Search results for: "Section 220"

Quantum Technology Partners IV, L.P. v. Ploom, Inc., C.A. No. 9054-ML (Del. Ch. May 14, 2014).

Why This Ruling is Noteworthy: This post-trial Master’s Final Report deserves careful reading by those who need to understand the nuances of either making a demand for books and records or defending such a demand based on DGCL Section 220. This 45-page decision includes one of the better and more complete explanations of: (i) the prerequisites that must be satisfied in order to obtain books and records pursuant to Section 220; (ii) the many nuances and shades and facets of potential defenses that a company can employ to make a stockholder’s exercise of Section 220 rights a very expensive experience; (iii) the categories of documents that the court may require to be produced in connection with a stated purpose to value shares in a closely held company; and (iv) the terms of a confidentiality agreement that production of documents will be subject to — including a description of what documents may be labeled merely “confidential” as compared to those documents that may bear the more restrictive designation of “highly confidential”. See discussion beginning at page 33.

Also notable is the discussion at page 32 about the Court retaining jurisdiction for a year so that a new Section 220 demand (and new lawsuit) would not need to be initiated in the event that the stockholder merely requested updated financials and related documents. Updated data are especially helpful for the valuation of fast-growing start-up companies as were involved here.

Although a Master’s Report may be modified upon review by a Vice Chancellor or Chancellor, the 135 footnotes in this decision provide a wealth of prior Delaware opinions that may be relied on for the various arguments and rebuttals that make Section 220 cases more complicated than may be apparent based on an initial reading of the statute.  Included in the copious citations, for example, is a prior Chancery decision that served as a reference point for the deciding the terms of a confidentiality order pursuant to which documents were produced.

The Court also expressed frustration with the parties for not making a more productive effort to resolve or clarify certain minor issues, such as whether the documents should be produced within 5 days or 10 days of the court’s final order. The Master’s Report begins with the observation that if the company reached a settlement before trial, then it likely would have produced fewer documents than what the Court ultimately determined to be required under Section 220.

Wal-Mart Stores, Inc. v. Indiana Electrical Workers, Del. Supr., No. 614, 2013.

A pending appeal before the Delaware Supreme Court addresses a claim under DGCL Section 220 for books and records of Wal-Mart in connection with allegations regarding misdeeds in their Mexican subsidiary.  While he was the Chancellor, the current Delaware Chief Justice made a preliminary ruling requiring the disclosure by Wal-Mart of some of its books and records.  The Delaware Supreme Court will decide if Wal-Mart is required to release the files of senior executives to determine in part what the board knew or did not know about the alleged impropriates in their Mexican subsidiary.  Michael Scher of the FCPA blog has written a helpful article about the case.  See link to his April 21, 2014 post.

Caspian Select Credit Master Fund Ltd. v. Key Plastics Corp., C.A. No. 8624-vcn (Del. Ch. Feb. 24, 2014).

Practical Insights on Decision: This Chancery opinion is one of many examples highlighted on these pages over the last 9 years or so, of the not infrequent inefficiency and unsatisfying nature of an action based on DGCL Section 220 in which a shareholder seeks books and records of a corporation. In this instance, the defendant company made the shareholder incur the substantial time and expense of going to trial based on what I would regard as a tactic by the company to make it as expensive and time-consuming as possible to obtain the books and records sought to value the shares of the company, notwithstanding the truism that valuation has been well-established as a proper purpose for a demand under Section 220.

The company’s defense, that only a lawyer could assert with a straight face, was that the stated proper purpose was merely a pretense for another unstated, improper purpose. It took the considerable expense of discovery and a trial for the court to conclude that the stated purpose of valuation was the “actual, real”, primary purpose, and any secondary purposes would not defeat the Section 220 claim. In an instance of the “pot calling the kettle black”, the defendant claimed, unsuccessfully, that the “real” purpose of the plaintiff was to use litigation as an expensive tactic to force a purchase of the plaintiff’s shares.

Bottom line: After the expense of a trial, even though the plaintiff stockholder won, the plaintiff now has the unfulfilling task (and continuing expense) of haggling with the defendant company about what documents the company claims to have that comply with the court’s ruling to produce the requested books and records.

