On May 21, 2013, the Delaware Court of Chancery issued a memorandum opinion in In re China Agritech, Inc. Shareholders Derivative Litigation denying defendants' motion to dismiss. The Court held that the plaintiff stockholder had provided sufficient facts in his complaint to support a reasonable inference that the board of a China-based Delaware corporation had breached its duty of oversight under Caremark and an allegation that seeking a demand on the board to pursue the litigation would have been futile.

China Agritech, Inc. was co-founded by Yu Chang and Xiao Rong Teng as a fertilizer manufacturing business in China. It accessed the US securities markets through a reverse merger with an inactive corporation that was still listed on the NASDAQ. Chang served as President, CEO, Secretary and Chairman, and was a controlling stockholder. Teng served as a director, and eventually also as the Company's COO.

After disclosing in its 10-K for fiscal year 2007 that its financial controls and procedures were not in compliance with US financial reporting standards, the company established an audit committee, compensation committee, and a nominating and governance committee, each filled with newly hired outside directors. The company reported in its next 10-K that its internal controls and procedures were now effective.

Following this disclosure, the company consummated two suspicious transactions:

Following these transactions, the company's material weaknesses returned. In brief, the company:

In June 2011, one of the company's stockholders, Albert Rish, sent a demand for books and records relating to the Yinlong Transaction, the termination of the two auditing firms, the allegations made in the seekingalpha.com report, and the nature and degree of oversight provided by the board and its committees. When the Company refused to produce any documents, Rish filed a books and records action, in response to which the company produced a total of only 227 pages of documents.

Rish then brought a derivative action, seeking to recover damages resulting from Chang and Teng's breach of fiduciary duties and the board's lack of oversight under Caremark. Beginning several days later and over the course of the next five months, four of the board's seven directors resigned (leaving only Chang, Teng and one other director whose daughter led the company's internal audit department), as did the company's CFO. Rish conceded that he did not make a litigation demand on the board before bringing his action, and the company opposed the litigation effort. The defendants filed a motion to dismiss based, in part, on the fact that Rish failed to plead that demand on the board would have been futile.

The Court denied the defendants' motion to dismiss, finding that it would have been futile for Rish to make a litigation demand on the board, under the standard set out in the Delaware Supreme Court's decision in Rales v. Blasband. The standard under Rales requires the plaintiff to plead sufficiently particularized facts that create a reasonable doubt that the board of directors could have exercised its independent and disinterested business judgment in determining whether to pursue the litigation sought in the demand. The plaintiff does not need to plead facts with such particularity to support a judicial finding, but rather just needs to include facts sufficient to raise a reasonable doubt.

In addition, as the Court of Chancery recently explained in Rich v. Chong, when directors resign under "highly suspicious circumstances," their ability to consider a demand on the board comes into question (see Legal Update, Rich v. Chong: Delaware Court of Chancery Finds Basis for "Caremark" Claims against Directors of China-based Delaware Corporation). The Rich v. Chong decision also provides a recent example of the Court's ruling in In re American International Group, Inc. that when a complaint alleges specific acts of fraud against a corporation, it does not need to tie the fraud to each particular director to survive a motion to dismiss.

Key to Rish's complaint was the allegation that China Agritech was a fraud and that the board had breached its Caremark duty to establish reporting and monitoring systems designed to provide the necessary information required for the board to stay informed concerning the Company's compliance with law and business performance. The Caremark standard is high and requires a "sustained or systemic failure of the board to exercise ovesight." Nevertheless, two other recent cases asserting Caremark claims against absentee directors of China-based Delaware corporations have survived motions to dismiss (see Rich v. Chong and Legal Update, In re Puda Coal: Delaware Court of Chancery Describes Efforts Required of Directors of Foreign-based Delaware Corporations).

To successfully assert a Caremark claim, the plaintiff must prove at least one of the following possible scenarios:

The Court here found that Rish's allegations supported a reasonable inference that the second scenario had occurred, including that:

The Court found that these facts taken together supported a reasonable inference that the board had acted in bad faith by disregarding its duty of oversight under Caremark.

This case presents another recent example of the Court of Chancery's willingness to entertain Caremark claims against inactive directors of China-based corporations. Though the facts in each of China Agritech, Rich v. Chong and Puda Coal reflected particularly poorly on the subject directors, the Court may also be signaling its general disapproval for "dummy directors" of foreign-based corporations and its opposition to the idea that directors can resign away from a company's troubles. In this regard, the Court at the outset of its decision in China Agritech sharply notes that it has no interest in supporting reverse mergers that contravene Delaware public policy by merging foreign corporations with dormant but publicly registered shell companies for the purpose of circumventing the federal securities regulatory regime.