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Caremark Claims Remain Difficult to Plead Successfully

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September 18, 2013
Morris James LLP
Delaware Business Court Insider

As frequently recognized by the Court of Chancery and as reflected in the Court of Chancery's recent decision in In re China Automotive Systems Derivative Litigation, Consol. C.A. No. 7145-VCN (Del. Ch.), a Caremark claim is one of the most difficult corporate law claims to plead. A Caremark claim is a claim that directors caused or permitted a corporation to break the law or failed to establish or oversee a monitoring system for a corporation's compliance with the law.

In China Automotive, the plaintiffs were stockholders of China Automotive Systems Inc. The plaintiffs brought derivative claims for breaches of fiduciary duty, insider trading and unjust enrichment against defendants Hanlin Chen, Qizhou Wu, Bruce Carlton Richardson, Robert Tung and Guangxun Xu. Chen was a majority stockholder of the company's common stock and served as chairman of the board. Wu was the CEO and served as a director. Richardson, Tung and Xu were directors and members of the audit, compensation and nominating committees.

The plaintiffs alleged that the defendants breached their fiduciary duties by failing to maintain adequate accounting controls and by utilizing improper accounting and audit practices that led to the company issuing false and misleading financial statements. Most of the accounting issues related to how the company accounted for convertible notes it issued in February 2008. An embedded conversion feature in the convertible notes required certain accounting treatment that the company failed to do correctly. According to the plaintiffs, the company's auditor, Schwartz Levitsky Feldman (SLF), was responsible for the incorrect accounting treatment, was not qualified to audit a Chinese company trading in the United States and was not subject to sufficient oversight by the board of directors. As a result of the incorrect accounting treatment of the convertible notes, the company announced in March 2011 that it would need to restate its financial statements for fiscal year 2009 and unaudited financial statements for the first three quarters of 2010. The adjustments reduced the company's net income for 2009 by $43 million and increased its net income for 2010 by $19 million. The plaintiffs alleged that Chen and Wu sold stock when the stock price was allegedly inflated by the incorrect accounting treatment of the convertible notes. In addition to alleging that the defendants breached their fiduciary duties by inadequately overseeing the company's accounting practices, the plaintiffs also alleged that Chen and Wu engaged in insider trading and that all of the defendants were unjustly enriched by receiving compensation while in breach of their fiduciary duties.

Because the plaintiffs filed a derivative action, they had to satisfy Court of Chancery Rule 23.1 by alleging that they had made a demand on the board of directors or by alleging demand would be futile. The plaintiffs, like almost all derivative plaintiffs, alleged demand was futile under Court of Chancery Rule 23.1. Accordingly, the court analyzed whether the plaintiffs sufficiently pleaded demand futility. In deciding whether the plaintiffs had pleaded demand futility, the court first had to determine whether or not the plaintiffs were challenging a decision of the board of directors in order to apply the correct test for demand futility. The court concluded that the plaintiffs were not challenging a decision of the board of directors, but were instead challenging the board's oversight of certain corporate activities. Therefore, the court applied the Rales v. Blasband, 634 A.2d 927 (Del. 1993), test for demand futility. Under Rales, demand is futile if particularized factual allegations create a reasonable doubt, at the time of the filing of the complaint, that the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.

As the court recognized, the plaintiffs had to allege facts creating a reasonable doubt that a majority of the board (three of five directors) could not have acted impartially in considering a demand. A director cannot act impartially if he or she is interested, not independent or faces a substantial threat of personal liability. The court focused on whether the plaintiffs had created such a reasonable doubt with respect to Richardson, Tung or Xu because they were not alleged to be insiders of the company or to have engaged in insider trading (unlike Chen and Wu). One possible way to plead demand futility for a Caremark claim is to allege particularized facts showing a majority of directors had knowledge of "red flags," such as multiple reports of potential accounting problems. Another way would be to allege that the company lacked an audit committee or the audit committee met rarely. The court noted it is insufficient, however, to allege merely that a director was a member of an audit committee or had caused the filing of misleading financial statements with the SEC. According to the court, the plaintiffs failed to make particularized allegations that Richardson, Tung or Xu knew the financial statements were wrong, had personal involvement in the preparation of the statements or personally reviewed SLF's auditing of the financial statements. Thus, the plaintiffs did not allege facts suggesting Richardson, Tung or Xu faced a substantial threat of personal liability. The plaintiffs also did not plead facts showing Richardson, Tung or Xu were interested or not independent of Chen or Wu. The court concluded, therefore, that the plaintiffs failed to show demand was excused for their accounting oversight claim.

With respect to the plaintiffs' insider trading claims against Chen and Wu, the court also decided that the plaintiffs had not demonstrated demand was futile. There were no particularized allegations that Richardson, Tung and Xu had engaged in insider trading themselves, gained a material benefit from insider trading or were indebted to Chen or Wu. Using the same analysis for the prior claims, the court held the plaintiffs had not shown demand was futile for their unjust enrichment claims.

China Automotive illustrates the difficulty of overcoming a motion to dismiss a Caremark claim. As discussed above, membership on the audit committee of a company that admits filing incorrect financial statements is not enough by itself to establish demand futility. Stockholder plaintiffs must find more information and allege more specific facts to show directors faced a substantial threat of personal liability for a company's accounting  improprieties.

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