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

In this memorandum opinion, the Delaware Court of Chancery denied a motion to dismiss derivative claims brought on behalf of Kandi Technologies Group, Inc. (“Kandi” or the “Company”) pursuant to Rule 23.1 for failure to plead demand futility and Rule 12(b)(6) for failure to state a claim on which relief can be granted. In reaching its decision, the Court held that four defendants, constituting a majority of the board that would have had to consider a demand, faced a substantial risk of liability under Caremark with respect to claims asserting that they failed to exercise their oversight duties in good faith.

Kandi is a Delaware corporation based in China which sells parts for the manufacture of electric vehicles. In the course of its yearly audits from 2011 through 2016, Kandi’s auditor identified a number of concerns with respect to certain related party transactions, but did not investigate those matters further and often failed to report them to Kandi’s audit committee.

In 2014, Kandi filed its 2013 10-K and stated therein that its “disclosure controls and procedures were not effective as of December 31, 2013, due to a material weakness.” The Company announced a number of efforts to fix its deficiencies, including its intention to revise its audit committee charter and to subject all related-party transactions to review by its audit committee.

From May 2014 to August 2016, the audit committee met only five times, each time for an hour or less. Those meetings were usually prompted by the requirement under federal law that the audit committee approve the Company’s 10-K or 10-Q filings. The Company’s board or audit committee often acted by written consent, after each audit committee meeting, to address matters under the audit committee’s purview, such as matters involving related party transactions or decisions to retain or replace the Company’s auditor.

In March 2017, the Company announced that its financial statements from 2014 through the third quarter of 2016 could not be relied upon and would be restated. The Company filed its 10-K for 2016 shortly thereafter, which disclosed that the Company lacked expertise regarding matters such as US GAAP and SEC disclosure requirements and the proper disclosure of related-party transactions.

In May 2017, plaintiff delivered a Section 220 demand to the Company and filed a Section 220 lawsuit, eventually obtaining documents after receiving Court guidance. Thereafter, plaintiff filed a complaint, which named the three members of the audit committee, the Company’s CEO/Chairman, and its three successive CFOs, as defendants. The Complaint asserted two counts: Count I asserted Caremark claims against all defendants, and Count II asserted an unjust enrichment claim against all defendants.

The Court decided to apply the Rales test to evaluate demand futility, while acknowledging this was a situation where the Rales and Aronson tests overlapped. The Court held that the members of the audit committee and the CEO faced a substantial likelihood of liability with respect to the asserted Caremark claims. In reaching that conclusion, the Court emphasized that the audit committee only met when federal securities laws required it to meet, despite known material weaknesses in the Company’s internal controls. The Court also focused on the short duration of the audit committee’s meetings and that the audit committee and board often acted by written consent after audit committee meetings to address issues the audit committee should have addressed at its meetings. The Court found that these allegations gave rise to the reasonable inference that the audit committee was not devoting adequate time to its work, and, when it did, was not devoting attention to important issues.

The Court rejected the Company’s argument that plaintiff could not meet its burden under Caremark because it had an audit committee, audit department, code of ethics, and independent auditor and therefore plaintiff was pleading only that monitoring systems already in existence should have been more effective. The Court found that plaintiff’s allegations supported an inference that the audit committee never implemented its own system for reporting and monitoring, instead choosing to rely upon management for decisions such as replacing its auditor and the appropriate policies for reviewing related party transactions, even though management had previously shown it did not accurately report related-party transactions. The Court explained that, while an audit committee can rely upon the reports of management, it cannot blindly defer to and totally rely upon management.

The Court also rejected the Company’s argument that the director defendants were not subject to liability because the 2017 restatement resulted in no changes to Kandi’s net income. The Court noted that, even if there was no harm to net income, the director defendants could still be liable for incidental damages, such as the costs of the restatement, reputational harm, and the costs of litigating lawsuits related to the restatement.

In light of the foregoing findings, the Court held that four directors (the three audit committee members and the CEO/Chairman) faced a substantial likelihood of liability under Caremark, and that the board lacked a disinterested and independent majority that could have considered a demand, rendering demand futile.

The Court then considered the unjust enrichment claim. In that claim, plaintiff asserted that the officer defendants were unjustly enriched because they received excessive compensation due to the Company’s overstated financial statements. The Court held that, because this was a form of damages for the same breach of fiduciary duty in the first count, the same demand futility analysis would apply, and it refused to dismiss the unjust enrichment claims.

Finally, the Court refused to dismiss under Rule 12(b)(6) because the Defendants offered no independent arguments under 12(b)(6) and Rule 23.1 has a more stringent standard.

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