Delaware Supreme Court Reverses Dismissal of Caremark Claim, Finding Lack of Board-Level Oversight and Director Independence

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Key Takeaways

  • Directors may be held liable for breaching their duty of loyalty under Caremark if they make no good faith effort to ensure that the company has in place any system of compliance controls addressing the company’s central compliance risks.
  • Regular board-level review and oversight of critical compliance issues must be appropriately documented in minutes of board meetings to evidence the board’s continued monitoring of such issues. The absence of any documentation of their discussion in the minutes of board and committee meetings may support an allegation that the board made no effort to implement a board-level system of information reporting, giving rise to an inference that the directors breached their duty of loyalty under Caremark.
  • When a board fails to implement any system to monitor a central compliance issue, the fact that management and the board discussed general operational issues and the board complied with state and federal regulations may not suffice to overcome an inference of bad faith.
  • Delaware courts will continue to scrutinize personal relationships among directors and will not hesitate to find that certain relationships are sufficiently close and personal so as to compromise a director’s independence for purposes of a pleadings-stage demand-futility analysis.
  • Accordingly, significant or controlling shareholders must analyze carefully their connections with director candidates whom they seek to elect or appoint as independent directors, or risk having director independence second-guessed by the courts. Complying with independence under stock exchange or similar objective criteria may not necessarily satisfy the scrutiny of the Delaware courts.
  • Where certain directors are entitled to multiple votes, the board’s independence is determined based on whether the majority of votes belong to independent directors, and not whether a simple majority of directors are independent.

In Marchand v. Barnhill et al. (“Blue Bell”),1 the Delaware Supreme Court on June 19 unanimously reversed the dismissal of a shareholder derivative lawsuit against the members of the board of directors and two officers of Blue Bell Creameries USA, Inc., one of the country’s largest ice cream manufacturers. The lawsuit arose out of a 2015 listeria outbreak in Blue Bell’s ice cream that caused three deaths and resulted in a total product recall that pushed the company to the verge of bankruptcy. The complaint alleges that the Blue Bell directors breached their duty of loyalty under Caremark2 by failing to institute any system of controls and information-reporting regarding food safety. In holding that the complaint adequately alleged that a majority of the board was not disinterested and independent to consider a shareholder demand, the Supreme Court made clear that it will continue to scrutinize closely allegations of personal and financial entanglements in considering director independence. And in holding that the allegations of a total absence of board-level oversight of food-safety compliance and monitoring gave rise to a Caremark claim, the Supreme Court reinforced the necessity for directors to understand, inform themselves about, and document the company’s most significant risks.

Breach of Loyalty Claims under Delaware Law

Under Delaware law, the board of directors carries responsibility for the management of the corporation's affairs, but the board may delegate day-to-day management of the corporation to officers and other full-time employees. While most corporate charters include exculpation provisions that protect directors from personal liability for breaches of the duty of care, directors cannot be exculpated under Section 102(b)(7) of the DGCL for breaches of the duty of loyalty, including where they act in bad faith. Bad faith is established where the board abdicates its oversight responsibilities by completely failing to implement any information systems or controls, an allegation of misconduct commonly referred to as a Caremark claim. But Caremark claims are notoriously difficult to prove, because they require proof that the directors demonstrated a conscious disregard of their duties through a systematic and continuous failure to oversee and monitor the company’s activities over an extended period of time. That is the case even where the company has suffered a major corporate crisis and even where employees, including senior executives, appear to have engaged in deliberate misconduct.

Courts are reluctant to allow claims to survive the pleading stage absent allegations of the directors’ direct knowledge of misconduct or red flags. In other words, “bad faith on the part of the corporation’s directors is a necessary condition to liability.”3 Bad faith is established under Caremark’s “duty of oversight” when the board of directors either: (a) failed to implement any reporting mechanisms or compliance controls sufficient to ensure it would receive adequate information to reveal the type of misconduct allegedly taking place; or (b) having implemented appropriate compliance controls, consciously failed to monitor or oversee the operation of that system.4

Moreover, when a shareholder brings a Caremark claim as a derivative action, she must satisfy the onerous prerequisites of Court of Chancery Rule 23.1, either by making a demand that the board of directors pursue the claim, or by demonstrating that a demand on the board would be futile. When a derivative plaintiff alleging board inaction elects not to make a demand upon the board, the plaintiff must plead particularized factual allegations that “create a reasonable doubt that, as of the time the complaint [was] filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.”5 To show lack of independence, the plaintiff must allege that “the director may feel either subject to the interested party’s dominion or beholden to that interested party.”6 In recent years, Delaware courts have identified certain types of close relationships with interested parties, such as property ownership and engagement in joint ventures that “one would expect to heavily influence a human’s ability to exercise impartial judgment.”7

