Hughes v. Hu

• Court: Court of Chancery of Delaware
• Decided: April 27, 2020
• Docket: C.A. No. 2019-0112-JTL
• Status: Published

Opinion

EFiled: Apr 27 2020 09:00AM EDT Transaction ID 65600595 Case No. 2019-0112-JTL IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE

WILLIAM HUGHES, JR., Derivatively ) on Behalf of Nominal Defendant KANDI ) TECHNOLOGIES GROUP, INC., ) ) Plaintiff, ) ) v. ) C.A. No. 2019-0112-JTL ) XIAOMING HU, XIAOYING ZHU, ) CHENG WANG, BING MEI, JERRY ) LEWIN, HENRY YU, LIMING CHEN, ) ) Defendants, ) ) and ) ) KANDI TECHNOLOGIES GROUP, ) INC., ) ) Nominal Defendant. )

MEMORANDUM OPINION

Date Submitted: February 6, 2020 Date Decided: April 27, 2020

Michael Van Gorder, FARUQI & FARUQI LLP, Wilmington, Delaware; Demet Basar, Veronica Bosco, WOLF HALDENSTEIN ADLER FREEMAN & HERZ LLP, New York, New York; Daniel B. Rehns, Kathryn A. Hettler, HACH ROSE SCHIRRIPA CHEVERIE LLP, New York, New York; Counsel for Plaintiff.

Stamatios Stamoulis, STAMOULIS & WEINBLATT, LLC, Wilmington, Delaware; Richard J.L. Lomuscio, RIKER, DANZIG, SCHERER, HYLAND & PERRETTI LLP, New York, New York; Counsel for Defendants Xioaming Hu, Xiaoying Zhu, Cheng Wang, Bing Mei, Jerry Lewin, Henry Yu, and Liming Chen.

LASTER, V.C. Kandi Technologies Group, Inc. (the “Company”) is a publicly traded Delaware

corporation based in China. The Company has struggled persistently with its financial

reporting and internal controls, encountering particular difficulties with related-party

transactions. The complaint describes problems dating back to 2010. In March 2014, the

Company publicly announced the existence of material weaknesses in its financial

reporting and oversight system, including a lack of oversight by the Audit Committee and

a lack of internal controls for related-party transactions. The Company pledged to

remediate these problems. Instead, in March 2017, the Company disclosed that its

preceding three years of financial statements needed to be restated. In connection with the

restatement, the Company disclosed that it lacked:

• Sufficient expertise relating to technical knowledge of US GAAP requirements and SEC disclosure regulations;

• Sufficient expertise to ensure the completeness of the disclosure of financial statements for equity investments;

• Sufficient expertise to ensure the proper disclosure of related-party transactions;

• Effective controls to ensure the proper classification and reporting of certain cash and non-cash activities related to accounts receivable, accounts payable, and notes payable; and

• Sufficient expertise to ensure the accuracy of the accounting and reporting of income taxes and related disclosures.

Despite having pledged three years earlier to get its house in order, the Company had none

of these necessary competencies.

The plaintiff is a stockholder in the Company. The plaintiff filed this suit on the

Company’s behalf to recover damages from (i) the three directors who comprised the Audit

1 Committee during the Company’s period of persistent problems, (ii) the Company’s CEO,

and (iii) the three CFOs who served in quick succession during the years leading up to the

March 2017 restatement. The plaintiff contends that the director defendants consciously

failed to establish a board-level system of oversight for the Company’s financial statements

and related-party transactions, choosing instead to rely blindly on management while

devoting patently inadequate time to the necessary tasks. The plaintiff contends that the

director defendants’ failures led to the March 2017 restatement, which caused the Company

harm. The plaintiff also contends that because the Company’s performance was inflated

during the pre-restatement period, the officer defendants received excessive compensation

and were unjustly enriched.

The defendants have moved to dismiss the complaint pursuant to Rule 23.1,

contending that the plaintiff failed to make a demand on the board or plead that demand

would have been futile. The plaintiff obtained books and records before filing suit. The

fruits of that investigation—and, just as important, what the Company conspicuously failed

to produce—have enabled the plaintiff to plead a complaint that supports a reasonable

pleading-stage inference of a bad faith failure of oversight by the named director

defendants. Four of the defendants comprise a majority of the board that would have

considered a demand, and the substantial threat of liability renders them incapable of

disinterestedly considering a demand. Demand would have been futile, so the Rule 23.1

motion is denied.

The defendants also have moved to dismiss the complaint pursuant to Rule 12(b)(6),

contending that the plaintiff failed to state a claim on which relief can be granted. Both

2 sides treated the analysis of the Rule 23.1 motion as dispositive of the Rule 12(b)(6)

motion. That motion is also denied.

I. FACTUAL BACKGROUND

The facts are drawn from the operative complaint and the documents it incorporates

by reference. At this stage of the proceedings, the complaint’s allegations are assumed to

be true, and the plaintiff receives the benefit of all reasonable inferences, including

inferences drawn from the documents.

The inferences that the plaintiff receives in this case are informed by the plaintiff’s

use of Section 220 of the Delaware General Corporation Law to obtain books and records.

In response to the plaintiff’s requests, the Company produced some documents and

stipulated that “any remaining materials requested by Plaintiff either do not exist or had

been withheld on privilege grounds.” Hughes v. Kandi Techs. Gp., Inc., C.A. No. 2017-

0700-JTL, Dkt. 24, Stipulation of Dismissal With Prejudice, at 2. Given this stipulation, if

the Company failed to produce a document that it would reasonably be expected to possess

if a particular event had occurred, then the plaintiff is entitled to a reasonable inference that

the event did not occur. See Morrison v. Berry, 191 A.3d 268, 275 n.20 (Del. 2018).

For example, the plaintiff asked the Company to produce minutes from board

meetings that took place between December 31, 2009, and May 10, 2017, at which specific

topics were discussed. See Compl. Ex. L, at 7. In response, the Company did not produce

any minutes evidencing any meetings addressing those topics until a meeting of the Audit

Committee on May 9, 2014. The plaintiff is entitled to the reasonable inference that no

earlier meetings took place at which those topics were addressed.

3 A. The Company, The Joint Venture, And The Service Company

The Company is a Delaware corporation based in Jinhua, China. The Company

accessed the United States capital markets in 2007 through a reverse merger with a defunct

but still publicly listed Delaware entity.

In March 2013, the Company entered into a joint venture with Geely Automobile

Holdings Ltd. (the “Joint Venture”). The complaint does not contain any allegations about

Geely, which is therefore inferred to be an unaffiliated third party. The Company sells parts

to the Joint Venture, which uses the parts to manufacture electric vehicles. The Company

and Geely each own 50% of the Joint Venture.

The Joint Venture sells the finished electric vehicles to Zhejiang ZuoZhongYou

Electric Vehicle Service Co., Ltd. (the “Service Company”), which sells and leases the

vehicles. The Company owns 9.5% of the Service Company.

Xiaoming Hu is the Company’s CEO and chairman of its board of directors. He

beneficially owns 28.4% of the Company. He also owns 13% of the Service Company.

The complaint alleges that the Joint Venture and Service Company were structured

to enable the Company to take advantage of subsidies that the Chinese government made

available to producers and purchasers of electric vehicles. Through its ownership in the

Joint Venture, the Company benefited from the subsidies provided to producers. Through

its ownership in the Service Company, the Company benefited from the subsidies provided

to purchasers. The complaint implies that by structuring its operations in this way, the

Company engaged in double-dipping that was contrary to how the Chinese government

intended the subsidies to function, but the complaint does not seek relief on the theory that

4 the double-dipping strategy was illegal. The complaint instead focuses on the Company’s

internal controls and accounting processes.

