December 10, 2019 Articles

“I Got a Bad Feeling About This”: Are Caremark’s Walls Closing In on Directors?

Two recent decisions holding that “mission critical” aspects of a corporation’s business require more rigorous board oversight might signal an emerging trend in Delaware that will make it easier for shareholder plaintiffs to plead and prove Caremark claims.

By Gregory L. Watts

In Star Wars: A New Hope, the original movie in the nine-film saga, heroes Princess Leia, Luke Skywalker, Han Solo, and Chewbacca, hemmed in by Stormtroopers, blast a hole in a grate and slide down a Death Star garbage chute to escape. The chute dumps them into a large metal room filled waist-high with water and garbage. After some bickering and splashing around, the room becomes quiet until a deep metallic clank is heard, as if releasing a giant latch. Han Solo, looking at the walls around him, worriedly says, “I got a bad feeling about this.” No sooner than these words cross his lips, two opposing walls start closing in on our heroes, and they realize they are in a giant trash compactor about to crush them. Based on an emerging trend in two recent Delaware opinions concerning director fiduciary duties, individuals serving on boards of directors may soon relate all too well to this iconic scene.

A breach of fiduciary duty claim against directors for a conscious failure of oversight and monitoring is commonly known as a Caremark claim. In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996). A Caremark claim can be pleaded and proved in two ways, often referenced by courts as prongs: (1) that “directors utterly failed to implement any reporting or information system or controls” or (2) that the directors, “having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.” Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006). In either instance, liability can be imposed only if the directors knew of and consciously disregarded their fiduciary duties.

This exceedingly high standard has caused courts to describe a Caremark claim as the “most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” Caremark, 698 A.2d at 967. As a result, in the more than two decades since the Caremark decision was issued, very few Caremark claims have resulted in an adverse judgment against directors. Indeed, such claims are rarely brought because a plaintiff’s prospects for success are slim to none. Until now.

The Delaware Supreme Court’s opinion in Marchand v. Barnhill, 212 A.3d 805 (Del. 2019), interpreting and applying prong 1, and the Delaware Court of Chancery’s opinion in In re Clovis Oncology, Inc. Derivative Litigation, 2019 WL 4850188 (Del. Ch. Oct. 1, 2019), interpreting and applying prong 2, signal a shift in the Delaware courts that may make it easier for plaintiffs to plead and prove Caremark claims. Following Marchand, plaintiffs may find it easier to plead a board’s utter failure to implement reporting systems under the first prong. Following Clovis Oncology, plaintiffs may find it easier to plead a board’s conscious failure of oversight and willful ignorance of red flags under the second prong. The heavy latch has been lifted. The walls of Caremark’s two prongs seem to be closing in, and directors and their counsel may start feeling squeezed.

Marchand and the Prong 1 Wall

In Marchand, a case precipitated by listeria contamination in ice cream manufactured and sold by Blue Bell Creameries that sadly resulted in consumer deaths, the Delaware Supreme Court held that the complaint adequately alleged a claim under the first prong of Caremark because it contained particularized facts supporting an inference “that no system of board-level compliance monitoring and reporting existed at Blue Bell” and that the board “failed to implement any system to monitor Blue Bell’s food safety performance or compliance.” 212 A.3d at 809, 822. The shareholder plaintiff had obtained board minutes and materials through a shareholder inspection demand. Relying on those documents, the shareholder plaintiff alleged and the court found the following allegations sufficient to plead a Caremark violation under the first prong: (1) the board had no committee specifically charged with monitoring or overseeing food safety; (2) the board did not have a process by which a portion of the board’s meetings each year were specifically devoted to food safety compliance; and (3) the board “was not presented with any material information about food safety,” because it had “no expectation” that it would receive such information. Id. at 809, 813.

