June 20, 2019

Delaware Supreme Court Says Plaintiff Pled Viable Caremark Claim

Breach of fiduciary duty allegations premised on a board’s failure to fulfill its oversight obligations are notoriously difficult to establish. One reason that these Caremark claims are so tough to make is that a plaintiff needs to show “bad faith,” meaning that the directors knew that they were not discharging their fiduciary obligations.  But earlier this week, in Marchand v. Barnhill, (Del. Sup.; 6/19), the Delaware Supreme Court overruled the Chancery Court and held that – at least for purposes of a motion to dismiss – a shareholder plaintiff stated a viable Caremark claim.

The case arose from a 2015 listeria outbreak at Blue Bell Creameries. In addition to being implicated in the deaths of three people, the outbreak resulted in a recall of all of the company’s products, a complete production shutdown, and a lay-off involving 1/3rd of its workforce.  Ultimately, the financial fallout from this incident prompted the company to seek additional financing through a dilutive stock offering.

As a result, the plaintiff brought a derivative action against the board & two of the company’s executives. The plaintiff alleged that the board failed in its oversight duties, but the Chancery Court rejected those allegations.  Vice Chancellor Slights determined that the plaintiff did not plead facts supporting allegations that the board his contention that the board “‘utterly’ failed to adopt or implement any reporting and compliance system,” but instead challenged the efficacy of that system.  VC Slights held that this wasn’t enough to support a Caremark claim.

The Supreme Court disagreed.  This excerpt from Steve Quinlivan’s recent blog on the case summarizes the key facts underlying its reasoning:

The Court noted that under Caremark, a director may be held liable if she acts in bad faith in the sense that she made no good faith effort to ensure that the company had in place any “system of controls.” Using facts discovered as a result of a books and records demand, the Court noted the complaint fairly alleged that before the listeria outbreak engulfed the company:

– no board committee that addressed food safety existed;

– no regular process or protocols that required management to keep the board apprised of food safety compliance practices, risks, or reports existed;

– no schedule for the board to consider on a regular basis, such as quarterly or biannually, any key food safety risks existed;

– during a key period leading up to the deaths of three customers, management received reports that contained what could be considered red, or at least yellow, flags, and the board minutes of the relevant period revealed no evidence that these were disclosed to the board;

– the board was given certain favorable information about food safety by management, but was not given important reports that presented a much different picture; and

– the board meetings were devoid of any suggestion that there was any regular discussion of food safety issues.

On top of this, the Court noted that government inspectors found food safety problems at the company’s plants that were so systemic that any reasonable monitoring system would have resulted in them being reported to the board.

The centrality of food safety issues to the company’s business played a key role in the Court’s assessment of the board’s performance of its oversight responsibility.  Manufacturing ice cream was the company’s only business, so the Court believed that food safety should have been a prominent board-level issue – and concluded that the record in front of it indicated that it wasn’t:

When a plaintiff can plead an inference that a board has undertaken no efforts to make sure it is informed of a 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.

Marchand involved a motion to dismiss, and it’s hard to tell whether case suggests that Caremark may be a more viable path to imposing liability than it has been in the past – but it’s worth noting that this decision is the second case in the last two years in which a Delaware court has characterized a Caremark claim against directors as being “viable.”

John Jenkins