Although Delaware’s courts recognized a cause of action for directors’ breach of the duty of oversight in the 1996 Caremark decision, claims against directors based on alleged oversight duty breaches have long been seen as difficult to plead and prove. However, in two 2019 rulings – the Marchand v. Barnhill decision (discussed here) and the Clovis Oncology decision (discussed here) – Delaware courts allowed breach of the duty of oversight claims to proceed. Now in a more recent ruling, the Delaware Court of Chancery has allowed yet another duty of oversight claim to proceed.
As noted in a May 1, 2020 post on the Duane Morris Delaware Business Law Blog (here), the most recent Delaware duty of oversight ruling reinforces the view that “directors and officers who neglect their oversight responsibilities may be personally liable for resulting harm to the company and its stockholders.” The Delaware Court of Chancery’s April 27, 2020 decision in Hughes v. Hu can be found here.
Kandi Technologies Company is a publicly traded Delaware corporation based in Jinhua, China. The company participates in ventures related to the production of auto parties for Chinese auto manufacturers.
Going all the way back to 2010, the company has persistently struggled with its financial reporting and internal controls, and particularly struggled with related-party transactions. In its 2013 10-K, the company publicly announced the existence of material weaknesses in its financial reporting and oversight system, including lack of oversight by the Audit Committee and a lack of internal controls for related-party transactions. The company pledged to address these shortcomings.
Notwithstanding the company’s commitment, the Audit Committee met just give times between May 2014 and August 2016; in March 2016 the Audit Committee gave unanimous written consents to approve all related-party transactions with an affiliate; and in May 2016, just one month after the company fired its internal auditor, the PCAOB sanctioned the auditor for its patter of wrongdoing from 2010 to 2013; and in November 2017, the company disclosed that since 2012 in had engaged in related-party transactions valued at over $60 million.
In March 2017, the company disclosed that its financial statements for the preceding three years needed to be restated. In its 2016 10-K, the company revealed, among other things, that it lacks sufficient expertise relating to technical knowledge of U.S. GAAP requirements and SEC disclosure regulations, sufficient expertise to ensure the completeness of disclosure of financial statements for equity investments, and sufficient expertise to ensure proper disclosure of related-party transactions. The company also disclosed that it lacked effective controls to ensure proper classification and reporting of certain cash and non-cash activities related to various accounting items, as well as to ensure the accuracy of accounting and reporting of income taxes and related disclosures.
As the Delaware Chancery Court subsequently said, “despite having pledged three years earlier to get its house in order, the Company had none of these necessary competencies.”
A plaintiff shareholder filed a shareholder derivative lawsuit in Delaware Chancery Court against the three directors on the Audit Committee; the company’s CEO; and the three individuals who had served as the company’s CFO during the years leading up to the March 2017 restatement. The plaintiff alleged that the director defendants consciously failed to establish a board-level system of oversight for the Company’s financial statements and related third-party transactions, choosing instead to rely blindly on management while devoting patently inadequate time to the necessary tasks. The plaintiff also alleged that because the company’s operating performance was inflated prior to the restatement, the officer defendants received excessive compensation.
The defendants moved to dismiss the plaintiff’s complaint based on the plaintiff’s failure to make a demand on the board or to plead that demand would have been futile, and also on the ground that the plaintiff had failed to state a claim upon which relief may be granted.
In its subsequent consideration of the defendants’ dismissal motion, the Court of Chancery noted that prior to filing his complaint, the plaintiff had filed a books and records request under Section 220 of the Delaware General Corporation Law, as a result of which the company failed to produce material that would have exonerated the defendants. Given the lack of production of board minutes and other materials, the plaintiff, the court said, is “entitled to reasonable inference,” for example, that meetings did not take place.
The April 27, 2020 Opinion
In an April 27, 2020, Vice Chancellor Travis Laster denied the defendants’ motion to dismiss, holding that the plaintiff had adequately alleged demand futility and that the complaint had adequately stated a claim for relief.
In considering the demand futility issue, Vice Chancellor Laster considered under Delaware law that a defendant cannot exercise disinterested business judgment regarding a litigation demand when potential litigation might expose the director to adverse personal judgment, including money damages. In order to determine whether the directors on the company’s board could face this type of litigation exposure, thereby making demand futile, Vice Chancellor Laster considered whether the directors faced potential liability for breach of their duties of oversight under Caremark.
Directors can be liable under Caremark, Vice Chancellor Laster said, if they knowingly or systematically fail to (1) implement reporting policies or a system of controls; or (2) monitor or oversee the Company’s operations. If the oversight failure results in losses to the company, the directors and officers could be held personally liable.
