Red Flags and Caremark: The Dawn of the Compliance Committee

Corporate directors were not always held personally liable for regulatory non-compliance. Recently, that has changed. In the land of corporate law, flowers are blossoming. But not sunflowers and orchids; instead, “cases alleging oversight failures… [are] blooming like dandelions after a warm spring rain.”[1] A landmark 2019 expansion of directory liability by the Delaware Supreme Court in Marchand v. Barnhill is to thank, and it’s gaining traction [2]. Professor Bainbridge of UCLA Law School, cited in a recent Court of Chancery opinion, wondered if the expansion might “swallow the whole of corporate law.”[3] As a result, corporate directors now need not only wear the hats of director and auditor, but also regulator. In a world where independent government agencies with authority to enforce compliance already exist, such a change is redundant and stifling to corporate function at best, and an invitation of moral hazard at worst. The government already regulates; let directors get back to business.

Relatively speaking, the audit committee — one of the “key” board committees required by most stock exchanges, together with compensation and nominating committees — itself is a recent invention [4]. In a 1978 history, then Securities and Exchange Commission (SEC) Commissioner Philip Loomis described how audit committees were only recommended by the SEC beyond financial service companies as early as 1940 after McKesson-Robbins, a pharmaceutical distributor, was found to have overstated revenue by $18 million [5]. The impetus for their widespread adoption, however, were 1972 and 1973 SEC and New York Stock Exchange endorsements, which buoyed adoption from 24% of listed companies in 1967 to 90% in 1977. According to Loomis, they aspired to “strengthen the independence of auditors from management,” which was “why outside auditors are brought in at all.”[6] The thought went that if such an independent committee did not exist, management could more easily play make-believe with numbers. To protect individual investors, instead of the SEC themselves playing the role of auditor, the SEC encouraged directors to check management by creating a separate communication channel — the audit committee.

Now, 50 years later, the court of Delaware — not the SEC — is forcing corporate directors to play an additional role: regulator. Perhaps the biggest elephant in the room is that the role of regulator is already played by a variety of government agencies fully independent of corporate management, such as the Food and Drug Administration (FDA) and Federal Aviation Administration (FAA). Yet a recent string of Delaware cases in 2019 and 2021 have expanded an already questionable 1996 settlement worth $814,000 into an effective corporate mandate [7]. That year, in Caremark Int’l, Vice Chancellor Allen expanded a director’s fiduciary duty to include corporate oversight: “In my opinion only a sustained or systematic failure of the board to exercise oversight — such as an utter failure to attempt to assure a reasonable information and reporting system exits — will establish the lack of good faith that is a necessary condition to liability.”[8] Before the decision, corporate directors owed only three fiduciary duties to a corporation: care, where they must make “informed, deliberative” decisions; loyalty, where they must decide to act or not act in good faith with the honest belief that the action is in the best interests of the company and all shareholders; and disclosure, where directors must promptly disclose facts which may compromise their independence [9]. Allen’s opinion effectively added a fourth: oversight. Instead of making the logical jump that a lack of oversight might constitute a breach of one’s duty of care [10] — which would not have been actionable on the basis that Delaware law had for over 18 years at that point allowed certificates of incorporation to exculpate director liability from breaches of care — Allen jumped through hoops to say that a lack of “reporting systems,” “in [his] opinion,” could constitute “lack of good faith” that could breach one’s fiduciary duty of loyalty [11]. To many, including Professor Bainbridge [12], the connection between oversight and loyalty, for which claims of the form became known as Caremark claims, seemed tenuous at best.

