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.
As highlighted in this recent post, in June 2019 in Marchand v. Barnhill (a decision in the aftermath of the listeria outbreak at Blue Bell Creameries) the Delaware Supreme Court reversed a trial court’s dismissal of a Caremark claim and allowed the claim to proceed.
Recently in this decision (In re Clovis Oncology), the Delaware Chancery Court also allowed a Caremark claim to proceed.
However, before declaring the start of a new trend, it is important to recognize that, like the Blue Bell matter, Clovis involved some unique facts – specifically a company producing a single product subject to a specific regulatory scheme. Nevertheless, In re Clovis, like the prior Blue Bell decision, will be of interest to anyone who follows corporate director fiduciary duties whether in the FCPA context or otherwise.
The Clovis decision begins with the following factual context.
“Like many upstart biopharmaceutical companies, [Clovis] had one drug among its drugs under development, Rociletinib (or “Roci”), that was especially promising. Roci, a therapy for the treatment of lung cancer, performed well during the early stages of its clinical trial. But data from later stages of the trial revealed the drug likely would not be approved for market by the Food and Drug Administration (“FDA”). Plaintiffs, Clovis stockholders, allege members of the Clovis board of directors (the “Board”) breached their fiduciary duties by failing to oversee the Roci clinical trial and then allowing the Company to mislead the market regarding the drug’s efficacy. These breaches, it is alleged, caused Roci to sustain corporate trauma in the form of a sudden and significant depression in market capitalization.
Defendants have moved to dismiss each of Plaintiffs’ derivative claims under Court of Chancery Rules 23.1 and 12(b)(6) for failure to plead demand futility with particularity and failure to state viable claims. As explained below, Plaintiffs have well-pled that Defendants face a substantial likelihood of liability under Caremark and our Supreme Court’s recent explication of Caremark in Marchand v. Barnhill. Clovis conducted its clinical trial of Roci subject to strict protocols and associated FDA regulations. Yet, assuming the pled facts are true, the Board ignored red flags that Clovis was not adhering to the clinical trial protocols, thereby placing FDA approval of the drug in jeopardy. With the trial’s skewed results in hand, the Board then allowed the Company to deceive regulators and the market regarding the drug’s efficacy.
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. Here, Plaintiffs have well-pled Roci was “intrinsically critical to the [C]ompany’s business operation, yet the Board ignored multiple warning signs that management was inaccurately reporting Roci’s efficacy before seeking confirmatory scans to corroborate Roci’s cancer-fighting potency violating both internal clinical trial protocols and associated FDA regulations. In other words, Plaintiffs have well pled a Caremark claim.
At the beginning of the Relevant Period, Clovis had no products on the market and generated no sales revenue. Accordingly, Clovis “reli[ed] solely on investor capital for all  operations.” The Company’s prospects rested largely on one of its three developmental drugs, Roci, a cancer drug designed to treat a previously untreatable type of lung cancer. Because of the estimated $3 billion annual market for drugs of its type, Clovis expected Roci to generate large profits if Clovis could secure FDA approval for the drug and shepherd it to market.
As the Roci clinical trial began, the Board knew time was of the essence. AstraZeneca’s competing drug, Tagrisso, was also in the race for FDA approval. Appreciating Roci’s importance to Clovis’ success, the Board was hyper-focused on the drug’s development and clinical trial. Indeed, it is alleged the Board Defendants “spent hours at Board meetings discussing [Roci] and were “regularly apprised” of the drug’s progress.”
The court’s analysis began by articulating the standards of a Caremark claim.
“The parties agree that Count I implicates Caremark, Stone v. Ritter and their progeny. These cases require well-pled allegations of bad faith to survive dismissal i.e., allegations “the directors knew that they were not discharging their fiduciary obligations, a standard of wrongdoing “qualitatively different from, and more culpable than . . . gross negligence.” Given this high bar, it is now indubitably understood, and oft-repeated, that a Caremark claim is among the hardest to plead and prove. At the pleadings stage, this means Plaintiffs must allege particularized facts that either (i) “the directors completely fail[ed] to implement any reporting or information system or controls, or . . . [(ii)] having implemented such a system or controls, consciously fail[ed] to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. Implicit in these standards is the requirement that plaintiffs plead particular facts allowing a reasonable inference the directors acted with scienter, which “requires proof that a director acted inconsistent with his fiduciary duties and, most importantly, that the director knew he was so acting.”
Caremark rests on the presumption that corporate fiduciaries are afforded great discretion to design context- and industry-specific approaches tailored to their companies’ businesses and resources.” Indeed, “[b]usiness decision-makers must operate in the real world, with imperfect information, limited resources, and uncertain future. To impose liability on directors for making a ‘wrong’ business decision would cripple their ability to earn returns for investors by taking business risks.” But, as fiduciaries, corporate managers must be informed of, and oversee compliance with, the regulatory environments in which their businesses operate. In this regard, as relates to Caremark liability, it is appropriate to distinguish the board’s oversight of the company’s management of business risk that is inherent in its business plan from the board’s oversight of the company’s compliance with positive law including regulatory mandates. As this Court recently noted, “[t]he legal academy has observed that Delaware courts are more inclined to find Caremark oversight liability at the board level when the company operates in the midst of obligations imposed upon it by positive law yet fails to implement compliance systems, or fails to monitor existing compliance systems, such that a violation of law, and resulting liability, occurs.”
