Caremark Claims on the Rise Fueled by Section 220 Demands
January 11, 2021
As the 25th anniversary of the seminal Delaware Court of Chancery decision In re Caremark Int’l Inc. Deriv. Litig. (Caremark) approaches, there has been a notable rise in the number of cases in which Delaware courts are allowing Caremark claims against company directors to survive motions to dismiss. Significant drivers of this trend appear to be plaintiffs’ increased use of books and records demands under Section 220 of the Delaware General Corporation Law and the expanding boundaries of stockholder inspection rights resulting from recent Delaware court decisions interpreting that statute. Often armed with considerable amounts of information gleaned from a corporation’s books and records with which to draft a complaint, and with the benefit of the inferences afforded to plaintiffs at the pleading stage, plaintiffs have, in some recent cases, been able to plead Caremark claims that have overcome the courts’ traditional reluctance to sustain such claims.
These decisions will likely encourage more stockholder plaintiffs in the coming year to demand books and records, particularly when some corporate “trauma” or bad publicity occurs, in an attempt to plead a Caremark claim against the board. Boards should prepare for such claims by ensuring they (i) are kept reasonably informed of all material risks facing the company and (ii) make informed decisions about how the corporation should navigate significant risks. Separately, but equally importantly, the board’s formal records – its minutes and centrally stored materials (e.g., board books) – should reflect (at a high level) all of the information the board receives and the decisions it makes so that the courts are not left to evaluate the board’s exercise of its oversight duties on an incomplete record.
The Blue Bell Case and Subsequent Caremark Decisions
In Caremark, the Court of Chancery explained that directors’ fiduciary duties require them to exercise reasonable oversight of the company’s affairs, but they may only be held liable for breach of that duty if they either (i) “completely failed to implement any reporting or information systems or controls” or (ii) “having implemented such a system or controls, consciously failed to monitor or oversee its operations.” Before the Delaware Supreme Court’s 2019 decision in Marchand v. Barnhill, Delaware courts routinely dismissed Caremark claims at the motion to dismiss stage, even in the face of substantial “corporate traumas,” underscoring Chancellor Allen’s oft-cited warning in Caremark that duty-of-oversight claims are “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”
That is not to say that plaintiffs never succeeded on their Caremark claims, but complaints were often dismissed on the grounds that, while the corporation may have engaged in wrongdoing, there were no factually specific allegations that the board was aware of such wrongdoing and consciously ignored it or had utterly failed to implement a reporting process to keep itself reasonably informed.
In its 2019 Marchand decision, the Delaware Supreme Court reversed a Court of Chancery decision and held that a Caremark claim could proceed against directors of one of the country’s largest ice cream manufacturers, following a deadly listeria outbreak caused by its products. The court found that plaintiffs had adequately alleged that the directors had failed to implement any food safety performance or compliance monitoring system. In particular, the court highlighted the centrality of food safety to Blue Bell’s success as a company with a single product (ice cream) subject to stringent regulations and faulted the board for having no system to monitor and report specifically on this mission-critical risk, even though the board received risk reports from management generally.
In the year and a half since Marchand, four Court of Chancery decisions have likewise allowed Caremark claims to proceed past the pleading stage. There are two noteworthy features of these decisions:
- As in Marchand, in all but one of these cases plaintiffs had conducted a pre-filing investigation by seeking books and records under Section 220, which the plaintiffs then used to craft a complaint with specific allegations concerning the board’s alleged failure to exercise its duty of oversight. In the only other case in this period, Inter-Marketing Group USA, Inc. v. Armstrong, the court specifically noted that the sufficiency of the plaintiff’s complaint did not suffer from its failure to seek books and records under Section 220 because the plaintiff had access to a fully developed criminal trial record involving the same underlying facts.
- In some instances, the courts relied on the absence of any board discussions about specific events in materials produced by the company in response to a Section 220 demand to infer that no such discussions took place. For example, one court stated that “if [a] [c]ompany failed to produce a document that it would reasonably be expected to possess if a particular event had occurred, the plaintiff is entitled to a reasonable inference that the event did not occur.” This is particularly noteworthy in the Caremark context, where plaintiffs may satisfy either prong of the Caremark test by showing an absence of board activity (either the absence of an appropriate monitoring system or the absence of any response to a red flag).
Despite the rise in the number of Caremark cases surviving a motion to dismiss, these decisions do not signal a marked expansion of Caremark liability so much as an increasingly effective use of Section 220 to plead detailed facts about board conduct. Four of the cases involved allegations of serious failures of board oversight of “mission critical” risks: food safety (Marchand), drug safety (In re Clovis Oncology, Inc. Deriv. Litig. and Teamsters Local 443 Health Services & Insurance Plan v. John G. Chou) and oil pipeline integrity (Inter-Marketing).
