This article originally appeared on Bloomberg Law, and is republished here with permission.
In Marchand v. Barnhill, a unanimous Delaware Supreme Court imposed substantial new procedural expectations on corporate directors to satisfy their fiduciary duty of oversight related to material risk areas and legal compliance.
Prior to Marchand, claims against directors for breach of fiduciary duty arising from a failure of oversight, known among corporate lawyers as Caremark claims, were believed to be among the most difficult legal theories on which a plaintiff might hope to win a judgment.
After the Marchand decision, written by Chief Justice Leo J. Strine Jr., corporate directors face an increased risk from shareholder lawsuits whenever the corporation suffers damage from a violation of the law or other material risk area, unless the board had a committee charged with continually monitoring these risks or the full board regularly devoted a specific portion of its board meetings to oversight of these matters.
Marchand also expects that board minutes and agendas will document oversight activities and that the board will explicitly require management to report regarding key risk area-related matters on a consistent and mandatory basis.
Marchand involved a shareholder suit against the board of Blue Bell Creameries, a privately held ice cream manufacturer, for breach of duty of loyalty and bad faith for failure to provide adequate oversight of food safety and legal compliance risks.
Blue Bell suffered a listeria outbreak in 2015, which forced the company to recall all of its products and shut down its plants. Three consumers died from eating contaminated ice cream.
Marchand is a classic example of bad facts making bad law. Blue Bell operated in a highly regulated industry, where it deployed robust food safety procedures at an operational level. Senior management undoubtedly was aware of multiple red flags indicating a risk of listeria contamination. The board met monthly with management reporting on operational matters, occasionally including food safety topics. Somehow, management failed to address the risk and to advise the board of the potential problem.
Vice Chancellor Joseph R. Slights III initially dismissed the lawsuit for failure to state a Caremark claim against the directors. In a well-reasoned opinion, which is consistent with established Delaware law, the vice chancellor found that the plaintiff did not really challenge the existence of monitoring and reporting controls but rather the effectiveness of these systems in a particular situation.
The Delaware Supreme Court reversed, holding that the complaint alleged particularized facts that supported a reasonable inference 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 and reporting system exists is an act of bad faith in breach of duty of loyalty”.
The characterization of the claim as a breach of the director’s duty of loyalty rather than the duty of care is extremely important because exculpation from monetary damages under Section 102(b)(7) of the DGCL
Many corporate practitioners would have thought, at least prior to Marchand, that a board of a private company that meets monthly with the CEO and vice president of operations present and regularly receives reports on operational issues, including food safety matters, could reasonably expect these two officers to alert them about listeria “red flags” known to them.
After all, as a matter of both agency law and Delaware corporate law, officers have a duty to provide the board of directors with information that the directors need to perform their statutory and fiduciary roles.
Traditionally, “bad faith” required an intentional dereliction of duty or conscious disregard of one’s responsibilities. Many will find it hard to fathom how the Blue Bell board’s failure to adopt procedural measures, that arguably were not even considered best practice at the time for private company boards, meets the standard for bad faith.
More likely than not, directors who attend monthly meetings and receive reports from senior management about the business and its challenges subjectively believe they are discharging their duty of oversight, at least as to problems actually known to the senior management present at the meeting.
In light of Marchand, boards are well advised to adopt specific board-level procedures reasonably designed to identify, monitor and mitigate material risks to the company, including legal compliance.
The two approaches endorsed by Marchand are appointing a committee to regularly monitor these risks or establishing a regular schedule, such as quarterly or biannually, for the board to consider the risk areas.
In addition, boards are well advised to establish explicit protocols that require management to keep the board apprised of key risk area-related matters, including the results of any investigations or inspections.
Finally, boards will want to make sure oversight-related activities are clearly documented in the board agendas, board minutes and other board materials.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.