SS M&A Litigation Outlook - Flipbook - Page 22
Hughes v. Hu,
C.A. No. 2019-0112-JTL (Del. Ch. April 27, 2020)
Why it is important
In Hughes v. Hu, the Delaware Court of Chancery
denied a motion to dismiss a complaint asserting
Caremark claims grounded in allegations of lack of
oversight over critical company operations – in this
case, auditing responsibilities. This decision follows
recent decisions in Marchand v. Barnhill and In re
Clovis Oncology, Inc. Derivative Litigation, in which
the Delaware courts similarly found that the plaintiff
had pleaded facts supporting a reasonably conceivable
claim that corporate directors had failed to adequately
monitor and implement controls to address “mission
critical” issues. Although Caremark duty of oversight
claims continue to be referenced as “possibly the
most difficult theory in corporation law upon which a
plaintiff might hope to win a judgment,” this decision
further reinforces that the pleading burden to state a
Caremark claim is not insurmountable.
In particular, this decision highlights the significance
of a prior Section 220 books and records inspection
demand in stating a Caremark claim, and provides
guidance to companies responding to Section 220
demands seeking to explore potential oversight failures.
Here, as a result of the company’s failure to produce
documents demonstrating attention to auditing
procedures, the court inferred that the documents did
not exist, or were not reviewed by the audit committee,
thus supporting an inference of wrongdoing at the
pleading stage. Companies responding to Section
220 demands should be mindful that the absence of
documents, as well as the presence of documents, may
be used to support a breach of fiduciary duty claim and
to defeat a motion to dismiss.
Summary
Beginning in 2011, audits of Kandi Technologies
Group, Inc. (KTG) suggested problems with disclosure
of related party transactions, including disguising
related parties with other names and parking large
amounts of KTG cash in the personal bank accounts
of its officers and employees. Similar issues emerged
in the next two years’ audits, prompting disclosure
in KTG’s 2013 10-K that “disclosure controls and
procedures were not effective as of December 31, 2013,
due to a material weakness.” The company pledged
to reform its reporting structure and improve the
audit committee’s effectiveness and involvement in
reviewing related-party transactions. In March 2017,
however, KTG disclosed that its preceding three years
of financial statements needed to be restated due to,
among other things, KTG’s management’s lack of
sufficient expertise related to US GAAP requirements,
SEC disclosure regulations, and disclosure of relatedparty transactions.
The plaintiff filed a derivative action on behalf of KTG,
alleging primarily a breach of the duty of oversight.
KTG moved to dismiss pursuant to Rule 23.1 for failure
to plead demand futility and Rule 12(b)(6) for failure to
state a claim. The Court of Chancery denied the motion.
The court held that a demand would have been futile
because a majority of the board faced a substantial
risk of liability arising from the shareholder’s claim
that they failed to exercise their oversight duties over
auditing procedures in good faith, and from related
claims of unjust enrichment.
The court further found that plaintiff had adequately
alleged a failure of oversight by the audit committee
because, among other things, the audit committee
met only once a year for no more than 50 minutes. In
addition, the audit committee often acted by written
consent after meetings to address issues it neglected
to address during the meetings. Significantly, the
audit committee claimed to have reviewed relevant
documents such as “Approval Procedures of
Relationship Transactions” or “Management Policy on
Related-Party Transactions,” but KTG did not produce
these documents in response to the plaintiff’s Section
220 books and records inspection demand. The court
therefore concluded that it was reasonable to infer
that the audit committee did not receive or review
those relevant documents, especially in light of the
short duration of those meetings. Ultimately, the court
concluded that the plaintiff’s allegations supported
an inference that KTG’s audit committee devoted
inadequate time to its work, had clear notice of
irregularities, and consciously turned a blind eye to
their continuation, such that KTG’s board, through its
audit committee, failed to provide meaningful oversight
over the company’s financial statements and system
of controls.
The court also rejected the defendants’ arguments that
KTG had suffered no harm because the March 2017
restatement had no effect on KTG’s net income, finding
that the defendants could still be liable for damages
incidental to their breach of duty. This included the
costs and expenses of the restatement, reputational
damages, and the costs of related litigation. The
court reached this decision even though several prior
shareholder class actions arising from the same 2017
restatement were dismissed for lack of damages.
Finally, the court also refused to dismiss the plaintiff’s
claim that the officer defendants were unjustly enriched
because they received excessive compensation due
to the company’s overstated financial statements.
Because unjust enrichment damages arose from
the same breach of fiduciary duty as the Caremark
claim, the court concluded that the demand futility
analysis would be identical and denied the motion
to dismiss.
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