Rich v. Chong, C.A. No. 7616-VCG (Del. Ch. Apr. 25, 2013) (Glasscock, V.C.)

In this opinion, the Court of Chancery denied a motion to dismiss a derivative action brought by a stockholder of Fuqi International, Inc. because the plaintiff pled facts that raised a reasonable doubt that the Fuqi board acted in good faith in responding to the plaintiff’s litigation demand. 

Fuqi is a Delaware corporation headquartered in China that sells precious metal jewelry.  Fuqi gained access to the U.S. capital markets through a reverse merger transaction and completed a $120 million public common stock offering in July 2009.  In March 2010, Fuqi announced that it had discovered accounting errors that would have a material impact on Fuqi’s previously issued quarterly financial statements for 2009 and would delay its annual report on Form 10-K for 2009.  Fuqi later revealed that its financial statements were “replete with basic accounting errors” and that between September 2009 and November 2010 over $130 million in cash had been transferred to entities in China that Fuqi had not verified as legitimate businesses. 

In July 2010, the plaintiff made a demand on the Fuqi board to commence an action for breach of fiduciary duty against certain of its directors and executive officers.  Fuqi never responded to the demand in writing, and the Court found that there was “no evidence” that the special committee formed by Fuqi’s board in response to the demand “performed any investigation.”  A parallel audit committee investigation of the cash-transfer transactions stalled when Fuqi management failed to pay the committee’s advisors and assumed responsibility for engaging an auditor without the approval of the audit committee, which caused two of the three members of the audit committee to resign in protest. 

The plaintiff filed his complaint in June 2012, and the defendants moved to dismiss under Rule 23.1 because the Fuqi board had not yet rejected the demand.  The Court denied the motion, finding that the plaintiff had pled particularized facts that raised a reasonable doubt that the board acted in good faith in responding to the demand.  In reaching its decision, the Court relied upon, among other things, the plaintiff’s well-pled allegations that the board abandoned the investigation into Fuqi’s accounting problems, management thwarted what efforts could have been taken by the audit committee, and the independent directors who could have conducted a meaningful investigation resigned their posts. 

The Court next considered the defendants’ motion to dismiss for failure to state a claim pursuant to Rule 12(b)(6).  The Court concluded that the plaintiff had stated a claim for bad-faith failure to monitor under the theory recognized in In re Caremark International Inc. Derivative Litigation because the numerous, self-disclosed accounting problems at the company led to the conclusion that Fuqi had no meaningful controls in place and that “there does not seem to have been any regulation of the company’s operations in China.”  The complaint also raised a reasonable inference that even if Fuqi had some system of internal controls in place, the board failed to monitor them even after the March 2010 announcement of material weaknesses in the company’s internal controls.  The Court further concluded that “even if the Defendants were not complicit” in the transfer of $130 million out of the company by its founder and chairman, “they were aware of the pervasive, fundamental weaknesses in Fuqi’s controls and knowingly failed to stop further problems from occurring,” including some transfers of cash as late as November 2010.

Finally, the Court denied the defendants’ motion to stay the case pending Fuqi’s release of audited financial statements and the completion of the SEC investigation because Fuqi had not released reliable audited financial statements in over four years and was unable to even suggest when the restatement process would be complete.  The Court also declined to stay the case in favor of prior pending actions in New York under the McWane doctrine because unlike a Delaware court, a court sitting in New York likely would not have personal jurisdiction over the individual defendants, many of whom are residents of China.

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