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China Agritech, Inc. Shareholder Derivative Litigation, C.A. No.
7163-VCL (Del. Ch. May 21, 2013) [an enhanced version of this opinion is available to lexis.com
Whether a complaint that fails to plead that demand was made on the Board and
fails to plead demand futility should be dismissed under Rules 23.1 or
No. Motions to dismiss denied.
This is a very interesting and instructive opinion for
practitioners, in part, because it provides guidance on the use of a Section
220 books and records action as a precursor to filing a derivative action on Caremark
claims. As with many Court of Chancery decisions, the "devil is in the
details" so care should be taken in the review of the facts. While the
Court specifically mentions on more than one occasion the important role that
the plaintiff's Section 220 demand for books and records played in the Court's
analysis, it is not for the typical reasons. Indeed, the Court's analysis
turns not on information that was produced in response to the Section 220 demand
and later the Section 220 Action, but rather what was not produced.
At the very outset of the opinion, the Court mentions the "glaring absence" of
information that the Company should have had in its possession and produced to
the plaintiff as well as the "inferences reasonably drawn from the absence of
records produced in response to the Section 220 demand." Practitioners
should make note of this and take care in addressing the scope of discovery in
a Section 220 case.
This decision also marks the latest in a series of cases
involving Delaware corporations formed to do business in Asia and especially
China. This is important for several reasons. As the recent
decisions in Puda Coal, Inc. Stockholders Litigation, C.A. No. 6476-CS
(Del. Ch., Feb. 6, 2013) highlighted here,
and Rich v. Chong, C. A. No. 7616-VCG (Del. Ch., April 25, 2013)
highlighted here, board
oversight issues have become a significant problem. In addition, there
are problems associated with entity formation and independent directors.
Vice Chancellor Laster noted with disfavor at the outset of this opinion that
China Agritech, Inc. ("China Agritech" or the "Company") "accessed the domestic
securities markets in February 2005 through a reverse merger with an inactive
corporation that had retained its NASDAQ listing." The Court noted:
[U]sing a defunct Delaware corporation that happens to
retain a public listing to evade the regulatory regime established by the
federal securities laws is contrary to Delaware public policy . . . Delaware
has no interest in facilitating reverse mergers with defunct but still publicly
registered shell corporations as a means to circumvent the regulatory
protections provided by the federal securities laws.
With respect to the issue of Chinese companies and
independent directors, problems arise when family members assume roles in the
corporation that require independence. As the Court noted in this case, a
director lacks independence when she is unable to base her decision on the
corporate merits of the issue before the board and close family relationships,
like the parent-child relationship, create a reasonable doubt as to the
independence of a director.
The plaintiff, Albert Rish, filed a derivative action to
recover damages resulting from (i) China Agritech's purchase of stock from a
corporation owned by defendants Chang and Teng, (ii) the suspected misuse of
$23 million raised by the Company; (iii) mismanagement that allegedly occurred
that resulted in the terminations of two outside auditing firms and the
resignations of six outside directors and two senior officers, (iv) the
Company's failure to make any federal securities filings; and (v) the eventual
delisting by NASDAQ. The defendants moved to dismiss pursuant to: (i)
Rule 23. 1, for failure to plead that demand was made on the board or would
have been futile; and (ii) Rule 12(b)(6), for failure to state a claim.
Alternatively, the defendants moved to stay the litigation in favor of three
other actions - two in California and one in Federal Court in Delaware.
The Court denied all of the motions.
Internal Controls and the Yinglong
China Agritech is a Delaware corporation that
manufactures fertilizer products in China. Defendant Chang founded China
Agritech and served as the company's President, Chief Executive Officer,
Secretary, and Chairman of the Board. Chang was also the controlling
shareholder. Defendant Teng co-founded China Agritech and served as a
director. Starting in early 2008, the Company disclosed that it did not
have in place the financial controls and procedures required to comply with
U.S. financial reporting standards. Attempts to correct the problem
included hiring a new CFO and controller, and expanding the number of members
of the board of directors by adding Gene Michael Bennett, Lun Zhang Dai, and
Hai Ling Zhang as directors. While it is unclear if the Company might
have rectified the problems temporarily, it is clear that the problems were not
In February 2009, Yinlong Industrial Co., Ltd. sold
its 10% equity interest in China Agritech's otherwise 90% owned subsidiary,
Pacific Dragon Fertilizers Co. Ltd. to China Agritech for $8 million.
Chang and Teng owned 85% and 15%, respectively, of Yinlong's shares.
