United States: Delaware Supreme Court Allows Caremark Duty Of Loyalty Claims Against Directors To Survive Dismissal Motion

Last Updated: July 15 2019
Article by Cydney Posner

In Marchand v. Barnhill (June 18, 2019), soon-to-be-retired Chief Justice Strine (see these statements from SEC Chair Clayton and Commissioner Jackson), writing for the Delaware Supreme Court, started out his analysis with the recognition that "Caremark claims are difficult to plead and ultimately to prove out," and constitute "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment." That's a rather high bar. What does it take to plead a Caremark case that can survive a motion to dismiss? Marchand provides an illustration—and a warning that directors should be proactive in conducting risk oversight and could face liability if they fail to "make a good faith effort to implement an oversight system and then monitor it."

Summary. In 2015, Blue Bell Creameries, a large manufacturer of ice cream, experienced a listeria outbreak, which infected its products and led to the death of three people. The company was compelled to recall its products and shut down production. Moreover, the shutdown was followed by a "liquidity crisis," which led the company to conduct a dilutive equity financing that caused the stock price to fall. A stockholder sued derivatively, alleging, among other things, that the directors breached their fiduciary duty of loyalty under Caremark. The Court of Chancery granted defendants' motion to dismiss on the basis of failure to plead demand futility and, most significantly for this post, failure to "plead any facts to support 'his contention that the [Blue Bell] Board 'utterly' failed to adopt or implement any reporting and compliance systems.'"

The Delaware Supreme Court reversed as to both holdings. With respect to the Caremark claim, the Court held that the complaint alleged "particularized facts that support a reasonable inference that the Blue Bell board failed to implement any system to monitor Blue Bell's food safety performance or compliance. Under Caremark and this Court's opinion in Stone v. Ritter, directors have a duty 'to exercise oversight' and to monitor the corporation's operational viability, legal compliance, and financial performance. A board's 'utter failure to attempt to assure a reasonable information and reporting system exists' is an act of bad faith in breach of the duty of loyalty."

Facts. For an ice cream maker like Blue Bell, "food safety was essential and mission critical." The company was heavily regulated by three different states and by the FDA, which required its operations to be sanitary and conducted under a written food safety plan prepared by the company. Beginning in 2009 through 2014, regulators identified a number of compliance failures that signaled that the company faced possible health safety risks. Although there were a number of positive tests showing the presence of listeria, including one from an outside lab, the relevant board minutes reflected "no board-level discussion of listeria." Moreover, according to the complaint, the board was not informed about listeria or food safety issues generally, even as the problem accelerated, until the initial listeria-forced recall. Even at that point, the Court observes, the board did not schedule any additional emergency board meetings to receive updates, essentially leaving the matter in the hands of management. Ultimately, the listeria outbreak spread, and a recall of all products was initiated. The CDC became involved and, after several deaths occurred, issued a recall and warning to grocers. Subsequent FDA plant inspections uncovered "major deficiencies" at each facility and showed little progress in remedying deficiencies despite increasingly frequent positive tests for listeria over several years. News reports emerged with tales of management's ignoring plant conditions. The company was compelled to shut down all production at all of its plants and lay off over a third of its workforce. The company then faced a liquidity crisis and ended up with a highly dilutive credit facility and warrant.

Chancery Court. A stockholder sued derivatively, alleging that "management turned a blind eye to red and yellow flags that were waved in front of it by regulators and its own tests, and the board—by failing to implement any system to monitor the company's food safety compliance programs—was unaware of any problems until it was too late." The Chancery Court dismissed the claims, concluding that there was a monitoring and reporting system in place, taking into account "Blue Bell's compliance with FDA regulations, ongoing third-party monitoring for contamination, and consistent reporting by senior management to Blue Bell's board on operations." At bottom, the Court of Chancery opined that "[w]hat Plaintiff really attempts to challenge is not the existence of monitoring and reporting controls, but the effectiveness of monitoring and reporting controls in particular instances." That, the Court of Chancery held, does not state a Caremark claim."