Background of the Blue Bell Litigation

Blue Bell suffered a listeria outbreak in early 2015, which caused three customer deaths and forced the company to order a total product recall and production shutdown. In addition to multiple lawsuits brought against Blue Bell by injured consumers, the recall and complete shutdown of production caused Blue Bell to lay off more than one-third of its workforce and prompted the company to warn its shareholders that it was on the brink of collapse.8

A shareholder of Blue Bell Creameries USA, Inc. (the holding company of the Blue Bell enterprise)9 filed a derivative action alleging that defendants breached their fiduciary duties to the company. The complaint alleged that the CEO and another senior officer breached their duties of care and loyalty by failing to respond appropriately to growing food-safety issues, and that the board breached its duty of loyalty, under Caremark, by failing to implement any board-level reporting system and thereby failing to inform itself about Blue Bell’s food-safety compliance. The complaint asserted that the board never received any information about listeria or about food-safety issues in general, despite reports of unsanitary conditions at the company’s three plants dating back to 2009, and reports of positive tests for listeria at plant in 2013.

The plaintiff claimed that a demand on the board of directors to pursue claims against the officers would be futile because a majority of the directors are long-time employees and/or otherwise beholden and loyal to the company’s founding family, of which the two officers are members. Granting defendants’ motion to dismiss, the Court of Chancery found that none of the non-family directors, constituting a majority of the board, had connections with the defendants or the founding family that would render them unable to exercise their independent judgment in considering a litigation demand. In doing so, the trial court rejected plaintiff’s allegation that one particular director, who was also the company’s former chief financial officer, lacked independence, despite his longstanding personal and business relationship with the company’s founding family.

The Supreme Court’s Analysis and Reversal

Because the Court of Chancery had concluded the board was independent by one vote, in reviewing the plaintiff’s demand-futility claim, the Supreme Court focused its independence analysis on the one director mentioned above, the former CFO of the company.

Close Relationship to CEO Undermines other Indicators of Independence

At issue was the relationship between the director and the CEO’s family. The challenged director had spent virtually his entire career at the company, rising from serving as a personal assistant to the current CEO’s grandfather to serve as the CFO of the company. However, the director had ceased working as an executive of the company four years earlier, and was not alleged to have received any compensation from the company other than directors’ fees.10 Moreover, the director had voted against the CEO on an initiative to split the CEO and Chairman roles, despite the CEO’s threats to resign as CEO if his roles were split.

Notwithstanding these pieces of evidence that the director could be trusted to exercise impartial judgment, the Supreme Court focused on the fact that the director had had a close personal relationship with the founding family for nearly the entirety of his three-decade career with the company. The Supreme Court highlighted that the family had led a charitable campaign to raise $450,000 for a local community college, which resulted in the naming of a college building after the director.11 The Supreme Court held that these facts, at the pleading stage, gave rise to an inference that the director “owes an important debt of gratitude and friendship” to the CEO and founding family that cast doubt on the director’s independence. The Supreme Court added that this inference was not overcome by the fact that the director had retired four years earlier and had demonstrated his independence through his vote on the Chairman-CEO role split. The Supreme Court reasoned that a decision over whether to sue the CEO was “materially different and more important” than deciding to vote against the CEO on a corporate governance change, notwithstanding the CEO’s threat to resign over that issue.12 Therefore, the Supreme Court reversed the trial court’s dismissal of the complaint for failure to make a pre-suit demand on the board.

Absence of Board-Level Oversight over Critical Safety Issue Raises Inference of Bad Faith

In addressing the plaintiff’s breach of loyalty claim, the Supreme Court directed its inquiry to whether the complaint had adequately alleged that Blue Bell’s board made no effort to implement a board-level system of monitoring and reporting food-safety compliance, so as to satisfy the high burden for a Caremark claim of a failure to exercise oversight. Chief Justice Strine, writing for the court, framed the analysis in terms of the attention to food safety that the board of a company with a single-product business line in the food industry—for which “food safety was essential and mission critical”13—must pay. The Supreme Court went on to find that the complaint created a reasonable inference that “that no board-level system of monitoring or reporting on food safety existed”14 and had thus adequately pled bad faith under Caremark.

Much of the analysis focused on evidence obtained through the plaintiff’s books and records request—particularly meeting minutes, which the Supreme Court found reflected no board-level discussion of food safety. The records also suggested that the company had no schedule for the board to consider key food-safety risks on a regular basis and no board committee to address food safety. The Supreme Court was particularly concerned by the fact that in the years leading up to the 2015 outbreak, management received testing reports identifying unsanitary conditions in several facilities and listeria contamination at one facility. However, despite management’s awareness of “red, or at least yellow, flags” during this period, the minutes showed that the board “remained uninformed (and thus unaware) of the problem.”15 The Supreme Court thus concluded that the board’s apparent failure to implement any such protocols resulted in widespread contamination going unreported, which it found was tantamount to bad faith.