In April 2010, China Agritech announced a $23 million public offering to
finance the construction of distribution centers for China Agritech's
Outside Auditors and the McGee Report
In its Form 10-Q dated August 16, 2010, China Agritech
again disclosed that it was having problems with its financial controls and
procedures. On November 13, 2010, three days after announcing that the control
problems were fixed, the Company fired its outside auditor, Crow Horvath LLP
and hired Ernst & Young ("E&Y"). The Audit Committee that
approved the termination of Crow Horvath consisted of Lun Zhang Dai, Michael
Bennett and Hai Ling Zhang. Six days later, Lingziao Dai, the daughter of
Lun Zhang Dai, a member of the Audit Committee, was named head of China Agritech's
internal audit department.
On December 15, 2010, E&Y informed the Audit
Committee of certain matters which, if not appropriately addressed, "could
result in audit adjustments, significant deficiencies or material weaknesses,
and delays in the filing of the Company's Form 10-K for 2010." There was
a dispute as to whether the Company's management subsequently addressed
those issues. At the same time that E&Y was raising issues with
Company management, a private investigator, Lucas McGee, was investigating China
Agritech. McGee prepared a report that identified a series of alleged
problems with the Company's business, including, among other things, (i) idle
factories that were supposed to be operating; (ii) the inability to find the
distribution centers the Company claimed to have or to be able to buy the
product that the Company said it sold; (iii) fictional revenue; and (iv)
fictitious suppliers. McGee concluded that "China Agritech is not a
currently functioning business that is manufacturing products. Instead it is,
in our view, simply a vehicle for transferring shareholder wealth from outside
investors into the pockets of the founders and inside management."
Special Investigation Committee and a
"Parade" of Director Resignations
The day after McGee issued his report, the Company posted
a press release on its website denying the allegations. On March 8, 2011,
E&Y met with the Audit Committee to discuss problems it had
identified. It was at this time that E&Y expressed concern about
relying on management's representations. Two days later, on March 10,
2011, the Board formed a Special Investigation Committee to investigate the
problems identified by E&Y. On March 12, 2011, Company management
drafted a press release stating that the Special Committee had been formed and
explaining that the action was taken due to allegations made by third parties
with respect to the Company and certain issues identified in connection with
the performance of the Company's year-end audit. However, when the actual
press release was issued, it omitted the phrase "identified in connection with
the performance of the Company's year-end audit." E&Y objected and
immediately advised the Company that the deletion was a material omission and
E&Y would resign if a corrective press release was not issued. No
correction was made and two days later, the Company fired E&Y without any
prior notice regarding its potential termination. Later that same day,
March 14, 2011, the Company issued a press release that questioned E&Y
independence because it had done some prior work for the Company regarding SOX
(which was exactly the opposite of what the Company told E&Y when it hired
them in November 2010). On December 1, 2011, the Company announced that
the Special Committee had completed its investigation and without providing any
details, concluded that, in essence, no problems or issued existed.
On January 6, 2012, Rish filed suit and not long
thereafter, there was a "parade" of five directors resigning from the
Board. As a result of the resignations, the only remaining directors were
cofounders Chang, Teng and Dai (whose daughter headed up the Company's internal
Section 220 Demand and a Dearth of
On June 10, 2011, Rish sent a demand to the Company for
books and records. While the Company initially refused to produce any
documents, after Rish filed a books and records action on July 15, 2011, the
Company began to produce what eventually totaled only 227 pages of documents,
approximately half of which were in Chinese. Interestingly, China
Agritech did not produce any Audit Committee meeting minutes or any other
document reflecting any discussion or review of the Yinlong Transaction by the
Audit Committee, the Governance Committee, or the full board. The Company
did produce signature pages for a written consent dated May 15, 2009 (the day
the Yinlong Transaction closed) but it did not produce the pages of the
resolution preceding the signature pages. The Company also produced a
copy of an agreement among Tailong, Pacific Dragon, and Yinlong in which
Yinlong agreed to transfer its 10% stake in Pacific Dragon for $50,000, which
is significantly lower than the amount that China Agritech disclosed in its
public filings when describing the Yinlong Transaction. Regarding the
termination of E&Y, the Company produced only three documents: (i) the
March 14, 2011 resolution of the Audit Committee, (ii) the March 14, 2011
resolution of the Board, and (iii) the letter E&Y sent to the Company on
March 15, 2011, to fulfill its obligations under Section 10A(b)(2) of the
Securities Exchange Act of 1934. Interestingly, none of those documents
suggested any concern about E&Y's independence before the Company decided
to terminate E&Y.
Rish asked for books and records relating to the principal
allegations made in the McGee Report (i.e., construction of distribution
centers, contracts with principal customers, and necessary operating permits)
by the Company in its responsive press releases. The dearth of
information that the Company produced regarding these significant claims
prompted the Court to note:
It would be reasonable to expect that a legitimate entity
with bona fide operations would be able to provide ample documents
demonstrating that fact. The problem for a legitimate entity would be the
potential burden of having too many responsive documents, not the difficulty of
digging up a few.
