INSIGHT: Delaware Cases Portent Key Developments in Board’s Caremark Duty

17 December 2019 Bloomberg Law Publication
Author(s): Gardner F. Davis Neda A. Sharifi

Corporate directors face an increased risk of shareholders’ lawsuits whenever the corporation suffers damage from a violation of law or other material risk area, in light of two recent Delaware cases, Foley Lardner attorneys explain. They recommend a board, or designated committee, actively monitor and oversee compliance with the regulatory environment.

Two recent Delaware cases portend important developments in a corporate board’s Caremark duty to monitor. These cases, read together, suggest that this risk of personal liability for directors increases substantially when comprehensive laws govern the company’s mission critical operations.

The Delaware courts now expect boards operating in highly regulated environments to rigorously exercise their oversight functions regarding legal compliance risks.

Historically, Caremark claims based on failure of duty of oversight were believed to be among the most difficult legal theories upon which a shareholder plaintiff might hope to win a judgment.

Where the shareholders’ claim of director liability for corporate loss is predicated upon ignorance of liability creating activities within the organization, only a sustained or systemic failure of the board to exercise oversight was believed sufficient for a suit to proceed to trial. Directors of a number of prominent corporations, including DuPont, Capital One, UPS, Duke Energy, Citi Group and General Motors, have all successfully defended Caremark claims in recent years.

In light of Marchand and Clovis, corporate directors face an increased risk of shareholders’ lawsuits whenever the corporation suffers damage from a violation of law or other material risk area.

In order to manage this risk, particularly for companies that operate in highly regulated industries, the board, or a designated committee, must actively monitor and oversee compliance with the regulatory environment.

Biopharmaceutical Startup, Food Safety Cases

The Delaware Chancery Court in Clovis permitted a lawsuit to proceed against the directors of a biopharmaceutical start-up that alleged the board consciously failed to monitor regulatory compliance in connection with the “mission critical” clinical trial of the company’s developmental cancer drug.

Clovis Oncology was a start-up biopharmaceutical company focusing on acquiring, developing, and commercializing drugs for cancer treatment. In order to obtain FDA approval, these new drugs, such as the Clovis drug, must prove their efficacy and safety in clinical trials that are conducted under strict standards, known as the clinical trial protocol. If the drug sponsor fails to adhere to the protocol, the FDA will not approve the drug for market.

In the Clovis case, the board received reports indicating Clovis was improperly conducting the trials and failing to adhere to the clinical trial protocol. Notwithstanding these revelations, the Clovis board did not act to correct the situation.

Clovis follows in the wake of the Delaware Supreme Court’s recent decision in Marchand, which permitted a lawsuit to proceed against the board of Blue Bell Creameries, a privately held ice cream maker, for breach of duty of loyalty and bad faith for failure to provide adequate oversight of food safety and legal compliance risks.

In Marchand, the Delaware Supreme Court held that the plaintiffs alleged sufficient particularized facts to conclude that the Blue Bell board failed to implement any system to monitor food safety risk. The Delaware Supreme Court stated that the board’s “utter failure to attempt to assure a reasonable information reporting system exists is an act of bad faith and breach of a duty of loyalty.”

These two cases, taken together, make clear that when comprehensive laws govern a company’s mission critical operations, the board must rigorously exercise its oversight function.

In Clovis, Vice Chancellor Joseph R. Slights III suggested that Delaware courts are more inclined to find Caremark oversight liability at the board level when a company operates in the midst of obligations imposed upon it by positive laws yet fails to implement compliance systems, or fails to monitor existing compliance systems, such that a violation of law and resulting liability occurs.

In Marchand, the Delaware Supreme Court admonished boards to implement formal protocols requiring senior management to promptly advise the directors regarding indications of potential problems, so-called red flags, related to substantial risk areas.

Steps to Take in Light of Decisions

In light of Marchand and Clovis, boards and their counsel are well advised to re-examine the corporate information reporting systems and whether they are reasonably designed to provide the board with timely, accurate information sufficient to allow the board to reach informed judgments concerning the corporation’s compliance with laws and business performance.

Boards and their counsel should specifically examine the company’s primary risk areas and the measures in place to oversee and monitor the corporation’s risk management.

Two board-level procedural safeguards noted with approval by the Delaware Supreme Court in Marchand are to appoint a committee to regularly monitor these risks and to establish a regular schedule, such as quarterly or bi-annually, for the full board to examine and discuss these risk areas.

Corporate secretaries should endeavor to provide board agendas and minutes that clearly document the board’s risk management and legal compliance oversight efforts in order to defend in the event a shareholder claims a failure to monitor.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

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