Hughes v. Hu ( 2020 )

EFiled: Apr 27 2020 09:00AM EDT
Transaction ID 65600595
Case No. 2019-0112-JTL
IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE
WILLIAM HUGHES, JR., Derivatively )
on Behalf of Nominal Defendant KANDI )
TECHNOLOGIES GROUP, INC., )
)
Plaintiff, )
)
v. ) C.A. No. 2019-0112-JTL
)
XIAOMING HU, XIAOYING ZHU, )
CHENG WANG, BING MEI, JERRY )
LEWIN, HENRY YU, LIMING CHEN, )
)
Defendants, )
)
and )
)
KANDI TECHNOLOGIES GROUP, )
INC., )
)
Nominal Defendant. )
MEMORANDUM OPINION
Date Submitted: February 6, 2020
Date Decided: April 27, 2020
Michael Van Gorder, FARUQI & FARUQI LLP, Wilmington, Delaware; Demet Basar,
Veronica Bosco, WOLF HALDENSTEIN ADLER FREEMAN & HERZ LLP, New York,
New York; Daniel B. Rehns, Kathryn A. Hettler, HACH ROSE SCHIRRIPA CHEVERIE
LLP, New York, New York; Counsel for Plaintiff.
Stamatios Stamoulis, STAMOULIS & WEINBLATT, LLC, Wilmington, Delaware;
Richard J.L. Lomuscio, RIKER, DANZIG, SCHERER, HYLAND & PERRETTI LLP,
New York, New York; Counsel for Defendants Xioaming Hu, Xiaoying Zhu, Cheng Wang,
Bing Mei, Jerry Lewin, Henry Yu, and Liming Chen.
LASTER, V.C.
Kandi Technologies Group, Inc. (the “Company”) is a publicly traded Delaware
corporation based in China. The Company has struggled persistently with its financial
reporting and internal controls, encountering particular difficulties with related-party
transactions. The complaint describes problems dating back to 2010. In March 2014, the
Company publicly announced the existence of material weaknesses in its financial
reporting and oversight system, including a lack of oversight by the Audit Committee and
a lack of internal controls for related-party transactions. The Company pledged to
remediate these problems. Instead, in March 2017, the Company disclosed that its
preceding three years of financial statements needed to be restated. In connection with the
restatement, the Company disclosed that it lacked:
• Sufficient expertise relating to technical knowledge of US GAAP
requirements and SEC disclosure regulations;
• Sufficient expertise to ensure the completeness of the disclosure of
financial statements for equity investments;
• Sufficient expertise to ensure the proper disclosure of related-party
transactions;
• Effective controls to ensure the proper classification and reporting of
certain cash and non-cash activities related to accounts receivable,
accounts payable, and notes payable; and
• Sufficient expertise to ensure the accuracy of the accounting and
reporting of income taxes and related disclosures.
Despite having pledged three years earlier to get its house in order, the Company had none
of these necessary competencies.
The plaintiff is a stockholder in the Company. The plaintiff filed this suit on the
Company’s behalf to recover damages from (i) the three directors who comprised the Audit
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Committee during the Company’s period of persistent problems, (ii) the Company’s CEO,
and (iii) the three CFOs who served in quick succession during the years leading up to the
March 2017 restatement. The plaintiff contends that the director defendants consciously
failed to establish a board-level system of oversight for the Company’s financial statements
and related-party transactions, choosing instead to rely blindly on management while
devoting patently inadequate time to the necessary tasks. The plaintiff contends that the
director defendants’ failures led to the March 2017 restatement, which caused the Company
harm. The plaintiff also contends that because the Company’s performance was inflated
during the pre-restatement period, the officer defendants received excessive compensation
and were unjustly enriched.
The defendants have moved to dismiss the complaint pursuant to Rule 23.1,
contending that the plaintiff failed to make a demand on the board or plead that demand
would have been futile. The plaintiff obtained books and records before filing suit. The
fruits of that investigation—and, just as important, what the Company conspicuously failed
to produce—have enabled the plaintiff to plead a complaint that supports a reasonable
pleading-stage inference of a bad faith failure of oversight by the named director
defendants. Four of the defendants comprise a majority of the board that would have
considered a demand, and the substantial threat of liability renders them incapable of
disinterestedly considering a demand. Demand would have been futile, so the Rule 23.1
motion is denied.
The defendants also have moved to dismiss the complaint pursuant to Rule 12(b)(6),
contending that the plaintiff failed to state a claim on which relief can be granted. Both
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sides treated the analysis of the Rule 23.1 motion as dispositive of the Rule 12(b)(6)
motion. That motion is also denied.
I. FACTUAL BACKGROUND
The facts are drawn from the operative complaint and the documents it incorporates
by reference. At this stage of the proceedings, the complaint’s allegations are assumed to
be true, and the plaintiff receives the benefit of all reasonable inferences, including
inferences drawn from the documents.
The inferences that the plaintiff receives in this case are informed by the plaintiff’s
use of Section 220 of the Delaware General Corporation Law to obtain books and records.
In response to the plaintiff’s requests, the Company produced some documents and
stipulated that “any remaining materials requested by Plaintiff either do not exist or had
been withheld on privilege grounds.” Hughes v. Kandi Techs. Gp., Inc., C.A. No. 2017-
0700-JTL, Dkt. 24, Stipulation of Dismissal With Prejudice, at 2. Given this stipulation, if
the Company failed to produce a document that it would reasonably be expected to possess
if a particular event had occurred, then the plaintiff is entitled to a reasonable inference that
the event did not occur. See Morrison v. Berry, 191 A.3d 268, 275 n.20 (Del. 2018).
For example, the plaintiff asked the Company to produce minutes from board
meetings that took place between December 31, 2009, and May 10, 2017, at which specific
topics were discussed. See Compl. Ex. L, at 7. In response, the Company did not produce
any minutes evidencing any meetings addressing those topics until a meeting of the Audit
Committee on May 9, 2014. The plaintiff is entitled to the reasonable inference that no
earlier meetings took place at which those topics were addressed.
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A. The Company, The Joint Venture, And The Service Company
The Company is a Delaware corporation based in Jinhua, China. The Company
accessed the United States capital markets in 2007 through a reverse merger with a defunct
but still publicly listed Delaware entity.
In March 2013, the Company entered into a joint venture with Geely Automobile
Holdings Ltd. (the “Joint Venture”). The complaint does not contain any allegations about
Geely, which is therefore inferred to be an unaffiliated third party. The Company sells parts
to the Joint Venture, which uses the parts to manufacture electric vehicles. The Company
and Geely each own 50% of the Joint Venture.
The Joint Venture sells the finished electric vehicles to Zhejiang ZuoZhongYou
Electric Vehicle Service Co., Ltd. (the “Service Company”), which sells and leases the
vehicles. The Company owns 9.5% of the Service Company.
Xiaoming Hu is the Company’s CEO and chairman of its board of directors. He
beneficially owns 28.4% of the Company. He also owns 13% of the Service Company.
The complaint alleges that the Joint Venture and Service Company were structured
to enable the Company to take advantage of subsidies that the Chinese government made
available to producers and purchasers of electric vehicles. Through its ownership in the
Joint Venture, the Company benefited from the subsidies provided to producers. Through
its ownership in the Service Company, the Company benefited from the subsidies provided
to purchasers. The complaint implies that by structuring its operations in this way, the
Company engaged in double-dipping that was contrary to how the Chinese government
intended the subsidies to function, but the complaint does not seek relief on the theory that
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the double-dipping strategy was illegal. The complaint instead focuses on the Company’s
internal controls and accounting processes.
