Plaintiffs in a number of recent decisions have successfully asserted Caremark claims against directors for their failure to make a good faith effort to implement an oversight system and then monitor it. Now the COVID-19 pandemic and the economic downturn combine to increase the possibility that stockholders will bring suit, alleging that the directors’ failed to implement and oversee procedures to identify and mitigate operational, financial and legal risks, causing the stockholders’ losses.
The triangulation of recent successful Caremark claims, the pandemic and the economic downturn—potentially increase directors’ liability and exposure and should further motivate directors to strengthen their oversight systems, to monitor such oversight and to document the same in the minutes.
Directors’ Caremark Liabilities
Under In re Caremark Int’l Inc. Derivative Litig., a director should make a good faith effort to oversee the company’s operations. Failing to make that good faith effort can breach the duty of loyalty and expose a director to liability. Moreover, the directors have a duty not only to exercise oversight but also to monitor the corporations’ operational viability, legal compliance and financial performance. Their failure to govern in a manner driven to ensure reasonable information and reporting systems exist is an act of bad faith in breach of the duty of loyalty.
For a plaintiff to prevail against a director on a Caremark claim, the plaintiff should show that a fiduciary acted in bad faith. Caremark has a bottom-line requirement—the board should make a good faith effort to try to put in place a reasonable board-level system of monitoring and reporting. Bad faith is established under Caremark when either (1) the directors fail to implement any reporting or information system or controls, or (2) the directors implement such a system or controls but consciously fail to monitor or oversee its operations thus preventing themselves from being informed of risks or problems requiring their attention.
Recent Caremark Applications
A Caremark claim against directors is among the hardest to plead and prove. In decisions dismissing Caremark claims, plaintiffs often lose as a result of conceding that board-level systems of monitoring and oversight exist, such as through the operation of a relevant committee. For example, in Stone v. Ritter, although the company paid $50 million in fines related to the failure by bank employees to comply with the federal Bank Secrecy Act, the board dedicated considerable resources to the Bank Secrecy Act compliance program and put into place numerous procedures and systems to attempt to ensure compliance. The court concluded that despite the violations a reasonable reporting system existed to prevent and detect them and there was thus no basis for the claims that the directors failed in their oversight duties.
Although Delaware case law emphasizes that Caremark liability should be exceedingly rare, recent Delaware courts have permitted Caremark claims against directors to survive beyond the motion to dismiss stage.
Marchand v. Barnhill
In Marchand v. Barnhill, a stockholder brought a derivative suit against key executives and directors of Blue Bell Creameries, an ice cream manufacturer, claiming breaches of their fiduciary duties arising from a listeria outbreak. The Delaware Chancery Court dismissed the Caremark claims, finding that the plaintiff did not plead any facts to support the contention that the Blue Bell board utterly failed to adopt or implement any reporting and compliance systems. The Delaware Supreme Court disagreed, holding that the complaint alleged particularized facts to support a reasonable inference that the Blue Bell board failed to implement any system to monitor Blue Bell’s food safety performance or compliance. The Marchand court emphasized that it was not examining the effectiveness of the board-level compliance and reporting system after the fact but was instead focusing on whether the complaint alleged facts supporting a reasonable inference that the board did not undertake good faith efforts to put a board-level system of monitoring and reporting in in place.
The Marchand court highlighted that the plaintiffs did as the law encourages and sought out books and records about the extent of board-level compliance efforts at Blue Bell regarding the single-line company’s central compliance issue—food and safety. The Marchand opinion provides that a Caremark breach may be inferred where the books and records confirm that regular reports to the board contain no information on an “intrinsically critical” compliance issue, especially involving public health and safety. The plaintiffs pleaded and the court accepted that the absence of Blue Bell board’sminutes with references to listeria or the frequent positive tests indicated that the directors were not informed of the then-current situation. The directors left the company’s response to management.
Marchand also highlights that even where Blue Bell complied with applicable laws and regulations (such as Food and Drug Administration regulations), its compliance did not imply that the company’s board implemented a monitoring system. The court will evaluate (1) the systems the board implements, aside from mandatory regulations, and (2) whether the board has made a good faith effort to monitor the system implemented.
In re Clovis Oncology, Inc.
In In re Clovis Oncology, Inc. Derivative Litigation, stockholders sued alleging members of the Clovis board breached their fiduciary duties by failing to oversee a clinical trial of Rociletinib, a therapy for treatment of lung cancer, and then allowing Clovis to mislead the market regarding the drug’s efficacy. In Clovis like in Marchand, the derivative claims against the directors survived beyond the motion to dismiss stage, where the court held that the board ignored red flags that Clovis was not adhering to the clinical trial protocols and then, with the trial’s skewed results in hand, allowed Clovis to deceive regulators and the market regarding the drug’s efficacy. Clovis turns on the second prong of Caremark—sufficient monitoring. The court found that the first prong was met—the board had a reporting system in place; however, the court found that the second prong was not met because the company failed to monitor the system it implemented by consciously ignoring red flags that revealed a mission critical failure to comply with protocols and regulations.
Inter-Marketing Group USA, Inc. v. Armstrong
In Inter-Marketing Group USA, Inc. v. Armstrong, after a Plains All American pipeline ruptured and spilled oil into an environmentally sensitive part of the west coast, a Plains unitholder filed a derivative suit alleging that Plains, related entities, and individual defendants all breached common law fiduciary duties by failing to implement or properly oversee a pipeline integrity reporting system. The Delaware Chancery Court refused to dismiss Caremark type claims against the general partner, finding that the general partner, through the board, violated its contractual duty to Plains by consciously failing to oversee its mission-critical objective of maintaining pipeline integrity.
