Delaware Supreme Court Provides Guidance on Board Oversight Obligations

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On June 18, 2019, the Delaware Supreme Court issued an opinion addressing the fiduciary obligation of directors and officers to exercise proper oversight over the corporation and to implement a system of controls to ensure the corporation's legal compliance. In a unanimous en banc opinion authored by Chief Justice Leo E. Strine, Jr., the court reversed the Delaware Court of Chancery's dismissal of derivative fiduciary duty claims against senior members of management and board members of Blue Bell Creameries USA arising from a 2015 listeria outbreak that resulted in three deaths and a series of negative effects on the company. The plaintiff sought monetary damages from the defendants based on the resulting losses that the company suffered: a recall of all of its products, a shutdown of production at its plants, the termination of over one-third of its workforce, and the company's need to accept "a dilutive private equity investment."

Although fiduciary duty oversight claims are historically difficult for plaintiffs, this decision provides a glimpse into when directors and members of management may be at risk of failing to satisfy their oversight obligations, at least for purposes of a motion to dismiss. In addition, the court's commentary provides valuable insight into the courts' expectations about board minutes and proper board processes, as well as the courts' assessment of board independence issues.

The Decision

As for the fiduciary duty claims, the court concluded that under Delaware's Caremark doctrine—referred to as such after a seminal 1996 case—the plaintiff had adequately alleged that the board failed to establish a system of controls and compliance protocols. Under that doctrine, as part of a board's fiduciary duties of care and loyalty, the board must act in good faith to establish a system of controls and to respond to red flags that arise. The case law further provides that board members generally can only face liability for oversight failures if they "utterly" fail to establish a system of controls or, having established a system of controls, "consciously" ignore red flags that put the directors on notice of wrongdoing.

In this case, the court's refusal to dismiss the claims rested on two fundamental sets of allegations by the plaintiff. First, in the years leading up to the listeria outbreak, the company's management had become increasingly aware of potential contamination risks at the company's facilities. A series of inspections by the U.S. Food and Drug Administration and state regulators had identified various failures and concerns, and the company had several positive tests for listeria at its facilities. Second, the plaintiff alleged that nothing in the board's minutes—which had been obtained in a books and records demand—reflected either discussion of the potential problems, or board-level protocols for monitoring food safety issues or ensuring that problems were reported up to the board. The only clearly relevant discussion regarding food safety in the board's minutes consisted of a reference to an outside audit firm providing positive feedback on the company's food sanitation. The court emphasized that, given that the company had a monoline business consisting of making only ice cream, food safety was central to the success of its business. Based on the plaintiff's allegations, the court held that the complaint created a reasonable inference that the directors failed to fulfill their duty of loyalty under Caremark because "the complaint pled facts supporting a fair inference that no board-level system of monitoring or reporting on food safety existed."

Importantly, in reaching its conclusion, the court noted which measures the company did not have in place. The court observed that even though food safety compliance was a critical issue for the company, the board did not have a committee "charged with monitoring food safety." Nor did the board methodically devote a portion of time at quarterly or biannual board meetings to reviewing food safety compliance issues. Furthermore, according to the decision, there was no evidence at the pleadings stage that the board had adopted protocols to ensure that food safety problems were reported up to the board—or that there was even an expectation that management would deliver reports or bring red- or yellow-flag issues to the board.

Finally, in addressing whether the plaintiff should have made "demand" on the board to bring a lawsuit on the company's behalf or whether the board lacked independence such that demand was excused, the court provided useful commentary on the assessment of director independence under Delaware law. Again reversing the trial court, the court determined that by a narrow margin, the board was not independent of the company's CEO, one of the central defendants in the litigation and a member of the family that had run the company for nearly 100 years. The court's analysis centered on one director who was the "swing" director in the analysis, concluding that he potentially had "very warm and thick personal ties" to the family. In particular, the court noted that the director had begun his career as an administrative assistant for the father of the current CEO who was the prior CEO of the company, that he owed the current CEO's father his entire decades-long career at the company, which included holding the position of CFO, and that the family had spearheaded a campaign that raised $450,000 to name a local college building after the director. The court explained that these allegations created a reasonable doubt as to whether the director could impartially assess whether to bring a lawsuit against those individuals. Accordingly, the court found that a demand on the board would have been futile and allowed the claims against the company's board, as well as its president and CEO and its vice president of operations, to go forward.

Takeaways

Although oversight claims are traditionally very difficult for plaintiffs—with the Delaware courts regularly commenting that such claims are among the most challenging to bring under Delaware law—this decision provides insight into when problems may be sufficiently severe for such a claim to survive a motion to dismiss. The outcome in this case underscores the importance of taking adequate measures to ensure that the company has a proper system of controls and reporting in place. Although the court did not conclusively state what is required of a board to have an appropriate system in place, the court's commentary about what the company lacked is instructive.

The decision also illustrates the importance of a careful, thorough board record. As is common in stockholder litigation, the court assessed the board's efforts based in large part on board minutes and meetings. Board members, with assistance from counsel, should ensure both that they are taking adequate steps to provide sufficient oversight and that their minutes and records reflect their efforts. In particular, the court relied on the fact that certain information was not included in the board minutes, which the court inferred meant the board had not taken certain acts in furtherance of its oversight obligations. The decision reinforces the need for boards to consider the appropriate amount of detail to include in minutes in order to best serve the board and protect the board against this type of oversight by omission claim. For similar reasons, it is also important to ensure that any loose ends are tied up in minutes and that the minutes reflect that the board has taken appropriate follow-up action on compliance matters.

Finally, the court's conclusion about director independence provides yet another important data point on an issue that frequently arises: whether a board is majority independent in a manner that permits the court to defer to a board. This issue arises in stockholder litigation in a multitude of contexts, ranging from the demand futility issue in this case to whether there is a disabling board conflict in a business decision, such as an M&A event, a secondary offering of stock, or a financing round. This decision reflects the ongoing approach of the Delaware courts to assess all facts based on the relationships that exist and whether directors appear capable of exercising impartial judgment.

Lori Will, Nate Emeritz, and James Griffin-Stanco contributed to the preparation of this WSGR alert.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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