The plaintiff in Xiaoming Hu, a stockholder of Kandi Technologies (Kandi), brought claims against Kandi’s directors for breach of fiduciary duty and unjust enrichment, alleging the board approved inaccurate financials and related-party transactions over a period of multiple years in bad faith, and employee directors were unjustly enriched through incentive compensation driven by inaccurately reported results. The plaintiff’s claims were brought on a “derivative” (as opposed to a “direct”) basis because the harm was suffered directly by the corporation (and the plaintiff was only indirectly harmed by virtue of his ownership interest in Kandi).
Although Delaware law gives significant deference and latitude to the corporate officials responsible for managing the business and affairs of Delaware corporations, Delaware law permits stockholders to pursue derivative claims on behalf of (and for the benefit of) the corporation because any recovery on behalf of the corporation will indirectly benefit the stockholder-plaintiff. In order to pursue and maintain a derivative claim, the stockholder-plaintiff must establish that any “demand” for the corporation’s officials to pursue the claims on behalf of the corporation would be futile. This is called “demand futility.”
In Xiaoming Hu, the stockholder-plaintiff’s complaint alleged a seven-year history of ineffective internal control for financial reporting and related-party transactions, much of which the company had publicly acknowledged, and an Audit Committee lacking required knowledge that generally met only once a year—for less than an hour—and deferred to management despite having reason to doubt their representations. The stockholder-plaintiff sued after first obtaining books and records under 8 Del. C. § 220. In response to the books-and-records demand, the corporation produced certain documents and represented there were no other non-privileged materials responsive to the books-and-records inspection demand.
The defendants moved to dismiss the derivative claim by arguing the stockholder-plaintiff failed to establish demand futility. Under Delaware law, for a plaintiff that did not make a pre-suit demand to be able to move forward on behalf of the company, the complaint must “allege with particularity the reasons for not making the effort to make a litigation demand.” The court must also determine based on those allegations that “demand is excused because the directors are incapable of making an impartial decision regarding whether to institute such litigation.”
Stockholders seeking to establish demand futility “must comply with stringent requirements of factual particularity that differ substantially from permissive notice pleadings.” Although conclusory allegations of fact or law not supported by the allegations of specific fact may not be taken as true under the heightened pleading standard, once a plaintiff pleads particularized allegations showing demand would be futile, then the plaintiff is entitled to all “reasonable inferences [that] logically flow from particularized facts alleged by the plaintiff.” “While the stockholder-plaintiff is required to allege specific facts, ‘he need not plead evidence.’” The stockholder-plaintiff in Xiaoming Hu argued demand would have been futile because a majority of the corporation’s directors faced a substantial likelihood of personal liability because they had approved or otherwise acquiesced to the misconduct alleged.
The Court of Chancery agreed with the stockholder-plaintiff and denied the defendants’ motion to dismiss after concluding the stockholder-plaintiff has sufficiently established that demand would have been futile. In reaching its demand-futility decision, the Court of Chancery relied heavily on the fact that, in response to the earlier books-and-records demand, the corporation had stipulated that responsive documents not produced were either privileged or nonexistent. The Court held the plaintiff was entitled to an inference, to the extent documents would reasonably be expected to exist in connection with an event and no such documents were produced, that the event did not occur:
The inferences that the plaintiff receives in this case are informed by the plaintiff’s use of [8 Del. C. § 220] of the Delaware General Corporation Law to obtain books and records. In response to the plaintiff's requests, the Company produced some documents and stipulated that ‘any remaining materials requested by Plaintiff either do not exist or had been withheld on privilege grounds.’ Given this stipulation, if the Company failed to produce a document that it would reasonably be expected to possess if a particular event had occurred, then the plaintiff is entitled to a reasonable inference that the event did not occur.
For example, the plaintiff asked the Company to produce minutes from board meetings that took place between December 31, 2009, and May 10, 2017, at which specific topics were discussed. In response, the Company did not produce any minutes evidencing any meetings addressing those topics until a meeting of the Audit Committee on May 9, 2014. The plaintiff is entitled to the reasonable inference that no earlier meetings took place at which those topics were addressed.
The Court’s reliance on the absence of books and records is noteworthy because it could have broader implications beyond helping establish demand futility. The absence of important books and records could provide substantive evidence that the corporate officials’ decision-making was not sufficiently thorough and calculated, which would provide a basis to hold those officials personally liable for mismanaging the corporation’s business and affairs.
Takeaways
- Corporate officials must take seriously corporate record-keeping and adhering to corporate formalities, including maintaining meeting minutes, financial statements, audit reports, tax returns, and stockholder reports.
- Lack of corporate record-keeping has resulted in Delaware courts stripping the board of directors of a key corporate asset—the business decision to cause a corporation to sue by allowing a shareholder to pursue those claims derivatively on behalf of the corporation.
- Failing to comply with record-keeping obligations can expose corporate officials to personal liability by creating a gap in corporate records that creates the appearance the corporate officials are not adequately overseeing and monitoring the business and affairs of the company for which they serve.
- Even if a Delaware corporation keeps accurate corporate records, an inadequate response to a stockholder’s books-and-records demand (or a director’s books- and-records demand), including a corporation’s failure to produce adequate documents, can open the door to more costly substantive litigation challenging the merits of the corporate officials’ decision-making.
Client Alert 2020-296
