27 April 2020

Caremark Claim Allowed to Proceed Against Audit Committee Members Based on Oversight Failures

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The Delaware Chancery Court recently denied a motion to dismiss a shareholder derivative suit against directors and officers of Kandi Technologies Group, Inc., a publicly traded Delaware corporation based in China. Hughes v. Hu (Del. Ch. Apr. 27, 2020). The company had persistent problems with financial reporting and internal controls, encountering particular difficulties with related-party transactions dating back to 2010. In March 2014, the company disclosed material weaknesses in financial reporting and oversight, including a lack of audit committee oversight and a lack of internal controls for related-party transactions. The company pledged to remediate these problems. However, in March 2017, the company disclosed that its preceding three years of financial statements needed to be restated and that it continued to lack sufficient expertise and/or controls relating to accounting and SEC reporting.

The plaintiff filed a derivative claim to recover damages from the three directors who comprised the audit committee during the period, the CEO and three CFOs who had served in quick succession. Prior to filing suit, the plaintiff obtained books and records under a Delaware General Corporation Law (DGCL) Section 220 demand and used those records to assert that directors “consciously failed” to establish a board-level system of oversight for the company’s financial statements and related-party transactions and simply relied blindly on management, while devoting inadequate time to audit committee matters—leading to the restatement and causing the company harm.

Defendants moved to dismiss the complaint and the Court denied the motion, finding that the books and records produced—and fair inferences from what the company failed to produce—supported a reasonable pleading-stage inference of a bad faith failure of oversight by the director defendants. The Court found that the plaintiff adequately pleaded that the audit committee “met sporadically, devoted inadequate time to its work, had clear notice of irregularities, and consciously turned a blind eye to their continuation” and that  “the board never established its own reasonable system of monitoring and reporting, choosing instead to rely entirely on management.”

Furthermore, the company failed to produce related-party agreements and review procedures that were referenced in audit committee meeting minutes and were responsive to the DGCL Section 220 demand, suggesting that they either did not exist or did not impose meaningful restrictions on company insiders. The Court explained that what the company produced—or rather “conspicuously failed to produce”—“is telling because ‘[i]tvis more reasonable to infer that exculpatory documents would be provided than to believe the opposite: that such documents existed and yet were inexplicably withheld’” (citing In re Tyson Foods, Inc., 919 A.2d 563 (Del. Ch. 2007)).

Because the Court determined that the defendant directors “face a substantial likelihood of liability under Caremark for breaching their duty of loyalty by failing to act in good faith to maintain a board-level system for monitoring the company’s financial reporting,” it declined to dismiss plaintiff’s claim. For more information on this decision and practical guidance for boards and their advisors to reduce the risk of derivative claims premised on a failure of board oversight, see our Sidley Update titled Board Oversight in Light of COVID-19 and Recent Delaware Decisions.