Board’s Good-Faith Oversight of “Mission Critical” Risks Insulates Directors from “Caremark” Claim

In 1996, the Delaware Court of Chancery issued its seminal decision in In re Caremark International Inc. Derivative Litigation, which establishes the framework for director oversight liability under Delaware law. Over time, Delaware courts frequently observed that this type of claim was “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment,” and these claims rarely advanced beyond the motion-to-dismiss stage. However, in a three-year span beginning in 2019, Delaware courts denied motions to dismiss Caremark claims in five cases, leading some to question whether the Caremark standard has been relaxed. A recent Court of Chancery decision issued earlier this summer provides an important counterpoint to this recent commentary, while underscoring that boards must exercise rigorous oversight over “mission critical” risks.

In City of Detroit Police & Fire Retirement System, Inc. v. Hamrock, Chancellor Kathaleen McCormick granted a motion to dismiss a shareholder derivative claim under Caremark for failure to plead demand futility. The case arose from a September 2018 natural gas overpressurization event in Massachusetts. NiSource, the nominal defendant in the shareholder derivative suit, owned a natural gas subsidiary called Columbia Gas of Massachusetts (“CMA”), which was involved in a construction project to replace old pipeline. An omission in the engineering plans led to the build-up of excess pressure in the system, which caused a series of fires and explosions. The damage from the incident ultimately led NiSource to report approximately $1 billion in losses. The National Transportation Safety Board investigated the incident. CMA was criminally prosecuted and entered into a plea agreement in February 2020, in which it pleaded guilty to one count of violating a federal gas pipeline safety regulation. NiSource entered into a deferred prosecution agreement.

As a precursor to the shareholder derivative litigation, a NiSource stockholder made a Section 220 demand for books and records, after which NiSource produced thousands of pages of books and records. Citing materials from the Section 220 production, and without first making a litigation demand on the Board of Directors (the “Board”), the stockholder filed a derivative suit against the Board, initially in federal court and then again in the Court of Chancery. (In the federal suit, the court dismissed with prejudice the plaintiff’s federal claims, but declined to reach the Delaware-law claims on jurisdictional grounds.) In the Court of Chancery, the defendant directors moved to dismiss, arguing that demand was not excused. The plaintiff’s sole theory of demand futility was a Caremark theory.

As regular readers of this blog will know, Caremark requires a plaintiff to allege that directors acted in bad faith by (1) completely failing to implement any reporting or information system or controls, or (2) consciously failing to monitor or oversee a company’s operations. The plaintiff in Hamrock argued that demand was futile because a majority of the Board faced a substantial likelihood of personal liability because the directors purportedly consciously ignored “mission critical” compliance risks at NiSource’s subsidiaries that would have alerted them to the risk of the September 2018 overpressurization event at CMA.

In a detailed 63-page opinion, Chancellor McCormick carefully analyzed the record and rejected the plaintiff’s arguments. She held that the plaintiff failed to allege that a majority of the Board faced a substantial likelihood of liability under Caremark, and therefore demand on the Board was not excused.

The opinion confirms that plaintiffs face a high hurdle when pursuing a claim under Caremark. Even with regard to “mission critical” risks, which require heightened oversight, plaintiffs can show demand futility only if they plead particularized facts establishing that the board “utterly failed” to put in place a reasonable system of monitoring and oversight. This standard is met only in rare circumstances, such as where a board leaves compliance entirely to management, or receives reports on “mission critical” risks solely at management’s discretion. The court held that this standard was not met in Hamrock. Among other things, the record demonstrated that the NiSource Board and a Board committee regularly monitored and discussed a variety of public safety matters, including gas pipeline safety matters. In fact, as the court observed, the Section 220 production showed that the Board and committee “monitored and actively discussed” the specific pipeline regulatory risks that the plaintiff focused on in opposing the motion to dismiss. In rejecting the plaintiff’s argument that these discussions occurred too infrequently, the court reiterated the familiar Caremark standard: “[T]his argument diverges too dramatically from the high ‘utter failure’ standard, even as understood through the refined lens of Marchand and Boeing. The bottom-line question that Caremark asks is whether the Board made a good faith effort to put in place a reasonable board-level system.” NiSource had such a system in place, the court concluded.

The court also rejected the plaintiff’s argument that the Board ignored “red flags” of the September 2018 overpressurization event. In so doing, Chancellor McCormick articulated several key legal principles that shape Delaware courts’ analysis of alleged “red flags” under Caremark. As the court explained, to serve as a basis for Caremark liability, (1) the board must have known about the alleged red flag before the corporate trauma at issue occurred; (2) the alleged red flag must be “sufficiently connected” to the corporate trauma to put a reasonable observer on notice of the risk that gave rise to the corporate trauma; and (3) the board must have acted with “conscious disregard” when confronted with the red flag. The plaintiff in Hamrock alleged a variety of putative red flags, each of which the court rejected for one or multiple reasons. For example, the court held that regulatory violations at one NiSource subsidiary were not a red flag of the overpressurization event at CMA, because the incidents concerned “different employees, in a different state, in unrelated projects.” As the court put it, the connection the plaintiff advanced was “too attenuated” to permit an inference of bad faith under Caremark. In another example, the court held that a management-level operational notice that addressed the importance of pressure-sensing lines for natural gas pipelines was not a red flag, because the plaintiff failed to allege particularized facts indicating that the Board was aware of the notice before the overpressurization event. More generally, the court closely reviewed the books and records on which the plaintiff purported to rely in evaluating whether those materials supported an inference that the Board consciously disregarded a risk that led to the September 2018 overpressurization event. The detailed books and records that NiSource produced in response to the plaintiff’s Section 220 demand, and which substantiated the NiSource Board’s good-faith exercise of oversight, were integral to the court’s assessment.

As plaintiffs and defendants continue to spar over the significance of the recent Delaware cases that have allowed Caremark claims to proceed into discovery, Hamrock reflects a thorough and well-reasoned opinion confirming that Caremark still requires a plaintiff to allege adequately that the board of directors engaged in bad faith, and that this continues to be a difficult standard to satisfy — even when the case involves a “mission critical” risk.

The defendants in Hamrock were represented by Walter Carlson, Nilofer Umar, Neil Conrad, and Caroline Wong of Sidley Austin LLP.

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.