Francis Pileggi recently observed that:
A recent Delaware Court of Chancery transcript ruling is notable for stating that there is no per se affirmative obligation, absent a request for stockholder action, in a closely held company, to produce financial statements. The court, held however, that under certain circumstance, for example in response to a demand under DGCL Section 220, it could raise a fiduciary duty question if no financial statement were prepared in order to keep the minority “in the dark.” The Ravenswood Investment Company, L.P. v. Winmill & Co. Inc., C.A. No. 7048-VCN (Transcript) (Del. Ch. Feb. 25, 2016).
This prompted Keith Paul Bishop to caution that:
In The Ravenswood Investment Company, L.P. v. Winmill & Co. Inc., C.A. No. 7048-VCN (Transcript) (Del. Ch. Feb. 25, 2016), former Vice Chancellor John W. Noble wrote:
That brings us to Delaware disclosure law which generally does not require disclosures to shareholders unless shareholder action is sought. Winmill seeks no such action. Thus, the failure to provide financial reporting, by itself, does not state a claim. Whether that is good policy or bad policy is not my task to resolve today.
The failure to provide the audited annual financial reports, without more, does not state a claim under Delaware law, especially because it appears that accounting records are maintained, bills are being paid, and one presumes tax returns are being filed.
That may be the law in Delaware, but many Delaware corporations maintain their executive offices in California or customarily hold meetings of their boards of directors in California. These corporations are subject to the annual report requirement in Section 1501 of the California Corporations Code. That statute requires the Board of Directors to cause an annual report to be sent to the shareholders not later than 120 days after the close of the fiscal year, unless in the case of a corporation with less than 100 holders of record of its shares (determined as provided in Section 605) this requirement is expressly waived in the bylaws. If no annual report for the last fiscal year has been sent to shareholders, the corporation must, upon the written request of any shareholder made more than 120 days after the close of that fiscal year, deliver or mail to the person making the request within 30 days thereafter the financial statements.
Even if a Delaware corporation does not maintain its executive office or customarily hold board meetings in California, it could be subject to the annual report requirement in Section 1501. Foreign corporations subject to Section 2115 of the Corporations Code are subject to Section 1501. Cal. Corp. Code § 2115(b).
Keith later elaborated by noting that:
The annual report requirement, however, does not apply if a corporation has fewer than 100 holders of records (as determined under Section 605 of the California Corporations Code) and expressly waives the annual report requirement in its bylaws. As a result, many California practitioners include such a waiver in their standard form of bylaws. However, I find that the option of waiving the annual report requirement is often overlooked in the case of foreign corporations. Although the title of this post refers to Delaware corporations, the statute can apply to any foreign corporation, as defined in Section 171 of the California Corporations Code.
All of which strikes me as sensible and good advice.
But I want to focus on VC Noble's observation that "the failure to provide financial reporting, by itself, does not state a claim. Whether that is good policy or bad policy is not my task to resolve today." In this post, I take up that task.
In my book Agency, Partnerships and LLCs, I discuss the legal rules governing disclosure within partnerships. This is a good place to start because close corporations are often referred to as "incorporated partnerships." Meiselman v. Meiselman, 309 N.C. 279, 288, 307 S.E.2d 551, 557 (1983) ("Indeed, the commentators all appear to agree that '[c]lose corporations are often little more than incorporated partnerships.'"). As a result, courts not infrequently "stress the ‘partnership’ nature of the close corporation and reason by analogy from the Partnership Law." Application of Surchin, 55 Misc. 2d 888, 890, 286 N.Y.S.2d 580, 582 (Sup. Ct. 1967). But while we may want to start here, we may not want to end up here.
In Day v. Sidley & Austin, 394 F. Supp. 986 (D.D.C. 1975), plaintiff was a senior partner in the defendant law firm and the managing partner of its Washington, DC, office. When Sidley & Austin merged with another DC law firm, Day was demoted (at least in his eyes) to co-chairman of the office. Day sued. Among other things, Day claimed that his fellow partners breached their fiduciary duties by not disclosing the effect the merger would have on internal firm governance. The court characterized Day’s claim as concerning non-disclosures relating to the internal structure of the firm, as to which the court held that no duty to disclose exists: “No court has recognized a fiduciary duty to disclose this type of information, the concealment of which does not produce any profit for the offending partners nor any financial loss for the partnership as a whole.” In other words, there is no freestanding duty of disclosure absent a conflict of interest. (There is some case law to the contrary, however. See, e.g., Appletree Square I Ltd. Partnership v. Investmark, Inc., 494 N.W.2d 889, 892 (Minn.App.1993) (“The relationship of partners is fiduciary and partners are held to high standards of integrity in their dealings with each other. … Parties in a fiduciary relationship must disclose material facts to each other.”).)
