Plaintiff Entitled to Inspect Additional Documents Where Proper Purpose Demonstrated as to Mismanagement and Wrongdoing
By: Joanna Diakos Kordalis and Pouya Ahmadi
In Paraflon Investments Ltd. v. Linkable Networks, Inc., C.A. No. 2017-0611-JRS (Del. Ch. April 3, 2020), the Delaware Court of Chancery (the “Court”) granted, in part, stockholder Paraflon Investments, Ltd.’s (“Paraflon”) request, after a trial on a paper record, for corporate books and records pursuant to Section 220 of the DGCL where proper purpose was shown with respect to the desire to investigate mismanagement and wrongdoing.
Paraflon (“Plaintiff”) first invested in defendant, Linkable Networks, Inc. (“Linkable” or the “Company”) (provides “a scalable network connecting [credit] card holders to a national group of brands, retailers and restaurants”) in October 2014, eventually contributing over $7 million, making it one of the Company’s largest investors. Paraflon’s investments, however, were not sufficient to meet Linkable’s voracious appetite for cash and the Company was never able to achieve profitability.
In desperate need of additional capital, Linkable approached Blue Chip Venture Capital (“Blue Chip”), a Linkable investor, for additional funding in late 2016. On November 8, 2016, Blue Chip signed a term sheet where it agreed to invest an additional $2.5 million in Linkable. At the time of this contract, Mark Wright, a Blue Chip affiliate, sat on Linkable’s board of directors (the “Board”). A few days later, however, Linkable backed out from the deal and accused Blue Chip of attempting to walk back on the term sheet and trying to pressure the Company into ridiculous terms.
On March 8, 2017, Paraflon was informed that the Company was on pace to run out of cash in two weeks. Linkable’s management initially recommended a sale to nonparty Peerlogix as part of a three-company roll-up. They eventually however decided against that transaction, and Linkable pursued a sale to a single strategic buyer.
The sale process resulted in the Company signing an asset purchase agreement with Collinson Group (“Collinson”), and Linkable notified Paraflon of the transaction on August 22, 2017. Following the transaction, Linkable co-founder and director Francis Correra entered into a consulting agreement with Collinson. A majority of Linkable’s stockholders approved the transaction, and it closed on September 1, 2017. Linkable was sold for pennies on the dollar.
Paraflon first requested books and records from the Company in May 2017, then made a formal demand for inspection under 8 Del. C. § 220 on August 11, 2017, asking for five categories of documents. It stated as its proper purpose a desire to investigate possible mismanagement and wrongdoing. The Company made some documents available, Paraflon demanded more, the Company demurred, and Paraflon filed suit on August 24, 2017.
After the Court denied Linkable’s motion to dismiss, the Company made an additional document production in an effort to resolve the dispute. Nevertheless, Paraflon pressed on. In its pretrial briefing, Paraflon focused on three document requests it claimed remain unaddressed: (1) documents surrounding the abandoned Blue Chip financing; (2) documents relating to the Collinson transaction; and (3) copies of consumer contracts Linkable apparently represented to Paraflon in order to induce it to invest in the Company. The request for consumer contracts was not included in Paraflon’s demand.
According to the Court, a stockholder of a Delaware corporation is entitled to inspect that corporation’s books and records for any “proper purpose” reasonably related to the stockholder’s “interest as a stockholder.” A desire to investigate mismanagement or wrongdoing is recognized as a proper purpose, but when such is the stockholder’s stated purpose, the stockholder must demonstrate “a credible basis from which a court can infer that mismanagement or wrongdoing may have occurred.” The credible basis standard is the lowest burden of proof in Delaware law, requiring that a plaintiff only present “some evidence of wrongdoing through documents, logic, testimony or otherwise.” The Court has wide autonomy in determining the proper scope of inspection.
Regarding the first set of documents requested, Paraflon alleged that the fact that Linkable declined to enforce its term sheet with Blue Chip provided a credible basis to suspect wrongdoing, especially in light of Blue Chip’s presence on the Company’s Board. It argued that abandoning this financing at a time when the Company was in dire financial condition could not be attributed to the exercise of business judgment and may have been a concession to the Board member, who was also a Blue Chip affiliate. The Court determined that Plaintiff met its low “credible basis” burden on the issue. According to the Court, Linkable’s decision not to attempt to enforce the term sheet Blue Chip had signed was at least questionable, and Paraflon had raised a valid concern that Blue Chip’s presence on the Board may have improperly influenced the decision not to enforce the term sheet. Accordingly, the Court ordered the Company to turn over to Paraflon all Board-level documents concerning the transaction, including emails and other electronic documents.
Paraflon next argued it had shown a credible basis to infer that “the Collinson transaction was the result of self-dealing on the part of Linkable’s officers and directors.” In this regard, Paraflon focused on the fact that Linkable co-founder and director Francis Correra entered into a consulting agreement with Collinson after the transaction, and argued this arrangement provides a credible basis to infer a breach of the duty of loyalty. The Court, however, disagreed. According to the Court, Linkable had provided evidence that the Collinson transaction was only agreed to after a robust, arms-length sales process. Accordingly, the Court held that in the face of an otherwise vigorous sales process, the mere fact that Correra was offered a short-term consulting role with Collinson post-closing does not provide a credible basis to suspect wrongdoing.
Finally, Paraflon alleged it was induced to invest in Linkable after the Company represented that it had entered into several contracts with prominent retailers. Linkable has allegedly refused to produce copies of those contracts and Paraflon now suspects those contracts do not exist, and asked the Court to order their inspection. Linkable, however, argued that the Court should not order production of the contracts because, as a threshold issue, the request for their inspection was not presented in the demand. The Court agreed and held that as a matter of law, Linkable does not have to produce these contracts because they were not included in Paraflon’s demand.
The Court ordered the Company to produce the documents requested surrounding the Blue Chip transaction. Judgment however was entered for the Company with respect to all other requests.