- FCPA Professor - http://fcpaprofessor.com -

Delaware Supreme Court Allows Caremark Claim To Proceed

Prior posts here [1], here [2] and here [3] concerned so-called “Caremark Claims.”

In short, a corporate director’s duty of good faith has evolved over time to include an obligation to attempt in good faith to assure that an adequate corporate information and reporting system exists. In Caremark (a 1996 decision by the Delaware Court of Chancery – a trial court), the court held that a director’s failure to do so, in certain circumstances, may give rise to individual director liability for breach of fiduciary duty. In 2006, in Stone v. Ritter, the Delaware Supreme Court provided the following necessary conditions for director oversight liability under the so-called Caremark standard: (i) a director utterly failed to implement any reporting or information system or controls; or (ii) having implemented such systems or controls, a director failed to monitor or oversee the corporation’s operations.

Caremark claims are often filed against officers and directors in the aftermath of DOJ/SEC corporate enforcement actions (in various areas not just in connection with FCPA enforcement actions). However, such claims rarely get past the motion to dismiss stage. Thus, this recent Delaware Supreme Court decision [4] in the aftermath of the listeria outbreak at Blue Bell Creameries is interesting in that the Delaware Supreme Court reversed a trial court’s dismissal of a Caremark claim and allowed the claim to proceed.

Although the case concerned some unique facts (a company producing a single product subject to various federal and state regulations), the decision will be of interest to anyone who follows corporate director fiduciary duties whether in the FCPA context or otherwise.

The decision by Chief Justice Leo Strine begins:

“Blue Bell Creameries USA, Inc., one of the country’s largest ice cream manufacturers, suffered a listeria outbreak in early 2015, causing the company to recall all of its products, shut down production at all of its plants, and lay off over a third of its workforce. Blue Bell’s failure to contain listeria’s spread in its manufacturing plants caused listeria to be present in its products and had sad consequences. Three people died as a result of the listeria outbreak. Less consequentially, but nonetheless important for this litigation, stockholders also suffered losses because, after the operational shutdown, Blue Bell suffered a liquidity crisis that forced it to accept a dilutive private equity investment.

Based on these unfortunate events, a stockholder brought a derivative suit against two key executives and against Blue Bell’s directors claiming breaches of the defendants’ fiduciary duties. The complaint alleges that the executives—Paul Kruse, the President and CEO, and Greg Bridges, the Vice President of Operations— breached their duties of care and loyalty by knowingly disregarding contamination risks and failing to oversee the safety of Blue Bell’s food-making operations, and that the directors breached their duty of loyalty under Caremark.

[…]

As to the Caremark claim, the Court of Chancery held that the plaintiff did not plead any facts to support “his contention that the [Blue Bell] Board ‘utterly’ failed to adopt or implement any reporting and compliance systems.” Although the plaintiff argued that Blue Bell’s board had no supervisory structure in place to oversee “health, safety and sanitation controls and compliance,” the Court of Chancery reasoned that “[w]hat Plaintiff really attempts to challenge is not the existence of monitoring and reporting controls, but the effectiveness of monitoring and reporting controls in particular instances,” and “[t]his is not a valid theory under . . . Caremark.”

[…]

As to the Caremark claim, we hold that the complaint alleges particularized facts that support a reasonable inference that the Blue Bell board failed to implement any system to monitor Blue Bell’s food safety performance or compliance. Under Caremark and this Court’s opinion in Stone v. Ritter, directors have a duty “to exercise oversight” and to monitor the corporation’s operational viability, legal compliance, and financial performance. A board’s “utter failure to attempt to assure a reasonable information and reporting system exists” is an act of bad faith in breach of the duty of loyalty.

As a monoline company that makes a single product—ice cream—Blue Bell can only thrive if its consumers enjoyed its products and were confident that its products were safe to eat. That is, one of Blue Bell’s central compliance issues is food safety. Despite this fact, the complaint alleges that Blue Bell’s board had no committee overseeing food safety, no full board-level process to address food safety issues, and no protocol by which the board was expected to be advised of food safety reports and developments. Consistent with this dearth of any board-level effort at monitoring, the complaint pleads particular facts supporting an inference that during a crucial period when yellow and red flags about food safety were presented to management, there was no equivalent reporting to the board and the board was not presented with any material information about food safety. Thus, the complaint alleges specific facts that create a reasonable inference that the directors consciously failed “to attempt to assure a reasonable information and reporting system exist[ed].”

