Corporate fraud and mismanagement are widespread and often go undetected for years. Witness, for example, Mercury Finance, Barings, New Era, Phar-Mor Discount, and the savings and loan crises.
The reason for the increase in unchecked corporate fraud seems clear: Over the last decade, one by one the restraints on corrupt managers have been loosened. Traditionally, three watchdogs have policed corporate management - government regulators, outside auditors or accountants and, ultimately, the investors themselves. Over the last decade, each of these watchdogs has been restrained.
What to do
So what is an investor who has real suspicions of corporate fraud or mismanagement to do? Today, such an investor essentially has four options.
First, the investor can do nothing and hope his suspicions are unfounded and his investment is safe.
Second, he can report his suspicions to state and federal regulators. But if the investor has no factual support for his suspicions, overworked regulators are likely to put the investor's complaint at the bottom of the pile.
Third, the investor can bring a lawsuit. Litigation, however, is time-consuming and costly, and without adequate factual support, his complaint is likely to be thrown out before he can obtain any factual discovery to support it.
Finally, the investor, whether an individual or an institution, could exercise the investor's "inspection rights" - probably the fastest and most effective way for an investor to confirm or dispel suspicions of corporate wrongdoing.
Inspection rights
The investor inspection right has been around for ages, having its origins in centuries-old common law. Today, every state has a statute that guarantees stockholders and generally also limited partners the right to inspect and copy any corporate records necessary to investigate fraud or mismanagement.
Because most U.S. corporations are incorporated in Delaware, its stockholder inspection rights statute has become the most used by stockholders. The Delaware Supreme Court, the final arbiter of inspection rights for investors in Delaware corporations, has strongly encouraged investors in Delaware corporations to use inspection rights to investigate claims before filing suit against the officers or directors of the corporation.
Unlike several other states, Delaware does not require the stockholder seeking inspection own a minimum number of shares - one share is sufficient.
Fiduciary exercise
For pension funds and other institutional investors, the institution acting as a fiduciary for the investor must exercise the investor's inspection rights for those rights to be enforced by the courts.
To demand inspection under most state statutes, an investor must send a letter noting the specific records he is seeking to inspect and the purpose for inspection, such as to investigate suspected fraud or mismanagement of corporate assets.
If the company or partnership refuses or ignores the demand, the investor can seek a summary court order to enforce the demand. Most inspection rights cases are settled or decided within one to three months of filing.
This action to obtain corporate records is shorter and simpler, and consequently much less expensive, than any other litigation the investor might bring to obtain the same information.
In most instances, to obtain court-ordered inspection, a stockholder must only establish that the stated purposes are proper and the documents the investor wants to inspect are "essential and sufficient" for these purposes. A stated purpose is proper under Delaware law when it is "reasonably related to such person's status as a stockholder."
Over the years, courts have upheld stockholder inspection of corporate records for a number of purposes - generally relating to determination of the value of the stockholder's shares, communication with other stockholders, or investigation of suspected mismanagement, fraud or waste or corporate assets.
Suspicion isn't enough
With respect to this last purpose, mere suspicion is insufficient. Courts generally require some evidence of possible mismanagement to warrant further investigation.
Once the company produces the relevant records for inspection, the investor can weigh other options.
If the records support the investor's suspicions of management fraud, the investor might bring an action on behalf of the company and its stockholders to recover stolen assets. Or, the investor can bring a class action on behalf of all stockholders to recover the depreciation in the value of their investments as a result of the fraud.
These actions based on corporate records showing the fraud have a much greater chance of success. Also, the shareholder's attorneys fees and other costs in bringing a successful stockholder suit can usually be recovered.
Cases resolved faster
Through the use of state inspection statutes, a stockholder who suspects corporate management of securities fraud, breaching fiduciary duties or wasting corporate assets can obtain on a relatively expedited and inexpensive basis the corporate records necessary to confirm or dispel the stockholder's suspicions.
This information could form the basis for an assessment of whether wrongdoing has occurred, and if so, whether to file a well-supported complaint.
As a result, this use of inspection rights addresses congressional and judicial concerns about unsubstantiated shareholder suits while preserving the shareholder's ability to police corporate management.
