Caremark Eroded – Director Liability In Delaware

This year has marked a string of cases eroding the long history of Delaware’s board of director protections from breach of fiduciary duty claims.  In Re Caremark International Inc. Derivative Litigation was a civil action in the Delaware Court of Chancery in 1996 which drilled down on a director’s duty of care in the oversight context.  Caremark found that generally directors do not need to approve or exercise oversight over most company decisions, other than mergers (see HERE), changes in capital structure and fundamental changes in business.

Caremark claims, which allege failures of board oversight, have long been regarded by Delaware courts as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” To plead and prove a Caremark claim, a stockholder plaintiff must show that the board either (i) “utterly failed to implement any reporting information restrictions or controls”; or (ii) having implemented them, “consciously failed to monitor or oversee their operations, thus disabling themselves from being informed of risks or problems requiring their attention.” In other words – bad faith.  Not surprisingly, these claims routinely fail at the pleading stage.

However, following Marchand v. Barnhill and In re Clovis Oncology Derivative Litigation which upheld claims against a board under Caremark last year, this year the Delaware Chancery Court also upheld claims in Hughes v. Hu and Teamsters Local 443 Health Services & Insurance Plan v. Chou.  Whether these cases are actually a change in the law or just examples of how boards are utterly failing at their duties remains to be seen.  Also, since these cases are all relatively new, we have yet to see whether Board of Director defendants will actually face personal liability.

Either way, they certainly act as a reminder of the importance of active, engaged board oversight of material risk and compliance issues.  Clearly boards should take proactive steps to ensure that directors do not face personal liability for a failure of oversight.  Part of those proactive steps include making a good faith effort to implement an oversight system and then actually monitoring it.  Protocols need to be in place so that issues are brought to the board or relevant board committee promptly.

Likewise, boards should regularly review what key or mission critical risks exist (or potentially exist) for oversight.  The board also needs to properly respond to risks or issues in a timely fashion and follow up with management.  Board minutes should include notes on all actions taken.

Marchand v. Barnhill

In Marchand v. Barnhill the Delaware Supreme Court overruled the Chancery Court’s order granting a motion to dismiss on Caremark claims.  Following the Caremark decision in 1996, almost all attempted negligent supervision causes of action were dismissed at the pleading stage.  Marchand, which resulted from a listeria outbreak at Blue Bell Creameries, marked the first in what is now a series of cases that survived a motion to dismiss and continue to be litigated.  In addition to being implicated in the deaths of three people, the outbreak resulted in a recall of all of the company’s products, a complete production shutdown, and a layoff involving 1/3rd of its workforce.

In determining that the Plaintiff had properly pled a case under Caremark, the Supreme Court noted that bad faith can be established by showing that no good faith efforts had been made.  In this case no board committee had considered food safety protocols; no procedures were in place that required management to inform the board of food safety compliance practices, risks or reports; there was no schedule for the board to consider food safety on any sort of regular basis (even annually); prior to the outbreak red flags were presented to management who did not disclose these matters to the board; and board minutes showed a complete lack of discussion related to food safety.  The Court noted that government inspectors found food safety problems at the company’s plants that were so systemic that any reasonable monitoring system would have resulted in them being reported to the board.

In other words, even though management did not disclose issues to the board, the board’s lack of inquiry or development of a plan to learn about food safety issues, in a food production company, rose to the level of bad faith supporting a complaint for lack of oversight.  The Marchand parties agreed to a $60 million settlement, ten days before trial was set to commence.

In re Clovis Oncology Derivative Litigation

In re Clovis Oncology Derivative Litigation the court found that the plaintiffs had adequately pled that the board breached its fiduciary duties by failing to oversee a clinical trial for the company’s experimental lung cancer drug and then allowing the company to mislead the market regarding the drug’s efficacy.  Clovis eventually disclosed these failures, resulting in a $1 billion drop in market value, a federal securities action, an SEC complaint, and the Delaware derivative action.  Here the judge stated that Delaware courts are more likely to find liability under Caremark for oversight failures involving compliance obligations under regulatory mandates than for those involving oversight of ordinary business risks.

The court indicated that Caremark rests on the presumption that corporate fiduciaries are afforded “great discretion to design context and industry-specific approaches tailored to their companies’ businesses and resources.” Indeed, “[b]usiness decision-makers must operate in the real world, with imperfect information, limited resources, and uncertain future. To impose liability on directors for making a ‘wrong’ business decision would cripple their ability to earn returns for investors by taking business risks.” But, as fiduciaries, corporate managers must be informed of, and oversee compliance with, the regulatory environments in which their businesses operate. In this regard, as relates to Caremark liability, it is appropriate to distinguish the board’s oversight of the company’s management of business risk that is inherent in its business plan from the board’s oversight of the company’s compliance with positive law—including regulatory mandates.

Caremark requires a plaintiff to establish that the board either “completely fail[ed] to implement any reporting or information system or controls” or failed to adequately monitor that system by ignoring “red flags” of non-compliance. Here the board’s governance committee was responsible for overseeing compliance with regulatory requirements applicable to the clinical trial, the judge held that the plaintiff adequately pled that it knowingly ignored red flags indicating that the company was not complying with those requirements. Accordingly, he declined to dismiss the case.  The case remains pending.

Hughes v. Hu

In Hughes v. Hu the Chancery Court held that the plaintiff adequately pled that the director defendants, who served on the company’s audit committee, breached their fiduciary duties by failing to oversee the company’s financial statements and related party transactions.  The audit committee only met when they needed to discuss its annual 10-K and the meeting was brief and perfunctory.  The plaintiff alleged that the directors made a conscious choice to avoid their duties and followed management blindly even after being presented with evidence of improper financial reporting and a failure to adequately disclose related party transactions.

In 2014 the public company even disclosed material weaknesses in its internal controls and a lack of oversight by the audit committee as financial controls and related party transactions. In 2017 the company had not fixed any of its problems and had to restate three years of financial statements.  Although the case survived the motion to dismiss, it is still ongoing and none of the defendants have been found liable as of yet.

Teamsters Local 443 Health Services & Insurance Plan v. Chou

In Teamsters Local 443 Health Services & Insurance Plan v. Chou the court found that the defendants ignored red flags of illegal activity.  The illegal activity involved a subsidiary of AmerisourceBergen Corporation (ABC) that was pooling excess overfill medication from cancer vials into additional syringes, which led to contamination.  ABC, through a subsidiary, is in the business of buying single-dose vials of oncology drugs from manufactures, putting the drugs in syringes and selling the syringes for use by cancer patients.  The vials included an overfill amount to account for human error in filling syringes and to avoid air bubbles.  The overfill amount is supposed to be discarded.  Instead, the subsidiary was pooling the drugs and filling additional syringes.

The company faced corporate criminal and civil penalties and stockholders brought a Caremark case against the directors.  In refusing to dismiss the case, the Court found that the directors ignored three red flags including: (i) a report from an outside law firm that the subsidiary was not integrated into ABC’s compliance and reporting function (and thus that compliance had substantial gaps); (ii) a former executive filed a lawsuit until seal in federal court alleging illegal activity and although the lawsuit was disclosed in the 10-K’s signed by the directors, they did not take any remedial action; and (iii) the subsidiary received a subpoena from federal prosecutors related to illegal activity and the board still did not take action.

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