B. The 2010 Audit

In March 2011, AWC (CPA) Limited audited the Company’s financial statements

for the year ending December 31, 2010 (the “2010 Audit”). Although purportedly acting

as an independent, outside auditor, AWC had no clients other than the Company.

During the 2010 Audit, AWC identified “key audit risks” and “a key control

weakness” involving the Company’s treatment of related-party transactions. Compl. Ex. A

¶ 28. AWC determined that when recording transactions with Kandi USA, one of the

Company’s five largest customers, the Company had used a different name for Kandi USA.

When AWC asked the Company whether the counterparty was a related party, the

Company dodged the question, and AWC did not follow up. Kandi USA was a related

party; it was owned by Wangyuan Hu, the son of CEO Hu.

In March 2011, five days before the Company filed its Annual Report on Form 10-

K for the year ending December 31, 2010, CEO Hu suggested that AWC resolve the issue

raised by the Company’s sales to Kandi USA by booking them to a different customer’s

account. Despite evidence that Kandi USA actually purchased the goods, AWC complied.

AWC also eliminated any references to Kandi USA from its audit trail.

During the 2010 Audit, AWC also found that the Company had parked large

amounts of cash in the personal bank accounts of its officers and employees. AWC

discovered that one unidentified employee was holding $3 million of the Company’s

reported year-end cash balance in a personal account. AWC did not take steps determine

5 why this was so. Nor did AWC verify that the cash actually existed. AWC also did not

explore whether the parking of this cash constituted a related-party transaction that needed

to be disclosed in the Company’s financial statements. AWC merely reported the

transaction to the Audit Committee as “evidence of a key internal control weakness.”

Compl. Ex. A ¶ 24.

AWC later discovered that the same unidentified individual was holding an

additional $2.5 million of the Company’s reported year-end cash balance in a different

bank account. AWC again did not take steps determine why this was so. AWC also did not

explore whether the parking of this cash constituted a related-party transaction that needed

to be disclosed in the Company’s financial statements. Unlike with the $3 million in parked

cash, AWC did not report this additional $2.5 million to the Audit Committee.

Most strikingly, AWC discovered that CEO Hu held another $1.6 million of the

Company’s reported year-end cash balance in a personal account. AWC did not take steps

determine why this was so. Nor did AWC explore whether this was a related-party

transaction that needed to be disclosed in the Company’s financial statements. As with the

additional $2.5 million of parked cash held by the unidentified employee, AWC did not

report CEO Hu’s holding of cash to the Audit Committee.

C. The 2011 Audit

In March 2012, AWC audited the Company’s financial statements for the year

ending December 31, 2011 (the “2011 Audit”). AWC identified “the collectability of notes

receivable as a key audit risk.” Compl. Ex. A ¶ 38. During the audit, AWC discovered that

a single note constituted $33.1 million of the Company’s $37.9 million notes receivable

6 balance. The borrower had not made any interest payments on the note in 2011. Despite

these warning signs, AWC did not evaluate the creditworthiness of the borrower or raise

concerns about the collectability of the note.

D. The 2012 Audit

In March 2013, AWC audited the Company’s financial statements for the year

ending December 31, 2012 (the “2012 Audit”). As with the 2010 Audit, AWC identified

related-party transactions as a key risk. During the audit, AWC discovered transactions

between the Company and Kandi USA. As in 2010, the related-party transactions did not

identify Kandi USA by name. This time, the entries referred to Kandi USA as Eliteway

Management (“Eliteway”), which was later revealed to be a trade name for Kandi USA.

The transactions were material, but AWC did not scrutinize them, nor did AWC identify

them as related-party transactions requiring disclosure.

E. The 2013 10-K

On March 17, 2014, the Company filed its Annual Report on Form 10-K for the

year ending December 31, 2013 (the “2013 10-K”). The Company disclosed that its

“disclosure controls and procedures were not effective as of December 31, 2013, due to a

material weakness.” Compl. ¶ 112.

The 2013 10-K identified multiple factors that contributed to this ostensibly singular

weakness. First, the head of the Company’s internal audit department reported to CEO Hu

rather than to the Audit Committee, which “impaired the independence and objectivity of

the internal control audit department.” Id. Second, there was a lack of communication

between the Company’s internal audit department and the Audit Committee. Third, the

7 Company did not evaluate the effectiveness of the Audit Committee on a yearly basis. The

2013 10-K also disclosed that the Company did not have adequate internal controls for

related-party transactions.

The 2013 10-K described the Company’s efforts to remediate its deficiencies. First,

the Company had changed its reporting structure so that the head of the internal audit

department reported to the Audit Committee. Second, the Company committed to revising

its Audit Committee’s charter to ensure that “regular and frequent reporting on the internal

audit related matters to the Audit Committee is carried out by the head of internal audit

department.” Id. ¶ 115. Third, the Company resolved to evaluate the effectiveness of the

Audit Committee on a yearly basis. The Company also pledged that all of its related-party

transactions would be subject to review by the Audit Committee.

F. The Audit Committee’s Actions In 2014

On May 9, 2014, two months after the filing of the 2013 10-K, the Audit Committee

met. The members of the Audit Committee at the time were Henry Yu, Liming Chen, and

Jerry Lewin. Yu had been a member of the Audit Committee since July 2011 and served

as Chair of the committee throughout that time. Chen had been a member of the Audit

Committee since May 2012. Lewin had been a member of the Audit Committee since

November 2010. The Company’s Chief Financial Officer at the time, Xiaoying Zhu, also

attended the meeting. So did two representatives of AWC: Albert Wong and Martin Wong.

The Audit Committee spent forty-five minutes discussing “matters relating to

relationship transaction[s].” Compl. Ex. G, at 1. During the meeting, the committee

members reviewed a document titled “sales contract entered into with Eliteway.” Id. at 2.

8 Yu stated that he would deliver agreements related to this “relationship transaction” to the

Audit Committee after the meeting. The Company did not produce any related-party

agreements in response to the plaintiff’s inspection demand. It is reasonable to infer that

the Audit Committee did not receive or review the agreements.

The Audit Committee also purportedly reviewed a document titled “Approval

Procedures of Relationship Transaction.” Id. The Company failed to produce this document

in response to the plaintiff’s inspection demand. It is reasonable to infer that the Audit

Committee did not receive or review this document.

On May 30, 2014, three weeks later, the Audit Committee met again. Lewin, Yu,

and Chen attended as members of the committee. So did Chenming Sun, the head of the

Company’s internal audit department.

This time, the meeting lasted for forty minutes. The Audit Committee purportedly

reviewed and approved a new “Internal Audit Activity Charter” and a new “Management

Policy on Related-Party Transactions.” Compl. ¶ 118; Compl. Ex. H. The Company did

not produce either of these documents in response to the plaintiff’s inspection demand. For

the “Management Policy on Related-party Transactions,” the absence of the document

from the production supports an inference that it did not exist. The same inference could

be drawn for the Audit Committee Charter, but it was publicly available at the time the

complaint was filed.

The Audit Committee Charter specified that the Audit Committee’s responsibilities

included the following:

9 • Reviewing the financial reports and other financial related information released by the Company to the public, or in certain circumstances, governmental bodies;

• Reviewing the Company’s system of disclosure controls and procedures, internal controls over financial reporting, and compliance with ethical standards adopted by the Company;

• Reviewing the Company’s accounting and financial reporting processes and the audits of the financial statements of the Company;

• Reviewing and appraising with management the performance of the Company’s independent auditors;

• Providing an open avenue of communication between the independent auditors, financial and senior management, the internal audit function, and the board of directors; and

• Overseeing the registered public accounting firm’s (independent auditor’s) qualifications and independence.

Compl. ¶ 196.

In July 2014, Yu met with management, the Company’s internal audit team, and

AWC to “review the progress of implementation of the remediation measures and

spearhead[] a comprehensive remediation plan to fully address the deficiencies in [the

Company’s] internal controls.” Id. ¶ 118. After continuing its remedial efforts, the

Company determined that its internal controls were effective as of September 30, 2014.

