In my non-FCPA life, I teach a variety of courses such as corporations and securities regulation.
Because of this, I continue to scratch my head as to the seeming inability of certain FCPA commentators to grasp certain basic aspects of the legal framework regarding corporate law and governance.
For instance, this recent post is titled “When Will Shareholders Force Boards to Do Compliance” and the commentator asserts: “[with] any of the companies which were embroiled in Foreign Corrupt Practices Act (FCPA) matters which recently settled, where was the Board when the company was busy paying out millions in bribes, in some cases literally across the globe?”
Did a few Foreign Corrupt Practices Act enforcement actions from 2016 involve a company paying “out millions in bribes in some cases literally across the globe” in the context of board participation and/or dereliction of duty?
However to suggest that all FCPA enforcement actions in 2016 involved such conduct or that all FCPA enforcement actions involve board dereliction of duty is just plain false.
As highlighted in this recent post titled titled”Taking Care of Caremark,” Delaware courts (the most prominent jurisdiction for corporate law and governance issues) have routinely recognized that a “director’s good faith exercise of oversight responsibility may not invariably prevent employees from violating criminal laws, or from causing the corporation to incur significant financial liability, or both.”
Rather, Delaware law instructs that “good faith in the context of oversight must be measured by the directors’ actions ‘to assure a reasonable information and reporting system exists’ and not by second-guessing after the occurrence of employee conduct that results in an unintended adverse outcome.'”
The latest Delaware decision to articulate this standard involved UPS and anyone suggesting board dereliction of duty just because a company resolves an FCPA enforcement action should read the decision and the remainder of this post provides a detailed summary the decision.
The decision began with a summary of the plaintiffs’ claims.
“Stockholders of United Parcel Service, Inc. (“UPS” or the “Company”) have brought this derivative action on behalf of the Company against members of its Board of Directors (the “Board”) alleging that they breached their fiduciary duty of loyalty by consciously failing to monitor and manage UPS’s compliance with state and federal laws governing the transportation and delivery of cigarettes.
Plaintiffs filed [their complaint] in which they set forth a single count—breach of fiduciary duty arising from a failure of oversight, well known in Delaware corporate law as a Caremark claim. They allege the directors either failed to implement a reporting and monitoring system with respect to the shipment of illegal cigarettes or, having implemented a system, they ignored red flags that UPS had abandoned its compliance with that system. The failure of oversight is all the more troubling, according to Plaintiffs, because it occurred in the wake of a prior government investigation of UPS’s illegal cigarette shipments that was resolved in 2005 by way of an Assurance of Discontinuance Agreement (“AOD”) in which UPS committed to comply with applicable laws and to establish effective monitoring systems going forward.”
However, the judge stated:
“I conclude that Plaintiffs have failed to plead facts from which it may reasonably be inferred that the Defendants consciously failed to oversee UPS’s compliance with its obligations to engage in proper shipping methods or its compliance with the AOD in a manner that would constitute bad faith.”
Under the heading Legal Analysis, the decision states:
“Caremark claims inevitably arise in the midst of or directly following “corporate trauma” of some sort or another. In this derivative action, Plaintiffs seek to hold the Director Defendants personally liable to UPS for breaching their fiduciary duties in bad faith in a manner that caused the corporate trauma. After carefully reviewing the Complaint, however, I am satisfied that Plaintiffs have “conflate[d] concededly bad outcomes from the point of view of the Company with bad faith on the part of the Board.”
After discussing various procedural aspects of derivative actions including an analysis of demand futility, the decision next contains an extensive discussion of the Caremark Liability Standard.
