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Senetas Corporation, Ltd. v. Deepradiology Corp.

Court of Chancery of Delaware

July 30, 2019

Senetas Corporation, Ltd.
DeepRadiology Corporation

          Submitted Date: June 11, 2019

          Daniel A. O'Brien, Esquire Jamie L. Edmonson, Esquire Venable, LLP

          Kenneth J. Nachbar, Esquire Morris Nichols Arsht & Tunnell, LLP

         Dear Counsel:

         This case involves a demand to inspect the books and records of a closely held company that develops artificial intelligence systems for medical visual recognition tasks, specifically diagnostic radiology tasks. The plaintiff, a major investor in the company, seeks to inspect the company's books and records in order to investigate potential corporate mismanagement and wrongdoing. The defendant alleges the plaintiff is not entitled to inspection because it has not shown a credible basis to infer wrongdoing or mismanagement, is a competitor with an ulterior motive for the inspection, and the scope of the demand is overbroad.

         I conclude the plaintiff has established a credible basis from which a court can infer that mismanagement or wrongdoing may have occurred, and the defendant has not shown that the plaintiff has an ulterior motive negating its proper purpose. I condition inspection on the parties entering into a confidentiality agreement. With regard to the scope of the inspection, the parties shall confer and submit to the Court their considerations on specific documents or categories of books and records that are necessary, sufficient and essential for the plaintiff's proper purpose, prior to the Court making further determinations. This is a final report.

         I. Background

         A. Factual Background[1]

         Plaintiff Senetas Corporation Limited ("Senetas") is a publicly listed Australian network encryption company.[2] Senetas' non-executive chairperson is Francis W. Galbally.[3] Defendant DeepRadiology ("DR") is a Delaware corporation involved in developing artificial intelligence systems for medical visual recognition tasks.[4] Kim Nguyen and Robert Lufkin founded DR on July 8, 2015.[5] Nguyen is DR's President, Secretary and Treasurer.[6]

         In May of 2017, Senetas invested approximately $1 million of seed capital in exchange for 397, 219 shares of DR's Series Seed-1 Preferred Stock, becoming a major investor/shareholder.[7] Senetas invested in DR because DR "had a leading medical application for artificial intelligence and machine learning, and had assembled a team of the most expert people around the world that were assisting in developing the application."[8] Senetas understood that, at the time it invested, the first iteration of DR's technology was awaiting FDA approval, and that approval was a key factor in Senetas' decision to invest in DR.[9] Senetas also expected that DR would pursue additional rounds of capital investment, thereby positioning DR as an acquisition target for other companies in the industry.[10]

         Galbally was appointed to DR's Board of Directors ("Board") as Senetas' designee, and served on the Board with Nguyen, Lufkin, and Robert Rankin, the designee of another investor.[11] The evidence shows that the Board held a meeting in August of 2017 during which no minutes were taken.[12] No further board meetings were held during Galbally's tenure on the board.[13]

         In January of 2018, in an attempt to obtain additional funding and without Board knowledge or approval, DR completed the preliminary steps of an Initial Coin Offering ("ICO").[14] Galbally attempted to schedule a special meeting of the Board to discuss the ICO as well as the company's overall financial needs and financing options.[15] This special Board meeting was held on February 23, 2018 with Galbally as the only member in attendance.[16] DR subsequently pulled the ICO offering from its website and never finalized the offering.[17] In a letter dated February 26, 2018, Galbally resigned from the Board and, shortly thereafter, unsuccessfully attempted to inspect DR's books and records at DR's offices.[18]

         The evidence shows that DR depleted all of its seed capital by February of 2018.[19] Since that time Nguyen and Lufkin have been funding the Company personally.[20]

         In August of 2018, Senetas wrote the DR investment off its books.[21] In September of 2018, Nguyen told Galbally and other investors that DR was going to stop seeking FDA approval and would deploy its technology in a manner that would not require FDA approval.[22] At that same meeting, she also promised access to DR's books and records.[23] Later in September, Jack Dwyer ("Dwyer"), a representative of another investor, inspected DR's books and records covering operations from December of 2016 through February of 2018, and requested additional information that DR has not provided.[24]

         B. Procedural Background

         On February 12, 2019, Senetas sent a written demand ("Demand") dated February 6, to inspect DR's books and records.[25] The letter demanded the right under 8 Del. C. § 220 of the Delaware General Corporation Law ("Section 220") to inspect nine categories of books and records. DR failed to respond to the Demand within the mandated five days.

         On February 28, 2019, Senetas filed a complaint in which they argue that, under Section 220, it has a proper purpose to inspect DR's stocklist and books and records because the information requested "bears on questions about the true value of the Company's assets, and whether its assets and opportunities are being managed and pursued in a way that maximizes shareholder value."[26]

         On April 1, 2019, DR filed an answer, in which it asserts Senetas "lacks a proper purpose . . . and, further, has an improper purpose and/or improperly seeks to use . . . the requested documents to the detriment of the Company."[27] And, DR claims the Demand fails "to establish a credible basis from which to infer any actual or possible mismanagement or wrongdoing"; its scope is overbroad; access to sufficient information has already been provided; and confidential and proprietary technical information should be protected from disclosure.[28] Both parties request attorneys' fees and costs.

