Don't be a “Dummy Director”
“Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors.” p. 21 of transcript, In re Puda Coal Stockholders Litigation, Del. Ch. C.A. 6476-CS (February 6, 2013).
A recent Delaware bench ruling considers some of the issues highlighted by fraud allegations against emerging market issuers like Sino-Forest Corporation and Zungui Haixi Corporation, and the Ontario Securities Commission’s recently issued Staff Notice 51-720 – Issuer Guide for Companies Operating in Emerging Markets.
In re Puda, shareholders sued the directors of the NYSE Amex-listed Puda Coal Inc. after an audit committee investigation uncovered that two China-based directors had misappropriated all of the company’s corporate assets. Among other things, shareholders alleged that the directors (even the three directors who investigated the fraud) had acted in bad faith by failing to adequately monitor the company. The fraud was uncovered 18 months and 2 public offerings after it occurred when it was discovered that Puda’s sole producing asset in China had been sold to a subsidiary controlled by the chairman.
The Court made the following comments before denying the directors’ motion to dismiss for failure to state a claim:
“If the assets are in [emerging markets,] you’re not going to be able to sit in your home in the U.S. and do a conference call four times a year and discharge your duty of loyalty. That won’t cut it. That there will be special challenges that deal with linguistic, cultural and others in terms of the efforts that you have to put in to discharge your duty of loyalty.” (p. 21 of transcript)
“That if you're going to have a company domiciled for purpose of its relations with investors in Delaware and the assets and operations of the 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. You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company” (pp. 17-8 of transcript)
The Court was also highly critical of the three directors who resigned instead of suing the directors who misappropriated corporate assets. As a consequence, the company was left in the hands of the director who allegedly misappropriated the corporate assets (p. 6, the second director implicated in the fraud resigned earlier).
“…there are some circumstances in which running away does not immunize you. It in fact involves a breach of fiduciary duty. And I think the extreme circumstances here might well constitute one.” (p. 23 of transcript)
Three quick take-aways:
- Be diligent. Stay informed. Retain experts when appropriate.
- The diligence applied may be protected by the business judgment rule under Canadian corporate law.
- Directors may be exposed to liability if they don’t pursue corporate wrongdoers. Resigning is not really an option if by doing so you leave shareholders in the hands of those who you believe have acted improperly.
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