The Delaware Supreme Court clarifies the standards for director oversight liability under Caremark

Introduction

Claims of disloyalty for a director's bad-faith failure to oversee the company's operations—so-called Caremark claims¹—have long been characterized as among "the most difficult theor[ies] in corporation law" on which to found judgment.² This week, in Marchand v. Barnhill³, the Delaware Supreme Court took the rare step of reviving a dismissed Caremark claim, shedding important light on the contours of the duties of oversight borne by the directors of a Delaware corporation. While reiterating that Caremark "is a tough standard" that imposes an "onerous pleading burden" on a shareholder plaintiff, the Court made clear that Caremark "ha[s] a bottom-line requirement": "the board must make a good faith effort—i.e., try—to put in place a reasonable board-level system of monitoring and reporting."⁴ As a result, when the well-pleaded facts of a complaint "support[] an inference that no system of board-level compliance monitoring and reporting existed," particularly in relation to "the corporation's central compliance risks," a Caremark claim will survive dismissal.⁵

Background

The case arose from the 2015 listeria outbreak at Blue Bell Creameries USA, Inc. ("Blue Bell"), one of the nation's largest ice cream manufacturers.⁶ Following a recall of all Blue Bell products and a wave of layoffs at the company, Blue Bell suffered a liquidity crisis that forced it to accept a dilutive private equity investment.⁷ A Blue Bell shareholder then brought a derivative suit against Blue Bell's directors and two key executives, charging that the directors had breached their duty of loyalty under Caremark and that the executives had breached their duties of care and loyalty by purportedly ignoring contamination risks and failing to oversee the safety of the company's operations.⁸

The complaint alleged a pattern of unheeded food-safety warnings at Blue Bell's plants beginning in 2009, coupled with the absence of any systems to monitor compliance and ensure that deficiencies were reported to the board.⁹ According to the complaint, from 2009 to 2013, state and federal regulators found various compliance failures at Blue Bell's facilities, and third-party laboratories reported several positive tests for listeria in Blue Bell product samples.¹⁰ "Despite management's knowledge of the growing problem," the complaint contended, "this information never made its way to the board, and the board continued to be uninformed about (and thus unaware of) the problem," as evidenced in part by the lack of discussion recorded in board minutes.¹¹ Drawing all inferences in the plaintiff's favor, the complaint "fairly pled" that (1) "Blue Bell had no board committee charged with monitoring food safety"; (2) "Blue Bell's full board did not have a process where a portion of the board's meetings each year . . . were specifically devoted to food safety compliance"; and (3) Blue Bell's board "did not have a protocol requiring or have any expectation that management would deliver key food safety compliance reports or summaries of these reports to the board on a consistent and mandatory basis."¹² In other words, "the complaint plead[ed] that the Blue Bell board had made no effort at all to implement a board-level system of mandatory reporting of any kind."¹³ Compounding matters, the complaint charged that the Blue Bell board had no discussion at all about listeria until the company was forced to initiate a limited recall—and even then, the board "left the company's response to management."¹⁴ The complaint further alleged that by the time the outbreak was contained, Blue Bell had ordered a complete recall of its products, several customers had fallen ill or died, and the company faced a liquidity crisis.¹⁵ All of this, the complaint stressed, "despite the critical nature of food safety for Blue Bell's continued success."¹⁶

The Delaware Court of Chancery dismissed the complaint in full, reasoning that pre-suit demand was not excused as futile on either of the plaintiff's claims.¹⁷ With respect to the fiduciary duty claims against the executives, the court held that the plaintiff had failed to plead particularized facts casting a reasonable doubt on the ability of a majority of Blue Bell's directors to impartially consider a demand.¹⁸ With respect to the Caremark claim, the court found that the complaint and documents incorporated by reference therein demonstrated that Blue Bell had complied with FDA regulations and had submitted to ongoing third-party monitoring for contamination, and its board received regular reports from management on operations generally.¹⁹ This, the court held, established the existence of a monitoring system at Blue Bell, such that the plaintiff's challenge was only to "the effectiveness of monitoring and reporting controls in particular instances"—a theory that cannot support a Caremark claim.²⁰

The decision

The Delaware Supreme Court, sitting en banc, unanimously reversed the Chancery Court's decision.²¹ Although the Court underscored the difficulty of pleading—and ultimately proving—a Caremark claim, it concluded that the particularized facts set out in the complaint crossed that critical threshold.²²

The Court began by focusing its inquiry on the nature of the plaintiff's Caremark claim. "[D]irectors have great discretion to design context- and industry-specific approaches tailored to their companies' businesses and resources," the Court observed, "[b]ut Caremark does have a bottom-line requirement that is important: the board must make a good faith effort—i.e., try—to put in place a reasonable board-level system of monitoring and reporting."²³ Where a plaintiff is unable to plead that the board failed to make that requisite good faith effort, no Caremark claim will lie even though illegal or harmful activities may have escaped detection.²⁴ The court's focus, therefore, is on whether the complaint permits the inference that the board "made no effort to put in place a board-level compliance system," rather than on whether the complaint casts doubt on the effectiveness of the board's compliance and reporting system after the fact.²⁵