Compare id. ¶ 116 (quoting the Company’s May 2014 disclosure that its “disclosure

controls and procedures were not effective”), and id. ¶ 118 (quoting the Company’s August

2014 disclosure that its “disclosure controls and procedures were not effective”), with id.

¶ 120 (quoting the Company’s November 2014 disclosure that its “disclosures and controls

were effective [as of September 30, 2014]”).

10 G. The Audit Committee’s Actions In 2015

After the Audit Committee’s meetings in May 2014, the committee did not meet

again until March 13, 2015. The catalyst for the March 2015 meeting appears to have been

the need to review, discuss, and approve the Company’s Annual Report on Form 10-K for

the year ending December 31, 2014 (the “2014 10-K”). The Audit Committee members

were still Yu, Chen, and Lewin. CFO Zhu also attended the meeting, as did Sun, the head

of the internal controls department. Martin Wong attended for AWC.

The meeting lasted fifty minutes. CFO Zhu summarized the Company’s year-end

financial results, and this discussion appears to have taken up most of the meeting. See

Compl. Ex. I. At the end of the meeting, the Audit Committee approved a “Policy of

Related-party Transaction Relating to JV Shareholder.” Id. at 4. Management had prepared

the policy, which authorized management to “conduct business activities with [the] JV.”

Id. It is reasonable to infer at the pleading stage that the policy did not place meaningful

restrictions on management. It is also reasonable to infer that with the Audit Committee

having not met for almost a year, there was no possible way that the Audit Committee

could have fulfilled all of the responsibilities it was given under the Audit Committee

Charter during a fifty-minute meeting.

On March 15, 2015, the Company filed the 2014 10-K. The Company described its

disclosure controls and procedures as “effective.” Compl. ¶ 124.

Three weeks later, on April 7, 2015, the Company’s board of directors acted by

unanimous written consent to adopt a series of resolutions. One resolution determined that

Yu, Chen, and Lewin, plus then-director Ni Guangzheng, qualified as independent

11 directors under the NASDAQ listing standards. Another resolution determined that Yu and

Lewin qualified as Audit Committee Financial Experts. Yet another resolution determined

that it was in the best interests of the Company to maintain AWC as the Company’s

independent auditor for the fiscal year ending December 31, 2015. These were

determinations that should have been made before the filing of the 2014 10-K. The Audit

Committee’s failure to address these issues during its March 2015 meeting reinforces the

inference that there was no possible way that the Audit Committee could have fulfilled all

of the responsibilities it was given under the Audit Committee Charter by meeting for just

fifty minutes after not meeting during the preceding ten months.

Two weeks after the execution of this written consent, CFO Zhu resigned from her

position as CFO, effective April 30, 2015. Cheng Wang took over as the Company’s Chief

Financial Officer.

H. The Audit Committee’s Actions In 2016

The Audit Committee did not meet again until March 7, 2016, approximately one

year later. The catalyst again appears to have been the need to approve the Company’s

Annual Report on Form 10-K for the year ending December 31, 2015 (the “2015 10-K”).

The members of the Audit Committee were still Yu, Chen, and Lewin. CFO Wang also

attended the meeting, as did Sun, the head of the internal audit department. Lai Wingwai

attended as a representative of AWC.

The meeting lasted for thirty minutes. CFO Wang summarized the Company’s year-

end financial results. CFO Wang then described related-party transactions that took place

in 2015. Management identified two related parties: Kandi USA and the Service Company.

12 Management represented that the Company had not engaged in any related-party

transactions with Kandi USA during 2015. Management reported that the Company had

engaged in related-party transactions with the Service Company, describing the

transactions as mainly involving “battery sales.” Compl. Exs. C, J, at 2. It is reasonable to

infer that with the Audit Committee having not met for a year, there was no possible way

that the Audit Committee could have fulfilled all of the responsibilities it was given under

the Audit Committee Charter during a thirty-minute meeting.

On March 14, 2016, filed the 2015 10-K. The Company described its disclosure

controls and procedures as “effective.” Compl. ¶ 143.

As it had one year previously, the Audit Committee acted just weeks later to address

issues that should have been addressed before the filing of the 2015 10-K. On March 22,

2016, the Audit Committee acted by unanimous written consent to ratify a very different

description of the related-party transactions between the Company and the Service

Company. In the consent, the Audit Committee signed off on related-party transactions

with the Service Company totaling $42,032,060. Management represented that the

consideration for the transactions was “based on fair market price.” Compl. Ex. K, at 1. In

the same written consent, the Audit Committee authorized management to engage in

related-party transactions with the Service Company during the remainder of 2016. The

Audit Committee’s failure to address these issues during its March 2016 meeting reinforces

the inference that there was no possible way that the Audit Committee could have fulfilled

all of the responsibilities it was given under the Audit Committee Charter by meeting for

just thirty minutes after not meeting for a year.

13 I. The Company Replaces AWC.

During a meeting on April 12, 2016, the Company’s board of directors resolved to

terminate AWC as the Company’s auditor, effective immediately. The seven members of

the board at the time were the three members of the Audit Committee—Yu, Chen, and

Lewin—plus CEO Hu, CFO Wang, Guangzheng, and Qian Jiansong. According to the

minutes, the board retained BDO China Shu Lun Pan CPAs as the Company’s new auditor,

effective immediately.

A separate document indicates that the Audit Committee acted by unanimous

written consent that same day to replace AWC with BDO China. The Audit Committee

consent attributed the change to a determination by “management of the Company” that it

was “in the best interest of the Company to change its independent auditors.” Compl. Ex.

B, at 1.

On May 18, 2016, one month after the Company parted ways with AWC, the Public

Company Accounting Oversight Board issued an order instituting disciplinary proceedings

against AWC, making findings about AWC’s conduct, and imposing sanctions on the firm

(the “PCAOB Order”). Compl. Ex. A. The sanctions addressed AWC’s handling of the

2010, 2011, and 2012 Audits and imposed monetary penalties on AWC and its principals.

After the issuance of the PCAOB Order, NASDAQ asked the Company to verify its

cash balances. CFO Wang arranged for an audit of the Company’s cash balances, and BDO

China began the audit on July 11, 2016. Lewin later asked if the audit generated any adverse

findings. BDO China reported none.

14 J. The August 2016 Audit Committee Meeting

On August 1, 2016, the Audit Committee convened to review the Company’s

Quarterly Report on Form 10-Q for the quarter ending June 30, 2016. The members of the

Audit Committee continued to be Yu, Chen, and Lewin. CFO Wang also attended, as did

Sun, the head of the internal audit department. Liu Yi and Mou Xun attended as

representatives of BDO China.

The meeting lasted for one hour. CFO Wang summarized the Company’s quarterly

financial results. The Audit Committee discussed the results of BDO China’s audit of the

Company’s cash balances. CFO Wang then reported on the Company’s related-party

transactions for the six months ending June 30, 2016. According to CFO Wang, sales to

the Service Company totaled nearly $4 million, while receivables from the Service

Company totaled nearly $11 million. Management did not identify any other related-party

transactions.

During the meeting, the Audit Committee also discussed a decision by the Chinese

government to delay its subsidy payments to the Joint Venture, which affected the

Company’s outlook for the remainder of the year. Lewin suggested that the Company

should consider alternatives to mitigate its reliance on the subsidies that the Chinese

government was providing to producers and purchasers of electric vehicles.

In September 2016, the Chinese government decided to phase out the subsidies. This

decision followed a months-long investigation into the Company and other Chinese

manufacturers who appeared to have structured their operations to take advantage of

subsidies as both producers and purchasers of vehicles.

