July 29, 2019
In a recent decision applying the famous Caremark doctrine, the Delaware Supreme Court confirmed several important legal principles that we expect will play a central role in the future of derivative litigation and that serve as important reminders for boards of directors in performing their oversight responsibilities. In particular, the Delaware Supreme Court held that a claim for breach of the duty of loyalty is stated where the allegations plead that “a board has undertaken no efforts to make sure it is informed of a compliance issue intrinsically critical to the company’s business operation.”
Although the case addressed extreme facts that will have no application to most mature corporations, the plaintiffs’ bar can be expected to attempt to weaponize the decision. With all the benefits that hindsight provides, derivative plaintiffs will more frequently contend that a board lacked procedures to monitor “central compliance risks” that were “essential and mission critical.” The Supreme Court’s decision reinforces that directors need to implement controls that enable them to monitor the most serious sources of risk, and may even caution in favor of a special discussion each year around critical risks.
Marchand involved problems at Blue Bell Creameries USA, Inc., “a monoline company that makes a single product—ice cream.” After several years of food-safety issues known by management, the company suffered a listeria outbreak. This outbreak led to a product recall, a complete operational shutdown, the layoff of one-third of employees, and three deaths. The operational shutdown, in turn, caused the company to accept a dilutive investment to meet its liquidity needs. After obtaining books and records, a stockholder sued derivatively alleging breach of fiduciary duties under Caremark. That theory requires sufficiently pleading that “the directors utterly failed to implement any reporting or information system or controls” or “having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of the risks or problems requiring their attention.”
The plaintiff, though, chose not to make a demand on the board before suing on behalf of the company, so he was subject to the burden of pleading that making a demand would have been futile. In an effort to do so, he tried to allege that a majority of the board was not independent because it could not act impartially in considering a demand and that the directors also faced liability under Caremark. The Delaware Court of Chancery rejected both arguments, holding that the plaintiff came up one director short on his independence theory and that the plaintiff failed to plead liability under Caremark. The Delaware Supreme Court reversed both holdings.
On independence, Chief Justice Strine continued his instruction from Delaware County Employees Retirement Fund v. Sanchez, 124 A.3d 1017 (Del. 2015) and Sandys v. Pincus, 152 A.3d 124 (Del. 2016) that Delaware law “cannot ignore the social nature of humans or that they are motivated by things other than money, such as love, friendship, and collegiality.” “[D]eep and long-standing friendships are meaningful to human beings,” the Chief Justice reasoned, and “any realistic consideration of the question of independence must give weight to these important relationships and their natural effect on the ability of parties to act impartially towards each other.” The director at issue, although recently retired from his role as CFO at the company, owed his “successful career” of 28 years at the company to the family of the CEO whom the director would be asked to sue. And that family “spearheaded” an effort to donate to a local college that resulted in the college naming a new facility after the director. These facts “support[ed] a pleading-stage inference” that the director could not act independently.
This was so despite the director’s previously voting against the CEO on whether to split the company’s CEO and Chairman position. Although the Court of Chancery reasoned that this militated against holding that the director was not independent, the Delaware Supreme Court held it was irrelevant to the demand futility analysis. Voting to sue someone, the Supreme Court explained, is “materially different” than voting on corporate-governance issues. The Supreme Court thus held that the number of directors incapable of acting impartially was sufficient to excuse demand.
On Caremark liability, the Court focused on the first prong of the Caremark test: whether the board had made any effort to implement a reporting system. It explained that a director “must make a good faith effort” to oversee the company’s operations. “Fail[ing] to make that effort constitutes a breach of the duty of loyalty” and can expose a director to liability. To meet this standard, the board must “try” “to put in place a reasonable system of monitoring and reporting about the corporation’s central compliance risks.”
For Blue Bell, food safety was “essential and mission critical” and “the obviously most central consumer safety and legal compliance issue facing the company.” Despite its importance, the complaint contained sufficient facts to infer that no system of board-level compliance monitoring and reporting over food safety existed at the company. For example:
These shortcomings convinced the Delaware Supreme Court that the plaintiff had pleaded sufficient allegations that Blue Bell’s “board ha[d] undertaken no efforts to make sure it [wa]s informed of a compliance issue intrinsically critical to the company’s business operation.” Id. at 33. So the Court could infer that the board “ha[d] not made the good faith effort that Caremark requires.”
That management “regularly reported” to the board on “operational issues” was insufficient to demonstrate that the board had made a good faith effort to put in place a reasonable system of monitoring and reporting about Blue Bell’s central compliance risks. So, too, was “the fact that Blue Bell nominally complied with FDA regulations.” Neither of these facts showed that “the board implemented a system to monitor food safety at the board level.” In light of these facts, the Supreme Court held that the plaintiff met his “onerous pleading burden” and was entitled to discovery to prove out his Caremark claim.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Securities Litigation or Securities Regulation and Corporate Governance practice groups, or the authors in Washington, D.C.:
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