While the Marchand decision repeats and affirms prior Delaware case law on the exceedingly high bar a plaintiff must clear to plead and prove a Caremark claim under the first prong and expressly states that the court was “not examining the effectiveness of a board-level compliance and reporting system after the fact,” id. at 822, the Delaware Supreme Court’s analysis seemed to engage in some baseline shifting with the benefit of hindsight. Blue Bell Creameries’ management did provide the board with regular reports regarding Blue Bell operations, including reports about audits of Blue Bell’s facilities. Id. at 817. While these regular reports could have and probably should have included information concerning food safety and Food and Drug Administration (FDA) regulatory compliance, the complaint alleged that they did not. One certainly could argue that these regular reports on operations and audit results provided a reporting or information system to the board, and thus there was no “utter failure” by the board to set up such a system, but that management just failed to provide the board with important information when those subjects were discussed. Instead, the Delaware Supreme Court concluded that the board should have had a committee specifically tasked, presumably in its charter, with the responsibility of food safety oversight and that there should have been a portion of board or committee meetings specifically devoted to food safety, presumably reflected in the agenda, minutes, and board materials. Id. at 813, 823–24. The court explained that food safety was “mission critical” for the company and therefore should have been a specific area of focus at the board level. Id. at 824. While food safety seems to be a critical component of a business almost entirely dedicated to the manufacture and sale of ice cream, its importance is certainly emphasized with the benefit of hindsight after a listeria outbreak, consumer deaths, and a product recall.

Following Marchand, the risk for directors is that Delaware courts will evaluate the “mission critical” nature of an area of oversight with the benefit of hindsight. It is human nature to believe that a catastrophic event could have been prevented or the impact minimized, had someone done something differently. For example, if a Blue Bell Creameries’ employee had inadvertently been locked in a freezer and died, would a Delaware court later conclude that occupational safety was “mission critical” and that a board committee should have been specifically tasked with oversight and that board meeting agendas, minutes, and management presentations should have expressly shown that a portion of board and committee meetings were devoted to occupational safety? If Blue Bell Creameries became a defendant in a ruinous trade secret dispute with a competitor over an allegedly stolen ice cream flavor recipe or an expensive patent dispute over an innovative ice cream bar machine, would a Delaware court later conclude that intellectual property was “mission critical” and that a board committee should have been specifically tasked with oversight and that board meeting agendas, minutes, and materials expressly show that a portion of board and committee meetings were devoted to intellectual property? Probably, and that is the problem.

Hindsight may now dictate an expectation of a specific and expressly referenced oversight responsibility. A committee charter identifying oversight of legal and regulatory compliance may be viewed by a court with the benefit of hindsight as too general when examining a Caremark claim premised on a catastrophic event related to a specific compliance area like food safety. Similarly, a board’s minutes, agendas, or other meeting materials referencing updates on legal and regulatory compliance may be viewed in hindsight as an insufficient system or control unless there is express elaboration of its constituent categories, including food safety. Until post-Marchand Delaware courts issue opinions dismissing prong 1 Caremark claims premised on catastrophic company events, boards cannot help but feel the prong 1 wall closing in.

Clovis Oncology and the Prong 2 Wall

The Delaware Court of Chancery’s recent decision in In re Clovis Oncology, Inc. Derivative Litigation applied the second prong of Caremark—a conscious failure to monitor or oversee the company’s operations despite the presence of “red flags” that did, or should have, put the board on notice. 2019 WL 4850188 (Del. Ch. Oct. 1, 2019). In Clovis Oncology, the plaintiffs alleged that, in pursuing FDA approval for the cancer drug Rociletinib, Clovis adopted a well-known clinical trial protocol called RECIST, which incorporated a success-defining metric called objective response rate (ORR). The plaintiffs further alleged that Clovis’s board knew that RECIST’s ORR did not include unconfirmed (as opposed to clinically confirmed) responses as meaningful, nor would the FDA approve the drug based on such unconfirmed results. Id. at *1.

Yet, despite such knowledge, the board, according to the plaintiffs, allowed the company to report an ORR of 60 percent, which was based in part on unconfirmed responses and which gave the market the impression that the drug was showing more promise than the “correct” ORR using only clinically confirmed responses would have indicated. Id. at *5–7. The board was also allegedly aware of other clinical trial violations and side effects, which indicated additional concerns about the drug, but the board did not ensure the company’s announcements with respect to the drug were tempered. When the “correct” ORR of 28–34 percent was disclosed to the market, Clovis’s stock price dropped 70 percent, wiping out $1 billion in market value and resulting in securities class actions and Securities and Exchange Commission (SEC) enforcement proceedings. Id. at *8–9.

