Hot on the heels of its decision instructing directors of global organizations on how to meet their duties regarding their international operations, the respected Delaware Chancery Court has now addressed the potential personal liability of directors of U.S.-based global firms, even after they have resigned.
Before the court was a request to dismiss or stay a derivative suit against the directors of a Delaware corporation with foreign operations. Two of the non-executive directors on the firm’s Audit Committee had resigned in protest over the company’s failure to fund their investigation into alleged wrongdoing. But they were still defendants in the lawsuit.
International Alert: Duties of Directors of Foreign Corporations: the View From Delaware (April 2013) As watchers of Delaware corporate governance matters would suspect, the Delaware court did not look kindly on those who abandon their posts in times of crisis. In fact this decision may signal that the personal wealth of independent directors can be at risk in shareholder lawsuits—even after they resign.
Before the Court
The motion to dismiss was brought by defendant Fuqi International, Inc., a Delaware company whose sole asset was stock in a Chinese jewelry company.
In March of 2010—just seven and a half months after a public offering—the company announced that its fourth-quarter 10-Q and 10-K would be delayed because it had discovered “certain errors related to the accounting of the Company’s inventory and cost of sales.” The identified errors were expected to have a material impact on the company’s 2009 quarterly financial statements—“at least one of the identified deficiencies constituted a material weakness”—requiring them to restate their 2009 financial statements. Following this, additional problems were disclosed, including the transfer of $130 million of company assets to third parties in China.
The firm was subsequently de-listed from NASDAQ.
Approximately 6 months later, the firm announced that the SEC had initiated a formal investigation into the organization, related to its failure to file timely periodic reports, among other matters. Then the disclosure of the asset transfer was made.
In the U.S., this means, “expect litigation.”
In July 2010, a shareholder made a demand to the board of directors to remedy breaches of fiduciary duty and weaknesses in internal controls. The company’s audit committee began an investigation, which was later abandoned due to management’s failure to pay the fees of the audit committee’s outside legal counsel, forensic specialists, and auditor. The company’s independent directors—i.e., those who had hired the auditors—then resigned.
Corporate Structure: No Shelter from Liability
The Delaware corporation’s primary operations are through a wholly-owned subsidiary, a British Virgin Islands corporation and its wholly owned subsidiary, a company established under the laws of China.
In 2006, the company was created in a reverse-merger transaction involving the British Virgin Islands entity and a corporation formed as part of the Chapter 11 reorganization of an internet company (visitalk.com).
The resulting company then reincorporated in Delaware. The firm subsequently completed that 2009 public offering, where the proceeds were roughly $120 million.
Shortly after missing its financial filings, stockholders filed several securities and derivative lawsuits against the defendants in federal and state courts.
The derivative suits allege that the directors and certain officers of the company breached their fiduciary duties by failing to adequately supervise and control the firm, resulting in its filing of false financial statements.
Importantly, for the legal action we are discussing, a derivative demand was also made to the board to begin an action against certain directors and executive officers (the Demand Letter). The Demand Letter asked the board of directors to “take action to remedy breaches of fiduciary duties by the directors and certain executive officers of the Company” and to “correct the deficiencies in the Company’s internal controls that allowed the misconduct to occur.”
The company never responded to the Demand Letter in writing. A derivative suit was brought in Delaware and a motion filed by the defendants to have it dismissed.
Rules of Play in Delaware Derivative Actions
In Delaware, a board of directors is entitled to a reasonable period of time to respond to a derivative demand. Until the board responds, the shareholder making the demand, generally, may not move forward with a derivative action (litigation).
Once the shareholder makes a derivative demand, the board has an affirmative duty to evaluate the demand and to determine whether the actions demanded are in the best interest of the shareholders.
Failure to Comply
If the board fails to comply with the plaintiff’s demand, in order to move forward, the plaintiff must set out with particularity why the board is wrong in failing to address the derivative demand (per Rule 23.1).
Failure to Respond
There have been relatively few Delaware cases in which a stockholder attempts to move forward with a derivative suit before a board formally responds to the shareholder’s derivative demand. (In this instance, there had been no response to the demand letter other than this motion to dismiss it, over a two-year period.)
Where the board does not respond to a derivative demand, the plaintiff may proceed if he or she can raise a reasonable doubt that the board’s lack of a response is consistent with its fiduciary duties.
The Business Judgment Rule Provides No Protection
Where a plaintiff raises a reasonable doubt that the directors are acting in good faith or with due care, the directors’ actions taken in response to a demand are not entitled to the business judgment rule.
The business judgment rule…provides no protection in cases of bad-faith conduct, such as “where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.”
Similarly, the business judgment rule does not apply if directors fail to inform themselves of all material information reasonably available to them and fail to act with requisite care.
Lesson: Implement Controls
It is easy to be sympathetic to the non-executive or independent directors in this case, as it is hard to see what they could do to ameliorate matters once the company failed to pay the fees of the advisers they were using in their investigation.
But as the court held, “[w]hen faced with knowledge that the company controls are inadequate, the directors must act, i.e., they must prevent further wrongdoing from occurring.” And the court found a number of red flags of wrongdoing at the Delaware company, before the problems came to light.
That [the wrongdoer] was able to transfer $130 million out of the company’s coffers, without the directors knowing about it for over a year, strains credulity. Either the directors knew about the cash transfers and were complicit, or they had zero controls in place and did not know about them. If the directors had even the barest framework of appropriate controls in place, they would have prevented the cash transfers.
In the eyes of the court in this case, the lack of controls was a critical flaw.
The defendants moved to dismiss the complaint for two reasons:
- First, under Rule 23.1, because the board had not yet rejected the plaintiff’s demand. This was dismissed because the court found that the plaintiff pled particularized facts that raise a reasonable doubt that the directors acted in good faith in response to the derivative demand.
- The second argument made by the defendants was under Rule 12(b)(6) for failure to state a claim upon which relief can be granted. Here, the court held that the plaintiff has pled facts that, assumed true, led the court to infer that the directors knew that the internal controls were deficient, yet failed to act.