As I have noted in several recent posts (most recently here), over the last several months Delaware’s Chancery Court has appeared increasingly skeptical of breach of the duty over oversight claims, seemingly underscoring the oft-stated proposition that so-called Caremark claims are among the most difficult to sustain. However, a recent decision out of the Northern District of California, applying Delaware law but arguably ruling contrary to the recent Delaware Chancery Court trends, sustained at least some of the breach of the duty of oversight claims alleged against Wells Fargo board of director in connection with discriminatory lending allegations against the company. As discussed in detail below, the Wells Fargo decision could have interesting implications for the evolving body of duty of oversight case law.

A copy of the court’s September 20, 2024, decision in the Wells Fargo derivative litigation can be found here. Allison Frankel’s September 23, 2024, Reuters article about the decision in the Wells Fargo derivative litigation can be found here.

Background

The Wells Fargo derivative lawsuit involves two sets of allegations. One relates to alleged discriminatory lending practices at the bank. The second set involves allegations of discriminatory hiring practices, including in particular the allegation that bank employees engaged in sham interviews of minority applicants in order to create the appearance of compliance with the bank’s internal diversity hiring requirements.

The discriminatory lending practices allegations arise in the context of a history of prior complaints related to discriminatory lending practices. For example, in 2012, the bank entered a $184.3 million settlement with the DOJ over allegations that minority loan applicants were given mortgages with higher interest rates and fees.

In March 2022, Bloomberg published two articles describing other allegedly discriminatory lending practices at Wells Fargo, including a much lower mortgage refinancing approval rate for minority applicants compared to white applicants.

With respect to the allegedly discriminatory hiring practices, the company had publicly claimed that it was expanding a policy requiring at least half of all candidates for certain positions to be diverse. In May and June 2022, the New York Times published two articles suggesting that the diversity requirements had led some employees to engage in fake interview, in order to create the appearance of compliance with the diverse candidate requirements.

Following these media reports, plaintiff shareholders filed a books and records action in Delaware and obtained nearly 7,000 pages of board level documents. Based on these materials and the public record, the plaintiffs filed a derivative lawsuit in the Northern District of California against certain Wells Fargo directors and officers. In a related development, other shareholders filed a separate securities class action lawsuit against the company and certain of its directors and officers in the Northern District of California. On July 29, 2024, the district court in the securities suit denied the defendants’ motion to dismiss the plaintiffs’ amended complaint.

The derivative lawsuit alleged that the defendants had breached their fiduciary duties under Delaware law by failing to implement reporting systems to monitor the alleged discrimination in mortgage lending and hiring (the “prong one” claims), and by consciously ignoring red flags regarding these purported issues (the “prong two” claims). The complaint further alleges that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder by “consciously issuing false and misleading statements to stockholders”; violated Section 14(a) of the Exchange Act by negligently causing the issuance of materially misleading statements in the 2021 and 2022 Proxy Statements; and violated Section 20(a) of the Exchange Act on the grounds that the Officer Defendants are control persons and thereby liable for the misleading statements.

The defendants in the derivative action filed a motion to dismiss arguing that the plaintiffs had failed to make the requisite pre-suit demand and further that the plaintiffs had failed to establish that demand was futile. The plaintiff contended that the record established demand futility.

The September 20, 2024, Order

In a highly detailed 49-page September 20, 2024, Order, Northern District of California Judge Trina L. Thompson granted in part and denied in part the defendants’ motion to dismiss. With respect to the plaintiffs’ duty of oversight claims, Judge Thompson denied the motion as to the plaintiffs’ “prong one” claims concerning discriminatory lending practices (that is, that the defendants had failed to establish reporting systems), but granted the motion to dismiss both the “prong one” and “prong two” claims as to discriminatory hiring practices. Judge Thompson granted the motion to dismiss as to plaintiffs’ Section 14(a) misleading proxy statement claims, and granted the motion to dismiss as to plaintiffs’ Exchange Act claims as to discriminatory lending practices statements, but denied the motion to dismiss plaintiffs’ Exchange Act claims as to discriminatory hiring practices statements.

In considering the court’s various rulings, it is important to keep in mind that the exercise in which the court was engaged was determining whether or not the plaintiffs had adequately pled demand futility. In determining whether or not the plaintiffs’ had adequately pled demand futility, the court applied Delaware law. Under Delaware law, in order to assess demand futility, the court must determine whether the plaintiff has alleged that a majority of the board faces as a substantial likelihood of liability on the claims alleged, such that the directors could not disinterestedly consider the otherwise required demand.

Duty of Oversight Claims: In considering whether or not the plaintiffs had adequately alleged a substantial likelihood of personal liability for lack of oversight, the court divided the plaintiffs’ allegations into “prong one” claims (failure to implement reporting systems) and “prong two” claims (failure to heed “red flags”). The court considered each of these two prongs as to each of the two categories of allegations, first, concerning allegations relating to discriminatory lending practices, and, second, as to allegations relating to discriminatory hiring practices.

