Chancery Court Confirms High Bar to Pleading Caremark Oversight Claims Against Officers

Earlier this year, in its McDonald’s decision, the Court of Chancery established for the first time that not only corporate directors but also officers have oversight duties under Caremark. In Segway v. Cai (Dec. 14, 2023), the court, for the first time since McDonald’s, has addressed officers’ Caremark duties.

Key Points

• The court confirmed that the same high bar to pleading a Caremark claim against a director also applies to pleading such a claim against an officer. The court stated that, although it was established in McDonald’s that an officer’s oversight duties under Caremark are “context-specific” and generally limited to matters within the scope of the officer’s corporate responsibilities, that framework does not “craft a lower standard for oversight claims brought against officers” than is applicable to such claims brought against directors. Notwithstanding what we would note is recent greater judicial receptivity to survival of Caremark claims in some circumstances, the court emphasized in Segway that “a Caremark claim [still] is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” The bar to successful pleading of a Caremark claim against an officer is high due to the requirement that the officer acted in bad faith (the focus in Segway), and, we would note, as discussed below, also due to the availability of the demand futility defense for derivative claims (not at issue in Segway).
• The court emphasized that bad faith by the defendant, whether a director or an officer, is a predicate to Caremark liability. Bad faith in this context means knowing and intentional disregard of the oversight obligation. Although the President of Segway allegedly had “consciously disregarded” financial discrepancies in her reports to the parent company about Segway’s declining customer base and rising accounts receivable, the court held that there were no allegations from which it could reasonably be inferred that she had acted in bad faith.
• Caremark claims are likely to be dismissed where the alleged misconduct involves “classic business decisions.” The court noted that Segway’s allegations were not that Cai had overlooked fraud, accounting improprieties or material legal violations, but that she had ignored matters relating to customers, sales, revenues, and accounts receivable that had come to her attention. “Such generic financial matters are far from the sort of red flags that could give rise to Caremark liability if deliberately ignored,” the court wrote. The decision also reinforces the line of cases in which the court has dismissed Caremark cases on the basis that knowledge of and ignoring general risks does not equate to conscious disregard of the risk of a specific corporate trauma.

Background. Segway Inc., which made personal transportation devices, was acquired in 2015 by a subsidiary of Ninebot (Beijing) Tech Co., Ltd., which produced similar vehicles. Segway sold its products alongside Ninebot’s, but otherwise continued to operate separately post-acquisition, with its own board of directors, officers, employees, and financial and accounting systems. Judy Cai was hired as Segway’s Vice President of Finance and soon was promoted to be President. Segway experienced a significant decline in sales, shrinking of its customer base, and rise in its accounts receivable. The company responded by turning away from selling its branded products; focusing instead on selling Ninebot’s products; and significantly downsizing its operations. Following the closing of the company’s main facility, Cai’s employment was terminated. It then became evident that the information Cai had been providing to Ninebot about shrinkage of customers and sales did not match the actual numbers in Segway’s financial records and that a significant portion of the accounts receivable had been improperly recorded or not booked. When Ninebot could not reconcile the discrepancies, and Cai declined Ninebot’s request to help in that effort, Segway commenced this action against Cai, alleging breach of her fiduciary duties of oversight under Caremark. After briefing and oral argument, Vice Chancellor Lori Will granted Cai’s motion to dismiss the case.

Discussion

Caremark claims. As the court explained, oversight duties arise from the duty of good faith, which is a subsidiary element of the duty of loyalty. Accordingly, to plead a viable claim for breach of the duty of oversight, a plaintiff must allege sufficient facts to support a reasonable inference that the fiduciary acted in bad faith. Under Caremark, bad faith can be established when fiduciaries: “(1) utterly fail to implement any reporting or information system or controls [(a so-called “Information Claim”)], or (2) having implemented such a system or controls, consciously fail to monitor or oversee its operations, which disables them from being informed of risks or problems requiring their attention [(a so-called “Red Flags Claim”)].”

The court suggested that the claim against Cai was more properly a duty of care claim than a Caremark claim. Segway asserted that Cai “knew or should have known that there were potential issues with some of Segway’s customers, which caused Segway’s accounts receivable to continuously rise”; and that Cai ignored these issues and their impact on Segway’s profitability. The court stated that, on that basis, the court had assumed that Segway was asserting a duty of care violation by Cai. Segway “was adamant,” however, that it was asserting a duty of loyalty violation—specifically, a Red Flags Claim under Caremark. Segway emphasized that Cai had “continuously ignored” red flags relating to the company’s declining sales and shrinking customer base “and did not advise the people she needed to advise.” The court therefore proceeded to analyze the claim only as a Caremark claim. (The court stated in a footnote that, even if Segway were raising a duty of care claim, it had not adequately pleaded gross negligence by Cai.)

Bad faith is a predicate to valid pleading of a Caremark claim. The court emphasized that the bad faith requirement applies whether a Caremark claim is against a director or an officer. To establish bad faith in connection with its Red Flags Claim, Segway had to “adequately plead that Cai consciously failed to act after learning about evidence of illegality—the proverbial ‘red flag.’” The court wrote: “At a minimum, a plaintiff pursuing an oversight claim against an officer would need to demonstrate that the officer failed to make a good faith effort to monitor central compliance risks within her remit that pose potential harm to the company or others.”