Rish also asked for books and records relating to the
Audit Committee's oversight of the Company's financial statements, financial
reporting process, and system of internal controls. In response, China
Agritech did not produce any Audit Committee meeting minutes for 2009 or 2010.
Motion to Dismiss and Rules 23.1 and 12(b)(6)
Demand Futility - Aronson and Rales
Rish acknowledged that he failed to make a demand on the
Board when the litigation was filed. The composition of the Board at that
time was Chang, Teng, Dai, Sim, Bennett, H. Zhang and X. Zhang (the "Demand
Board"). Rish also conceded that the Company opposed his efforts to
pursue litigation. Therefore, under Stone v. Ritter, the Court
For Rish to obtain authority to move forward on behalf of
China Agritech, his Complaint must allege with particularity . . . the reasons
. . . for not making the effort [to make a litigation demand], Ch. Ct. 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.
In analyzing the issue under Aronson and Rales
as to whether the Board could have validly considered a litigation demand, the
The Complaint challenges at least three events that
involved actual decisions: the Yinlong Transaction, the terminations of the
outside auditors, and the Special Committee's determination to take no action.
Five of the seven members of the Demand Board were directors at the time those
decisions were made. Because less than a majority of the directors making
the decision have been replaced, Aronson provides the demand futility
standard for the five participating directors. Rales would provide the
standard for the two remaining directors, but because the Aronson
analysis establishes demand futility, I do not reach the Rales aspect.
The outcome would be no different if Rales were used for all seven
directors, because the Rales test asks whether a director would face a
substantial risk of liability as a result of the litigation.
The litigation also alleges a systematic lack of
oversight at China Agritech. That challenge does not involve an actual board
decision, so Rales governs. The allegations of the Complaint, which rely
on both books and records the Company produced in response to the Section 220
Demand and on the absence of books and records in critical areas, support a
reasonable inference that the members of the Demand Board face a substantial
risk of liability for oversight violations. Under Rales, it would have
been futile for Rish to make a litigation demand with respect to the
defendants' failures of oversight.
The Yinlong Transaction
With respect to the Yinlong Transaction, the Court
concluded that it was futile under Aronson for Rish to make a litigation
demand. Two members of the Demand Board members, Chang and Teng, stood on both
sides of the transaction, in which China Agritech purchased shares from an
entity they owed. Three directors were members of the Audit Committee
when it approved the Yinlong Transaction. In addition, the Court found that
"[b]ecause a document produced in response to the Section 220 Demand supports a
reasonable inference that the actual value of the interest was approximately
$50,000, the litigation risk that the Audit Committee members would face in an
entire fairness challenge to the Yinlong Transaction raises a reasonable doubt
about their ability to disinterestedly consider a litigation demand."
Thus, because five of the seven members of the Demand Board could not properly
consider a litigation demand addressing the Yinlong Transaction, the Court
found that demand was futile under Aronson and that it did not need consider
the remaining two directors under Rales.
Caremark Claims and a Bad Faith Finding
With respect to the claims for fraud and the board's
oversight failure, the Court applied the Rales test to evaluate demand
futility. Under Caremark, a board has a fiduciary obligation to
adopt internal controls 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 law and its
business performance." Here the Court found that the allegations of the
Complaint support a reasonable inference that "China Agritech had a formally
constituted audit committee [that] failed to meet" and in response to the
Section 220 Demand, China Agritech failed to produce any Audit Committee
meeting minutes for 2009 or 2010. This was the time period during which
the Company "engaged in the Yinlong Transaction, conducted the Offering,
disclosed a material weakness in its disclosure controls and procedures,
claimed to have fixed the problem, terminated Crowe Horwath as its outside
auditor, hired Ernst & Young as its new outside auditor, and named Dai's
daughter as head of China Agritech's internal audit department."
The Court also noted that its conclusions were
supported by the discrepancies in the Company's public filings with
governmental agencies which reinforced the inference of an Audit Committee that
did not function. The Court stated:
Although the Delaware state courts have not yet
confronted the implications of dramatic divergences between U.S. and Chinese
regulatory filings, the federal district courts have considered whether alleged
divergences can support a claim of securities fraud under the Private
Securities Litigation Reform Act and Federal Rule of Civil Procedure 9(b). When
the financial statements differ significantly, courts have generally credited
an inference of fraud. When the differences have been less marked, courts
have granted motions to dismiss complaints that did not adequately explain why
the discrepancy was material and would support an inference of fraud. A
federal court previously found that the drastically different figures China
Agritech filed with the SEC and SAIC supported an inference of scienter.