For the next 20 years, the court dismissed many, if not all, Caremark claims of director liability as a result of oversight. In a 2013 opinion, the court quoted Caremark as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”[13] The crux was that the court needed to maintain the “force of the business judgment rule and its protection of corporate management decisions,”[14] which freed the Board of Directors “to take risks without a constant fear of lawsuits affecting their judgment.”[15]

A post dot-com case with Nvidia highlights the proper high bar, if the standard is to exist at all. After Nvidia’s shares tumbled 80% from their highs in 2000 through 2002, in part due to an SEC investigation that caused Nvidia to re-state revenue, shareholders sued directors, including Jensen Huang, for selling stock during that period, claiming a breach of fiduciary duty for a “lack of adequate system of financial controls.”[16] Plaintiffs claimed that “examples would include stopping shipments before the end of a quarter to prevent revenue from being too high and using a nearly-fictional returns reserve to manage expenses.”[17] But their claims did not “come close to meeting” the necessary burden, since the plaintiffs failed to provide, at the very least, any particularized accounts of how the board treated its accounting policy or which directors were aware of the mis-statement, let alone whether they were connected to share sales or not [18]. Other claims were dismissed because they were “simply too attenuated to support a Caremark claim,”[19] because “directors [have] no duty to monitor the personal affairs of employees,”[20] or because alleged “red flags must put directors on a heightened alert.”[21]

Oversight duties are not required, as directors are already liable for breaches of loyalty and disclosure. Three cases of a breach of loyalty are clarifying. In 2016, one co-founder of a cargo seal company attempted to sell all of their patents and assets to another company for $1 and “plead ignorant” to the other co-founder, thereby swindling their co-founder out of any deserved revenue from those patents [22]. In 2006, Mark Zuckerberg diluted a co-founder’s stake in the company from 24% to 10% [23]. In 2015, a director of a blank-cheque vehicle arranged for a $4.6 million success fee for an independent auditor of a target company if the auditor manipulated financials before handing responsibilities off mid-transaction to another auditing firm too small to check all of the previous firm’s work in time, which, being “willfully ignored” by other directors, the majority of whom were interested in the deal closing for personal gain irrespective of the chance that the completed merger would soon file for bankruptcy, rose to the level of “gross negligence,” bad faith, and therefore breach of loyalty [24]. In early 2022, a board of SPAC failed to disclose the loss of a major customer before a merger, failing their fiduciary duty of disclosure. In November of that year, Dell and Silver Lake paid the largest settlement in Chancery court history of $1B [25] for coercion after directors attempted to force a transaction by creating a committee for minority shareholders to negotiate with the majority that was ill-equipped to negotiate in any way [26].

But generally, few if any pleas survived dismissal — that is, until the Delaware Supreme Court overruled a Caremark claim dismissal in Marchand v. Barnhill [27]. In summary, managers of an ice cream company, Blue Bell, flouted FDA recommendations for years without telling its board, until conditions got so poor that listeria outbreaks in multiple states necessitated a nationwide recall [28]. Shareholders sued, arguing that there were “no reasonable compliance system and protocols” at the board level, even if the company “nominally complied with FDA regulations.”[29] The court, in a landmark case, sided with the plaintiff, departing from precedent:

“Here, the Blue Bell directors just argue that because Blue Bell management, in its discretion, discussed general operations with the board, a Caremark claim is not stated. But if that were the case, then Caremark would be a chimera. If Caremark means anything, it is that a corporate board must make a good faith effort to exercise its duty of care. A failure to make that effort constitutes a breach of the duty of loyalty.”

The opinion went on to expand Caremark to necessitate the existence of “compliance system and protocols” to meet the “most central consumer safety and legal compliance issue facing the company” or “mission-critical regulatory” item [30]. Notably, however, the original failure was with the FDA, since Blue Bell had “nominally” complied with regulations but had not taken “remedial action” after having received “official notices of food safety deficiency for years.”[31] The issue, in the case of Blue Bell, was with the enforcement policies of the FDA, yet the judge took it upon themself to place the burden on the board of directors. With that, the effective compliance committee was born.

