Court Refuses to Dismiss Caremark Claims; Touts Benefits of Pre-Complaint Section 220 Books and Records Action in Demand Futility Analysis

In Re China Agritech, Inc. Shareholder Derivative Litigation, C.A. No. 7163-VCL (Del. Ch. May 21, 2013).

Issue Addressed:  Whether a complaint that fails to plead that demand was made on the Board and fails to plead demand futility should be dismissed under Rules 23.1 or 12(b)(6).

Short Answer:  No.  Motions to dismiss denied.

Practice Tips

This is a very interesting and instructive opinion for practitioners, in part, because it provides guidance on the use of a Section 220 books and records action as a precursor to filing a derivative action on Caremark claims.  As with many Court of Chancery decisions, the “devil is in the details” so care should be taken in the review of the facts.  While the Court specifically mentions on more than one occasion the important role that the plaintiff’s Section 220 demand for books and records played in the Court’s analysis, it is not for the typical reasons.  Indeed, the Court’s analysis turns not on information that was produced in response to the Section 220 demand and later the Section 220 Action, but rather what was not produced.  At the very outset of the opinion, the Court mentions the “glaring absence” of information that the Company should have had in its possession and produced to the plaintiff as well as the “inferences reasonably drawn from the absence of records produced in response to the Section 220 demand.”  Practitioners should make note of this and take care in addressing the scope of discovery in a Section 220 case.

This decision also marks the latest in a series of cases involving Delaware corporations formed to do business in Asia and especially China.  This is important for several reasons.  As the recent decisions in Puda Coal, Inc. Stockholders Litigation, C.A. No. 6476-CS (Del. Ch., Feb. 6, 2013) highlighted HERE, and Rich v. Chong, C. A. No. 7616-VCG  (Del. Ch., April 25, 2013) highlighted HERE, board oversight issues have become a significant problem.  In addition, there are problems associated with entity formation and independent directors.  Vice Chancellor Laster noted with disfavor at the outset of this opinion that China Agritech, Inc. (“China Agritech” or the “Company”) “accessed the domestic securities markets in February 2005 through a reverse merger with an inactive corporation that had retained its NASDAQ listing.”  The Court noted:

[U]sing a defunct Delaware corporation that happens to retain a public listing to evade the regulatory regime established by the federal securities laws is contrary to Delaware public policy . . . Delaware has no interest in facilitating reverse mergers with defunct but still publicly registered shell corporations as a means to circumvent the regulatory protections provided by the federal securities laws.

 With respect to the issue of Chinese companies and independent directors, problems arise when family members assume roles in the corporation that require independence.  As the Court noted in this case, a director lacks independence when she is unable to base her decision on the corporate merits of the issue before the board and close family relationships, like the parent-child relationship, create a reasonable doubt as to the independence of a director.

Background

The plaintiff, Albert Rish, filed a derivative action to recover damages resulting from (i) China Agritech’s purchase of stock from a corporation owned by defendants Chang and Teng, (ii) the suspected misuse of $23 million raised by the Company; (iii) mismanagement that allegedly occurred that resulted in the terminations of two outside auditing firms and the resignations of six outside directors and two senior officers, (iv) the Company’s failure to make any federal securities filings; and (v) the eventual delisting by NASDAQ.  The defendants moved to dismiss pursuant to: (i) Rule 23. 1, for failure to plead that demand was made on the board or would have been futile; and (ii) Rule 12(b)(6), for failure to state a claim.  Alternatively, the defendants moved to stay the litigation in favor of three other actions – two in California and one in Federal Court in Delaware.  The Court denied all of the motions.

Internal Controls and the Yinglong Transaction

China Agritech is a Delaware corporation that manufactures fertilizer products in China.  Defendant Chang founded China Agritech and served as the company’s President, Chief Executive Officer, Secretary, and Chairman of the Board.  Chang was also the controlling shareholder.  Defendant Teng co-founded China Agritech and served as a director.  Starting in early 2008, the Company disclosed that it did not have in place the financial controls and procedures required to comply with U.S. financial reporting standards.  Attempts to correct the problem included hiring a new CFO and controller, and expanding the number of members of the board of directors by adding Gene Michael Bennett, Lun Zhang Dai, and Hai Ling Zhang as directors.  While it is unclear if the Company might have rectified the problems temporarily, it is clear that the problems were not fixed permanently.

In February  2009, Yinlong Industrial Co., Ltd. sold its 10% equity interest in China Agritech’s otherwise 90% owned subsidiary, Pacific Dragon Fertilizers Co. Ltd. to China Agritech for $8 million.  Chang and Teng owned 85% and 15%, respectively, of Yinlong’s shares.  In April 2010, China Agritech announced a $23 million public offering to finance the construction of distribution centers for China Agritech’s fertilizer products.

