Delaware is America’s venue of choice for business incorporation. This popularity means most corporate directors are subject to the whims of Delaware’s powerful, but little known, non-jury trial court: The Court of Chancery. This is good for most directors. The Chancery is known for making quick work of frivolous suits; it normally insulates directors from liability by doing so. Given the court’s speed, most weak suits are also settled quickly (with little compensation for the plaintiffs).1 However, there has been one recent exception. Cases brought under the “Caremark Doctrine” are now regularly being sustained.2 This is unusual. Historically, Caremark was so rarely enforced that the decision was once considered essentially irrelevant. 3 Now, some directors have to become very familiar with this formerly obscure doctrine.
The original Caremark doctrine is simple and uncontroversial. It is an extension of the duty of care’s requirement that directors must oversee their companies. From there, the doctrine holds that directors must ensure that their companies are complying with applicable laws and regulations. The titular Caremark case, In re: Caremark, held that a Board must do so by insuring “that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with law and its business performance.”4 Surprisingly, this empowers boards. The power conferred comes from the fact that the design of these systems is considered a business judgment. The business judgment designation means that courts will defer to directorial decisions about the matter unless there is a conflict of interest, bad faith, or the formation of the system is done without due care.5 This is a very forgiving standard– so much so that a 2018 law review discussing Caremark called the decision “largely symbolic.”6
However, Caremark sprung back to life in 2019. For the first time, in more than twenty years, a derivative claim alleging a breach of Caremark duties by a board was sustained.7 This case, Marchand v. Barnhill, revived Caremark. This is not surprising: the facts of the case are uniquely repugnant and displayed a clear violation of Caremark duties. The company involved unintentionally produced bacteria-laden food despite warnings from the authorities that their production plants were unsanitary.8 Three consumers died as a result.9 Due to its failure to implement any kind of monitoring, the board had no way to know about the warnings the company’s managers received or learn about the safety of their plants at any point—despite the fact that the company did nothing aside from creating one kind of food product.10 This failure caused a deluge of liability and a liquidity crisis for the company, which in turn forced it to accept a dilutive investment on unfavorable terms.11
Marchand’s facts were so abhorrent that it was easy for the Delaware Supreme Court to sustain the claim. However, the Court did not stop there. The Court’s opinion also focused on the fact that the corporation in question was a ‘monoline’ company.12 From there, it reasoned that the directors had to be especially in tune to threats to the company’s sole product, as regulatory threats to it were “essential and mission critical.”13. Charging directors of companies with different fiduciary duties based on a business’s diversification is a new development.14
Whether or not Marchand creates heightened duties for some directors is a challenging question— and one that would be normally impossible to answer given the scarcity of successful Caremark claims. But Marchand marked the start of a trend. Within two years, the Delaware Courts sustained more post-Marchand cases that sounded in Caremark liability. The two most prominent of these cases involved oversight of the main primary product of alleged monoline companies. More curiously, one did not.
The case which did not involve a monoline company, Hughes v. Hu, is a useful analytical tool. In Hughes, a company suffered a series of failures related to their internal accounting and financial reporting procedures.15 These issues unfolded over seven years.16 The board knew about the problems; at times, they even publicly pledged to fix certain issues. They never did so.17 The board also never created a meaningful oversight apparatus to head off future problems.18 These failures lead to an inquiry into the company’s finances by the company’s exchange and PCAOB sanctions against the company’s accountants.19. Like Marchand, the case is a clear-cut example of a board ignoring Caremark duties. The court analyzed the allegations as such.20 The court’s use of Caremark as an analytical tool and standard in Hughes shows that Marchand is not a replacement for Caremark. The usage also shows that Marchand does not limit Caremark duties to monoline companies.
The repercussions of the two cases dealing with monoline companies are less straightforward. The first, Inter-Marketing Group USA v. Armstrong, deals with a company that controlled thousands of miles of oil pipelines.21 One of the company’s pipelines burst after years of corrosion.22 This caused an expensive cleanup, criminal consequences, a drop in share prices, and a sharp loss of revenue.23 At no time prior to the breach did the company have a mechanism to monitor pipeline integrity.24. The second, In re: Clovis Oncology Derivative Litigation, deals with a pre-revenue company that was developing several pharmaceutical products.25 One was particularly promising; it eventually became the company’s star (potential) product.26 However, the company did nothing to marshal the drug through the FDA approval process. Instead, the tests of the drug actively ran afoul of FDA regulations and clinical protocols.27 The board then falsified data about these issues and gave the data to regulators.28 This failure eventually caused the FDA to delay approval of the drug. When the truth about the drug’s low efficacy rate was revealed, the company’s share price plummeted 70%.29
Both cases survived the motions to dismiss. Their shared fate is baffling for two reasons.