In reviewing the “prong one” claims as to discriminatory lending, the court first found, with clear reference to the Delaware courts’ decision in the Marchand v. Barnhill case and in the Boeing case, that “it is fair to say that fair lending compliance is a mission critical risk to bank like food safety compliance is to an ice cream company or like flight safety compliance is to an airline.”

In considering whether the Wells Fargo board had established reporting mechanisms sufficient to fulfill its duty to monitor a mission critical risk, the court looked to the factors that the Delaware courts had considered in the Marchand and Boeing cases. The court found that, as in those Delaware cases, the Wells Fargo had not established a board committee to monitor the mission critical risk, and that the board did not monitor, discuss, or address fair lending compliance on a regular basis, nor did they have regular processes or reporting protocols that required management to keep the board apprise of fair lending compliance. The court also found that plaintiffs had adequately alleged that red or yellow flags on fair lending compliance issues were reported to management, but that these were not reported to the board.

The court found that the plaintiffs had sufficiently alleged that the director defendants face a substantial likelihood of liability on the prong one claim as to fair lending practices and that demand on the board therefore would have been futile and therefore is excused. Because the court found that the plaintiffs had sufficiently alleged demand futility to the prong one claims concerning the discriminatory lending allegations, the court did not consider the plaintiffs’ allegations as to prong two claims concerning discriminatory hiring.

The court then turned to the “prong one” claims as to the discriminatory hiring allegations. As a threshold matter, the court found that “while diversity hiring is undisputably crucial to a company like Wells Fargo, it is not precedentially mission critical to its operations like fair lending compliance.” The court, citing the board’s various consideration of hiring concerns, also found that plaintiffs’ arguments “fail to demonstrate how Defendants ‘utterly failed’ to implement oversight systems” as to the hiring issues. Accordingly, the court concluded that the plaintiffs had not sufficiently alleged a substantial likelihood of liability as to the prong one claims concerning discriminatory hiring.

The court then considered the plaintiffs’ “prong two” allegations as to discriminatory hiring. The “red flags” on which the plaintiffs sought to rely in support of the prong two claims were the two New York Times articles about the use of sham interviews, as well as other communications the board received. In reviewing the record of the board’s response to these articles and communications, the court said that the “plaintiffs have failed to allege that the Board did nothing in response to those red flags.” The plaintiffs, the court said, “have not sufficiently alleged that the director defendants face a substantial likelihood of liability on the Caremark prong two as to discriminatory hiring practices. Demand on the board would not have been futile.”

Securities Law Claims: Finally, the court then considered the sufficiency of the demand futility allegations as the federal securities law claims. The court found that the defendants did not face a substantial likelihood of liability as the Section 14(a) proxy statement claims, as Section 14 claims are negligence claims, and the company’s bylaws exculpate the board for negligence. Largely in reliance on the court’s prior holdings in the parallel securities class action lawsuit, the court found that the defendants did face a substantial likelihood of liability under Sections 10(b) and 20(a) of the Exchange Act as to the discriminatory hiring allegations; however, with respect to the discriminatory lending practice allegations, the court concluded that the plaintiffs had not adequately alleged scienter, and granted the defendants’ motion to dismiss as to the Section 10(b) and 20(a) allegations concerning the discriminatory lending practices.

Discussion

There is a lot in the court’s opinion, with the motion granted as to some claims and the motion denied as to other claims. However, amidst all of the discussion and legal analysis, the key point (at least for purposes of this blog post) is that the duty of oversight claims as to the discriminatory lending practices allegations survived the motion to dismiss. This conclusion largely depends on the court’s conclusion that fair lending compliance is a “mission critical” issue for a bank, based on the court’s observation that fair lending compliance is like food safety for an ice cream manufacturer (Marchand) or flight safety for an airline manufacturer (Boeing).

The court’s conclusion that fair lending compliance is mission critical stands in contrast to its conclusion that nondiscriminatory hiring, while important, is not mission critical as such. Even if one can generally agree with the court’s “mission critical” determinations, one may also be forgiven for worrying a little bit about what standard the court is using to make this determination. It would have been useful and illuminating for the court to explain more about how the “mission critical” determination is to be assessed, analyzed, and determined. Without more, the determination seems disconcertingly subjective.

There is a further particular aspect of the court’s consideration of these issues that also bears consideration, and that is the fact that this is a decision of a federal district court of another state making rulings under Delaware law, rather than a decision of a Delaware court. While there is nothing extraordinary about a federal court interpreting the state law, the fact that this court denied the motion to dismiss here on the duty of oversight claims at least in part is noteworthy if for no other reason that duty of oversight claims have recently proven to be difficult to sustain in Delaware’s own courts.

