Gail Weinstein et al. wrote an article for the Harvard Law School Forum on Corporate Governance titled Caremark Liability for Regulatory Compliance Oversight (8 July 2019).
« In Marchand v. Barnhill (“Blue Bell”) (June 18, 2019), the plaintiff-stockholder claimed that the directors of Blue Bell Creameries USA, Inc., an ice cream manufacturer (the “Company”), breached their fiduciary duty of loyalty under Caremark by having failed to oversee and monitor the Company’s food safety operations. The suit was brought after an outbreak of listeria contamination in the Company’s ice cream led to the sickening and (in three cases) the death of consumers who ate the ice cream—as well as the recall of all of the Company’s products, the shuttering of all of the Company’s plants, and, ultimately, a liquidity crisis that led the Company to accept a dilutive private equity deal. »
« “Caremark claims” are claims that directors breached the fiduciary duty of loyalty by not making “a good faith effort to oversee the company’s operations.” These claims, which if successful can result in personal liability for directors, are known to be (as the Supreme Court reiterated in Blue Bell) “among the most difficult of corporate claims” to pursue successfully—because a required element of a claim for breach of the duty of loyalty is “bad faith” (i.e., intentional wrongdoing) by directors. Caremark established that, with respect to a board’s oversight obligation, 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 [personal] liability [of directors].” »
« It continues to be difficult to prevail on a Caremark The Supreme Court reiterated in Blue Bell the high standard for validly pleading a Caremark claim—as noted, that a board “utterly failed” to put into place “any” monitoring system for oversight. The Supreme Court acknowledged that the validity of a Caremark claim does not depend on whether a board’s oversight system actually worked in any given case to inform the board as to compliance matters, but only whether a reasonable system existed and was monitored by the board. In this case, the Supreme Court found that the complaint alleged specific facts that, at the pleading stage, created a reasonable inference that the directors had “consciously failed” to attempt to assure that a reasonable information and reporting system existed with respect to the Company’s “central issue” of food safety compliance. »
« The decision thus underscores the critical importance of the board assuring a system of oversight by the board itself of the company’s key operations—particularly with respect safety issues involved in the manufacture of its products. An oversight system should include both (i) management reporting to the board about risks and developments relating to the company’s central operations and (ii) the board proactively seeking out this information from management. »
« The plaintiff-stockholder obtained books and records (including the board’s minutes) through a Section 220 request and then brought suit in the Court of Chancery against the directors, the CEO and the Vice President of Operations. »
« The Caremark doctrine. In Caremark (1996), the Court of Chancery discussed in detail the parameters of a board’s duty of oversight. Personal liability for directors with respect to their oversight function may “arise from an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss.” Accordingly, to fulfill their duty of loyalty (as confirmed in Blue Bell), “directors must make a good faith effort to implement an oversight system and then monitor it.” At the same time, Caremark established that 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 [personal] liability [of directors].” Caremark also established that the sufficiency of the systems established by the board would be evaluated under the deferential business judgment rule. Thus, Caremark claims have been recognized by the Delaware courts as “among the most difficult of corporate claims” to pursue successfully. Decisions amplifying Caremark have emphasized the following:
- Bad Faith. A showing of “bad faith” is a necessary condition to director oversight liability, as Section 102(b)(7) of the Delaware General Corporation Law contemplates personal liability of directors only for breaches of the duty of loyalty, including acting in “bad ” In the Caremark context, “bad faith” encompasses “scienter,” “intentional wrongdoing” or “intent to harm,” and would be established by “intentional dereliction of duty” or “complete and utter failure to act in the face of a known duty to act.”
- Particularized Facts. The complaint must plead particularized facts showing that oversight systems were not in place (rather than a “conclusory complaint” that there was not oversight).
- “Red Flags.” The existence of “red flags” that should have alerted management and the board to compliance problems will not alone indicate “bad faith” without “particular allegations as to how the defendants knew of…inadequacies [in the oversight systems] and consciously ignored them.” »
« In Blue Bell, the Supreme Court acknowledged that “Caremark is a tough standard for plaintiffs to meet” but found that “the plaintiff has met it here.” The Supreme Court stated: “When a plaintiff can plead an inference that a board has undertaken no efforts to make sure it is informed of a compliance issue intrinsically critical to the company’s business operation, then that supports an inference that the board has not made the good faith effort that Caremark requires.” Bad faith is established under Caremark, the Supreme Court wrote, when “the directors completely fail to implement any reporting or information system or controls, or having implemented such a system or controls, consciously fail to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention” (emphasis added). The critical issue, the Supreme Court acknowledged, is not whether “illegal or harmful company activities escaped detection [of the board]” (i.e., not whether the board put into place an effective compliance and reporting system) but whether the board “failed to make the required good faith effort to put a reasonable compliance reporting and compliance system in place [and monitor it].” The important “bottom-line requirement” of Caremark is that “the board must make a good faith effort—i.e., try—to put in place a reasonable board-level system of monitoring and reporting” and then monitor it. »
Related reading: Boards that Lead: When to Change, When to Partner, and When to Stay Out of the Way by Ram Charan, Dennis Carey, Michael Useem
Articles of Interest 