*October 16, 2019: Update On Caremark Claims Following the Delaware Supreme Court’s Decision in Marchand v. Barnhill
In In re Clovis Oncology, Inc., C.A. No. 2017-0222-JRS, 2019 Del. Ch. LEXIS 1293 (Del. Ch. Oct. 1, 2019), the Delaware Court of Chancery applied Marchand on a motion to dismiss and determined that the complaint adequately pled a Caremark claim against a biopharmaceutical company’s board of directors. The board allegedly ignored red flags indicating the company was not adhering to FDA-required protocols in its clinical trials for the only promising drug of three drugs it then had under development, causing the FDA to withhold approval. The resulting corporate “trauma” included a 70% market capitalization loss. Like the ice cream manufacturer in Marchand, the Chancery Court characterized the company as a “monoline company operat[ing] in a highly regulated industry,” where compliance with FDA-required protocols constitute an “intrinsically critical” business operation involving a “mission critical product.” Although it acknowledged that Caremark claims remain “among the hardest to plead and prove,” it noted that Caremark liability is more likely to attach when the alleged oversight failure concerns “compliance with positive law” as opposed to the “manag[ing] of business risk.” It portrayed Marchand as further “underscor[ing] the importance of the board’s oversight function when [a] company is operating in the midst of ‘mission critical’ regulatory compliance risk.” According to the Chancery Court, Marchand “makes clear” that, in such instances, “the board’s oversight function must be more rigorously exercised.”
Clovis provides a first glimpse at the Delaware Chancery Court’s reaction to the Delaware Supreme Court’s Marchand decision. Clovis confirms that, in complying with public health and safety regulations (including those governing clinical trials), a heightened level of oversight is expected, particularly when the oversight failure may result in trauma that is significant relative to the company’s overall operations.
In Marchand v. Barnhill, No. 533, 2018, 2019 Del. LEXIS 310 (Del. June 18, 2019), the Delaware Supreme Court (Strine, C.J.) reversed a Delaware Court of Chancery (Slights, V.C.) order dismissing a derivative claim alleging that an members of the board of directors of an ice cream company breached their duty of loyalty under In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996). The Caremark claim was brought after the company experienced a listeria outbreak and sold listeria-contaminated ice cream, resulting in consumer deaths. This incident also led to severe economic consequences for the company. The Court held that the complaint alleged facts raising a reasonably conceivable inference that the company’s directors failed to adopt a reporting and monitoring system sufficient to ensure they remained informed specifically about food-safety issues. The opinion suggests a Caremark breach may be inferred if regular reports to the board contain no information on an “intrinsically critical” compliance issue, especially involving public health and safety.
Blue Bell Creameries USA, Inc. (“Blue Bell”) sold one product: ice cream. Between 2009 and 2014, it received notices from the Food & Drug Administration (“FDA”) and state regulators citing food-safety violations at all three of its plants. Management did not include this information in its regular reports to the board on the company’s operations. Nor did their regular reports mention numerous test results reflecting the presence of listeria at the company’s plants during 2013 and 2014. Starting in early 2015, management learned that ice cream samples tested positive for listeria. The board remained uninformed. Only after management commenced a limited product recall did the board learn of the listeria contamination. As the outbreak continued to unfold, the company had to fully recall its products, cease all ice cream production and lay off more than a third of its workforce. Ultimately, three deaths were traced to its products.
Plaintiff, a Blue Bell stockholder, brought a purported derivative action that included a Caremark claim against Blue Bell’s directors for utterly failing to adopt or implement a system of controls and reporting on food-safety risks. A Caremark claim seeks to hold directors personally liable for losses a company suffers as a result of the directors’ knowing failure to oversee and monitor the company’s compliance with law in breach of the duty of loyalty to the company.
The Court of Chancery dismissed the Caremark claim, observing that plaintiff alleged no facts showing that the company lacked monitoring systems required by FDA and other regulations. It further noted that, as alleged, management had provided the board with regular reports on the company’s general “operations” (although none specifically addressed food-safety). According to the Chancery Court, the complaint’s allegations raised questions about the effectiveness of the reporting system the board put in place but not its existence (or lack thereof) of such a reporting system, and so failed to state a Caremark claim.
The Supreme Court reversed. It stated that “[u]nder Caremark, directors must make a good faith effort to implement and monitor oversight systems.” It then observed that before the listeria outbreak engulfed the company, the directors formed no board committee to address food safety, instituted no regular process by which management would keep the board informed of food safety risks and compliance practices and adopted no schedule by which the board would take up and consider key food safety risks. It further noted that Blue Bell’s nominal compliance with FDA-imposed food-safety monitoring requirements did not show a board-level monitoring program existed. Ultimately, the Court held that a board must undertake efforts “to make sure it is informed about a compliance issue intrinsically critical to the company’s business operations.” It then determined that, as alleged, no reporting system required Blue Bell’s management to relay food-safety information to the board. Rather, Blue Bell’s management, in its discretion, reported to the board on general “operational issues,” and management decided whether these reports covered food safety or not. According to the Court, Caremark “would be a chimera” if such a discretionary reporting system could suffice in circumstances when compliance is “essential and mission critical.”
Marchand offers a rare example of a successfully pled Caremark claim. It suggests a court may infer a Caremark breach from facts showing a board received no reports about an issue “intrinsically critical” to a company’s business. As to what makes an issue “intrinsically critical,” it is reasonable to conclude that where a company’s product or services could impact public health or safety — e.g., food and drugs, common carriers — a court will expect to see at the board level a heightened degree of effort and information to ensure safety compliance.