See Dean v. China Agritech, 2011 U.S. Dist. LEXIS 124264 (C.D.
Cal. Oct. 27, 2011) [enhanced version].
Based upon that analysis, the Court made a significant
finding decision that would later present a serious hurdle for the Board
members when the Court concluded that "the factual allegations of the Complaint
support a reasonable inference that the members of the Audit Committee acted in
bad faith in the sense that they consciously disregarded their duties."
Based upon their service on the Audit Committee during the
applicable time period, Dai, Bennett, and H. Zhang faced a substantial risk of
liability for knowingly disregarding their duty of oversight. Thus, these
directors could not validly consider a litigation demand concerning the
problems that occurred while they were members of the Audit Committee.
Thus, Dai was in a unique situation in that his daughter, Lingxiao Dai, served
as Vice President of Finance from May 1, 2009 until November 19, 2010, and as
head of the internal audit department thereafter. Further, Dai could not
consider a demand that would place Chang or Teng at risk because his daughter
served at the pleasure of the Company's controlling stockholders.
Citing Rich v. Chong, the Court noted that Bennett
and H. Zhang's resignations further call into question their ability to
consider a demand. Bennett was the Chair of the Audit Committee and Special
Committee. Bennett resigned from both committees shortly after the firing
of the two outside auditors and Wang's resignation. He later resigned
from the board. The Court concluded that "Bennett's resignation supports
a reasonable inference that he could not meaningfully supervise Chang, which in
turn contributes to an inference that he could not properly consider a
litigation demand." H. Zhang also was a member of the Audit Committee and
Special Committee but he continued to serve on both committees during the time
when the Special Committee was conducting its investigation of the events
surrounding the firing of the outside auditors. Shortly after the Special
Committee completed its work and announced that it would take no action as a
result of its investigation, H. Zhang resigned. The Court concluded that
"H. Zhang's resignation supports a reasonable inference that he had washed his
hands of the Company and its problems, which in turn contributes to the
inference that he could not properly consider a litigation demand."
Finally, the Court found that Chang could not validly
consider a demand because he would face a substantial risk of liability in that
[p]ointed the finger directly at Chang and his
management team by advising the Audit Committee that it did not believe it
could rely on management's statements. [E&Y] also contended that it was
senior management that made a materially misleading disclosure regarding
[E&Y]'s termination. Chang's potential culpability and the potential [adverse]
consequences [to the Company] combine to raise reasonable doubt as to whether
he can disinterestedly consider a demand.
Chang, Dai, Bennett, and H. Zhang comprise a
majority of the Demand Board. The Court found that demand was futile
under Rales for purposes of the Caremark claim, the termination
of the outside auditors and what the Court referred to as a "sham" Special
Litigation Committee, rendering it unnecessary to consider the other three
directors. As a result, the motion to dismiss under Rule 23.1 was denied.
The defendants also argued that the Complaint
failed to state a claim on which relief can be granted. The pleading standards
for purposes of a Rule 12(b)(6) motion are minimal. The operative test in
a Delaware state court thus is one of reasonable conceivability. This
standard asks whether there is a "possibility of recovery." The standard
for pleading demand futility under Rule 23.1 is more stringent than the
standard under Rule 12(b)(6) . . . ." Thus, if a complaint pleads a
substantial threat of liability for purposes of Rule 23.1, it will also survive
a 12(b)(6) motion to dismiss. The Court concluded that "[b]ecause Chang,
Teng, Dai, Bennett, and H. Zhang face a substantial threat of liability on the
plaintiffs' claims for purposes of Rule 23. 1", the Court found that the
Complaint stated a claim against these directors for purposes of Rule 12(b)(6).
Section 102(b)(7) Exculpatory Language and Bad
The defendants also moved to dismiss the Complaint in
light of the exculpatory provision in China Agritech's certificate of
incorporation. The Complaint challenged the Yinlong Transaction, which was an
interested transaction with a controlling stockholder and entire fairness
becomes the standard of review. When that standard applies, "the
inherently interested nature of those transactions renders the claims
inextricably intertwined with issues of loyalty." Because Chang and Teng
benefitted directly from the transaction, and Dai, Bennett, and H. Zhang
approved it, the Court concluded that it could not dismiss these defendants.
With respect to whether the directors acted in good
faith, the Court stated that "[a] Section 102(b)(7) provision can exculpate
directors from monetary liability for a breach of the duty of care, but not for
conduct that is not in good faith or a breach of the duty of loyalty. The
standard for Caremark liability parallels the standard for imposing
liability when directors failed to act in good faith." The Court then
gave a "hat tip" to Professor Stephen M. Bainbridge and his article, The
Convergence of Good Faith and Oversight, 55 UCLA L. Rev. 559 (2008).
Read more Delaware business
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