Cody v. Young

Background

Graham Cody, described in the opinion as an AXT, Inc. shareholder, filed a verified amended shareholder derivative complaint against Morris S. Young, Gary L. Fischer, David C. Chang, Jesse Chen, Christine Russell, and Leonard J. LeBlanc. AXT was also named as a defendant, but the opinion states that Cody did not assert a claim against AXT. The individual defendants included AXT’s current board members, a former board member, and its chief financial officer.

The complaint alleged a single claim for breach of fiduciary duty. Cody alleged that AXT’s 2021 through 2024 annual filings failed to disclose that AXT’s subsidiary, Beijing Tongmei Xtal Technology Co., Ltd., had been sued for trade-secret violations, that authorities had referred the matter for criminal prosecution, and that the matter could jeopardize the subsidiary’s planned initial public offering and cause AXT to refund $49 million to investors. After a research report discussed those issues, AXT’s stock price allegedly fell approximately 34.9 percent.

Defendants moved to dismiss under Federal Rule of Civil Procedure 12(b)(1), which concerns subject-matter jurisdiction, and Rule 12(b)(6), which concerns whether a complaint states a legally sufficient claim.

Subject-Matter Jurisdiction

Cody relied on diversity jurisdiction. The court found that the complaint sufficiently alleged the required amount in controversy and that the parties, as initially aligned, had diverse citizenship. Defendants argued that AXT should be realigned as a plaintiff because a corporation is ordinarily the real party in interest in a shareholder derivative action. That realignment, they argued, would eliminate diversity because AXT and most of the individual defendants were alleged to be citizens of California.

The court held that AXT was properly aligned as a defendant. It explained that a corporation may remain aligned as a defendant when its officers or directors are antagonistic to the shareholder plaintiff’s interests. All four current AXT board members were defendants and were alleged to have breached fiduciary duties to AXT. The court found that this factor strongly supported antagonism and that no countervailing factors showed the board lacked antagonism when the lawsuit began. The court therefore did not dismiss the amended complaint for lack of subject-matter jurisdiction.

Failure to State a Claim

The court next applied Federal Rule of Civil Procedure 23.1. That rule requires a shareholder bringing a derivative action who did not first ask the corporation’s directors to take the requested action to plead, with particularity, the reasons for not making that request. Cody alleged that he had made no pre-suit demand on AXT’s board, so he had to plead facts showing that such a demand would have been futile.

Because AXT is incorporated in Delaware, the court applied Delaware law to the demand-futility question. Under the Delaware Supreme Court’s test, Cody had to plead particularized facts showing that at least half of the directors on the demand board either received a material personal benefit from the alleged misconduct, faced a substantial likelihood of liability, or lacked independence from someone who did.

Cody relied on two theories of liability. First, he argued that the directors knowingly or recklessly disseminated false information. The court found that his allegations relied on multiple layers of hearsay, including a research report, an article in Chinese, and a machine translation. The court held that these allegations did not sufficiently establish, much less establish with particularity, that the alleged lawsuit or referral for criminal prosecution actually occurred. Cody therefore did not adequately plead this theory against any demand-board member.

Second, Cody relied on a director-oversight theory. The court explained that this theory requires facts showing either that the directors completely failed to establish reporting or information systems and controls, or that, after establishing such systems, they consciously failed to monitor or oversee them while knowing they were not meeting their fiduciary obligations. The complaint itself alleged that AXT’s board had created an audit committee responsible for the integrity of AXT’s disclosures and for overseeing business and operational risks. Cody did not allege that the board completely failed to establish controls or provide specific facts showing that the audit-committee members consciously failed to monitor or oversee them. The court therefore found this theory inadequately pleaded as well.

Cody also argued that Young lacked independence because he was AXT’s chief executive officer and might be unwilling to sue directors who controlled his continued employment or fellow managers. The court did not decide whether those allegations were sufficient as to Young because Cody had not adequately pleaded demand futility as to enough other directors.

Disposition

Judge Maxine M. Chesney granted defendants’ motion to dismiss. The court dismissed the amended complaint for failure to state a claim under Rule 23.1 and allowed Cody to file a second amended complaint by April 11, 2025, for the purpose of complying with that rule.