Reed Smith Client Alerts

A recent decision from the Delaware Court of Chancery, William Hughes Jr. v. Xiaoming Hu, et al., 2020 WL 1987029 (Del. Ch. Apr. 27, 2020), serves as useful guidance to corporate officials of Delaware entities about the importance of corporate record-keeping. The Court held the absence of certain books and records supported a finding that a stockholder of the Delaware corporation had standing to pursue a derivative lawsuit against the corporation’s fiduciaries. The Court of Chancery’s decision in Xiaoming Hu demonstrates there are serious repercussions if the corporation fails to maintain adequate records or otherwise does not conduct a good-faith search for, and production of, documents responsive to a stockholder’s books-and-records request. The gap in the corporation’s records can provide strong evidence of mismanagement and expose the corporation—and potentially the directors—to costly, drawn-out litigation.

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.