B. The 2010 Audit
In March 2011, AWC (CPA) Limited audited the Company’s financial statements
for the year ending December 31, 2010 (the “2010 Audit”). Although purportedly acting
as an independent, outside auditor, AWC had no clients other than the Company.
During the 2010 Audit, AWC identified “key audit risks” and “a key control
weakness” involving the Company’s treatment of related-party transactions. Compl. Ex. A
¶ 28. AWC determined that when recording transactions with Kandi USA, one of the
Company’s five largest customers, the Company had used a different name for Kandi USA.
When AWC asked the Company whether the counterparty was a related party, the
Company dodged the question, and AWC did not follow up. Kandi USA was a related
party; it was owned by Wangyuan Hu, the son of CEO Hu.
In March 2011, five days before the Company filed its Annual Report on Form 10-
K for the year ending December 31, 2010, CEO Hu suggested that AWC resolve the issue
raised by the Company’s sales to Kandi USA by booking them to a different customer’s
account. Despite evidence that Kandi USA actually purchased the goods, AWC complied.
AWC also eliminated any references to Kandi USA from its audit trail.
During the 2010 Audit, AWC also found that the Company had parked large
amounts of cash in the personal bank accounts of its officers and employees. AWC
discovered that one unidentified employee was holding $3 million of the Company’s
reported year-end cash balance in a personal account. AWC did not take steps determine
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why this was so. Nor did AWC verify that the cash actually existed. AWC also did not
explore whether the parking of this cash constituted a related-party transaction that needed
to be disclosed in the Company’s financial statements. AWC merely reported the
transaction to the Audit Committee as “evidence of a key internal control weakness.”
Compl. Ex. A ¶ 24.
AWC later discovered that the same unidentified individual was holding an
additional $2.5 million of the Company’s reported year-end cash balance in a different
bank account. AWC again did not take steps determine why this was so. AWC also did not
explore whether the parking of this cash constituted a related-party transaction that needed
to be disclosed in the Company’s financial statements. Unlike with the $3 million in parked
cash, AWC did not report this additional $2.5 million to the Audit Committee.
Most strikingly, AWC discovered that CEO Hu held another $1.6 million of the
Company’s reported year-end cash balance in a personal account. AWC did not take steps
determine why this was so. Nor did AWC explore whether this was a related-party
transaction that needed to be disclosed in the Company’s financial statements. As with the
additional $2.5 million of parked cash held by the unidentified employee, AWC did not
report CEO Hu’s holding of cash to the Audit Committee.
C. The 2011 Audit
In March 2012, AWC audited the Company’s financial statements for the year
ending December 31, 2011 (the “2011 Audit”). AWC identified “the collectability of notes
receivable as a key audit risk.” Compl. Ex. A ¶ 38. During the audit, AWC discovered that
a single note constituted $33.1 million of the Company’s $37.9 million notes receivable
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balance. The borrower had not made any interest payments on the note in 2011. Despite
these warning signs, AWC did not evaluate the creditworthiness of the borrower or raise
concerns about the collectability of the note.
D. The 2012 Audit
In March 2013, AWC audited the Company’s financial statements for the year
ending December 31, 2012 (the “2012 Audit”). As with the 2010 Audit, AWC identified
related-party transactions as a key risk. During the audit, AWC discovered transactions
between the Company and Kandi USA. As in 2010, the related-party transactions did not
identify Kandi USA by name. This time, the entries referred to Kandi USA as Eliteway
Management (“Eliteway”), which was later revealed to be a trade name for Kandi USA.
The transactions were material, but AWC did not scrutinize them, nor did AWC identify
them as related-party transactions requiring disclosure.
E. The 2013 10-K
On March 17, 2014, the Company filed its Annual Report on Form 10-K for the
year ending December 31, 2013 (the “2013 10-K”). The Company disclosed that its
“disclosure controls and procedures were not effective as of December 31, 2013, due to a
material weakness.” Compl. ¶ 112.
The 2013 10-K identified multiple factors that contributed to this ostensibly singular
weakness. First, the head of the Company’s internal audit department reported to CEO Hu
rather than to the Audit Committee, which “impaired the independence and objectivity of
the internal control audit department.” Id. Second, there was a lack of communication
between the Company’s internal audit department and the Audit Committee. Third, the
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Company did not evaluate the effectiveness of the Audit Committee on a yearly basis. The
2013 10-K also disclosed that the Company did not have adequate internal controls for
related-party transactions.
The 2013 10-K described the Company’s efforts to remediate its deficiencies. First,
the Company had changed its reporting structure so that the head of the internal audit
department reported to the Audit Committee. Second, the Company committed to revising
its Audit Committee’s charter to ensure that “regular and frequent reporting on the internal
audit related matters to the Audit Committee is carried out by the head of internal audit
department.” Id. ¶ 115. Third, the Company resolved to evaluate the effectiveness of the
Audit Committee on a yearly basis. The Company also pledged that all of its related-party
transactions would be subject to review by the Audit Committee.
F. The Audit Committee’s Actions In 2014
On May 9, 2014, two months after the filing of the 2013 10-K, the Audit Committee
met. The members of the Audit Committee at the time were Henry Yu, Liming Chen, and
Jerry Lewin. Yu had been a member of the Audit Committee since July 2011 and served
as Chair of the committee throughout that time. Chen had been a member of the Audit
Committee since May 2012. Lewin had been a member of the Audit Committee since
November 2010. The Company’s Chief Financial Officer at the time, Xiaoying Zhu, also
attended the meeting. So did two representatives of AWC: Albert Wong and Martin Wong.
The Audit Committee spent forty-five minutes discussing “matters relating to
relationship transaction[s].” Compl. Ex. G, at 1. During the meeting, the committee
members reviewed a document titled “sales contract entered into with Eliteway.” Id. at 2.
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Yu stated that he would deliver agreements related to this “relationship transaction” to the
Audit Committee after the meeting. The Company did not produce any related-party
agreements in response to the plaintiff’s inspection demand. It is reasonable to infer that
the Audit Committee did not receive or review the agreements.
The Audit Committee also purportedly reviewed a document titled “Approval
Procedures of Relationship Transaction.” Id. The Company failed to produce this document
in response to the plaintiff’s inspection demand. It is reasonable to infer that the Audit
Committee did not receive or review this document.
On May 30, 2014, three weeks later, the Audit Committee met again. Lewin, Yu,
and Chen attended as members of the committee. So did Chenming Sun, the head of the
Company’s internal audit department.
This time, the meeting lasted for forty minutes. The Audit Committee purportedly
reviewed and approved a new “Internal Audit Activity Charter” and a new “Management
Policy on Related-Party Transactions.” Compl. ¶ 118; Compl. Ex. H. The Company did
not produce either of these documents in response to the plaintiff’s inspection demand. For
the “Management Policy on Related-party Transactions,” the absence of the document
from the production supports an inference that it did not exist. The same inference could
be drawn for the Audit Committee Charter, but it was publicly available at the time the
complaint was filed.
The Audit Committee Charter specified that the Audit Committee’s responsibilities
included the following:
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• Reviewing the financial reports and other financial related
information released by the Company to the public, or in certain
circumstances, governmental bodies;
• Reviewing the Company’s system of disclosure controls and
procedures, internal controls over financial reporting, and compliance
with ethical standards adopted by the Company;
• Reviewing the Company’s accounting and financial reporting
processes and the audits of the financial statements of the Company;
• Reviewing and appraising with management the performance of the
Company’s independent auditors;
• Providing an open avenue of communication between the independent
auditors, financial and senior management, the internal audit function,
and the board of directors; and
• Overseeing the registered public accounting firm’s (independent
auditor’s) qualifications and independence.
Compl. ¶ 196.
