A recent Delaware Court of Chancery decision serves as a reminder that Caremark claims are among the most difficult corporate litigation claims to make against directors. Melbourne Municipal Firefighters’ Pension Trust Fund v. Jacobs, C.A. No. 10872-VCMR (Del. Ch. Aug. 1, 2016). Of course, most readers are aware that Caremark is the colloquial reference for claims that a board of directors breached its duty of loyalty because it was on notice of risky corporate conduct and consciously disregarded its duty to remedy or prevent such misconduct.
This case involved claims that the directors of Qualcomm, Incorporated, were aware of violations of antitrust laws in the U.S. and in other countries in which it operates, based on fines levied or settlements paid for antitrust violations in several countries, but nevertheless the board allegedly did not take sufficiently proactive action to prevent such antitrust violations from taking place.
Useful Principles of Law for Corporate Litigators
The court provides a useful reiteration of the well-known corporate litigation rules regarding pre-suit demand and demand futility. Plaintiffs contended that pre-suit demand was excused pursuant to Court of Chancery Rule 23.1, which excuses pre-suit demand when a plaintiff demonstrates: “That any such demand would have been futile and, therefore, that the demand is excused.”
Where, as in this case, the allegation is that a company suffered corporate trauma because the board acted in bad faith by consciously disregarding their duty to oversee the company’s compliance with applicable laws, Delaware courts generally apply the test to analyze demand futility employed in the Delaware Supreme Court decision of Rales v. Blasband, 634 A.2d 927 (Del. 1993).
Pre-Suit Demand Futility
In Rales, the high court of Delaware explained that when a plaintiff challenges the inaction of directors, as opposed to a specific action, in that instance “a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” The Court of Chancery in this case explained that: “Demand is not excused solely because the directors would be deciding to sue themselves, and the mere threat of personal liability . . . is insufficient to challenge either the independence or disinterestedness of directors.” See footnote 39. The court continued that under the demand futility test, it is necessary that “a majority of the board must face a ‘substantial likelihood’ of personal liability for demand to be excused.”
A practical explanation of the elements of a Caremark claim were explained by the court in this opinion. See In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). The court observed that:
“In a typical Caremark case, plaintiffs argue that the defendants are liable for damages that arise from a failure to properly monitor or oversee employee misconduct or violations of law. The claim is that the directors allowed a situation to develop and continue which exposed the corporation to enormous legal liability and that in so doing they violated a duty to be active monitors of corporate performance. A Caremark claim is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment, and bad faith on the part of the corporation’s directors is a necessary condition to liability.”
See footnotes 47 through 49. The court elaborated that it is common for plaintiffs attempting to satisfy the elements of a Caremark claim to plead that the board “had knowledge of certain ‘red flags’ indicating corporate misconduct and acted in bad faith by consciously disregarding its duty to address that misconduct.” See footnote 51.
The court found that in this case the complaint did not plead facts from which the court could reasonably infer that the board acted in bad faith. Nor did the court find that the board ignored red flags or that there was any causation between red flags that were allegedly ignored and damages to the company.
Bad Faith Defined
Bad faith requires adequately alleging particularized facts from which it can be reasonably inferred that a board consciously disregarded its duties by intentionally failing to act in the face of a known duty to act. The court defined “conscious disregard” as involving “an intentional dereliction of duty which is more culpable than simple inattention or failure to be informed of all facts material to the decision.” See footnote 59.
The necessary inaction and the lack of good faith necessary for a Caremark claim requires “a sustained or systematic failure of the board to exercise oversight. Simply alleging that a board incorrectly exercised its business judgment and made a ‘wrong’ decision in response to red flags, however, is insufficient to plead bad faith.” See footnote 62. The court distinguished the facts of this case from the Massey and Pyott cases which involved more egregious facts and admissions of wrongdoing.
Moreover, the board in this case was under the impression that its conduct did not violate applicably antitrust laws. The court concluded that the allegations did not satisfy the essential elements of a claim for bad faith.