One issue I have been monitoring on this site recently is the apparent revival of claims against corporate directors and officers for breach of the duty of oversight. Up until now, my focus has been on developments in Delaware’s courts. However, a recent Ohio federal district court decision in an opioid-related derivative suit against the board of the pharmaceutical distribution firm Cardinal Health examined issues addressed sufficiency of breach the duty of oversight allegations under Ohio law.
In an interesting February 8, 2021 decision (here) highlighting the fact these issues are relevant under other states’ laws, Southern District of Ohio Judge Sarah D. Morrison denied the defendants’ motion to dismiss the plaintiff’s breach of the duty of oversight claims against the Cardinal Health board, although she granted the defendants’ motion to dismiss the plaintiffs’ claim for waste of corporate assets.
Background
Cardinal Health is one of the three largest pharmaceutical products distributors in the United States. The Comprehensive Drug Abuse Prevention and Control Act of 1970 (often referred to as the “Controlled Substances Act” or the CSA) requires distributors of controlled substances to maintain controls against diversion; identify suspicious orders of controlled substances; inform the Drug Enforcement Administration (DEA) of suspicious orders; and to conduct meaningful diligence. The DEA has extensive enforcement authority under the CSA and may revoke or suspend a distributor’s registration for CSA violations.
In an escalating series of enforcement actions beginning in 2007, Cardinal Health was the target of extensive DEA investigative and enforcement activity relating to the distribution of opioids. In 2008, in the first of a series of consent agreements with the DEA, the company committed to a series of measures to address CSA violations. Among other things, the company paid a $34 million fine. In 2011, the DEA began investigating further suspected violations, which ultimately led to a second agreement with the DEA in 2012 requiring the company to take remedial measures concerning opioid distribution.
A series of further lawsuits and investigations followed the company’s entry into the 2012 order. Among other things, the West Virginia attorney general filed a lawsuit against the company for injunctive relief and money damages under the state’s SCA. Other lawsuits followed, as did adverse publicity in a variety of newspapers and other media publications questioning the company’s role in the opioid epidemic. In 2018, the company entered a settlement with several states’ attorneys general, in which the company admitted to violations in certain of its facilities. In March 2017, a Senate committee initiated an investigation into DEA enforcement of SCA requirements; among other things, the committee examined Cardinal Health’s SCA compliance activities.
As Judge Morrison would later put it in her opinion (discussed below), the “pressure” on Cardinal Health “reached a fever pitch around the turn of 2018.” George Barrett stepped down as the company’s CEO. A group of activist shareholders sought to bring about changes to the company’s governance practices. On February 8, 2018 the board held a meeting in which the board was briefed on the company’s CSA compliance and on the various pending lawsuits and regulatory matters; as Judge Morrison put it in her opinion, “only then did the Board resolve to create a committee ‘to assist the Board in administering its oversight responsibilities.’” By the end of the year, the Senate Committee issued a report that was critical of Cardinal Health and its peers and faulted the companies’ CSA compliance and reporting.
The Litigation
In June 2019, a plaintiff shareholder launched the first of several derivative lawsuits against certain current and former members of Cardinal Health’s board of directors as well as against the company itself as nominal defendant. The lawsuits ultimately were consolidated. Prior to launching the lawsuits, the plaintiffs, as Judge Morrison later put it, “availed themselves” of their right to examine the company’s books and records, including, in particular, records relating to the activities of the board.
In their lawsuit, the plaintiffs essentially alleged that through the more than ten-year period described in the complaint, “the Books and Records paint a consistent picture of the Board’s passive receipt of information rather than the directors’ active engagement.” The plaintiffs, as Judge Morrison put it “challenge the Board’s inaction in response to red flags they allege should have spurred affirmative action in overseeing management and the CSA compliance program.”
The defendants moved to dismiss the plaintiffs’ complaint, arguing that the plaintiffs lacked standing to bring the derivative action because they failed to make pre-suit demand on the board and that their complaint does not establish that demand was excused. The defendants also moved to dismiss the plaintiffs’ claim for corporate waste.
The February 8, 2021 Opinion
In her February 8, 2021 opinion, Judge Morrison denied the defendants’ motion to dismiss the plaintiffs’ breach of the duty of oversight claims, finding that the complaint sufficiently alleged demand futility. Judge Morrison granted the motion to dismiss as to the corporate waste claim.
