January 2024 in Brief: Corporations, LLCs & Partnerships

Court of Chancery Dismisses “Red-Flags” Caremark Claim against Corporate Officer for Failure to Plead that Defendant Acted in Bad Faith in Response to “Everyday Business Problems”

Segway Inc. v. Hong Cai, C.A. No. 2022-1110-LWW (Del. Ch. Dec. 14, 2023)

By Christopher D. Renaud and Rebecca Bolinger, Potter Anderson & Corroon LLP

In this memorandum opinion, the Delaware Court of Chancery dismissed a Caremark claim asserted against a corporation’s former president. The Court held that the plaintiff’s complaint did not adequately plead that the defendant acted in bad faith or that potential wrongdoing even occurred. The company claimed the defendant breached her fiduciary duties by continuously ignoring customer issues (which caused the company’s accounts receivable to rise and negatively impacted profitability) and by failing to address or to advise its board of these issues. The company framed these allegations as a “Red-Flags Claim” for breach of the duty of oversight under the second prong of Caremark (a “Red-Flags Claim”).

The Court explained that a viable Red-Flags Claim against a corporate officer requires a plaintiff to plead that (1) the officer “consciously failed to act after learning about evidence of illegality—the proverbial ‘red flag’” and, (2) under the framework recently set out in In re McDonald’s Corporation Stockholder Derivative Litigation, 289 A.3d 343 (Del. Ch. 2023), that the oversight violation fell within the officer’s “sphere of corporate responsibility.”

The Court held that the company had not alleged any potential wrongdoing—e.g., “overlook[ing] accounting improprieties, fraudulent business practices, or other material legal violations”—that fell within the defendant’s purview as an officer. Rather, the Court held that the company’s assertion of generic financial issues with unspecified customers, revenue decreases for a product line, and increases in receivables are not “red flags that could give rise to Caremark liability if deliberately ignored.” The Court also ruled that the company did not allege facts suggesting the defendant acted in bad faith, explaining that “[b]ad things can happen to corporations despite fiduciaries exercising the utmost good faith.”

The Court cautioned against using the Caremark doctrine as “a tool to hold fiduciaries liable for everyday business problems,” stating instead that it “is intended to address the extraordinary case where fiduciaries’ ‘utter failure’ to implement an effective compliance system or ‘conscious disregard’ of the law gives rise to a corporate trauma.” The Court also made clear that the stringent Caremark standard is no different for claims against officers, and an argument for a lower standard was “a distressing reading of our law.”