Concluding Comment: DGCL Section 220 as a basis to demand books and records of a company (despite the apparent simplicity of the statute and the courts’ frequent exhortation to use Section 220 before filing a plenary action), is a tool that is neither suitable for the fainthearted nor for those who lack the financial stamina to deal with recalcitrant companies. Stated another way, unless there is substantial money at stake in terms of the value of one’s shares, if a company is determined to wage a war of financial attrition, Section 220 is not an economically rational option for most non-institutional or non-substantial shareholders to exercise.

King v. DAG SPE Managing Member, Inc., C.A. No. 7770-VCP (Del. Ch. Dec. 23, 2013).

Issue Presented:  Whether a former director has standing to demand books and records under DGCL Section 220(d) or under the common law. Short Answer:  No.

Brief Overview:

This Court of Chancery decision granted a motion to dismiss under Chancery Rule 12(b)(6) for failure to state a claim by a former director who sought books and records covering the prior period of his directorship.  Although the stated purpose was to investigate mismanagement or breaches of duty during the period of his directorship, the complaint failed based on standing.  In sum, the statutory rights under Section 220 supplanted the prior common law right and Section 220(d) only gives the right to a current director to seek books and records.

The Court distinguished other similar cases, for example those cases addressing the right of a director to access corporate books and records as part of normal discovery when personally involved in litigation either as a plaintiff or as a defendant in a plenary case.  Chancery has previously explained rights under Section 220 are not to be conflated with the rights to discovery as part of conventional litigation.

In addition, the Court rejected the argument that a former director possesses a “right of equal access to board information” comparable to that of other directors.  This argument was rejected because that concept of “equal access” only would apply in the context of an action, for example, under DGCL Section 225 or other litigation asserting a legal claim against the company, such as the assertion by a corporate defendant of the attorney/client privilege over documents that the former director plaintiff sought.  See footnote 50 and accompanying text.  Unlike the instant case, those cases deal with former directors pursuing or defending substantive claims and their right to discovery as litigants in connection with those claims.

In this case, the plaintiff, former director, is not challenging his removal as a director under Section 225.  Although he presumably could have enforced his rights under Section 220 while he was a sitting director, he is not pursuing a legal claim against the company in which the corporate documents he is seeking would be relevant.

In conclusion, there is no allegation that any claim has been asserted against the former director based on his service as a director and therefore no exceptions would apply to the general rule that Section 220(d) only refers to the rights of current directors to seek books and records from the corporation.

Sutherland v. Sutherland, C.A. No. 2399-VCN (Del. Ch. May 30, 2013).

Issue Addressed:  Whether certain directors violated their fiduciary duties by benefiting from a system of charging for administrative expenses for personal matters that was more favorable to certain directors.

Short Answer:  No.

Background: Many prior Delaware decisions in this long-running internecine family business dispute have been highlighted on these pages. See, e.g., this link.  This latest installment also addresses the important principle that a books and records action under Section 220 may toll a claim that is related to the books and records demand.  See footnote 64.

Analysis 

Under Delaware law the statute of limitations is tolled for claims of wrongful self-dealing until an investor knew or had reason to know of the facts constituting the wrong.  See footnote 66.

Footnote 70 has a further explanation of when a Section 220 case might toll the statute of limitations and in this case in particular, the court determined that notwithstanding the arguments about whether the 220 action would toll the statute of limitations, because the plaintiff filed her original complaint within three years of the earliest date that she would have inquiry notice of any potential wrongful self-dealing, her claim in this matter regarding the flat-fee system is not barred.  The court similarly rejected the laches argument.

No Waiver for Failure to Make Allegations against All Directors

The court disregarded arguments that the claims against only two of the directors were waived because the plaintiff shareholder did not believe that a former director, her deceased father, had breached any fiduciary duties.  The opinion explains that the decision about whether a director violated his fiduciary duties is for the court, not for the parties to make.  Moreover, the court explained that a:

“daughter may assess her father’s conduct in different ways and for different reasons.  It is understandable that a daughter might seek to avoid accusing her (deceased) father of wrongdoing, and that human impulse may impair her capacity to draw proper conclusions about his conduct.  In any event, Martha’s apparent concessions about her father’s actions – – admittedly not all different from those of [her brothers and current directors] Perry and Todd – – does not bar her fiduciary duty claims asserted at trial.”