“In Caremark, Chancellor Allen reviewed the state of director oversight law and described the circumstances under which stockholders could hold directors personally liable for harm caused to the corporation under the theory that the directors “violated a duty to be active monitors of corporate performance.” Chancellor Allen first observed in Caremark, and has been oft-repeated by this court, proving liability for a failure to monitor corporate affairs is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” A decade later, our Supreme Court embraced the Caremark standard and clarified that in order to impose personal liability on directors for a failure of oversight there must be evidence that “the directors knew that they were not discharging their fiduciary obligations.” At the pleadings stage, a plaintiff must allege particularized facts that satisfy one of the necessary conditions for director oversight liability articulated in Caremark: either that (1) “the directors utterly failed to implement any reporting or information system or controls”; or (2) “having implemented such a system or controls, [the directors] consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.”
This liability standard “draws heavily upon the concept of director failure to act in good faith.” As our Supreme Court explained in Disney, the “intentional dereliction of duty” or “conscious disregard for one’s responsibilities,” which “is more culpable than simple inattention or failure to be informed of all facts material to the decision,” reflects that directors have acted in bad faith and cannot, by default, avail themselves of defenses grounded in a presumption of good faith. In order to plead a claim under Caremark, therefore, a plaintiff must plead facts that allow a reasonable inference that the directors acted with scienter which, in turn, “requires [not only] proof that a director acted inconsistently with his fiduciary duties,” but also “most importantly, that the director knew he was so acting.”
Our law recognizes that alleging directors failed to act in good faith is significantly different from alleging that corporate wrongdoing has occurred. This distinction takes into account that “directors’ good faith exercise of oversight responsibility may not invariably prevent employees from violating criminal laws, or from causing the corporation to incur significant financial liability, or both.” Accordingly, “Delaware courts routinely reject the conclusory allegation that because illegal behavior occurred, internal controls must have been deficient, and the board must have known so.” Rather, a plaintiff must plead with particularity “a sufficient connection between the corporate trauma and the board.”One way to plead the requisite connection is to plead particularized facts which, if proven, would establish the first Caremark prong for imposing oversight liability—that the directors “utterly failed to implement any reporting or information system or controls.” A second, alternative, way “[t]o establish such a connection [is to] plead that the board knew of evidence of corporate misconduct—the proverbial ‘red flag’—yet acted in bad faith by consciously disregarding its duty to address that misconduct.” Plaintiffs have attempted to plead both theories.”
Under the heading, “No Well-Pled Derivative Claim That the Board Utterly Failed to Implement Any Reporting or Information Systems or Controls,” the decision states:
“Plaintiffs’ argument that they have pled particularized facts that the Director Defendants utterly failed to adopt any reporting and compliance systems is perplexing. The Complaint and the documents it incorporates by reference acknowledge that UPS implemented the corporate governance changes required by the AOD. Plaintiffs admitted as much more than once. The Complaint also acknowledges that UPS has a Legal Department, an Internal Audit, Compliance & Ethics Department and an Audit Committee of the Board. And, according to the Complaint, “[t]he [Director Defendants] . . . were provided updates about legal compliance through reports from the UPS Legal Department.” The Audit Committee’s Charter, also referenced in the Complaint, establishes that the Audit Committee’s general responsibility for oversight includes oversight of “the Company’s compliance with legal and regulatory requirements. . . .” Thus, the Complaint itself reveals that the Plaintiffs have not plead particularized facts that the Board “utterly” failed to adopt or implement any reporting and compliance systems.
Notwithstanding the allegations in their Complaint acknowledging the existence of reporting and compliance systems at UPS, Plaintiffs advance two arguments as to why the Complaint still adequately pleads factual bases upon which the Board faces a substantial likelihood of liability under the first prong of Caremark. First, they argue that documents produced in response to their Section 220 demand reveal an absence of any Board minutes or other Board materials relating to the monitoring of compliance with the AOD from January 1, 2010 to February 12, 2014. They contend this informational void supports a reasonable inference that the Director Defendants “did absolutely nothing to oversee UPS’s compliance with the [AOD] or cigarette laws in any way.” According to Plaintiffs, this period of “deafening silence” at the Board level is a “clear indication of the Board’s conscious disregard of its duties and utter lack of oversight over its known duties under the [AOD].” Second, Plaintiffs contend that, regardless of the oversight mechanisms in place, the Director Defendants were “merely going through the motions” in monitoring UPS’s compliance obligations. In this regard, they note that “recent rulings make clear that merely going through the motions . . . is not sufficient oversight to satisfy a director’s fiduciary duty of loyalty with regard to overseeing that the Company is adhering to its fundamental obligation to obey positive law.” Neither argument is convincing.