         DR and Senetas filed their pre-trial briefs on June 6, 2019, the pre-trial conference was held on June 7, 2019, and the trial on June 11, 2019.

         II. Analysis

         "Stockholders of Delaware corporations enjoy a qualified right to inspect the corporation's books and records."[29] Section 220 requires that a stockholder seeking inspection of books and records: (1) be a stockholder of record; (2) comply with the form and manner requirements when making the demand; and (3) state a proper purpose for the requested inspection.[30] Section 220 defines a "proper purpose" as one "reasonably related to the party's interest as a stockholder."[31]

         It is undisputed that Senetas was a stockholder of record and adhered to Section 220's form and manner requirements. The issues in this case are: (A) does Senetas have a proper purpose for seeking to inspect DR's books and records; (B) was Senetas' proper purpose offered under false pretenses, or an attempt to "side-step" the proper purpose requirement; and (C) should the inspection be conditioned on a confidentiality agreement?[32]

         A. Is Senetas' Demand for a proper purpose?

         Senetas states its purpose as determining the "true value of the Company's assets, and whether its assets and opportunities are being managed and pursued in a way that maximizes shareholder value."[33] It intends to inspect the books and records "to determine if [DR] is being properly managed."[34] Senetas argues it is entitled to inspect DR's books and records for a proper purpose - to investigate mismanagement, waste and wrongdoing - and that it has demonstrated more than a credible basis from which the Court can infer possible mismanagement. It claims DR's management failed to follow corporate governance mechanics and made critical business decisions without consulting with the Board or stockholders; failed to act with due diligence related to undertaking an ICO and discontinuing efforts to pursue FDA approval of DR's product; failed to keep systematic or accurate financial records; failed to keep the Board reasonably informed about DR's operations; misled investors; and breached their duty of loyalty and their employment agreements by diverting time and attention from DR's operations, and by misappropriating DR's intellectual property, to organize and promote a competitor.[35] DR asserts that Senetas does not "articulate a cognizable purpose for much of its Demand," and that Senetas knows that "there has been no misappropriation of its investment."[36]

         The predominate factor in determining whether a stockholder is entitled to inspection is the propriety of their purpose.[37] The stockholder has the burden of showing that it has a proper purpose for seeking to inspect books and records.[38]Valuation of a stockholder's shares is a proper purpose for inspection.[39] And, it is well settled that the investigation of mismanagement, waste and wrongdoing is a proper purpose for inspection.[40] Stockholders "need only show, by a preponderance of the evidence, a credible basis from which the Court of Chancery can infer there is possible mismanagement that would warrant further investigation," and are not required to show actual wrongdoing or mismanagement.[41] This threshold requirement "sets the lowest possible burden of proof," and may be met "by a credible showing, through documents, logic, testimony or otherwise, that there are legitimate issues of wrongdoing."[42] But, a stockholder "must do more than state in a conclusory manner, a generally accepted proper purpose" - the investigation of corporate mismanagement "must be to some end."[43] "Mere curiosity or a desire for a fishing expedition will not suffice."[44]

         With these principles in mind, I turn to the books and records demand in this case. Each case involving a shareholder request for inspection of corporate books and records rests on its own facts.[45] DR is a small closely held corporation, with Nguyen serving as DR's president, secretary, treasurer and bookkeeper. Its co-founders, Nguyen and Lufkin, are experts in medical imaging, and also serve as Board members. The Series Seed-1 Preferred Stock Purchase Agreement, under which Senetas became a major investor, requires that DR maintain internal accounting controls sufficient for a company of its size and type.[46] And, DR's Investors' Rights Agreement provides that DR shall furnish to each major investor "when available" DR's annual and quarterly unaudited financial statements "all prepared in accordance with generally accepted accounting principles and practices."[47]

         Nguyen admitted that she does not use accounting programs to track income and expenses, and that she is "not a good person for all this stuff."[48] There is no evidence that DR's management properly maintained DR's financial records or established internal accounting controls or prepared financial statements "in accordance with generally accepted accounting principles and practices," on an annual or quarterly basis (and shared those statements with its major investors).[49]

         Under DR's Certificate of Incorporation ("Charter"), as amended on March 1, 2017, "the management of the business and the conduct of the affairs of the Corporation [is] vested in its Board of Directors."[50] Contrary to the Charter, important decisions were made on behalf of DR without obtaining the Board's input. Those decisions included DR's taking concrete steps towards an ICO in early 2018, [51] as well as DR's decision not to continue to pursue FDA approval.[52]This failure to adhere to proper corporate governance is also reflected in the fact that the Board met only once - in August of 2017 - while Galbally was a Board member, and no minutes of that meeting were prepared.[53] Galbally and others made requests to Nguyen that additional Board meetings be held, to no avail.[54]