Chief Justice Strine was not persuaded by the argument that the board had satisfied its fiduciary duties by virtue of the company’s nominal compliance with FDA and state food-safety regulations, viewing such compliance as mere evidence of the “mundane reality” that Blue Bell operates in a highly regulated industry, without demonstrating food-safety monitoring at the board level.16 Chief Justice Strine also downplayed the significance of general operational reports that were shared with the board—which included audit reports of Blue Bell’s facilities—holding that such reports would be typical for any board meeting at any company and do not establish the existence of any board-level oversight.17

Implications

The Blue Bell decision is an important reminder that Delaware courts will continue to scrutinize director independence and corporate oversight obligations. The Supreme Court’s willingness to allow the Caremark claim to proceed is a warning to directors that they must identify, regularly review, and document their oversight of key risks facing their companies. It remains to be seen whether this decision will be limited to its unfortunate facts—a single-product company with a history of safety violations ultimately leading to consumer deaths and a total product recall—or whether it signals a new receptiveness by Delaware courts to challenges to directors’ oversight activities. While directors have discretion to develop their own approaches to industry risks that take into account the company’s specific business model, the Supreme Court made clear that there must be at least an attempt to implement a reasonable board-level system of controls. And for businesses involving a single, regulated product, Blue Bell stresses that compliance with the relevant regulation should be a primary concern for the board. In this regard, the decision’s focus on the board’s level of oversight is key; if a plaintiff can adequately plead that the board failed to even attempt to implement a monitoring and information system for an “intrinsically critical issue,” directors cannot shield themselves from liability by pointing to the company’s compliance with state and federal regulatory requirements, or the receipt of reports from management on general operational issues.

Blue Bell also provides a valuable lesson in corporate governance and housekeeping. The plaintiff was able to use meeting minutes obtained from a books and records demand to allege a complete lack of a reasonable information and reporting system at the board level, an evidentiary hurdle that typically kills Caremark claims at the pleading stage. Thus, in addition to having the necessary discussion, board or board committee minutes must reflect proper compliance and oversight efforts.

With respect to director independence, particularly in those companies where directors have super-voting rights, boards should consider the nature and extent of personal relationships between directors and interested parties. The Supreme Court appeared to base its decision on the theory that certain personal relationships are sufficiently material as to compromise a director’s independence. However, unlike similar cases reaching the same conclusion, the Supreme Court did not specifically pinpoint which material aspect of the relationship rendered the director beholden to Blue Bell’s founding family. And while there were facts that pointed to the former CFO’s independence, the alleged deeply personal relationship with the CEO rose to a level that caused the Supreme Court to doubt, at least at the pleading stage, the director’s ability to exercise impartiality in the face of a demand to sue the CEO’s family. The current trend in Delaware case law suggests that directors with longstanding relationships to a significant shareholder, such as an operating partner or a longstanding external consultant, will be unlikely to be considered as independent at least with respect to matters in which the appointing shareholder is interested.

Footnotes

1) No. 533, 2018, 2019 WL 2509617 (Del. June 19, 2019).

2) In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996).

3) Id. at 967.

4) See Stone v. Ritter, 911 A.2d 362, 370-372 (Del. 2006).

5) Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993).

6) Sandys v. Pincus, 152 A.3d 124, 128 (Del. 2016).

7) Id. at 103; see also Sciabacucchi v. Liberty Broadband Corp., 2018 WL 3599997, at *14 (Del. Ch. July 26, 2018).

8) Marchand v. Barnhill, No. CV 2017-0586-JRS, 2018 WL 4657159, at *8 (Del. Ch. Sept. 27, 2018).

9) Blue Bell Creameries USA, Inc. owns a majority interest in the Blue Bell operating subsidiary, Blue Bell Creameries, L.P., and wholly owns Blue Bell Creameries, Inc., the general partner of Blue Bell Creameries, L.P. The holding company and the general partner had the same executives and directors. Thus, in analyzing the complaint, the Court of Chancery collapsed the boards of the Blue Bell enterprise, analyzing the conduct of the holding company’s executives as “dual fiduciaries,” even though all of the alleged corporate misconduct occurred at the level of the operating subsidiary. The Supreme Court provided no further insight on the responsibilities of directors of a company whose sole assets lie in an operating subsidiary, but sanctioned the trial court’s approach in a footnote without detailed analysis. Id. at *3, n. 14 (stating that “the Court of Chancery sensibly and properly collapsed the enterprise for purposes of analyzing the complaint”).

10) The four-year period since the director’s retirement, and lack of any compensation from the company other than directors’ fees during that time, would easily satisfy the requirements of director independence applicable to a director of a public company under relevant stock exchange rules. See NYSE Listed Company Manual §303A.02(b)(ii), NASDAQ Rule 5605(a)(2)(B) and IM-5605. While those rules were not directly at issue in Blue Bell because Blue Bell is privately held, the Supreme Court’s treatment of director independence is an important reminder that Delaware courts will not hesitate to use their own judgment in determining independence.

11) 2019 WL 2509617, at *9.

12) Id. at *11.

13) Id. at *15.

14) Id.

15) Id. at *4-5.

16) Id. at *14.

17) Id

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