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Sep 09, 2024

Lessons for directors as personal liability evolves in Delaware courts

Brian Rivas Boessenecker and Achyut Phadke explain how boards and counsel can limit director liability following an important period for Delaware case law

Five years after the Delaware Supreme Court’s landmark decision in Marchand vs Barnhill, Delaware law has undergone significant development with regard to director oversight liability. Post-Marchand cases show how adverse business, legal or environmental hazards facing corporations may result in personal liability for their officers and directors. They also contain lessons about practices that officers, directors and their legal advisers can use to minimize the risk of such liability.

Marchand involved Blue Bell Creameries, an ice cream company that suffered a listeria outbreak at its production plants that caused fatalities and substantial financial losses for the corporation. Reversing the trial court’s dismissal, the Delaware Supreme Court held that allegations Blue Bell’s board failed to implement a reasonable system of monitoring and reporting because the directors had no committee or board-level process to address food safety issues – an ‘essential and mission-critical’ business risk for an ice cream company – stated a viable claim for bad faith conduct in violation of their oversight duty.

Marchand reinvigorated litigation brought under the test set by the 1996 case In re Caremark International Inc Derivative Litigation. Caremark established that directors have a duty to monitor their organization and establish reporting systems intended to ensure compliance with the law and escalate any issues to the board and its committees.

For a plaintiff to prove a Caremark claim, a Delaware corporation’s directors must have either (i) ‘utterly failed to implement any reporting or information system’ or (ii) ‘consciously failed to monitor or oversee its operations’ to breach their oversight duty, resulting in harm to the corporation. Either failure constitutes bad faith conduct in violation of their duty of loyalty to the corporation.

Delaware courts variously refer to these different types of Caremark claims as ‘prong one’ or ‘information systems’ claims (failure to implement a reporting or information system), or ‘prong two’ or ‘red-flag’ claims (failure to monitor or act in response to reports received from information systems).

For decades following the Caremark ruling, Delaware courts emphasized that claims for breach of fiduciary duty based on a lack of oversight must overcome a very high hurdle. They were ‘possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment’, according to oft-cited language from the Caremark decision. Caremark claims were infrequently brought and rarely survived motions to dismiss.

After Marchand, shareholders have found success in bringing derivative lawsuits alleging failures of oversight duties. Many of these lawsuits build on Marchand’s emphasis on ‘essential and mission-critical’ risks that require board attention and responsive action. These lawsuits indicate a growing recognition of the importance of rigorous compliance and risk-management frameworks within corporations, consistent with the broader movement toward enhanced corporate accountability and governance for public companies.

Post-Marchand developments in Caremark case law
The first round of cases after Marchand allowed Caremark claims to proceed in a broad cross-section of businesses. Caremark claims had previously been considered dubious, if not dead on arrival; since Marchand, however, courts have permitted oversight claims to survive the pleading stage and enter discovery, where detailed allegations have shown the directors failed to act in the face of plausible red flags regarding events that ultimately caused harm to the corporation.

For example, where directors utterly fail to:

  • Investigate allegations of criminal conduct by a whistleblowing executive, leading to hundreds of millions of dollars in government settlements
  • Fulfill basic financial oversight roles such as holding regular audit committee meetings, resulting in a restatement
  • Respond to warnings regarding a business-critical clinical drug trial, resulting in a large stock price decline.

In such cases, courts have sustained Caremark claims and denied motions to dismiss. Here are takeaways for in-house counsel and corporate secretaries from recent case law.

Red flags can emerge from many places
In In re Boeing Company Derivative Litigation, the court denied a motion to dismiss litigation by derivative plaintiffs seeking to hold Boeing’s board liable for oversight claims related to the two fatal Boeing 737-Max plane crashes in 2018 and 2019.

The court concluded that plaintiffs successfully pleaded both prong one and prong two Caremark claims. First, noting that at the time of the crashes, ‘[n]one of Boeing’s board committees were specifically tasked with overseeing airplane safety, and every committee charter was silent as to airplane safety’, and finding (unsurprisingly) that airplane safety was just as mission-critical to Boeing as food safety was to Blue Bell, the court found a Caremark prong one claim was properly pleaded.

As to prong two (failure to respond to red flags), despite the lack of formal oversight of airplane safety issues, the court also found allegations sufficient to sustain a claim based on the board’s lack of response to the first fatal plane crash. The court found that the Section 220 books and records produced by Boeing ‘do not reveal evidence of any director seeking or receiving additional written information’ regarding airplane safety issues, even after the first crash occurred.

Emphasizing that ‘[u]nlike many harms in the Caremark context, which include financial misconduct that the board can likely discover only through an internal system’, the court found that the first fatal crash was clearly a red flag: it was ‘[w]idely reported in the media, those reports reached the board and the board ignored them.’ Boeing’s board therefore faced both prong one and prong two Caremark claims in discovery. The derivative litigation was ultimately settled for $237.5 mn.