In reliance on the existence of a variety of processes and procedures, the defendants argued that they had fulfilled their oversight obligations. Vice Chancellor Laster acknowledged that the company “had the trapping of oversight,” including the existence of an Audit Committee, a Chief Financial Officer, and internal audit department, a code of ethics, and an external auditor, these “trappings” were insufficient; “the Company’s Audit Committee met sporadically, devoted inadequate time to its work, had clear notice of irregularities, and consciously turned a blind eye to their continuation.” The mere existence of mechanisms charged with oversight was inadequate to rebut the existence of a Caremark claim. The Company’s directors simply failed to make a good faith effort to put in place a reasonable, board-level system of monitoring and reporting.
Vice Chancellor Laster also rejected the defendants’ argument that they cannot be subject to liability because their conduct did not cause the Company to lose income or value. Vice Chancellor Laster rejected this argument, because damages to the company from the defendants’ alleged breach of the duty of oversight could include the expense of restating the company’s financial statements; the reputational harm from the apparent lack of discipline and controls, and the cost of defending against lawsuits.
Laster concluded that demand was excused because a majority of the company’s board faced a substantial likelihood of liability for breach of the duty of oversight based on their failure to act in good faith by maintaining a board-level system for monitoring related party transactions and financial reporting. The plaintiff’s allegations with respect to demand futility were also sufficient to state a claim for which relief could be granted.
As I noted at the outset, Vice Chancellor Laster’s ruling in this case represents the third recent instance in which a Delaware court has ruled that a Caremark duty of oversight case can go forward. As UCLA law professor Stephen Bainbridge noted in his May 3, 2020 post on his ProfessorBainbridge.com blog entitled “Is Caremark still the hardest claim for plaintiffs to win in corporate law” (here), “One is reminded of the aphorism that once is happenstance, two is coincidence, and three is enemy action.”
The three recent Delaware decisions taken collectively serve to underscore the conclusion that under Delaware law corporate directors have a fiduciary duty to oversee their companies by creating and implementing systems of control and by monitoring the company’s management and operations, and that the failure to take these steps could result in the imposition of personal liability.
In analyzing the issues presented in the most recent case, it is clear that Vice Chancellor was most concerned about the defendants’ response to previously revealed problems. As the company’s 2013 10-K disclosed, the company and its directors and officers were already on notice that the company had problems with its internal controls and financial reporting, particularly with respect to related party transactions.
As Vice Chancellor Laster noted, despite these prior developments, “the allegations in this case support inferences that the board members did not make a good faith effort to do their jobs.” The audit committee met only when required to do so by federal securities laws and their “abbreviated meetings suggest that they devoted patently inadequate time to their work.” The pattern of behavior “indicates that they followed management blindly, even after management had demonstrated an inability to report accurately about related-party transactions.”
Vice Chancellor Laster’s conclusions have a number of implications for board members. First and foremost, board and board committee members need to be able to show that they spent sufficient time and gave sufficient effort to address known concerns, in order to be able to substantiate that they made a “good faith effort” to monitor management and operations.
Along those lines, and in terms of what boards need to be able to show, it is important here that Vice Chancellor Laster drew as an adverse inference against the defendants that in response to the books and records request the company had been unable to produce documents that might have exonerated the defendants (that is, documents showing that the committees met, examined key documents and company officials, and sought to ensure that appropriate controls were in place and operating). The implication is that board and board committees will be well served to document their processes and actions, in order to be able to demonstrate that they did in fact take good faith actions to oversee management and operations.
As far as what the directors want to be able to show to substantiate their good faith effort, it is relevant to note that in its 2017 restatement, this company had to acknowledge that it lacked expertise in a number of critical operational and financial reporting functions. At a minimum, this suggests that in order to be able to demonstrate that they have made a good faith effort to oversee company operations, directors will want to be able to show that they identify areas where technical expertise is required and to be able to show the steps they took to try to ensure that the requisite expertise was put in place.
These developments may be particularly relevant now, as we anticipate claims that may arise in connection with the current coronavirus outbreak. The possibility that adverse company developments might result in breach of the duty of oversight claims has been a topic of discussion, particularly with respect to the first of the three recent Delaware duty of oversight cases, Marchand v. Barnhill.
Marchand involved a food manufacturer whose operations were shut down after a listeria outbreak resulted in the deaths of three customers. Because of the health related aspect of the underlying business problem and because of the resulting shut down, some commentators have suggested that the case might point toward future oversight breach cases arising out of the pandemic. The Duane Morris Business Law Blog to which I linked at the outset of this post notes that in light of these oversight duty concerns during the current coronavirus outbreak, “directors and officers have created and are implementing adequate controls and monitoring to avoid the potential that unforeseen events” might arise and lead to their potential liability.