Supreme Court Analysis. The Supreme Court disagreed. Under Caremark and Stone v. Ritter, the Court said, failure to make a good faith effort to oversee the company's operations "breaches the duty of loyalty and can expose a director to liability. In other words, for a plaintiff to prevail on a Caremark claim, the plaintiff must show that a fiduciary acted in bad faith—'the state of mind traditionally used to define the mindset of a disloyal director.'" Although "directors have great discretion to design context- and industry-specific approaches tailored to their companies' businesses and resources[,] Caremark does have a bottom-line requirement that is important: the board must make a good faith effort— i.e., try—to put in place a reasonable board-level system of monitoring and reporting." The key issue then was not whether the system was effective, but rather whether the Court could reasonably infer from the pleadings "that the board did not undertake good faith efforts to put a board-level system of monitoring and reporting in place."

To that end, the Court examined the pleadings and concluded that "the complaint supports an inference that no system of board-level compliance monitoring and reporting existed at Blue Bell." To support that conclusion, the Court identified a number of factors, including the failure of the board to establish a board committee to monitor food safety or to periodically devote a portion of its meetings to food safety compliance. According to the complaint, the board minutes did not reflect evidence that any red flags were discussed. Importantly, the board did not proactively require management to regularly provide information about mission-critical risks: the company did not "have a protocol requiring or have any expectation that management would deliver key food safety compliance reports or summaries of these reports to the board on a consistent and mandatory basis. In fact, it is inferable that there was no expectation of reporting to the board of any kind." Had a reasonable reporting system been in place prior to the listeria outbreak that required management to report to the board on food safety issues, the board could have required the company to take action to rectify the systematic deficiencies identified by the FDA at Blue Bell's plants, perhaps preventing the debacle that ensued. Below are the specific failures that the Court identified from pleadings:

  • "no board committee that addressed food safety existed;
  • no regular process or protocols that required management to keep the board apprised of food safety compliance practices, risks, or reports existed;
  • no schedule for the board to consider on a regular basis, such as quarterly or biannually, any key food safety risks existed;
  • during a key period leading up to the deaths of three customers, management received reports that contained what could be considered red, or at least yellow, flags, and the board minutes of the relevant period revealed no evidence that these were disclosed to the board;
  • the board was given certain favorable information about food safety by management, but was not given important reports that presented a much different picture; and
  • the board meetings are devoid of any suggestion that there was any regular discussion of food safety issues."

"Although Caremark is a tough standard for plaintiffs to meet," the Court held, "the plaintiff has met it here. 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." Nominal compliance with FDA regulations did not cut it: "It does not rationally suggest that the board implemented a reporting system to monitor food safety or Blue Bell's operational performance." Similarly, regular reporting by management regarding "operational issues" was too generic to defeat the claim: "if that were the case, then Caremark would be a chimera," given that companies probably discuss operational issues of some kind at most meetings.

"If Caremark means anything," the Court concluded,

"it is that a corporate board must make a good faith effort to exercise its duty of care. A failure to make that effort constitutes a breach of the duty of loyalty. Where, as here, a plaintiff has followed our admonishment to seek out relevant books and records and then uses those books and records to plead facts supporting a fair inference that no reasonable compliance system and protocols were established as to the obviously most central consumer safety and legal compliance issue facing the company, that the board's lack of efforts resulted in it not receiving official notices of food safety deficiencies for several years, and that, as a failure to take remedial action, the company exposed consumers to listeria-infected ice cream, resulting in the death and injury of company customers, the plaintiff has met his onerous pleading burden and is entitled to discovery to prove out his claim."

So what is the lesson here? No doubt a Caremark claim is still a tough claim for a plaintiff to establish. But, as Marchand shows, a board can help establish one if it simply leaves compliance and risk oversight entirely to the prerogatives of management. As the Court made clear, boards need to oversee compliance and monitor risks. And, to effectively carry out their responsibilities, boards will need to make good faith efforts to proactively establish reporting systems or other communication protocols that require management to report to the board—whether it be to a risk committee or regularly to the board as a whole—about risk and compliance issues that are "intrinsically critical to the company's business operation."

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