In an important decision that highlights the liability exposures facing corporate boards for claims alleging breaches of the duty of oversight, a Delaware Court of Chancery Vice Chancellor denied in substantial part the defendants’ motion to dismiss in the shareholder derivative suit pending against the board of Boeing relating to the 737 Max air crashes. The court concluded that the plaintiff had sufficiently alleged that the company’s board had breached its oversight obligations by failing to establish safety oversight mechanisms prior to the October 2018 Lion Air crash and ignoring red flags about safety issues after the Lion Air crash and before the March 2019 Ethiopian Airlines crash. Vice-Chancellor Morgan Zurn’s September 7, 2021 opinion can be found here.
The plaintiffs’ allegations in this shareholder derivative suit are unusually detailed, making brief summarization challenging. Suffice it to say that in response to competition from Airbus, Boeing undertook a redesign of its 737 model aircraft. The reconfigured model was unbalanced, and Boeing implemented a software fix (MCAS) to compensate for the balance issues. There were defects in the MCAS system sensors that could trigger the compensation function and force the aircraft’s nose downward. Airline customers, pilots, and regulators were not told of these issues, which allegedly caused the two air crashes.
The plaintiffs allege that prior to the Lion Air crash, the board had no committees or processes to oversee safety issues; rather, the complaint alleges, the board was focused on production and financial issues. The plaintiffs further alleged that the board did not regularly address or discuss safety issues. The plaintiffs also allege that there were no regular processes to apprise the board of airline safety; rather the information flow was ad hoc and dictated by management rather than by the board itself. Even though management was aware of “red flag” issues, the information never reached the board. The plaintiffs also allege that even after the Lion Air crash, the board did not implement safety oversight processes or elevate safety concerns at the board level.
The plaintiffs’ complaint names as defendants certain current and former directors and officers of Boeing. The company is named as a nominal defendant. The plaintiffs’ complaint asserts two claims. Count I of the plaintiffs’ complaint alleges that the director defendants consciously breached their fiduciary duties and violated their corporate responsibilities, in three ways: before the Lion Air crash by failing to implement any reasonable information and reporting system to monitor and oversee the safety of Boeing’s airplanes; after the Lion Air crash, despite being made aware of red flags concerning the MCAS system, consciously disregarding their duty to investigate and remedy misconduct; and after the Ethiopian Air crash by terminating the company’s then-CEO in a way that allowed the CEO to cash out his unvested equity-based compensation. Count II alleged breach of fiduciary duty against the officer defendants.
The defendants moved to dismiss on the grounds that the plaintiffs had not made the requisite demand on the board to take up the claims. The plaintiffs contend that because of the directors’ potential liability, demand on the board would have been futile, and therefore was excused.
The September 7, 2021 Opinion
In 103-page September 7, 2021 opinion, Vice Chancellor Zurn in substantial part denied the defendants’ motion to dismiss, holding that the defendant directors faced sufficient risk of potential liability for the alleged breaches of the duty of oversight that that demand on them to take up the claims would have been futile. However, Vice Chancellor Zurn did hold that plaintiffs had not sufficiently alleged that the board could not sufficiently consider taking up the CEO compensation issue and the officers’ alleged breach of fiduciary duty, so the motion to dismiss was granted as to those issues.
In taking up the issue of the board members’ potential risk of liability for the breach of the duty of oversight claims, Vice Chancellor Zurn repeated the oft-quoted words from Caremark that breach of the duty of oversight is “possibly the most difficult theory in corporation law upon which plaintiff might hope to win a judgment.” She also reviewed the Delaware Supreme Court’s 2019 decision in Marchand v. Barnhill, in which the Court concluded that the board of an ice cream manufacturer had breached their duty of oversight for failing to monitor mission-critical food safety issues.
Vice Chancellor Zurn identified numerous parallels between the allegations in Marchand and the plaintiffs’ allegations against Boeing. In both cases, safety issues were “essential and mission critical.” The Vice Chancellor said that Marchand was “dispositive” in view of the “remarkably similar factual allegations,” including the absence of a board committee charged with safety responsibilities; the lack of regular discussion of safety issues at the board level; and the board’s dependence on management for safety issue reporting. The Vice Chancellor found that the directors failed to take action in response to the “red flags” about the MCAS system after the Lion Air crash.
