Expansive Interpretation of Caremark Creates Challenges for Private Company Boards

16 August 2019 Thomson Reuters Westlaw Journal Publication
Authors: Gardner F. Davis Neda A. Sharifi

This article originally appeared in Thomson Reuters Westlaw Journal - Corporate Officers & Directors Liability, and is republished here with permission.

In Marchand v. Barnhill, No. 533, 2018, 2019 WL 2509617 (Del. June 18, 2019), the Delaware Supreme Court provided an expansive interpretation of a claim against directors for breach of fiduciary duty arising from a failure of oversight, well known in Delaware corporate law as a Caremark claim. The case will create new challenges for boards of privately held companies.

Company History

Marchand involves a suit against the board of Blue Bell Creameries USA Inc., an ice cream manufacturer with plants located in Brenham, Texas; Broken Arrow, Oklahoma; and Sylacauga, Alabama. Blue Bell generated about $850 million in annual revenue.

Blue Bell suffered a listeria outbreak in early 2015, which forced the company to recall all of its products, shut down production at all of its plants and lay off over one-third of its workforce. Three people died as a result of the outbreak. Blue Bell stockholders suffered major losses because, after the operational shutdown, Blue Bell suffered a liquidity crisis that forced it to accept a dilutive private equity investment.

Unlike prior high-profile Caremark cases, Marchand involved the board of a privately held family company. Three generations of the Kruse family have managed the company for the past 100 years, and the family owns at least 42% of the company’s stock. The company’s status as a subchapter S corporation under the Internal Revenue Code indicates that it has no more than 100 total shareholders.

The 10-member board had exceptionally deep knowledge of the company, averaging 20 years of service. Directors included the current president, the current vice president of operations, the current vice president of sales, two retired CEOs and a retired chief financial officer.

The company had extensive food safety “procedures and systems for training, operations, quality control, reporting and sanitation,” including new employee training and periodic “new refresher videos and coursework.” Blue Bell distributed a sanitation manual with standard operating and reporting procedures, and it promulgated written procedures for processing and reporting consumer complaints.

It also conducted its own food safety testing program, engaged a third-party laboratory and food safety auditor to test for contamination in its facilities, and its facilities were periodically inspected by various governmental authorities.

The Blue Bell board met monthly. Its CEO and the vice president of operations provided regular reports to the board regarding the company’s operations, including reports regarding food safety related matters, such as inspections by the third-party food safety auditor. However, the minutes of the meetings do not provide detail regarding discussion of food safety and compliance activities.

From 2009 to 2013, government inspectors found what in hindsight appear to be troubling food safety problems at Blue Bell’s facilities. The vice president of operations and the CEO failed to respond adequately to these warning signs prior to the listeria outbreak.

Despite management’s knowledge of growing problems, the information never made its way to the board.

The Caremark Claim

A shareholder sued Blue Bell’s directors, alleging a breach of their duty to monitor under Caremark.

The plaintiff’s theory was that the Blue Bell board utterly failed in its oversight duty because it “had no audit or other supervisory structure or committee with responsibility for oversight of health, safety and sanitation controls and compliance.”

The Delaware Chancery Court dismissed the Caremark claim at the motion-to-dismiss stage. Vice Chancellor Joseph R. Slights noted that the plaintiff cited no authority for the proposition that a board must create a committee to monitor and manage every aspect of risk the corporation might face, particularly when there is undisputed evidence that risk management measures have been taken in the company’s operational theater and the board received reports regarding operations at regular intervals.

According to Vice Chancellor Slights, what the plaintiff really was trying to challenge was not the existence of monitoring and reporting controls but the effectiveness of monitoring and reporting controls in particular instances. The vice chancellor held this is not a valid Caremark claim because to state such a claim, the plaintiff must plead particularized facts to support his contention that the Blue Bell board “utterly” failed to adopt or implement any reporting and compliance systems.

The Delaware Supreme Court reversed in a unanimous decision, holding that the complaint alleges particularized facts that support a reasonable inference that the board failed to implement any system to monitor Blue Bell’s food safety performance or compliance.

The Delaware Supreme Court held under Caremark, directors have a duty “to exercise oversight” and to monitor the corporation’s operational viability, legal compliance and financial performance, so a board’s utter failure to attempt to ensure a reasonable information and reporting system exists is an act of bad faith in breach of a duty of loyalty.

