Two recent Delaware Chancery Court cases have provided guidance to directors who are confronting difficult and challenging operational problems in a company and who are considering whether to resign from the board to avoid further liability. Rich v. Chong (Fuqi), CA No. 7616-VCG (Del. Ch. April 25, 2013) and In re Puda Coal, Inc. Stockholder Litigation Consolidated CA No. 6476-CS (Del. Ch. February 6, 2013) (transcript ruling) demonstrate that resignation is not always the safest or most advisable course of action, particularly if directors are faced with so-called Caremark1 claims. These two recent cases address board liability in the face of egregious actions of management of Chinese-based companies who had gone public in the United States after incorporation in the state of Delaware. These decisions also offer lessons for directors facing less sensational, but difficult management or operational situations here in the US.

The Fuqi Decision

In Fuqi, a Delaware entity by that name whose sole asset was stock of a Chinese jewelry company, completed a public offering in the US in 2009, but in March 2010 announced a need to restate its 2009 financial statements. Fuqi later disclosed the transfer of $120 million of cash from the company to third parties in China authorized by the chairman of the board pursuant to an oral agreement with Fuqi‟s bank. Fuqi was unable to confirm the accuracy of the business addresses or the extent or nature of the business operations of the entities receiving the transfers. It later reported that the company had been repaid in full with no loss resulting from the transfers, but at the time of the decision by Vice Chancellor Glasscock, the company had not been able to produce audited financial statements confirming the amounts were repaid. The audit committee commenced an investigation, but before that investigation was completed, management failed to pay the fees of the audit committee‟s outside legal counsel, forensic specialists and auditor. These professionals withdrew from the engagement or suspended their services to the audit committee.

Two independent directors then resigned in protest of the defunding. Fuqi disclosed to stockholders that the cash-transfer transactions were the result of material weaknesses in Fuqi‟s internal controls, acknowledging that the company‟s treasury controls did not require that internal fund transfer applications identify any specific business purpose or be accompanied by supporting documentation, such as a copy of a relevant invoice, purchase order or pre-payment statement. From June 2010 until March 2012, Fuqi‟s board and executive team experienced mass defections, including the resignations of four directors (two of whom expressly resigned, as noted above, due to management‟s failure to pay the professional service providers engaged by the audit committee, as well as a protest to management assuming authority for engaging an accounting firm without the approval of the audit committee).

Plaintiffs made a demand on Fuqi, but two years later the board had not acted in response to the demand. Fuqi had set up a special committee to consider the demand, but it held no meetings, released no progress reports, and all members resigned shortly after formation with essentially no activity. More than two years had passed since the demand letter was sent to Fuqi, and plaintiffs submitted that Fuqi‟s board had sufficient time to investigate.

Vice Chancellor Glasscock considered the board‟s "abandonment of the investigation as an abdication of its duty to investigate the demand," noting that the protections of the business judgment rule do not apply...where directors have either abdicated their functions or absent a conscious decision, failed to act." The investigation "has been left in limbo, with no progress, for several months," and therefore the Vice Chancellor concluded that Fuqi management was not entitled to the business judgment rule. The Vice Chancellor then observed that "[t]o make matters worse, the independent directors, who could have conducted a meaningful investigation on behalf of the company, have resigned from their posts." The Vice Chancellor concluded that the plaintiff "pled with particularity facts that create a reasonable doubt that the Fuqi board [has] acted in good faith in investigating" the facts underlying the demand.

The Vice Chancellor then considered whether to grant a motion to dismiss the complaint for failure to plead facts that show that the directors "consciously and in bad faith failed to implement any reporting or accounting system or controls." The Vice Chancellor declined to consider claims against the defendants individually. He noted that some of the former independent directors who had been on the audit committee and had resigned in protest, as noted above, might have attempted to fulfill their duties in good faith. He observed, however, that Chancellor Strine had recently commented in In re Puda that "it is troubling that independent directors would abandon a troubled company to the sole control of those who had harmed the company." Vice Chancellor Glasscock then explained directors would not be "automatically exonerated because of their resignations."

...directors would not be "automatically exonerated because of their resignations."

The Vice Chancellor refused to dismiss the Caremark claims, holding that Fuqi‟s public disclosures led him to believe that Fuqi "had no meaningful controls in place," and that even if Fuqi had some system of internal controls in place, he could infer that "the board‟s failure to monitor that system was a breach of fiduciary duty." He also concluded that the board was aware of "red flags" as to the deficiencies in Fuqi‟s internal controls, and that it was reasonable to infer from the facts pled "that the directors knew that the internal controls were inadequate and failed to act in the face of a known duty." He noted that the fact that the CEO "was able to transfer $130 million out of the company‟s coffers, without the directors knowing about it for over a year, strains credulity... If the directors had even the barest framework of appropriate controls in place, they would have prevented the cash transfers."

The Vice Chancellor explained that "when faced with knowledge that the company controls are inadequate," the directors "must act, i.e., they must prevent further wrongdoing from occurring." He concluded that the directors were either complicit in the money transfers, or were "aware of the pervasive, fundamental weaknesses in Fuqi‟s controls and knowingly failed to stop further problems from occurring." Thus he held that the complaint stated a claim for breach of the duty of good faith under Caremark. He also noted that failing to "utilize an existing audit committee [is] an example of directors‟ disabling themselves from being informed."