Plaintiffs’ positions rely upon the assumption that this board of directors of a large public company owed the Company and its stockholders a duty to take active steps affirmatively to “monitor the monitors” even after implementing a well-constituted monitoring and reporting system. In this regard, Plaintiffs point to paragraph 53 of the AOD which they claim created a Board level obligation to ensure compliance with the AOD beyond ensuring that the Company implemented compliance systems. Even in the absence of the AOD, the UPS Board owed a fiduciary duty to stockholders not to cause UPS to violate positive law and not to sit on its hands as it watched others within the Company do so. The Director Defendants’ duty to oversee compliance with these laws, therefore, was not created or somehow heightened by the existence of the AOD. It derives, instead, from the fiduciary duty of loyalty and the obligation to discharge that duty in good faith in the best interests of the corporation they serve. The Board cannot be held liable for breaching this duty, under the first prong of Caremark, unless it can be proven that its members “utterly failed to implement any reporting or information systems or controls.” This is so even if the reporting systems they implemented and relied upon, without reason to suspect they were not working, did not ultimately detect corporate wrongdoing or bring it to their attention. “[G]ood faith, not a good result, is what is required of the board.” Indeed, “the one thing that is emphatically not a Caremark claim is the bald allegation that directors bear liability where a concededly well-constituted oversight mechanism, having received no specific indications of misconduct, failed to discover fraud.”
To repeat, the Plaintiffs’ own allegations acknowledge the creation and implementation of a system of internal controls following UPS’s acceptance of the AOD. The system functioned well, at least for a time, after the AOD was finalized and the Complaint makes no particularized allegation that the system was intentionally disabled or diminished within UPS. That the Plaintiffs did not turn up any Board documents specifically referencing continued compliance with the AOD during a specific time period is not sufficient to allege that the system was not in place or that the Board was simply going through the motions when overseeing compliance. At best, the Complaint might support an inference that employees charged with the responsibility to implement UPS’s oversight systems failed to report issues to the Board. This is not enough to sustain a Caremark claim.
Plaintiffs have not pled particularized factual allegations to support a reasonable inference that the Director Defendants face a substantial likelihood of liability based on an utter failure to implement any reporting or information system or controls. Therefore, demand on the Board cannot be excused as futile on that basis.”
Under the heading “No Well-Pled Derivative Claim That the Board Consciously Disregarded Red Flags,” the decision states:
“To establish demand futility under Caremark’s second prong, the Complaint must “plead [particularized facts] that the board knew of evidence of corporate misconduct—the proverbial ‘red flag’—yet acted in bad faith by consciously disregarding its duty to address that misconduct.” In this context, bad faith means “the directors were conscious of the fact that they were not doing their jobs, and that they ignored red flags indicating misconduct in defiance of their duties.” Plaintiffs raise four red flags they allege were waved before the Director Defendants and consciously ignored: (1) the AOD itself, (2) the November 2010 Brothers Report to the Audit Committee, (3) the September 16, 2011 internal memo, and (4) the 2014 Audit Committee Presentations. I address these purported red flags ad seriatim in chronological order.
Plaintiffs’ first proffered red flag is nothing more than another attempt to argue that the AOD placed on the Board an additional affirmative duty above and beyond what is required by Caremark. According to Plaintiffs, “common sense dictates that legal requirements that the Company failed to adhere to in the past are a red flag for knowledge that there may be continued reluctance to comply in the future.” Typically, however, the red flag analogy depicts events or reports that serve as warning signs to the Board of corporate wrongdoing after a system of reporting and compliance is in place. These red flags put the board on notice that the system is not working properly. If the members of the board become aware of the red flags and do nothing in response, and thereby consciously disregard their fiduciary duties, then they each individually are subject to liability for a failure of oversight. In Plaintiffs’ view, however, the occurrence of the AOD in 2005 somehow emerged as a red flag for the Board in 2010 and then continued to wave unattended through 2011. I cannot share that view.
