A recent decision of the Delaware Court of Chancery provides a scholarly and practical explanation of the onerous prerequisites that must be satisfied before a Caremark claim will meet the rigors of the demand futility analysis in order to justify the absence of pre-suit demand on the board.
The 82-page decision in Oklahoma Firefighters Pension & Retirement System v. Corbat, C.A. No. 12151-VCG (Del. Ch. Dec. 18, 2017), deserves to be read in its entire glory for an understanding of the important factual nuances, but for purposes of this short blog post I will highlight several of the most important legal principles with the widest applicability.
Background Facts: This lengthy opinion describes in great detail the important and extensive facts that are a necessary part of the reasoning and conclusion of the court. The court praised the plaintiffs for using Section 220 and producing “a ponderous omnibus of a complaint.”
But, unfortunately for the plaintiffs, notwithstanding the extensive details alleged and the incorporation of many documents by reference, the complaint failed to demonstrate that it was reasonably conceivable that the directors acted in bad faith.
Key Principles Explained: One of the most noteworthy aspects of this decision was the comprehensive explanation of the many shades and hues that are part of the challenging prerequisites that need to be met in order to plead a successful Caremark claim. The court described the following key principles involved in a Caremark claim:
- The essence of a Caremark claim is an attempt by the owners of the company, its stockholders, to force the directors to personally make the company whole for the losses suffered when the corporation violates laws or regulations and as a result is subject to fines or penalties.
- Caremark claims often involve the following two situations: (1) When directors fail to install a system whereby they may be made aware of and oversee corporate compliance with law; or (2) Where the board has an oversight system in place, but nonetheless fails to act to promote compliance. In the latter situation, the directors may be liable only where their failure to act represents a non-exculpated breach of duty.
- Where the directors are on notice of systemic wrongdoing but nonetheless act in a manner that demonstrates a reckless indifference towards the interests of the company, they may be liable for a breach of duty of care, but in order to be liable when an exculpation clause applies, the inaction of directors in the face of “red flags” putting them on notice of systemic wrongdoing must implicate the duty of loyalty. To imply director liability, the response of the directors must have been in bad faith. That is, the inaction must suggest not merely inattention, but actual scienter. In other words, the conduct must imply that the directors are knowingly acting for reasons other than the best interests of the corporation. The court describes this as the “essence of a Caremark claim.” See footnotes 2, 3 and 4.
Demand Futility in the Caremark Context: The court explained that the well-known pre-suit demand requirements of Rule 23.1 require particularized facts showing that demand would have been futile. These stringent requirements differ substantially from the permissive notice pleadings governed solely by Chancery Rule 8(a).
- Because director inaction is involved in a Caremark claim alleging violation of oversight duties, the applicable test is found in Rales v. Blasband, 634 A.2d 927 (Del. 1993)–as compared to the Aronson test.
- In the context of a Caremark claim, a plaintiff must allege 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 more importantly, that the director knew he was so acting. See footnote 251.
- The court added that one way to establish a connection between the red flags ignored by the board and corporate trauma, is to allege facts suggesting 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.” See footnotes 255 and 256 (emphasis added).
- Moreover, the corporate trauma in question “must be sufficiently similar to the misconduct implied by the red flags such that the board’s bad faith, conscious inaction proximately caused that trauma. See footnote 258.
- In a particularly quotable portion of the court’s reasoning, the court emphasized that when the duty of loyalty is at issue: “A board’s efforts can be ineffective, its action obtuse, its results harmful to the corporate weal, without implicating bad faith. Bad faith may be inferred where the directors knew or should have known that illegal conduct was taking place, yet took no steps in a good faith effort to prevent or remedy that situation.”
- The court also reasoned that the pleadings fell short in this case because: (1) The court could not infer that the defendants consciously allowed Citigroup to violate the laws so as to sustain a finding that they acted in bad faith. (2) The second problem was that the purported red flags were not waved in front of the defendant directors.
- Importantly, as stated in many other Delaware decisions, “Delaware law does not charter law breakers, and a fiduciary of a Delaware corporation cannot be loyal to a Delaware corporation by knowingly causing it to seek profit by violating the law.” In this case, however, there were no allegations supporting an inference that any of the directors decided to cause Citigroup to break the law and pursue the profits.
- The court’s concluding reasoning was that the “directors may be faulted for lack of energy or for accepting incremental efforts of management advanced at a testudinal cadence, when decisive action was called for instead” [,] but that does not satisfy the prerequisites for a Caremark claim. If it did, and if simple gross negligence were enough, it would discourage able persons from serving on boards and would make it difficult for them to bring business judgment to bear on decisions involving risk.
- In sum, the court concluded that because: (i) the pleadings did not imply scienter on the part of the director defendants; and (ii) the bad results that plaintiffs point to do not imply bad faith; and (iii) there is no substantial likelihood of liability, therefore, for any of the director defendants, based on the facts alleged, demand was not excused, and the motion to dismiss was granted.
Supplement: Large volumes of commentary exist on the many cases discussing the issues addressed in this case. A prolific, nationally prominent corporate law scholar often cited in decisions of the Delaware courts, and friend of this blog, Prof. Stephen Bainbridge, in one of his many writings on this issue, provides insights on some of the seminal decisions on Caremark claims, and also quoted from an article I wrote on an earlier Chancery decision on this topic, that captures the essence of the nuances involved in this challenging topic.