The court discussed the well known principles underpinning the business judgment rule and the presumptions that is provides.  The court explained that in order to rebut that presumption, the plaintiff must introduce evidence either of director self interest, if not self-dealing, or that the director either lacked good faith or failed to exercise due care.  If the plaintiff fails to meet that burden or establish facts rebutting the presumption, the business judge rule, “as a substantive rule of law, will attach to protect the directors and the decisions they make.”  See footnote 88.  Only when the business judgment rule is rebutted will the burden shift to the defendants to demonstrate the entire fairness of the challenged transaction.

The Court of Chancery explained that self-dealing requires more than the receipt of the benefit from a transaction.  Rather, self-dealing “requires that such benefit not be generally available to other stockholders.”  Moreover, the benefit must be material.  In order for allegations of self-interest to rebut the business judgment rule, a stockholder must show that the director’s self-interest “materially affected their independence.”  That type of materiality requires that the benefit be “significant enough in the context of the director’s economic circumstances, as to make it improbable that the director could perform her fiduciary duties to the shareholders without being influenced by her overriding personal interest.  To be disqualifying, the nature of the director interest must be substantial, not merely incidental.”  See footnote 95.

The court conducted an extensive review of the charges to the various shareholders and directors for the work performed and billed on a flat-fee basis, and concluded that the plaintiff shareholder did not establish by a preponderance of the evidence that the flat-fee system was a material benefit to the directors being challenged.  Thus she did not rebut the business judgment rule presumption and the defendants did not have the burden of proof shifted to them to justify their actions under the entire fairness standard.

The court also rejected, after careful discussion, the claims that there was a breach of the duty of care because Perry and Todd allegedly failed to inform themselves about the bills and fees generated under the flat fee system.

The court explained that for a board to be informed,

“it need not know every single fact relating to a transaction.  A board only needs to consider material facts that are reasonably available, those that are relevant and of the magnitude to be important to directors in carrying out their fiduciary duty of care and decision making.  There is no prescribed procedure or any special method that must be followed to satisfy the duty of due care.  The standard to determine whether a board’s decision is informed is gross negligence.  In the duty of care context, gross negligence is conduct that constitutes reckless indifference or actions that are without the bounds of reason.”

Moreover, the court explained that “in the duty of care context, DGCL Section 141(e) protects directors who rely in good faith upon information presented to them from various sources, including any other person as to matters a member reasonably believes are within such person’s professional or expert competence and who has been selected with reasonable care by and on behalf of the corporation.”

The court found that tax professionals and other experts were relied upon and Perry and Todd, and they reasonably believed that those opinions they received were within the professional competence of the advisors.  Section 141(e) protects defendants against any claim that they may have violated their duty of care.

Attorneys’ Fees and Costs

The court retained jurisdiction to address whether Martha should recover attorneys’ fees for her success on certain claims pursued in this action and in which she was successful, as explained in prior opinions, such as amendments made to the employment agreements of Perry and Todd.  See Sutherland v. Sutherland, 2010 WL 1838968 (Del. Ch. May 3, 2010) (summary judgment opinion).

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.

                    *          *          *          *

 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):

 

 

Pyott v. Louisiana Municipal Police Employees’ Retirement System, No. 380, 2012 (Del. Supr., April 4, 2013)

Issues Addressed:  (1) Whether or not a prior ruling by a California court dismissing a derivative suit served as a bar to subsequent Delaware derivative suits; and (2) Whether the failure to use Section 220 before filing suit created a presumption that the plaintiff was an inadequate representative.

Short Answers:  (1) Collateral estoppel prevented the second derivative suit; and (2) There is no irrebuttable presumption that applies simply because Section 220 was not used before the derivative suit was filed.

Brief Overview 

This 12-page Delaware Supreme Court decision reversed an 80-page decision by the Court of Chancery.  The trial court decision was highlighted on these pages here.  This decision also diminishes the impact of a separate decision by the Court of Chancery in South v. Baker, highlighted on these pages here, which had questioned the adequacy of plaintiffs who filed derivative cases with Caremark claims that had not used Section 220 beforehand.