The sole exception – Hughes v. Hu – involved an extreme set of facts. In Hughes, the company, based in China, had publicly acknowledged material weaknesses in its financial reporting and oversight systems and had pledged to remediate those problems, but the directors nevertheless allegedly ignored red flags indicating that the company was failing to take the necessary remedial steps, resulting in three years of financial restatements.
Indeed, even in the past year, the Court of Chancery dismissed Caremark claims in which plaintiffs did not allege the requisite particularized facts to show that the directors’ failures implicated the bad faith or disloyalty necessary to sustain a Caremark claim, for example, because there were no specific allegations that the directors failed to implement a reasonable monitoring system or consciously ignored red flags.
The Growing Use and Expansion of Section 220
Concurrently with the recent uptick in Caremark claims – and significantly contributing to that uptick – stockholder demands for books and records have been on the rise in recent years. For years, Delaware courts exhorted stockholders to use the tools at hand – namely, Section 220 –before filing derivative lawsuits. Stockholders appear to be listening. Section 220 actions increased 13-fold from 1981–1993 to 2004–2018. In addition, in the past couple of years, Delaware courts have significantly expanded the boundaries of Section 220, both with respect to what purposes are considered proper for making a Section 220 demand and the scope of books and records review that courts will grant to plaintiffs, as detailed below. Although data is not yet available, anecdotal evidence suggests Section 220 demands have exploded in the past couple years from their already elevated levels.
- Purpose. Delaware courts have long held that investigating possible wrongdoing to gather facts before filing derivative litigation against a board of directors is a proper purpose for making a Section 220 demand so long as the stockholder can show a credible basis from which to infer the possibility of wrongdoing. In early 2020, the Court of Chancery issued a decision, which was subsequently affirmed by the Delaware Supreme Court in December 2020, that extended the circumstances in which investigating wrongdoing could be used by stockholders as the purpose for a Section 220 demand. In Lebanon Cnty. Emp. Ret. Fund v. AmerisourceBergen Corp., the court held that a stockholder (i) need not state what it plans to do with the fruits of its investigation and (ii) need not demonstrate a credible basis to suspect actionable wrongdoing on the part of the board. The court further held that, consequently, the existence of an exculpatory charter provision would not preclude the stockholder from obtaining books and records to investigate possible wrongdoing by the company even when the stockholder cannot show a credible basis to suspect bad faith or disloyal conduct by the board. In a subsequent decision, the Court of Chancery warned that if corporations continue to withhold books and records on these grounds – and refuse to produce any documents, even core board-level materials – they may be liable for the stockholder plaintiffs’ attorneys’ fees.
- Scope. In 2019, the Delaware Supreme Court held that electronic communications, including emails and text messages used for board-related communications, may be available as part of a books and records demand when formal board-level materials are not sufficient to satisfy the stockholder’s demand. Subsequent Court of Chancery decisions, including several in 2020, continue to delineate the circumstances in which stockholders are entitled to electronic communications. In sum, these decisions suggest that requests for electronic communications will only be granted when formal board materials are insufficient because, for example, there is evidence that the board conducts much of its business informally via electronic communications or there are “gaps” in the formal board materials that may be “filled” by electronic communications.
Key Takeaways for Boards in 2021
- In 2021, boards of Delaware companies should expect that any significant negative event affecting the company will be followed by demands for books and records by stockholder plaintiffs, potentially followed by Caremark claims alleging that the board failed to exercise adequate oversight. This trend will likely further accelerate in light of the increased focus on environmental, social and governance (ESG) issues and as a result of the anticipated uptick in enforcement activity expected under the Biden administration, which we discuss in Priorities, Trends and Developments in Enforcement and Compliance in this memo.
- Boards should prepare for such claims by ensuring they (i) are kept reasonably informed of all material risks facing the company and (ii) make informed decisions about how the corporation should navigate significant risks. This includes consideration of the mission-critical risks facing the company and ensuring that there are specific reporting systems in place that are designed to keep the board informed of those risks. While no reporting system is perfect, it is also critical that when an issue is brought to the board’s attention, the board promptly considers it and makes an informed business judgment as to how it should be handled.
- As important, the board’s formal records – including board minutes, board books and other centrally maintained files – should reflect, at a high level, all of the information the board receives and the decisions it makes so that courts are not left to evaluate the board’s exercise of its oversight duties on an incomplete record. The board’s minutes need not, and should not, be overly detailed, but they should reflect a summary of the information brought to the board’s attention, as well as summaries of any decisions the board makes. Boards should be aware that the absence of discussion about a particular topic and corresponding board action or recommendation in meeting minutes may create a pleading stage inference that the board never discussed that topic or took any action, potentially allowing a Caremark claim to proceed to discovery that might otherwise have been dismissed. Moreover, ensuring that formal board records are reasonably complete will mitigate the risk that a court will order the company to produce electronic communications in response to a Section 220 demand.