DE Chancery Court Curbs Inspection to Investigate Alleged Fraud

In Scaramellino v. Arencibia Holdco, LLC, Delaware’s Chancery Court recently approved a limited liability company’s narrow production in response to a broad books and records inspection demand, despite the petitioner’s detailed allegations of fraud by the company’s chief executive officer (CEO). The case illustrates the importance of strict adherence to the procedural requirements for making inspection demands and also demonstrates the benefits of carefully crafted governance document provisions regulating inspections.

Petitioner Thomas Scaramellino—an equity holder and former senior vice president and director—claimed to have found anomalies in Arencibia’s invoicing and billing while employed by the company. Scaramellino claimed the entries were fraudulent and had been authorized by the company’s CEO. When he raised his concerns, he was terminated.

In addition to drafting a 93-page derivative complaint, Scaramellino made a 59-page demand to inspect nine broad books and records categories including all documents and communications relating to invoices, customer communications, and financial audits. The stated purposes were to investigate “(i) fraudulent and unlawful conduct on the part of management; (ii) potential breaches of fiduciary duty by members of the ... [Board] and (iii) whether to bring a lawsuit or take other appropriate action.” Arencibia (the Company) offered to produce, subject to a confidentiality agreement, “all formal Board level materials ‘concerning Arencibia's audit function and financial oversight of the Company’ and ‘practices related to customer invoices and its current written policy and procedure documents related to finance, accounting, and customer invoice functions’.”

Arencibia’s Unitholders’ Agreement entitled holders of at least five percent of the outstanding units to “business …, financial and other information reasonably appropriate to monitor and manage its ownership interests in the Company and such other information as it may reasonably request from time to time.” The court upheld the Company’s proposal, finding additional materials were not “‘reasonably appropriate to monitor and manage [Petitioner's] ownership interests in the Company,’ particularly given “the extensive information already in his possession.”’

The court also found Scaramellino’s inspection demand failed to comply with Section 18-305 of Delaware’s LLC Act, which requires that demands by a unitholder’s counsel “shall be accompanied by a power of attorney or such other writing which authorizes the attorney ... to so act on behalf of the member.’” Scaramellino’s demand, issued by his counsel, did not attach a power of attorney. The court held the “form-and-manner requirements are not onerous, but they are strictly enforced.”

Attorneys in Ballard Spahr’s Securities Enforcement and Corporate Governance Litigation Group and Business and Transactions Department are available to assist both companies and stakeholders in maneuvering through this complicated landscape.

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