Applying these standards, the Court held that the complaint stated a Caremark claim because it "support[ed] an inference that no system of board-level compliance monitoring and reporting existed at Blue Bell."²⁶ The Court reasoned that although Blue Bell is a monoline company that could thrive only if consumers were confident in the safety of its ice cream, the complaint alleged no protocol for the board to be advised of food safety reports and developments and provided particularized facts supporting an inference that material information concerning food safety issues were not reported to the board. Specifically, the Court relied on seven factual allegations in support of this conclusion: before the listeria outbreak, (1) no board committee addressing food safety existed; (2) no regular processes requiring management to advise the board of food safety compliance practices or risks existed; (3) no schedule for the board to consider key food safety risks on a regular basis existed; (4) management received reports containing potential yellow or red flags of health safety risks and positive listeria tests identified by regulators and third-party laboratories that evidently were not disclosed to the board; (5) the board received information about food safety from management that was incomplete and misleading by omission; and (6) there was apparently no regular board discussion of food safety issues; and, after the listeria outbreak, (7) the FDA "discovered a number of systematic deficiencies in all of Blue Bell's plants . . . that might have been rectified had any reasonable reporting system that required management to relay food safety information to the board on an ongoing basis been in place."²⁷ As the Court succinctly explained, "[w]hen a plaintiff can plead an inference that a board has undertaken no efforts to make sure it is informed of a critical compliance issue intrinsically critical to the company's business operation, then that supports an inference that the board has not made the good faith effort that Caremark requires."²⁸

The Court quickly dispatched with Blue Bell's remaining arguments. With respect to Blue Bell's defense that it met FDA and state regulatory requirements for food safety and maintained employee manuals detailing safety practices, the Court distinguished between "these types of routine regulatory requirements," which "are not typically directed at the board," and the duty Delaware law imposes on directors to oversee the company's operations in good faith: "The mundane reality that Blue Bell is in a highly regulated industry and complied with some of the applicable regulations does not foreclose any pleading-stage inference that the directors' lack of attentiveness rose to the level of bad faith indifference required to state a Caremark claim."²⁹ Likewise, the Court rebuffed Blue Bell's invocation of management's "regular[] report[s]" to the board on "operational issues," declaring that "Caremark would be a chimera" if Blue Bell's argument were accepted.³⁰ "At every board meeting of any company, it is likely that management will touch on some operational issue," and "[a]lthough Caremark may not require as much as some commentators wish, it does require that a board make a good faith effort to put in place a reasonable system of monitoring and reporting about the corporation's central compliance risks."³¹ Indeed, Caremark claims typically fail because the plaintiff "must concede the existence of board-level systems of monitoring and oversight"—the very systems allegedly missing at Blue Bell.³²

Key takeaways

Marchand is a noteworthy decision, both because it illustrates the outer bounds of directors' oversight duties and because it represents a rare instance of prospective Caremark liability. Lessons include:

Caremark remains one of the hardest theories of recovery under Delaware law

The Delaware Supreme Court repeatedly went out of its way to emphasize the difficulty of stating a Caremark claim. The Court cited, with approval, previous decisions of the Supreme Court and the Court of Chancery describing Caremark claims as "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."³³ It also cited at least five decisions dismissing Caremark claims despite allegations of serious undetected misconduct resulting in substantial harm to the company.³⁴

Caremark claims turn chiefly on the existence of monitoring and reporting systems, not their efficacy

Blue Bell's directors could be liable under Caremark because the well-pleaded facts in the complaint permitted the reasonable inference that the company made no effort to implement a board-level compliance system directed at the company's central compliance risk. The Court made clear that, where appropriate board-level oversight systems exist, Caremark claims generally fail.

Even still, it is not enough merely to establish monitoring and reporting systems

Of course, Marchand is not a blank check for directors to escape liability by relying on the existence of generalized oversight systems alone. Those systems still must be implemented in good faith, must be governed by appropriate procedures, and must be tailored to the company's business and its core compliance risks.

Directors should identify the central compliance risks facing their company and ensure that their monitoring and reporting systems address those risks

The Court did not hide its displeasure with Blue Bell's alleged failure to monitor food safety in a methodical way and ensure that food safety-related issues were communicated to the board, given that whether the only product it makes, ice cream, is safe to eat has to be one of the most central issues at the company. Given that the risk factors listed in a public company's Form 10-K generally represent the company's core areas of concern, directors should review their company's recent Forms 10-K and evaluate whether the company has adequate board-level oversight mechanisms in place to address relevant risk factors. The specific deficiencies at Blue Bell listed by the Court serve as a helpful guide to the minimum best practices under Delaware law: a board should consider (1) dedicating a committee to its main compliance risks; (2) establishing protocols requiring management to keep it apprised of compliance practices, risks, and reports; (3) setting a schedule to assess its main compliance risks on a regular basis; (4) formulating procedures for the communication of red or yellow flags to the board and memorializing the associated discussions in board minutes; and (5) arranging for and documenting regular discussions of compliance risks at board meetings. 

A special thanks to compliance lawyer Elisabeth Sinclair, who works directly under the supervision of Seth M. Kruglak, for her assistance in preparing this text.