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This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

The Delaware Court of Chancery recently ruled Boeing Company directors must face shareholder charges that they breached their oversight duty by insulating themselves from safety problems with the new 737 MAX and ignoring red flag warnings of deadly stability defects that crashed two of the jetliners within five months. In Re The Boeing Company Derivative Litigation, No. 2019-0907-MTZ opinion issued, (Del. Ch. Sept. 9, 2021).

In her Sept. 9 opinion, Vice Chancellor Morgan Zurn found pension fund plaintiffs’ director oversight claims met the tough pleading standards of the Delaware Supreme Court’s milestone Marchand ruling with well-supported allegations that a majority of the directors are likely liable for Boeing’s billions of dollars in losses and penalties and can’t be entrusted to bring breach-of-duty charges. Marchand v. Barnhill, 212 A.3d 805 (Del. 2019)

Marchand was the high court’s preeminent interpretation of Chancellor William Allen’s 1996 pioneering In re Caremark International ruling that set standards for shareholder plaintiffs to recover on behalf the corporation itself in the rare oversight case where, “directors, otherwise unconflicted, should nonetheless take actions knowingly inimical to the corporate interest, such as ignoring a known duty to act to prevent the corporation from violating positive law.” In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).

Vice Chancellor Zurn’s ruling repeatedly pointed to the Marchand standards in finding that Boeing’s directors:

1. Got no regular safety information on the 737 MAX or any of its planes due to their “complete failure” to establish a committee or regular board reports on safety issues,
2. After the first crash, did not immediately investigate what caused the 737 MAX to repeatedly push its nose down in a series of disastrous dives at low speeds and instead virtually ignored the problem even though safety was a “mission critical” area,
3. Intentionally misled federal regulators about the scope and seriousness of a computer pilot training program meant to help them use software that would allegedly minimize nose-down dives,
4. Allegedly lied to the public and regulators about how comprehensive, good faith and quickly implemented their post-crash safety program was.
5. Never pressed the CEO for more information or questioned his conclusions when he repeatedly told the board the 737 MAX was safe and blamed the crashes on pilot and maintenance errors.

However, she found insufficient proof for charges that Boeing’s officers stifled defect reports and that the board bought ex-CEO Dennis Muilenburg’s silence about their liability with an overly rich exit package.

Some legal experts have questioned whether Vice Cancellor Zurns’ opinion fits into what they see as a trend of recent rulings that have allegedly made it less difficult to meet what the Delaware courts have traditionally called the “onerous” pleading standards of a Caremark duty claim.

Background
Two public pension funds were the co-lead plaintiffs in a shareholder suit that claimed Boeing’s directors were liable for lax safety that caused two crashes of the new 737 MAX jetliner, killing all aboard both planes — which were grounded by federal regulators for 20 months with large financial losses. They contended that the directors were too conflicted by their likelihood of liability to press claims, giving the shareholders standing as derivative plaintiffs.

Was demand futile?
Defendants’ motion to dismiss argued that plaintiffs could not meet the very high hurdle pleading standards for their Caremark claims but Vice Chancellor Zurn found the amended complaint meets both prongs of the threshold demand requirements of Court of Chancery Rule 23.1 under the seminal Rales v. Blasband, 634 A.2d 927 (Del. 1993) opinion “and is therefore permitted to assume control of a claim belonging to the corporation.” She found demand on the board would have been futile because there was adequate support for charges that a majority of the directors lacked both independence and disinterest.

The directors “face a substantial likelihood of liability for failure to fulfill their oversight duties under the standards set forth in Caremark, as applied by the Delaware Supreme Court in Marchand, the vice chancellor wrote, adding that the complaint adequately alleges bad faith, “a necessary condition to director oversight liability.”

In response to defendants’ argument that they met the Federal Aviation Administration’s requirements for certification of the plane and its accompanying training and operation program, the court said, “under Marchand, minimal regulatory compliance and oversight do not equate to a per se indicator of a reasonable reporting system.”

Takeaways
Legal scholars may debate for some time to come whether Boeing and/or any of its predecessors in the past few years used degraded pleading requirements — and what the resultant effect might have been on the “onerous” Caremark standard. However, readers are referred to a previous synopsis on these pages of  another Caremark decision with an interesting similarity. Teamsters Local 443 Health Services & Insurance Plan et al. v. Chou, et al., No. 2019-0816-SG opinion issued (Del. Ch. Aug. 24, 2020).