 Outside Auditors and the McGee Report

In its Form 10-Q dated August 16, 2010, China Agritech again disclosed that it was having problems with its financial controls and procedures. On November 13, 2010, three days after announcing that the control problems were fixed, the Company fired its outside auditor, Crow Horvath LLP and hired Ernst & Young (“E&Y”).  The Audit Committee that approved the termination of Crow Horvath consisted of Lun Zhang Dai, Michael Bennett and Hai Ling Zhang.  Six days later, Lingziao Dai, the daughter of Lun Zhang Dai, a member of the Audit Committee, was named head of China Agritech’s internal audit department.

On December 15, 2010, E&Y informed the Audit Committee of certain matters which, if not appropriately addressed, “could result in audit adjustments, significant deficiencies or material weaknesses, and delays in the filing of the Company’s Form 10-K for 2010.”  There was a dispute as to whether the  Company’s management subsequently addressed those issues.  At the same time that E&Y was raising issues with Company management, a private investigator, Lucas McGee, was investigating China Agritech.  McGee prepared a report that identified a series of alleged problems with the Company’s business, including, among other things, (i) idle factories that were supposed to be operating; (ii) the inability to find the distribution centers the Company claimed to have or to be able to buy the product that the Company said it sold; (iii) fictional revenue; and (iv) fictitious suppliers.  McGee concluded that “China Agritech is not a currently functioning business that is manufacturing products. Instead it is, in our view, simply a vehicle for transferring shareholder wealth from outside investors into the pockets of the founders and inside management.”

Special Investigation Committee and a “Parade” of Director Resignations

The day after McGee issued his report, the Company posted a press release on its website denying the allegations. On March 8, 2011, E&Y met with the Audit Committee to discuss problems it had identified.  It was at this time that E&Y expressed concern about relying on management’s representations.  Two days later, on March 10, 2011, the Board formed a Special Investigation Committee to investigate the problems identified by E&Y.  On March 12, 2011, Company management drafted a press release stating that the Special Committee had been formed and explaining that the action was taken due to allegations made by third parties with respect to the Company and certain issues identified in connection with the performance of the Company’s year-end audit.  However, when the actual press release was issued, it omitted the phrase “identified in connection with the performance of the Company’s year-end audit.”  E&Y objected and immediately advised the Company that the deletion was a material omission and E&Y would resign if a corrective press release was not issued.  No correction was made and two days later, the Company fired E&Y without any prior notice regarding its potential termination.  Later that same day, March 14, 2011, the Company issued a press release that questioned E&Y independence because it had done some prior work for the Company regarding SOX (which was exactly the opposite of what the Company told E&Y when it hired them in November 2010).  On December 1, 2011, the Company announced that the Special Committee had completed its investigation and without providing any details, concluded that, in essence, no problems or issued existed.

On January 6, 2012, Rish filed suit and not long thereafter, there was a “parade” of five directors resigning from the Board.  As a result of the resignations, the only remaining directors were cofounders Chang, Teng and Dai (whose daughter headed up the Company’s internal audit department).

Section 220 Demand and a Dearth of Information

On June 10, 2011, Rish sent a demand to the Company for books and records.  While the Company initially refused to produce any documents, after Rish filed a books and records action on July 15, 2011, the Company began to produce what eventually totaled only 227 pages of documents, approximately half of which were in Chinese.  Interestingly, China Agritech did not produce any Audit Committee meeting minutes or any other document reflecting any discussion or review of the Yinlong Transaction by the Audit Committee, the Governance Committee, or the full board.  The Company did produce signature pages for a written consent dated May 15, 2009 (the day the Yinlong Transaction closed) but it did not produce the pages of the resolution preceding the signature pages.  The Company also produced a copy of an agreement among Tailong, Pacific Dragon, and Yinlong in which Yinlong agreed to transfer its 10% stake in Pacific Dragon for $50,000, which is significantly lower than the amount that China Agritech disclosed in its public filings when describing the Yinlong Transaction.  Regarding the termination of E&Y, the Company produced only three documents: (i) the March 14, 2011 resolution of the Audit Committee, (ii) the March 14, 2011 resolution of the Board, and (iii) the letter E&Y sent to the Company on March 15, 2011, to fulfill its obligations under Section 10A(b)(2) of the Securities Exchange Act of 1934.  Interestingly, none of those documents suggested any concern about E&Y’s independence before the Company decided to terminate E&Y.

Rish asked for books and records relating to the principal allegations made in the McGee Report (i.e., construction of distribution centers, contracts with principal customers, and necessary operating permits) by the Company in its responsive press releases.  The dearth of information that the Company produced regarding these significant claims prompted the Court to note:

It would be reasonable to expect that a legitimate entity with bona fide operations would be able to provide ample documents demonstrating that fact. The problem for a legitimate entity would be the potential burden of having too many responsive documents, not the difficulty of digging up a few.