15 K. The November 2016 Disclosures

On November 2, 2016, the Company disclosed for the first time that it had engaged

in material transactions in 2012 with Kandi USA using its trade name, Eliteway. The

Company also disclosed that it had engaged in material transactions in 2013 and 2014 with

Kandi USA, again using the trade name Eliteway. The total amount of the transactions was

identified as $9,888,751. The Company claimed that all of the transactions had been at

arm’s length.

The Company also disclosed additional related-party transactions with the Service

Company, resulting in additional receivables due from the Service Company. As of

December 31, 2014, the receivables totaled over $40 million. As of December 31, 2016,

the receivables totaled $10.4 million.

The Company’s failure to disclose these transactions earlier reinforces the inference

that the Audit Committee was not carrying out the duties it was given under the Audit

Committee Charter. On November 14, 2016, two weeks after these disclosures, CFO Wang

resigned from the position of Chief Financial Officer and became the Company’s Chief

Strategy Officer. Bing Mei took over as the Company’s Chief Financial Officer.

L. The March 2017 Announcement

On March 16, 2017, the Company announced that its financial statements from 2014

through the third quarter of 2016 could not be relied upon and needed to be restated (the

“March 2017 Announcement”). As part of the restatement, the Company committed to

provide separate audited financial statements for the Company’s equity investment in the

Joint Venture. The restated financials would include:

16 • Corrections to the classification of notes receivable and notes payable in the Company’s statements of cash flow;

• Revisions in the Company’s financial statement presentation to separately identify certain related-party accounts;

• Amendments to financial statement footnotes discussing the Company’s tax situation;

• Adjustments of previously recorded “construction-in-progress;”

• Expansions of two tables of sales to and purchases from the Joint Venture; and

• The removal of “unaudited” labels from certain tables in footnotes discussing the Company’s tax situation.

Compl. ¶ 163. In addition, the Company announced that it was “reassessing its internal

controls over its financial reporting and compliance programs.” Id.

Shortly after the March 2017 Announcement, the Company filed its Annual Report

on Form 10-K for the year ending December 31, 2016 (the “2016 10-K”). The 2016 10-K

disclosed that the Company lacked:

• Sufficient expertise relating to technical knowledge of US GAAP requirements and SEC disclosure regulations;

• Sufficient expertise to ensure the completeness of the disclosure of financial statements for equity investments;

• Sufficient expertise to ensure the proper disclosure of related-party transactions;

• Effective controls to ensure the proper classification and reporting of certain cash and non-cash activities related to accounts receivable, accounts payable, and notes payable; and

• Sufficient expertise to ensure the accuracy of the accounting and reporting of income taxes and related disclosures.

17 M. The Federal Litigation

After the March 2017 Announcement, various stockholders filed four securities

class actions and one derivative lawsuit in the United States District Court for the Southern

District of New York. The federal court consolidated the securities actions.

On September 30, 2019, while this lawsuit was pending, the federal court granted

the defendants’ motion to dismiss the securities actions. In its decision, the court held that

the plaintiffs had not pled facts with sufficient particularity to support a strong inference of

scienter, as required by the federal securities laws and their implementing regulations. See

In re Kandi Techs. Gp., Inc. Sec. Litig., 2019 WL 4918649, at *3–6 (S.D.N.Y. Oct. 4,

2019). In reaching these conclusions, the district court noted that “the fact that [the

Company’s] restatements had no impact on [the Company’s] corporate income severely

undercuts an inference of fraud.” Id. at *8.

N. The Plaintiff’s Investigation

On May 10, 2017, the plaintiff sought to inspect books and records of the Company

pursuant to Section 220. See Compl. Ex. L. After the Company’s board of directors

declined to respond, the plaintiff filed an action in this court. For nearly a year, the plaintiff

and the Company engaged in protracted negotiations. After guidance from this court, the

Company produced documents responsive to the plaintiff’s demand. The parties stipulated

to the dismissal of the Section 220 Action on September 28, 2018.

On February 14, 2019, the plaintiff filed this plenary action. The lengthy complaint

spans 116 pages and contains 306 numbered paragraphs. It names as defendants the

18 members of the Audit Committee (Yu, Chen, and Lewin), CEO Hu, and the Company’s

three successive CFOs (Zhu, Wang, and Mei).

In Count I, the complaint asserts that the defendants “individually and collectively,

breached their fiduciary duties by willfully failing to maintain an adequate system of

oversight, disclosure controls and procedures, and internal controls over financial

reporting.” Compl. ¶ 293. The complaint alleges that as a result of the defendants’ breaches

of duty, the Company suffered harm. Id. ¶ 300.

In Count II, the complaint asserts a claim for unjust enrichment. The Complaint

alleges that the defendants “either benefitted financially” from the conduct described in the

Complaint or benefitted indirectly from “unjustly lucrative bonuses tied to the false and

misleading statements, or received bonuses, stock options, or similar compensation from

[the Company] that was tied to the performance or artificially inflated valuation of [the

Company], or received compensation that was unjust in light of Defendants’ bad faith

conduct.” Id. ¶ 304.

II. LEGAL ANALYSIS

The defendants have moved to dismiss the complaint pursuant to Court of Chancery

Rule 23.1 on the grounds that the plaintiff did not make demand on the board and failed to

plead that demand would have been futile. The defendants have also moved to dismiss

pursuant to Court of Chancery Rule 12(b)(6) on the grounds that the complaint failed to

state a claim upon which relief can be granted. Both motions are denied.

19 A. Rule 23.1

When a corporation suffers harm, the board of directors is the institutional actor

legally empowered under Delaware law to determine what, if any, remedial action the

corporation should take, including pursuing litigation against the individuals involved. See

8 Del. C. § 141(a). “A cardinal precept of the General Corporation Law of the State of

Delaware is that directors, rather than shareholders, manage the business and affairs of the

corporation.” Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984).1 “Directors of Delaware

corporations derive their managerial decision making power, which encompasses decisions

whether to initiate, or refrain from entering, litigation, from 8 Del. C. § 141(a).” Zapata

Corp. v. Maldonado, 430 A.2d 779, 782 (Del. 1981) (footnote omitted). Section 141(a)

vests statutory authority in the board of directors to determine what action the corporation

will take with its litigation assets, just as with other corporate assets. See id.

1 In Brehm v. Eisner, 746 A.2d 244, 253–54 (Del. 2000), the Delaware Supreme Court overruled seven precedents, including Aronson, to the extent they reviewed a Rule 23.1 decision by the Court of Chancery under an abuse of discretion standard or otherwise suggested deferential appellate review. Id. at 253 n.13 (overruling in part on this issue Scattered Corp. v. Chi. Stock Exch., 701 A.2d 70, 72–73 (Del. 1997); Grimes v. Donald, 673 A.2d 1207, 1217 n.15 (Del. 1996); Heineman v. Datapoint Corp., 611 A.2d 950, 952 (Del. 1992); Levine v. Smith, 591 A.2d 194, 207 (Del. 1991); Grobow v. Perot, 539 A.2d 180, 186 (Del. 1988); Pogostin v. Rice, 480 A.2d 619, 624–25 (Del. 1984); and Aronson, 473 A.2d at 814). The Brehm Court held that going forward, appellate review of a Rule 23.1 determination would be de novo and plenary. Brehm, 746 A.2d at 254. The seven partially overruled precedents otherwise remain good law. This decision does not rely on any of them for the standard of appellate review. Having described Brehm’s relationship to these cases, this decision omits the cumbersome subsequent history, because stating that they were overruled by Brehm creates the misimpression that Brehm rejected a series of foundational Delaware decisions.

20 In a derivative suit, a stockholder seeks to displace the board’s authority over a

litigation asset and assert the corporation’s claim. Aronson, 473 A.2d at 811. Because

directors are empowered to manage, or direct the management of, the business and affairs

of the corporation, the right of a stockholder to prosecute a derivative suit is limited to

situations where (i) the stockholder has demanded that the directors pursue the corporate

claim and they have wrongfully refused to do so or (ii) demand is excused because the

directors are incapable of making an impartial decision regarding the litigation. Rales v.