Three pleas have survived dismissal since: In Clovis Oncology, Inc. Derivative Litig., the court wrote about how managers of a biotech company seeking FDA approval found that a crucial success metric was only 42%, when an equity offering signed by the board the next day claimed that it was 60% [32]. The opinion stated that fiduciaries are liable to oversight of “compliance with positive law — including regulatory mandates.”[33] In Teamsters v. Chou, the court affirmed that the board had disregarded “red flags” that were “waived in one's face or displayed so that they are visible to” one whose “gaze is fixed on the company's mission critical regulatory issues.”[34] Specifically, one of the company’s smallest business lines was a pharmacy that, instead of disposing of “overfill” in some syringes, which helped minimize air bubbles, unhygienically pooled the overfill together and sold the additional syringes [35]. As a pharmacy, not a drug manufacturer, they avoided FDA oversight. At one point, particulates in the resulting drugs were visible enough to the naked eye that they were called “floaters” and removed. ABC’s board was found, by signing a 2010 10-K that mentioned a lawsuit from a former COO raising concerns, to have been aware of such red flags and “criminal enterprise.”[36] Most recently, in Boeing Co. Derivative Litig., plaintiff’s hit the jackpot [37], and a $225 million settlement ensued [38]. Factually, in Boeing’s race to get a new plane to market to catch up to Airbus, which would include getting approval for minimal pilot training, engineers retrofitted the older 737 with new engines and solved a center of gravity problem where the nose would go up when accelerating upward with one — not two or three, crucially — sensors that would push the nose of the plane down [39]. As many may know, that sensor often malfunctioned, in large part due to Boeing obfuscating the role that it played from the FAA using “jedi mind tricks,” according to emails, leading to two plane crashes within a year, at a time when the new plane was 60% of the company’s $101.1 billion in annual revenue and 80% of their $8 billion in net income [40]. The court ruled that the board’s “Board's utter failure to try to satisfy this ‘bottom-line requirement’ caused ‘material suffering,’” and that the Caremark claim would not be dismissed [41].

A sexual assault claim against an officer at Mcdonald’s even originally survived dismissal [42] on Caremark grounds, saying that Caremark fiduciary duties of oversight extended to officers, since they may materially impact the culture of the company. However, in the wake of backlash from the legal community [43], the court issued a revised opinion at the beginning of March of this year, stating that such an issue should be a matter of employment law, not equity law [44].

In all four cases that have survived dismissal since 2019, including Marchand v. Barnhill, the fault has been with the regulating agency. One is left with the sense, then, that the Delaware court may soon walk back further. Boards may breach their duty of loyalty by favoring some shareholders over others, as was the case with the cargo seal company and Zuckerberg, but lack of regulatory oversight should not qualify as a breach of loyalty. Unlike audits, which are paid for by the company, regulatory inspections are already carried out and supervised by an independent body — the government. To say that the board members should carry that liability is to abdicate regulating bodies of their responsibility. In effect, such would be a vote of no confidence and an invitation of moral hazard. If the FAA and FDA fall short, that is their liability. The SEC has never broadly recommended “mission-critical regulatory” committees. Should a board in its own discretion decide that they might want to prioritize safety and create their own committee, that should fully be their prerogative. With their pockets lined with a fresh $225 million, corporate litigants will be suing for Caremark — directors be forewarned.

Bibliography

1. Shearman & Sterling LLP. "Delaware Court Of Chancery Dismisses Caremark Claims Alleging Breaches Of Fiduciary Duty Following A Cyberattack". Newstex Blogs JD Supra. September 16, 2022 Friday. https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=news&id=urn:contentItem:66D7-H1Y1-JCMN-Y203-00000-00&context=1516831.

2. Marchand v. Barnhill, 212 A.3d 805, 2019 Del. LEXIS 310, 2019 WL 2509617 (Supreme Court of DelawareJune 20, 2019, Filed). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:5WC9-ST51-JFDC-X0M7-00000-00&context=1516831.

3. Stephen Bainbridge, “In Re McDonald's Corp.. Stockholder Litig.: Caremark Is the Chicken Heart,” ProfessorBainbridge.com, January 25, 2023, https://www.professorbainbridge.com/professorbainbridgecom/2023/01/in-re-mcdonalds-corp-stockholder-litig-caremark-is-the-chicken-heart.html.

