A New Caremark Era: Causes and Consequences

Roy Shapira is Associate Professor at IDC Herzliya Radzyner Law School. This post is based on his recent paper, forthcoming in the Washington University Law Review, 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).

Compliance has become a key corporate governance issue across the globe. Yet until recently, corporate law played a seemingly very limited role. The prevalent standard for director oversight duties (Caremark duties) was set high, effectively demanding that plaintiffs show scienter without having access to discovery. As a result, derivative actions over directors’ failure of oversight were routinely dismissed at the pleading stage, and many commentators considered Caremark duties largely irrelevant.

Against this background, it was noteworthy when, starting in June 2019, four Caremark claims succeeded in surviving the motion to dismiss (Marchand, Clovis, Hughes, and Chou). Practitioners immediately took notice, and started debating the meaning of the string of successful cases—including on this blog. Does it signify a meaningful trend of a “stricter Caremark era,” or is it merely a coincidence of cases with extremely egregious facts? And if there is, indeed, a resurgence in director oversight duties, why now? What changed around 2019 that sparked the resurgence?

In my recent paper, titled “A New Caremark Era: Causes and Consequences” (forthcoming in Washington University Law Review), I suggest that the answers, are (1) “yes,” and (2) “section 220.” Yes, there is a trend of revamped director oversight duties. And this trend is here to stay, partly because it is driven by a seemingly disparate development in shareholders’ rights to information from the company, nestled in DGCL §220.

Section 220 grants shareholders a qualified right to inspect the company’s books and records. In recent years Delaware courts have liberalized their interpretation of section 220 requirements: both in terms of whether to provide internal documents (the “proper purpose” requirement), and in terms of what internal documents to provide (the “permissible scope” requirement). Armed with such newfound pre-filing discovery powers, shareholders and their attorneys can use the internal documents to plead with particularity facts that implicate directors’ mental state and awareness, thereby overcoming the once-insuperable Caremark pleading hurdle. Plaintiffs can now more easily show that the board never even discussed a critical compliance issue, or that they knew about critical problems but chose to ignore them. In a separate project I focused on how the expansion of section 220 has revamped judicial oversight of deal negotiations; in this project I focus on how it revamped director oversight duties as well. The resurgence of inspection rights led to a resurgence of oversight duties.

The paper delineates the contours of this new mode of Caremark litigation, beyond the abovementioned emphasis on pre-filing investigations. Two trends stand out. First, Delaware courts have been carving a constantly-growing exception to the deferential standard, in the form of “mission critical compliance.” In situations where meeting certain regulatory demands is critical to the firm’s success, the courts explained, directors should be especially alert to yellow and red flags, and proactively monitor compliance. Second, Delaware courts have been emphasizing the need for proper documentation of oversight activities. If in the past one could claim that lack of documentation evidences that directors were not aware of the problem (and so no pleading-stage indication of bad faith exists), the new Caremark cases clarify that lack of documentation can evidence lack of needed follow-ups and actions on part of the board to remedy potential oversight issues.

The combination of the courts’ increased willingness to scrutinize directors’ conduct in this context, with plaintiffs’ increased ability to document directors’ conduct, is likely to continue generating successful Caremark claims going forward. Indeed, the section 220 actions—that is, litigation over what documents shareholders can get in order to investigate potential failures of oversight—should be considered themselves a part of the new Caremark era. Within the past year, plaintiffs have succeeded in getting internal documents, including not just formal board materials but also private emails, to investigate failures of oversight on the part of Facebook’s directors in the Cambridge Analytica scandal, or AmerisourceBergen’s directors in the opioid crisis, to name two examples. In other words, the trend is bigger than the MarchandClovisHughes-Chou quadfecta.

Yet it is one thing to say that plaintiffs are now more likely to succeed in failure-of-oversight claims, and another to say that the new turn in Caremark litigation is desirable from a societal perspective. For one, the expansion of pre-filing discovery comes with its own set of costs, such as potentially bringing back the dreaded fishing expeditions through the backdoor. And, critics may claim, thus far it has produced no meaningful benefits: success in section 220 actions or the motion to dismiss does not mean that these cases will ultimately be decided in favor of the plaintiffs. We therefore cannot conclude that the new Caremark era will generate more compensation for shareholders or better deterrence, the argument goes. In fact, such an objection misconstrues how Delaware corporate law works (deters). In corporate law, in general, corporate decision-makers almost never pay out of pocket for their misbehavior. Yet deterrence cannot be measured solely on the basis of sanctions imposed in verdicts coming after a full trial.

Corporate law’s impact on oversight rather comes from paying settlements ex post and, pertinently, planning how to avoid the risks and costs of litigation ex ante. Part of the law’s effects on behavior comes from the memos that legal advisors send their clients, explaining how they should behave going forward. My paper details how the new Caremark cases created a wave of law firms’ memos (many appeared on this blog), calling on boards to place compliance issues on the agenda and make sure deliberations are being properly recorded. Another part of the law’s effects on behavior is through imposing (uninsurable) non-legal costs, such as emotional costs (stress, embarrassment) and reputational costs (having details about your misbehavior dug out and made public, for all other market participants to see). My paper illustrates how the expansion of section 220 has increased these non-legal costs for failure of oversight, thereby ramping up deterrence.

While it is still too early to empirically assess the costs and benefits of the new mode of Caremark litigation, my paper provides several indications that suggest it is likely to prove overall desirable. For one, the increased emphasis on documentation can combat the problems of information silos and upward flows of information, forcing directors to take ownership of certain aspects of corporate behavior. More generally, the revamped mode of Caremark litigation is an example of how Delaware corporate law functions when it is at its best. It rests on an ecosystem of expert judges effectively micro-managing the process: they stagger the costs of (targeted, pre-filing) discovery, as a function of the information asymmetries and the credibility of the allegations at hand. They make sure that bounty hunters (activist shareholders or plaintiff attorneys) get their bounty only when they contribute to shareholders as a group. And when the system works that way, it also generates a positive externality of quality information on corporate behavior, which in turn helps in shaping reputational discipline and business norms (which is, in a sense, how Chancellor Allen originally envisioned Caremark liability).

The full paper is available for download here.

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