One of the more noteworthy recent developments in corporate and securities litigation has been the resurgence of Delaware law “duty of oversight” claims, as I noted in my recent annual round-up of D&O liability issues. Delaware courts have sustained several of these kinds of “Caremark duty” claims, which until recently were distinctly disfavored – which raises the questions of why these claims are now proving viable, and whether the renewed risk of duty of oversight claims is here to stay? In a December 2020 paper entitled “A New Caremark Era: Causes and Consequences” (here), Professor Roy Shapira of IDC Herzliya Radzyner Law School identifies what he believes to be the causes of the recent revival of duty of oversights, and presents his view that the changes are here to stay. Professor Shapira’s views are summarized in a January 18, 2021 post (here) on the Harvard Law School Forum on Corporate Governance.
Delaware’s courts first recognized that corporate directors have an affirmative duty to monitor their company and can be liable for failures of oversight in the 1986 Delaware Chancery Court opinion, In re Caremark International Inc. Derivative Litigation. While these types of Caremark claims have been around for many years, they were notoriously hard to sustain, owing to a very high threshold to plead failure of oversight. The high threshold translated into frequent early dismissals of these kinds of claims.
Despite this backdrop, in June 2019, the Delaware Supreme Court reversed the Chancery Court’s dismissal of the Blue Bell case, in Marchand v. Barnhill (here). Chief Justice Strine noted that the fact that the plaintiffs alleged that the board of a food-manufacturing company never even discussed food safety issues indicates a possible utter failure of compliance, which justified denying the defendants’ motions to dismiss. Shortly after the Marchand case, in October 2019, in the Clovis Oncology case (here), the court also denied the defendants’ motion to dismiss a duty of oversight claim, reasoning that for a “monoline” drug company operating in a highly regulated environment, meeting FDA protocols is “mission critical,” and that problems in this context were “red flags” that the directors should not have ignored.
These two 2019 rulings were followed by an April 2020 decision in Hughes v. Hu (discussed here), in which the court sustained a breach of the duty of oversight claim against a Chinese auto parts company, which struggled to meeting financial reporting requirements, finding that the “trappings of oversight” such as the mere existence of audit committees and compliance departments were insufficient to rebut a Caremark claim. Finally, in August 2020, in Teamsters Local 443 v Chou, the Chancery court sustained a breach of the duty of oversight claim against the board of AmerisourceBergen Company, based on allegations that the directors had ignored “red flags” of regulatory and operational non-compliance at a subsidiary, based, among other things, on the board’s failure to require updates and progress reports after the deficiencies were flagged.
These four cases, taken collectively, stand for the proposition that under Delaware law corporate directors have a fiduciary duty to create and implement a system of controls in order to monitor company management and operations, particularly with respect to “mission critical” operations, and that directors must heed and follow-up on “red flags.”
The Academic Paper
In his recent paper, Professor Shapira asks whether these four cases signify a “meaningful trend of a ‘stricter Caremark era’” or whether the four cases represent only a “coincidence of cases with extremely egregious facts?” And if there is indeed a resurgence of director oversight duty claims, why now? What sparked the resurgence?
In Professor Shapira’s view, “there is a systemic change in the failure-of-oversight litigation,” which he describes as “a new Caremark era.” The reason he thinks the trend “is here to stay” is that “it is connected to and driven by a seemingly disparate development in shareholders’ right to information in the company,” through pre-lawsuit investigations using books and records requests in Delaware General Corporate Law Section 220.
As Professor Shapira notes, Delaware’s courts have “liberalized their interpretation of Section 220,” giving shareholders access to “more internal documents, including even informal electronic communications via emails and private LinkedIn messages.” Armed with the results available from this powerful tool, “shareholders can now plead with particularity facts indicating that red flags were flown in the directors’ face, thereby surviving the once-insuperable Caremark pleading hurdle.”
As Professor Shapira notes in his summary in the Harvard Law School Forum blog, “plaintiffs can now more easily how that board members never even discussed a critical compliance issue, or that they knew about critical problems but chose to ignore them.” As he puts it, “the resurgence of inspection rights led to a resurgence of oversight duties.”
There are two noteworthy “contours” of the new mode of Caremark litigation. First, Delaware’s courts have been carving out a “constantly-growing exception” to the formerly deferential standard that had characterized oversight claims, in the form of “mission critical compliance,” particularly where regulatory compliance is critical to the firm’s success. Under these standards, directors should be particularly alert to red and even yellow flags, and proactively monitor compliance. Second, the new Caremark cases “clarify that lack of documentation can lack of needed follow-ups and actions on the part of the board to remedy potential oversight issues.”
The combination of the court’s increased willingness to scrutinize directors conduct and plaintiffs’ increased ability to document directors’ conduct is “likely to continue generating successful Caremark claims going forward.” Section 220 actions “should be considered themselves a part of the new Caremark era.”
These developments beg the question whether these new developments are desirable from a social perspective. The expansion of pre-filing discovery “comes with its own set of costs, such as potentially bringing back the dreaded fishing expeditions through the backdoor.” Moreover, at this point at least, it is too early to conclude that “the new Caremark era will generate more compensation for shareholders or better deterrence.”
Professor Shapira argues that the test of whether these new standards are working is not whether they are producing more or bigger litigation payouts; rather, he argues, the measure is how these developments are affecting board behavior. He notes that following the new era decisions discussed above, law firms launched a flood of memos “calling on boards to place compliance issues on the agenda and make sure deliberations are being properly recorded.” While it is “still too early to empirically assess the costs and benefits of the new mode of Caremark litigation,” Shapira believes it is “likely to prove overall desirable,” through improved board documentation, improved information flow to corporate boards, and through concerted efforts toward shaping “reputational discipline and business norms.”
At a minimum, the recent Caremark duty decisions represent developments about which boards must be aware and that boards must consider in shaping both their agendas and their processes. Not only must boards establish monitoring mechanisms, particularly with respect to mission critical operations, but they must also be able to show that they were monitoring the mechanisms and responding to red flags and other alerts. All of these new points of emphasis carry their own need for improved documentation. The overall indication is toward a more active and attentive board.
The developments also have important negative implications as well, which is that the boards that fall short of these measures can be held accountable and may be held liable. As Professor Shapira notes, there are likely to be further Caremark duty claims, and the combination of heightened standards and increased ability of claimants to conduct pre-lawsuit investigations may translate into increased numbers of sustainable Caremark claims going forward.
Although these developments present risks in many different business contexts, the context of the current pandemic may represent a particular risk. Several of the recent Caremark cases involve business whose operations present health concerns – for example, the food safety issues that the Blue Bell Ice Cream company faced in the Marchand case. In the current pandemic, many businesses are facing important health concerns, both for the customers and for their employees. In the current era of increased board oversight expectations, the coronavirus-related circumstances may involve the kind of mission critical concerns that the courts have held give rise to board duties of oversight. Thus, the pandemic may present circumstances that could give rise to duty of oversight claims.
By the same token, as I have previously noted, cybersecurity concerns may represent mission critical issues for many enterprises, which could in turn create obligations for boards to implement oversight mechanisms, and in the event of oversight failures lead to Caremark claims. In other words, there are no shortage of current contexts within which Caremark claims might arise.
There are of course important lessons for boards and their advisors, in order for directors to be able to document and demonstrate that they were monitoring mission critical operations and responding to alarms and concerns that may arise. The evolving duty of oversight may have important implications for D&O insurance underwriters, and not simply because the new Caremark era presents the risk of increased D&O liability. The evolving duty of oversight may present incentives in favor of increased underwriting surrounding board processes and board reporting mechanisms.