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Emory Corporate Governance and Accountability Review

Lynn Bai

Abstract

Jurisdictions are split on the standard of proof for shareholder inspection lawsuits when inspections are for the purpose of investigating managerial misconduct. Delaware and its followers apply a credible basis standard that calls for extrinsic evidence, beyond mere suspicion, curiosity, or disagreement with management, to permit an inference of misconduct. A minority of jurisdictions require shareholders to show merely a rational belief that mismanagement likely happened. Rational belief can be satisfied by sound logic without referencing extrinsic evidence. The Delaware Supreme Court rejected rational belief for fear that a permissive standard would lead to a cascade of frivolous inspections, although numerous factors suggest otherwise. This paper offers the first empirical verification of the court’s assumption. The Delaware Supreme Court also dismissed shareholders’ argument that credible basis was an insurmountable obstacle to their exercise of statutory inspection rights, reasoning that the standard had only barred inspections in a couple of cases out of a “myriad” of inspection lawsuits. This paper is the first to offer empirical evidence that the court grossly underestimated the deterrence effect of credible basis. The paper shows that both the evil of frivolous lawsuits under rational belief and the evil of over-deterrence under credible basis exist, but the latter overshadows the former in magnitude. The paper suggests that the court adopts rational belief for inspection lawsuits against private companies where credible basis poses the biggest problem, and simultaneously implements cost-shifting for inspection items that impose an onerous burden on the target corporation.

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