The issue on appeal was whether the Court of Chancery was required to dismiss a Delaware derivative complaint after a California federal court entered a final judgment dismissing essentially the same complaint brought by different stockholders.

Procedural History 

The Court of Chancery held that it was not required to give preclusive effect to the California judgment for two reasons.  First, the Court of Chancery held as a matter of law that the stockholder plaintiffs in both jurisdictions are not in privity with each other.  Next, the Court of Chancery determined that the California stockholders were not adequate representatives of the defendant corporation.

The Delaware Supreme Court ruled that the Court of Chancery was wrong on both points.  The High Court of Delaware determined that California law controlled the issue of privity, and that the derivative stockholders were in privity when they acted on behalf of the corporation.  In addition, the trial court erred in holding that there was a presumption of inadequacy without any record to support the factual premise on which the presumption was based.

The background facts are described in more detail in the summary of the trial court opinion highlighted on these pages at this link.

Substantially similar complaints were filed in both California and in the Court of Chancery, although the Court of Chancery allowed the UFCW to intervene after it employed Section 220 to inspect books and records of the company involved, Allergan.  Motions to dismiss were filed in both courts and the federal court in California granted the motion to dismiss with prejudice prior to the ruling by the Court of Chancery.  The Court of Chancery held that the California judgment did not bar the Delaware action and denied the motion to dismiss the Delaware case.  An interlocutory appeal followed.

Short Overview of Reasoning by the Delaware Supreme Court 

The Delaware Supreme Court relied on the Full Faith and Credit Clause of the United States Constitution at Article IV, §1, which provides that:  “Full Faith and Credit shall be given in each State to the public Acts, Records, and Judicial Proceedings in every other state.”  This clause has been understood to encompass the doctrine of res judicata, claim preclusion, and collateral estoppel or issue preclusion.  The United States Supreme Court has held that a state court is required to give a federal judgment the same force of effect as it would be given under the preclusion rules of the state in which the federal court is sitting.  The Delaware Supreme Court applied this law to require the state of Delaware to give Full Faith and Credit to the California federal judgment.

The Delaware Supreme Court then determined that the Court of Chancery failed to apply this settled law because it “conflated collateral estoppel with demand futility.”  The Court reasoned that a motion to dismiss should have been addressed exclusively on the basis of federalism, comity, and finality.  The interest that Delaware has in the internal affairs of its corporations:  “must yield to the stronger national interests that all state and federal courts have in respecting each other’s judgments.”  See footnote 11.

Privity

The Supreme Court did not directly address the analysis under Delaware law about whether an individual derivative claim has preclusive effect on derivative claims of other stockholders because the Delaware Supreme Court determined that California law and not Delaware law applied to the preclusive effect issue.  The court also noted that “although the Court of Chancery is divided on the privity issue as a matter of law, we cannot address the merits of that issue in this case.”  See footnote 20.

Section 220 and Alleged Inadequacy of Representative Plaintiffs

The Delaware Supreme Court rejected the “fast filer” presumption of inadequacy referenced in the trial court, and reasoned that:

“undoubtedly there will be cases where a fast filing stockholder also was an inadequate representative.  But, there is no record support for the trial court’s premise that stockholders who file quickly, without bringing a Section 220 books and records action, are a priori acting on behalf of their law firms instead of the corporation.  This court understands the trial court’s concerns about fast filers, but remedies for the problems they create should be directed at the lawyers, not the stockholder plaintiffs or their complaints.”  See footnotes 23 and 24.

The net result of the foregoing quote is that the trial court decision in Pyott, and the separate Chancery decision in South v. Baker, highlighted on these pages here, will not likely be relied on for the imposition of a prerequisite of using Section 220 before a derivative claim is filed.

Alison Frankel of Thomson Reuters penned an insightful article about the case at this link. Ted Mirvis authored an insider’s viewpoint in a piece published on The Harvard Law School Corporate Governance Blog at this link. Kevin LaCroix provides insightful commentary about the case at this link.

Amalgamated Bank v. Dauphin County Employees Retirement Fund, No. 67-2013 (Del. Supr., Feb. 26, 2013). This short Order of the Delaware Supreme Court is noteworthy because it declined to address an issue that has filled many of the pages of this blog over the last 8 years or so: What is the appropriate role of DGCL Section 220 (which provides limited rights of a shareholder to obtain books and records of a company), in connection with the timing of a derviative or class action suit against a company.

