Horizon 2020
Trends in Delaware litigation
Managing the threat of stockholder action
Several decisions from the Delaware courts in 2019 are relevant to boards as we head into 2020. Chief among them are a number of Caremark-related rulings that highlight the importance of active, engaged board oversight of “mission critical” risk and compliance issues, and the continued use of (and litigation surrounding) Section 220 requests for books and records.
What Marchand and Clovis mean for boards
Delaware courts have long acknowledged that Caremark claims – which allege failure of board oversight – are among the “toughest” for plaintiffs to plead and prove. More than a decade ago, the Delaware Supreme Court held that to survive the pleading stage and ultimately succeed, stockholders must show that boards either 1. “utterly failed to implement any reporting information restrictions or controls”; or 2. having implemented them, “consciously failed to monitor or oversee their operations, thus disabling themselves from being informed of risks or problems requiring their attention.” Since then, virtually no cases alleging Caremark claims have survived the pleading stage.
However in 2019, in Marchand v. Barnhill, the Delaware Supreme Court ruled that claims under the first prong of Caremark against the directors of an ice cream manufacturer, Blue Bell Creameries, could go forward past the pleading stage, following a 2015 listeria outbreak in which three people died. The court ruled that the complaint had alleged facts from which it could be inferred that Blue Bell’s directors had failed to put in place a board-level oversight system for food safety – which was “mission critical” for the monoline company – and as a result had not received official notices of deficiencies for several years.
Among other things, the Supreme Court noted that the complaint alleged that there was no board committee that addressed food safety; no regular process or protocols that required management to keep the board apprised of food safety compliance practices, risks or reports; and no schedule for the board to consider on a regular basis any key food safety risks that existed. The Supreme Court explained that “… as with any other disinterested business judgment, directors have great discretion to design context and industry-specific approaches” to compliance oversight, but “Caremark does have a bottom-line requirement that is important: the board must make a good faith effort – i.e. try – to put in place a reasonable board-level system of monitoring and reporting.”
As explained in Marchand, to satisfy their duty of loyalty, directors must make a good faith effort to implement an oversight system and then monitor it. This is especially so when a monoline company operates in a highly regulated industry.
The Clovis case involved the second Caremark prong, and revolved around a monoline company’s flagship lung cancer drug, Rociletinib (“Roci”). The complaint alleged that Clovis’s management overstated Roci’s efficacy in clinical trials, using unconfirmed data on tumor shrinkage (a violation of both accepted trial protocols and Federal Drug Administration standards). Clovis eventually came clean, with the subsequent $1bn drop in its market value sparking a securities class action, an SEC complaint and the derivative claim. In the latter, the Delaware Court of Chancery denied a motion to dismiss, ruling that the complaint alleged facts from which it could be inferred that while the company had compliance systems in place, directors “ignored multiple warning signs” that management was inaccurately reporting Roci’s efficacy based on certain presentations that had been made to the board. As was the case in Marchand, it remains to be seen whether the allegations in both cases will be proven in later phases of the litigation.
So, what are the lessons from Marchand and Clovis? While neither signals any change in Delaware law, they are good reminders of the need for boards to implement and monitor a risk oversight system for material risks that a company faces. This is particularly true for boards of monoline companies, and boards of businesses in regulated sectors, who should pay close attention to any core risks and compliance requirements. In Clovis, the Court noted that where “externally imposed regulations govern a company’s ‘mission-critical’ operations, the board’s oversight function must be more rigorously exercised.” As always, boards should map these critical risks and ensure that they have the right monitoring and reporting structures, and board expertise, in place.
Practical guidance for boards
Directors should identify any key or material risks to their business, set up board-level compliance and monitoring systems (including appointing directors with the knowledge to understand technical issues), and make good faith efforts to ensure that these mechanisms are working as they should.
Boards should also review the efficacy of their compliance and monitoring on a regular basis, whether biannually or even quarterly.
It is important to pay close attention to the documentation of board oversight and monitoring. Have the reporting and monitoring mechanisms been appropriately documented? Have all reported issues been noted, as well as any actions taken by the board to address known risks and deficiencies? Does the documentation show what directors are doing to stress-test their compliance systems?
Section 220 litigation
Section 220 demands relate to stockholders’ statutory right to inspect certain corporate books and records for a “proper purpose”. They are a tool for plaintiffs to obtain discovery ahead of litigation against directors, and are also utilized by activist investors.
2019 saw a further rise in Section 220 demands, as well as a continued increase in related litigation. While limits have been set around their use in recent years, the cases outlined below show that the Chancery Court will enforce Section 220 demands where it believes investors have met the statutory requirements.
- Inter-Local Pension Fund GCC/IBT v. Calgon Carbon Corp. was filed after Calgon’s board refused to produce information in connection with the company’s sale to Kuraray. The Section 220 demand related to the board’s process and knowledge before the deal was signed, and allegations of wrongdoing in connection with compensation and benefits paid to Calgon’s senior officers. The Court held that the plaintiff’s purported purposes to inspect were genuine and that they had established a credible basis to suspect mismanagement. Despite this, the Court ruled that the plaintiff was only entitled to limited production – and did not have the right to see emails between Calgon’s management and Kuraray.
- In Kozinski v GGP Inc. – which related to the merger between GGP and Brookfield – the defendant argued that the Section 220 demand and subsequent litigation were lawyer-driven, and that there was no credible basis to infer misconduct. Again, the Court permitted inspection, although this time the scope was left to be negotiated in the first instance between the parties.
- Similarly, in Donnelly v. Keryx Biopharmaceuticals Inc., the stockholder sought books and records regarding suspected breaches of loyalty and improper disclosure by the board following Keryx’s 2018 merger with Akebia. Once more the Court found a proper purpose for inspection and credible basis to suspect mismanagement or wrongdoing, rejecting the assertion that the demand was counsel-driven and pretextual. However, the Court declined to shift attorneys’ fees, finding that the company had raised a good-faith dispute over the purpose and scope of the demand. The Court again left it to the parties to negotiate the proper scope of documents to be produced.
- Finally, Bucks County Employees Retirement Fund v. CBS Corp. was filed after CBS’s board refused to produce certain documents requested in connection with allegations surrounding the company’s merger with Viacom. As with Calgon, the Court held that a proper purpose for inspection had been stated, but also ruled that a “narrow” set of certain emails linked to a specific meeting did have to be produced. The Court emphasized that it “[did] not mean to endorse the plaintiff’s approach here as a ‘playbook’ that should be followed by other stockholders who may seek to challenge transactions preclosing.”
Practical guidance for boards
The Delaware courts continue to enforce the use of Section 220 demands where the statutory requirements are met.
They have allowed shareholders access to board documents, and in limited circumstances to certain emails, including where there are gaps in official board documentation.
Directors should ensure that their minutes and corporate records are sufficiently detailed and complete to mitigate demands for email communications.
