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Do Ineffective Internal Controls Expand A Shareholder's Right Of Inspection?

Section 1601 of the California Corporations Code establishes a shareholder's right to inspect the "accounting books and records and minutes of proceedings of the shareholders and the board and committees of the board".  A shareholder's inspection, however, must be for a "purpose reasonably related" to the shareholder's interest as a shareholder. Id.  This is commonly referred to as a "proper purpose" requirement.

When a corporation provides its audited financial statements to its shareholders, can a shareholder have a proper purpose in seeking inspection of the underlying financial records?  Professor Harold Marsh Jr. theorized that in such cases, a shareholder would have to show that "there was some substantial reason to believe that the reports submitted to the shareholders were erroneous".  Marsh's California Corporation Law §15.09[B].  

In  Farnum v. Iris Biotechnologies, 2018 Cal. App. Unpub. LEXIS 8069, the California Court of Appeal took note of a corporation's disclosure in its Form 10-K that management had concluded that the corporation's internal controls over financial reporting were not effective.  Thus, the Court concluded that the company had recognized that its "audited financial statement" [sic] was "incomplete".  This is an odd statement in light of the fact that the company's Form 10-K included the requisite financial statements and an auditor's opinion.  Nonetheless, the case is an example of ineffective internal controls over financial reporting providing a basis for expanded shareholder inspection.  The opinion, however, is not precedential because the court did not certify it for publication or order it to be published.  Accordingly, courts and parties may not cite or rely on it, except as specified in Rule 8.1115 of the California Rules of Court.  

Lastly, I can't help but note that the Court of Appeal refers to my 2016 blog post discussing the scope of shareholder inspection in Delaware and California.

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30172DBAB0084D3A8F39D7AF0A8E79BC.ashx Keith Paul Bishop
Partner at Allen Matkins
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