(Article from Securities Law Alert, August/September 2019)
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On July 29, 2019, the Delaware Chancery Court dismissed with prejudice a derivative action because the plaintiff failed to allege that a majority of the directors faced a substantial likelihood of personal liability in connection with the claims at issue, which concerned the company’s price comparison advertising policy and practices. Rojas v. Ellison, 2019 WL 3408812 (Del. Ch. 2019) (Bouchard, C.). The court found the plaintiff could not allege a violation under the first prong of Caremark because the plaintiff conceded the existence of a board-level reporting system.[1] With respect to the plaintiff’s failure-to-monitor allegations under the second prong of Caremark, the court found that a settlement without admission of wrongdoing or liability does not, standing alone, constitute a “red flag.”
The court rejected what it found to be a “faint-hearted attempt to argue that the members of the Demand Board face a substantial likelihood of personal liability under the first prong of Caremark for ‘utterly failing’ to implement any reporting or information system or controls with respect to the [c]ompany’s advertising and pricing policies.” The court noted that the Delaware Supreme Court in Stone v. Ritter, 911 A.2d 362 (Del. 2006), was “quite deliberate in its use of the adverb ‘utterly’—a ‘linguistically extreme formulation’—to set the bar high when articulating the first way to hold directors personally liable for a failure of oversight under Caremark.” More recently, in Marchand v. Barnhill, 212 A.3d 805 (Del. 2019), the Delaware Supreme Court held that Caremark imposes “a bottom-line requirement” that “the board must make a good faith effort—i.e., try—to put in a place a reasonable board-level system of monitoring and reporting.”[2] The Marchand court observed that “[i]n decisions dismissing Caremark claims, the plaintiffs usually lose because they must concede the existence of board-level systems of monitoring and oversight such as a relevant committee, a regular protocol reporting board-level reports about the relevant risks, or the board’s use of third-party monitors, auditors, or consultants.” The Rojas court found “[t]hat is the case here,” as the plaintiff admitted that the board did in fact have a reporting system in place.
The Rojas court found similarly meritless plaintiff’s allegations that the directors knew or should have known the company was violating the law, but failed to monitor the company’s operations under the second prong of Caremark. The plaintiff claimed the settlement of a consumer class action “put the full [b]oard on notice that the [c]ompany’s pricing policies violated Consumer Protection Laws.” But the court found “[a] settlement of litigation or a warning from a regulatory authority . . . [does not necessarily] demonstrate that a corporation’s directors knew or should have known that the corporation was violating the law.” The court explained that the issue of “[w]hen such events become a ‘red flag’ depends on the circumstances.”
Here, the court found the settlement was made without any admission of liability. The court observed that the class action “was not brought against the backdrop of a prior settlement where clear, repeated violations of a law had been found.” Rather, the suit “was a purely civil matter of the type that commercial parties routinely settle after motion practice.” The court rejected the plaintiff’s contention that “the sheer amount of the settlement payment . . . and the fact that the [c]ompany lost multiple motions . . . should satisfy his pleading burden” to allege demand futility. The court found the plaintiff’s allegations “far from sufficient in the context of the overall circumstances to support the inference of scienter necessary to demonstrate that [the company’s] directors acted in bad faith.”
[1] In In re Caremark Int’l Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), the court addressed the scope of directors’ obligations to monitor corporate operations. The court held that directors must “attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists.” The court further held that directors may be liable for “failing adequately to control” the company’s employees if “the directors knew or . . . should have known that violations of law were occurring” and “took no steps in a good faith effort to prevent or remedy that situation” and “such failure proximately resulted in . . . losses” to the corporation.
[2] Please click here to read our discussion of the Delaware Supreme Court’s decision in Marchand.