Day likely would be in a much better position today. UPA (1914) § 20 limited intra-partnership disclosure duties (other than access to the books) to situations in which a partner made demand for information of all things affecting the partnership. In contrast, UPA (1997) § 408(c)(1) imposes a duty to disclose, without demand, any information concerning the partnership’s business and affairs reasonably required for the proper exercise of the partner’s rights and duties. This includes “any information concerning the partnership’s … financial condition … which the partnership knows and is material to the proper exercise of the partner’s rights and duties,” which presumably includes financial statements. (Going back to Mr. Day, because Day had a right to vote on the merger, the partnership and its partners had a duty to disclose any information relating to the merger.)
I tend to think that a rule mandating disclosure is optimal in the partnership setting. I base my argument here on Michael P. Dooley, Enforcement of Insider Trading Restrictions, 66 VA. L. REV. 1, 64-66 (1980), which argued that if partners can withhold information from each other, then each has an incentive to drive the other out so as to take full advantage of the information. As each incurs costs to exclude the other, or to take precautions against being excluded, the value of the firm declines. Accordingly, a legal rule vesting the firm with a property right to the information and requiring disclosure is more efficient than forcing the partners to draft disclosure agreements and monitor one another’s behavior. Note that this rule does not discourage the production of new information; the partners still have incentives to produce information because they share in its value to the firm. As no one will withhold information, however, the firm’s productivity is maximized.
If we think of close corporations as incorporated partnerships, then mandatory disclosure would make sense in that context too. But therein lies the difficulty. Unlike the partnership setting, it is far less clear to me that mandatory disclosure makes sense in the public corporation context. See my article Mandatory Disclosure: A Behavioral Analysis. 68 University of Cincinnati Law Review 1023 (2000) (available at SSRN: http://ssrn.com/abstract=329880).
So should we treat close corporations like partnerships or like public corporations. As we saw above, courts have often opted for the former. In general, however, I have a strong presumption in favor of the latter. In my book Corporate Law, I critique the analogous question of whether the Massachusetts line of cases imposing partnership-like fiduciary duties on close corporations:
… while the partnership analogy is a useful one, we should not overstate it. Investors are heterogeneous and the best approach may be to offer them standard form contracts—off the rack rules—that provide significant choice. Corporate and partnership law differs in many respects. Courts will maximize investor welfare by letting investors choose the form best suited to their business. If investor choice is a virtue, in other words, Massachusetts’ decision to harmonize close corporation and partnership law was wrongheaded. A better approach would be to retain a real choice by not imposing higher fiduciary duties on close corporation shareholders. To be sure, in the past, some investors probably preferred partnership rules but felt it necessary to incorporate so as to get the benefit of limited liability. These days, such investors can form a limited liability company, which combines a more-or-less partnership-like governance structure with limited liability. Accordingly, the case for maintaining a clear distinction between partnership and corporate law has become even stronger.
So is this is a case for the general rule? Or for an exception? I think the former. Section 410 of the Uniform Limited Liability Company Act adopts the same rule as the partnership statute. Hence, if a rule of mandatory disclosure is optimal in the parties’ setting, they can get it by forming an LLC without giving up the benefit of limited liability. In turn, a clear rule against mandatory disclosure in the close corporation setting would force parties who want a corporation rather than an LLC to solve the issue by contract tailored to their needs.
In closing, I caution that if courts opt to impose such a duty, they ought to limit it to very basic financial information like a balance sheet and income statement. The last thing we want to do is to use state law fiduciary duties to replicate the overly burdensome and costly federal securities law disclosure regime. (Avoiding doing so strikes me as another reason for opting against a duty of affirmative disclosure in the close corporation setting.)