There might well be a reasonably conceivable scenario where the AOD itself could have taken the form of a red flag. For instance, if UPS had entered the AOD in 2005 and then continued a pattern of non-compliant shipments immediately thereafter and through 2014, one might reasonably infer that the Board had consciously disregarded UPS’s commitments under the AOD and its own oversight responsibilities. But that is not what Plaintiffs have alleged. Instead, the Complaint acknowledges that UPS complied with AOD in 2005, 2006, 2007, 2008, 2009 and at least part of 2010. No red flags waved on any UPS mast during these more than five years; from the Board’s perspective, the compliance systems were working as intended. Even so, Plaintiffs would have the Court conclude they have adequately pled that the Board acted in bad faith from 2010 through 2014 because it did not presume that UPS was engaging in ongoing non-compliant behavior after the AOD and did not take steps to address the non-compliance. Yet the only particularized fact they have alleged in support of this claim is that UPS resolved disputed allegations of non-compliant behavior more than five years prior. Plaintiffs have failed to point to any Delaware law that would support the conclusion they have asked me to draw and I am aware of none. I decline to set that precedent here.
The first of the post-AOD red flags identified by Plaintiffs is the November 2010 Brothers Report to the Audit Committee. Plaintiffs allege that Norman Brothers made a presentation to the Audit Committee on November 3, 2010, and that six of the Director Defendants were present at the meeting. They also allege that the presentation made by Brothers reviewed “significant matters and trends.” Based on these allegations, Plaintiffs argue that it is reasonable to infer that Brothers, “given his authority and knowledge under the [AOD], his direct reporting relationship with the Audit Committee, and his status of Vice Secretary of the Audit Committee . . . , knew of UPS’s abandonment of its obligations under the [AOD] and reported the same to the Audit Committee in November 2010. . . .” Plaintiffs would have the Court make two inferential leaps here: (1) Brothers knew of compliance issues related to the AOD; and (2) he reported those issues to the Audit Committee.
Plaintiffs’ invitation to play inferential hopscotch does not comport with Rule 23.1’s “stringent requirements of factual particularity.” While the Court must “draw all reasonable inferences in the plaintiff’s favor,” our Supreme Court has made clear that “conclusory allegations are not considered as expressly pleaded facts or factual inferences.” Even reasonable inferences “must logically flow from particularized facts alleged by the plaintiff.” Plaintiffs’ allegations that Brothers had knowledge of the AOD because he was charged with the ultimate responsibility to implement it, and that he must have advised the Audit Committee that UPS had abandoned its obligations when he reported on “significant matters and trends,” are both wholly conclusory. Plaintiffs have not tied these allegations to any particularized facts about what Brothers knew, when he knew it or what he actually told the Audit Committee. Such inferential layering, all the more glaring in that it follows Plaintiffs’ receipt of Section 220 documents, does not satisfy the factual particularity required of Plaintiffs seeking demand excusal.
Plaintiffs’ next proffer as a post-AOD red flag the September 16, 2011, memorandum from “BD Memo” which shows that at least one UPS business department was aware of violations of the AOD. This internal company memo reported that the ATF and NYTF were investigating UPS and had determined that UPS customers had illegally shipped cigarettes within New York in violation of the AOD. Plaintiffs maintain that “[i]t is reasonable to infer that, as the contact person for the NYAG, Brothers would have been informed by the NYAG of the [AOD] violations.” Going one step further, as Plaintiffs must in order to show that the information reached the Director Defendants, Plaintiffs say that “[g]iven that the Board was bound by the [AOD], and given the Company’s wholesale disregard for the [AOD] and cigarette laws and regulations, it is more than reasonable to infer that Brothers informed the Audit Committee at this time of the wrongdoing, given Brothers’ knowledge and his duty to report to the Audit Committee.”
