BETTER OVERSIGHT THAN HINDSIGHT: Hughes v. Xiaming Hu demonstrates that directors and officers who fail to adequately oversee their company’s management expose themselves to personal liability

By Oderah C. Nwaeze

Across the United States, the Coronavirus has caused widespread devastation, marking its arrival with debilitating symptoms and tens of thousands of deaths.  The virus also is responsible for significant economic destruction, rendering 30 million Americans jobless requiring $660 billion in payroll loans, and necessitating a $2.2 trillion in stimulus package.  History likely will reveal that poorly run companies are repeat victims of the financial hardships precipitated by COVID-19.  Even without a pandemic, a company likely will fail (or suffer significant harm) if its directors and officers do not adequately oversee the company’s management.  But, there is another reason to avoid oversight failures.  As the Delaware Court of Chancery’s April 27, 2020 decision in Hughes v. Xiaming Hu et al. reinforces, directors and officers who neglect their oversight responsibilities may be personally liable for resulting harm to the company and its stockholders.

The Company’s Directors and Officers Allowed Significant Errors in Financial Reports and Attempted to Hide Questionable Related-Party Transactions

In Hughes, the plaintiff sought damages from the directors and officers of a Delaware corporation (the “Company”), including the CEO and three successive CFOs, for pervasive oversight issues that often manifested in the form of inaccurate financial reporting and a lack of transparency regarding related-party transactions.  To be specific, the Complaint alleged that:

  • in 2011, the Company instructed its internal auditor to conceal the fact that the CEO’s son owned one of the Company’s five largest customers, as well as transactions with that customer;
  • in 2011, the Company’s auditor discovered and failed to investigate why the Company parked millions of dollars in the personal bank accounts of its officers and employees;
  • in 2012, the Company’s auditor took no action after learning that a single note constituted $33.1 million of the Company’s $37.9 million notes receivable, and that the borrower did not make any interest payments in 2011;
  • in 2013, the Company’s auditor discovered, but failed to investigate, why the Company hid material transactions with a customer owned by the CEO’s son;
  • the Company’s 2013 10-K admitted to inadequate “disclosure controls and procedures,” caused by (1) the fact that the head of the audit department reported directly to the CEO rather than to the Company’s Audit Committee; (2) a lack of communication between the audit department and the Audit Committee; and (3) the Company’s failure to evaluate the Audit Committee on an annual basis;
  • the Audit Committee met just five (5) times between May 2014 and August 2016, and never long enough to fulfill “all of the responsibilities it was given under the Audit Committee Charter;”
  • in March 2016, the Audit Committee used unanimous written consents to approve all related-party transactions with an affiliate, who, in 2016, already had entered into deals valued at $42 million;
  • in May 2016, just one month after the Company fired its internal auditor, the Public Company Accounting Oversight Board sanctioned the auditor for its pattern of wrongdoing from 2010 to 2013;
  • in November 2016, the Company belatedly disclosed that since 2012, it had engaged in related-party transactions, valued at over $60 million, but did not describe the process that the Company used to ensure that the transactions were fair; and
  • on March 16, 2017, the Company disclosed that it must restate its financials from 2014 through the third quarter of 2016.

Moreover, the Company’s 2016 10-K revealed that the Company lacked sufficient expertise in (1) US GAAP requirements and SEC disclosure regulations; (2) the disclosure of financial statements for equity investments; (3) the proper disclosure of related-party transactions; (4) the proper classification and reporting of certain cash and non-cash activities related to accounts receivable, accounts payable, and notes payable; and (5) the accuracy of the accounting and reporting of income taxes and related disclosures.  Finally, the plaintiff alleged that the Company’s oversight failures were so significant they necessitated the conclusion that the Company’s directors and officers received some direct or indirect benefit from the mismanagement, including increased compensation based on inflated financials.

The Court of Chancery Finds that the Plaintiff’s Claims, and Requests for Relief from Individual Directors and Officers, were Sufficient to Survive a Motion to Dismiss

The defendants moved to dismiss the plaintiff’s claims under Rule 23.1, for failure to establish demand futility, and under Rule 12(b)(6), for failure to state a claim on which relief can be granted.  The Court of Chancery denied the defendants’ motion.  It found that the Complaint adequately alleged demand futility by asserting that the majority of the board could not disinterestedly consider whether to file suit regarding bad faith oversight failures because there were sufficient facts to infer that those failures of oversight exposed the directors to the substantial likelihood of personal liability.  The Court also held that those same facts were sufficient to defeat the defendants’ contention that the plaintiff failed to state a claim for relief.

