In re Puda Coal: A Reminder About “Good Faith”

Detailed Harvard Law Blog entry below, analysis byDavis Polk here. You have to admirethe direct language in this ruling: [I]f you’re going to have a company domiciled for purposes of its relations with its investors in Delaware and the assets and operations of that company are situated in China that, in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot. You better have in place a system of controls to make sure that you know that you actually own the assets. You better have the language skills to navigate the environment in which the company is operating.

(Davis, Polk) -Delaware Court of Chancery Declines to Dismiss Claims Against U.S. Independent Directors for Failure to Monitor China-Based Company

February 20, 2013 – In a bench ruling issued on February 6 in In re Puda Coal, Inc. Stockholders Litig., the Delaware Court of Chancery declined to dismiss breach of loyalty claims against the U.S. independent directors of a Delaware company with assets and operations solely in China. Chancellor Strine found it “perfectly conceivable” that the directors breached their fiduciary duties of oversight when they failed to discover that the Chairman/CEO had “stolen the company” through the unauthorized transfers of its operating subsidiary. Although the pleaded facts here are extreme, the decision serves as a reminder that independent directors of Delaware-incorporated companies must take all necessary steps to satisfy their fiduciary duties, even when faced with the obvious challenges of a company whose assets and operations are primarily outside the U.S.

Directors of Delaware corporations have a fiduciary duty to act in good faith to exercise reasonable oversight over the management and operations of the corporation. Traditionally, though, the Delaware courts have imposed a high standard for plaintiffs to demonstrate that directors’ failure to oversee management constitutes a breach of their fiduciary duties. Indeed, only a “sustained or systematic failure of the board to exercise oversight – such as an utter failure to attempt to assure a reasonable information and reporting system exists – will establish the lack of good faith that is a necessary condition to liability.” In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d at 959, 971 (1996).

In Puda Coal, the Court ruled that, as applied to Delaware companies with primarily foreign operations and assets (particularly companies such as this one, which accessed the U.S. public securities market through a reverse merger with a Delaware shell), Caremark requires directors to be active, present and conversant in the environment in which the company operates. As applied to this situation, the Court said:

“if you’re going to have a company domiciled for purposes of its relations with its investors in Delaware and the assets and operations of that company are situated in China that, in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot.”

Directors must make reasonable and “proportional” efforts to ensure that the company complies with the law and has in place adequate systems of control to manage and oversee its assets and operations, including “having the language skills to navigate the environment in which the company is operating.” In short, independent directors “have a duty not to be dummy directors.”

In this case, the Court had no difficulty concluding, at the motion to dismiss stage, that the complaint sufficiently pled a claim that the independent directors failed to make the required efforts and to implement adequate controls. The independent directors allegedly failed to notice that the company’s entire asset base had been transferred out of the company, even though the transfers were reported in Chinese government documents. Also, the Court viewed the directors as at least partially responsible for allowing the company to repeatedly file false and misleading statements with the SEC during this period.

The Court expressly distinguished this case from the “typical” Caremark case because of its extreme facts, and the opinion may reflect the recent public focus on problems associated with reverse mergers of Chinese-controlled companies with Delaware shells. But more broadly, the Puda Coal decision is yet another reminder that directors and potential directors should make sure that they are up to the task, particularly where the company has substantial assets abroad. Given the rise in foreign-headquartered companies incorporated in Delaware (there are currently 1,238) and the growing appetite for easier access to the U.S. investor markets, this decision could affect an increasing number of directors.

A further element of the case may have broader application. Faced with the mounting evidence of fraud, the independent directors of Puda Coal, who constituted a majority of the board, concluded that the better part of valor was to resign. While this reaction may perhaps have been understandable, the opinion suggests that not only would such a resignation not cure prior failings, but that in the circumstances the resignation itself might be a breach of fiduciary duties, as it left the company wholly controlled by the errant CEO. The lesson here, which may be instructive even in less extreme circumstances, is that in some cases directors may have a duty to stay and help clean up the mess.

Click here for a copy of In re Puda Coal, Inc. Stockholders Litig., C.A. No. 6476-CS (Del. Ch. Feb. 6, 2013). http://bdti.mastertree.jp/f/wj74lzax

If you have questions regarding this publication, please call any of the lawyers listed below or your regular Davis Polk contact.

John D. Amorosi 212 450 4010 john.amorosi@davispolk.com
George R. Bason, Jr. 212 450 4340 george.bason@davispolk.com
William M. Kelly 650 752 2003 william.kelly@davispolk.com
Scott B. Luftglass 212 450 4155 scott.luftglass@davispolk.com
Phillip R. Mills 212 450 4618 phillip.mills@davispolk.com
Miranda So +852 2533 3373 miranda.so@davispolk.com
Mutya Fonte Harsch 212 450 4289 mutya.harsch@davispolk.com

Detailed entry on the Harvard Law Blog: http://hvrd.me/15DTz8C

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