         Senetas asked repeatedly for updated information on DR's operations and financial status, and only limited information, primarily in the form of written updates, was provided.[55] Updates on DR's status were provided to stockholders/investors on three occasions - November 2, 2017, May 14, 2018, and March 1, 2019.[56] There are a number of ways in which information provided to Senetas and other investors could be considered misleading. Contrary to the statements in the updates, Nguyen testified that none of DR's products has been deployed and DR has had no revenue. Information provided to Senetas and others, in November of 2017, January of 2018, and March of 2019, give the inaccurate impression that DR's products were being deployed or were already deployed, and also indicated that revenue was forthcoming - anticipated "as early as the first quarter of 2018."[57] Further, there are questions about the information reported to investors on the status of DR's patent applications, [58] and Nguyen and Lufkin's efforts with and's potential effect on DR's interests.[59]

         Based upon the foregoing, I recommend that the Court find Senetas has met its low burden of showing sufficient evidence for the Court to infer possible mismanagement and wrongdoing at DR. DR has not shown it has systematic record-keeping procedures or a detailed accounting documenting its financial affairs; that proper governance procedures were followed since major decisions were made without Board knowledge or approval; and some of the information provided to stockholders was misleading. Senetas should be given the information necessary to effectively address these concerns.[60]

         B. Was Senetas' proper purpose offered under false pretenses, or an attempt to "side-step" the proper purpose requirement?

         DR claims that Senetas is wholly or primarily driven by its desire to gain competitive access to DR's artificial intelligence technology and human resources for use in Senetas' cyber-security business, or for EON Reality, Inc. ("EON"), another company in which Senetas has invested.[61] DR further argues that Senetas attempted to destroy DR when it publicly wrote off its investment in DR, and by actively interfering with DR's business and investor relationships.[62] Senetas responds that it is not a competitor since DR's artificial intelligence technology for the medical field is not of any value to Senetas, whose business relates to "encrypting communications in government systems."[63]

         A "defendant may not rebut a proper purpose solely by demonstrating that a secondary improper purpose or additional ulterior motive also exists."[64] "[O]nce a proper purpose has been established, any secondary purpose or ulterior motive of the stockholder becomes irrelevant."[65] Instead, the defendant must demonstrate that the stockholder's stated purpose was offered under false pretenses, or an attempt to "side-step" the proper purpose requirement, and is improper.[66] And, "[a]n examination of books and records to ascertain the condition of corporate affairs and the propriety of certain actions is a proper purpose even though the one who seeks the inspection may be hostile to management" or a business competitor.[67] "A stockholder's status as a competitor may limit the scope of, or require imposing conditions upon, inspection relief, but that status does not defeat the shareholder's legal entitlement to relief."[68]

         Here, Senetas has established a proper purpose of investigating wrongdoing or mismanagement, so the Court discounts any purported or actual secondary or ulterior motive, unless DR shows that Senetas' stated purpose is not its actual purpose. DR claims that Senetas' real purpose is to gain access to DR's artificial intelligence technology and experts for its own purposes as a competitor and is adverse to DR's interests. DR points to Senetas' public announcement when it invested in DR and its involvement with EON to show that Senetas is a competitor who wants access to DR's technology and experts.[69]

         Senetas claims it is not a competitor to DR since its business is encrypting communications in government systems, military and government communications, it has no involvement with assisted analysis of medical imaging data, radiology or healthcare, and artificial intelligence technology is not one size fits all so DR's technology is not useful to it.[70] It appears that, at the time Senetas announced its investment in DR, it believed that a relationship with DR and DR's personnel, and a "joint collaboration" would be valuable. That said, DR has not met its burden to show that Senetas is a competitor to DR. The potential for a "joint collaboration" between Senetas and DR does not necessarily mean they are competitors. Senetas operates in a different market than DR and there is no evidence that Senetas is trying to enter the healthcare field or that DR's artificial intelligence technology, in its current form, is transferable to the cybersecurity field.

         DR also asserts that Senetas' stated purpose is not its actual purpose and that its intention is to harm DR, as evidenced by publicly announcing its write down of its investment in DR and its counsel's letters to DR's partners/experts.[71] Senetas publicly announced on August 27, 2018 that it was writing down the carrying value of its investment in DR to "nil," after acknowledging that DR's failure to achieve FDA approval for its technology and missing "milestone and projected revenue targets."[72] Although Senetas understood that such an action could negatively affect DR's future funding, [73] it states that, as a publicly traded company in Australia, it is required to review its carrying value of its investments semi-annually and, when appropriate, write down its investments, such as it did with DR, in a public way.[74] I do not find that Senetas' primary purpose in publicly announcing its write down of the DR investment was to harm DR.[75]

         DR also argues that letters sent to DR's partners/experts by Senetas' counsel on June 4, 2018 were intended as a threat, "deliberately designed to disrupt any relationship between the recipients of the letters and [DR]."[76] Those letters related to the dispute between DR and, and sought information from recipients about their involvement with[77] I do not find that Senetas' intention in sending the letters was to harm DR, ...

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