In re China Agritech, Inc. S’holder Deriv. Litig., C.A. No. 7163-VCL (Del. Ch. May 21, 2013) (Laster, V.C.)

In this memorandum opinion, the Court of Chancery denied Defendants’ motion to dismiss after determining that demand would have been futile under the Aronson and Rales analyses and that the Plaintiff had stated a claim on which relief could be granted under Rule 12(b)(6).

China Agritech (the “Company”) is a company that develops and markets fertilizer products in China.  Through a reverse merger with an inactive corporation, the Company accessed public listing through NASDAQ.  Defendant Chang founded the Company and served as President, CEO, Secretary, and Chairman of the Company during the relevant time period.  As owner of 55% of the Company’s common stock, Chang controlled the Company.  To correct internal control problems, the Company hired new executives and expanded its board in 2008.  After engaging in an interested transaction whereby the Company acquired the remaining interest in its subsidiary from a company owned by Chang and another executive (the “Yinlong Transaction”), the Company announced a public offering of common stock to allegedly finance the construction of distribution centers for its products (the “Offering”).  In August 2010, the Company revealed material weaknesses that undermined its disclosure controls, which it claimed to have fixed and subsequently fired its outside auditor, Crowe Horwath.  The Audit Committee of the Company approved the termination.  The Company then hired Ernst & Young Hua Ming (“Ernst & Young”) as its new auditor.  Following that decision, a board and Audit Committee member’s daughter was hired as the head of the Company’s internal audit department.  Ernst & Young raised several concerns of material weaknesses and significant deficiencies within the Company.  At the same time, Lucas McGee (“McGee”), a consultant and private investor, authored a report disclosing multiple problems within the Company, including the complete absence of any manufacturing activity, the absence of a license to manufacture one of the Company’s lead products, no distribution centers (which raised questions about the use of the proceeds from the Offering), and anomalies in the Company’s financial reports to the SAIC and SEC.  Shortly after the report was issued, the Company posted rebuttal press releases and letters denying the allegations.  The Company formed a Special Investigation Committee (the “Special Committee”) to investigate Ernst & Young’s allegations of mismanagement, of which three of the four members were also members of the Audit Committee, whose actions Ernst & Young was concerned with.  Before the Special Committee completed its investigation, the Company terminated Ernst & Young.  Following this decision, multiple members of the Special Committee and Audit Committee resigned.  In April 2011, NASDAQ delisted the Company based on public interest concerns and failure to file its 2010 form 10-K on time. 

In July 2011, the Plaintiff commenced a Section 220 books and records action after the Company refused to produce documents related to the Yinlong Transaction, the termination of the two auditors, the McGee report, the Company’s response, and the oversight provided by the board and its committees (the “220 Action”).  In response to the 220 Action, the Company produced very few responsive books and records and produced no Audit Committee meeting minutes related to any of the contested issues.  In December 2011, the Special Committee announced that it had completed its investigation and had found no problems in any of the relevant areas.  Following this announcement, multiple members of the board resigned, leaving only Chang and two other members on the board.  The Plaintiff subsequently brought the current derivative suit for damages related to the above-mentioned issues. 

In analyzing demand futility, the Court applied the Aronson test for the five directors who remained on the board since the time of the disputed decisions and the Rales test for the two directors who were not on the board at the time of the decisions.  However, since the Court found that demand futility was established upon application of the Aronson test to the five participating directors, it did not reach the Rales analysis.  The Court also applied the Rales analysis to the claim of systematic lack of oversight alleged in the Complaint, since this claim did not challenge an actual board decision.  The Court found that the books and records produced in response to the 220 demand and the absence of books and records produced in critical areas supported a reasonable inference that the members of the board faced a substantial risk of liability for oversight violations.  Therefore, under Rales, it would have been futile for the Plaintiff to make a litigation demand with regard to the failure of oversight.  Regarding the Defendants’ Rule 12(b)(6) argument, the Court held that the operative standard is “reasonable conceivability.”  Because a majority of the board members faced a substantial threat of liability on the Plaintiff’s claims for purposes of Rule 23.1 on demand futility, it follows that the Complaint states a claim under the less stringent Rule 12(b)(6) standard.  In denying the motion to dismiss, the Court also rejected Defendants’ argument under Section 102(b)(7) that the Defendants could not be held liable in light of an exculpatory provision in the Company’s certificate of incorporation.  Since the Complaint raised questions invoking the duty of loyalty and good faith, rather than the duty of care, the Court held that the exculpatory provision in the certificate did not exculpate the directors.

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