Insights

Delaware Supreme Court Underscores the Importance of Board-Level Monitoring in Marchand (Duty of Loyalty)

September 25, 2019

Management Liability/D&O

Corporate board members beware: At any given time, you may need to demonstrate that you’ve implemented reasonable procedures to bring information to the board.

A June 2019 Delaware Supreme Court decision, Marchand v. Barnhill et al., highlights how important it is for a board to implement board-level reporting and monitoring systems to fulfill its fiduciary duty of loyalty.

(The Marchand case also addresses the issue of board member independence, something I addressed in a separate blog.)

image of vanilla ice cream in a bowl

In 2015, a listeria outbreak impacted ice cream from Delaware corporation Blue Bell Creameries USA, Inc. This resulted in product recalls, plant shutdowns, layoffs, and sadly, three consumer deaths.

A shareholder sued derivatively, alleging breaches of fiduciary duties. The allegations included a breach of the duty of loyalty, citing standards articulated in the well-known Caremark International, Inc. Derivative Litigation case.

Historically, Caremark oversight cases have been very difficult for plaintiffs, rarely surviving the defendant board of director’s motion to dismiss.

Marchand v. Barnhill was first brought in the Delaware Court of Chancery, where the case was dismissed, as expected. On appeal, however, the Delaware Supreme Court reversed the Chancery court’s decision.

Reporting and Compliance Claims

The Court of Chancery originally concluded that Blue Bell board had monitoring systems in place because the company had systems designed to comply with FDA regulations, had ongoing third-party contamination monitoring, and senior management gave reports on operations to Blue Bell’s board.

In the Chancery Court’s view, this was enough to establish that the board had a monitoring system in place, and the plaintiffs were really instead challenging the effectiveness of this system.The Delaware Supreme Court disagreed, instead finding that the Blue Bell Board “failed to implement any system to monitor Blue Bell’s food safety performance or compliance.” (Emphasis added.)

Chief Justice Shrine explained, saying that:

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.”

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

The Court noted that, as a company that only produced ice cream, food safety was the single most important risk the company faced. Yet there was no board committee to oversee food safety, nor were there any processes for reporting and addressing food and safety issues at the board level. Instead, these issues were left entirely to management.

The Blue Bell board sought to defend itself by pointing to the company’s regulatory compliance efforts. The Court was not persuaded, explaining that systems implemented by management to promoted regulatory compliance are not “board implemented” systems designed “to monitor food safety at the board level.” (Italics in the original.)

The Court was particularly troubled by Blue Bell board’s laissez-faire attitude towards receiving reports from management. In order to make their pleading with particularity, the plaintiffs had used a Section 220 Books and Records request to examine the minutes of the board. These minutes revealed that management gave the board reports at management’s discretion and not in a regular and mandatory cadence:

…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.

The Court ultimately provided a useful list as to why the plaintiffs had adequately pled that the board acted in bad faith:

  • 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.

Not only did the Blue Bell board lose its motion to dismiss, but its members now face having to defend themselves in a trial over a potential Caremark violation, something that could lead to personal liability for the directors in the cross hairs of the suit.

Lessons Learned

Boards should evaluate the facts of Marchand and how it applies to their own business. This is particularly true for companies in heavily regulated industries that to date may have been relying on management-implemented compliance systems instead of insisting on board-level monitoring protocols.

Moreover, boards should identify their companies’ most important risks and assure themselves that they have sufficient board-level compliance and reporting systems in place that relate to the company’s central risk and compliance issues. The Court usefully provided a list of the Blue Bell board’s failures, which of course provides the rest of us with a roadmap for success.

Boards should also take care to ensure that their efforts are being recorded diligently in the minutes of the board meeting. It will be helpful if these minutes reflect the board-mandated nature of reports by management and the like.

It’s also a good idea to have a board-level plan in place to handle crises, unlike the Blue Bell board that allegedly failed to swing into action in a timely way when its customers started becoming ill.

Finally, to help mitigate the risk of director personal liability when being sued, companies should look to a properly brokered D&O insurance program that includes some extra Side A insurance. Side A responds to protect directors when corporations cannot indemnify them, such as when settling a derivative suit claim.

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