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In re China Auto. Sys. Inc. Deriv. Litig., C.A. No. 7145-VCN (Del. Ch. Aug. 30, 2013) (Noble, V.C.)

August 30, 2013

In this memorandum opinion, the Court of Chancery held that the plaintiff stockholders had not pled particularized facts sufficient to show demand futility and dismissed with prejudice the plaintiffs’ board oversight, insider trading, and unjust enrichment claims for failure to comply with Court of Chancery Rule 23.1.

The plaintiffs brought this derivative action against the five members of the board of directors (the “Board”) of China Automotive Systems, Inc. (“China Automotive”) alleging that the Board breached its fiduciary duties by failing to implement reliable systems of control that would prevent China Automotive from issuing false and misleading financial statements.  In particular, the plaintiffs alleged that the three members of the Board’s Audit Committee (the “Audit Committee Members”) retained an auditor that was not licensed to audit the company’s records, used their influence on the committee to cause the company to issue materially misleading statements, and failed to timely correct the misleading statements.  According to the plaintiffs, the price of China Automotive’s stock was artificially inflated as a result of these misstatements.  The Court characterized the plaintiffs’ board oversight claim as a Caremark claim, or a claim that the Board, and particularly the Audit Committee Members, failed to monitor adequately China Automotive’s accounting practices. 

The plaintiffs did not make a demand on the Board to pursue the alleged claims.  The Court found that because the plaintiffs did not challenge any particular business decision of the Board, the Rales test for determining whether pre-suit demand was excused, rather than the Aronson test, applied to the board oversight claim.  Under Rales, the Court considered whether a majority of the Board could have properly exercised its independent and disinterested business judgment in responding to a demand. Although the plaintiffs alleged that two of the members of the Board engaged in insider trading, the Court found that the allegation was insufficient to show that a majority of the Board was interested or not independent.  The plaintiffs also alleged that the entire Board was beholden to the chair of the Board, who allegedly had majority control of the company.  The Court found that majority control alone does not demonstrate demand futility without allegations that the Board acted at the control of the majority stockholder.

The Court noted that demand might also be excused when half of the members of a board of directors face a “substantial threat of personal liability” as to the alleged claims, thus compromising the board’s ability to act impartially on a demand.  Considering the likelihood of personal liability, the Court relied on precedent specifically with respect to cases involving a board’s oversight of accounting practices.  The Court noted that demand might be excused if at least half of the directors had knowledge of “red flags,” if the board did not have a functioning audit committee, or if the members of the board had direct and personal involvement in the preparation of the challenged financial statements.  The Court found that the plaintiffs’ conclusory allegations that the Board had confidential information and caused the issuance of misleading statements did not support demand excusal.  The Court also noted the lack of particularized allegations of a conscious disregard of Audit Committee meetings or responsibilities or of any direct or personal involvement by the members of the Board in China Automotive’s preparation of financial statements.  The Court disagreed with the plaintiffs’ assertion that the chair or other members of the Audit Committee should be held to a heightened standard of constructive knowledge about the financial statements.  In light of these findings, the Court held that the plaintiffs did not allege particularized facts showing bad faith or a “sustained or systematic failure of the [B]oard to exercise oversight,” as is required for a meritorious Caremark claim. 

The plaintiffs also alleged that the two members of the Board who were not on the Audit Committee breached their fiduciary duties by selling stock of the company at artificially inflated prices while in possession of material, non-public information.  Since the plaintiffs did not sufficiently allege that the Audit Committee Members were interested, that they lacked independence, or that they faced a substantial threat of personal liability under the insider trading allegations, the majority of the Board survived scrutiny under a demand futility analysis. 

Finally, the plaintiffs alleged that the members of the Board were unjustly enriched by receiving compensation while breaching their fiduciary duties.  Because the unjust enrichment claims were premised on the purported misleading statements, which did not support a breach of fiduciary claim, and upon the purported insider trading, which did not implicate a majority of the Board, the plaintiffs failed to plead particularized facts sufficient to show demand futility.

Having found that the plaintiffs failed adequately to plead demand excusal, the Court declined to address the defendants’ motion to dismiss for failure to state a claim under Court of Chancery Rule 12(b)(6).

The full opinion is available here