Delaware Business Litigation Report

Chancery Compares Aronson and Rales Tests for Demand Futility; Finds Well-Pled Caremark Claim Showing No Good Faith Effort to Oversee Financial Reporting and Related-Party Transactions Made Demand Futile

Hughes v. Hu, C.A. No. 2019-0112-JTL (Del. Ch. Apr. 27, 2020).

Everyone from bar applicants to seasoned litigators and counsel advising boards of directors can find something of interest in Hughes v. Hu, which (i) provides a comprehensive review of how the Court of Chancery evaluates demand futility in derivative actions and (ii) discusses the type of allegations that will support a well-pled Caremark claim for failure to take affirmative steps to ensure an effective board-level monitoring reporting system is in place.

According to Plaintiff, for several years Defendants exercised no meaningful oversight over the company’s financial reporting and auditing. This alleged lack of oversight lead to, inter alia, failures to understand and disclose related-party transactions, company funds being held in directors’ personal accounts, and inaccurate financial and tax reporting. Although the company promised to correct these deficiencies in 2014, the problems persisted virtually unabated for three more years. For example, the company continued using problematic auditors, who while purportedly “independent” had no other clients, and the board’s audit committee typically met for less than one hour just once per year. Plaintiff asserted that demand would have been futile because four of the Defendants comprised a majority of the six-member board that would have considered the demand. And some of those same members had also been on the audit committee.

Before turning to the specifics of the case, the Court provided a thorough exposition of the observation that the Court and legal commentators have made for years: the two tests used to evaluate demand futility “ultimately focus on the same inquiry.” The Court began with a casebook-worthy history of the two tests, Aronson and Rales. The earlier Aronson framework applies when the directors who committed the alleged wrong are the same directors who would consider a plaintiff’s litigation demand. Under Aronson, a plaintiff must plead facts which create a reasonable doubt that the directors are disinterested and independent and that the board’s action was a valid exercise of business judgment. The broader Rales framework applies to all situations not addressed by Aronson, such as when the board failed to act or when the board’s membership changed. Rales requires a plaintiff to plead that a majority of directors are “either interested in the alleged wrongdoing or not independent of someone who is.”

As the Court explains it, “[c]onceptually ... the Aronson test is a special application of Rales” even though Rales came later. Rales asks generally “whether a director could be interested in the outcome of a demand because the director would face a substantial risk of liability if litigation were pursued” whereas Aronson examines a specific subset when the threat of liability comes from a transaction that the same directors approved.

Using this discussion as a springboard, the Court observed that the case illustrated the overlap between Rales and Aronson. Technically, Aronson would apply because a majority of directors considering the demand were same directors who allegedly failed to provide financial oversight. But because Plaintiff challenged an alleged failure of oversight -- i.e., a Caremark claim -- rather than a specific board act, the Court determined that the broader Rales standard would typically apply.

The Court concluded that, because the well-pled facts showed a majority of the board faced a substantial risk of liability under Caremark and its progeny, Plaintiff pleaded sufficient facts to establish demand futility. First, the Court concluded that the chronic deficiencies in financial oversight supported a pleadings-stage inference that the board (acting through its audit committee) failed to provide financial oversight or to install a system of financial controls. Defendants attempted to rely upon the fact that the company did have some financial controls – e.g., an audit committee. But Plaintiff had made a pre-suit inspection demand under 8 Del. C. § 220, and obtained books and records showing the board’s activities in this area over the pertinent time period, as well as a certification affirming that the production was complete with respect to its subject matter. The Court criticized the board and audit committee’s general lack of activity despite known problems with financial controls and obtaining transparency into related-party transactions. The Court concluded that the audit committee likely did not fulfill its obligations under its charter. Because of such deficiencies, four of the six board members faced a substantial likelihood of liability for breaching their duty of loyalty, and thus, the board lacked an independent, disinterested majority to consider a demand. The Court denied Defendants’ motion.

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