Plaintiffs’ arguments on this supposed red flag can fare no better than their arguments related to the 2010 Audit Committee presentation because both rest on unsupported and therefore unreasonable inferences. Plaintiffs ask the Court to infer that Norman Brothers received the information contained in the 2011 BD Memo based solely on his position at UPS without tying their allegation to any particularized facts. Once again, the best Plaintiffs can do to prop up the inference they ask the Court to draw is point to the absence of Section 220 documents on the topic of the AOD or illegal cigarette shipments and then argue, given the current federal enforcement action, that Brothers and the Board must have known of ongoing violations. As before, this falls well short of the particularized factual pleading mark set by Rule 23.1.
Moreover, even if the Complaint did plead particularized facts that Norman Brothers knew of the information contained in the BD Memo, Plaintiffs’ red flag argument would fail for the independent reason that they have not pled that Brothers actually reported to the Director Defendants after the date of the memo. Brothers 2010 report to the Audit Committee pre-dates the 2011 BD Memo. Therefore, Plaintiffs were required to allege that at some time after the date of the BD Memo Brothers reported information contained in the memo to the Director Defendants. The Complaint says nothing of the sort.
The Eighth Circuit’s analysis in Cottrell on behalf of Wal-Mart Stores, Inc. v. Duke is instructive with respect to the appropriate treatment of strained inferences. In Duke, the plaintiffs adequately alleged that the chair of the Walmart audit committee had received a report of serious criminal wrongdoing and that he was a direct report to the Walmart board of directors. Nevertheless, applying Delaware law, the court concluded that “Delaware courts have consistently rejected . . . the inference that directors must have known about a problem because someone was supposed to tell them about it.” In this regard, the court observed that “[o]ther than [pleading facts regarding the officers’] reporting obligations, the shareholders did not plead any facts supporting the inference that the officers actually shared their knowledge.” The court noted that “[t]here are no specific allegations showing any of the identified officers met with the board, talked to board members, or otherwise made reports . . .” In the absence of such allegations, the court held that Plaintiffs had not adequately pled demand futility and affirmed the trial court’s dismissal of the complaint under Rule 23.1.
Plaintiffs would have the court draw the same unsupportable inferences that were squarely rejected in Duke—that Brothers must have informed the Audit Committee of alleged violations of the AOD—without pleading any particularized facts that he actually met with or reported to the Director Defendants after he allegedly obtained this information. This yawning gap between the pled facts and the requirement to plead bad faith cannot be bridged under Delaware law, even at this early stage of the litigation.
The third proffered post-AOD red flag is a series of three Audit Committee Presentations from Mohammad Azam, a member of the UPS Internal Audit, Compliance and Ethics department, which brought possible issues of noncompliance to the Director Defendants. The issue raised here is not whether these presentations served as red flags, but whether the Director Defendants reacted to them or consciously disregarded them by doing nothing.
Plaintiffs, of course, allege that the Board did nothing in response to the Azam presentations. The documents Plaintiffs incorporated by reference in the Complaint, however, tell a different story. For example, following the February 12, 2014 Audit Committee Meeting, when the Audit Committee was informed of an enforcement action against FedEx and that New York City had approached UPS with similar issues, the presentation reflects that UPS was going to “increase employee training frequency in the areas with the highest risk,” “improve reporting quality by establishing a Help Line for processing and documenting reports,” “add a Data Analytics program to identify prospective offenders” and “establish [a] process for investigation to ensure consistency.”
