Bad Investments, Not Bad Faith: Caremark Claims Have Limits
In its recent decision in Marchner v. B. Riley Financial, Inc., the Delaware Court of Chancery reaffirmed the principle that Caremark cannot be used to repackage hindsight attacks on failed investments as fiduciary breaches. The court explained that directors’ oversight duties are focused on internal compliance, not on detecting misconduct by third parties—even where the company has significant financial exposure. The message is clear: robust process, not perfect outcomes, remains the key to meeting fiduciary obligations.
Background
The case arose from an investment banking and financial services company’s take-private acquisition of a large franchise conglomerate. Months after the deal closed, the target’s principal—who also happened to be a friend of the investment company’s founder—was implicated in securities fraud at a separate asset management firm. In the wake of that scandal and weakening performance by the target franchise conglomerate, the investment company was forced to take significant write-downs on its investment. A shareholder soon filed a derivative lawsuit against the directors of the investment company, alleging that they breached their fiduciary duties by approving the take-private transaction despite alleged “red flags” about the target’s principal and potential misconduct at other businesses with which he was affiliated.
The directors moved to dismiss for failure to plead demand futility under Court of Chancery Rule 23.1. Because the shareholder had not made a pre-suit demand on the Board, he was required under the Delaware Supreme Court’s Zuckerberg test to show that demand would have been futile because at least half of the board (1) was conflicted due to a material personal benefit from the alleged misconduct, (2) faced a substantial likelihood of liability, or (3) lacked independence from someone who was conflicted or faced a substantial likelihood of liability.
Demand Futility Analysis
Although three of the directors were clearly conflicted, the court dismissed the complaint because it found that a majority of the Board was disinterested and independent; therefore, demand was not futile under the three steps of the Zuckerberg test.
First, the court found that the directors’ receipt of customary compensation for their service on the Board did not create a conflict of interest, as otherwise every director on every board could be deemed biased.
Second, the court determined that the majority of directors did not face a substantial likelihood of liability for the shareholder’s claims. The company’s inclusion of a § 102(b)(7) exculpatory provision eliminated liability for duty-of-care claims, and the shareholder was therefore limited to non-exculpated Caremark claims for bad-faith oversight. To state a Caremark claim, a shareholder must allege either (1) that the board utterly failed to implement any reporting system or controls or (2) having implemented such an oversight system, the board consciously failed to monitor or oversee its operations. Noting that Caremark theories are among the most difficult in corporation law for shareholders to pursue, the court held that plaintiffs failed to plead a viable oversight claim under either prong of the doctrine.
As to the first prong of a Caremark claim, the shareholder’s allegations established that the company maintained functioning board-level oversight processes, including an active audit committee and engagement of outside advisors. That those oversight mechanisms may have been flawed or ineffective did not mean that the Board “utterly failed” to implement a reporting system.
With respect to the second Caremark prong, the Board also did not consciously ignore “red flags” because the warning signs the shareholder alleged—including declining financial projections, debt downgrades, and concerns about loan collateral that the audit committee allegedly should have recognized—were not indicators of illegality. The court emphasized that Caremark liability cannot be based on such a theory of constructive knowledge; instead, liability arises only where directors actually know of and disregard evidence of legal non-compliance. The “red flags” the shareholder identified also suggested only ordinary business risks, not illegality, and Caremark does not apply where directors merely make or oversee risky business decisions that later turn out poorly. Moreover, some of the alleged misconduct the shareholder focused on (i.e., the securities fraud) occurred at a third party, not at the take-private target or within the company itself—and the court declined to extend Caremark to require that boards detect fraud at outside companies, even those with close financial ties. Finally, when concerns arose, the audit committee demonstrated active oversight by engaging multiple outside firms to investigate. Ultimately, the court determined that the claim amounted to little more than an allegation of flawed diligence, which is precisely the type of duty-of-care-based claim that is protected by the exculpatory provision and the business judgment rule.
The court also rejected the shareholder’s alternative theory that the directors faced a substantial likelihood of liability relating to allegedly false and misleading disclosures, as the shareholder failed to allege any disloyalty arising from those disclosures or even explain how the directors were involved in them.
Third, the court determined that the majority of directors were independent from the principal of the investment company, who was the only director alleged to face a substantial likelihood of liability. The court reasoned that ordinary director compensation, social media connections, overlapping board service in the past, and other similar surface-level social or business relationships cannot overcome the presumption of independence, absent particularized facts showing a given director is beholden to the conflicted director.
Conclusion
This decision reaffirms that a Caremark claim provides a narrow pathway to allege demand-futility and cannot be used as a tool for second-guessing business decisions that turn out to be poor investments—especially when the investment turns sour because of alleged wrongdoing or illegality by loosely connected third parties and not by the company itself. Boards that maintain and document their robust oversight mechanisms, as well as their responses to “red flags” raised about potential illegality or wrongdoing, should be well-positioned to defend against such claims.
Law clerk Kate Hostal contributed to this blog post.
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.
