13 October 2021

Delaware Chancery Court Affirms Importance of Director Oversight in Wake of Boeing Crashes

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Two years ago the Delaware Supreme Court, in Marchand v. Barnhill, allowed Caremark claims to proceed against a group of directors in connection with a listeria outbreak at their company’s ice cream manufacturing plants. Applying Caremark — often quoted as “possibly the most difficult theory in corporat[e] law” — the court determined the board failed to implement reasonable oversight and monitoring on “mission critical issues.” There, food safety was “mission critical.” Since Marchand¸ courts have applied these principles to, among other cases, a biopharmaceutical company’s failure to comply with FDA regulations and an auto parts company’s failure to properly monitor its financial reporting.  Now, the Delaware Chancery Court has provided another guidepost, this time in the aerospace industry, finding that certain of Boeing’s stockholders adequately pled Caremark claims against Boeing’s Board.

In re the Boeing Company Derivative Litigation arose following two crashes of Boeing 737 Max planes: the Lion Air crash in October of 2018 and the Ethiopian Airlines crash in March of 2019.  The cause of these crashes was eventually revealed to be faulty sensors and software intended to correct a balance issue with the aircraft.  The sensors were vulnerable to false readings and if triggered could “correct” the aircraft by pushing the nose down.  Consequently, numerous investigations and legal actions ensued in the wake of the crashes, including criminal proceedings, with Boeing ultimately agreeing to pay penalties and other compensation exceeding $2.5 billion.

In the Delaware Chancery Court, several plaintiffs made books and records demands and filed derivative litigations in 2019.  The Chancery Court consolidated these proceedings and appointed lead plaintiffs in August of 2020.  In their Consolidated Amended Complaint, Plaintiffs asserted derivative breach of fiduciary duty claims against certain of Boeing’s directors, alleging that (i) before the Lion Air crash, they failed to implement a reporting system to monitor the safety of Boeing’s airplanes; (ii) after the Lion Air crash, they ignored red flags and disregarded their duty to investigate; and (iii) after the Ethiopian Airlines Crash, they terminated the CEO in a manner that allowed him to cash out his equity compensation.  Plaintiffs also brought claims for breach of fiduciary duty against certain of Boeing’s officers on similar grounds.

Plaintiffs did not make a demand on Boeing’s Board and instead alleged that demand would have been futile because a majority of the Board faced a substantial likelihood of liability.  Outlining the Caremark standard, the Chancery Court iterated that a plaintiff must allege particularized facts that either “(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 risks or problems requiring their attention.”  On the first prong, board oversight for “mission critical” issues must be “rigorously exercised,” which involves “sensitivity to compliance issues intrinsically critical to the company.”  Applying this standard, the Court found that Plaintiffs had adequately pled a claim against the director defendants.

First, the Court explained the Board had no committee charged with direct responsibility to monitor airplane safety, and the Board at large was not formally monitoring or discussing safety on a regular basis.  The Court was particularly concerned that, following the Lion Air crash, the agenda for an upcoming Board meeting reflected discussion items for restoration of profitability and efficiency, but not safety.  While defendants pointed to discussions of safety in certain other Board materials, as well the Board’s general oversight of the 737 Max development and production, the Court found these to be “passive invocations of quality and safety . . . [that] fall short of the rigorous oversight Marchand contemplates.”  The Court expressed additional concern that Boeing lacked any internal reporting system through which whistleblowers and employees could raise safety concerns.

Second, the Board did not require management to deliver regular safety reports or summaries.  As a result of this reporting structure, management communicated with the board on an ad hoc basis and tended to provide only certain favorable information while withholding information concerning various safety defects. The Chancery Court criticized the Board for not pushing back and instead “passively accept[ing] management’s assurances and opinions.”

Third, the Chancery Court found that the record — supplemented by numerous documents obtained through a Section 220 production and incorporated by reference into the pleadings — supported an explicit finding of scienter.  In particular, the Chancery Court referred to a “lessons learned” email wherein one Board member circulated a series of points based on his prior board experience and suggested board meetings always begin with a review of product quality and safety.  According to the Court, this communication (and those similar to it) confirmed that the Board knew it should already have had better oversight mechanisms in place.  The Chancery Court similarly criticized the Board’s public statements where it purported to be taking safety precautions the Company was not in fact taking.  This “public crowing” further revealed that the Board knew what it should have been doing all along.  The Chancery Court also found that Plaintiffs had stated a claim under prong two of Caremark, based on allegations that the Board “passively accepted” management’s assurances that the 737 Max was safe, and that it did not take action in the face of alleged red flags such as the Lion Air crash and a Wall Street Journal article documenting engineering defects in the 737 Max.

The Chancery Court separately granted the portions of the motion to dismiss related to allegations concerning the CEO’s termination, as well as claims against the officers.  As to the former, the Court noted that Plaintiffs did not “meaningfully challenge” the Board’s independence in this regard.  And, even if the termination was designed for the CEO “to go quietly and with full pockets to avoid further public criticism,” it was reasonable for the Board to infer “that doing so was in furtherance of the legitimate business objective of avoiding further reputational and financial harm to the Company.”  As to the latter, the Court noted that the Board was capable of pursuing claims against officers.  This aspect of the decision presents an interesting procedural situation in which the litigation against the directors may proceed at the same time many of those same directors must determine whether to pursue claims against officers based on the same underlying facts.

While Boeing does not alter the Caremark standard, it serves as a reminder that boards should not take a passive oversight approach to their company’s “mission critical” issues.  In this regard, boards should assess steps they are taking to document their diligence of such issues, particularly in light of the potential that stockholders may seek discovery of such records in connection with Section 220 demands or otherwise.