Chancery Court Reminds Bricklayers of Sturdy Foundation Required to Plead Demand Futility for Caremark Claims
Last month, in Bricklayers Pension Fund of Western Pennsylvania v. Brinkley, Delaware’s Court of Chancery dismissed a stockholder plaintiff’s derivative suit against the directors and officers of Centene Corporation for purported breaches of fiduciary duty in connection with their oversight of company compliance with Medicaid laws and regulations. The Court concluded that the plaintiff failed to establish demand futility pursuant to Court of Chancery Rule 23.1. Put another way, the plaintiff failed to demonstrate that it had standing to pursue claims on behalf of Centene.
Our blog occasionally discusses developments in Delaware’s demand futility jurisprudence (see, for example, our posts here and here). For those unfamiliar with this concept, a stockholder may derivatively pursue a cause of action belonging to a corporation—i.e., bring a lawsuit on behalf of a corporation for the purported benefit of the corporation—only if (i) the stockholder expressly demands that the company’s directors pursue the claim and the directors wrongfully decline to do so, or (ii) the stockholder makes an adequate showing that such demand is excused because the directors are incapable of making an impartial decision whether to pursue the claim on the company’s behalf.
Bricklayers serves as an important reminder of the foundational standards that a stockholder must satisfy before it will be permitted to supplant a board’s statutory authority to manage the business and affairs of the company it oversees, including any litigation assets belonging to the company.
Background
Beginning in 2018, Centene, a healthcare company that administers Medicaid plans, experienced numerous compliance and public perception issues stemming from its Medicaid pricing practices. These practices were legal, but controversially lacked transparency, and Centene’s Board had been kept apprised of the attendant risks. For example, the Board’s compliance committee oversaw annual compliance program assessments, including for the company’s state Medicaid plans. Those assessments were conducted by a management-level compliance team that reported directly to the compliance committee. The committee also met frequently to discuss compliance risks and policies, and reported to the full Board each quarter. In addition, Centene’s audit committee oversaw annual internal audits conducted by management, which included assessments of each of the company’s state Medicaid plans, and annual external audits conducted by an outside auditor. The Board also received regular updates about the company’s response to Medicaid pricing issues, including corrective actions management was taking.
In mid-2021, a state attorney general filed a complaint against Centene and its subsidiaries, asserting violations of state health care law, breach of contract, and conspiracy. The complaint alleged that Centene and its subsidiaries inaccurately reported Medicaid plan-related costs and sought reimbursement to which they were not entitled. This scheme had been devised by four officers to increase their incentive-based compensation, and as result of their deception, each of the participating officers received inflated incentive payments ranging from $890,000 to $3.9 million. Upon learning of the complaint, the Board promptly conducted an investigation, which resulted in the termination of one officer alleged to have carried out the scheme and the abrupt resignation of another.
Other state attorneys general brought similar actions. By November 2022, Centene had settled thirteen government enforcement actions for more than $600 million, was negotiating settlements for others, and announced a reserve of $1.2 billion to resolve the government inquiries.
The Complaint
Plaintiff’s putative derivative suit asserted, among other things, breaches of the duty of oversight (i.e., Caremark) claims against Centene’s directors and advanced two theories of liability: (i) a “prong-one” Caremark claim—also called an “information systems” claim—by which the plaintiff alleged the Board failed to make a good-faith effort to implement compliance policies and systems to monitor compliance with applicable Medicaid law, and (ii) a “prong-two” Caremark claim—also called a “red flags” claim—by which plaintiff alleged the Board consciously ignored “red flags” indicating that Centene and its subsidiaries were not complying with applicable law. Specifically, the plaintiff asserted that the Board acted in bad faith by (i) failing to maintain a compliance system to detect the officers’ payment-incentive scheme, and (ii) failing to respond to the information it received regarding Centene’s Medicaid payment compliance risks. The plaintiff contended that the directors faced a substantial likelihood of liability regarding these claims and, therefore, a litigation demand to the Board to pursue those claims ought to have been excused.
The Decision
In assessing the plaintiff’s “prong-one” Caremark claim, the Court explained that Delaware law “gives deference to boards and has dismissed Caremark cases even when illegal or harmful company activities escaped detection,” unless a plaintiff credibly pleads that the board failed to make a good-faith effort to put reasonable compliance and reporting systems in place. “[A] bad outcome, without more, does not equate to bad faith,” and the fact that illegal behavior occurred does not mean that internal controls were insufficient or that the Board knew they were insufficient. The Court emphasized the “need to prevent hindsight from dictating the result of a Caremark action.”