Rish also asked for books and records relating to the Audit Committee’s oversight of the Company’s financial statements, financial reporting process, and system of internal controls.  In response, China Agritech did not produce any Audit Committee meeting minutes for 2009 or 2010.

Motion to Dismiss and Rules 23.1 and 12(b)(6)

Demand Futility – Aronson and Rales

Rish acknowledged that he failed to make a demand on the Board when the litigation was filed.  The composition of the Board at that time was Chang, Teng, Dai, Sim, Bennett, H. Zhang and X. Zhang (the “Demand Board”).  Rish also conceded that the Company opposed his efforts to pursue litigation.  Therefore, under Stone v. Ritter, the Court stated that:

For Rish to obtain authority to move forward on behalf of China Agritech, his Complaint must allege with particularity . . . the reasons . . . for not making the effort [to make a litigation demand], Ch. Ct. R. 23.1, and this Court must determine based on those allegations that demand is excused because the directors are incapable of making an impartial decision regarding whether to institute such litigation.

 In analyzing the issue under Aronson and Rales as to whether the Board could have validly considered a litigation demand, the Court concluded:

The Complaint challenges at least three events that involved actual decisions: the Yinlong Transaction, the terminations of the outside auditors, and the Special Committee’s determination to take no action. Five of the seven members of the Demand Board were directors at the time those decisions were made.  Because less than a majority of the directors making the decision have been replaced, Aronson provides the demand futility standard for the five participating directors. Rales would provide the standard for the two remaining directors, but because the Aronson analysis establishes demand futility, I do not reach the Rales aspect. The outcome would be no different if Rales were used for all seven directors, because the Rales test asks whether a director would face a substantial risk of liability as a result of the litigation.

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 The litigation also alleges a systematic lack of oversight at China Agritech. That challenge does not involve an actual board decision, so Rales governs. The allegations of the Complaint, which rely on both books and records the Company produced in response to the Section 220 Demand and on the absence of books and records in critical areas, support a reasonable inference that the members of the Demand Board face a substantial risk of liability for oversight violations. Under Rales, it would have been futile for Rish to make a litigation demand with respect to the defendants’ failures of oversight.

 The Yinlong Transaction

With respect to the Yinlong Transaction, the Court concluded that it was futile under Aronson for Rish to make a litigation demand. Two members of the Demand Board members, Chang and Teng, stood on both sides of the transaction, in which China Agritech purchased shares from an entity they owed.  Three directors were members of the Audit Committee when it approved the Yinlong Transaction.  In addition, the Court found that “[b]ecause a document produced in response to the Section 220 Demand supports a reasonable inference that the actual value of the interest was approximately $50,000, the litigation risk that the Audit Committee members would face in an entire fairness challenge to the Yinlong Transaction raises a reasonable doubt about their ability to disinterestedly consider a litigation demand.”  Thus, because five of the seven members of the Demand Board could not properly consider a litigation demand addressing the Yinlong Transaction, the Court found that demand was futile under Aronson and that it did not need consider the remaining two directors under Rales.

Caremark Claims and a Bad Faith Finding

With respect to the claims for fraud and the board’s oversight failure, the Court applied the Rales test to evaluate demand futility.  Under Caremark, a board has a fiduciary obligation to adopt internal controls that are “reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with law and its business performance.”  Here the Court found that the allegations of the Complaint support a reasonable inference that “China Agritech had a formally constituted audit committee [that] failed to meet” and in response to the Section 220 Demand, China Agritech failed to produce any Audit Committee meeting minutes for 2009 or 2010.  This was the time period during which the Company “engaged in the Yinlong Transaction, conducted the Offering, disclosed a material weakness in its disclosure controls and procedures, claimed to have fixed the problem, terminated Crowe Horwath as its outside auditor, hired Ernst & Young as its new outside auditor, and named Dai’s daughter as head of China Agritech’s internal audit department.”

 The Court also noted that its conclusions were supported by the discrepancies in the Company’s public filings with governmental agencies which reinforced the inference of an Audit Committee that did not function.  The Court stated:

Although the Delaware state courts have not yet confronted the implications of dramatic divergences between U.S. and Chinese regulatory filings, the federal district courts have considered whether alleged divergences can support a claim of securities fraud under the Private Securities Litigation Reform Act and Federal Rule of Civil Procedure 9(b). When the financial statements differ significantly, courts have generally credited an inference of fraud.  When the differences have been less marked, courts have granted motions to dismiss complaints that did not adequately explain why the discrepancy was material and would support an inference of fraud.  A federal court previously found that the drastically different figures China Agritech filed with the SEC and SAIC supported an inference of scienter.  See Dean v. China Agritech, 2011 WL 5148598, at * 4 (C.D. Cal. Oct. 27, 2011) (emphasis added).

