Securities Regulation Daily Demand excused given audit committee actions
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Wednesday, April 29, 2020

Demand excused given audit committee actions

By Amy Leisinger, J.D.

Demand on a company’s board would have been futile considering directors’ failure to address accounting concerns.

The Delaware Chancery Court has declined to dismiss a complaint against an electric vehicle company, finding that the plaintiff adequately pleaded demand futility. According to the court, the company’s "chronic deficiencies" in accounting supported a reasonable inference its board of directors, through its audit committee, failed to provide meaningful oversight over the company’s financial statements and financial controls. The audit committee deferred to management in decisions concerning review of related-party transactions and the hiring and firing of auditors, and the complaint’s allegations support an inference that the board did not establish a proper system of monitoring and reporting and was not fulfilling its oversight duties, the court found (Hughes v. Hu, April 27, 2020, Laster, J.).

Accounting problems. Kandi Technologies Group entered into a joint venture with Geely Automobile Holdings to sells parts for electronic vehicles in a joint venture. Through its ownership in the joint venture, the company benefited from Chinese subsidies provided to producers. As issues with the company’s internal controls and accounting processes came to light, shareholders started filing securities class actions, which were ultimately dismissed for failure to plead scienter with sufficient particularity.

However, a shareholder also filed a derivative lawsuit against the company’s directors alleging a lack of oversight by the board of directors’ audit committee and a lack of internal controls for related-party transactions. The plaintiff contended that the director and audit-committee failures to review reports and agreements, disclosure-control systems, internal controls over financial reporting, and compliance with ethical standards led to a financial restatement. These actions harmed the company, and, because performance was inflated, officers received excessive compensation and were unjustly enriched, the plaintiff alleged.

The defendants moved to dismiss for failure to make a demand on the board or plead that demand would have been futile.

Demand futile. The court noted that the company "conspicuously failed" to produce certain documents, which supports an inference of a bad-faith failure of oversight by the director defendants. Under Rales, a director cannot exercise independent business judgment regarding a litigation demand if the director is either interested or not independent of someone who is, and a derivative plaintiff must plead particularized facts to demonstrate a benefit.

However, the court stated, "[t]his case illustrates how Rales and Aronson overlap." The plaintiff challenged the independence of the members of the audit committee who approved the company’s financial statements, the adequacy of internal controls, and related-party transactions. Technically, Aronson would govern given the replacement of directors, the court explained, but the complaint alleged persistent problems over a prolonged period, and "[t]he core theory is a duty of oversight claim." Four of the directors (a majority of the board) would have been subjected to potential liability, rendering them incapable of disinterested consideration of a demand, the court stated.

The court also noted that a plaintiff can state a Caremark claim by alleging that an audit committee met only sporadically or had clear notice of serious accounting irregularities. The plaintiffs alleged facts to support an inference of these facts and "consciously turned a blind eye," according to the court.

The court concluded that it is reasonable to infer that the audit committee could not have fulfilled its responsibilities in its sporadic and short meetings, deferred to management on whether to replace the company’s outside auditor, and failed to engage in independent, meaningful oversight. As such, the court refused to dismiss the action based on the lack of shareholder demand.

The case is C.A. No. 2019-0112-JTL.

Attorneys: Michael Van Gorder (Faruqi & Faruqi, LLP) for William Hughes, Jr. Stamatios Stamoulis (Stamoulis & Weinblatt, LLC) for Xiaoming Hu.

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