Yet another Caremark claim has survived a motion to dismiss. One is reminded of the aphorism that once is a happenstance, two is a coincidence, and three is enemy action.
The case is Hughes v. Hu. VC Travis Laster summarized the company's deficiencies:
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 opinion has an extended analysis of how Rales v. Blasband and Aronson v. Lewis apply to Caremark claims.
As to the merits, Laster reported that:
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. ...
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 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.
For blog commentary see Lynn Jokela, Steve Quinlivan, and Oderah Nwaeze. The latter helpfully focuses on the role the company's poor responses to plaintiffs Section 220 request:
- In Hughes, the Court of Chancery drew some negative inferences about the conduct of the Company’s board because the Company failed to produce exculpating information in response to the plaintiff’s demand under Section 220 of the Delaware General Corporation Law. Those negative inferences then were used to justify denying the defendants’ motion to dismiss.
- Given this reality, companies should be strategic about what information they withhold in response to a Section 220 demand. Recognizing that most companies are reluctant to produce sensitive business information that could be used to support meritless claims, entities faced with a Section 220 demand must make sure to produce documents, communications, and other materials that may stop the Court of Chancery from crediting a plaintiff’s allegations against the company’s board and/or officers.