Of particular interest is Vice Chancellor Zurn’s conclusion that the plaintiffs had sufficiently alleged scienter — that is, not only that the directors acted inconsistently with their fiduciary duties, but they also “knew of their shortcomings.” Zurn noted that in Marchand the Delaware Supreme Court inferred scienter from the numerous oversight shortcomings alleged; Zurn said that “those allegations support an inference of scienter [in this case] as well.” Zurn added further that no inference is needed in this case, in light of the board’s own words showing that “directors knew the Board should have had structures in place to receive and consider safety information.” Zurn quoted from emails sent after the Ethiopian Air crash, in which the need for Board reporting on safety issues; she also referred to numerous public statements in which the Board was “crowing” about “taking specific actions to monitor safety that it did not actually perform.” These statements “evidence that at the least [the company’s new CEO and board chair] knew what the Company should have been doing all along.”
In summarizing his conclusion that the plaintiffs had met their “onerous pleading burden” in this case, Zurn said, in reliance on Marchand, that “the Board has a rigorous oversight obligation where safety is mission critical, as the fallout from the Board’s utter failure to try to satisfy this ‘bottom-line requirement’ can cause ‘material suffering’ … among customers or to the public at large, and attendant reputational and financial harm to the company.”
Though it is often stated that a claim for breach of the duty of the oversight is the “most difficult” for plaintiffs to sustain, there have been a number of high-profile rulings in recent years, starting with Marchand, in which the plaintiffs breach of the duty of oversight claims have survived a dismissal motion. There is no doubt that exposure to claims of this type represent a significant and important liability risk for corporate boards, one that boards must take seriously and consider in structuring their processes and functions.
But while there have been several significant recent cases in which breach of the duty of oversight claims have been sustained, even the rulings allowing these kinds of claims to go forward have emphasized pleading requirements that may not be satisfied in many circumstances. The holdings in these cases emphasize that to state a claim, the plaintiff must be able to allege that the company operation is “mission critical” for the oversight duty to be triggered. In order to establish that the board failed in its oversight, the plaintiff must allege the absence of any board committee function or board processes to supervise the critical operation. And while Vice Chancellor Zurn concluded here that the Boeing board acted with scienter, establishing that a board acted with awareness of its oversight shortcomings is going to be a significant pleading hurdle for plaintiffs in many instances.
I think there are important and distinct circumstances involved here that have a lot to do with the outcome. The exceptional occurrence of two tragic air disasters not only dramatically highlight the critical importance of safety issues for Boeing (just as the deaths from the listeria outbreak did the same in Marchand), but put the actions and inactions of the board in a particularly harsh light. The way Zurn’s opinion is written suggests that she was troubled by the plaintiffs’ allegations, a perspective that undoubtedly has something to do with the two fatal air crashes only five months apart. I emphasize this because it is going to be a relatively rare set of circumstances where board actions are subjected to this kind of harsh light.
All of that said, I do think the recent spate of breach of the duty of oversight cases will encourage plaintiffs to pursue these kinds of claims and to include claims of breach of the duty of oversight in cases in which companies have experienced significant adverse circumstances in important operations. I suspect we are going to see an increase of claims of this type.
With respect to the issue of whether we will see more of these kinds of claims, UCLA Law Professor Stephen Bainbridge has an interesting take on his ProfessorBainbridge.com blog (here). He expresses his concern that, despite the clichéd rhetoric about how difficult it is to plead Caremark claims, it is in fact getting “easier and easier” to plead such claims. Professor Bainbridge is correct that language in Vice Chancellor’s opinion, such as her reference to boards’ “rigorous” oversight responsibilities, could be used against boards in future claims. Bainbridge’s concern about the growing risk of breach of the duty of oversight claims is interesting and worth considering.
The risk of these kinds of claims has important implications for corporate boards. At a minimum, boards should conduct a comprehensive review of their companies’ operations to identify particular functions that could be viewed as mission critical. With respect to the mission critical operations, boards should ensure that they have reporting processes to ensure that the board can supervise the key operations. Boards should not be dependent on management for identifying issues with respect to the mission critical operations, but should have board inquiry and review processes in place. The board should document its involvement in these oversight processes.