Insufficient books and records production can fuel Caremark claims but a robust production can head them off
Caremark oversight claims are typically litigated following a request for board minutes and materials pursuant to a Delaware stockholder’s statutory information rights under Section 220.

A Section 220 books and records production in the context of a Caremark claim typically provides an overall picture of the board’s formal activity with respect to business issues on which the oversight claim is based. Plaintiffs asserting Caremark claims will often focus on a (perceived) absence of board activity related to the ‘corporate trauma’ that allegedly occurred as a result of the board’s oversight failure. Pertinent board documents are typically incorporated by reference into any derivative complaint later brought by the stockholder.

The standard for successfully pleading a derivative claim in Delaware is high and generally requires a particularized factual showing that the directors are potentially subject to liability through allegations creating a reasonable inference of bad faith conduct. As a result, a Section 220 production that shows a robust record of board-level oversight activity can often defuse a potential derivative complaint before it is filed or support a successful motion to dismiss if the derivative suit is filed.

Therefore, care must be taken that a production is not excessively limited. Unlike in full-bore discovery, Delaware courts generally permit Section 220 productions to redact non-responsive material in light of the sensitivity surrounding the key topics discussed and analyzed at board meetings. But where a corporation’s Section 220 production is too heavily redacted, courts have been highly skeptical of arguments by counsel for the board asserting that it adequately fulfilled its oversight duty.

Officers can be liable for Caremark claims – but exculpation is now permitted
In a series of post-Marchand cases, Delaware courts have extended oversight liability to executive officers in addition to directors, having concluded that the same principles regarding failure of oversight should apply to officers charged with oversight of specific business areas. But courts have also made it clear that such claims remain challenging to plead and may not be used to hold officers accountable for good faith business decisions that turned out poorly in hindsight.

Recent amendments to Section 102(b)(7) of the Delaware General Corporation Law also permit companies to amend their charters to offer additional protection to executive officers from fiduciary breach claims similar to the protection already available to directors. Corporate secretaries and counsel should consider whether enacting similar protections for executive officers would be in the best interests of their corporations.

Weak, hindsight-motivated claims still dismissed
Although Marchand and its progeny breathed new life into oversight claims, the rigorous pleading standard and deference that Delaware courts show to director action still lead to weak cases often being dismissed at the pleading stage. Multiple lawsuits seeking to assert Caremark claims against directors challenging their response to business risks or challenges have been dismissed. In Clem vs Skinner, for example, the court granted a motion to dismiss a Caremark claim against Walgreens’ board following the settlement of a lawsuit related to internal billing practices for a single pharmaceutical production.

The court noted that many recent Caremark cases ‘fall outside the narrow confines of the Caremark doctrine. Fueled by hindsight bias, they seek to hold directors personally liable for imperfect efforts, operational struggles, business decisions and even when the corporation is the victim of a crime. The present lawsuit is an unexceptional member of this broader group.’ The court emphasized that ‘[t]he board was required to exercise good faith oversight – not to employ a system to the plaintiffs’ liking.’

Similarly, in Conte vs Greenberg, the court explained that ‘some risks are of such a magnitude that inaction alone can support an inference of bad faith’ but that ‘as the magnitude or severity of the risk decreases, more facts are required to support an inference of bad faith: continued monitoring, or even intentional inaction, may not alone rebut the business judgment rule.’

The court found that the asserted misconduct – allegedly excessive perquisite use by executives – was ‘of a relatively minimal magnitude’ and not a ‘widespread operational deficiency’ and that, in any event, the plaintiff merely criticized the manner and timing of the board’s response. As a result, the court found that the allegations did not rise to the level of bad faith necessary for Caremark liability.

Finally, In re ProAssurance Corp S’holder Derivative Litig saw alleged oversight claims centered on a classic business risk for an insurance company (insufficient loss reserves) summarily dismissed. The court explained that ’[t]hese events, quite obviously, involve a commercial decision that went poorly – the stuff that business judgment is made of’ and that ‘[o]versight claims should be reserved for extreme events.’ The court found that the allegations simply second-guessed decisions regarding a classic business risk and dismissed the complaint on the basis that it could not ‘reasonably support an inference of bad faith.’

Key takeaways
Marchand and its progeny cases show that the doctrine behind Caremark claims continues to develop. They highlight the need in all circumstances for corporate counsel to focus before any compliance issues arise on having robust board processes and documentation.

Key steps to achieve this include:

  • Addressing and assigning responsibility for key compliance and risk management issues at the board level and clearly documenting those responsibilities in materials shared with the board
  • Ensuring minutes and pre-read materials are accurate and comprehensive in capturing director oversight activity
     
  • Ensuring board materials include and are produced with sufficient context to permit a court to understand oversight activity in any prospective litigation.

Brian Rivas Boessenecker is an associate and Achyut Phadke is a partner with Munger, Tolles & Olson

Brian Rivas Boessenecker

Associate

Munger, Tolles & Olson