Our Supreme Court’srecent decision in Marchand v. Barnhill underscores the importance of the board’s oversight function when the company is operating in the midst of “mission critical” regulatory compliance risk. The regulatory compliance risk at issue in Marchand was food safety and the failure to manage it at the board level allegedly allowed Blue Bell Creameries to distribute mass quantities of ice cream tainted by listeria. The Court held that Blue Bell’s board had not made a “good faith effort to put in place a reasonable system of monitoring and reporting” when it left compliance with food safety mandates to management’s discretion rather than implementing and then overseeing a more structured compliance system.187
As Marchand makes clear, when a company operates in an environment where externally imposed regulations govern its “mission critical” operations, the board’s oversight function must be more rigorously exercised. Key to the Supreme Court’s analysis was the fact that food safety was the “most central safety and legal compliance issue facing the company.” To be sure, even in this context, Caremark does not demand omniscience. But it does demand a “good faith effort to implement an oversight system and then monitor it.” This entails a sensitivity to “compliance issue[s] intrinsically critical to the company.”
The so-called first prong of Caremark requires Plaintiffs to well-plead that the Board “completely fail[ed] to implement any reporting or information system or controls[.]” But Plaintiffs acknowledge the Board’s Nominating and Corporate Governance Committee was “specifically charged” with “provid[ing] general compliance oversight . . . with respect to . . . Federal health care program requirements and FDA requirements.” And they further acknowledge “[t]he Board . . . reviewed detailed information regarding [Roci’s] TIGER-X trial at each Board meeting.” Given these acknowledged facts, it is difficult to conceive how Plaintiffs would prove the Board had no “reporting or information system or controls[.]”
Caremark’s second prong is implicated when it is alleged the company implemented an oversight system but the board failed to “monitor it.” To state a claim under this prong, Plaintiffs must well-plead that a red flag” of noncompliance waived before the Board Defendants but they chose to ignore it.
In this regard, the court must remain mindful that “red flags are only useful when they are either waived in one’s face or displayed so that they are visible to the careful observer.” But, as Marchand makes clear, the careful observer is one whose gaze is fixed on the company’s mission critical regulatory issues. For Clovis, this was Roci’s TIGER-X trial and the clinical trial protocols and related FDA regulations governing that study.
Plaintiffs have alleged particularized facts supporting reasonable inferences that: (i) the Board knew the TIGER-X protocol incorporated RECIST; (ii) RECIST requires reporting only confirmed responses; (iii) industry practice and FDA guidance require that the study managers report only confirmed responses; (iv) management was publicly reporting unconfirmed responses to keep up with Tagrisso’s response rate; and (v) the Board knew management was incorrectly reporting responses but did nothing to address this fundamental departure from the RECIST protocol. When Clovis’ serial non-compliance with RECIST was finally revealed to the regulators, Roci was doomed. And when the drug’s failure was revealed to the market, Clovis’ stock price tumbled.
Roci was Clovis’ mission critical product. And the Board knew, upon completion of the TIGER-X trial, the FDA would consider only confirmed responses when determining whether to approve Roci’s NDA per the agency’s own regulations. As pled, these regulations, and the reporting requirements of the RECIST protocol, were not nuanced. The Board was comprised of experts and the RECIST criteria are well-known in the pharmaceutical industry. Moreover, given the degree to which Clovis relied upon ORR when raising capital, it is reasonable to infer the Board would have understood the concept and would have appreciated the distinction between confirmed and unconfirmed responses. The inference of Board knowledge is further enhanced by the fact the Board knew that even after FDA approval, physicians (i.e., future prescribers) would evaluate Roci based on its ORR.
Defendants argue the FDA blessed Clovis’ plan to report unconfirmed responses for “interim” results because Roci was on an accelerated approval track. Additionally, Defendants claim FDA guidance was not as clear as the Complaint depicts. But, again, that is not what the Complaint alleges. Whether Plaintiffs allegations hold up during discovery, at summary judgment or at trial remains to be seen.
Drawing all reasonable inferences in Plaintiffs’ favor, I am satisfied they have well-pled that the Board consciously ignored red flags that revealed a mission critical failure to comply with the RECIST protocol and associated FDA regulations. Additionally, at this stage, Plaintiffs’ allegation that this failure of oversight caused monetary and reputational harm to the Company is sufficient to provide a causal nexus between the breach of fiduciary duty and the corporate trauma. Therefore, Defendants’ motion to dismiss Count I (Plaintiffs’ Caremark claim) under Rules 23.1 and 12(b)(6) must be denied.”
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