Delaware Court of Chancery Sustains Caremark Claim Against Audit Committee
The Delaware Court of Chancery recently sustained a Caremark claim filed by a stockholder of Kandi Technologies Group, Inc., a publicly-traded Delaware corporation based in Jinhua, China (Company). [1] The derivative suit sought to recover damages from (i) the three directors who comprised the Audit Committee during the period of persistent problems, (ii) the Company’s Chief Executive Officer, and (iii) the three chief financial officers who served in quick succession during the years leading up to the Company’s March 2017 financial restatement. The complaint alleged that the defendants breached their fiduciary duties by willfully failing to maintain an adequate system of oversight, disclosure controls and procedures, and internal control over financial reporting. The defendants moved to dismiss the claim pursuant to Chancery Court Rule 23.1, on the grounds that the plaintiff did not make a pre-suit demand on the board before filing a derivative claim and failed to plead that a demand would have been futile. Disposing of the defendants’ arguments, the Court denied their motion to dismiss under Rule 23.1 and Rule 12(b)(6) for failure to state a claim.
A Caremark claim is conceptualized as flowing from an overarching failure by the directors to take the action necessary to protect the corporation and is historically one of the most difficult corporate law claims to plead. As articulated in Caremark, “the board of a Delaware corporation has a fiduciary obligation to adopt internal information and reporting systems 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.” [2] Delaware courts previously have determined that “[t]he mere existence of an audit committee and the hiring of an auditor does not provide universal protection against a Caremark claim.” [3]
Though rare, Delaware courts have found that directors face a substantial threat of liability under Caremark where the directors either utterly failed to implement any reporting or information system or controls; or, 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. [4] Delaware courts have stated that “a showing of bad faith conduct is essential to establish director oversight liability” and that a plaintiff can establish bad faith by “showing that the directors knew that they were not discharging their fiduciary obligations.” [5] Under Caremark, “[g]enerally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation . . . only a sustained or systemic failure of the board to exercise oversight . . . will establish the lack of good faith that is a necessary condition to liability.” As the Delaware Supreme Court opined in the recent case Marchand v. Barnhill, “failing to make that good faith effort breaches the duty of loyalty and can expose a director to liability.” [6]
The Court in Hughes found that the complaint’s allegations support a pleading-stage inference that “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.” [7] According to the allegations of the complaint, the Company had experienced persistent struggles with its financial reporting and internal controls, dating as far back as 2010. The complaint further alleged, by way of example, that the Company had instructed its internal auditor to conceal certain related-party transactions (including transactions with a company owned by the CEO’s son) and that the Company’s auditor discovered but failed to investigate the Company’s parking of large amounts of cash in the personal bank accounts of its officers and employees. Subsequently, in March 2014, the Company publicly announced the existence of material weaknesses in its financial reporting and oversight systems, including a lack of oversight by the Audit Committee and a lack of internal controls for related-party transactions, but pledged to remediate these problems. Yet, after this announcement, according to the complaint, the Company’s Audit Committee went on to meet only when prompted by the requirements of the federal securities laws and such meetings were short and regularly overlooked important issues and irregularities. After three more years of such behavior, in March 2017, the Company disclosed that its preceding three years of financial statements needed to be restated and disclosed that it lacked sufficient expertise related to: GAAP and SEC disclosure requirements, the proper disclosure of related-party transactions, the accuracy of accounting-related disclosures, effective controls to ensure proper classifications and financial reporting, and other matters.
Significantly, the Court also determined that, in response to plaintiff’s books and records request pursuant to Section 220 of the Delaware General Corporation Law, the Company could have produced documents that would have rebutted this inference, concluding that the absence of those documents was telling because, as the Delaware Chancery court previously has acknowledged, “it is more reasonable to infer that exculpatory documents would be provided than to believe the opposite: that such documents existed and yet were inexplicably withheld.” [8] Additionally, the documents that the Company produced indicated that the Audit Committee never met for longer than one hour and typically only once per year. Each time, the Audit Committee purported to cover multiple agenda items that included a review of the Company’s financial performance in addition to reviewing its related-party transactions. On at least two occasions, the Audit Committee missed important issues that it then had to address after the fact through action by written consent. Thus, the Court found it apparent that the board of directors had failed to establish a reasonable system of monitoring and reporting in the first instance, choosing instead to rely entirely on management. As a result, the Court determined that the plaintiff was entitled to the inference that the board was not fulfilling its oversight duties.
Hughes also reaffirmed, however, that Delaware directors are at risk of Caremark liability only if they “utterly fail to implement any reporting or information system or controls” or, “having implemented such a system or controls, consciously fail to monitor or oversee its operations.” [9] The Court went on to state that while such a bar is indeed high, it was met in Hughes only because the complaint alleged that the Audit Committee met infrequently and briefly, routinely overlooking important issues, and that the board had chronic deficiencies that supported a reasonable inference that the board, acting through its Audit Committee, failed to provide any meaningful oversight.
The decision of the Court in Hughes reinforces the connection between good corporate governance, accurate and detailed recordkeeping, and Caremark liability risk, with the Court stating that “the board is obligated to establish information and reporting systems that allow management and the board, each within its own scope, to reach informed judgements concerning both the [Company’s] compliance with law and its business performance.” [10] It is critical that companies implement reporting systems that provide directors with timely information regarding key risks and that directors react promptly when these reporting systems suggest the need for remedial action. Furthermore, it is essential that these processes be well-documented in order to provide stockholders and courts a fair and accurate picture of the work done by directors. To that end, companies should be reminded by this decision that they must be thoughtful and measured when responding to a Section 220 demand for corporate books and records, as not only what is produced may be critiqued by plaintiffs and courts alike, but also what is not produced may prove to be just as important.
[1] Hughes v. Hu, C.A. No. 2019-0112-JTL, 2020 WL 1987029 (Del. Ch. Apr. 27, 2020).
[2] Id. at *13.
[3] Id. at *14.
[4] Id. at *14.
[5] Id.
[6] 212 A.3d 805, 820 (Del. 2019).
[7] Hughes, 2020 WL 1987029, at *14.
[8] Id. at *17 (citing In re Tyson Foods, Inc., 919 A.2d 563, 578 (Del. Ch. 2007)).
[9] Id. at *14.
[10] Id. at *16.