Document: George Rich, Jr. v. Yu Kwai Chong, et al., C.A. No. 7616-VCG (Del. Ch. Apr. 25, 2013)
The Delaware Court of Chancery denied defendant directors’ motion to dismiss plaintiffs’ claims that the directors breached their fiduciary duties under Caremark by failing to establish sufficient internal controls and ignoring “red flags” in connection with the corporation’s operation of a jewelry company based in China. This action followed on the heels of the company’s public announcement in 2010, of the likely restatement of its 2009 financial statements and the apparent disappearance of $120 million of the company’s cash (the entire amount it received in a 2009 public offering), which apparently had been transferred (upon the CEO’s oral instructions) to third persons in China whose business addresses could not be verified.
Nominal defendant Fuqi International, Inc. (“Fuqi”), whose sole asset consists of stock in a Chinese jewelry company, completed a U.S. public offering in 2009. The public offering followed a reverse triangular merger pursuant to which Fuqi gained access to U.S. capital markets. In March 2010, Fuqi announced that, due to deficiencies in internal controls, the filing of its fourth quarter 10-Q and its 10-K for 2009 would be delayed. In July 2010, plaintiff made a demand on Fuqi’s board to remedy alleged breaches of fiduciary duties in connection with the deficiencies in the company’s internal controls. By September 2010, the Securities and Exchange Commission (“SEC”) began investigating Fuqi for failure to file timely periodic reports. In October 2010, Fuqi formed a special committee of directors to respond to plaintiff’s allegations. However, Fuqi continued to have trouble controlling its finances and, in 2011, Fuqui announced that it would be restating many of its previously filed financial statements because of accounting errors. Fuqi also announced that its audit committee was investigating cash-transfer transactions to third parties in China which totaled over $120 million and for which there were no written records. The audit committee later abandoned its investigation after several of its members resigned and its advisors quit.
Plaintiff commenced this action in June 2012, after receiving no response from the Fuqi special committee formed to investigate his allegations. Defendants moved to dismiss plaintiff’s complaint for failure to state a claim and on the basis that plaintiff could not proceed with this action until Fuqi responded to his demand under Chancery Court Rule 23.1. The Court disagreed and found that the requirements of Rule 23.1 had been satisfied because plaintiff’s complaint raised a reasonable doubt that the board had acted in good faith under a Caremark theory of liability. The Court also found that plaintiff’s complaint stated a claim for breach of the duty of loyalty arising from the Fuqi directors’ failure to exercise oversight over the company’s finances. In this case, the Court found that Fuqi’s own public filings allowed the Court to infer that: (1) Fuqi had no meaningful controls in place, and (2) Fuqi’s board members were aware of, but knowingly failed to address, the pervasive inadequacies in the company’s internal controls.