Blasband, 634 A.2d 927, 932 (Del. 1993).

The plaintiff in this case chose not to make demand. Consequently, for the plaintiff

to be able to move forward on behalf of the Company, the complaint must “allege with

particularity . . . the reasons . . . for not making the effort [to make a litigation demand],”

Ct. Ch. R. 23.1, and this court must determine based on those allegations that “demand is

excused because the directors are incapable of making an impartial decision regarding

whether to institute such litigation.” Stone v. Ritter, 911 A.2d 362, 367 (Del. 2006).

Stockholders choosing this route “must comply with stringent requirements of factual

particularity that differ substantially from . . . permissive notice pleadings.” Brehm, 746

A.2d at 254. Under the heightened pleading requirements of Rule 23.1, “conclusionary

[sic] allegations of fact or law not supported by the allegations of specific fact may not be

taken as true.” Grobow, 539 A.2d at 187. But once a plaintiff pleads particularized

allegations, then the plaintiff is entitled to all “reasonable inferences [that] logically flow

from particularized facts alleged by the plaintiff.” Beam ex rel. Martha Stewart Living

Omnimedia, Inc. v. Stewart, 845 A.2d 1040, 1048 (Del. 2004). While Rule 23.1 requires

21 that a plaintiff allege specific facts, “he need not plead evidence.” Aronson, 473 A.2d at

816; accord Brehm, 746 A.2d at 254.

At the time the complaint was filed, the Company’s board comprised CEO Hu,

Lewin, Yu, Chen, and non-parties Feng Zhu and Yi Lin (the “Demand Board”). The

operative question for demand futility is whether the Demand Board had a majority of

disinterested and independent directors who could properly consider a demand to bring

litigation. Demand is futile if there is a reasonable basis to doubt whether at least three of

the six directors could exercise independent judgment when deciding whether to bring the

litigation.

1. Demand Futility Analysis

The Delaware Supreme Court has established two tests for determining whether the

allegations of a complaint sufficiently plead demand futility. Wood v. Baum, 953 A.2d 136,

140 (Del. 2008) (“Two tests are available to determine whether demand is futile.”). In

Aronson, the seminal demand-futility decision, the Delaware Supreme Court considered a

scenario where a plaintiff challenged a transaction that had been approved by the same

directors who would consider a demand. The central legal question was therefore whether

the complaint’s allegations about the directors’ involvement in the decision to approve the

challenged transaction rendered them incapable of making an impartial decision regarding

whether to institute litigation concerning the transaction. The high court rejected the

possibility that “any board approval of a challenged transaction automatically connotes

‘hostile interest’ and ‘guilty participation’ by directors, or some other form of sterilizing

influence upon them,” explaining that “[w]ere that so, the demand requirements of our law

22 would be meaningless, leaving the clear mandate of Chancery Rule 23.1 devoid of its

purpose and substance.” Aronson, 473 A.2d at 814.

The Delaware Supreme Court held instead that when considering demand futility in

this scenario, the trial court “must decide whether, under the particularized facts alleged, a

reasonable doubt is created that: (1) the directors are disinterested and independent and (2)

the challenged transaction was otherwise the product of a valid exercise of business

judgment.” Id. The first of the two inquiries examines “the independence and

disinterestedness of the directors” with respect to the transaction being challenged. Id.

“Certainly, if this is an ‘interested’ director transaction, such that the business judgment

rule is inapplicable to the board majority approving the transaction, then the inquiry

ceases.” Id. at 815. Under those circumstances, the defendant directors face sufficient risk

from a lawsuit challenging the transaction they approved for demand to be futile. By

contrast, if a disinterested and independent board majority had approved the underlying

transaction, then the business judgment rule presumptively would apply, protecting the

directors and their decision.

The Aronson inquiry did not stop there, because the Delaware Supreme Court

anticipated that there could be situations where a disinterested and independent majority

made the decision, and yet the business judgment rule did not apply. See id. at 812–13. The

Delaware Supreme Court therefore instructed the trial court to conduct a second inquiry by

examining whether the plaintiff “ha[d] alleged facts with particularity which, taken as true,

support a reasonable doubt that the challenged transaction was the product of a valid

exercise of business judgment.” Id. at 815. If the business judgment rule protected the

23 underlying transaction, then demand would not be futile, and the Rule 23.1 motion would

be granted. Id. at 812. If a reasonable doubt existed that business judgment rule protected

the underlying transaction, then the directors could face a sufficient threat of liability from

the litigation that demand would be futile. As the Delaware Supreme Court explained, “the

mere threat of personal liability for approving a questioned transaction, standing alone, is

insufficient to challenge either the independence or disinterestedness of directors, although

in rare cases a transaction may be so egregious on its face that board approval cannot meet

the test of business judgment, and a substantial likelihood of director liability therefore

exists.” Id. at 815.

Because the Aronson test addressed a situation where the same board that would

consider a demand had made the decision being challenged in the derivative suit, it did not

translate easily to other situations, such as cases where the board had not acted or where

the board’s membership had changed. In Rales, the Delaware Supreme Court confronted a

board whose members had not participated in the underlying decision challenged by the

derivative action, and therefore “the test enunciated in [Aronson] . . . [was] not

implicated.” 634 A.2d at 930. In response, the Delaware Supreme Court framed a second

and more comprehensive demand futility standard that asked “whether or not the

particularized factual allegations of a derivative stockholder complaint create a reasonable

doubt that, as of the time the complaint is filed, the board of directors could have properly

exercised its independent and disinterested business judgment in responding to a

demand.” Id. at 934.

24 The Rales court explained that the decision to respond to a litigation demand

involves a two-step process. “First, the directors must determine the best method to inform

themselves of the facts relating to the alleged wrongdoing . . . .” Id. at 935. “If a factual

investigation is required, it must be conducted reasonably and in good faith.” Id. (footnote

omitted). “Second, the board must weigh the alternatives available to it, including the

advisability of implementing internal corrective action and commencing legal

proceedings.” Id. “In carrying out these tasks, the board must be able to act free of personal

financial interest and improper extraneous influences.” Id.

Under Rales, a director cannot exercise independent and disinterested business

judgment regarding a litigation demand, free of personal financial interest and improper

extraneous influences, if the director is either interested in the alleged wrongdoing or not

independent of someone who is. In order to create a reasonable doubt that a director is

disinterested, a derivative plaintiff must plead particularized facts to demonstrate that a

director “will receive a personal financial benefit from a transaction that is not equally

shared by the stockholders” or, conversely, that “a corporate decision will have a materially

detrimental impact on a director, but not on the corporation and the stockholders.” Id. at

936 (citations omitted). In this latter situation, “a director cannot be expected to exercise

his or her independent business judgment without being influenced by the adverse personal

consequences resulting from the decision.” Id. In order to create a reasonable doubt that a

director is independent, “a plaintiff can plead facts showing a director is sufficiently loyal

to, beholden to, or otherwise influenced by an interested party to undermine the director’s

25 ability to judge the matter on its merits.” Frederick Hsu Living Tr. v. ODN Hldg. Corp.,

2017 WL 1437308, at *26 (Del. Ch. Apr. 14, 2017).

A decision to implement internal corrective action or institute litigation could have

a materially detrimental impact on a director. As under Aronson, “the mere threat of

personal liability . . . , standing alone, is insufficient.” Rales, 634 A.2d at 936 (quoting

Aronson, 473 A.2d at 815). A disqualifying interest exists when “the potential for liability

is not ‘a mere threat’ but instead may rise to a ‘substantial likelihood.’” Id. (citing Aronson,

473 A.2d at 815). To plead that a director faces a substantial risk of liability, a plaintiff

does not have to demonstrate a reasonable probability of success on the claim. In Rales,

the Delaware Supreme Court rejected such a requirement as “unduly onerous.” Id. at 935.

