Court Declines To Dismiss Caremark Claims Against Directors Of Delaware Corporation Based In China

Rich v. Chong, C. A. No. 7616-VCG  ( Del. Ch., April 25, 2013).

Issue Addressed:  Whether a motion to dismiss Caremark claims in a derivative action against directors of a Delaware Corporation can proceed where the plaintiff shareholder made a demand on the board but the board failed to respond to the demand for over two years.

Short Answer:  Yes.  A prior decision in this dispute on a motion to compel a stockholders’ meeting  is addressed [here]

Brief Overview

The Court of Chancery denied a motion to dismiss a derivative complaint  alleging  breaches  of fiduciary duty brought by Defendant Fuqi International, Inc. and its directors. The plaintiff, George Rich, a stockholder of Fuqi, had made a demand asking the corporation to prosecute claims against its officers and directors for violating their Caremark duties.  Because the individual Defendants not only failed to respond to the demand over the next two years, but allegedly took actions making a meaningful response to the demand unlikely if not impossible, the Court found that the plaintiff could pursue a derivative action, notwithstanding Court of Chancery Rule 23.1.

Background

Fuqi was formed as the result of  a  reverse-merger  transaction involving Fuqi BVI and VT Marketing Services, Inc. in November 2006.  Fuqi initially reported very strong growth but then three and one-half years after it was created, Fuqi announced that its fourth quarter 10-Q and 10-K for 2009 would be delayed because it had discovered “certain errors related to the accounting of the Company’s inventory and cost of sales.”  On September 8, 2010, Fuqi announced that the SEC had initiated a formal investigation into Fuqi, related to its failure to file timely periodic reports, among other matters.  Fuqi subsequently released  additional  negative  information  about  its  accounting  errors,  lack  of internal controls, and mismanagement of corporate resources.

Plaintiff Makes Demand on Board

On July 19, 2010, plaintiff made a demand to the Fuqi Board asking the board of directors to “take action to remedy breaches of fiduciary duties by the directors and certain executive officers of the Company” as well as to “correct the deficiencies in the Company’s internal controls that allowed the misconduct to occur.”  While Fuqi never responded to the demand, the directors formed a “Special Internal Investigation Committee” which the board authorized to retain experts and advisors to investigate whether the claims in the demand were meritorious. However, the plaintiff contended that the Special Committee “never conducted any investigation or any other activity during its short-lived existence.”  By March 2012, the Special Committee effectively ceased to exist.

Although there was no evidence that the Special Committee performed any investigation, the Audit Committee did begin an investigation into Fuqi’s accounting problems.  Unfortunately, whatever progress the Audit Committee made in uncovering and correcting the problems ended when  Fuqi management failed to pay the fees of the Audit Committee’s outside legal counsel, forensic specialists, and auditor.   Because the Audit Committee had failed to complete its audits of years 2009, 2010, and 2011, Fuqi did not file any audited financial statements for over three years.  In March 2012, Fuqi represented to the SEC and to the Court of Chancery that it is unable to estimate when it will file its audited financial statements.

Motion to Dismiss – Rule 23.1

Court of Chancery Rule 23.1 permits a stockholder to pursue an action on behalf of a corporation derivatively, where “the corporation . . . [has] failed to enforce a right which may properly be asserted by it . . . ”  Rule 23.1 requires a stockholder to make (or justify excusal of) a demand to the board of directors before the stockholder may bring a suit derivatively.  A stockholder must allege with particularity “the efforts, if any, made by the plaintiff to obtain the action he desires from the directors . . . and the reasons for his failure to obtain the action or for not making the effort.”  Once the stockholder makes a demand, the board has an affirmative duty to evaluate the demand and to determine if the litigation demanded is in the best interest of the stockholders.  Where the board has not responded to a demand, the plaintiff satisfies the rule, and may proceed, upon raising a reasonable doubt that the board’s lack of a response is consistent with its fiduciary duties.