In July 2014, Yu met with management, the Company’s internal audit team, and
AWC to “review the progress of implementation of the remediation measures and
spearhead[] a comprehensive remediation plan to fully address the deficiencies in [the
Company’s] internal controls.” Id. ¶ 118. After continuing its remedial efforts, the
Company determined that its internal controls were effective as of September 30, 2014.
Compare id. ¶ 116 (quoting the Company’s May 2014 disclosure that its “disclosure
controls and procedures were not effective”), and id. ¶ 118 (quoting the Company’s August
2014 disclosure that its “disclosure controls and procedures were not effective”), with id.
¶ 120 (quoting the Company’s November 2014 disclosure that its “disclosures and controls
were effective [as of September 30, 2014]”).
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G. The Audit Committee’s Actions In 2015
After the Audit Committee’s meetings in May 2014, the committee did not meet
again until March 13, 2015. The catalyst for the March 2015 meeting appears to have been
the need to review, discuss, and approve the Company’s Annual Report on Form 10-K for
the year ending December 31, 2014 (the “2014 10-K”). The Audit Committee members
were still Yu, Chen, and Lewin. CFO Zhu also attended the meeting, as did Sun, the head
of the internal controls department. Martin Wong attended for AWC.
The meeting lasted fifty minutes. CFO Zhu summarized the Company’s year-end
financial results, and this discussion appears to have taken up most of the meeting. See
Compl. Ex. I. At the end of the meeting, the Audit Committee approved a “Policy of
Related-party Transaction Relating to JV Shareholder.” Id. at 4. Management had prepared
the policy, which authorized management to “conduct business activities with [the] JV.”
Id. It is reasonable to infer at the pleading stage that the policy did not place meaningful
restrictions on management. It is also reasonable to infer that with the Audit Committee
having not met for almost a year, there was no possible way that the Audit Committee
could have fulfilled all of the responsibilities it was given under the Audit Committee
Charter during a fifty-minute meeting.
On March 15, 2015, the Company filed the 2014 10-K. The Company described its
disclosure controls and procedures as “effective.” Compl. ¶ 124.
Three weeks later, on April 7, 2015, the Company’s board of directors acted by
unanimous written consent to adopt a series of resolutions. One resolution determined that
Yu, Chen, and Lewin, plus then-director Ni Guangzheng, qualified as independent
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directors under the NASDAQ listing standards. Another resolution determined that Yu and
Lewin qualified as Audit Committee Financial Experts. Yet another resolution determined
that it was in the best interests of the Company to maintain AWC as the Company’s
independent auditor for the fiscal year ending December 31, 2015. These were
determinations that should have been made before the filing of the 2014 10-K. The Audit
Committee’s failure to address these issues during its March 2015 meeting reinforces the
inference that there was no possible way that the Audit Committee could have fulfilled all
of the responsibilities it was given under the Audit Committee Charter by meeting for just
fifty minutes after not meeting during the preceding ten months.
Two weeks after the execution of this written consent, CFO Zhu resigned from her
position as CFO, effective April 30, 2015. Cheng Wang took over as the Company’s Chief
Financial Officer.
H. The Audit Committee’s Actions In 2016
The Audit Committee did not meet again until March 7, 2016, approximately one
year later. The catalyst again appears to have been the need to approve the Company’s
Annual Report on Form 10-K for the year ending December 31, 2015 (the “2015 10-K”).
The members of the Audit Committee were still Yu, Chen, and Lewin. CFO Wang also
attended the meeting, as did Sun, the head of the internal audit department. Lai Wingwai
attended as a representative of AWC.
The meeting lasted for thirty minutes. CFO Wang summarized the Company’s year-
end financial results. CFO Wang then described related-party transactions that took place
in 2015. Management identified two related parties: Kandi USA and the Service Company.
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Management represented that the Company had not engaged in any related-party
transactions with Kandi USA during 2015. Management reported that the Company had
engaged in related-party transactions with the Service Company, describing the
transactions as mainly involving “battery sales.” Compl. Exs. C, J, at 2. It is reasonable to
infer that with the Audit Committee having not met for a year, there was no possible way
that the Audit Committee could have fulfilled all of the responsibilities it was given under
the Audit Committee Charter during a thirty-minute meeting.
On March 14, 2016, filed the 2015 10-K. The Company described its disclosure
controls and procedures as “effective.” Compl. ¶ 143.
As it had one year previously, the Audit Committee acted just weeks later to address
issues that should have been addressed before the filing of the 2015 10-K. On March 22,
2016, the Audit Committee acted by unanimous written consent to ratify a very different
description of the related-party transactions between the Company and the Service
Company. In the consent, the Audit Committee signed off on related-party transactions
with the Service Company totaling $42,032,060. Management represented that the
consideration for the transactions was “based on fair market price.” Compl. Ex. K, at 1. In
the same written consent, the Audit Committee authorized management to engage in
related-party transactions with the Service Company during the remainder of 2016. The
Audit Committee’s failure to address these issues during its March 2016 meeting reinforces
the inference that there was no possible way that the Audit Committee could have fulfilled
all of the responsibilities it was given under the Audit Committee Charter by meeting for
just thirty minutes after not meeting for a year.
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I. The Company Replaces AWC.
During a meeting on April 12, 2016, the Company’s board of directors resolved to
terminate AWC as the Company’s auditor, effective immediately. The seven members of
the board at the time were the three members of the Audit Committee—Yu, Chen, and
Lewin—plus CEO Hu, CFO Wang, Guangzheng, and Qian Jiansong. According to the
minutes, the board retained BDO China Shu Lun Pan CPAs as the Company’s new auditor,
effective immediately.
A separate document indicates that the Audit Committee acted by unanimous
written consent that same day to replace AWC with BDO China. The Audit Committee
consent attributed the change to a determination by “management of the Company” that it
was “in the best interest of the Company to change its independent auditors.” Compl. Ex.
B, at 1.
On May 18, 2016, one month after the Company parted ways with AWC, the Public
Company Accounting Oversight Board issued an order instituting disciplinary proceedings
against AWC, making findings about AWC’s conduct, and imposing sanctions on the firm
(the “PCAOB Order”). Compl. Ex. A. The sanctions addressed AWC’s handling of the
2010, 2011, and 2012 Audits and imposed monetary penalties on AWC and its principals.
After the issuance of the PCAOB Order, NASDAQ asked the Company to verify its
cash balances. CFO Wang arranged for an audit of the Company’s cash balances, and BDO
China began the audit on July 11, 2016. Lewin later asked if the audit generated any adverse
findings. BDO China reported none.
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J. The August 2016 Audit Committee Meeting
On August 1, 2016, the Audit Committee convened to review the Company’s
Quarterly Report on Form 10-Q for the quarter ending June 30, 2016. The members of the
Audit Committee continued to be Yu, Chen, and Lewin. CFO Wang also attended, as did
Sun, the head of the internal audit department. Liu Yi and Mou Xun attended as
representatives of BDO China.
The meeting lasted for one hour. CFO Wang summarized the Company’s quarterly
financial results. The Audit Committee discussed the results of BDO China’s audit of the
Company’s cash balances. CFO Wang then reported on the Company’s related-party
transactions for the six months ending June 30, 2016. According to CFO Wang, sales to
the Service Company totaled nearly $4 million, while receivables from the Service
Company totaled nearly $11 million. Management did not identify any other related-party
transactions.
During the meeting, the Audit Committee also discussed a decision by the Chinese
government to delay its subsidy payments to the Joint Venture, which affected the
Company’s outlook for the remainder of the year. Lewin suggested that the Company
should consider alternatives to mitigate its reliance on the subsidies that the Chinese
government was providing to producers and purchasers of electric vehicles.
In September 2016, the Chinese government decided to phase out the subsidies. This
decision followed a months-long investigation into the Company and other Chinese
manufacturers who appeared to have structured their operations to take advantage of
subsidies as both producers and purchasers of vehicles.
