Recent Delaware Court of Chancery Decision Sustains Another Caremark Claim at the Pleading Stage

Meredith Kotler and Pamela Marcogliese are partners and Marques Tracy is an associate at Freshfields Bruckhaus Deringer LLP. This post is based on their Freshfields memorandum and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

After decades of routinely dismissing such claims, Vice Chancellor Laster’s recent 41-page decision in Hughes v. Hu represents the third time since the Delaware Supreme Court’s decision last year in Marchand v. Barnhill that the Court of Chancery has sustained a Caremark duty of oversight claim at the pleading stage. It remains unlikely that these recent decisions signal some change in the law, but rather reflect allegations of unique or extreme examples of certain corporate behavior. That said, these cases serve as a reminder of the importance of active, engaged board oversight of “mission critical” risk and compliance issues, and boards should take proactive steps to ensure that directors do not face personal liability for a failure of oversight.

Marchand, Clovis, and Inter-Marketing Group

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.” Not surprisingly, these claims routinely fail at the pleading stage.

As we previously discussed in our Horizon 2020 report, however, the Delaware Supreme Court last year reversed a Court of Chancery decision and held that a case brought under the first Caremark prong could proceed against the directors of Blue Bell Creameries, one of the nation’s largest ice cream manufacturers, following a deadly 2015 listeria outbreak. [1] The Court ruled that the complaint had alleged facts from which it could be inferred that Blue Bell’s directors had failed to put in place a board-level oversight system for food safety—which was “mission critical” for the monoline company—and as a result had not received official notices of food safety concerns for several years.

Among other things, the Supreme Court noted that the complaint alleged that there was no board committee that addressed food safety; no regular process or protocols that required management to keep the board apprised of food safety compliance practices, risks or reports; and no schedule for the board to consider on a regular basis any key food safety risks that existed. While reiterating that, “as with any other disinterested business judgment, directors have great discretion to design context and industry-specific approaches,” the Supreme Court stressed that “Caremark does have a bottom-line requirement that is important: the board must make a good faith effort—i.e., try—to put in place a reasonable board-level system of monitoring and reporting.”

Last month, the Marchand parties agreed to a $60 million settlement, ten days before trial was set to commence.

In the Clovis case, [2] the Court of Chancery allowed a claim to proceed under the second Caremark prong against the directors of Clovis Oncology. There, the complaint alleged that members of the Clovis board breached their fiduciary duties by failing to oversee the clinical trial of the company’s flagship lung cancer drug, Rociletinib (or “Roci”), and then allowing the Company to mislead the market regarding the drug’s efficacy by using unconfirmed data on tumor shrinkage. 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. In denying the motion to dismiss the derivative action, the Court found sufficient plaintiffs’ allegations—accepted as true at the pleading stage—that “the Board ignored red flags that Clovis was not adhering to the clinical trial protocols, thereby placing FDA approval of the drug in jeopardy,” and “[w]ith the trial’s skewed results in hand, the Board then allowed the Company to deceive regulators and the market regarding the drug’s efficacy.”

In January of this year, the Court of Chancery allowed a contract-based oversight liability claim to proceed against the general partner of Plains All American Pipeline (“Plains”). Consistent with the parties’ own briefing and oral argument, the Court in Inter-Marketing Group [3] analyzed the claim under the second prong of Caremark. The plaintiff, a Plains unitholder, brought a derivative action alleging a failure to implement or properly oversee a pipeline integrity reporting system, which resulted in a Plains pipeline rupturing and spilling 3,400 barrels of oil into an environmentally sensitive part of the west coast. In addition to a costly clean-up effort, Plains also faced fines, a federal securities action, lost revenue, reputational harm, a decline in its stock market price, and criminal convictions.

In permitting the claim to proceed, the Court gave significant weight to trial testimony of Plains’ CEO, Gregory Armstrong, in California criminal proceedings in which Armstrong testified that pipeline integrity was “not discussed at the board level.” While defendants pointed to the existence of an audit committee, the Court noted the absence of any documents “showing that the audit committee actually conducted pipeline integrity review.”

Hughes v. Hu

Last month, the Court of Chancery issued a third post-Marchand decision concerning Caremark liability, under Caremark’s second prong. In Hughes, [4] the plaintiff brought a derivative action against three members of the audit committee, the CEO, and three successive CFOs of Kandi Technologies Group, Inc., a Delaware corporation based in Jinhua, China. Plaintiff alleged that the director defendants consciously failed to establish a system of oversight for Kandi’s financial statements and related-party transactions, “choosing instead to rely blindly on management while devoting patently inadequate time to the necessary tasks.”