Hughes v. Hu
Finally, in Hughes v. Hu, a stockholder sued directors and executives, contending that the director defendants consciously failed to establish a board-level system of oversight for Kandi Technologies Group’s financial statements and related-party transactions, choosing instead to blindly rely on management. Kandi persistently struggled with its financial reporting and internal controls, encountering difficulties with related-party transactions, and although Kandi had pledged to remediate these problems after a 2014 announcement of the existence of material weaknesses in its financial reporting and oversight system, in 2017, Kandi disclosed that it needed to restate its preceding three years of financial statements. A plaintiff can state a Caremark claim by alleging that the company had an audit committee that met only sporadically and devoted patently inadequate time to its work, or that the audit committee had clear notice of serious accounting irregularities and simply chose to ignore them. The plaintiff adequately plead that Kandi’s audit committee met sporadically, devoted inadequate time to its work, had clear notice of irregularities and consciously turned a blind eye to their continuation. The Delaware Chancery Court refused to dismiss the derivative claims against the Kandi directors.
Caremark, Marchand and their progeny emphasize the importance of directors (1) implementing a reporting system, and (2) actually and continuously monitoring that system. Importantly, it is not the effectiveness of the controls that makes for the alleged bad faith fiduciary breach but whether there were processes in place that were being utilized. As a result, to reduce their exposure in light of recent success of Caremark claims, directors should analyze their board and committee-level processes and document them thoroughly in the minutes as described in more detail below.
Current Climate and Director Liability
The COVID-19 pandemic and the resulting economic contraction have caused significant losses. In the face of such losses, stockholders and other potential plaintiffs (such as creditors) may seek to bring suit asserting that such losses were deepened by or in some cases even stem from directors’ failure to discharge their fiduciary duties under Caremark. This increase in the possibility of a lawsuit paired with recent successful Caremark claims should lead directors to focus more on their oversight, systems, monitoring of such oversight and documenting the same in the minutes. In increasing such oversight, it may be helpful to review the following:
Reassess Key Operational, Financial and Legal Risks
Post-Marchand, directors should identify the key risks of the company and understand the oversight and monitoring of those risks. Marchand and Clovis emphasize that identifying key risks is even more important when the company operates a single line of business that affects health and safety of the general public—such as companies in food manufacturing, healthcare, bioscience or transportation.
To assist, directors could invite key members of management to attend board or committee meetings and discuss the risks of their particular roles. Directors should reassess key operational, financial and legal risks, including:
- Outlook and contingency planning regarding operations, operational continuity and disaster preparedness, including the supply chain, distributors and customers;
- Outlook and contingency planning regarding personnel;
- Liquidity and finance arrangements;
- Potential insolvency;
- Outlook of revenues and expenses;
- Earnings guidance;
- Privacy and cybersecurity issues; and
- Regulators’ expectations in the current climate.
In addition, audit or risk committees should review their charters for necessary scope expansion and to ensure sufficient resources are available to execute their mandate.
Increase Oversight
Directors should consider scheduling more or additional meetings with management to discuss key risks and critical COVID-19 and related economic issues, ensuring the right people are in the conversation. Although the audit committee is critical for mitigating risk as it relates to compliance, the audit committee should not be the only committee. Directors could rely on established risk committee or even consider forming a board subcommittee or special committee specifically to oversee COVID-19 issues and its potential impacts on the company.
Review Processes
Directors could review each of the reassessed key risks and ensure a reporting and monitoring system exists that is sufficient to ensure they remain informed about these key risks. Directors should ensure specifically that that the company has implemented COVID-19 reporting systems at the board level.
In Clovis, the Delaware courts highlight that even if a system is in place, the board should make a good faith effort to monitor the system implemented. Directors should pay special attention to whether the systems that have implemented are being closely monitored.
Boards of public companies should assess their required ethics hotlines and other compliance tools. For example, directors should confirm that (1) the ethics hotline number and email work, (2) there are posters up, (3) the person(s) charged with receiving complaints are the correct person(s), and (4) there is a process for receiving, reviewing and escalating or reporting employee or anonymous complains. Such confirmation will assist in ensuring that a “culture of compliance” exists.
Increase Documentation
In almost all of the above cases, the plaintiffs’ pleadings of the Caremark claims were supported by demand to inspect books and records under 8 Del. C. section 220. In Marchand specifically, the lack of minutes to support that the board addressed the key risk of health and safety supported the inference that they had not implemented a system to do so. Thus, directors should document effectively the systems and oversight they have in place and their monitoring of the same.
The minutes of board meetings should demonstrate that the directors are adequately exercising their fiduciary duties by demonstrating the level of information provided and the depth of review and discussion. Directors should keep in mind that possible plaintiffs will cite to such minutes in support of potential derivatives suits. Balancing the details in the minutes is a fine art. The note taker should be careful to include in the notes the topics that the board considers and addresses but may want to be more discrete in covering the substance and finer considerations, especially if attorney-client privileged communications are a part of the discussion.
Mackenzie S. Wallace is a Dallas trial partner focused on healthcare, securities, antitrust, white collar, and general business and commercial litigation. She is a past president of the Dallas chapter of the Federal Bar Association.
Catherine C. Rowsey is an associate in Dallas focusing her practice on complex commercial litigation and arbitration matters, government investigations and enforcement actions, and corporate governance and internal investigations.