The plaintiffs need only “make a threshold showing, through the allegation of

particularized facts, that their claims have some merit.” Id. at 934 (citing Aronson, 473

A.2d at 811–12). This standard recognizes that the purpose of the particularity requirement

is not to prevent derivative actions from going forward, but rather “to ensure only

derivative actions supported by a reasonable factual basis proceed.” In re Dow Chem. Co.

Deriv. Litig., 2010 WL 66769, at *6 (Del. Ch. Jan. 11, 2010).

The Delaware Supreme Court envisioned that the Rales test would be used

in three principal scenarios: (1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced; (2) where the subject of the derivative suit is not a business decision of the board; and (3) where . . . the decision being challenged was made by the board of a different corporation.

Rales, 634 A.2d at 934 (footnotes omitted). Conceptually, however, the Rales test

supersedes and encompasses the Aronson test, making the Aronson test a special

26 application of Rales.2 The Aronson and Rales tests both ultimately focus on the same

inquiry, i.e., whether “the derivative plaintiff has shown some reason to doubt that the

board will exercise its discretion impartially and in good faith.” In re INFOUSA, Inc.

S’holders Litig., 953 A.2d 963, 986 (Del. Ch. 2007). The Rales test asks the question

generally. As part of that general inquiry, it considers whether a director could be interested

in the outcome of a demand because the director would face a substantial risk of liability

if litigation were pursued. The Aronson test examines one specific type of litigation that

could trigger the latter concern: whether the directors face a substantial threat of liability

from litigation challenging a transaction that they themselves approved.

2 See Buckley Family Tr. v. McCleary, 2020 WL 1522549, at *9 (Del. Ch. Mar. 31, 2020) (“This court has commented on many occasions that the Aronson and Rales tests look different but they essentially cover the same ground.”); Park Empls.’ & Ret. Bd. Empls.’ Annuity & Benefit Fund of Chicago v. Smith, 2017 WL 1382597, at *5 (Del. Ch. Apr. 18, 2017) (“The analyses in both Rales and Aronson drive at the same point; they seek to assess whether the individual directors of the board are capable of exercising their business judgment on behalf of the corporation.”); In re Wal-Mart Stores, Inc. Del. Deriv. Litig., 2016 WL 2908344, at *11 (Del. Ch. May 13, 2016) (“[T]he Rales test encompasses all relevant aspects of the Aronson test.”); Teamsters Union 25 Health Servs. & Ins. Plan v. Baiera, 119 A.3d 44, 57 n.131 (Del. Ch. 2015) (“[O]ur jurisprudence would benefit . . . from the adoption of a singular test to address the question of demand futility.”); David B. Shaev Profit Sharing Account v. Armstrong, 2006 WL 391931, at *4 (Del. Ch. Feb. 13, 2006) (“[T]he Rales test, in reality, folds the two-pronged Aronson test into one broader examination”), aff’d, 911 A.2d 802 (Del. 2006) (TABLE); Guttman v. Huang, 823 A.2d 492, 501 (Del. Ch. 2003) (“At first blush, the Rales test looks somewhat different from Aronson, in that [it] involves a singular inquiry . . . . Upon closer examination, however, that singular inquiry makes germane all of the concerns relevant to both the first and second prongs of Aronson.”); Donald J. Wolfe, Jr. & Michael A. Pittenger, Corporate and Commercial Practice in the Delaware Court of Chancery § 11.03(c)(4)(ii), at 11-113 (2019) (“From this perspective, one might argue that the current state of this area of the law is conceptually inverted; i.e., that it would be both simpler and more direct to regard the original Aronson analysis as a subpart of the more generally applicable and consistently relevant test set forth in Rales. Indeed, recent decisional law seems to be trending incrementally toward a recognition of and preference for the more efficient utility of the Rales analysis.”).

27 This case illustrates how Rales and Aronson overlap. The fundamental question

presented by the defendants’ Rule 23.1 motion is whether the Demand Board could have

validly considered a litigation demand. See Ct. Ch. R. 23.1. The complaint challenges the

Company’s handling of its financial statements over multiple years, during which time four

members of the Demand Board served on the Company’s board. Three of them were

members of the Audit Committee who made a series of decisions during this time period,

including decisions to approve the Company’s financial statements for purposes of its

Form 10-Ks, determinations regarding the adequacy of the Company’s internal controls,

determinations regarding director independence and financial expertise, and decisions

regarding related-party transactions. Technically, because less than “a majority of the

directors making the decision have been replaced,” Rales, 634 A.2d at 934, Aronson would

govern.

The complaint is not framed, however, as an Aronson-style lawsuit that challenges

a specific transaction or a particular decision. The complaint instead alleges that there were

persistent problems with the Company’s system of financial oversight over a prolonged

period, leading ultimately to the Company suffering harm. The core theory is a duty of

oversight claim. See In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996).

A Caremark claim is conceptualized as flowing from an overarching failure by the

28 directors to take the action necessary to protect the corporation, so the more generalized

Rales standard is routinely applied.3

This decision applies Rales to evaluate demand futility for purposes of the

Caremark claim. When doing so, this decision gives weight to the fact that Lewin, Yu,

Chen, and CEO Hu were key corporate decision-makers during the multi-year timeline that

ultimately led to the oversight problems at the Company.

2. Count I

Count I asserts that the defendants “breached their fiduciary duties by willfully

failing to maintain an adequate system of oversight, disclosure controls and procedures,

and internal controls over financial reporting.” Compl. ¶ 293. “The board of a Delaware

corporation has a fiduciary obligation to adopt internal information and reporting systems

that are ‘reasonably designed to provide to senior management and to the board itself

timely, accurate information sufficient to allow management and the board, each within its

scope, to reach informed judgments concerning both the corporation’s compliance with

3 See, e.g., City of Birmingham Ret. & Relief Sys. v. Good, 177 A.3d 47, 55 (Del. 2017) (“For alleged violations of the board’s oversight duties under Caremark, the test articulated in Rales v. Blasband applies to assess demand futility.”); Wood, 953 A.2d at 140 (“The [Rales] test applies where the subject of a derivative suit is not a business decision of the Board but rather a violation of the Board’s oversight duties.”); In re LendingClub Corp. Deriv. Litig., 2019 WL 5678578, at *7 (applying the Rales test for demand futility to director oversight claims); Horman v. Abney, 2017 WL 242571, at *6 (Del. Ch. Jan. 19, 2017) (same); Reiter ex rel. Capital One Fin. Corp. v. Fairbank, 2016 WL 6081823, at 6* (Del. Ch. Oct. 18, 2016) (same); Melbourne Mun. Firefighter’s Pension Tr. Fund v. Jacobs, 2016 WL 4076369, at *6 (Del. Ch. Aug. 1, 2016) (same); South v. Baker, 62 A.3d 1, 14 (Del. Ch. 2012) (same); In re Goldman Sachs Gp., Inc. S’holder Litig., 2011 WL 4826104, at *7 (Del. Ch. Oct. 12, 2011) (same); In re Dow Chem. Co. Deriv. Litig., 2010 WL 66769, at *12 (Del. Ch. Jan. 11, 2010) (same); Desimone v. Barrows, 924 A.2d 908, 927–28 (Del. Ch. 2007) (same).

29 law and its business performance.’” In re China Agritech, Inc. S’holder Deriv. Litig., 2013

WL 2181514, at *18 (Del. Ch. May 21, 2013) (quoting Caremark, 698 A.2d at 970).

“Failing to make that good faith effort breaches the duty of loyalty and can expose a

director to liability.” Marchand v. Barnhill, 212 A.3d 805, 820 (Del. 2019).