The Delaware Court of Chancery held that the company’s board did not utterly fail to implement a reporting system or controls (the alleged failure of the Blue Bell Creameries board in Marchand) because it was clear that the Clovis Oncology board’s nominating and corporate governance committee was charged with oversight over compliance with FDA requirements and the board reviewed detailed information at each board meeting regarding the clinical trial. Id. at *13. With respect to prong 2, however, the court held that particularized pleaded facts indicated the board “consciously ignored red flags that revealed a mission critical failure to comply with the [company’s own disclosed] protocol and associated FDA regulations.” Id. at *15. The court denied the defendants’ motion to dismiss and found that reasonable inferences could be drawn from board minutes, board materials, and the expertise of the directors that (1) the board knew the trial protocol included RECIST and that RECIST requires reporting only clinically confirmed responses, (2) industry practice and FDA guidance require that study managers report only clinically confirmed responses, (3) management was publicly reporting unconfirmed responses, and (4) the board knew management was incorrectly reporting unconfirmed responses but did nothing to address this departure from the protocol. Id. at *13. In essence, the court concluded that the directors knew or should have known that the company’s practices and public disclosures did not match the RECIST protocol, and that the board at the very least should have “connected the dots” or probed these inconsistencies. Id.

In reaching its conclusion, the Court of Chancery followed Marchand’s “mission critical” phraseology and stated that “when a company operates in an environment where externally imposed regulations govern its ‘mission critical’ operations, the board’s oversight function must be more rigorously exercised.” Id. This author predicts that “mission critical” is going to become a key test or trigger, unavoidably employed with the benefit of hindsight, to require more heightened oversight responsibility under both Caremark prongs. While “mission critical” is, for now, at least nominally coupled with a requirement that it is governed by “externally imposed regulations” before heightened oversight is required, it seems clear that a court can find any area of oversight both “mission critical” and governed by regulation.

In both Marchand and Clovis Oncology, the externally imposed regulations were FDA regulations related to food safety or clinical trial protocols, respectively, governing the companies’ core products. But what else qualifies as a “mission critical” regulatory issue requiring more rigorous board oversight under prong 2? Regardless of the type of business, companies are subject to data privacy, occupational safety and health, labor, environmental, antitrust, taxation, and a host of other state and federal regulations. Every publicly traded company is regulated by the SEC and required to comply with the listing standards of the public exchanges on which its stock trades. Is compliance with SEC regulations or with New York Stock Exchange or Nasdaq listing requirements mission critical? The Clovis Oncology opinion seems to indicate as much because one of the board’s alleged oversight failures was not ensuring that the company’s public disclosures were accurate. The bottom line is that if a company suffers a catastrophic event, a court in hindsight might find the risk, no matter how objectively insignificant or peripheral to the business before the event, mission critical and regulated, and therefore requiring a more rigorous exercise of board oversight. If “mission critical” is a post hoc analysis, a board might feel compelled to practice defensive governance, like defensive medicine, and obsess over every aspect of the business because a court in hindsight might view it as such. Clovis Oncology is the first post-Marchand case issued by the Delaware Court of Chancery. Only time will tell if Clovis Oncology is an outlier or the first indicator of the prong 2 wall closing in on directors.

Conclusion

The standards for pleading and proving a Caremark claim under either prong appear to be loosening. This will result in shareholder plaintiffs more frequently alleging Caremark claims and courts more frequently denying motions to dismiss such claims. Because Caremark claims are characterized as breaches of the duty of loyalty, not the duty of care, and because outside director exculpation provisions in corporation bylaws preclude personal liability for duty of care violations only, this trend could increase the real risk of outside director liability. The Caremark walls may be closing in on directors. Maybe the next dozen Caremark opinions from the Delaware Court of Chancery will allay my fears. Maybe a follow-up decision by the Delaware Supreme Court will clarify what is “mission critical.” Maybe I am just paranoid. Maybe I have watched Star Wars far too many times. But, for now, I got a bad feeling about this.

Gregory L. Watts is a member of Wilson Sonsini Goodrich & Rosati. This article expresses his own views and not necessarily those of his colleagues or clients.

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