Corporate boards will continue to face higher risks of liability. As the last bastion of legal privilege and protection, the wall of protection is crumbling bit by bit. Eventually, corporate stakeholders will demand that board members improve performance.
At the core of board member protection from liability is the well-known Caremark doctrine that requires corporate boards to make a good faith effort to implement a system for compliance program monitoring and reporting. For years, Delaware courts easily rebuffed shareholder derivative suits challenging board members’ performance after a corporate scandal occurred. The Caremark standard was reinforced in Stone v. Ritter, where the court stated director oversight liability requires a showing of either “the directors utterly failed to implement any reporting or information system or controls” or the directors, “having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.”
In response to demands for greater accountability and corporate accountability, the Delaware courts have been cutting back the Caremark standard and rejecting motions to dismiss filed by defendants. Recent cases are continuing to down this path and raising the expectations for board members exercising their duty of loyalty and duty of care.
In the Blue Bell Creameries case, Marchand v. Barnhill, the Delaware Supreme Court rejected a motion to dismiss where Blue Bell suffered a listeria outbreak that killed three consumers and multiple cases of illness. Blue Bell “failed to implement any system to monitor Blue Bell’s food safety performance or compliance.” Plaintiff’s eventually reached a $60 million settlement shortly before the scheduled trial date.
In a second significant case, In re Clovis Oncology, the Delaware Court of Chancery rejected a motion to dismiss because the board members failed to respond or take any action in response to significant information that the ongoing clinical trial was being conducted in violation of required standards and misleading investors and regulators.
Hughes v. Hu
Since these important cases, the Delaware Court of Chancery issued another important decision, in Hughes v. Hu, in which it sustained a plaintiff’s duty of oversight claim against three members of the audit committee, CEO, and three successive CFOs of Kandi Technologies Group, Inc., a Delaware company based in Jinhua, China.
The plaintiffs’ claimed that the director defendants consciously failed to establish a system of oversight for Kandi’s financial statements and related-party transactions, “choosing instead to rely blindly on management while devoting patently inadequate time to the necessary tasks.” According to the plaintiffs’ allegations, Kandi repeatedly suffered from persistent weaknesses in its accounting controls and oversight system. Three years later, Kandi announced the restatement of three years of financial statements.
As set out in the complaint, Kandi’s audit committee failed to meet often as required and when they met, the meetings were short and failed to devote adequate time and attention to the issues, especially in light of the known internal controls issues. In addition, the audit committee frequently acted through written consent as opposed to addressing issues during in-person meetings. Also, Kandi’s outside auditor failed to report on key issues and when it did so, the audit committee failed to respond or follow up. In rejecting the motion to dismiss, the court found that it was reasonable to infer that Kandi’s board failed to implement a system for reporting and monitoring, and blindly relied on management, even after management had demonstrated that it could not report accurately on financial and related-party transactions.
In another case, the Delaware Court of Chancery allowed a board oversight liability claim to proceed against the general partner of Plains for failure to implement or properly oversee a pipeline integrity reporting system, which resulted in a Plains pipeline rupturing and spilling 3,400 barrels of oil into an environmentally sensitive part of the west coast. Plains also faced fines, a federal securities action, lost revenue, reputational harm, a decline in its stock market price, and criminal convictions.
In permitting the claim to proceed, the court cited the CEO’s testimony in a criminal proceeding that pipeline integrity was “not discussed at the board level,” and there were no documents “showing that the audit committee actually conducted pipeline integrity review.”
Teamsters Local 443 Health Services & Insurance Plan v. Chou
In this case, the plaintiff shareholders alleged director oversight liability claims against certain directors of AmerisourceBergen Corporation (ABC) for failing to exercise proper oversight of an acquired company, Oncology Supply Pharmacy Services (Pharmacy). After the acquisition, Pharmacy engaged in a massive illegal and dangerous business relating to filling and distribution of cancer medication in syringes that led to contamination of the cancer medication syringes. Pharmacy also paid kickbacks to doctors to increase sales of the tainted syringes.
Further, Pharmacy evaded FDA oversight by falsely portraying itself as a state-regulated entity. A Justice Department investigation resulted in a criminal prosecution of ABC and Pharmacy, resulting in ABC’s guilty plea and payment of a $260 million penalty, and a civil False Claims Act settlement of $625 million. ABC shareholders alleged that the ABC directors failed to satisfy their fiduciary duty of oversight.
The court denied defendants’ motion to dismiss finding that there was sufficient evidence from which to infer that the directors consciously disregarded multiple instances when red flags became apparent to the directors.
First, in 2007, Davis Polk submitted a report to ABC which claimed that Pharmacy’s operations were not integrated into ABC’s compliance and reporting function. The ABC board took no steps to respond to the Davis Polk report or implement any of the suggested changes and improvements.
Second, Michael Mullen, a former Pharmacy executive, identified significant compliance issues across all of Pharmacy’ product lines. After spending months attempting to raise these issues internally to Pharmacy and ABC, Mullen was terminated. Senior management never reported any of these matters to the ABC board. Mullen filed a False Claims Act case and ABC disclosed the filing of the case. The ABC board failed to take any remedial actions in response to the allegations.
Lastly, ABC knew that Pharmacy received a federal grand jury subpoena relating to allegations raised by the former executive, and ABC failed to discuss or even mention the issue in any board or committee meeting minutes.
The court’s decision in Teamsters suggests that a board must establish procedures and protocols to ensure that corporate risks and red flags are elevated to the board and the board must then take appropriate steps to respond to and address the issues raised by the red flags.
In light of all of these cases, companies need to ensure that robust monitoring, compliance, and reporting systems notify the board of key risks and that the board responds in a timely fashion. These actions have to be documented appropriately in meeting minutes to confirm the board’s actions and effective operation of the board reporting system.