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K. The November 2016 Disclosures
On November 2, 2016, the Company disclosed for the first time that it had engaged
in material transactions in 2012 with Kandi USA using its trade name, Eliteway. The
Company also disclosed that it had engaged in material transactions in 2013 and 2014 with
Kandi USA, again using the trade name Eliteway. The total amount of the transactions was
identified as $9,888,751. The Company claimed that all of the transactions had been at
arm’s length.
The Company also disclosed additional related-party transactions with the Service
Company, resulting in additional receivables due from the Service Company. As of
December 31, 2014, the receivables totaled over $40 million. As of December 31, 2016,
the receivables totaled $10.4 million.
The Company’s failure to disclose these transactions earlier reinforces the inference
that the Audit Committee was not carrying out the duties it was given under the Audit
Committee Charter. On November 14, 2016, two weeks after these disclosures, CFO Wang
resigned from the position of Chief Financial Officer and became the Company’s Chief
Strategy Officer. Bing Mei took over as the Company’s Chief Financial Officer.
L. The March 2017 Announcement
On March 16, 2017, the Company announced that its financial statements from 2014
through the third quarter of 2016 could not be relied upon and needed to be restated (the
“March 2017 Announcement”). As part of the restatement, the Company committed to
provide separate audited financial statements for the Company’s equity investment in the
Joint Venture. The restated financials would include:
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• Corrections to the classification of notes receivable and notes payable
in the Company’s statements of cash flow;
• Revisions in the Company’s financial statement presentation to
separately identify certain related-party accounts;
• Amendments to financial statement footnotes discussing the
Company’s tax situation;
• Adjustments of previously recorded “construction-in-progress;”
• Expansions of two tables of sales to and purchases from the Joint
Venture; and
• The removal of “unaudited” labels from certain tables in footnotes
discussing the Company’s tax situation.
Compl. ¶ 163. In addition, the Company announced that it was “reassessing its internal
controls over its financial reporting and compliance programs.” Id.
Shortly after the March 2017 Announcement, the Company filed its Annual Report
on Form 10-K for the year ending December 31, 2016 (the “2016 10-K”). The 2016 10-K
disclosed that the Company lacked:
• Sufficient expertise relating to technical knowledge of US GAAP
requirements and SEC disclosure regulations;
• Sufficient expertise to ensure the completeness of the disclosure of
financial statements for equity investments;
• Sufficient expertise to ensure the proper disclosure of related-party
transactions;
• Effective controls to ensure the proper classification and reporting of
certain cash and non-cash activities related to accounts receivable,
accounts payable, and notes payable; and
• Sufficient expertise to ensure the accuracy of the accounting and
reporting of income taxes and related disclosures.
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M. The Federal Litigation
After the March 2017 Announcement, various stockholders filed four securities
class actions and one derivative lawsuit in the United States District Court for the Southern
District of New York. The federal court consolidated the securities actions.
On September 30, 2019, while this lawsuit was pending, the federal court granted
the defendants’ motion to dismiss the securities actions. In its decision, the court held that
the plaintiffs had not pled facts with sufficient particularity to support a strong inference of
scienter, as required by the federal securities laws and their implementing regulations. See
In re Kandi Techs. Gp., Inc. Sec. Litig., 2019 WL 4918649, at *3–6 (S.D.N.Y. Oct. 4,
2019). In reaching these conclusions, the district court noted that “the fact that [the
Company’s] restatements had no impact on [the Company’s] corporate income severely
undercuts an inference of fraud.” Id. at *8.
N. The Plaintiff’s Investigation
On May 10, 2017, the plaintiff sought to inspect books and records of the Company
pursuant to Section 220. See Compl. Ex. L. After the Company’s board of directors
declined to respond, the plaintiff filed an action in this court. For nearly a year, the plaintiff
and the Company engaged in protracted negotiations. After guidance from this court, the
Company produced documents responsive to the plaintiff’s demand. The parties stipulated
to the dismissal of the Section 220 Action on September 28, 2018.
On February 14, 2019, the plaintiff filed this plenary action. The lengthy complaint
spans 116 pages and contains 306 numbered paragraphs. It names as defendants the
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members of the Audit Committee (Yu, Chen, and Lewin), CEO Hu, and the Company’s
three successive CFOs (Zhu, Wang, and Mei).
In Count I, the complaint asserts that the defendants “individually and collectively,
breached their fiduciary duties by willfully failing to maintain an adequate system of
oversight, disclosure controls and procedures, and internal controls over financial
reporting.” Compl. ¶ 293. The complaint alleges that as a result of the defendants’ breaches
of duty, the Company suffered harm. Id. ¶ 300.
In Count II, the complaint asserts a claim for unjust enrichment. The Complaint
alleges that the defendants “either benefitted financially” from the conduct described in the
Complaint or benefitted indirectly from “unjustly lucrative bonuses tied to the false and
misleading statements, or received bonuses, stock options, or similar compensation from
[the Company] that was tied to the performance or artificially inflated valuation of [the
Company], or received compensation that was unjust in light of Defendants’ bad faith
conduct.” Id. ¶ 304.
II. LEGAL ANALYSIS
The defendants have moved to dismiss the complaint pursuant to Court of Chancery
Rule 23.1 on the grounds that the plaintiff did not make demand on the board and failed to
plead that demand would have been futile. The defendants have also moved to dismiss
pursuant to Court of Chancery Rule 12(b)(6) on the grounds that the complaint failed to
state a claim upon which relief can be granted. Both motions are denied.
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A. Rule 23.1
When a corporation suffers harm, the board of directors is the institutional actor
legally empowered under Delaware law to determine what, if any, remedial action the
corporation should take, including pursuing litigation against the individuals involved. See
8 Del. C. § 141(a). “A cardinal precept of the General Corporation Law of the State of
Delaware is that directors, rather than shareholders, manage the business and affairs of the
corporation.” Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984).1 “Directors of Delaware
corporations derive their managerial decision making power, which encompasses decisions
whether to initiate, or refrain from entering, litigation, from 8 Del. C. § 141(a).” Zapata
Corp. v. Maldonado, 430 A.2d 779, 782 (Del. 1981) (footnote omitted). Section 141(a)
vests statutory authority in the board of directors to determine what action the corporation
will take with its litigation assets, just as with other corporate assets. See id.
1
In Brehm v. Eisner, 746 A.2d 244, 253–54 (Del. 2000), the Delaware Supreme Court
overruled seven precedents, including Aronson, to the extent they reviewed a Rule 23.1 decision
by the Court of Chancery under an abuse of discretion standard or otherwise suggested deferential
appellate review. Id. at 253 n.13 (overruling in part on this issue Scattered Corp. v. Chi. Stock
Exch., 701 A.2d 70, 72–73 (Del. 1997); Grimes v. Donald, 673 A.2d 1207, 1217 n.15 (Del. 1996);
Heineman v. Datapoint Corp., 611 A.2d 950, 952 (Del. 1992); Levine v. Smith, 591 A.2d 194, 207
(Del. 1991); Grobow v. Perot, 539 A.2d 180, 186 (Del. 1988); Pogostin v. Rice, 480 A.2d 619,
624–25 (Del. 1984); and Aronson, 473 A.2d at 814). The Brehm Court held that going forward,
appellate review of a Rule 23.1 determination would be de novo and plenary. Brehm, 746 A.2d at
254. The seven partially overruled precedents otherwise remain good law. This decision does not
rely on any of them for the standard of appellate review. Having described Brehm’s relationship
to these cases, this decision omits the cumbersome subsequent history, because stating that they
were overruled by Brehm creates the misimpression that Brehm rejected a series of foundational
Delaware decisions.
