Connecticut Supreme Court Rejects Tough Delaware Standard in Allowing Member Inspections of Manager-Managed LLC Books and Records – Or Does It?

November 23, 2021 Alerts and Newsletters

Before allowing the inspection of corporate books and records, Delaware courts require a shareholder seeking information about possible mismanagement to come forward with evidence demonstrating a reasonable basis to suspect mismanagement.[1] In Benjamin v. Island Management, LLC,[2] the Connecticut Supreme Court was asked, as a matter of first impression, to apply that standard to a request for inspection of the books and records of a Connecticut manager-managed limited liability company. On November 2, 2021, the Court declined the invitation. Justice Mullins’ opinion for a unanimous Court rejected the LLC’s claim that Connecticut should follow Delaware by requiring the member seeking inspection to “produce credible proof that mismanagement may have occurred as a precondition for exercising the member’s statutory inspection right.” Rather, the Court held that, as set forth in the applicable statute,[3] (1) the member seeking inspection must be doing so for a purpose “reasonably related” to the member’s interest as a member, (2) the member’s demand must be stated with “reasonable particularity,” (3) the information sought must be “directly connected” to the member’s purpose, and (4) the inspection must be “just and reasonable.”

The case before the Court arose out of a dispute among the children of William Ziegler III. In 2002, Mr. Ziegler had created six trusts – one for each of his children. The trusts were the owners of Island Management, LLC, a Connecticut manager-managed limited liability company, which managed the family’s assets –collectively valued in 2015 by Forbes Magazine in excess of $2.8 billion. Island Management derived income from management services agreements with two of the family’s businesses. After the patriarch’s death, squabbles broke out among some of his children over the amount of the distributions their trusts were receiving from Island Management: Helen Ziegler Benjamin, who had no children, wanted more of the LLC’s earnings to be distributed to her generation, while other siblings, who had children, wanted more of the earnings to be preserved for future generations. The instrument creating the six trusts didn’t specify either approach, and neither did Island Management’s Operating Agreement. The disagreement caused trustees of Helen’s siblings’ trusts to approach her about a buyout. Their offer was a good deal less than what Helen’s interest would have been worth under the valuation estimate by Forbes. Helen obtained her own valuation, which (unsurprisingly) came in much higher than her siblings’ offer.

This state of affairs led Helen, as trustee of her trust, to start making demands – four of them, in fact – for inspection of the LLC’s books and records. The final demand sought twenty-seven categories of financial information, for the claimed purposes of determining the valuation of Helen’s trust’s interest in the LLC and enabling that trust to exercise its rights in an informed manner, particularly with respect to potential conflicts of interest on the part of two of her siblings as a result of their multiple roles in the management and ownership of Island Management and related businesses to which Island Management provided services. According to the demand, Helen wanted the information to assist her in evaluating fees paid to Island Management by other family entities and fees paid to her siblings for managing that LLC. The demand alleged that Island Management’s prior refusal to grant access to this payment information gave Helen a reasonable basis to suspect possible irregularities, and that the information she sought was necessary to investigate the propriety of the payments.

Island Management agreed to provide updates to various categories of information it had produced in response to Helen’s earlier demands but refused to produce any additional information. It claimed that the requests were unreasonable and the information was unnecessary because Helen had already received enough information to achieve her valuation purpose. It also asserted that the request was improper with respect to the claimed mismanagement purpose because – invoking the standard adopted in Delaware – the inspection right granted by statute requires credible proof of mismanagement, which Helen’s demand lacked.

Helen brought suit in Connecticut Superior Court seeking a writ of mandamus to compel the LLC to comply with her demands. The parties were able to resolve some but not all of Helen’s claims; after a trial, the court ruled that Helen’s successor trustees (who had been substituted for her as plaintiffs) were entitled to inspect the categories of information that remained in dispute. The court noted that a shareholder’s desires to value shares and to determine whether there had been improper transactions are proper inspection purposes. It rejected Island Management’s claim that Connecticut courts should follow the Delaware courts’ interpretation of that state’s corporate records inspection statute by holding that § 34-555i of the Connecticut General Statutes requires credible proof of mismanagement before allowing inspection of an LLC’s books and records for the claimed purpose of investigating mismanagement. Island Management appealed to the Appellate Court, and the Supreme Court transferred the appeal to itself.

The Court began its discussion by noting that, although the Connecticut inspection statute at issue, § 34-255i of the General Statutes, finds its origin in the Uniform Limited Liability Company Act of 2006 (“ULLCA”), the counterpart section of the uniform act had not been the subject of judicial analysis in any of the jurisdictions in which that act had been adopted. Nonetheless, the Court noted that the corporate records inspection provisions of the ULLCA were the same as comparable provisions for corporate records inspection, which have been addressed in numerous cases – as has the common law right of shareholder inspection.

In reviewing that body of law, the Supreme Court noted that no jurisdiction requires a shareholder seeking corporate records for the purpose of investigating mismanagement to come forward with allegations or proof of actual mismanagement, although Delaware and others require such a shareholder to “come forward with facts that demonstrate a reasonable basis to suspect mismanagement.”[4] Some courts imposing that requirement have relied on the common law principle that inspection will not be allowed for speculative purposes or fishing expeditions. Others have deemed that the requirement strikes a proper balance between a shareholder’s legitimate needs for information and the burden that inspection requests impose on the corporation. Still others have justified it as being required to meet a statutorily imposed burden.[5]

Continuing its survey, the Supreme Court noted that other courts have declined to impose a requirement to come forward with such specific facts. The justifications advanced for that view are that the corporation’s books and records aren’t the private property of corporate directors and managers, but rather they are held in trust for the shareholders; that requiring shareholders to show evidence of mismanagement in order to obtain records demonstrating mismanagement can be tantamount to a denial of the right to inspect; and that, absent a clear statutory directive to the contrary, it suffices to require the shareholder to allege a proper purpose in general terms, while allowing the corporation to respond with evidence that the shareholder’s true purpose is an improper one.[6]

