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Caremark Claim Against Audit Committee Survives Dismissal

By | April 28, 2020

Kandi Technologies Group, Inc. is a publicly traded Delaware corporation based in China. The Company struggled persistently with its financial reporting and internal controls, encountering particular difficulties with related-party transactions. The complaint filed in Hughes v. Hu 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 also disclosed it lacked sufficient expertise related to GAAP, SEC disclosure requirements, effective controls and other matters.

The plaintiff commenced litigation on the Company’s behalf to recover damages from, among others, the three directors who comprised the Audit Committee during the Company’s period of persistent problems.  The plaintiff brought a Caremark claim and contended that the director defendants consciously failed to establish a board-level system of oversight for the Company’s financial statements and related-party transactions, choosing instead to rely blindly on management while devoting patently inadequate time to the necessary tasks. The plaintiff also contended that the director defendants’ failures led to the March 2017 restatement, which caused the Company harm.

The defendants moved to dismiss the complaint pursuant to Rule 23.1, contending that the plaintiff failed to make a demand on the board or plead that demand would have been futile.  The Court noted 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.

The Court found 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 instance, documents that the Company produced indicated that the Audit Committee never met for longer than one hour and typically only once per year. Each time they purported to cover multiple agenda items that included a review of the Company’s financial performance in addition to reviewing its related-party transactions. On at least two occasions, they missed important issues that they then had to address through action by written consent. According to the Court, the plaintiff was entitled to the inference that the board was not fulfilling its oversight duties.

Given the persistent and prolonged problems at the Company, the Court found the defendants faced a substantial likelihood of liability under Caremark for breaching their duty of loyalty by failing to act in good faith to maintain a board-level system for monitoring the Company’s financial reporting. The Court also found defendants who face a substantial likelihood of liability constituted a majority of the relevant board members. Accordingly, the Board lacked a disinterested and independent majority that could have considered a demand, rendering demand futile and dismissal under Rule 23.1 was denied.

It is important to note that the Court has not found any of the defendants are liable for the actions alleged in the complaint.

Contact Steve Quinlivan for more information.