pre-ownership documents is reasonably related to their proper purpose as shareholders.
Analysis:
This case clarifies the scope of shareholder inspection rights under Delaware General Corporation Law Section 220, particularly in the context of derivative litigation for corporate wrongdoing like options backdating. It reaffirms that a 'proper purpose' includes gathering facts necessary to overcome the demand futility hurdle, even if those facts pertain to events predating the shareholder's ownership. The decision underscores the importance of the Caremark doctrine as a basis for excusing demand in cases of systemic oversight failure and provides a vital tool for shareholders to investigate and pursue derivative claims for such governance breaches.