According to the plaintiff’s allegations, over the years, Kandi had persistently struggled with its financial reporting and internal controls. In March 2014, the company announced the existence of a material weakness in its financial reporting and oversight system and committed to remediating those problems. Three years later, however, the company announced the restatement of three years of financial statements.

As alleged in the complaint, the Kandi audit committee met sporadically and only when required by the federal securities laws, and their “abbreviated meetings” suggested that they devoted inadequate time to their work, particularly given the known internal controls issues. In addition, according to the allegations, the audit committee frequently acted through written consent as opposed to addressing issues during live meetings. Also, it was alleged that the company’s outside auditor, which was later sanctioned by the PCAOB, failed to adequately identify and report key issues relating to the company’s financial performance, and when it did, the audit committee failed to follow up or investigate.

The Court found that the allegations, which had to be accepted as true at the pleading stage, supported an inference of bad faith failure of oversight. This included an inference that the audit committee failed to devote the necessary time and attention to addressing known deficiencies, and never implemented its own system for reporting and monitoring, instead relying blindly on management, even after management had demonstrated an inability to report accurately about related-party transactions.

What Can We Take Away from These Cases?

While the number of cases in the last year permitting Caremark claims to proceed is a departure from what was seen previously, it is unlikely that it signals any shift in the law.

At no point in Marchand did the Court suggest that it was changing the standards applicable to Caremark claims and, in fact, reiterated the “onerous pleading burden” a plaintiff must meet. Similarly, none of the post-Marchand cases have suggested that Marchand weakened the burden on plaintiffs, either at the pleading stage or trial. Indeed, since Marchand, at least four Chancery Court decisions have granted motions to dismiss Caremark claims. [5]

The Caremark cases that have recently advanced past the pleading stage have all involved unique fact patterns, with allegations accepted as true for purposes of a motion to dismiss. Blue Bell, Clovis, and Plains were monoline companies operating in regulated sectors, and in each case, the plaintiff alleged failures of board oversight over “mission critical” systems: food safety, clinical drug trials, and oil pipeline integrity. Similarly, in Hughes, Kandi had publicly acknowledged material weaknesses in internal controls relating to its financial statements and promised to remediate them, but then ignored red flags about related-party transactions, resulting in three years of restatements.

What Steps Should Boards Take to Protect Themselves?

Even if Caremark claims remain the “most difficult” to plead and prove, boards would be wise to take certain measures to protect directors from personal liability for a failure of corporate oversight.

Most fundamentally, companies need to ensure that they have monitoring, compliance, and reporting systems in place to alert the board of key or mission critical risks or issues. Such systems are important for any company, but particularly so for monoline companies and those in regulated industries. These systems also need to be effective. Protocols need to be in place so that issues are brought to the board or relevant board committee promptly. Boards should regularly review the systems and be comfortable that they are sufficient to ensure that they provide an adequate process for raising to the board key risks and issues that could significantly impact the company. This is particularly true for mission-critical risks. 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 when follow up steps are requested by the board, management should promptly provide any additional information to the board, and the board should expect, and indeed ensure, that they receive answers or information that satisfies their requests at subsequent board meetings. In addition, the board and committee minutes should reflect that follow up action was sought, that the requested steps were taken, and that the board concluded they were satisfactory.

Indeed, documentation of the existence, use, and review of monitoring systems is critical. Given the continued rise in Section 220 demands for books and records, boards need to have a strong record documenting and explaining their monitoring and decision-making processes.

Endnotes

1Marchand v. Barnhill, 212 A.3d 805 (Del. 2019).(go back)

2In re Clovis Oncology, Inc. Derivative Litig., C.A. No. 2017-0222-JRS, 2019 WL 4850188 (Del. Ch. Oct. 1, 2019).(go back)

3Inter-Marketing Group USA, Inc. v. Armstrong, C.A. No. 2017-0030-TMR, 2020 WL 756965 (Del. Ch. Jan. 31, 2020).(go back)

4Hughes v. Hu, C.A. No. 2019-0112-JTL, 2020 WL 1987029 (Del. Ch. Apr. 27, 2020).(go back)

5See In re GoPro, Inc. Stockholder Derivative Litig., C.A. No. 2018-0784-JRS, 2020 WL 2036602 (Del. Ch. Apr. 28, 2020); Owens v. Mayleben, C.A. No. 12985-VCS, 2020 WL 748023 (Del. Ch. Feb. 13, 2020); In re LendingClub Corp. Derivative Litig., C.A. No. 12984-VCM, 2019 WL 5678578 (Del. Ch. Oct. 31, 2019); Rojas v. Ellison, C.A. No. 2018-0755-AGB, 2019 WL 3408812 (Del. Ch. July 29, 2019).(go back)

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