M & A Law Prof Blog

Editor: Brian JM Quinn
Boston College Law School

Monday, April 29, 2013

Delaware courts and liability of independent directors of Chinese companies

I'll be the first the first to admit that the whole reverse merger situation with Chinese corporations really reveals the most cynical aspects of our capital markets.  For those of you who haven't been paying attention to this issue, towards the end of the credit bubble and early on during the financial crisis there were a large of number of reverse mergers in the US involving Chinese corporations.  The reverse merger is a back door way to take a company public.  A privately held foreign company, in this case Chinese, acquires a publicly listed, but thinly traded, US corporation, usually a Delaware corporation through a reverse merger (the acquirer is the disappearing corporation and the target is the surviving corporation).  The suriving corporation then changes its name to the Chinese corporation and presto, you have a publicy traded Chinese corporation incorporated in Delaware.     

OK, so far so good.  The next step is where things start to get 'hinky'.  The newly public Chinese corporation then raises additional equity on US markets through a public offering.  The money is transfered back to China and then ... it disappears.  Surprised?   There are lots of people who you might point a finger at in this exercise.  The lawyers and investment bankers who arrange the reverse merger, the lawyers, investment bankers, and accountants who sign off on the public offering, the analysts who recommend shareholders buy shares in these companies.  The list is very long.  Now add to that list, the independent directors, usually US persons, who are required to sit on the boards of these companies (pursuant to the listing rules).

Reuters' Tom Hals points us to an opinion handed down late last week by Vice Chancellor Glasscock (Rich v Fuqi):

[Fuqi] listed its shares on Nasdaq through a reverse merger and in 2009 it raised $120 million through a public stock offering. Less than a year later, the company said it found accounting errors and uncovered transfers of cash out of the company totaling more than $130 million to entities that Fuqi has yet to verify were legitimate businesses. Fuqi has said the cash was recovered.

Fuqi's audit committee started to investigate, but its work stalled when management stopped paying the lawyers and accountants hired by the audit committee. The company said the lack of payment stemmed from a dispute with its insurer.

In protest, [independent directors] Brody and Hollander resigned from the board.

Shareholders sued the directors of Fuqi, including Brody and Hollander, who resigned in protest.  Prior to suing, the shareholders had made demand, but the corporation sat on the shareholders' demand for over two years.  The shareholders argued that notwithstanding the fact that they had previously made demand, it was futile because of the two year delay in responding.  The essence of the shareholders claim was a Caremark oversight claim - that directors failed in the duty to monitor the corporation's activities and permitted more than $130 million to disappear.  Glasscock sided with shareholders. 

Glasscock found:

... lead me to believe that Fuqi had no meaningful controls in place.  The board of directors
may have had
regular meetings, and an Audit Committee may have existed, but there
does not seem to have been any
regulation of the company’s operations in China.

The Vice Chancellor noted that independent directors had ignored several 'red flags' with respect to problems with internal controls and that directors did nothing to ensure that reporting mechanisms were accurate.  The lack of internal controls was so bad that $130 million was transferred out of the company in Novermber 2010, but it wasn't found out by the directors until March 2011.

Also, and this is critically important for independent directors, a strategy of "noisy withdrawal" will not immunize independent directors from liability for bad acts that took place on their watch.  Glasscock's ruling in Fuqi and Chancellor Strine's earlier in re Puda decision  make two things clear:  first, Caremark is alive - although it's a difficult standard to meet, there are facts that will meet that standard; and second, if you are an independent director, remember that it is serious business.  Resigning in protest won't help.  Better stick around and clean up the mess you created by your own inattentiveness.



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