The plaintiff’s allegations did not support an inference of bad faith by Cai. The plaintiff alleged that Cai, as President, oversaw Segway’s “financial performance, including its accounts receivable”: “managed the daily operations of the finance department”; and “was involved in compiling and/or reviewing summaries of Segway’s finances” for Ninebot. The plaintiff alleged that Cai “was aware of serious issues with customers that led to significant increases in accounts receivable and willfully ignored [and did not report internally] problems within her areas of responsibility.” The court found these allegations “an ill fit for a Caremark claim,” however. The court stated that “[n]o potential wrongdoing (much less within Cai’s purview) [was] alleged.” The court noted that Segway did not, for example, allege that Cai “overlooked accounting improprieties, fraudulent business practices, or other material legal violations.” Rather, Segway merely asserted that Cai at some point learned of “issues” with unspecified customers, decreases in revenues in a product line, and increases in receivables. According to the court, Segway appeared to be trying, “with 20/20 hindsight,” to hold Cai accountable for a decrease in sales and increase in receivables. However, the court stressed, these generic financial issues were more in the nature of classic business decisions than red flags of legal noncompliance. The court wrote that oversight duties under Delaware law are not designed to subject fiduciaries to personal liability “for failure to predict the future and to properly evaluate business risk”—whether the fiduciaries at issue are officers or directors.

The decision furthers the line of cases dismissing Caremark claims where the court concluded either that: (i) the alleged knowledge of “general risks” regarding non-compliance with law or regulations did not constitute a red flag of a “specific corporate trauma” or (ii) the alleged misconduct involved a “classic business decision” and no “red flags of illegality” were pled. The court distinguished McDonald’s, where it had found it reasonably conceivable that the defendant officer of McDonald’s—its head of human resources—faced potential Caremark liability for a failure of oversight of the alleged widespread sexual harassment of the company’s employees by management. The McDonald’s officer, the court stated in Segway, allegedly had “ignored massive red flags within his remit including multiple rounds of coordinated EEOC complaints, widespread strikes, and a thirty-city walkout” in protest of the alleged sexual harassment, which was squarely within the officer’s area of corporate responsibility.

Practice Points

• Officers’ increased vulnerability to Caremark claims. Post-McDonald’s, Caremark claims can be brought (by a board or derivatively by the stockholders) against the company’s officers. Caremark claims by stockholders are now likely to be brought against both directors and officers.
• Officers’ duty of oversight.  Officers should work to establish and monitor information and reporting systems, and should report up the chain of authority any “red flags,” relating to the company’s key risks within the officer’s sphere of corporate responsibility (or, if sufficiently material and depending on the circumstances, also outside the officer’s areas of responsibility). Officers (together with the company’s audit committee and outside auditors) should keep the board focused on and apprised of key developments with respect to issues and risks that are central to the business. There should be regular processes and protocols in place requiring management to keep the board apprised of key compliance and other practices, risks or reports. When management learns of red flags (or “yellow flags”), the board should be told, and it should address the issues.
• Consider reviewing current officer titles and areas of responsibility. As an officer’s duty of oversight will vary with the officer’s level of authority and areas of responsibility, companies may wish to review their policies and practices with respect to awarding officer titles and describing officers’ responsibilities. Such a review may be particularly important for companies with many officers, and for companies that award officer titles that may not comport with the responsibilities implied thereby. As an officer’s essential duty of oversight is to report information up the chain of authority, a company should also consider whether to clarify the reporting obligations of officers at various levels.
• Consider a charter amendment for exculpation of officers. With recent focus on the increased potential for liability of officers, including under Caremark, companies may wish to consider amending the charter to provide for exculpation of liability for officers (as has been permitted, effective as of August 1, 2022, under an amendment to DGCL Section 102(b)(7)). Notably, such exculpation would not apply to Caremark claims brought against officers, however—as such claims are derivative and, under the DGCL amendment, the charter cannot be amended to exculpate officers for derivative claims.
• Demand futility defense to Caremark claims brought by stockholders against officers. Although not an issue in Segway, we note that—as highlighted in the court’s third decision in the McDonald’s case (Mar. 31, 2023)— for Caremark claims brought by stockholders against officers, the high bar to success, even at the pleading stage, is based not only on the requirement of bad faith but also on the fact that Caremark claims, being derivative, are subject to all of the usual defenses to derivative claims, including the demand futility defense. Thus, Caremark claims brought by stockholders against officers probably will be dismissed at the pleading stage on demand futility grounds, even if it appears that the officers breached their Caremark duties—unless the directors also appear to have breached their Caremark duties (or the directors are otherwise not independent and disinterested with respect to the misconduct at issue). After such a dismissal, an officer would face potential liability only if (i) the board (on its own, or after receiving a stockholder litigation demand) decides to bring a claim against the officer; (ii) other stockholders bring suit, asserting a different basis for demand futility than the original plaintiffs asserted; or (iii) the original stockholder-plaintiffs are successful in having the court reopen the case (under Court of Chancery Rule 30(b)) based on newly discovered evidence supporting the basis for demand futility that they had asserted and the court had rejected.