The appellant in this case intervened for purposes of filing an interlocutory appeal when the Court of Chancery refused to postpone a determination of the selection of lead counsel in consolidated cases (in which the appellant had not yet joined), until after the appellant completed its Section 220 efforts. I suppose one could read more into this short Order than might be appropriate. The Order merely says that the High Court did not exercise its discretion to accept this interlocutory appeal.

For the practitioner, it means that Section 220 is still a dual-edged sword and not always as effective as one might hope. See, e.g., the Section 220 law review article the the authors of this blog published, which notes the absence of any Delaware authority on the issue of whether ESI is covered by Section 220.

See prior Chancery ruling in this case, on a different issue, highlighted here on these pages.

Doerler v. American Cash Exchange, Inc., C.A. No. 7640-VCG (Del. Ch. Feb. 19, 2013).

This gem of a Chancery decision provides an excellent overview of both the basic prerequisites of a claim for books and records under DGCL Section 220 as well as the nuances of certain defenses that may be–and may not be available to the corporation.

Commonly rejected defenses discussed on page 9 include: (1) ulterior motives that may be less honorable than the primary purpose; (2) hostility towards management, which will not defeat a Section 220 claim. (3) The claim was also not defeated even though the court suspected that an ulterior purpose may be to contact shareholder creditors to seek an involuntary bankruptcy–but mere communication with shareholders is a proper purpose. However, the corporation may prevail if it can demonstrate that a request, if granted, would be “adverse to corporate interests”. See footnotes 55 to 58 and related text.

Another useful aspect of this opinion is that it explains why the request is overbroad and how the court tailored the requested documents to a more precise scope that complied with the requirement that the documents requested must related to the proper purpose. This opinion should be consulted by those who are requesting documents for purposes of valuation and to investigate credible claims of mismanagement.

Compare: Bench ruling highlighted on these pages here, in which a longer list of documents was allowed for purposes of a Section 220 demand based on a purpose of valuation.

See generally, Supreme Court of Delaware’s Order of Feb. 26, 2013, denying an interlocutory appeal on a Section 220 issue.

The Ravenswood Investment Company, L.P. v. Winmill & Co., Inc., C.A. No. 7048-VCN (Del. Ch., Jan. 31, 2013). Issue Addressed: Whether a fiduciary duty claim can be combined with a Section 220 claim in the same complaint.   Short Answer: No.

Brief Summary

This case involved a complaint that sought relief under DGCL Section 220 and also asserted fiduciary duty claims based on the argument that the board of directors of Winmill withheld information for the purpose of suppressing the stock price, resulting in the reluctance of investors to acquire shares in a company that refuses to disclose information.  The argument was that such a lowered stock price would give insiders an opportunity to acquire a greater percentage of ownership in the private company at a lower price.

This letter opinion begins with a thoughtful observation that is applicable to virtually every litigated matter:

“Sometimes disputes that arise during the course of litigation can be resolved by resort to grand principles.  Sometimes a practical approach offers a better option for moving the matter along.  The current disagreement seems to fall in the latter category.”

The Court observed that a Section 220 action is intended as a summary proceeding, and a companion fiduciary duty claim would slow the pace.  Therefore the two claims should not have been brought together.  See footnote 4.

The Court also addressed the somewhat unique aspects of limited discovery in a Section 220 case, which is very narrow in purpose and scope and is typically very limited as it relates to the corporate defendant.  Nonetheless, in this case the Court allowed the functional equivalent of a Rule 30(b)(6) deposition of a corporate designee and depending on the results of that deposition, allowed for the possibility of the plaintiff deposing members of the board of directors of the corporate defendant, in order to inquire about why the defendant was insisting as a condition of producing documents that the plaintiff not trade on the information that it received and otherwise to inquire into the reluctance of the corporate defendant to produce records based on their concern about what the plaintiff might do if it received the non-public corporate financial information.

In support of this inquiry, the Court stated that if the corporate defendant refused to produce its directors for deposition on this issue, those corporate directors would not be entitled to testify at trial.

See generally two prior Chancery decisions between these parties highlighted on these pages.