[5]

As to certain of the unique facts in the case, the opinion states:

“As a U.S. food manufacturer, Blue Bell operates in a heavily regulated industry. Under federal law, the Food and Drug Administration (“FDA”) may set food quality standards, require food manufacturing facilities to register with the FDA, prohibit regulated manufacturers from placing adulterated food into interstate commerce, and hold companies liable if they place any adulterated foods into interstate commerce in violation of FDA rules. Blue Bell is “required to comply with regulations and establish controls to monitor for, avoid and remediate contamination and conditions that expose the Company and its products to the risk of contamination.”

Specifically, FDA regulations require food manufacturers to conduct operations “with adequate sanitation principles” and, in line with that obligation, “must prepare . . . and implement a written food safety plan.” As part of a manufacturer’s food safety plan, the manufacturer must include processes for conducting a hazard analysis that identifies possible food safety hazards, identifies and implements preventative controls to limit potential food hazards, implements process controls, implements sanitation controls, and monitors these preventative controls. Appropriate corporate officials must monitor these preventative controls.

Not only is Blue Bell subject to federal regulations, but it must also adhere to various state regulations. At the time of the listeria outbreak, Blue Bell operated in three states, and each had issued rules and regulations regarding the proper handling and production of food to ensure food safety.”

Regarding the Caremark claim, the opinion concluded:

“The plaintiff also challenges the Court of Chancery’s dismissal of his Caremark claim. Although Caremark claims are difficult to plead and ultimately to prove out, we nonetheless disagree with the Court of Chancery’s decision to dismiss the plaintiff’s claim against the Blue Bell board.

Under Caremark and Stone v. Ritter, a director must make a good faith effort to oversee the company’s operations. Failing to make that good faith effort breaches the duty of loyalty and can expose a director to liability. In other words, for a plaintiff to prevail on a Caremark claim, the plaintiff must show that a fiduciary acted in bad faith—“the state of mind traditionally used to define the mindset of a disloyal director.”

Bad faith is established, under Caremark, when “the directors [completely] fail[] to implement any reporting or information system or controls[,] or . . . having implemented such a system or controls, consciously fail[] to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.” In short, to satisfy their duty of loyalty, directors must make a good faith effort to implement an oversight system and then monitor it.

As with any other disinterested business judgment, directors have great discretion to design context- and industry-specific approaches tailored to their companies’ businesses and resources. 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. Thus, our case law gives deference to boards and has dismissed Caremark cases even when illegal or harmful company activities escaped detection, when the plaintiffs have been unable to plead that the board failed to make the required good faith effort to put a reasonable compliance and reporting system in place.

For that reason, our focus here is on the key issue of whether the plaintiff has pled facts from which we can infer that Blue Bell’s board made no effort to put in place a board-level compliance system. That is, we are not examining the effectiveness of a board-level compliance and reporting system after the fact. Rather, we are focusing on whether the complaint pleads facts supporting a reasonable inference that the board did not undertake good faith efforts to put a board-level system of monitoring and reporting in place.

Under Caremark, a director may be held liable if she acts in bad faith in the sense that she made no good faith effort to ensure that the company had in place any “system of controls.” Here, the plaintiff did as our law encourages and sought out books and records about the extent of board-level compliance efforts at Blue Bell regarding what has to be one of the most central issues at the company: whether it is ensuring that the only product it makes—ice cream—is safe to eat.

