In Teamsters Local 443 Health Services & Insurance Plan v. Chou, the Delaware Court of Chancery held, at the pleading stage, that plaintiff stockholders had stated a claim for Caremark [1] oversight liability against certain of the directors of AmerisourceBergen Corporation (ABC). Although a Caremark claim is notoriously one of the most difficult theories of liability to plead and prove under Delaware corporate law, the Court’s decision is the latest in a series of decisions over the past year that have upheld plaintiff stockholders’ complaints premised on such oversight liability.
Background
ABC acquired Medical Initiatives, Inc. d/b/a Oncology Supply Pharmacy Services (Pharmacy) in 2001 as part of a merger. Pharmacy is an indirect subsidiary of ABC and a direct subsidiary of AmerisourceBergen Specialty Group (Specialty). Pharmacy’s business involved buying single-dose vials of oncology drugs from manufacturers, putting those drugs into syringes, and then selling the syringes for injection into a cancer patient’s body. Manufacturers intentionally include an overfill amount of medication to account for human error when filling syringes and to avoid air bubbles when administering the medication. However, rather than discharging the overfill amount, which is not intended for patient use, according to the court, Pharmacy illegally pooled the overfill amounts and used them to fill additional syringes, which led to contamination of the pooled medication.
The court also stated that Pharmacy was not registered with the Food and Drug Administration (FDA) and was operated in a way that made it appear as a state-licensed pharmacy to avoid the FDA’s oversight. Corporate criminal and civil penalties ensued in 2017 when Specialty pleaded guilty as part of a criminal investigation launched by the Department of Justice. Plaintiffs, stockholders in ABC, brought suit, alleging, among other things, that the ABC directors had failed to comply with their fiduciary duty of oversight under Caremark. Defendants moved to dismiss.
Court’s Analysis
The court began its analysis by restating the “cardinal precept” under Delaware law that the board of directors (and not the stockholders) manages the business and affairs of the corporation, including the ability to determine when to pursue litigation on behalf of the corporation. A stockholder may sue on behalf of the corporation when the board fails to do so by submitting a demand to the board unless the demand would be futile. A stockholder may demonstrate that demand would be futile by showing that the directors are incapable of making an impartial decision as to whether to institute the litigation. This showing can be made by raising a reasonable doubt as to a director’s interestedness by alleging facts that reveal board inaction of a nature that would expose at least half of the directors to a substantial likelihood of personal liability.
Applying that standard, the court held that a majority of the members of ABC’s board of directors at the time suit was filed faced a substantial likelihood of liability under Caremark sufficient to excuse the demand requirement. Under Caremark, a director is obligated to make a good faith effort to oversee the corporation’s operations and exercise oversight responsibilities. A Caremark claim necessarily involves a showing of bad faith, which involves the additional hurdle of establishing scienter. This requirement is part of the reason why Caremark claims are especially difficult to successfully plead. Caremark claims can be successfully pled by showing that either (i) directors of a corporation utterly failed to implement any reporting or information system or controls or, (ii) having implemented a system of controls, the directors consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention.
Plaintiffs alleged that certain of the ABC directors faced a substantial likelihood of liability under both theories, but the court only found it necessary to address the so-called “second prong” theory of liability, i.e., that the directors consciously disregarded red flags. In so doing, the court held that plaintiffs had adequately pled that the ABC board of directors had consciously disregarded three separate instances of red flags. First, an outside law firm report had previously identified that Specialty, and by extension, Pharmacy, was not integrated into ABC’s compliance and reporting function, which according to the court, constituted a red flag that Specialty’s compliance mechanisms had substantial gaps that the audit committee had failed to follow-up on and rectify. Next, a former executive of Specialty had filed a complaint under seal in federal district court, alleging that Pharmacy’s business was essentially an illegal operation and, although ABC’s 2010 and 2011 Form 10-K disclosed the suit and was signed by ABC’s board of directors, the ABC board failed to take any remedial steps. Finally, Specialty had received a subpoena from federal prosecutors which ABC believed, according to plaintiffs, related to the former Specialty executive’s action, which was subsequently disclosed in ABC’s 2012 Form 10-K, which was also signed by the ABC directors, and which was not referenced in the minutes of board or committee meetings.
Takeaways
The court’s decision in Teamsters is the latest reminder to boards of directors and audit committees of Delaware corporations to ensure that adequate mechanisms are in place to ensure that red flags from management, including management at direct and indirect subsidiaries, are reported to the board and acted upon. Indeed, as the Teamsters decision makes clear, not only must the board establish protocols and procedures to ensure that corporate risks are disclosed to the board, the board or audit committee must also diligently follow-up on and at least attempt to rectify any risks identified through the established compliance and reporting mechanisms that the board or audit committee previously put in place.
As part of this process, corporate fiduciaries and practitioners alike should be aware that corporate fiduciaries will be deemed to have knowledge of disclosures contained in filings and documents that they have executed (such as a Form 10-K). In this regard, it is especially important that directors are aware of, understand, and ask questions about what they are signing as a matter of compliance with their fiduciary duties. In addition, Teamsters is evidence that minutes of board of directors and audit committee meetings will be heavily scrutinized in litigation. As applied in Teamsters, the absence of references to a red flag in minutes is equivalent to the board of directors or committee never having discussed the matter. Thus, counsel engaged in the representation of boards of directors and audit committees, as well as corporate officers, should be especially vigilant when drafting minutes in connection with the investigation and resolution of red flags. Minutes should reflect that the risk or red flag was disclosed to the board or audit committee, that the board or audit committee followed-up on that risk and sought additional information, and ultimately, that the board either took at least some action to rectify that risk or red flag or determined that the risk or red flag was not necessary to further address.
[1] In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).