Because Fuqi did not formally reject the plaintiff’s demand, the Court was required to determine whether the plaintiff had pled particular facts creating a reasonable doubt that the Fuqi  Board’s lack of a response was acting in good faith and with due care in investigating the facts underlying the Demand to assess whether the plaintiff has satisfied Rule 23.1 and may proceed derivatively.  The Court noted that the plaintiff had alleged the following: (1) he made a demand; (2) Fuqi took steps to begin an investigation; (3) that investigation appeared to have uncovered some amount of corporate mismanagement; (4) Fuqi did not act on the information that it uncovered; (5) the Special Committee appointed by the Board to investigate the demand ended without making a recommendation; (6) by failing to pay the advisors to the Audit Committee, the company deliberately abandoned the investigation, and has taken no action through the Audit Committee for at least 12 months; and (7) the independent directors have left the company, some in protest of management’s actions.  Based upon those allegations, the Court found that the plaintiff had pled with particularity facts that create a reasonable doubt that the Fuqi board acted in good faith in investigating the plaintiff’s demand.

Motion to Dismiss Caremark Claim – Rule 12(b)(6)

Plaintiff alleged that Fuqi’s directors were liable for Caremark violation in failing to oversee the operations of the corporation.  In its Motion to Dismiss, Fuqi argued that the Complaint failed to plead facts that show that the directors “consciously and in bad faith failed to implement any reporting or accounting system or controls.”  Under 12(b)(6), when considering a defendant’s motion to dismiss, a trial court must accept all well-pleaded factual allegations in the complaint as true, accept even vague allegations in the complaint as “well-pleaded” if they provide the defendant notice of the claim, draw all reasonable inferences in favor of the plaintiff, and deny the motion unless the plaintiff could not recover under any reasonably conceivable set of circumstances susceptible of proof.  The Court noted that “[a] Caremark claim is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”

Under Delaware Supreme Court precedent, there are two possible scenarios in which a plaintiff can successfully assert a Caremark claim:  (a) the directors utterly failed to implement any reporting or information system or controls, or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.  Under either scenario, a finding of liability is conditioned on a plaintiff’s showing that the directors knew they were not fulfilling their fiduciary duties.  “Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing  to  discharge  that  fiduciary  obligation  in  good  faith.”

Fuqi Had No Meaningful Controls in Place.

While the Court noted that Fuqi had some sort of compliance system in place, it appeared to have be “woefully inadequate.”  The Court needed only to look at Fuqi’s own press releases to see detailed evidence of Fuqi’s problems including: “(i) incorrect carve-out of the retail segment from the general ledger; (ii) unrecorded purchases and accounts payable, (iii) inadvertent inclusion of consigned inventory, (iv) incorrect and untimely recordkeeping of inventory movements of retail operation; and (v) incorrect diamond inventory costing, unrecorded purchases and unrecorded accounts payable.”  Moreover, there were allegations that the board ignored the following warning signs: (i) the board knew that it had problems with its accounting and inventory processes by March 2010 at the latest, because it announced that the 2009 financial statements would need restatement at that time; (ii) Fuqi acknowledged  the  likelihood  of  material  weaknesses  in  its internal controls; and (iii) Fuqi received a letter from NASDAQ in April 2010 warning Fuqi that it would face delisting if it did not bring its reporting requirements up to date with the SEC.

When faced with these and other signs that the company controls were inadequate, the directors were required to take steps to prevent further wrongdoing from occurring.  After noting that “[a] conscious failure to act, in the face of a known duty, is a breach of the duty of loyalty,” the Court found that the plaintiff had alleged facts sufficient to state a claim for breach of the duty of good faith under Caremark.

No Stay of Delaware Action in Favor of New York Actions

Fuqi argued that the Court of Chancery should stay or dismiss the Delaware action in favor of several securities actions and two derivative actions pending in New York.  The Court denied the request to stay the case until audited financial statements were released or the SEC investigation was completed expressing concern that, among other things, the New York courts did not have personal jurisdiction over the individual defendants (many of whom are residents of China) while Delaware did have jurisdiction over each of the individual defendants because they are directors of a Delaware corporation.

Supplement: Professor Usha Rodrigues provides insightful commentary on the topics involved in this case, and other commentators have addressed the resignation of a director and how that may impact his pre-resignation liability.