Claims Found Adequate

The Delaware Supreme Court held that as a monoline company that makes a single product — ice cream — Blue Bell could thrive only if its consumers enjoyed its products and were confident that they were safe to eat. Therefore, Blue Bell’s central compliance issue is food safety.

The complaint alleges:

  • Blue Bell had no board committee charged with monitoring food safety.
  • The full board did not require that any portion of board meetings be devoted specifically to food safety compliance.
  • The Blue Bell board did not have a protocol requiring or having any expectation that management would deliver key food safety compliance reports or a summary of these reports to the board on a consistent and mandatory basis. In fact, it was inferable that there was no expectation of reporting to the board of any kind.

The Delaware Supreme Court ruled that the complaint alleges facts that create a reasonable inference that the Blue Bell directors consciously failed “to attempt to assure a reasonable information and reporting system existed.”

Adequate Reporting?

The Delaware Supreme Court characterized Blue Bell management’s obligation to report to the board regarding consumer safety and legal compliance issues as “discretionary” rather than “mandatory” and found that there was “no protocol by which the board was expected to be advised” of these issues. This view arguably is inconsistent with Delaware corporate and agency law and the general expectation of most corporate directors.

Officers are corporate fiduciaries who owe the same fiduciary duties as directors. “Officers … have a duty to provide the board of directors with information that the directors need to perform their statutory and fiduciary roles.” Officers breach their fiduciary duty of loyalty by failing to bring material information to the board.

Officers also are agents who report to the board of directors in its capacity as the governing body of a corporation. Under the law of agency, an agent owes the principal a duty to provide information to the principal that the agent knows or has reason to know the principal would wish to have. The agent must act with candor and loyalty.

The Missing Signs

The Delaware corporate statute expressly provides that directors shall be fully protected in relying in good faith upon information, opinions, reports or statements presented by any of the corporation’s officers as to matters reasonably believed to be within such person’s professional competence.

Blue Bell management’s failure to advise the board of the warning signs leading up to the listeria outbreak as part of their monthly briefings on overall company operations would be a material omission.

Presumably, these issues will be litigated at trial.

The Delaware Supreme Court also found that the complaint adequately pleads the Blue Bell board acted in bad faith — a state of mind traditionally used to define the mindset of a disloyal director — by making no effort to implement a board-level system of mandatory reporting of any kind.

To constitute bad faith, as opposed to a breach of duty of care entitled to the protection of the business-judgment rule, the Blue Bell directors must have acted with scienter and known they were not discharging their fiduciary duties.

Most corporate directors would reject out-of-hand the suggestion that the Blue Bell board was guilty of intentional dereliction of duty given the company’s extensive food safety training and protocols, the plaintiff’s allegation the directors did not have any knowledge of the listeria problem and the fact that the directors’ careers, fortunes and family legacy were linked to the quality of Blue Bell ice cream.

The Blue Bell board received reports from senior management at monthly board meetings. Most businesspeople in a similar position would reasonably expect these briefings to include material food safety issues known to senior management, given the critical nature of food safety to Blue Bell’s business.

Prior to Marchand, proving liability for failure to monitor corporate affairs was believed to be “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” Up until now, Delaware courts routinely rejected the conclusory allegation that because illegal behavior occurred, internal controls must have been deficient and the board must have known so.

Conclusions

Going forward, when the corporation suffers any catastrophic trauma, directors face the threat stockholder plaintiffs will allege they acted in bad faith and therefore should be personally liable for the loss notwithstanding the business judgment rule because the board did not appoint a committee to monitor the risk or make the risk a standing issue for periodic documented discussion at board meetings.

In light of Marchand, boards of both public and private companies should consider either appointing a committee to monitor the legal compliance and safety risks facing the company or make the subject a periodic topic for board presentations and discussion. The board should also explicitly require that senior officers promptly and candidly advise the board of all information indicating material problems with the company’s safety performance or legal compliance.

Privately held companies need to revisit their practice relating to the preparation of minutes. Many privately held companies prepare brief minutes that only note general topics of discussion at board meetings. Going forward, substantially greater detail regarding discussion of legal compliance and consumer safety issues should be included to document the board provided effective compliance monitoring.

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