Directors face a substantial threat of liability under Caremark if “(a) the directors

utterly failed to implement any reporting or information system or controls; or (b) having

implemented such a system or controls, consciously failed to monitor or oversee its

operations thus disabling themselves from being informed of risks or problems requiring

their attention.” Stone, 911 A.2d at 370. For both potential sources, “a showing of bad faith

conduct . . . is essential to establish director oversight liability.” Id. A plaintiff establishes

bad faith by “showing that the directors knew that they were not discharging their fiduciary

obligations.” Id. “Generally where a claim of directorial liability for corporate loss is

predicated upon ignorance of liability creating activities within the corporation . . . only a

sustained or systemic failure of the board to exercise oversight . . . will establish the lack

of good faith that is a necessary condition to liability.” Caremark, 698 A.2d at 971

(emphasis added).

For purposes of Caremark’s first path, “a director may be held liable if she acts in

bad faith in the sense that she made no good faith effort to ensure that the company had in

place any ‘system of controls.’” Marchand, 212 A.3d at 822. “[D]irectors have great

discretion to design context- and industry-specific approaches tailored to their companies’

businesses and resources. But Caremark does have a bottom-line requirement that is

important: the board must make a good faith effort—i.e., try—to put in place a reasonable

30 board-level system of monitoring and reporting.” Id. If a corporation suffers losses caused

by the directors’ failure “to attempt in good faith to assure that a corporate information and

reporting system, which the board concludes is adequate, exists,” then the directors can be

held liable. Caremark, 698 A.2d at 970.

A plaintiff can state a Caremark claim by alleging that “the company had an audit

committee that met only sporadically and devoted patently inadequate time to its work, or

that the audit committee had clear notice of serious accounting irregularities and simply

chose to ignore them or, even worse, to encourage their continuation.” Guttman, 823 A.2d

at 507. The mere existence of an audit committee and the hiring of an auditor does not

provide universal protection against a Caremark claim. Compare Ash v. McCall, 2000 WL

1370341, at *15 n.57 (Del. Ch. Sept. 15, 2000) (concluding that audit committee and

independent auditor were “some evidence” that the requisite systems existed), with Rich

ex rel. Fuqi Int’l, Inc. v. Yu Kwai Chong, 66 A.3d 963, 983 (Del. Ch. 2013) (concluding

that despite existence of audit committee and independent auditor, the company “had no

meaningful controls in place”).

The complaint alleges facts that support an inference 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. As detailed in the

Factual Background, the Company suffered from pervasive problems with its internal

controls, which the Company acknowledged in March 2014 and pledged to correct. Yet

after making that commitment, the Audit Committee continued to meet only when

31 prompted by the requirements of the federal securities laws. When it did meet, its meetings

were short and regularly overlooked important issues.

For example, in May 2014, the Audit Committee convened for the first time after

disclosing two months earlier that its “disclosure controls and procedures were not

effective as of December 31, 2013, due to a material weakness.” Compl. ¶ 112. The

meeting lasted just forty-five minutes. During that time, the Audit Committee purportedly

reviewed new agreements governing the Company’s related-party transactions with Kandi

USA. Neither the agreements nor the review procedures were produced in response to the

plaintiff’s demand for books and records, supporting a reasonable inference that they either

did not exist or did not impose meaningful restrictions on the Company’s insiders. Three

weeks later, the Audit Committee purportedly reviewed and approved a new policy that

management had prepared governing related-party transactions. The Company also did not

produce this policy in response to the plaintiff’s demand for books and records, supporting

a reasonable inference that it too either did not exist or did not impose meaningful

restrictions on the Company’s insiders.

The Audit Committee did not meet again for almost an entire year. The committee

next convened in March 13, 2015, spurred by the need to review the Company’s financial

results for purposes of the 2014 10-K. The meeting lasted only fifty minutes. During this

time, the Audit Committee ostensibly discussed the financial results and purportedly

approved a new policy that management had prepared to govern related-party transactions

involving the Joint Venture. It is reasonable to infer that the policy did not place meaningful

restrictions on management and that the Audit Committee failed to establish its own

32 monitoring system for related-party transactions. It is also reasonable to infer that during

this fifty-minute meeting, the Audit Committee could not have fulfilled its responsibilities

under the Audit Committee Charter for purposes of nearly a year’s worth of transactions.

Once again, the Audit Committee did not meet for almost an entire year. The

committee next convened on March 7, 2016, again spurred by the need to review the

Company’s financial results for purposes of the 2015 10-K. During a meeting that lasted

just thirty minutes, the Audit Committee discussed the financial results and reviewed the

related-party transactions that management had identified, which ostensibly consisted of

minimal transactions with Services Company involving battery sales. Just two weeks later,

and one week after the Company had filed its 2015 10-K, the Audit Committee acted by

written consent on March 22 to ratify a very different description of the related-party

transactions between the Company and the Service Company, this time totaling over $42

million. In the same written consent, the Audit Committee authorized management to

engage in related-party transactions with the Service Company during the remainder of

2016. It is reasonable to infer that during this thirty-minute meeting, the Audit Committee

could not have fulfilled its responsibilities under the Audit Committee Charter for purposes

of a year’s worth of transactions. It is also reasonable to infer from the contrast between

the Audit Committee meeting and the action by written consent that the Audit Committee

was not adequately overseeing the Company’s related-party transactions and did not have

its own system in place for monitoring this critical aspect of the Company’s finances.

Just one month later, on April 12, 2016, the Audit Committee relied on

management’s determination that it was necessary to replace AWC. Whether the Audit

33 Committee should have acted earlier to replace AWC remains an open question,

particularly given the red flags that AWC had no other clients and the problems with

AWC’s prior audits. For present purposes, it is reasonable to infer that the Audit Committee

deferred to management on the question of replacing the Company’s outside auditor and

did not engage in independent oversight of this important role.

These chronic deficiencies support a reasonable inference that the Company’s board

of directors, acting through its Audit Committee, failed to provide meaningful oversight

over the Company’s financial statements and system of financial controls. Despite

identifying Yu and Lewin as Audit Committee Financial Experts in 2015, the Company

later disclosed in the 2016 10-K that it lacked personnel with sufficient expertise on US

GAAP and SEC disclosure requirements for equity investments and related-party

transactions. The directors charged with implementing a system to oversee the Company’s

financial reporting thus lacked the expertise necessary to do so all along. Instead, the Audit

Committee deferred to management, which dictated the policies and procedures for

reviewing related-party transactions and hired and fired the Company’s auditor, even

though management’s actions suggested that it was either incapable of accurately reporting

on related-party transactions or actively evading board-level oversight.

In response, the defendants argue 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. They rely on this court’s holding in General

Motors that a plaintiff cannot meet its Caremark burden by pleading that board-level

monitoring systems existed but that they should have been more effective. See In re Gen.

34 Motors Co. Deriv. Litig., 2015 WL 3958724 (Del. Ch. June 26, 2015). The facts of this

case are distinguishable from those of General Motors.

In General Motors, the plaintiffs brought Caremark claims against the company’s

directors after the company recalled 28 million vehicles due to faulty ignition switches. Id.

at *2. The General Motors plaintiffs faced a Caremark catch-22 because their pre-suit

investigation demonstrated that the board was exercising “some oversight.” Id. at *15. For

example, the board regularly reviewed the company’s risk management structure,

identified the top risks facing the company’s business, and received presentations on

product safety and quality. Id. The plaintiffs therefore had to argue that the board “failed

to implement a reporting system which would have apprised them specifically of serious

injuries and deaths resulting from safety defects.” Id. at *11. They alternatively argued that

the General Motors board failed to monitor any reporting systems that did exist. Id. This

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.” Id. at *15.

