Risk Oversight in China Operations

Third Quarter 2013
Corporate Board Member
by Matthew Solum, Kirkland & Ellis LLP

So far this year, a series of Delaware cases has underscored the duty of directors to oversee operations overseas and, specifically, in China.

The allegations in the cases follow a strikingly similar pattern. Each of the cases involved a corporation that was the result of a reverse merger between a corporation with operations in China and a Delaware corporation. Internal controls at the successor corporations were insufficient and insiders allegedly dissipated assets.  Board members resigned. Lawsuits followed.

In the lawsuits, breaches of fiduciary duty claims were allowed to proceed against the corporations’ directors because the directors allegedly failed to monitor the corporation’s operations. These claims are considered Caremark claims, that is, claims against a director who has “utterly failed to implement any reporting or information system or controls” or “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.”

The allegations in the cases are extreme—involving the transferring of all of the corporate assets out of the corporation (Puda Coal), transferring $130 million cash out of the corporation (Rich v. Chong), and overarching allegations of corporate fraud (China Agritech)—but the cases do provide some guidance to directors overseeing operations in China and overseas generally. For example, in the cases, the courts explain that directors should pay particular attention to the following areas:

Retaining appropriate advisors. Directors should retain accountants and lawyers who are fit to the task of maintaining a system of controls over a public company.

Forming an audit committee. Directors should form an audit committee and have that committee meet and actively oversee the company’s operations.

Ensuring adequate language skills. With respect to significant operations outside of the U.S., directors should have appropriate language skills to navigate the environment in which the company is operating.

Travel. Directors need to be onsite—often. If a company’s assets and operations are situated in China, periodically board members’ boots need to be on the ground there as well.

Directors should also consider causing the corporation to explain in its U.S. public filings any discrepancy between its financial statements in its filings with the SEC and the filings with the State Administration for Industry and Commerce (the “SAIC”) in China. When financial statements filed with the SEC and the SAIC differ significantly, U.S. courts have allowed shareholders to pursue securities fraud claims against the company, and, in some cases, Delaware courts have inferred that board members disregarded their duties if these statements reflect discrepancies.

In sum, a director’s duty to oversee operations of a corporation includes both its domestic and overseas operations. Thus, to satisfy this duty, directors should consider, among other things, retaining the appropriate advisors with local/overseas expertise, establishing an active audit committee with appropriate expertise, developing applicable language skills, and traveling to the operations periodically.

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