In that opinion, the Chancery Court found that shareholder plaintiffs also passed the Caremark pre-suit demand test because they adequately alleged that the defendant pharmaceutical company’s directors insulated themselves from bad news and turned a blind eye to red flags concerning a subsidiary’s criminal enterprise of dangerous cancer drug repackaging.

The takeaway from that blog post speculated that, “most may read the ruling as a signal from the nation’s preeminent business court that in this post-Covid world, failure-to-supervise claims involving the director response to red-flagged problems with mission-critical operations at closely-regulated health-related businesses deserve increased scrutiny – especially at the crucial pleading stage.

And some may even see the need to apply that increased scrutiny to director decisions in suits against any closely-regulated business, especially one that impacts human health.”

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

The Delaware Court of Chancery recently decided AmerisourceBergen Corporation shareholders’ breach-of-duty suit was one of the few Caremark claims to pass Delaware’s pre-suit demand test because it may prove the directors and officers turned a blind eye to a subsidiary’s criminal enterprise of cancer drug repackaging in Teamsters Local 443 Health Services & Insurance Plan et al. v. Chou, et al., No. 2019-0816-SG memorandum opinion issued (Del. Ch. Aug. 24, 2020).

Vice Chancellor Sam Glasscock’s Aug. 24 memorandum opinion refused to dismiss charges by employee pension fund plaintiffs that sufficiently alleged ABC’s directors likely faced bad faith liability and therefore lacked the independence and objectivity necessary to decide, as the company’s managers, whether the derivative suit should live or die.

In an opinion that will be studied in law offices and boardrooms nationwide, the vice chancellor acknowledged the widely-held belief of Delaware jurists and litigators that Caremark duty-to-supervise charges are the most difficult to get past the threshold test for claims brought against officers and directors on behalf of the company.

What the directors didn’t do

He said that’s because Caremark suits center not on what the defendant officers and directors purportedly did but what they allegedly didn’t do – and whether there is proof that shareholders suffered because directors and officers intentionally “utterly failed” to establish or check monitoring systems for the company’s “mission critical” operations that hinged on regulatory compliance.

Chancellor William Allen’s 1996 In re Caremark International ruling set tough standards for shareholder plaintiffs to recover on behalf the corporation itself in the rare case where, “directors, otherwise unconflicted, should nonetheless take actions knowingly inimical to the corporate interest, such as ignoring a known duty to act to prevent the corporation from violating positive law.” Vice Chancellor Glasscock said. In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).

Background

According to the 2019 complaint, that is exactly what happened in 2001 when AmerisourceBergen Corp., a Delaware-chartered pharmaceutical distribution and sourcing company based in Chesterbrook, Pa., acquired Oncology Supply Pharmacy Services and made it part of AmerisourceBergen Specialty Group.

The consolidated complaint of a half-dozen union pension plans says that company’s sole official business was to buy single-dose sterile vials of oncology drugs, put those drugs into syringes, and sell the syringes for injection into a cancer patient’s body; but instead, OSPS emptied the syringes—including the excess in each used to eject air bubbles — into a pool of medicine that produced enough for extra syringes with full dosages.

The complaint alleged that Pharmacy not only illegally “pooled” and sold the overfill as extra syringe doses, its unsterile process produced medicine contaminated with “floaters,” in more than 32,000 pre-filled syringes between 2007 and 2013 alone. Pharmacy and ABC both pocketed the extra revenue, and undercut the competition by providing kickbacks to buyers to increase market share, the complaint said. In addition, Pharmacy was not really a pharmacy, but it generated fake prescriptions to masquerade as a pharmacy business in order to avoid scrutiny by the U.S. Food and Drug Administration as a drug manufacturer.

ABC’s directors and top officers – including Steven H. Collis, ABC’s Chairman, President, and Chief Executive Officer, who was President of Pharmacy from 1999 until its closure in 2014 – moved to dismiss, arguing that Pharmacy’s business accounted for a comparatively small slice of ABC’s total business.

