Delaware Court Again Finds Potential Director Liability for a Breach of the Duty of Oversight
By Rick S. Horvath & Austin M. Prouty
For the second time in three months, a Delaware court held last week that directors faced potential liability for a breach of their duty of oversight pursuant to In re Caremark International Inc. Derivative Litigation
New Life for Caremark Claims?
Over ten years ago the Delaware Supreme Court in Stone v. Ritter articulated the standard for pleading a Caremark claim for a failure of oversight.
Grounded in scienter, the Stone test imposes a significant pleading burden on plaintiffs. For many years it has been far more likely that an oversight claim would be dismissed at the pleading stage rather than proceed into discovery, as was the case in Stone and the overwhelming majority of oversight cases filed across the country.
For the first time, the Delaware Supreme Court found in June that a plaintiff pled an oversight claim.
The decision in Clovis likewise involves a company focused on a specific product and operating in a heavily regulated industry.
After the FDA insisted the company comply with the RECIST protocol, Clovis informed the public that Roci was less effective than previously thought. The company lost over $1 billion in market value. A securities class action complaint, regulatory enforcement, and the Clovis derivative action followed.
The Court of Chancery held the Clovis complaint did not survive the first prong of the Stone test because, in part, the board “reviewed detailed information regarding [Roci’s clinical trial] at each board meeting.”
The Court did hold, however, that the board allegedly failed to monitor the company’s existing compliance systems as required by the second prong of the Stone test.
What Should Boards Do?
The Marchand and Clovis decisions indicate that Delaware courts will not hesitate to scrutinize whether directors have fulfilled their oversight obligations. As Chief Justice Strine wrote in Marchand, directors must at least “try.”
Directors must do more than rely on compliance programs operating within the organization or trust that management has everything running smoothly. Directors must instead understand the organization’s critical compliance risks, receive reports on those risks, and act on any red flags presented to the board.
In-house counsel should take the opportunity presented by Marchand and Clovis to refresh their board-level controls and risk oversight. Steps could include:
Identify the company’s “mission critical” risks, taking into account its regulatory environment and public disclosures.
Ensure there are appropriate board-level reporting systems for each critical risk.
Assess whether there are enough directors with the expertise to engage with management on these critical risks.
Determine whether each critical risk can be managed by the board or an existing board committee, or if a new standing committee would aid the board in performing its oversight function.
Remind directors of their obligation to question management if the directors perceive even “yellow flags” of potential misconduct.
Document the board’s response to warning flags and its follow-up with management.
In preparing such documentation, weigh the risk that, even if privileged, the record could be reviewed in a later stockholder action.
Reexamine the company’s director and officer liability insurance coverage needs.
Reassess the utility of a Delaware forum bylaw provision that would govern internal corporate claims.
With experienced counsel, many companies would likely find that updating their board-level controls and risk oversight could result in meaningful protections for directors and, ultimately, benefit the company’s shareholders.