20
In a derivative suit, a stockholder seeks to displace the board’s authority over a
litigation asset and assert the corporation’s claim. Aronson, 473 A.2d at 811. Because
directors are empowered to manage, or direct the management of, the business and affairs
of the corporation, the right of a stockholder to prosecute a derivative suit is limited to
situations where (i) the stockholder has demanded that the directors pursue the corporate
claim and they have wrongfully refused to do so or (ii) demand is excused because the
directors are incapable of making an impartial decision regarding the litigation. Rales v.
Blasband, 634 A.2d 927, 932 (Del. 1993).
The plaintiff in this case chose not to make demand. Consequently, for the plaintiff
to be able to move forward on behalf of the Company, the complaint must “allege with
particularity . . . the reasons . . . for not making the effort [to make a litigation demand],”
Ct. Ch. 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.” Stone v. Ritter, 911 A.2d 362, 367 (Del. 2006).
Stockholders choosing this route “must comply with stringent requirements of factual
particularity that differ substantially from . . . permissive notice pleadings.” Brehm, 746
A.2d at 254. Under the heightened pleading requirements of Rule 23.1, “conclusionary
[sic] allegations of fact or law not supported by the allegations of specific fact may not be
taken as true.” Grobow, 539 A.2d at 187. But once a plaintiff pleads particularized
allegations, then the plaintiff is entitled to all “reasonable inferences [that] logically flow
from particularized facts alleged by the plaintiff.” Beam ex rel. Martha Stewart Living
Omnimedia, Inc. v. Stewart, 845 A.2d 1040, 1048 (Del. 2004). While Rule 23.1 requires
21
that a plaintiff allege specific facts, “he need not plead evidence.” Aronson, 473 A.2d at
816; accord Brehm, 746 A.2d at 254.
At the time the complaint was filed, the Company’s board comprised CEO Hu,
Lewin, Yu, Chen, and non-parties Feng Zhu and Yi Lin (the “Demand Board”). The
operative question for demand futility is whether the Demand Board had a majority of
disinterested and independent directors who could properly consider a demand to bring
litigation. Demand is futile if there is a reasonable basis to doubt whether at least three of
the six directors could exercise independent judgment when deciding whether to bring the
litigation.
1. Demand Futility Analysis
The Delaware Supreme Court has established two tests for determining whether the
allegations of a complaint sufficiently plead demand futility. Wood v. Baum, 953 A.2d 136,
140 (Del. 2008) (“Two tests are available to determine whether demand is futile.”). In
Aronson, the seminal demand-futility decision, the Delaware Supreme Court considered a
scenario where a plaintiff challenged a transaction that had been approved by the same
directors who would consider a demand. The central legal question was therefore whether
the complaint’s allegations about the directors’ involvement in the decision to approve the
challenged transaction rendered them incapable of making an impartial decision regarding
whether to institute litigation concerning the transaction. The high court rejected the
possibility that “any board approval of a challenged transaction automatically connotes
‘hostile interest’ and ‘guilty participation’ by directors, or some other form of sterilizing
influence upon them,” explaining that “[w]ere that so, the demand requirements of our law
22
would be meaningless, leaving the clear mandate of Chancery Rule 23.1 devoid of its
purpose and substance.” Aronson, 473 A.2d at 814.
The Delaware Supreme Court held instead that when considering demand futility in
this scenario, the trial court “must decide whether, under the particularized facts alleged, a
reasonable doubt is created that: (1) the directors are disinterested and independent and (2)
the challenged transaction was otherwise the product of a valid exercise of business
judgment.” Id. The first of the two inquiries examines “the independence and
disinterestedness of the directors” with respect to the transaction being challenged. Id.
“Certainly, if this is an ‘interested’ director transaction, such that the business judgment
rule is inapplicable to the board majority approving the transaction, then the inquiry
ceases.” Id. at 815. Under those circumstances, the defendant directors face sufficient risk
from a lawsuit challenging the transaction they approved for demand to be futile. By
contrast, if a disinterested and independent board majority had approved the underlying
transaction, then the business judgment rule presumptively would apply, protecting the
directors and their decision.
The Aronson inquiry did not stop there, because the Delaware Supreme Court
anticipated that there could be situations where a disinterested and independent majority
made the decision, and yet the business judgment rule did not apply. See id. at 812–13. The
Delaware Supreme Court therefore instructed the trial court to conduct a second inquiry by
examining whether the plaintiff “ha[d] alleged facts with particularity which, taken as true,
support a reasonable doubt that the challenged transaction was the product of a valid
exercise of business judgment.” Id. at 815. If the business judgment rule protected the
23
underlying transaction, then demand would not be futile, and the Rule 23.1 motion would
be granted. Id. at 812. If a reasonable doubt existed that business judgment rule protected
the underlying transaction, then the directors could face a sufficient threat of liability from
the litigation that demand would be futile. As the Delaware Supreme Court explained, “the
mere threat of personal liability for approving a questioned transaction, standing alone, is
insufficient to challenge either the independence or disinterestedness of directors, although
in rare cases a transaction may be so egregious on its face that board approval cannot meet
the test of business judgment, and a substantial likelihood of director liability therefore
exists.” Id. at 815.
Because the Aronson test addressed a situation where the same board that would
consider a demand had made the decision being challenged in the derivative suit, it did not
translate easily to other situations, such as cases where the board had not acted or where
the board’s membership had changed. In Rales, the Delaware Supreme Court confronted a
board whose members had not participated in the underlying decision challenged by the
derivative action, and therefore “the test enunciated in [Aronson] . . . [was] not
implicated.” 634 A.2d at 930. In response, the Delaware Supreme Court framed a second
and more comprehensive demand futility standard that asked “whether or not the
particularized factual allegations of a derivative stockholder complaint create a reasonable
doubt that, as of the time the complaint is filed, the board of directors could have properly
exercised its independent and disinterested business judgment in responding to a
demand.” Id. at 934.
24
The Rales court explained that the decision to respond to a litigation demand
involves a two-step process. “First, the directors must determine the best method to inform
themselves of the facts relating to the alleged wrongdoing . . . .” Id. at 935. “If a factual
investigation is required, it must be conducted reasonably and in good faith.” Id. (footnote
omitted). “Second, the board must weigh the alternatives available to it, including the
advisability of implementing internal corrective action and commencing legal
proceedings.” Id. “In carrying out these tasks, the board must be able to act free of personal
financial interest and improper extraneous influences.” Id.
Under Rales, a director cannot exercise independent and disinterested business
judgment regarding a litigation demand, free of personal financial interest and improper
extraneous influences, if the director is either interested in the alleged wrongdoing or not
independent of someone who is. In order to create a reasonable doubt that a director is
disinterested, a derivative plaintiff must plead particularized facts to demonstrate that a
director “will receive a personal financial benefit from a transaction that is not equally
shared by the stockholders” or, conversely, that “a corporate decision will have a materially
detrimental impact on a director, but not on the corporation and the stockholders.” Id. at
936 (citations omitted). In this latter situation, “a director cannot be expected to exercise
his or her independent business judgment without being influenced by the adverse personal
consequences resulting from the decision.” Id. In order to create a reasonable doubt that a
director is independent, “a plaintiff can plead facts showing a director is sufficiently loyal
to, beholden to, or otherwise influenced by an interested party to undermine the director’s
25
ability to judge the matter on its merits.” Frederick Hsu Living Tr. v. ODN Hldg. Corp.,
2017 WL 1437308, at *26 (Del. Ch. Apr. 14, 2017).
A decision to implement internal corrective action or institute litigation could have
a materially detrimental impact on a director. As under Aronson, “the mere threat of
personal liability . . . , standing alone, is insufficient.” Rales, 634 A.2d at 936 (quoting
Aronson, 473 A.2d at 815). A disqualifying interest exists when “the potential for liability
is not ‘a mere threat’ but instead may rise to a ‘substantial likelihood.’” Id. (citing Aronson,
473 A.2d at 815). To plead that a director faces a substantial risk of liability, a plaintiff
does not have to demonstrate a reasonable probability of success on the claim. In Rales,
the Delaware Supreme Court rejected such a requirement as “unduly onerous.” Id. at 935.
