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Company Ordered to Produce Records Related to Subsidiaries

October 15, 2014
Thomas E. Hanson, Jr.
Delaware Business Court Insider

In Oklahoma Firefighters Pension & Retirement System v. Citigroup, C.A. No. 9587-ML (Del. Ch. Aug. 13, 2014), a stockholder sought books and records related to a company's board of directors and senior management regarding certain public investigations of two of the company's wholly owned subsidiaries. Citigroup Inc. argued that the stockholder failed to demonstrate a nexus between the subsidiaries' wrongdoing and the board or senior management, and therefore failed to show a credible basis to infer possible mismanagement or wrongdoing. The master in chancery disagreed with the company's argument and recommended the court find that the stockholder stated a proper purpose for the inspection.


In Oklahoma Firefighters, the plaintiff stockholder, pursuant to 8 Del. C. Section 220, sought to inspect the parent company's books and records related to one subsidiary's fraud and an investigation into alleged money laundering with respect to another subsidiary. In February, the company publicly disclosed its discovery of fraud related to approximately $585 million of short-term credit extended by the first subsidiary through an accounts receivable financing program. Under the program, the subsidiary extended credit to finance accounts receivable due from the client's primary customer. When that customer discontinued its business with the subsidiary's client, the company reviewed its credit exposure and learned that the accounts receivable were overstated by approximately $400 million. The $400 million difference between the recorded and actual accounts receivable was charged to operating expenses and required the company to make a downward adjustment of its financial results by an estimated $235 million after tax. The adjustment lowered the company's 2013 net income from $13.9 billion to $13.7 billion.

In April, the company announced that it had uncovered a second fraud at the subsidiary, which involved $30 million in loans. The second fraud resulted in a $112 million reduction in the first-quarter net profit of the subsidiary's affiliate due to reserves set aside in connection with the fraud. As a result of the fraud at the company's subsidiary, one employee was terminated almost immediately and 11 additional employees were terminated after the company's internal investigation. The firings included top executives, such as the heads of corporate banking, institutional risk, trade finance and treasury solutions. Likewise, it appeared that the company was the subject of a federal investigation into whether it willfully ignored possible warning signs and lacked proper controls to prevent the fraud from occurring.

In addition to the fraud at the company's subsidiary, a second subsidiary of the company had received grand jury subpoenas regarding compliance with the Bank Secrecy Act (BSA) and anti-money laundering (AML) requirements under federal law and banking regulations. The subpoenas were preceded by a series of consent orders the company entered into with various regulators in 2012 and 2013 regarding BSA and AML compliance. As a result of an August 2012 consent order, which the company entered into with the Federal Deposit Insurance Co. and the California Department of Financial Institutions, the company's board was required to improve internal controls, risk management and oversight of BSA and AML compliance.

Following disclosure of the above information, the stockholder sought eight categories of information, which it subsequently narrowed to the following four: "(1) board and committee meeting materials, (2) meeting preparation materials, (3) director and officer communications, and (4) policies and procedures regarding detection and prevention of fraud and risk management." Following a trial on the papers, it was recommended that the court order inspection of "(1) board and committee meeting materials, (2) materials containing talking points, scripts, or other summaries of remarks or reports that were delivered at a board or committee meeting, and (3) policies and procedures," but only to the extent the books and records related to the first subsidiary's fraud and the BSA and AML matters related to the second subsidiary. It was found that the stockholder had not shown that director and officer communications were necessary and essential to the stated purpose of the request.


In its exceptions, the company primarily argued that there was no nexus linking the board or senior management to any alleged wrongdoing by the subsidiary. Instead, according to the company, the only evidence at trial showed that the company's CEO and its board acted promptly to investigate and address the subsidiary's fraud. The company also argued that the master's findings ignored the corporate separateness of the subsidiary and the company and that the evidence did not support the requisite inference of possible mismanagement at the company.

In analyzing the company's arguments, the court applied the "familiar" standard under Section 220(b). Under Section 220(b), a stockholder seeking to inspect books and records must demonstrate a "proper purpose" for the inspection. A proper purpose is one "reasonably related to such person's interest as a stockholder." To show a proper purpose to investigate waste, mismanagement or wrongdoing, the stockholder must provide "some evidence" to suggest a "credible basis" from which the court may infer "possible" wrongful conduct. Mere suspicion, or a subjective belief of wrongdoing, without more, is not sufficient.

In construing the company's exception, the court recognized that the mere fact that wrongdoing occurred at a subsidiary is not a credible basis to infer mismanagement by the board or senior management of the parent company. The court, however, determined that the scope of the subsidiary's fraud, the significance of the subsidiary to the company's profits, the publicly reported deficiencies in the company's internal controls and the role of a senior executive of the company in overseeing the subsidiary's board presented "some evidence" of a credible basis to infer possible mismanagement or misconduct. In so finding, the court rejected the company's argument that the stockholder was required to show specific and concrete evidence of possible wrongdoing or mismanagement by the board or senior management. According to the court, applying such a standard "would both ignore the very low burden of proof required by the credible-basis standard and would threaten to render meaningless the Delaware courts' repeated urging that stockholder plaintiffs seek books and records before filing class or derivative complaints."

Accordingly, the master in chancery recommended that the court order Citigroup to permit inspection of the board and senior management information related to the subsidiary's fraud and investigation with respect to BSA and AML compliance.

Delaware Business Court Insider  |  October 15, 2014