Four red flags

In his opinion, Vice Chancellor Glasscock said the key to establishing that officers and directors showed bad faith in utterly failing to supervise Pharmacy so that it would operate within the law and the regulations of the pharmaceutical industry was the proof that they failed to respond to four critical “red flags:”

1. On September 11, 2017, the United States Department of Justice filed a Criminal Information against Pharmacy and its parent, charging that the repackaging program illegally introduced misbranded drugs into interstate commerce under the Food and Drug Commission Act under 21 U.S.C. §§ 33c1(a), 333(a)(1), 352(o), and 360, and 18 U.S.C. §§ 2, 3551, et seq. On September 27, 2017 Pharmacy and its parent pleaded guilty to violating the FDCA and the companies paid $260 million to the Department of Justice, consisting of a $208 million criminal fine and a criminal money forfeiture of $52 million ABC had obtained from unlawful sales of pre-filled syringes.

During the relevant time period, the ABC board did not set aside a portion of board meetings devoted to drug safety and compliance and the Criminal Information served as the first disclosure to ABC’s stockholders of the alleged misconduct that occurred at Pharmacy. The board did not act or even discuss what to do, the court said.

2. In 2007 ABC, engaged Davis Polk & Wardwell to undertake an assessment of the adequacy of ABC’s compliance program, to recommend improvements and to report the results of the assessment — that Specialty was not integrated into ABC’s compliance and reporting function and that oversight responsibilities were being left to officers and directors of the various ABC subsidiaries. But the ABC board and its committees allegedly never followed up on any of the recommendations that came from the report.

3. Michael Mullen was an executive at Specialty beginning in 2003 and promoted to COO of Specialty in September 2009, where he was responsible for Specialty’s eight business units including Pharmacy. By January 2010, Mullen had identified significant issues across all of Specialty’s business units, including serious issues with Specialty’s oncology business model that created regulatory exposure. After months of raising concerns about Specialty’s oncology business and lobbying for ABC to address the compliance issues at Specialty, Mullen was terminated on April 8, 2010, and management never told the board about Mullen’s compliance concerns or firing. The reporting system failed completely, the court said.

Mullen filed a qui tam complaint under seal in federal district court in New York on October 21, 2010, but no remedial action was taken against any employee for the misconduct identified in Mullen’s qui tam complaint, and appears not to have even been discussed by the board, the vice chancellor said.

4. In January 2014, ABC and Specialty ended the Pre-Filled Syringe Program by closing the Oncology facility in Dothan, Alabama. The board’s audit committee’s first mention of ending the Pre-Filled Syringe Program was on April 23, 2014, where the Audit Committee was informed that “the [Specialty] operating income included the loss of income from a [Specialty] pharmacy closure in Dothan, Alabama.” No board discussion occurred regarding why the Oncology facility was closing.

Ruling based on Rales

Vice Chancellor Glasscock ruled that because the plaintiffs challenged board inaction, and not a specific board decision, demand futility is analyzed under the test articulated in Rales v. Blasband, 634 A.2d 927 (Del. 1993). Under that standard, the high probability that the majority of the directors face liability for their failure to oversee ABC’s legal operation means they could not have made an independent or objective decision on any charges against the directors and officers, so pre-suit demand would have been futile under either prong of Caremark he said.

Under “prong one,” of 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.” A “prong two” claim, on the other hand, arises where “having implemented such a system or controls, [the directors] consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention,” the Vice Chancellor’s decision says.

He found that the importance of the directors’ attention to the company’s “mission critical” regulatory issues is outlined in the Delaware Supreme Court’s Marchand v. Barnhill decision because the ABC board’s failure to both institute monitoring systems and to implement them exposed the company to significant liability. Marchand v. Barnhill 212 A.3d 805 (Del. 2019).

Time-will-tell take-aways?

A possible time-will-tell take-away from this opinion could make it easier for Caremark claim plaintiffs to survive the pre-suit demand test. Jurists and corporate attorneys may minimize the impact of this ruling if most of them see it as an outlier produced mainly by unusual facts.

But most may read it as a signal from the nation’s preeminent business court that in this post-Covid world, failure-to-supervise claims involving the director response to red-flagged problems with mission-critical operations at closely-regulated health-related businesses deserve increased scrutiny – especially at the crucial pleading stage.

And some may even see the need to apply that increased scrutiny to director decisions in suits against any closely-regulated business, especially one that impacts human health.