Caremark Developments -- Do You Know What You Don’t Know?
In 1996, the Delaware courts created what has become known as a Caremark claim: an allegation that directors failed to exercise oversight of the organization. Directors are expected to create and monitor “information and reporting systems” that provide “timely, accurate information sufficient to allow management and the board... to reach informed judgements concerning both the corporation’s compliance with the law and its business performance.”
Actions attempting to show breach of this broad standard have until recently had limited success; the Delaware courts insisting that those alleging a failure of oversight show that the board knew that they were breaching their fiduciary obligations either by utterly failing to implement a reporting system or ignoring “red flags” generated by a reporting system.
In June 2019, the Delaware Supreme Court added a new path to a successful Caremark claim; one that, some fear, will become a multi-lane highway for plaintiff lawyers to attack directors when something goes wrong. The case behind this new ruling is undeniably tragic; listeria contaminated ice cream produced by Blue Bell Creameries (“Blue Bell”) killed three and sickened many. The resulting recall and plant shutdown caused a mass layoff and a liquidity crisis solved only by private equity investment that severely diluted shareholders. Blue Bell’s management was well aware of the food safety issues in its plants; this information, did not, however, make it to the board itself.
The Delaware court believed the plaintiff had sufficiently alleged that the board had “undertaken no efforts to make sure it is informed of a compliance issue intrinsically critical to the company's business operation.” Even though Blue Bell operated in a “highly regulated industry,” this external oversight was not, prima facie, a replacement for internal board oversight. Blue Bell’s directors tried to argue that management always discussed general operations with the board. In response, the court stated that, “[a]t every board meeting of any company it is likely that management will touch on some operational issue” and, that if this were sufficient oversight, Caremark would be a “chimera.” Instead of general oversight systems, the court stated that Delaware law requires that a board actively monitor “central compliance risks;” risks that are “mission critical.”
This new “mission critical” oversight standard was put to the test in another case that came before the Delaware courts just a few months later. Clovis Oncology, Inc. (“Clovis”), a pharmaceutical company, overstated results of a clinical trial on its most promising candidate for lung cancer treatment. The Delaware court pointed out a number of instances where the board was informed that the drug was not performing as expected but “[w]ith hands on their ears to muffle the alarms,” the board signed the annual report that misstated the trial results. Disclosure of the actual trial results caused what the Court of Chancery called a “corporate trauma in the form of a sudden and significant depression in market capitalization.” The court again signaled that external regulatory oversight is not a substitute for internal board oversight; “as fiduciaries, corporate managers must be informed of, and oversee compliance with, the regulatory environments in which their businesses operate.” The court interpreted the Blue Bell case as “underscor[ing] the importance of the board's oversight function when the company is operating in the midst of ‘mission critical’ regulatory compliance risk.” The court stated that, while it “does not demand omniscience,” it expected directors have a “sensitivity” to mission critical areas.
Recent SEC Action on Regulation of Proxy Advisor Voting Advice
Background. In its Concept Release on the U.S. Proxy System dated July 14, 2010 (“2010 Concept Release”), the SEC solicited comment on various aspects of the U.S. Proxy System. In discussing the relationship between voting power and economic interest, the SEC included a discussion of the role of proxy advisory firms in the proxy voting process. Recognizing the increased use over the years of proxy voting advice by institutional investors and investment advisors, who must vote for themselves or their clients on complex issues at a large number of companies, the Concept Release pointed out a number of potential issues raised by the use of proxy advisory firms. For example, it noted that informed shareholder voting could be impaired by insufficient disclosure of conflicts of interest and inadequate accountability for informational accuracy in the development and application of voting standards. The Concept Release also recognized arguments that proxy advisory firms are controlling or significantly influencing shareholder voting without appropriate oversight and without having an actual economic stake in the issuer. In discussing the state of regulation of proxy advisory firms, the Concept Release referred back to prior releases and guidance in which the SEC took the position that, as a general matter, the furnishing of proxy voting advice would be considered a “solicitation” for purposes of the proxy rules.
2019 Guidance. On August 21, 2019, the SEC issued its Commission Interpretation and Guidance Regarding the Applicability of the Proxy Rules to Proxy Voting Advice (“Guidance”) in which it reiterated its position that, in general, proxy voting advice constitutes a solicitation under Section 14(a) of the Exchange Act. Section 14(a) makes it unlawful for any person to solicit a proxy, consent or authorization in respect of a security registered pursuant to Section 12 of the Exchange Act in contravention of SEC rules and regulations. The Guidance reflects the SEC’s belief that proxy advisory firms may be subject to the proxy rules because they provide voting recommendations that are reasonably calculated to result in the procurement, withholding, or revocation of a proxy, (i) even when they are not seeking a proxy authority for themselves, (ii) even when they are actually indifferent to the outcome of the vote, (iii) even if they are providing recommendations based on the application of the client’s own tailored voting guidelines, and (iv) even in circumstances where the client may not follow this advice. The fact that the proxy voting advice is given for the purpose of influencing shareholders’ decisions with respect to a vote is key to this analysis.
In the Guidance, the SEC acknowledges that persons engaged in a solicitation arising from the provision of proxy voting advice may avail themselves of applicable exemptions from the information and filing requirements of the federal proxy rules when specified conditions are met. Such exempted solicitations would, however, remain subject to the antifraud provisions of Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact and which must not omit to state any material fact necessary in order to make the statements therein not false or misleading. In discussing how Rule 14a-9 may apply in this context, the Guidance further discusses additional disclosures that may be needed to avoid Rule 14a-9 concerns. Accordingly, under the Guidance, the provider of proxy voting advice should consider whether it may need to disclose material information concerning: (i) the methodology used to formulate its voting advice on a particular matter, (ii) third-party information sources, and (iii) conflicts of interest that arise in connection with providing the proxy voting advice.
ISS Lawsuit. On October 31, 2019, ISS brought suit against the SEC in the United States District Court for the District of Columbia, seeking declaratory and injunctive relief and arguing that the Guidance is unlawful for several reasons. First, ISS argues that the Guidance exceeds the SEC’s statutory authority under Section 14(a) of the Exchange Act and is contrary to the plain language of the statute. ISS argues that a proxy advisor offers independent advice and research to its clients about how to vote their shares based on the proxy voting policy guidelines selected by the client, compared to a person who “solicits” a proxy by urging shareholders to vote a certain way in order to achieve a specific outcome in a shareholder vote. In addition, ISS argues that the Guidance is procedurally improper because it is a substantive rule that the SEC failed to promulgate pursuant to the notice-and-comment procedures of the Administrative Procedure Act and that it must be set aside as arbitrary and capricious. As to the latter position, ISS states that even though the Guidance marks a significant change in the regulatory regime applicable to proxy advice, the SEC has denied that it is changing its position at all.
Proposed Amendments to Proxy Rules. On November 5, 2019, the SEC proposed amendments to the proxy rules to codify its interpretations in the Guidance. In addition, the SEC proposed amendments to the exemptions from the information and filing requirements normally relied on by proxy advisors to add substantive new requirements and conditions to such reliance. Finally, the SEC proposed to amend Rule 14a-9 to highlight the types of information that a proxy voting firm may need to disclose to avoid a potential violation of the proxy rules.