 Based upon that analysis, the Court made a significant finding decision that would later present a serious hurdle for the Board members when the Court concluded that “the factual allegations of the Complaint support a reasonable inference that the members of the Audit Committee acted in bad faith in the sense that they consciously disregarded their duties.”  Based upon their service  on the Audit Committee during the applicable time period, Dai, Bennett, and H. Zhang faced a substantial risk of liability for knowingly disregarding their duty of oversight. Thus, these directors could not validly consider a litigation demand concerning the problems that occurred while they were members of the Audit Committee.  Thus, Dai was in a unique situation in that his daughter, Lingxiao Dai, served as Vice President of Finance from May 1, 2009 until November 19, 2010, and as head of the internal audit department thereafter.  Further, Dai could not consider a demand that would place Chang or Teng at risk because his daughter served at the pleasure of the Company’s controlling stockholders.

Citing Rich v. Chong, the Court noted that Bennett and H. Zhang’s resignations further call into question their ability to consider a demand.  Bennett was the Chair of the Audit Committee and Special Committee.  Bennett resigned from both committees shortly after the firing of the two outside auditors and Wang’s resignation.  He later resigned from the board.  The Court concluded that “Bennett’s resignation supports a reasonable inference that he could not meaningfully supervise Chang, which in turn contributes to an inference that he could not properly consider a litigation demand.”  H. Zhang also was a member of the Audit Committee and Special Committee but he continued to serve on both committees during the time when the Special Committee was conducting its investigation of the events surrounding the firing of the outside auditors.  Shortly after the Special Committee completed its work and announced that it would take no action as a result of its investigation, H. Zhang resigned.  The Court concluded that “H. Zhang’s resignation supports a reasonable inference that he had washed his hands of the Company and its problems, which in turn contributes to the inference that he could not properly consider a litigation demand.”

Finally, the Court found that Chang could not validly consider a demand because he would face a substantial risk of liability in that E&Y:

 [p]ointed the finger directly at Chang and his management team by advising the Audit Committee that it did not believe it could rely on management’s statements. [E&Y] also contended that it was senior management that made a materially misleading disclosure regarding [E&Y]‘s termination. Chang’s potential culpability and the potential [adverse] consequences [to the Company] combine to raise reasonable doubt as to whether he can disinterestedly consider a demand.

 Chang, Dai, Bennett, and H. Zhang comprise a majority of the Demand Board.  The Court found that demand was futile under Rales for purposes of the Caremark claim, the termination of the outside auditors and what the Court referred to as a “sham” Special Litigation Committee, rendering it unnecessary to consider the other three directors.  As a result, the motion to dismiss under Rule 23.1 was denied.

 The defendants also argued that the Complaint failed to state a claim on which relief can be granted. The pleading standards for purposes of a Rule 12(b)(6) motion are minimal.  The operative test in a Delaware state court thus is one of reasonable conceivability.  This standard asks whether there is a “possibility of recovery.”  The standard for pleading demand futility under Rule 23.1 is more stringent than the standard under Rule 12(b)(6) . . . .”  Thus, if a complaint pleads a substantial threat of liability for purposes of Rule 23.1, it will also survive a 12(b)(6) motion to dismiss.  The Court concluded that “[b]ecause Chang, Teng, Dai, Bennett, and H. Zhang face a substantial threat of liability on the plaintiffs’ claims for purposes of Rule 23. 1”, the Court found that the Complaint stated a claim against these directors for purposes of Rule 12(b)(6).

 Section 102(b)(7) Exculpatory Language and Bad Faith

The defendants also moved to dismiss the Complaint in light of the exculpatory provision in China Agritech’s certificate of incorporation. The Complaint challenged the Yinlong Transaction, which was an interested transaction with a controlling stockholder and entire fairness becomes the standard of review.  When that standard applies, “the inherently interested nature of those transactions renders the claims inextricably intertwined with issues of loyalty.”  Because Chang and Teng benefitted directly from the transaction, and Dai, Bennett, and H. Zhang approved it, the Court concluded that it could not dismiss these defendants.

With respect to whether the directors acted in good faith, the Court stated that “[a] Section 102(b)(7) provision can exculpate directors from monetary liability for a breach of the duty of care, but not for conduct that is not in good faith or a breach of the duty of loyalty.  The standard for Caremark liability parallels the standard for imposing liability when directors failed to act in good faith.”  The Court then gave a “hat tip” to Professor Stephen M. Bainbridge and his article, The Convergence of Good Faith and Oversight, 55 UCLA L. Rev. 559 (2008).

Postscript:  Professor Stephen Bainbridge also weighed in with two posts on this decision (here) and (here):