Using these books and records, the complaint fairly alleges that before the listeria outbreak engulfed the company:

no board committee that addressed food safety existed;

no regular process or protocols that required management to keep the board apprised of food safety compliance practices, risks, or reports existed;

no schedule for the board to consider on a regular basis, such as quarterly or biannually, any key food safety risks existed;

during a key period leading up to the deaths of three customers, management received reports that contained what could be considered red, or at least yellow, flags, and the board minutes of the relevant period revealed no evidence that these were disclosed to the board;

the board was given certain favorable information about food safety by management, but was not given important reports that presented a much different picture; and

the board meetings are devoid of any suggestion that there was any regular discussion of food safety issues.

And the complaint goes on to allege that after the listeria outbreak, the FDA discovered a number of systematic deficiencies in all of Blue Bell’s plants—such as plants being constructed “in such a manner as to [not] prevent drip and condensate from contaminating food, food-contact surfaces, and food-packing material”—that might have been rectified had any reasonable reporting system that required management to relay food safety information to the board on an ongoing basis been in place.

In sum, the complaint supports an inference that no system of board-level compliance monitoring and reporting existed at Blue Bell. Although Caremark is a tough standard for plaintiffs to meet, the plaintiff has met it here. When a plaintiff can plead an inference that a board has undertaken no efforts to make sure it is informed of a compliance issue intrinsically critical to the company’s business operation, then that supports an inference that the board has not made the good faith effort that Caremark requires.

In defending this case, the directors largely point out that by law Blue Bell had to meet FDA and state regulatory requirements for food safety, and that the company had in place certain manuals for employees regarding safety practices and commissioned audits from time to time. In the same vein, the directors emphasize that the government regularly inspected Blue Bell’s facilities, and Blue Bell management got the results.

But the fact that Blue Bell nominally complied with FDA regulations does not imply that the board implemented a system to monitor food safety at the board level. Indeed, these types of routine regulatory requirements, although important, are not typically directed at the board. At best, Blue Bell’s compliance with these requirements shows only that management was following, in a nominal way, certain standard requirements of state and federal law. It does not rationally suggest that the board implemented a reporting system to monitor food safety or Blue Bell’s operational performance. The mundane reality that Blue Bell is in a highly regulated industry and complied with some of the applicable regulations does not foreclose any pleading-stage inference that the directors’ lack of attentiveness rose to the level of bad faith indifference required to state a Caremark claim.

In answering the plaintiff’s argument, the Blue Bell directors also stress that management regularly reported to them on “operational issues.” This response is telling. In decisions dismissing Caremark claims, the plaintiffs usually lose because they must concede the existence of board-level systems of monitoring and oversight such as a relevant committee, a regular protocol requiring board-level reports about the relevant risks, or the board’s use of third-party monitors, auditors, or consultants. For example, in Stone v. Ritter, although the company paid $50 million in fines related “to the failure by bank employees” to comply with “the federal Bank Secrecy Act,” the“[b]oard dedicated considerable resources to the [Bank Secrecy Act] compliance program and put into place numerous procedures and systems to attempt to ensure compliance.” Accordingly, this Court affirmed the Court of Chancery’s dismissal of a Caremark claim. 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. At every board meeting of any company, it is likely that management will touch on some operational issue. Although Caremark may not require as much as some commentators wish, it does require that a board make a good faith effort to put in place a reasonable system of monitoring and reporting about the corporation’s central compliance risks. In Blue Bell’s case, food safety was essential and mission critical. The complaint pled facts supporting a fair inference that no board-level system of monitoring or reporting on food safety existed.

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. Where, as here, a plaintiff has followed our admonishment to seek out relevant books and records and then uses those books and records to plead facts supporting a fair inference that no reasonable compliance system and protocols were established as to the obviously most central consumer safety and legal compliance issue facing the company, that the board’s lack of efforts resulted in it not receiving official notices of food safety deficiencies for several years, and that, as a failure to take remedial action, the company exposed consumers to listeria-infected ice cream, resulting in the death and injury of company customers, the plaintiff has met his onerous pleading burden and is entitled to discovery to prove out his claim.”

FCPA Institute - Boston (Oct. 3-4)

A unique two-day learning experience ideal for a diverse group of professionals seeking to elevate their FCPA knowledge and practical skills through active learning. Learn more, spend less. CLE credit is available.

Learn More & Register [6]