[co-author: Charles Edward Smith]
Recent rulings underscore the attention boards of directors and management must continue to pay to the risks faced by companies across all sectors of the economy and their potential impact on business operations. Last year’s decision in In re Boeing Co. Derivative Litigation1 only serves as the most recent reminder of the potential exposures (including personal liability) companies, boards of directors and management may face.
Caremark, its progeny and Director Liability
In Caremark,2 the Delaware Court of Chancery stated that, when directors of a Delaware corporation are exculpated from liability for a breach of the duty of care or attention, they may nonetheless be held liable on a breach of loyalty theory if such directors have (1) utterly failed to implement any reporting system or controls and (2) consciously failed to monitor such a system. The court stated, “only a sustained or systematic 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.” As a result of Caremark, the board, among its other fiduciary obligations, must undertake a duty of oversight to make a good faith effort to put into place a reasonable board-level system of monitoring and reporting.
Recently in Marchand,3 plaintiffs’ breach of fiduciary duty allegations against a certain company’s board of directors survived a motion to dismiss. The Delaware Supreme Court concluded that the plaintiff had adequately pled a Caremark claim that directors had acted in bad faith and breached their duty of loyalty by failing to have a board-level compliance monitoring and reporting system related to food safety. The court, focusing on regulatory risks, held that board oversight must be “rigorously exercised” when dealing with “mission critical” risks. The Marchand decision provides that the directors’ lack of attentiveness to key risks in their oversight role may rise to the level of “bad faith indifference” required for a Caremark claim.
Subsequently, in Clovis Oncology,4 the Delaware Court of Chancery again allowed the plaintiffs’ Caremark claim to survive a motion to dismiss. The court relied on the second prong of the Caremark test in which a company “implemented an oversight system but the board failed to ‘monitor it.’” The court denied the motion to dismiss finding that plaintiffs had successfully plead “that the Board consciously ignored red flags that revealed a mission critical failure to comply with [federal health care protocols] and associated FDA [Food and Drug Administration] regulations.” The Clovis Oncology decision highlights the importance of not only having in place a system for board oversight, but also for the board to actively use and monitor that system.
Boeing Decision
The Delaware Court of Chancery most recently permitted claims against the Boeing board to survive a motion to dismiss, in a case that some commentators believe has further expanded potential board oversight liability. In denying the board’s motion to dismiss, the court concluded that the complaint sufficiently pled that the board that had “failed to establish a reporting system” for airplane safety. Further, the court stated that the complaint had adequately pled that the first of the two crashes “was a red flag . . . that the Board should have heeded but instead ignored,” and “the Board was aware or should have been aware that its response to the [first crash] fell short.”
The court pointed to safety being “essential and mission critical” to Boeing’s business. The court recognized that plaintiffs’ pleading burden was onerous, but found that they had made sufficient allegations related to the board’s lack of oversight systems to survive the motion to dismiss and were entitled to pursue discovery to prove their claims.
Conclusion and Recommendations
Caremark claims likely remain one of the most difficult theories for plaintiffs to use to establish director liability in Delaware. Nevertheless, some commentators believe that decisions subsequent to Caremark demonstrate that it has become easier to for plaintiffs to survive the motion to dismiss stage, where the court must assume the plaintiff’s allegations are true and draw all reasonable inferences in favor of the plaintiff.
Boards should consider taking proactive steps to minimize the likelihood of facing similar lawsuits in the first place. The composition and culture of the board can go a long way in this regard. To insulate itself from potential claims, boards should:
- Include members who have knowledge of or experience with the industry and demonstrate objectivity.
- Avoid too many interrelationships between board members that make it difficult to obtain objective opinions.
- Cultivate an environment where potential problems can be freely discussed and where constructive criticism is appreciated.
Additionally, boards can potentially limit the likelihood of facing a suit by adopting practices such as:
- Reviewing their board committees and charters, and evaluating whether committee mandates and reviews should be expanded to cover key risks.
- Ensuring the board structure reflects the industry and its specific needs and risks.
- Reviewing safety issues regularly, memorializing the efforts to oversee issues to demonstrate that the board and/or committees regularly engage in oversight and compliance programs.
- Assessing notification and follow-up protocols for an environmental or personal safety issues in order to resolve the situation and prevent a reoccurrence of the issue.
- Discussing worst case scenarios frequently. This can improve the board’s ability to react quickly and effectively in the event an actual issue arises.
- Enforcing accountability whenever problems arise to inspire trust and faith in the board, making it less likely for shareholders to file suit.
1 In re the Boeing Co. Derivative Litig., No. 2019-0907 (Del. Ch. Sept 7, 2021).
2 In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).
3 Marchand v. Barnhill, 212 A.3d 805 (Del. 2019).
4 In re Clovis Oncology, Inc. Derivative Litig., No. CV 2017-0222-JRS, 2019 WL 4850188, (Del. Ch. Oct. 1, 2019).
