Are the allegations in Hughes v. Hu an example of the SEC/PCAOB’s recent cautionary Statement on emerging market risks come to life? (See this PubCo post.) The case involves a Caremark claim against the audit committee and various executives of Kandi Technologies, a publicly traded Delaware company listed on the Nasdaq Global Select Market and based in an emerging market country. The complaint alleged that they 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.” You might recall that, in Marchand v. Barnhill (June 18, 2019), then-Chief Justice Strine, writing for the Delaware Supreme Court, started out his analysis with the recognition that “Caremark claims are difficult to plead and ultimately to prove out,” and constitute “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” (See this PubCo post.) Although Caremark presented a high hurdle, the complaint in Marchand was able to clear that bar and survive a motion to dismiss. In the view of the Delaware Chancery Court, Hughes proved to be comparable—the Court denied two motions to dismiss, holding that the allegations in the complaint were sufficient to support “a reasonable pleading-stage inference of a bad faith failure of oversight by the named director defendants.” Is clearing the Caremark bar becoming a thing?
Kandi, which is based in China and went public through a reverse merger, sells parts to a joint venture, which uses the parts to manufacture electric vehicles. As described by the Court, the company had long been plagued by serious issues with its financial reporting, disclosure controls and internal control over financial reporting, particularly with respect to related-party transactions. After reporting material weaknesses in its ICFR in 2014, the company failed, over a three-year period, to remediate them, culminating in a financial restatement in 2017. The plaintiff then sued the audit committee members and several executives derivatively, alleging a Caremark failure of oversight as well as unjust enrichment of the executives as a result of compensation based on inflated financial performance.
The complaint, which was presumed for purposes of the motions to be true, identified financial oversight issues and material weaknesses dating back to 2010 including:
- the company’s “independent” auditors, whose only client was the company, failing to identify related-party transactions and locating company cash held in personal executive accounts, but not reporting it to audit committee;
- internal audit reporting to the CEO, not to the audit committee;
- very infrequent (typically once a year), but nevertheless very brief (not more than an hour), meetings of the audit committee, leading to the presumption by the Court that “there was no possible way that the Audit Committee could have fulfilled all of the responsibilities it was given” in that timeframe;
- actions of the committee by written consent covering matters that should have been covered during previous meetings;
- belated disclosures of numerous material related-party transactions; and
- disciplinary proceedings instituted by the PCAOB related to three audit years against the company’s audit firm a month following the company’s termination of the firm, a decision approved by the audit committee relying on management’s determination.
Notably, the defendants failed to produce a number of policies, procedures and other documents referred to in the company’s minutes—which would have most likely helped their case—leading the Court to infer that the documents did not exist.
Finally, in 2017, the company disclosed that it was restating several years of its financial statements, and, with the filing of its Form 10-K, disclosed that the company did not have:
- “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.”
Following disclosure of the restatement, four securities class actions, later consolidated, were filed in the SDNY, but the action was dismissed on the basis of failure to plead facts with sufficient particularity to support a strong inference of scienter, particularly given that the restatement did not affect income, thus undercutting an inference of fraud.
The plaintiff then filed this action, alleging breach of “fiduciary duty by willfully failing to maintain an adequate system of oversight, disclosure controls and procedures, and internal controls over financial reporting” and unjust enrichment, either directly or tied to compensation. The defendants moved to dismiss on the basis of failure to make a demand on the board (or to plead demand futility) as well as failure to state a claim on which relief could be granted. According to the Court, demand would be considered futile if there was “a reasonable basis to doubt whether at least three of the six directors could exercise independent judgment when deciding whether to bring the litigation.” In that regard, an interest could be disqualifying if there were a “substantial likelihood” of liability, which required only “a threshold showing, through the allegation of particularized facts, that [plaintiffs’] claims have some merit.”
According to the Court, 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.’’ Looking back over the company’s history, the Court concluded that the audit committee’s “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.” Although two members of the audit committee were identified as “audit committee financial experts,” the company had, in effect, disclosed in 2017 that the “directors charged with implementing a system to oversee the Company’s financial reporting…lacked the expertise necessary to do so all along.” Instead, the Court concluded, the committee simply deferred to management.
Defendants argued that the company had an audit committee, an internal audit department, a code of ethics, and an independent auditor, but the Court viewed these attributes as merely “the trappings of oversight.” Instead, the Court compared these directors 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.’…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 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.”
The Court concluded that the complaint did indeed allege “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.” Given the “persistent and prolonged problems at the Company,” the Court concluded that demand would have been futile because the audit committee, which constituted a majority of the board, faced 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.” The motion to dismiss for failure to state a claim was denied on the same basis.
Although the allegations in the complaint may seem flagrant, it’s worthwhile remembering that they did not suffice to show scienter for purposes of the earlier motion to dismiss in federal court in the securities litigation. They did suffice, however, for purposes of this Caremark case. In any event, the case should serve as a reminder—especially in this era of COVID-19—of the importance of establishing “a reasonable board-level system of monitoring and reporting” regarding risks affecting the company. Not to mention the importance of good record-keeping.