(Article from Securities Law Alert, January 2018)
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On December 15, 2017, the Delaware Supreme Court affirmed dismissal of a derivative suit against the directors of an energy company for failure to plead demand futility based on an alleged Caremark violation. City of Birmingham Ret. & Relief Sys. v. Good, 2017 WL 6397490 (Del. 2017) (Seitz, J.). Plaintiffs alleged that demand was excused because the directors faced a substantial likelihood of personal liability for failing to ensure the company’s compliance with environmental regulations.[1] The company ultimately faced criminal consequences, along with hefty fines and sizable remediation costs. The Delaware Supreme Court reaffirmed that plaintiffs cannot plead the bad faith necessary to state a Caremark violation merely by pointing to a “bad outcome.”
In In re Caremark International Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), the Delaware Chancery Court recognized that directors may face personal liability for failure to ensure corporate compliance with the law. Plaintiffs asserting a Caremark claim “must allege that the directors intentionally disregarded their oversight responsibilities such that their dereliction of fiduciary duty rose to the level of bad faith.” City of Birmingham, 2017 WL 6397490. Given “the difficulties in proving bad faith director action,” the Delaware Supreme Court reiterated that “a Caremark claim is ‘possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.’” Id. (quoting Caremark, 698 A.2d 959).
Plaintiffs Cannot Rely on a Bad Outcome to Allege Bad Faith
In the case before the court, plaintiffs alleged that certain board presentations and minutes demonstrated that the board knew the company was flouting environmental regulations, yet failed to take steps to ensure compliance. The Delaware Supreme Court determined that these presentations and minutes instead confirmed that “the board was not only informed of environmental problems, but also the steps being taken to address them.” The court held these materials did “not lead to the inference that the board consciously disregarded its oversight responsibility by ignoring environmental concerns.”
The Delaware Supreme Court found plaintiffs’ allegations similar to those at issue in Stone v. Ritter, 911 A.2d 362 (Del. 2006). There, plaintiffs asserted a Caremark violation where the company had paid large fines for legal violations, even though the board had monitored the company’s operations through periodic reports from the company’s officers. The Stone court held that plaintiffs could not state a Caremark claim by “equat[ing] a bad outcome with bad faith.” Stone, 911 A.2d 362. “As in Stone,” the Delaware Supreme Court in City of Birmingham found that plaintiffs were attempting to “conflate the bad outcome of the criminal proceedings with the actions of the board.”
Allegations of Business-Friendliness Are Not Sufficient to Allege Regulator Corruption
Plaintiffs further claimed that the directors had “improperly colluded with regulators to avoid remediating environmental problems.” The Delaware Supreme Court found plaintiffs merely “alleged that [the regulator] in general did not aggressively enforce environmental laws.” The court explained that “general allegations regarding a regulator’s business-friendly policies are insufficient to lead to an inference that the board knew [the company] was colluding with a corrupt regulator.” Rather, plaintiffs must “allege in sufficient detail that [the company] illegally colluded with a corrupt regulator,” and then “tie the improper conduct to an intentional oversight failure by the board,” to allege a Caremark violation on this basis.
Chief Justice Strine, Dissenting, States That “Conclusive Proof” Is Not Necessary to Allege a Caremark Claim
Chief Justice Strine, dissenting, expressed his view that plaintiffs need not “have conclusive proof of all their contentions” to meet the particularized pleading requirement for demand futility. He observed that “[r]arely will [the] evidence involve admissions by experienced managers and board advisors that the strategy they are undertaking involves a conscious decision to violate the laws.” Chief Justice Strine opined that plaintiffs do not “have to prove at this stage that there was collusion between a weak local regulator” and the company to state a Caremark violation. Rather, plaintiffs only have to “plead facts supporting an inference that [the company] consciously was violating the law, taking steps that it knew were not sufficient to come into good faith compliance, but which it believed would be given a blessing by a [business-friendly] regulatory agency.”
[1] Plaintiffs may plead demand futility by alleging particularized facts that “create a reasonable doubt of the board’s independence and disinterestedness when the demand would reveal board inaction of a nature that would expose the board to ‘a substantial likelihood’ of personal liability.” Horman v. Abney, 2017 WL 242571 (Del. Ch. 2017) (quoting Rales v. Blasband, 634 A.2d 927 (Del. 1993)).