The Court of Chancery’s March 30 decision in LendingClub is another example of the significant difficulty plaintiffs face in adequately alleging demand futility in the context of a derivative corporate oversight claim governed by Caremark, especially so in the face of an applicable exculpatory provision contained in a corporate charter.
Under Delaware law, directors, not shareholders, manage the corporation. Accordingly, it is the responsibility of the directors, not shareholders, to decide whether to bring a derivative claim in the first instance. Stockholders wishing to pursue a derivative claim on behalf of the corporation, pursuant to Court of Chancery Rule 23.1, must either make a demand on the board or allege, with particularity, that such a demand would have been futile, i.e., that a majority of the board faced a substantial likelihood of liability for failing to discharge their fiduciary obligations.
Among other fiduciary obligations, Caremark provides that the board of a Delaware corporation must make a good faith effort to put into place a reasonable board-level system of monitoring and reporting. In order to establish liability for breach of this oversight obligation, however, plaintiffs must show that (1) the directors utterly failed to implement any reporting or information system or controls, or (2) having implemented such a system or controls, the directors consciously failed to monitor or oversee its operations thus disabling themselves from being informed of the risks or problems requiring their attention. Both prongs of the Caremark test also include a scienter requirement such that the directors must have had knowledge that they were not discharging their fiduciary obligations. These requirements present a formidable barrier to oversight claims. Here, Plaintiffs argued that both prongs were satisfied, as evidenced by a lawsuit the FTC filed against the company in 2018 alleging it engaged in unfair and deceptive consumer practices.
Because the total absence of such a system of reporting and monitoring is exceedingly difficult to establish, Caremark’s first prong is rarely satisfied. In this regard, the LendingClub court concluded that the mere existence of an internal reporting system flowing up to the board level established that the board had made a good faith attempt to implement the required monitoring structure. Given the existence of this system, the court concluded that it could not be said that the board had “utterly failed” to implement “any reporting or information system or controls” and, accordingly, the members of the board were not exposed to a substantial likelihood of liability under the first Caremark prong.
With respect to Caremark’s second prong, the LendingClub court determined that plaintiffs had failed to provide specific factual allegations to support the existence of a deliberate oversight failure, declining to infer a conscious failure to monitor based on allegations that did not identify specific “red flags” related to alleged illegal conduct. Rather, the court explained that generalized allegations related to board presentations referencing an increase in customer complaints and board discussion of an ongoing FTC investigation were insufficient to adequately allege “board knowledge of ongoing legal violations” (emphasis original). The LendingClub court’s Caremark analysis, and a similar dismissal affirmed days ago by the Delaware Supreme Court in In re Metlife, are the latest reminder of the heavy burden associated with any Caremark case.
Of further note, the LendingClub decision also reinforces that the presence of an exculpatory provision in a corporate charter in and of itself creates a high bar for purposes of a demand futility analysis. As the court explained, “the standard under Delaware law for imposing liability on a director exculpated from breaches of the duty of care is an exacting one that requires evidence of bad faith.” As for disclosure violations, this means a plaintiff must plead “particularized factual allegations” suggesting that the “disclosure violation was made in bad faith, knowingly, or intentionally.”
While establishing oversight liability under Caremark is notoriously demanding, a few recent successes (discussed elsewhere on this blog, with one example here) illustrate that it is not impossible. Rather, boards should think carefully about the fiduciary obligations established by Caremark and take the necessary steps to insulate themselves against oversight risk. First, although Caremark insulates directors against oversight claims, it also establishes the board’s fiduciary duty to institute a reasonable system of board-level reporting and controls. Second, when applying Caremark, Delaware courts generally scrutinize the information provided to the board and the actions taken, if any, in response to those reports. Accordingly, boards should establish committees tasked with reviewing reported information and demonstrate that those reporting systems are integrated into the corporate governance structure. By developing robust monitoring and reporting structures at the board level, and including exculpatory provisions in corporate charters, directors can greatly reduce their exposure to personal liability and, in the process, significantly decrease the likelihood that shareholders would be able to successfully plead a derivative action based on an oversight claim.