Marc Paul v. China MediaExpress Holdings, Inc., C.A. No. 6570-VCP (Del. Ch. Jan. 5, 2012) (Parsons, V.C.)

The Delaware Court of Chancery held that a stockholder, Marc Paul (“Paul”), established a credible basis to support two proper purposes to inspect the books and records of China MediaExpress Holdings, Inc. (“CME”) under Section 220 of the Delaware General Corporation Law (“Section 220”).  The Court granted the shareholder’s demand to inspect certain documents insofar as necessary for these proper purposes.  The Court denied CME’s request to stay this action under the Securities Litigation Uniform Standards Act (“SLUSA”) until after a motion to dismiss in federal court was resolved. 

This action arose from allegations of fraud and mismanagement at CME.  Beginning in January 2011, a financial research firm, Citron Research, and two shortsellers, Bronte Capital and Muddy Waters LLC, released reports alleging CME’s financial statements and operations were fraudulent.  On March 11, CME’s independent auditor, Deloitte Touche Tohmatsu (“DTT”), formally resigned stating that it was no longer able to rely on management’s representations, certain accounting issues should be addressed through an independent investigation, and these accounting issues may have adverse implications for prior periods’ financial reports.  In March and April 2011, three of CME’s directors resigned citing concerns over DTT’s resignation.  NASDAQ also suspended trading in CME’s stock.  In May 2011, CME’s audit committee retained DLA Piper to conduct an internal investigation of DTT’s concerns.  CME’s shares were also delisted by NASDAQ.

In March 2011, Starr Investments Cayman II, Inc. (“Starr”), a CME investor, filed a complaint in the U.S. District Court for the District of Delaware alleging violations of Delaware law and federal securities laws against CME, DTT, and two CME directors (the “Federal Action”).  Under the Private Securities Litigation Reform Act, discovery in the Federal Action was stayed until the federal defendants’ motion to dismiss was resolved.  

On May 17, 2011, Paul served CME with a written demand under Section 220 for inspection of CME’s books and records (the “Demand”).  The Demand asserted  two purposes:  (a) to investigate potential fraud and mismanagement (the “First Purpose”); and (b) to ascertain whether CME’s directors are independent and have acted, and are capable of acting, in good faith as to CME’s potential misconduct (the “Second Purpose”).  CME did not respond to the Demand. 

On June 16, Paul filed a complaint in the Court of Chancery commencing this action (the “220 Action”).  CME claimed that the Demand failed to state a proper purpose under Section 220 and argued that the 220 Action should be stayed under SLUSA until the motion to dismiss in the Federal Action was resolved. 

After trial the Court held that Paul had established a credible basis to support both the First and Second Purposes.  With respect to the First Purpose, the Court found that Paul had established a credible basis to warrant suspicion of fraud and mismanagement at CME due to:  (a) third-party reports alleging fraudulent conduct at CME; (b) NASDAQ’s halting of trading in, and subsequent delisting of, CME’s stock; (c) DTT’s resignation; (d) the noisy resignations of three of CME’s directors; and (e) CME’s initiation of its own internal investigation.  The Court also found that the Second Purpose was proper because Paul, as a stockholder, would have standing to assert direct or derivative claims against CME following the requested inspection.  In that regard, the Court noted that Paul need not prove that he would qualify as a representative plaintiff in a later class or derivative action to demonstrate a proper purpose.

After finding both the First and Second Purposes to be proper, the Court determined that Paul was only entitled to inspect targeted documents necessary for the Demand’s purposes.  Paul was not entitled to inspect documents pursuant to requests for which he had failed to establish a credible basis to suspect wrongdoing and requests that were worded like sweeping discovery requests.  The Court also conditioned Paul’s right to receive documents on Paul entering into a confidentiality agreement to protect the information obtained in the 220 Action from being shared with the plaintiff in the Federal Action.

The Court next acknowledged that the district court in the Federal Action may have authority under SLUSA to stay the 220 Action and noted that federal courts analyze three factors to decide whether to stay a state action:  (a) the risk that a federal plaintiff will obtain a state plaintiff’s discovery and whether a confidentiality agreement or order can minimize that risk; (b) whether the underlying facts and legal claims in the state and federal actions overlap; and (c) the burden that state court discovery will impose on the federal defendants. 

Based on the foregoing, the Court concluded that the 220 Action should not be stayed.  First, Starr was unlikely to obtain the documents Paul was entitled to inspect.  Paul was not a party to the Federal Action.  Paul was required to execute a confidentiality agreement preventing information from being shared with Starr.  There was little to no risk of further discovery disputes or public proceedings that would reveal the documents to which Paul was entitled until after the motion to dismiss the Federal Action was decided. 

Second, there was little risk of an inconsistency between a judgment in the 220 Action and a ruling on the motion to dismiss in the Federal Action.  Although arising from the same facts, the 220 Action and the Federal Action involved different legal claims.  A Section 220 proceeding results in a determination of whether a stockholder is entitled to inspect certain books and records and not a determination of the merits of the underlying matter a stockholder seeks to investigate.  Insofar as the 220 Action constituted the “embryonic stages” of a state derivative action, it was unlikely that any judgment would issue from such a future derivative action before the district court could decide the motion to dismiss.      

Third, the 220 Action would not create an unreasonable discovery burden for the federal defendants.  Paul was only granted the right to inspect a limited amount of targeted documents.  CME would not be required to submit to any depositions or answer any interrogatories.  There was only a minimal risk of further disputes over the scope of documents CME was required to provide to Paul.

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