Similarly, at the May 7, 2014 Audit Committee Meeting, when the Audit Committee was informed of allegations from the City and State of New York that UPS was not in compliance with the AOD, the Audit Committee was told that UPS would be performing a “compliance audit of high risk areas in New York,” that its “Enhanced Tobacco Compliance Program Draft” had been reviewed by the State of New York, and that UPS had identified “data analytics application updates to improve compliance activity.” Lastly, at the August 6, 2014 Audit Committee Meeting, when there was follow-up on the allegations of non-compliance with the AOD, the presentation reflects that UPS had “identified high-risk New York accounts” and that there was “confirmation with all high risk accounts of their regulatory compliance.”
The relevant inquiries under the second prong of Caremark are whether the Board was made aware of red flags and then whether the Board responded to address them. The documents incorporated by reference into Plaintiffs’ Complaint demonstrate that when red flags were waved in front of the Audit Committee, the Board responded. Plaintiffs’ counsel admitted as much at oral argument. Plaintiffs have not pled particularized facts that would allow the Court reasonably to infer that the Director Defendants face a substantial likelihood of liability based on having ignored red flags in a manner that demonstrates a conscious failure to monitor or oversee corporate operations. Demand on the Board cannot be excused as futile on the basis that the Board consciously ignored red flags.”
Under the heading “The Complaint Fails to Plead Particularized Facts that Support a Reasonable Inference that the Director Defendants Acted in Bad Faith Based on the Magnitude and Duration of Wrongdoing,” the decision states:
“Plaintiffs’ final argument is that “[t]he magnitude and duration of UPS’s wrongdoing [support] a reasonable inference that the Board was aware of the Company’s policy to renege on its obligations under the [AOD].” According to Plaintiffs, their pleading of this dynamic amounts to an adequate pleading of scienter. I disagree.
Plaintiffs’ pleading burden is to allege particularized facts that create a reasonable inference that the Director Defendants were “conscious that they were not doing their jobs.” Accordingly, to show that the Director Defendants acted in bad faith on the theory Plaintiffs espouse, the pled facts must allow a reasonable inference that the corporate wrongdoing was of such a magnitude and duration that the Board must have known they were not doing their job to look after the corporation’s best interests. To be sure, Plaintiffs make numerous allegations concerning the number of deliveries of untaxed cigarettes made by UPS. What Plaintiffs have not alleged, however, are any particularized facts that would allow the Court to consider the magnitude of these deliveries in the context of UPS’s overall operations. In this contextual vacuum, the Court is asked to infer that the Director Defendants must have known they were failing in their oversight obligations based on the magnitude of AOD non-compliance. Saying something is “huge” doesn’t make it huge; and saying something is bad faith, without more, does not adequately plead bad faith.
UPS’s 2015 Form 10k … discloses that UPS makes more than 18.3 million package deliveries per day. The Complaint alleges that UPS made approximately 78,000 shipments of illegal cigarettes between 2010 and 2014.90 This is hardly a ratio that alone would support an inference of bad faith. This court’s analysis in Armstrong is instructive on this point:
The court accepts, in principle, that a director could be found liable for remaining ignorant of a large fraud occurring in plain sight, even if the director is able to show that the company had established a full set of supervisory controls. In this case, however, all the plaintiff has said is that the Enron and WorldCom relationships turned out to have material consequences. The complaint does not even allege that either of the challenged relationships formed an unusually large part of Citigroup’s business while the relationships were ongoing. The well-pleaded facts provide no basis to believe, therefore, that the directors ignored a mammoth fraud. Rather, the facts only show that, as in Caremark itself, the ‘liability that eventuated in this case was huge.’
While UPS’s ultimate liability may turn out to be significant, as Plaintiffs point to a figure of at least $180 million in fines and penalties to which UPS may be exposed, our law holds that “[a]bsent any facts to show that a board’s ignorance can only be explained by a breach of fiduciary duty, such as allegations as to the centrality of the fraudulent relationships to the corporation’s business, the size of any financial loss is not a sufficient basis on which to rest liability.” Plaintiffs have not, therefore, pled particularized facts from which it can reasonably be inferred that the Director Defendants acted in bad faith based solely upon the size or duration of the alleged wrongdoing.”
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