4. Smith, Jamie, Kellie Huennekens, and Steve Klemash. 2018. “A Fresh Look at Board Committees.” The Harvard Law School Forum on Corporate Governance. July 10, 2018. https://corpgov.law.harvard.edu/2018/07/10/a-fresh-look-at-board-committees/

5. Philip A Loomis, “Audit Committees - The American Experience,” Securities and Exchange Commission, November 3, 1978, https://www.sec.gov/news/speech/1978/110378loomis.pdf.

6. Ibid.

7. In re Caremark Int'l, 698 A.2d 959, 1996 Del. Ch. LEXIS 125 (Court of Chancery of Delaware, New Castle September 25, 1996, DATE DECIDED ). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:3RR5-FWC0-003C-K012-00000-00&context=1516831.

8. Ibid.

9. Skadden, Arps, Slate, Meagher Flom LLP. (February 20, 2020 Thursday). Directors' Fiduciary Duties: Back to Delaware Law Basics. Newstex Blogs JD Supra. https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=news&id=urn:contentItem:5Y84-GFY1-JCMN-Y2SB-00000-00&context=1516831.

10. David Katz, Sabastian Niles, and Theodore N. Mirvis, “Delaware Approves Permitting Exculpation of Officers from Personal Liability,” The Harvard Law School Forum on Corporate Governance, August 4, 2022, https://corpgov.law.harvard.edu/2022/08/04/delaware-approves-permitting-exculpation-of-officers-from-personal-liability/.

11. Skadden, Arps, Slate, Meagher Flom LLP. (February 20, 2020 Thursday). Directors' Fiduciary Duties: Back to Delaware Law Basics. Newstex Blogs JD Supra. https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=news&id=urn:contentItem:5Y84-GFY1-JCMN-Y2SB-00000-00&context=1516831.

12. Stephen Brainbridge, “After Boeing, Caremark Is No Longer ‘the Most Difficult Theory in Corporation Law upon Which a Plaintiff Might Hope to Win a Judgment,’” ProfessorBainbridge.com, September 8, 2021, https://www.professorbainbridge.com/professorbainbridgecom/2021/09/after-boeing-caremark-is-no-longer-the-most-difficult-theory-in-corporation-law-upon-which-a-plainti.html.

13. In re Caremark Int'l, 698 A.2d 959, 1996 Del. Ch. LEXIS 125 (Court of Chancery of Delaware, New Castle September 25, 1996, DATE DECIDED ). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:3RR5-FWC0-003C-K012-00000-00&context=1516831.

14. Morefield v. Bailey, 959 F. Supp. 2d 887, 2013 U.S. Dist. LEXIS 111362, 2013 WL 4010295 (United States District Court for the Eastern District of Virginia, Alexandria DivisionAugust 6, 2013, Filed). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:592S-84V1-F04F-F02G-00000-00&context=1516831.

15. Gagliardi v. Trifoods Int'l, 683 A.2d 1049, 1996 Del. Ch. LEXIS 87 (Court of Chancery of Delaware, New Castle July 19, 1996, Date Decided ). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:3RRT-8BX0-003C-K0VY-00000-00&context=1516831.

16. Guttman v. Jen-Hsun Huang, 823 A.2d 492, 2003 Del. Ch. LEXIS 48 (Court of Chancery of Delaware, New Castle May 5, 2003, Decided ). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:48NR-WTC0-0039-4509-00000-00&context=1516831.

17. Ibid.

18. Ibid.

19. In re Dow Chem. Co. Derivative Litig., 2010 Del. Ch. LEXIS 2, 2010 WL 66769 (Court of Chancery of Delaware, Sussex January 11, 2010, Decided). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:7XJ4-D6F0-YB0M-B00G-00000-00&context=1516831.

20. Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, 833 A.2d 961, 2003 Del. Ch. LEXIS 98 (Court of Chancery of Delaware, New Castle September 30, 2003, Decided ). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:49S7-R6B0-0039-4564-00000-00&context=1516831.

21. In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106, 2009 Del. Ch. LEXIS 25 (Court of Chancery of Delaware February 24, 2009, Decided). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:4VS4-XCK0-TXFP-22YW-00000-00&context=1516831.

