(Article from Securities Law Alert, July 2019)
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On June 19, 2019, the Delaware Supreme Court reversed dismissal of a derivative suit alleging that the directors of an ice cream manufacturing company “breached their duty of loyalty under Caremark” by failing to oversee the company’s operations.[1] Marchand v. Barnhill, 2019 WL 2509617 (Del. 2019) (Strine, C.J.) (Marchand II). The Supreme Court held that the plaintiff adequately pled a Caremark violation by alleging “particularized facts that support a reasonable inference that the [company’s] board failed to implement any system to monitor [the company’s] food safety performance or compliance.” The court further found that the plaintiff adequately alleged demand futility with respect to breach of fiduciary duty claims against the company’s officers.
Background
In early 2015, an outbreak of listeria “caus[ed] the company to recall all of its products, shut down production at all of its plants, and lay off over a third of its workforce.” The listeria outbreak resulted in the death of three consumers of the company’s ice cream products, and also precipitated a major liquidity crisis for the company.
One of the company’s stockholders filed a books and records request pursuant to 8 Del. C. § 220 to investigate the board’s oversight of the company’s food safety practices. The stockholder subsequently brought a Caremark claim alleging that that the board “had no committee overseeing food safety” or “reporting system in place about food safety,” and “did not discuss food safety at its regular board meetings.” The plaintiff further alleged that the lack of a reporting system was evidenced by management’s failure to report listeria issues to the directors until a crisis erupted, even though management allegedly had “two years of evidence that listeria was a growing problem for [the company].” The plaintiff also asserted breach of fiduciary duty claims against the company’s CEO and one other officer. Defendants moved to dismiss the complaint.
The Chancery Court found that “there was a monitoring system in place” in view of the company’s “compliance with FDA regulations, ongoing third-party monitoring for contamination, and consistent reporting by senior management to [the company’s] board on operations.” Marchand II, 2019 WL 2509617. The Chancery Court held that the plaintiff failed to state a Caremark claim because he was not challenging “the existence of monitoring and reporting controls, but the effectiveness of monitoring and reporting controls in particular instances.” Id. (quoting Marchand v. Barnhill, 2018 WL 4657159 (Del. Ch. 2018) (emphasis in original)).
The Chancery Court also ruled that the plaintiff was one director short of alleging that a majority of the board could not impartially consider a demand with respect to breach of fiduciary duty claims against the company’s CEO. The plaintiff alleged, inter alia, that the CEO’s family had made donations totaling $450,000 to a university building named in honor of the dispositive director. The Chancery Court nevertheless found that the director was independent of the CEO and his family because the director had voted in favor of separating the CEO and Chairman positions—which the CEO strongly opposed. The plaintiff appealed.
Caremark Imposes a “Bottom-Line” Requirement of a Board-Level Oversight System
On appeal, the Supreme Court recognized that “Caremark is a tough standard for plaintiffs to meet” and imposes an “onerous pleading burden.” The court noted that “directors have great discretion to design context- and industry-specific approaches tailored to their companies’ businesses and resources” when establishing a board-level oversight system. The court also observed that Delaware “case law gives deference to boards and has dismissed Caremark cases even when illegal or harmful activities escaped detection” by the board’s oversight system. However, the Supreme Court underscored that Caremark imposes a “bottom-line requirement” that directors must at least “try . . . to put in place a reasonable board-level system of monitoring and reporting.”
The Supreme Court held that “the complaint supports an inference that no system of board-level compliance monitoring and reporting existed at [the company].” The court found the company’s “nominal[ ]” compliance with FDA regulations insufficient to demonstrate “that the board implemented a system to monitor food safety at the board level.” The court reasoned that “these types of regulatory requirements, although important, are not typically directed at the board.” The court explained that the company’s compliance with regulatory requirements “does not rationally suggest that the board implemented a reporting system to monitor food safety or [the company’s] operational performance.”
The Supreme Court further found that the directors could not avoid Caremark liability merely because “management regularly reported to them on ‘operational issues.’” The court noted that “[a]t every board meeting of any company, it is likely that management will touch on some operational issue.” The court reasoned that “Caremark would be a chimera” if the board’s oversight responsibilities could be satisfied by management’s discretionary discussions with the board concerning the company’s general operations.
Director’s Vote Against the CEO on a Corporate Governance Matter Did Not Establish the Director’s Disinterestedness to Consider a Suit Against the CEO
The Supreme Court also found the Chancery Court erred in determining that one of the director’s ties to the CEO’s family “did not matter” because the director voted against the CEO on a corporate governance matter. The court explained that “the decision whether to sue someone is materially different and more important than the decision whether to part company with that person on a vote about corporate governance.” The Supreme Court stated that the Chancery Court was “bound to accord the plaintiff the benefit of all reasonable inferences, and the pled facts fairly support the inference that [the director] owes an important debt of gratitude to the [CEO’s] family for giving him his first job, nurturing his progress from an entry level position to a top manager and director, and honoring him by spearheading a campaign to name a building at an important community institution after him.” The court explained that Delaware “law has recognized that deep and longstanding friendships are meaningful to human beings and that any realistic consideration of the question of independence must give weight to these important relationships and their natural effect on the ability of the parties to act impartially toward each other.” The Supreme Court held that the plaintiff had adequately pled demand futility by alleging that a majority of the board could not impartially consider demand as to the claims against management, and reversed dismissal of these claims.
[1] In In re Caremark International Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), the Delaware Chancery Court stated that “where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation . . . only a sustained or systemic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists—will establish the lack of good faith that is a necessary condition to liability.”