Pharmally International Holding Company Limited (“Pharmally”) was listed on the Taiwan Stock Exchange in 2015. In 2018, its stock price peaked at NT$538 per share, earning it the reputation of being the “King of Biotech Stocks.” However, in August 2020, the management team and auditing accountants of Pharmally and its subsidiaries resigned suddenly. Pharmally's chairman went missing. Subsequently, a series of suspicions of stock price manipulation and misrepresentation of financial reports were exposed. In September 2022, the Financial Supervisory Commission (“FSC”) promptly disciplined two responsible accountants for failing to conduct necessary audit procedures. The Securities and Futures Investors Protection Center began accepting claims for investors' compensation and filed a class-action lawsuit against Pharmally's directors, independent directors, auditing accountants, and the auditing firm. In 2023, Taiwan Taipei District Court ruled that the defendants should pay a total of NT$5.055 billion for the misrepresentation in financial statements, drawing significant attention in the market.

In compensation cases of financial statement misrepresentation, there are several issues worth discussing, e.g. the calculation of damages and the establishment of causation. By the Pharmally case, this article aims to explore the dilemma faced by non-executive and independent directors when the malicious fraud is perpetrated by executive directors.

According to Article 23 of the Company Act, directors have the fiduciary duty. Under the U.S. law, the fiduciary duty has evolved to encompass the duty of care, duty of loyalty, and duty of monitor and oversight. There was a case where the court held that directors failed to fulfill their duty of monitor and oversight, and consequently rejected their defense of good faith reliance on accountants (see Civil Judgement by Taiwan Shilin District Court 95-Jing-Zi-19).

During the litigation proceedings of the Pharmally case, non-executive and independent directors argued that the information regarding the misrepresentation in financial statements had not been approved by the board, and that they were therefore unable to be aware of the situation. They also claimed that they acted in good faith by relying on the financial statements audited by the accountants. However, the court held that the directors, in addition to reviewing the internal control system, must also ensure that the company continuously examines and updates such system. The company must be able to respond to changes in the internal and external environment to ensure that such system continues to be effective. The court reiterated that the directors cannot invoke good faith reliance on the accountants to exempt themselves from civil liabilities. The court's reasoning may stem from the concern that if the company's internal control system does not work properly, it may allow malicious actors to engage in misconduct without being detected. Therefore, the court concluded that director's duty of monitor and oversight include the obligation to review the internal control system. Pharmally's directors failed to promptly detect the misrepresentation in financial statement should have constituted a breach of such duty.

While the judgment of Pharmally case provides guidance on how the directors should fulfill their duty of monitor and oversight, it also reveals certain practical challenges. In this case, the undisclosed collateral arrangements were maliciously orchestrated by the chairman. There may be a significant gap between ideal practice and the reality as to how an internal control system can continue to function effectively and alert other directors to such misconduct, when the management team is purposefully siphoning off company assets. In practice, it remains a major challenge for non-executive and independent directors to act in a manner that would be recognized by court as having fully fulfilled their duties. The appellate court's position on the Pharmally case will likely influence how this challenge will be addressed, making it an issue worthy of our attention.

(The article is originally in Chinese which can be found here.)