As I noted in my recent round up of hot topics in D&O liability and insurance, the Delaware Court of Chancery has in a series of decisions over the last few months “emphatically shot down would-be duty of oversight claims.” Indeed, as I detailed in the round up, the Delaware courts have bemoaned the “proliferation” of these duty of oversight claims. Recently the Delaware courts have seemed firmly committed to establishing that duty of oversight claims, sometimes referred to as Caremark claims, are indeed, as many Delaware courts have said over the years, “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”

There is, as Allison Frankel noted in her Reuters article to which I linked at the top of this post, “significantly less precedent on Caremark lawsuits outside of Delaware, mainly because so many corporations have forum selection clauses requiring shareholders to litigate derivative claims in Chancery Court.”  This dearth of precedent outside of Delaware is one of the things that makes the court’s partial dismissal motion denial in the Wells Fargo case so interesting – particularly, as Frankel points out, in light of the decision just last month by Northern District of Illinois Judge Sunil Harjani in the Abbott Laboratories derivative lawsuit.

The Abbott Laboratories case involved the company’s alleged misrepresentations with respect to infant formula safety. While Judge Harjani granted the motion to dismiss many of the shareholder plaintiffs’ allegations, the court, applying Delaware law, denied the motion to dismiss as to the plaintiff’s breach of the oversight duty, saying that plaintiffs had met the standard requiring them to plead “”utterly failed to implement any reporting or information system or controls” as to a mission critical aspect of the company’s operations. A copy of the Court’s opinion in the Abbott Labs case can be found here.

Together, the Wells Fargo and the Abbott Laboratories rulings represent an interesting subset of duty of oversight case law, involving federal district courts interpreting and applying Delaware law in the Caremark context. As Frankel commented in her article, “Federal judges don’t have much occasion to evaluate this ‘most difficult theory,’ so it’s worth paying attention when they do.” Frankel adds that “it’s hard to know if the Wells Fargo and Abbott decisions are mere outliers or early signals that federal judges are sympathetic to Caremark claims. In journalism, the old saying is that three examples make a trend.”

From my perspective, even if there are not yet three examples, the two cases on the table do seem to suggest that federal courts may be more receptive to Caremark claims than are Delaware’s own courts. That said, it is also true, as Frankel notes and as I quoted above, that many companies these days have forum selection clauses requiring derivative suits to be litigated in the Delaware Chancery court, so the federal court approach arguably is less momentous than might otherwise be the case.

All of that said, and setting aside the federal court/Delaware court aspect of the decision, it is noteworthy and concerning that the duty of oversight claims survived the motion to dismiss in both the Wells Fargo and Abbott Laboratories cases. The survival of these kinds of claims in any court has important implications for corporate governance and for the needs for corporate boards of directors to establish and monitor critical aspects of the companies’ operations, and, to document doing so.

The court did grant the defendants’ motion to dismiss the plaintiffs’ breach of the duty of oversight claims relating to discriminatory hiring practices allegations. However, the plaintiffs’ discriminatory hiring-related allegation under Sections 10(b) and 20(a) of the Exchange Act survived the motion to dismiss, as did the same allegations in the parallel securities class action lawsuit. I emphasize this point because these claims arguably represent examples of the kind of allegations that have characterized ESG-related litigation.

I say that these are examples of ESG litigation because, as I noted at the time when the parallel securities class action lawsuit was filed, the allegations relate to the “S” pillar of ESG. Indeed, many of the statements on which the various plaintiffs rely in both the securities lawsuit and the derivative lawsuit appeared in the company’s so-called Sustainability Statement and ESG Statement. These allegations are similar to many of the kinds of allegations that have appeared in ESG-related litigation, in that it is not the ESG laggards that are getting sued, but rather companies that are proactive and attempting to burnish their ESG credentials but that fall short or overstate their efforts.

In this case, the company’s well-publicized efforts to diversity its workforce led to fake job interviews and other actions intended to suggest compliance with the diversity objectives. The fact that these allegations survived the dismissal motions, at least in part, in both the securities litigation and in the derivative lawsuit, represent examples of the ways in which exaggerated ESG-related claims can translate into potentially dangerous corporate and securities litigation.

One final note if interest to the readers of this blog. One argument the plaintiffs tried to make in the Wells Fargo case to try to establish demand futility is the contention that demand would be futile because the company’s D&O insurance policy has an insured vs. insured exclusion. The implication is that it would be futile to demand that the board bring the claim, because if they did, the claim would have involved an insured vs. insured claim for which the D&O insurance policy would not provide coverage. The board, the argument suggests, would not bring a claim for which there is no insurance coverage. Judge Thompson had very little time for this argument. As she said (on page 20 of the opinion), “court have routinely rejected the argument that such an exclusion demonstrates an inability of the directors to disinterestedly consider a demand.”