The plaintiffs need only “make a threshold showing, through the allegation of
particularized facts, that their claims have some merit.” Id. at 934 (citing Aronson, 473
A.2d at 811–12). This standard recognizes that the purpose of the particularity requirement
is not to prevent derivative actions from going forward, but rather “to ensure only
derivative actions supported by a reasonable factual basis proceed.” In re Dow Chem. Co.
Deriv. Litig., 2010 WL 66769, at *6 (Del. Ch. Jan. 11, 2010).
The Delaware Supreme Court envisioned that the Rales test would be used
in three principal scenarios: (1) where a business decision was made by the
board of a company, but a majority of the directors making the decision have
been replaced; (2) where the subject of the derivative suit is not a business
decision of the board; and (3) where . . . the decision being challenged was
made by the board of a different corporation.
Rales, 634 A.2d at 934 (footnotes omitted). Conceptually, however, the Rales test
supersedes and encompasses the Aronson test, making the Aronson test a special
26
application of Rales.2 The Aronson and Rales tests both ultimately focus on the same
inquiry, i.e., whether “the derivative plaintiff has shown some reason to doubt that the
board will exercise its discretion impartially and in good faith.” In re INFOUSA, Inc.
S’holders Litig., 953 A.2d 963, 986 (Del. Ch. 2007). The Rales test asks the question
generally. As part of that general inquiry, it considers whether a director could be interested
in the outcome of a demand because the director would face a substantial risk of liability
if litigation were pursued. The Aronson test examines one specific type of litigation that
could trigger the latter concern: whether the directors face a substantial threat of liability
from litigation challenging a transaction that they themselves approved.
2
See Buckley Family Tr. v. McCleary, 2020 WL 1522549, at *9 (Del. Ch. Mar. 31, 2020)
(“This court has commented on many occasions that the Aronson and Rales tests look different but
they essentially cover the same ground.”); Park Empls.’ & Ret. Bd. Empls.’ Annuity & Benefit
Fund of Chicago v. Smith, 2017 WL 1382597, at *5 (Del. Ch. Apr. 18, 2017) (“The analyses in
both Rales and Aronson drive at the same point; they seek to assess whether the individual directors
of the board are capable of exercising their business judgment on behalf of the corporation.”); In
re Wal-Mart Stores, Inc. Del. Deriv. Litig., 2016 WL 2908344, at *11 (Del. Ch. May 13, 2016)
(“[T]he Rales test encompasses all relevant aspects of the Aronson test.”); Teamsters Union 25
Health Servs. & Ins. Plan v. Baiera, 119 A.3d 44, 57 n.131 (Del. Ch. 2015) (“[O]ur jurisprudence
would benefit . . . from the adoption of a singular test to address the question of demand futility.”);
David B. Shaev Profit Sharing Account v. Armstrong, 2006 WL 391931, at *4 (Del. Ch. Feb. 13,
2006) (“[T]he Rales test, in reality, folds the two-pronged Aronson test into one broader
examination”), aff’d, 911 A.2d 802 (Del. 2006) (TABLE); Guttman v. Huang, 823 A.2d 492, 501
(Del. Ch. 2003) (“At first blush, the Rales test looks somewhat different from Aronson, in that [it]
involves a singular inquiry . . . . Upon closer examination, however, that singular inquiry makes
germane all of the concerns relevant to both the first and second prongs of Aronson.”); Donald J.
Wolfe, Jr. & Michael A. Pittenger, Corporate and Commercial Practice in the Delaware Court of
Chancery § 11.03(c)(4)(ii), at 11-113 (2019) (“From this perspective, one might argue that the
current state of this area of the law is conceptually inverted; i.e., that it would be both simpler and
more direct to regard the original Aronson analysis as a subpart of the more generally applicable
and consistently relevant test set forth in Rales. Indeed, recent decisional law seems to be trending
incrementally toward a recognition of and preference for the more efficient utility of the Rales
analysis.”).
27
This case illustrates how Rales and Aronson overlap. The fundamental question
presented by the defendants’ Rule 23.1 motion is whether the Demand Board could have
validly considered a litigation demand. See Ct. Ch. R. 23.1. The complaint challenges the
Company’s handling of its financial statements over multiple years, during which time four
members of the Demand Board served on the Company’s board. Three of them were
members of the Audit Committee who made a series of decisions during this time period,
including decisions to approve the Company’s financial statements for purposes of its
Form 10-Ks, determinations regarding the adequacy of the Company’s internal controls,
determinations regarding director independence and financial expertise, and decisions
regarding related-party transactions. Technically, because less than “a majority of the
directors making the decision have been replaced,” Rales, 634 A.2d at 934, Aronson would
govern.
The complaint is not framed, however, as an Aronson-style lawsuit that challenges
a specific transaction or a particular decision. The complaint instead alleges that there were
persistent problems with the Company’s system of financial oversight over a prolonged
period, leading ultimately to the Company suffering harm. The core theory is a duty of
oversight claim. See In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996).
A Caremark claim is conceptualized as flowing from an overarching failure by the
28
directors to take the action necessary to protect the corporation, so the more generalized
Rales standard is routinely applied.3
This decision applies Rales to evaluate demand futility for purposes of the
Caremark claim. When doing so, this decision gives weight to the fact that Lewin, Yu,
Chen, and CEO Hu were key corporate decision-makers during the multi-year timeline that
ultimately led to the oversight problems at the Company.
2. Count I
Count I asserts that the defendants “breached their fiduciary duties by willfully
failing to maintain an adequate system of oversight, disclosure controls and procedures,
and internal controls over financial reporting.” Compl. ¶ 293. “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
3
See, e.g., City of Birmingham Ret. & Relief Sys. v. Good, 177 A.3d 47, 55 (Del. 2017)
(“For alleged violations of the board’s oversight duties under Caremark, the test articulated in
Rales v. Blasband applies to assess demand futility.”); Wood, 953 A.2d at 140 (“The [Rales] test
applies where the subject of a derivative suit is not a business decision of the Board but rather a
violation of the Board’s oversight duties.”); In re LendingClub Corp. Deriv. Litig., 2019 WL
5678578, at *7 (applying the Rales test for demand futility to director oversight claims); Horman
v. Abney, 2017 WL 242571, at *6 (Del. Ch. Jan. 19, 2017) (same); Reiter ex rel. Capital One Fin.
Corp. v. Fairbank, 2016 WL 6081823, at 6* (Del. Ch. Oct. 18, 2016) (same); Melbourne Mun.
Firefighter’s Pension Tr. Fund v. Jacobs, 2016 WL 4076369, at *6 (Del. Ch. Aug. 1, 2016) (same);
South v. Baker, 62 A.3d 1, 14 (Del. Ch. 2012) (same); In re Goldman Sachs Gp., Inc. S’holder
Litig., 2011 WL 4826104, at *7 (Del. Ch. Oct. 12, 2011) (same); In re Dow Chem. Co. Deriv.
Litig., 2010 WL 66769, at *12 (Del. Ch. Jan. 11, 2010) (same); Desimone v. Barrows, 924 A.2d
908, 927–28 (Del. Ch. 2007) (same).