The allegations in this case depict a board that was far less active than the directors

in General Motors. The complaint in this case depicts directors who acted similarly to their

counterparts in Marchand, who failed “to make a good faith effort—i.e., try—to put in

place a reasonable board-level system of monitoring and reporting.” Marchand, 212 A.3d

at 821. The allegations in this case support inferences that the board members did not make

a good faith effort to do their jobs. The Audit Committee only met when spurred by the

requirements of the federal securities laws. Their abbreviated meetings suggest that they

35 devoted patently inadequate time to their work. Their pattern of behavior indicates that

they followed management blindly, even after management had demonstrated an inability

to report accurately about related-party transactions.

An Audit Committee may of course rely in good faith upon reports by management

and other experts. See 8 Del. C. § 141(e). In doing its job, the members of an Audit

Committee will necessarily rely on management. But Caremark envisions some degree of

board-level monitoring system, not blind deference to and complete dependence on

management. The board is obligated to establish information and reporting systems that

“allow management and the board, each within its own scope, to reach informed judgments

concerning both the corporation’s compliance with law and its business performance.”

Caremark, 698 A.2d at 959 (emphasis added)).

The complaint’s allegations support a pleading-stage inference that the board never

established its own reasonable system of monitoring and reporting, choosing instead to rely

entirely on management. The Company could have produced documents in response to the

plaintiff’s Section 220 demand that would have rebutted this inference. The absence of

those documents is telling because “[i]t is more reasonable to infer that exculpatory

documents would be provided than to believe the opposite: that such documents existed

and yet were inexplicably withheld.” In re Tyson Foods, Inc., 919 A.2d 563, 578 (Del. Ch.

2007). The documents that the Company produced indicate that the Audit Committee never

met for longer than one hour and typically only once per year. Each time they purported to

cover multiple agenda items that included a review of the Company’s financial

performance in addition to reviewing its related-party transactions. On at least two

36 occasions, they missed important issues that they then had to address through action by

written consent. The plaintiff is entitled to the inference that the board was not fulfilling its

oversight duties.

The defendants additionally argue that even if the directors failed to fulfill their

oversight duties, they should not be subject to liability because the Company did not suffer

harm as a result. The defendants observe that the March 2017 restatement had no effect on

the Company’s net income, and they point out that this argument carried significant weight

in the federal securities action, where it undercut the inference of fraud. In re Kandi Techs.

Gp., Inc. Sec. Litig., 2019 WL 4918649, at *8.

For purposes of this litigation, the defendants’ observation is misplaced. “Delaware

law dictates that the scope of recovery for a breach of the duty of loyalty is not to be

determined narrowly.” Thorpe ex rel. Castleman v. CERBCO, Inc., 676 A.2d 436, 445

(Del. 1996). In the absence of quantifiable damages to net income, defendants are “still

liable for damages incidental to their breach of duty.” Id. The plaintiff claims that the

Company suffered incidental damages that include “costs and expenses incurred with the

restatements, significant reputational harm in the markets, the defense of several lawsuits

filed against the Company for violations of federal securities law, and the defense of an

action commenced by Plaintiff pursuant to 8 Del. C. § 220.” Compl. ¶ 12. At the pleading

stage, this allegation is sufficient to support a claim for relief.

Given the persistent and prolonged problems at the Company, CEO Hu, Lewin, Yu,

and Chen face 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

37 the Company’s financial reporting. The defendants who face a substantial likelihood of

liability constitute a majority of the Demand Board. Accordingly, the Demand Board lacks

a disinterested and independent majority that could have considered a demand, rendering

demand futile. As to Count I, the motion to dismiss is denied.

3. Count II

Count II asserts a claim for unjust enrichment. The plaintiff alleges that the officer

defendants (CEO Hu and CFOs Zhu, Wang, and Mei) received excessive compensation

because the Company’s inaccurate financial statements overstated its performance. The

complaint also cited the compensation received by the directors, but at oral argument, the

plaintiff’s counsel clarified that Count II does not seek to recover damages from the

Company’s non-officer directors for the compensation they received as directors. Count II

only seeks damages based on the excessive compensation paid to CEO Hu and CFOs Zhu,

Wang, and Mei, but it seeks to hold all of the defendants jointly and severally liable for the

resulting damages.

One approach would be to use Aronson to analyze whether demand on Count II is

futile. Four of the six members of the Demand Board approved the officer defendants’

compensation, so technically Aronson could apply. Indeed, Aronson would logically apply

if the plaintiff was arguing that the members of the board breached their fiduciary duties

when approving the officers’ compensation.

The plaintiff, however, is making a different argument. The plaintiff contends that

the oversight claim articulated in Count I had a secondary consequence of inflating the

Company’s financial results, leading to unjust enrichment for the officer defendants who

38 were compensated based on the misstated results. The unjust enrichment claim in Count II

is thus properly conceived as a form of additional damages dependent on the plaintiff

proving the oversight claim asserted in Count I.

The demand futility analysis for purposes of Count II thus necessarily treads the

same path as the demand futility analysis for Count I. To evaluate a demand to assert the

claim posited in Count II, the Demand Board would have to investigate and then assert

litigation based on the breaches of the duty of oversight that are the subject of Count I. This

decision has already held that four of the six members of the Demand Board—CEO Hu,

Lewin, Yu, and Chen—are interested for purposes of a litigation demand involving the

conduct underlying Count I because they face a substantial threat of liability for the

oversight claims asserted in Count I. The unjust enrichment claim asserted in Count II

would implicate the same conduct. For the same reason, demand is futile.

B. Rule 12(b)(6)

When considering a motion to dismiss under Rule 12(b)(6), a court applying

Delaware law (i) accepts as true all well-pleaded factual allegations in the complaint, (ii)

credits vague allegations if they give the opposing party notice of the claim, and (iii) draws

all reasonable inferences in favor of the plaintiffs. Central Mortg. Co. v. Morgan Stanley

Mortg. Capital Hldgs. LLC, 27 A.3d 531, 535 (Del. 2011). Dismissal is inappropriate

“unless the plaintiff would not be entitled to recover under any reasonably conceivable set

of circumstances.” Id.

Although the defendants purportedly moved separately pursuant to Rule 12(b)(6),

they did not offer any independent arguments for dismissal under that rule. For purposes

39 of Count I, the analysis under Rule 23.1 is dispositive. “The standard for pleading demand

futility under Rule 23.1 is more stringent than the standard under Rule 12(b)(6), and a

complaint that survives a motion to dismiss pursuant to Rule 23.1 will also survive a

12(b)(6) motion to dismiss, assuming that it otherwise contains sufficient facts to state a

cognizable claim.’” In re Citigroup Inc. S’holder Deriv. Litig., 964 A.2d 106, 139 (Del.

Ch. 2009); see also China Agritech, 2013 WL 2181514, at *24 (“A complaint that pleads

a substantial threat of liability for purposes of Rule 23.1 ‘will also survive a 12(b)(6) motion

to dismiss.’” (quoting McPadden v. Sidhu, 964 A.2d 1262, 1270 (Del. Ch. 2008))).

This decision concluded that demand was futile for purposes of Count II because of

its interrelationship with Count I. It would not be duplicative, therefore, to analyze the

unjust enrichment claim that appears in Count II on the merits. The defendants, however,

did not engage in any discussion of the unjust enrichment claim, nor did the plaintiff. This

decision will not discuss the claim either, except to reiterate that as framed by the plaintiff

at oral argument, it depends on the plaintiff proving the Caremark claim alleged in Count

I, at which point the plaintiff maintains that the officer defendants would have received

excessive compensation that would be subject to a claim for unjust enrichment.

III. CONCLUSION

The defendants’ motions to dismiss under Rules 23.1 and 12(b)(6) are denied. The

parties will confer regarding a schedule for moving forward with the action and file a status

report within thirty days.