As Hughes illustrates, a plaintiff who chooses not to make a demand on the board of directors must allege with particularity that the majority of the board is incapable of making an impartial decision regarding whether to initiate litigation, thereby excusing the demand requirements.  In seeking to resolve that issue, in Hughes, the Court of Chancery applied the demand futility test outlined in Rales v. Blasband, 634 A.2d 927 (Del. 1993).  The Rales standard is appropriate in circumstances where a plaintiff asserts general violations of the board’s oversight duties under In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996).  Rales dictates that a director cannot exercise independent and disinterested business judgment regarding a litigation demand when potential litigation might expose the director to adverse personal consequences, including money damages.

Directors and officers of a Delaware corporation are duty-bound to adopt internal control and reporting systems that are reasonably designed to provide them with timely, accurate information sufficient to make informed decisions.  Directors and officers face a substantial threat of liability under Caremark if they knowingly or systemically fail to (1) implement reporting policies or a system of controls; or (2) monitor or oversee the Company’s operations.  If the oversight failures result in losses to the company, the directors and officers responsible could be held personally liable.

Relying upon these corporate governance principles, the Hughes Court found that the Complaint sufficiently stated a Caremark claim because it established that the Company suffered from significant issues with respect to financial reporting and related-party transactions.  The Vice Chancellor specifically rejected the defendants’ argument that the Company “had the trappings of oversight, including an Audit Committee, a Chief Financial Officer, an internal audit department, a code of ethics, and an independent auditor,” reasoning that “the Company’s Audit Committee met sporadically, devoted inadequate time to its work, had clear notice of irregularities, and consciously turned a blind eye to their continuation.”  Given the clear impotence of the Company’s oversight features, the Court determined that the mere existence of committees and departments responsible for oversight was inadequate to rebut a Caremark claim.

The Court also distinguished the plaintiff’s claims from those in In re Gen. Motors Co. Deriv. Litig., 2015 WL 3958724 (Del. Ch. June 26, 2015).  In that case, the court held that “the plaintiffs could not plead that the directors faced a substantial likelihood of Caremark liability by arguing that the board ‘should have[] had a better reporting system” because the plaintiffs admitted that the board reviewed the corporation’s risk management structure, identified top risks, and analyzed presentations on product safety and quality.  The allegations in Hughes support the inference that, unlike the General Motors board, the Company’s directors simply failed to make a good faith effort to put in place a reasonable, board-level system of monitoring and reporting.  The Court of Chancery was especially comfortable reaching that conclusion because the board had the opportunity to produce exculpating documents, but failed to do so in response to the plaintiff’s demand for books and records under Section 220.

Unable to escape the looming likelihood of liability for Caremark claims, the defendants last argued that even if they failed to exercise sufficient oversight, they cannot be subject to liability because their conduct did not cause the Company to lose income or value.  That position, however, carries no weight with respect to a Caremark claim because damages could include the cost and expense of restating financials, the significant reputational harm resulting from an obvious lack of discipline and controls, and the cost of defending against several mismanagement-related lawsuits.

Ultimately, the Hughes Court held that demand was excused because a majority of the board faced a substantial likelihood of liability under Caremark for breaching their duty of loyalty by failing to act in good faith to maintain a board-level system for monitoring related-party transactions and the Company’s financial reporting.  And, since the standard for pleading demand futility is more stringent than the standard under Rule 12(b)(6), the Court found that the allegations giving rise to demand futility also were sufficient to state a claim for which relief could be granted.

Lessons Learned from Hughes

  • Directors and officers of a Delaware corporation have the fiduciary duty to use good faith to create and implement systems of control and monitoring over the corporation’s management. Failing to do so likely will result in a Caremark claim and the potential of personal liability for those directors and officers.
      • In times of financial crises or natural disasters, failures of oversight could result in greater harm to the company; thus, increasing the potential liability to directors and officers. As a result, directors and officers should ensure that they have created and are implementing adequate controls and monitoring to avoid the potential that unforeseen events might magnify the effects of their mismanagement and their potential liability.
  • In Hughes, the Court of Chancery drew some negative inferences about the conduct of the Company’s board because the Company failed to produce exculpating information in response to the plaintiff’s demand under Section 220 of the Delaware General Corporation Law. Those negative inferences then were used to justify denying the defendants’ motion to dismiss.
    • Given this reality, companies should be strategic about what information they withhold in response to a Section 220 demand. Recognizing that most companies are reluctant to produce sensitive business information that could be used to support meritless claims, entities faced with a Section 220 demand must make sure to produce documents, communications, and other materials that may stop the Court of Chancery from crediting a plaintiff’s allegations against the company’s board and/or officers.