29
law and its business performance.’” In re China Agritech, Inc. S’holder Deriv. Litig., 2013
WL 2181514, at *18 (Del. Ch. May 21, 2013) (quoting Caremark, 698 A.2d at 970).
“Failing to make that good faith effort breaches the duty of loyalty and can expose a
director to liability.” Marchand v. Barnhill, 212 A.3d 805, 820 (Del. 2019).
Directors face a substantial threat of liability under Caremark if “(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.” Stone, 911 A.2d at 370. For both potential sources, “a showing of bad faith
conduct . . . is essential to establish director oversight liability.” Id. A plaintiff establishes
bad faith by “showing that the directors knew that they were not discharging their fiduciary
obligations.” Id. “Generally 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.” Caremark, 698 A.2d at 971
(emphasis added).
For purposes of Caremark’s first path, “a director may be held liable if she acts in
bad faith in the sense that she made no good faith effort to ensure that the company had in
place any ‘system of controls.’” Marchand, 212 A.3d at 822. “[D]irectors have great
discretion to design context- and industry-specific approaches tailored to their companies’
businesses and resources. But Caremark does have a bottom-line requirement that is
important: the board must make a good faith effort—i.e., try—to put in place a reasonable
30
board-level system of monitoring and reporting.” Id. If a corporation suffers losses caused
by the directors’ failure “to attempt in good faith to assure that a corporate information and
reporting system, which the board concludes is adequate, exists,” then the directors can be
held liable. Caremark, 698 A.2d at 970.
A plaintiff can state a Caremark claim by alleging that “the company had an audit
committee that met only sporadically and devoted patently inadequate time to its work, or
that the audit committee had clear notice of serious accounting irregularities and simply
chose to ignore them or, even worse, to encourage their continuation.” Guttman, 823 A.2d
at 507. The mere existence of an audit committee and the hiring of an auditor does not
provide universal protection against a Caremark claim. Compare Ash v. McCall, 2000 WL
1370341, at *15 n.57 (Del. Ch. Sept. 15, 2000) (concluding that audit committee and
independent auditor were “some evidence” that the requisite systems existed), with Rich
ex rel. Fuqi Int’l, Inc. v. Yu Kwai Chong, 66 A.3d 963, 983 (Del. Ch. 2013) (concluding
that despite existence of audit committee and independent auditor, the company “had no
meaningful controls in place”).
The complaint alleges facts that support an 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. As detailed in the
Factual Background, the Company suffered from pervasive problems with its internal
controls, which the Company acknowledged in March 2014 and pledged to correct. Yet
after making that commitment, the Audit Committee continued to meet only when
31
prompted by the requirements of the federal securities laws. When it did meet, its meetings
were short and regularly overlooked important issues.
For example, in May 2014, the Audit Committee convened for the first time after
disclosing two months earlier that its “disclosure controls and procedures were not
effective as of December 31, 2013, due to a material weakness.” Compl. ¶ 112. The
meeting lasted just forty-five minutes. During that time, the Audit Committee purportedly
reviewed new agreements governing the Company’s related-party transactions with Kandi
USA. Neither the agreements nor the review procedures were produced in response to the
plaintiff’s demand for books and records, supporting a reasonable inference that they either
did not exist or did not impose meaningful restrictions on the Company’s insiders. Three
weeks later, the Audit Committee purportedly reviewed and approved a new policy that
management had prepared governing related-party transactions. The Company also did not
produce this policy in response to the plaintiff’s demand for books and records, supporting
a reasonable inference that it too either did not exist or did not impose meaningful
restrictions on the Company’s insiders.
The Audit Committee did not meet again for almost an entire year. The committee
next convened in March 13, 2015, spurred by the need to review the Company’s financial
results for purposes of the 2014 10-K. The meeting lasted only fifty minutes. During this
time, the Audit Committee ostensibly discussed the financial results and purportedly
approved a new policy that management had prepared to govern related-party transactions
involving the Joint Venture. It is reasonable to infer that the policy did not place meaningful
restrictions on management and that the Audit Committee failed to establish its own
32
monitoring system for related-party transactions. It is also reasonable to infer that during
this fifty-minute meeting, the Audit Committee could not have fulfilled its responsibilities
under the Audit Committee Charter for purposes of nearly a year’s worth of transactions.
Once again, the Audit Committee did not meet for almost an entire year. The
committee next convened on March 7, 2016, again spurred by the need to review the
Company’s financial results for purposes of the 2015 10-K. During a meeting that lasted
just thirty minutes, the Audit Committee discussed the financial results and reviewed the
related-party transactions that management had identified, which ostensibly consisted of
minimal transactions with Services Company involving battery sales. Just two weeks later,
and one week after the Company had filed its 2015 10-K, the Audit Committee acted by
written consent on March 22 to ratify a very different description of the related-party
transactions between the Company and the Service Company, this time totaling over $42
million. In the same written consent, the Audit Committee authorized management to
engage in related-party transactions with the Service Company during the remainder of
2016. It is reasonable to infer that during this thirty-minute meeting, the Audit Committee
could not have fulfilled its responsibilities under the Audit Committee Charter for purposes
of a year’s worth of transactions. It is also reasonable to infer from the contrast between
the Audit Committee meeting and the action by written consent that the Audit Committee
was not adequately overseeing the Company’s related-party transactions and did not have
its own system in place for monitoring this critical aspect of the Company’s finances.
Just one month later, on April 12, 2016, the Audit Committee relied on
management’s determination that it was necessary to replace AWC. Whether the Audit
33
Committee should have acted earlier to replace AWC remains an open question,
particularly given the red flags that AWC had no other clients and the problems with
AWC’s prior audits. For present purposes, it is reasonable to infer that the Audit Committee
deferred to management on the question of replacing the Company’s outside auditor and
did not engage in independent oversight of this important role.
These chronic deficiencies support a reasonable inference that the Company’s board
of directors, acting through its Audit Committee, failed to provide meaningful oversight
over the Company’s financial statements and system of financial controls. Despite
identifying Yu and Lewin as Audit Committee Financial Experts in 2015, the Company
later disclosed in the 2016 10-K that it lacked personnel with sufficient expertise on US
GAAP and SEC disclosure requirements for equity investments and related-party
transactions. The directors charged with implementing a system to oversee the Company’s
financial reporting thus lacked the expertise necessary to do so all along. Instead, the Audit
Committee deferred to management, which dictated the policies and procedures for
reviewing related-party transactions and hired and fired the Company’s auditor, even
though management’s actions suggested that it was either incapable of accurately reporting
on related-party transactions or actively evading board-level oversight.
In response, the defendants argue that the Company had the trappings of oversight,
including an Audit Committee, a Chief Financial Officer, an internal audit department, a
code of ethics, and an independent auditor. They rely on this court’s holding in General
Motors that a plaintiff cannot meet its Caremark burden by pleading that board-level
monitoring systems existed but that they should have been more effective. See In re Gen.
34
Motors Co. Deriv. Litig., 2015 WL 3958724 (Del. Ch. June 26, 2015). The facts of this
case are distinguishable from those of General Motors.
In General Motors, the plaintiffs brought Caremark claims against the company’s
directors after the company recalled 28 million vehicles due to faulty ignition switches. Id.
at *2. The General Motors plaintiffs faced a Caremark catch-22 because their pre-suit
investigation demonstrated that the board was exercising “some oversight.” Id. at *15. For
example, the board regularly reviewed the company’s risk management structure,
identified the top risks facing the company’s business, and received presentations on
product safety and quality. Id. The plaintiffs therefore had to argue that the board “failed
to implement a reporting system which would have apprised them specifically of serious
injuries and deaths resulting from safety defects.” Id. at *11. They alternatively argued that
the General Motors board failed to monitor any reporting systems that did exist. Id. This
court held that the plaintiffs could not plead that the directors faced a substantial likelihood
of Caremark liability by arguing that the board “should have[] had a better reporting
system.” Id. at *15.