First, Clovis Oncology was decided on Marchand grounds: the board was judged as directors of a monoline company dealing with mission critical compliance issues.30 However, the company wasn’t a truly monoline corporation— it was developing a variety of products.31 This stands in contrast to the company in Inter- Marketing, who only managed pipelines. The Clovis designation also makes little sense for other reasons. It can’t be argued that this pre-revenue company was a de-facto monoline company because it had, say, one drug which comprised most of its income. It had no income.32 The only reason to designate the company as monoline is that the company’s stock dropped 70% after the FDA’s actions.33 But even this isn’t conclusive. It’s possible that this decline in price was because the company also had a concurrent securities fraud issues (which later resulted in officers disgorging profits).34 Investors could also have been thrown by the board’s decision to produce false documents. It’s also possible this small-cap company was too minor to be traded in an efficient market— assuming one even accepts the validity of the Efficient Markets Hypothesis.35
Secondly, the courts provide no answer as to when something is “mission critical” or “essential.” While the courts explain why each of the companies in the above cases’ failures were uniquely catastrophic, they only do so in fact-specific terms. The Marchand court discusses how the failures triggered civil liability, a liquidity crisis, and a quasi-fire sale.36 The Clovis court discusses lost market capitalization and SEC violations.37 The Inter-Marketing court discusses lost revenue, shrinking market cap, and criminal charges.38 Each of these metrics is backwards looking. They are also nebulous. A director can’t look at something and clearly state the amount of market capitalization tied to it, or how much revenue would be lost if several things related to the thing went wrong, or if an issue with something would cause more than a certain amount of criminal or civil liability accrue (in most cases).
The totality of these two issues leads to a frustrating conclusion: directors can’t know when they’re at the helm of a monoline company. They also can’t know if they’re handling a truly mission-critical item. This begs the question: when do they have heightened duties? The inconsistency of Caremark cases post-Marchand makes this impossible to answer. Frustratingly, we know these questions matter. As Hughes shows, Caremark survives. But as Clovis shows, we know heightened Caremark duties exist for directors of monoline companies. When these enhanced duties kick into effect is a mystery.
See, e.g.,Gregory A. Markel et al., Over 50 M&A Deals Have Been Challenged This Year by a Single Group of Lawyers,Lexology(June 12, 2020), https://www.lexology.com/library/detail.aspx?g=f275b650-6822-4bc1-9e56-0314b51dd760. ↩
Kevin LaCroix, A “New Era” of Caremark Claims?, The D&O Diary (Jan. 20, 2021), https://www.dandodiary.com/2021/01/articles/director-and-officer-liability/a-new-era-of-caremark-claims/. ↩
See generally Paul E. McGreal, Caremark In The Arc Of Compliance History, 90 Temp. L. Rev. 647 (2018). ↩
In re Caremark Int’l, 698 A.2d 959, 970 (Del. Ch. 1996). ↩
Id. at 967-68. ↩
McGreal, supra note 3, at 648. ↩
Sarah T. Runnells Martin & Jacob J. Fedechko, Delaware Courts Examine Caremark After Marchand and Clovis, Skadden (Dec. 18, 2020), https://www.skadden.com/insights/publications/2020/12/insights-the-delaware-edition/delaware-courts-examine-caremark. ↩
Marchand v. Barnhill, 212 A.3d 805, 811 (Del. 2019). ↩
Id. at 807. ↩
Id. at 809. ↩
Id. at 807; Press Release, Dep’t of Justice, Blue Bell Creameries Ordered To Pay $17.25 Million In Criminal Penalties In Connection With 2015 Listeria Contamination (Sept. 17, 2020) (https://www.justice.gov/opa/pr/blue-bell-creameries-ordered-pay-1725-million-criminal-penalties-connection-2015-listeria). ↩
Marchand, 212 A.3d at 809. ↩
Id. at 824 ↩
Katherine L. Henderson et al., “Bad” v. “Bad-Faith” Oversight: Navigating the Risks of Potential Oversight Liability Following Marchand v. Barnhill, Wilson Sonsini 2 (Mar. 1, 2021), https://www.jdsupra.com/legalnews/bad-v-bad-faith-oversight-navigating-6908836/. ↩
Hughes v. Hu, No. 2019-0112-JTL, 2020 WL 1987029, at *1 (Del. Ch. Apr. 27, 2020). ↩
Id. at *15. ↩
Id. at *7, *14. ↩
Id. at *15. ↩
Inter-Mktg. Grp. USA, Inc. v. Armstrong, No. CV 2017-0030-TMR, 2020 WL 756965, at *1 (Del. Ch. Jan. 31, 2020). ↩
Id. at *3. ↩
Id. at *1. ↩
Id. at *13 ↩
In re Clovis Oncology, Inc. Derivative Litig., No. CV 2017-0222-JRS, 2019 WL 4850188 (Del. Ch. Oct. 1, 2019). ↩
Id.at *1. ↩
Id.at 8. ↩
Id.at *1, *15. ↩
Id. at *1. ↩
Id.at *4. ↩
Id.at *8. ↩
Id.at 9. ↩
See generally Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, 25 J. Fin. 383 (1970). ↩
Marchand, 212 A.3d at 807. ↩
In re Clovis, 2019 WL 4850188 at *8-9. ↩
Inter-Mktg., 2020 WL 756965 at *1. ↩