The In re Puda Coal Ruling

In In re Puda Coal, Chancellor Leo Strine issued a transcript ruling concerning three independent directors who had resigned from the board of directors of Puda Coal after a lawsuit against them was filed in Delaware. An audit committee comprised of those three directors had reported publicly that the CEO and Chairman, Messrs. Zhu and Zhao, had sold the company‟s assets to an affiliate without compensation to the company, or essentially the assets had been "stolen out from under them." See the Form 8-K filed by Puda Coal, Inc., on September 1, 2011. The three directors did not cause the company to sue to recover the assets, although they controlled the board, but instead resigned. Mr. Zhu had already resigned, and thus the three directors‟ resignation left one of the thieves, Mr. Zhao, as the sole remaining director.

Chancellor Strine noted that the purported effect of the resignations by the three directors was to immunize each of the three from suit "while simultaneously making it impossible for the company itself to sue to recover the assets." The Chancellor therefore excused demand because the controlling independent directors had quit rather than commencing a lawsuit against the perpetrators. Chancellor Strine noted that the directors "were faced with...the most extreme sort of fiduciary violation you could imagine." He noted that those same directors attempted to use the procedural demand futility standard to "disable the derivative plaintiffs from even going after the bad guys." Later he noted that "knowing that they could actually cause the company to join the lawsuit and pursue things, these directors quit" and thereby "leave the company under the sole dominion of a person they believe has pervasively breached his fiduciary duty." He declined to premise a dismissal of the lawsuit on demand excusal grounds for this reason, terming such a dismissal as "Kafkaesque" and noting it would subject the Delaware courts to ridicule.

In explaining the Caremark claim, Chancellor Strine noted in his transcript ruling that "if you are going to have a company domiciled for purposes of its relationships with its investors in Delaware and the assets and operations of that company are situated in China, that in order for you to meet your obligations of good faith, you‟d better have your physical body in China an awful lot." He observes:

  • "You better have in place a system of controls to make sure that you know that you actually own the assets."
  • "You better have the language skills to navigate the environment in which the company is operating."
  • "You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company."

These are sound, common sense prescriptions for directors acting in companies with their primary operations and assets overseas, to be able to exercise required oversight and control. Chancellor Strine found that the allegations here, including the magnitude of wrongdoing and the length of time it went undiscovered, to give rise to a Caremark claim.

In reviewing this case, Chancellor Strine supports the business judgment rule. He explains that Delaware law permits "dummy directors," but "you have to be an active dummy director." The Chancellor observes that a director "can be trying and misses stuff get credit for that." He notes that "what you can‟t be is a dummy director in the sense of an actual dummy. Like...a mannequin, somebody who allows themselves to be appointed to something without any serious effort to fulfill the duties." He then explains:

"Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors." He continues: "if the assets are in Russia, if they are in Nigeria, if they are in the Middle East, if they are in China, then you are not going to be able to sit in your home in the US and do a conference call four times a year and discharge your duty of loyalty." In evaluating the Caremark claims, the Chancellor notes that one picks independent directors "not for their industry expertise, but because of their independence and their ability to monitor the people who are managing the company." In that regard, he observes that "if I don‟t understand how the company makes money, that‟s a danger...if all the flow of information is in a language I don‟t understand in a culture where there‟s frankly not legal structures or...ethical mores...where I am would be very difficult..."

Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors.

Beyond the failure to provide oversight, Chancellor Strine finds that the resignations themselves here state a claim for breach of fiduciary duty, explaining that "[th]ere are some circumstances where running away does not immunize you." He advised that if at the time these directors quit, "they believed that the chief executive officer of the company had stolen the assets out from under the company, and they did not cause the company to sue or do anything but simply quit," that decision may be a breach of fiduciary duty. Accordingly, Chancellor Strine denied the motion to dismiss the lawsuit.

Lessons from Fuqi and In Re Puda Coal

Obviously, the facts faced by the independent directors in Fuqi and In re Puda Coal were egregious and unusual. Nevertheless, one can draw some important "rules of the road" for independent directors generally. Here are some take-aways:

  • Directors cannot ignore or abdicate their duties without a risk of personal liability. Directors do not have the protection of the business judgment rule if they fail to act, or in Chancellor Strine‟s words, if they act like "mannequins."
  • A key criteria for selection of independent directors is their ability to monitor the people who are managing the company. Independent directors should keep this key oversight responsibility top of mind in performing their duties as directors, and in deciding whether to take on a new director role.
  • Directors need to pay attention to red flags and monitor internal controls.
  • Directors serving in companies with significant assets in a foreign country should have a clear understanding of the internal controls over the company‟s assets and operations in that foreign country, and language skills to permit understanding of the activities in the foreign country. They should make sure that the company has professional advisors who can monitor and advise the board with respect to appropriate internal controls. Directors in such companies should plan to spend sufficient time in the company‟s foreign operations to make sure the director has a good understanding of the foreign business, assets and internal controls, and should assess the culture of compliance.
  • If directors see red flags, they need to act to prevent further harm to the company and further wrongdoing.
  • Resignations will not necessarily immunize or exonerate a director if he should have taken action to prevent wrongdoing.
  • A resignation that leaves the company in the control of a looter is a potential breach of the resigning director‟s duty if the director fails to act to seek redress and his resignation leaves the company unable to take such action.

Resignations will not necessarily immunize or exonerate a director if he should have taken action to prevent wrongdoing.

In summary, a director considering a resignation must carefully consider the impact of that resignation on the company. If the resignation will leave the company worse off, unable to pursue a remedy against a wrongdoer or to pursue the board‟s fiduciary duties, due to the composition of the remaining board or otherwise, the director should consider the risks of potential liability not just for the period prior to the resignation, but for consequences of the resignation. A director may have liability stemming from facts arising before the resignation, and should keep in mind that once the director has resigned, that director cannot take any further steps to correct the deficiencies or problems. Directors of troubled companies do not have an easy road whichever path they take, particularly where management is unresponsive or suspected of malfeasance, but must consider the best interests of stockholders as well as their personal interests.