The allegations in this case depict a board that was far less active than the directors
in General Motors. The complaint in this case depicts directors who acted similarly to their
counterparts in Marchand, who failed “to make a good faith effort—i.e., try—to put in
place a reasonable board-level system of monitoring and reporting.” Marchand, 212 A.3d
at 821. The allegations in this case support inferences that the board members did not make
a good faith effort to do their jobs. The Audit Committee only met when spurred by the
requirements of the federal securities laws. Their abbreviated meetings suggest that they
35
devoted patently inadequate time to their work. Their pattern of behavior indicates that
they followed management blindly, even after management had demonstrated an inability
to report accurately about related-party transactions.
An Audit Committee may of course rely in good faith upon reports by management
and other experts. See 8 Del. C. § 141(e). In doing its job, the members of an Audit
Committee will necessarily rely on management. But Caremark envisions some degree of
board-level monitoring system, not blind deference to and complete dependence on
management. The board is obligated to establish information and reporting systems that
“allow management and the board, each within its own scope, to reach informed judgments
concerning both the corporation’s compliance with law and its business performance.”
Caremark, 698 A.2d at 959 (emphasis added)).
The complaint’s allegations support a pleading-stage inference that the board never
established its own reasonable system of monitoring and reporting, choosing instead to rely
entirely on management. The Company could have produced documents in response to the
plaintiff’s Section 220 demand that would have rebutted this inference. The absence of
those documents is telling because “[i]t 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.” In re Tyson Foods, Inc., 919 A.2d 563, 578 (Del. Ch.
2007). The documents that the Company produced indicate that the Audit Committee never
met for longer than one hour and typically only once per year. Each time they 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
36
occasions, they missed important issues that they then had to address through action by
written consent. The plaintiff is entitled to the inference that the board was not fulfilling its
oversight duties.
The defendants additionally argue that even if the directors failed to fulfill their
oversight duties, they should not be subject to liability because the Company did not suffer
harm as a result. The defendants observe that the March 2017 restatement had no effect on
the Company’s net income, and they point out that this argument carried significant weight
in the federal securities action, where it undercut the inference of fraud. In re Kandi Techs.
Gp., Inc. Sec. Litig., 2019 WL 4918649, at *8.
For purposes of this litigation, the defendants’ observation is misplaced. “Delaware
law dictates that the scope of recovery for a breach of the duty of loyalty is not to be
determined narrowly.” Thorpe ex rel. Castleman v. CERBCO, Inc., 676 A.2d 436, 445
(Del. 1996). In the absence of quantifiable damages to net income, defendants are “still
liable for damages incidental to their breach of duty.” Id. The plaintiff claims that the
Company suffered incidental damages that include “costs and expenses incurred with the
restatements, significant reputational harm in the markets, the defense of several lawsuits
filed against the Company for violations of federal securities law, and the defense of an
action commenced by Plaintiff pursuant to 8 Del. C. § 220.” Compl. ¶ 12. At the pleading
stage, this allegation is sufficient to support a claim for relief.
Given the persistent and prolonged problems at the Company, CEO Hu, Lewin, Yu,
and Chen 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
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the Company’s financial reporting. The defendants who face a substantial likelihood of
liability constitute a majority of the Demand Board. Accordingly, the Demand Board lacks
a disinterested and independent majority that could have considered a demand, rendering
demand futile. As to Count I, the motion to dismiss is denied.
3. Count II
Count II asserts a claim for unjust enrichment. The plaintiff alleges that the officer
defendants (CEO Hu and CFOs Zhu, Wang, and Mei) received excessive compensation
because the Company’s inaccurate financial statements overstated its performance. The
complaint also cited the compensation received by the directors, but at oral argument, the
plaintiff’s counsel clarified that Count II does not seek to recover damages from the
Company’s non-officer directors for the compensation they received as directors. Count II
only seeks damages based on the excessive compensation paid to CEO Hu and CFOs Zhu,
Wang, and Mei, but it seeks to hold all of the defendants jointly and severally liable for the
resulting damages.
One approach would be to use Aronson to analyze whether demand on Count II is
futile. Four of the six members of the Demand Board approved the officer defendants’
compensation, so technically Aronson could apply. Indeed, Aronson would logically apply
if the plaintiff was arguing that the members of the board breached their fiduciary duties
when approving the officers’ compensation.
The plaintiff, however, is making a different argument. The plaintiff contends that
the oversight claim articulated in Count I had a secondary consequence of inflating the
Company’s financial results, leading to unjust enrichment for the officer defendants who
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were compensated based on the misstated results. The unjust enrichment claim in Count II
is thus properly conceived as a form of additional damages dependent on the plaintiff
proving the oversight claim asserted in Count I.
The demand futility analysis for purposes of Count II thus necessarily treads the
same path as the demand futility analysis for Count I. To evaluate a demand to assert the
claim posited in Count II, the Demand Board would have to investigate and then assert
litigation based on the breaches of the duty of oversight that are the subject of Count I. This
decision has already held that four of the six members of the Demand Board—CEO Hu,
Lewin, Yu, and Chen—are interested for purposes of a litigation demand involving the
conduct underlying Count I because they face a substantial threat of liability for the
oversight claims asserted in Count I. The unjust enrichment claim asserted in Count II
would implicate the same conduct. For the same reason, demand is futile.
B. Rule 12(b)(6)
When considering a motion to dismiss under Rule 12(b)(6), a court applying
Delaware law (i) accepts as true all well-pleaded factual allegations in the complaint, (ii)
credits vague allegations if they give the opposing party notice of the claim, and (iii) draws
all reasonable inferences in favor of the plaintiffs. Central Mortg. Co. v. Morgan Stanley
Mortg. Capital Hldgs. LLC, 27 A.3d 531, 535 (Del. 2011). Dismissal is inappropriate
“unless the plaintiff would not be entitled to recover under any reasonably conceivable set
of circumstances.” Id.
Although the defendants purportedly moved separately pursuant to Rule 12(b)(6),
they did not offer any independent arguments for dismissal under that rule. For purposes
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of Count I, the analysis under Rule 23.1 is dispositive. “The standard for pleading demand
futility under Rule 23.1 is more stringent than the standard under Rule 12(b)(6), and a
complaint that survives a motion to dismiss pursuant to Rule 23.1 will also survive a
12(b)(6) motion to dismiss, assuming that it otherwise contains sufficient facts to state a
cognizable claim.’” In re Citigroup Inc. S’holder Deriv. Litig., 964 A.2d 106, 139 (Del.
Ch. 2009); see also China Agritech, 2013 WL 2181514, at *24 (“A complaint that pleads
a substantial threat of liability for purposes of Rule 23.1 ‘will also survive a 12(b)(6) motion
to dismiss.’” (quoting McPadden v. Sidhu, 964 A.2d 1262, 1270 (Del. Ch. 2008))).
This decision concluded that demand was futile for purposes of Count II because of
its interrelationship with Count I. It would not be duplicative, therefore, to analyze the
unjust enrichment claim that appears in Count II on the merits. The defendants, however,
did not engage in any discussion of the unjust enrichment claim, nor did the plaintiff. This
decision will not discuss the claim either, except to reiterate that as framed by the plaintiff
at oral argument, it depends on the plaintiff proving the Caremark claim alleged in Count
I, at which point the plaintiff maintains that the officer defendants would have received
excessive compensation that would be subject to a claim for unjust enrichment.
III. CONCLUSION
The defendants’ motions to dismiss under Rules 23.1 and 12(b)(6) are denied. The
parties will confer regarding a schedule for moving forward with the action and file a status
report within thirty days.
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