Financial Reporting and the Law

The U.S. District Court for the Northern District of California recently granted a motion to dismiss a derivative action in which the plaintiff alleged that the directors of VeriFone Systems, Inc. breached fiduciary duties based on their failure to address VeriFone’s inadequate internal controls. In Zoumboulaskis v. VeriFone Systems, Inc., No. 5:13-cv-02379, the plaintiff asserted that the directors were on notice of internal control problems because most of the directors, including members of the audit committee, had consented to a permanent injunction against improper financial reporting and internal controls in a 2009 SEC action.

The plaintiff argued that her claims should not be governed by the Caremark standard, which provides that directors have a duty of oversight, because her allegations were based on the directors’ own decisions to “consciously disregard their obligations to ensure properly functioning internal controls, rather than the oversight of officers or employees.” The plaintiff noted that the directors had affirmatively represented in their consents to the SEC action that “they would ensure VeriFone’s internal controls were adequate.” The court, however, agreed with the directors that the claims were properly governed by the Caremark standard because the plaintiff did not assert that the “[d]efendants were directly responsible for implementing and maintaining VeriFone’s internal controls, but rather assert[ed] that [the d]efendants were either negligent in not knowing about the alleged internal control deficiencies or knew about them and failed to address them.”

With respect to the members of the audit committee, the plaintiff asserted that they “failed to ensure that internal controls were sufficient to prevent false disclosures, and presided over a culture where widespread and pervasive inadequate internal controls continued unabated for years.” Given the plaintiff’s failure “to plead with particularity which specific internal controls were not functioning properly” and the fact that the audit committee’s charter “explicitly . . . tasked the members with ‘oversight responsibility,’” the court concluded that the Caremark standard applied to them as well.

Because the court found that the case was governed by the Caremark standard, the plaintiff had to plead with particularity facts to support a substantial likelihood that the directors, including the members of the audit committee, acted in bad faith in failing to address the internal control issues. The court found that the plaintiff failed to show bad faith because she did not plead with particularity “specific aspects of the internal controls that were inadequate, or how these alleged deficiencies impacted the financial statements allegedly leading to [the p]laintiff’s losses.”