As has been frequently noted on this page, the Delaware Supreme Court’s landmark 2019 decision, Marchand v. Barnhill, marked the beginning of a series of cases in which Delaware courts refused to dismiss shareholder derivative actions alleging oversight breaches—so-called Caremark claims, which are often quoted as “possibly the most difficult theory in corporat[e] law” on which to bring a successful lawsuit. Typically following a books and records demand, these cases shine a spotlight not only on the oversight that boards perform, but also on the manner in which that oversight is documented in a company’s formal records. This post reviews, from a corporate record-keeping perspective, themes drawn from a selection of recent cases in which Delaware courts permitted cases to proceed on Caremark theories and implications for best practices in light of these themes.
Themes from Recent Caremark Cases Clearing the Demand Futility Hurdle
Failure to Focus on Mission-Critical Issues: Marchand v. Barnhill. This case arose from a listeria outbreak in an ice cream producer’s manufacturing plants, which caused three deaths and substantial financial losses for the company. Following a books and records demand, plaintiff prevailed at the pleading stage because the court found that the company “had no committee overseeing food safety, no full board-level process to address food safety issues, and no protocol by which the board was expected to be advised of food safety reports and developments.” Accordingly, the court found, the directors had failed to put in place a reasonable system of monitoring and reporting regarding matters that were essential and mission critical to the company in violation of the “first prong” of Caremark (requiring that directors not “utterly fail” to implement any reporting information system or controls).
Key Issues Absent from Corporate Record: Hughes v. Xiaoming Hu. In this 2019 Delaware Chancery Court decision, a company that had pledged in 2014 to remediate material weaknesses in financial reporting and oversight ultimately announced in 2017 that the last three years of financial statements needed to be restated, prompting several lawsuits. The court expressly referenced the company’s books and records production, noting that the company’s audit committee and board minutes did not reflect any attention to many of the key topics at issue in the litigation. The court found that the most reasonable inference from this absence of records (along with other facts, such as an apparent sporadic audit committee meeting schedule) was that the board failed to attend to the issues. Accordingly, the court found, among other things, that plaintiffs adequately alleged demand futility on the basis of the “first prong” of Caremark. Recently, the court affirmed these principles again in the In re Boeing Co. Derivative Litigation decision. Relying on documents produced in response to a books and records demand, the court found, following 737 Max crashes in 2018 and 2019, that the board lacked a system of oversight with respect to airplane safety—a “mission-critical” issue to Boeing.
Corporate Record Fails to Reflect Remediation of Key Issues: In re Clovis Oncology, Inc. Derivative Litigation. In this 2019 Delaware Chancery Court opinion, plaintiffs alleged that a drug developer inflated the reported performance of its first drug in ongoing clinical trials, using a methodology that violated FDA regulations. The court held that the board had established an information and reporting system, Caremark’s first prong, because books and records showed that the company had a governance committee charged with FDA compliance and the board regularly received detailed information concerning its key drug’s ongoing clinical trial. However, the court found that the board failed to use this system to monitor FDA compliance. The court held that this failure implicated the second prong of Caremark, which requires that, having implemented a system of controls, directors must not consciously fail to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention. Numerous management presentations to the board disclosed facts about the performance metrics showing that the methodology did not follow FDA regulations. But internal records did not reflect that the board asked questions about the methodology, or that it in any way further investigated the drug’s performance metrics.
Implications for Board Record-Keeping
Ensure that any attention to mission-critical issues, areas of government regulation, and known compliance issues is well-documented. Cases since Caremark have emphasized that mission-critical issues (like product safety for food or aircraft, or government approval for new drugs), areas subject to government regulations (like bank security, FDA regulations, public financial filings, etc.), and known compliance issues require dedicated information and reporting systems. Of course, the first step is to ensure that these crucial reporting structures are in place. From a shareholder litigation perspective, however, it is equally important that any board-level reporting with regard to these matters be documented so that all issue-specific reporting is reflected. Records also should reflect the degree to which the board has specifically built a system of controls to address these issues, and the amount or frequency of reporting. For instance, to the extent the reporting occurs through a dedicated channel or on a regular schedule, that information can help to build a strong record as well.
Ensure that minutes are sufficiently robust to reflect significant matters reported to the board, good or bad. Minutes should not shy away from including reports of bad news to the board. If a board attends to a matter but the board’s attention is not reflected in the minutes, there is a risk that courts will permit a case regarding the matter to advance beyond the demand futility stage on the ground that the board ignored an important issue, in violation of the first prong of Caremark. For the same reasons, it can be beneficial to include reports that the board asked questions or otherwise engaged with a topic, to the extent it is accurate, so that the record reflects the degree and intensity of the board’s attention to the topic.
Materials should report remediation by management or the board, not merely problems. While it is advisable to include reports of bad news to the board in minutes, including only problems, without plans for remediation, can risk creating the impression that the board ignored a red flag, violating the second prong of Caremark. Accordingly, when reporting problems, corporate records should also reflect specific action plans recommended or implemented by the board, documentation that the board received reports on management action plans, and evidence that the board engaged to ensure appropriate solutions were sought where problems arose (for instance by asking questions and assuring themselves regarding the responses, or directing management to address an issue).
This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.