The Court then observed that the plaintiff hadn’t attempted to plead that Centene lacked an adequate oversight framework writ large, but rather that the Board knew the existing framework was inadequate because it was aware of Medicaid pricing compliance issues generally. The Court rejected this theory, noting that the complaint (and the Section 220 books and records upon which it was based) made clear that the Board’s compliance committee received regular updates about management’s actions to address known compliance shortcomings. The Court also rejected the plaintiff’s invitation to infer from redactions in Board materials that the directors took no action in response to compliance committee updates about Medicaid-related pricing deficiencies. The Court noted that if it were to infer that the compliance committee notified the Board of compliance framework issues, then “it would be unreasonable to infer the committee did not also inform the Board of the actions taken to address those deficiencies.” The Court thus rejected the plaintiff’s contention that the Board failed to oversee improvements to Centene’s Medicaid compliance systems, or knew that Centene did not have adequate controls in place.
The Court further rejected the plaintiff’s invitation to infer bad faith on the part of the directors “from the mere absence of any Board or committee discussion of Medicaid compliance” for a given period of time. The Court observed that the company had Board committees responsible for Medicaid compliance oversight, that documents upon which the plaintiff relied showed that those committees had conducted such oversight, and that the plaintiff did not identify any known issue with the compliance framework that did not reach the Board.
The Court then turned to and rejected the plaintiff’s “prong-two” Caremark claim. The Court explained that absent a finding of wrongdoing, determining whether information constitutes “red flags” depends on circumstances and context. The plaintiff’s allegation that Centene’s audit committee learned of a government subpoena two years before the Board learned of the illicit incentive-payment scheme was not a “red flag” pointing to the payment scheme: The subpoena did not refer to the scheme or contain other specific information about the investigation. Accordingly, the subpoena “could not have put the demand board on notice of any impending corporate trauma.” Similarly, the Board’s awareness of regulatory scrutiny into Medicaid pricing practices did not support a credible inference that the Board had reason to suspect the four officers’ illegal incentive compensation scheme. The payment practices that had attracted regulatory and public scrutiny were different; they were legal but controversial for other reasons. Meanwhile, the Board had received regular updates that management was actively working to mitigate risk exposure related to Medicaid pricing policies.
In all, the plaintiff’s allegations failed to raise a credible inference that the Board acted in bad faith, either by failing to implement reasonable compliance systems or by consciously ignoring Medicaid payment compliance issues. The allegations thus failed to support a sufficient basis to excuse the plaintiff’s failure to make a litigation demand upon the Board and, because no such demand had been made, the plaintiff lacked standing to pursue its Caremark claims derivatively on behalf of the company.
Conclusion
Bricklayers is an important reminder that, notwithstanding the occasional outlier case, derivative Caremark oversight liability remains one of the most difficult theories of liability for stockholder plaintiffs to plead. The decision reaffirms that corporate directors generally will not face meaningful Caremark liability absent “extreme” circumstances, such as where a board fails to meet and consider compliance-related issues or policies. Here, Centene’s Board and certain of its committees established and utilized information and reporting systems that kept the directors apprised of compliance issues and remedies. As the Court of Chancery noted, the Board did not “make a conscious decision to violate the law,” and it was reasonable for the directors to accept management’s repeated reports that known compliance issues were being addressed. A Caremark action that lacks a sturdy foundation is susceptible to early dismissal, as was the case here.
Bricklayers also underscores the principle that, even in an egregious situation in which illegal conduct abounds at the management level, “a bad outcome, without more, does not equate to bad faith” on the part of the company’s directors. Hindsight should not dictate the result of a Caremark action, and the Court’s summation should prove to be a useful touchstone (and sound bite) going forward.
Finally, Bricklayers makes the important point that an absence of information in board minutes or other materials—due to silence or appropriate redactions—does not necessarily support a negative inference regarding a contested issue. Here, the Court opined that, if it accepted the plaintiff’s inference that Centene’s compliance committee updated the full Board regarding certain compliance-related deficiencies and problems, it would be unreasonable for the Court to then disregard an equal inference that the committee also updated the Board regarding actions the company was taking to address those issues.
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.