In considering the demand futility issue, Judge Morrison applied Ohio law, under which the demand requirement is excused only if a board is considered incapable of making a disinterested and independent decision because of particularized allegations presenting a substantial likelihood of liability. Under Ohio law, directors face personal liability only if shown by clear and convincing evidence that they acted with reckless disregard for the company’s best interests. In failure of oversight cases, Judge Morrison added, “liability hinges on whether the directors ‘ignore red flags’ that actually come to their attention, warning of compliance problems.”
Judge Morrison found that the plaintiffs’ allegations were sufficient to establish that a majority of the Cardinal Health board members “acted with reckless disregard for the corporation’s best interests by failing to take action on CSA compliance.”
In reaching this conclusion, Judge Morrison reviewed the company’s CSA enforcement history and the series of red flags – starting with the 2008 settlement agreement – which she said put the board on notice “that CSA noncompliance could pose an existential threat to Cardinal Health’s core business.” Despite the series of red flags over the course of several years “the Board remained passive.” The board’s “failure to engage on the issue of CSA compliance, which receiving regular and clear indications that the problem persisted, supports an inference that [a majority of the board] acted, at the least, with reckless disregard for Cardinal Health’s best interests.”
Judge Morrison then addressed and rejected the defendants’ arguments against demand futility, including their challenge to the sufficiency of the allegations. In rejecting this argument, Judge Morrison noted that the plaintiffs’ complaint alleges specific facts showing that the individual defendants “had actual knowledge of red flags related to CSA compliance.” She noted further that, while the evidence ultimately may show that the board acted consistently with its fiduciary duties, the complaint’s allegations, which are taken as true at the initial pleading stage “lend themselves easily to the inference that the Board failed to act in the face of red flags.”
Discussion
Because so many publicly traded companies are organized under the laws of Delaware, developments under Delaware law tend to dominate the discussion of board duties and liabilities. This case is a reminder that Delaware law does not always control, and in many instances the law of states other than that of Delaware will govern board liability issues.
As developments regarding the duty of oversight have evolved in recent months, the focus has been on the various rulings out of the Delaware courts on these issues. This ruling underscores the fact that developments in other jurisdictions’ courts can be relevant and important as well.
The interesting thing about Judge Morrison’s analysis of the duty of oversight issues under Ohio law is that, though she never cites the various recent Delaware holdings on the duty of oversight, her analysis and conclusions appear entirely consistent with the recent Delaware decisions. The gist of her ruling is that on mission critical aspect of their company’s operations, corporate boards have a responsibility to monitor and address red flags that signal problems that could challenge or damage the company. This ruling is completely in line with the recent Delaware decisions, including for example the Delaware Supreme Court’s 2019 decision in Marchand v. Barnhill.
In connection with the recent developments in Delaware on duty of oversight issues, I have suggested the recent apparent revival of duty of oversight could prove to be an increasingly important component of board liability exposures going forward, particularly when it comes to enterprise-critical considerations such as, for example, cybersecurity and perhaps even climate change. While breach of the duty of oversight claim remain notoriously challenging for plaintiffs to plead sufficiently, they also could represent an important potential source of director liability, as well. As this decision shows, duty of oversight issues are not limited to Delaware law or Delaware courts.
It is worth noting that this derivative suit is only one of several opioid-related derivative lawsuits filed against pharmaceutical distribution firms and other companies. For example, the board of the pharmaceutical distribution firm McKesson Corp. also was hit with an opioid-related derivative suit alleging, among other things, breach of the duty of oversight. As discussed here, the McKesson opioid-related derivative suit settled in early 2020 for $175 million. (The settlement was funded entirely by D&O insurance.)
Opioid-related lawsuits continue to be filed, as well. As I noted in a recent post (here), in January 2021, a shareholder plaintiff filed an opioid-related securities class action lawsuit against Walmart, which was in turn filed in the wake of the U.S. Department’s December 2020 opioid-related lawsuit against the company.
As I noted in my post about the recent Walmart lawsuit, “it does appear as if opioids have as their own special quality a sort of reverse-Midas touch, in which everything they touch turns to dross (and if this were not a family-oriented publication I would use a stronger word that ‘dross’). The baleful effect of opioids seems to spell the ruination of everything and everyone who becomes involved with the drugs.”