In weighing these conflicting results, the Court observed that the decision whether or not to require factual support for the purpose investigating possible mismanagement appeared to turn on two factors: whether it is a prerequisite for such an inspection that the shareholder is seeking the information in good faith, and, if so, whether it is the shareholder’s burden to prove good faith or the entity’s burden to prove bad faith.[7] And as to those factors, the Court noted a difference between the Connecticut Business Corporations Act (“CBCA”) and the ULLCA as adopted in Connecticut (“CULLCA”): the former requires that a shareholder’s demand be “made in good faith and for a proper purpose,”[8] but the latter does not mention good faith, except in the case of a demand made by a dissociated member.[9] “The absence of a statutory good faith requirement for current LLC members,” said the Court, “cuts strongly against imposing a credible proof requirement on such members.”[10]

Although it declined to impose a “credible proof” standard on manager-managed LLC members seeking inspection of corporate records to investigate mismanagement, the Supreme Court was quick to explain that its decision did not leave LLCs defenseless against baseless inspection demands. For one thing, the statutory requirements that the inspection must be sought for a purpose “reasonably related to the member’s interest as a member,” that the demand must be stated with “reasonable particularity,” and that the information sought must be “directly connected” to the member’s purpose give courts discretion to require specificity as to what is being sought and why. For another, the requirement that inspection can only be conducted to the extent it is “just and reasonable” to do so allows courts to impose limits on inspection requests that are “too burdensome or inadequately justified.” Moreover, the LLC itself can offer evidence to show that the statutory conditions are not satisfied – for example, by trying to convince the court that the member’s true purpose is an improper one. The LLC can even submit the requested documents to the court for in camera inspection. And last but not least, the CUCCLA allows an LLC’s operating agreement to impose restrictions on the availability and use of information obtained under § 34-255i.[11]

Thus, although the Supreme Court declined to read a “credible proof of mismanagement” requirement into § 34-255i, it recognized that, for all of these reasons, a trial court would be justified in “consider[ing] the absence of facts demonstrating a basis to suspect mismanagement, in combination with other factors, in determining whether an improper purpose is the true reason for the demand and the extent to which disclosure is just and reasonable under the circumstances.”[12]

Despite the Court’s reliance on the absence in the CULLCA of a “good faith” requirement as found in the CBCA, it was careful to note that it expressed no opinion as to whether the presence of that requirement in the CBCA “would support a credible proof of mismanagement requirement” for corporations.[13] But given the extent to which the Court emphasized actions that trial courts can, in their discretion, take to avoid burdening LLCs with unwarranted inspection demands, it would appear difficult to know where – or even if – a line can be drawn between inspection demands that would necessarily pass muster § 34-255i and those that would have to be rejected for failing to meet Delaware’s “credible proof” requirement. A trial court that has been given the wide swath of discretion to rule that an inspection demand is or is not “reasonably related” to member’s interest, that it is or is not stated with “reasonable particularity,” that it is or is not “directly connected” to a member’s purpose in seeking information, and that it is or is not “just and reasonable” has, in effect, been given discretion to decide whether or not the member’s demand is supported by credible proof that mismanagement may have occurred.

As the Court itself noted in introducing the various safeguards that trial courts can adopt to guard against unwarranted inspection demands:

If history is any guide, it demonstrates that, in most cases, a person seeking inspection of records in order to investigate mismanagement will provide facts evidencing a basis to suspect mismanagement in order to justify the scope of inspection sought. That was so in the present case. When such facts are not provided, there are mechanisms other than the credible proof requirement to vindicate the defendant’s concerns.[14]

Trial courts, in other words, have discretion to adopt requirements compensating for the failure of the member’s demand to provide facts that meet the credible proof requirement. A member may not have to satisfy that requirement to be allowed in the front door, but trial courts can, in effect, let it in the back door.

How all this will play out in future cases will be interesting to see. Will the Supreme Court read the credible proof requirement into the CBCA in light of that statute’s imposition of a good faith obligation? How wide is the discretion granted to trial courts to remedy the failure of an LLC member’s demand to “provide facts evidencing a basis to suspect mismanagement?” How light or how heavy a burden can a trial court impose on such a member without being reversed for abusing that discretion? Will Connecticut’s requirements end up being essentially equivalent to Delaware’s despite the Supreme Court’s disagreement (at least for manager-managed LLCs) with Delaware’s articulation of that state’s requirements? Will Connecticut manager-managed LLCs decide that they don’t want to wait for the courts to resolve these questions and write their operating agreements to restrict inspection demands?

Stay tuned.

[1] “[A] party needs to show, by a preponderance of the evidence, that there is a legitimate chance that [the party’s] reason for suspecting mismanagement is credible.” Brehm v. Eisner, 746 A.2d 244, 267 n. 75 (Del. Supr. 2000).

[2] ___ Conn. ___, No. SC 20501, 2021 WL 5098658 (Nov. 2, 2021).

[3] Conn. Gen. Stat. § 34-255i.

[4] 2021 WL 5098658 at *11.

[5] Id. at *11-12.

[6] Id. at 12-13.

[7] Id. at 13.

[8] Conn. Gen. Stat. § 33-946(d).

[9] Conn. Gen. Stat. § 34-255(c)(2).

[10] 2021 WL 5098658 at *13.

[11] Id. at *14.

[12] Id. at *15.

[13] Id. at *13 n. 25.

[14] Id. at 13 (footnote omitted; emphasis added).