Adam Downing had a rather ordinary request under North Carolina corporate inspections law. As a shareholder in Cycle Holdings, Inc. he wanted to inspect financial and business records of Cycle Labs, Inc. – a holding of Cycle Holdings – to determine possible impact on the value of his shares of additional investors in Cycle Labs. North Carolina corporation law provides a straight-forward path to extend the inspection rights Downing has in Cycle Holdings to Cycle Labs:
A qualified shareholder of a corporation that has the power to elect, appoint, or designate a majority of the directors of another domestic or foreign corporation or of a domestic or foreign nonprofit corporation, has the inspection rights provided in this section with respect to the records of that other corporation.
N.C.G.S. § 55-16-02(h). In Downing v. Cycle Holdings, Inc., 2023 NCBC 10, the Business Court easily determined that Cycle Labs’ Certificate of Incorporation established rules under which this provision would apply to Downing because Cycle Holdings held a majority of the stock in Cycle Labs and was entitled to elect a majority of its directors. Id. ¶¶ 36-38.
But the infusion of third-party capital into Cycle Labs also came with a wrinkle that impacted Downing’s ability to force information out of it. Cycle Holdings, Cycle Labs, and the new investor all entered a Voting Agreement which left intact the voting rights Cycle Holdings had under the Cycle Labs’ Certificate but contained agreed-to constraints about how Cycle Holdings would vote its shares. Id. ¶ 43. If the voting agreement meant that Cycle Holdings no longer could elect a majority of Cycle Labs’ directors, Downing no longer had inspection rights in that entity.
Delaware law controlled the validity of a voting agreement for Cycle Labs, created under that state’s laws, and allows stockholders to agree in writing that “the shares held by them shall be voted as provided by the agreement” or in accord with another “procedure agreed upon by them.” 8 Del. C. § 218(c). (North Carolina has a similar statute – N.C.G.S. § 55-7-31.) Judge Davis noted that Delaware courts interpret the provision broadly. Downing, ¶ 49 (quoting Schreiber v. Carney, 447 A.2d 17, 25 (Del. Ch. May 11, 1982) (“Delaware law has for quite some time permitted stockholders wide latitude in decisions affecting the restriction or transfer of voting rights.”)
The Business Court found the Voting Agreement served as a “contractual overlay” which didn’t negate the rights accorded to Cycle Holdings but “instead simply constrain[ed] the manner in which the shareholder exercises that power.” Id. ¶¶ 54, 56. But the application of that holding under Delaware law to Downing’s inspection rights under North Carolina law was still a nuanced exercise.
While the North Carolina inspection statute would extend Downing’s rights where Cycle Holdings had “the power to elect, appoint, or designate a majority of the directors” in Cycle Labs, the Business Court placed an important caveat on the scope of the statute. The Voting Agreement left Cycle Holdings with the ability to vote three director seats out of five, but constrained by agreement about how it would exercise its third selection. Judge Davis held that even though Cycle Holdings would still vote a majority of the director seats, it “would only control two of the five members of the board – falling short of a majority.” Id. ¶ 47.
- The Business Court’s decision places an important restriction on inspection rights of which drafters of voting agreements should be wary. As holding companies make compromises in voting agreements that may attract outside investors, they should note that their shareholders’ inspection rights could be limited where a “majority” of director seats is not tantamount to “control.”
Brad Risinger is a partner in the Raleigh office of Fox Rothschild LLP.