22. Smith v. Kleynerman, 2016 WI App 57, 370 Wis. 2d 786, 882 N.W.2d 870, 2016 Wisc. App. LEXIS 367 (Court of Appeals of Wisconsin, District OneJune 16, 2016, Filed). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:5K1C-00H1-F04M-D06J-00000-00&context=1516831.

23. Nicholas Carlson, “Here's the Email Zuckerberg Sent to Cut His Cofounder out of Facebook,” Business Insider (Business Insider, May 15, 2012), https://www.businessinsider.com/exclusive-heres-the-email-zuckerberg-sent-to-cut-his-cofounder-out-of-facebook-2012-5.

24. AP Servs., LLP v Lobell, 2015 N.Y. Misc. LEXIS 2314, 2015 NY Slip Op 31115(U) (Supreme Court of New York, New York County June 19, 2015, Decided). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:5GCM-DFP1-F04J-8078-00000-00&context=1516831.

25. Kevin LaCroix, “Guest Post: Dell Agrees to $1 Billion Shareholder Suit Settlement,” The D&O Diary, December 1, 2022, https://www.dandodiary.com/2022/12/articles/securities-litigation/guest-post-dell-agrees-to-1-billion-shareholder-suit-settlement/.

26. In re Dell Techs. Inc. Class V Stockholders Litig., 2020 Del. Ch. LEXIS 211, 2020 WL 3096748 (Court of Chancery of Delaware June 11, 2020, Decided). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:603X-40N1-FCCX-62KD-00000-00&context=1516831.

27. Marchand v. Barnhill, 212 A.3d 805, 2019 Del. LEXIS 310, 2019 WL 2509617 (Supreme Court of Delaware June 20, 2019, Filed). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:5WC9-ST51-JFDC-X0M7-00000-00&context=1516831.

28. Ibid.

29. Ibid.

30. Ibid.

31. Ibid.

32. In re Clovis Oncology, Inc. Derivative Litig., 2019 Del. Ch. LEXIS 1293, 2019 WL 4850188 (Court of Chancery of Delaware October 1, 2019, Decided). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:5X5P-W9N1-JPP5-20XJ-00000-00&context=1516831.

33. Ibid.

34. Teamsters Local 443 Health Servs. & Ins. Plan v. Chou, 2020 Del. Ch. LEXIS 274 (Court of Chancery of Delaware August 24, 2020, Decided). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:60NN-BC21-FGJR-201J-00000-00&context=1516831.

35. Ibid.

36. Ibid.

37. In re Boeing Co. Derivative Litig., 2021 Del. Ch. LEXIS 197, 2021 WL 4059934 (Court of Chancery of Delaware September 7, 2021, Decided). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:63JK-44W1-F30T-B4DW-00000-00&context=1516831.

38. Andrew Tangel, “Boeing Shareholders Reach Settlement in 737 MAX Board Oversight Suit,” The Wall Street Journal (Dow Jones & Company, November 5, 2021), https://www.wsj.com/articles/boeing-shareholders-reach-settlement-in-737-max-board-oversight-suit-11636076012.

39. Ibid.

40. Ibid.

41. Ibid.

42. In re McDonald's Corp. Stockholder Derivative Litig., 2023 Del. Ch. LEXIS 23, 2023 WL 387292 (Court of Chancery of Delaware January 25, 2023, Decided). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:67D8-J5G1-FFMK-M0YG-00000-00&context=1516831.

43. Stephen Bainbridge, “In Re McDonald's Corp.. Stockholder Litig.: Caremark Is the Chicken Heart,” ProfessorBainbridge.com, January 25, 2023, https://www.professorbainbridge.com/professorbainbridgecom/2023/01/in-re-mcdonalds-corp-stockholder-litig-caremark-is-the-chicken-heart.html.

44. In re McDonald's Corp. S'holder Derivative Litig., 2023 Del. Ch. LEXIS 53, 2023 WL 2293575 (Court of Chancery of Delaware March 1, 2023, Decided). https://advance-lexis-com.ezp-prod1.hul.harvard.edu/api/document?collection=cases&id=urn:contentItem:67NR-HJ21-JNCK-22H6-00000-00&context=1516831.