September 30, 2021

Recent Delaware Decision Highlights Heightened Board Oversight Requirements in Caremark Cases

Holland & Knight Alert
Martin L. Seidel | Ira N. Rosner | Marie E. Larsen | Sophie L. Kletzien

Highlights

  • The Delaware Court of Chancery on Sept. 7, 2021, allowed a derivative stockholder lawsuit to proceed against The Boeing Company (Boeing), alleging that Boeing's board of directors breached their fiduciary duties by failing to implement proper oversight and monitoring procedures over "mission critical" airplane safety risks.
  • The In re The Boeing Company Derivative Litigation case is the latest in a string of decisions in which failure of oversight claims against corporate directors (commonly termed Caremark claims) have survived a motion to dismiss.
  • As a result, boards and board committees should review the oversight duties identified in their charters and the regular internal reporting mechanisms to align them to the risks inherent in the business of their companies.

The Delaware Court of Chancery on Sept. 7, 2021, allowed a derivative stockholder lawsuit to proceed against The Boeing Company (Boeing), alleging that Boeing's board of directors breached their fiduciary duties by failing to implement proper oversight and monitoring procedures over "mission critical" airplane safety risks. In In re The Boeing Company Derivative Litigation (hereinafter, In re Boeing),1 Vice Chancellor Morgan T. Zurn denied a motion to dismiss seeking dismissal of stockholder claims against the members of Boeing's management and board of directors in connection with two fatal crashes of the model 737 MAX airplane. The two crashes – one in 2018 and the other in 2019 – caused severe reputational harm to the company, resulting in the grounding of the 737 MAX, cancellation of billions of dollars in aircraft orders and billions of dollars in lost revenue, as well as significant litigation and non-litigation costs. In the 103-page decision, the court found that the plaintiffs had sufficiently alleged that the directors had failed to establish an airplane safety reporting system and, by "turning a blind eye to a red flag," opened themselves up to a "substantial likelihood of liability for Boeing's losses."

The In re Boeing case is the latest in a string of decisions in which failure of oversight claims against corporate directors (commonly termed "Caremark" claims after In re Caremark International Inc. Derivative Litigation; hereinafter Caremark 2 ) have survived a motion to dismiss. While Caremark claims have been described as "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment," these cases highlight the risk that traditional oversight mechanisms, not tailored to specific risks, as well as undue reliance on management reporting on an ad hoc basis, may not be sufficient to obtain early dismissal of Caremark claims. As a result, boards and board committees should review the oversight duties identified in their charters and the regular internal reporting mechanisms to align them to the risks inherent in the business of their companies.

Key Takeaways

  1. Risk categories that are essential and mission critical to a company's business require additional oversight (e.g., airplane safety is mission critical to an aircraft manufacturer's business and requires specific risk monitoring).
  2. Boards must set up systems to ensure board oversight of mission critical risks. Broad and nonspecific language putting an audit committee or other board committee in charge of overseeing general risk, without more, may not insulate a board from liability. Boards should review their constitutional documents, regular management reports and meeting agendas to ensure that their stated oversight responsibilities are explicitly tailored to the company's inherent business risks. The board or appropriate committee should also periodically review emerging risks for potential inclusion in the process.
  3. Boards should tailor regularly scheduled reporting to substantively monitor and address these risks. An internal monitoring system should also be put in place for whistleblowers and employees to report concerns that reach the board or board committees. Courts may not credit such systems if they are curated by senior management, or worse, the information does not regularly reach the board or relevant board committees.
  4. Corporations must be mindful that company-prepared records obtained by stockholders under Delaware General Corporate Law (DGCL) Section 220 Demands may be used against them in derivative lawsuits at the pleading stage, and that internal crisis-management, investor relations and public relations documents should be prepared and reviewed with the expectation that they will be disclosed to regulators or derivative plaintiffs.
  5. Finally, when a crisis occurs, the board and its advisers must be proactive – not passive. They should respond quickly and rigorously and should not sit back and wait for management to handle the issue. The key is a record of board oversight. A record of asking questions and digging into a problem will go a long way to assist the defense of a subsequent Caremark claim.

Delaware Court of Chancery Decision

Under In re Caremark International, directors need only make a "good faith effort to put into place a reasonable board-level system of monitoring and reporting" in order to satisfy their duty of loyalty. In Marchand v. Barnhill (hereinafter Marchand),3 the court noted that Caremark claims are "possibly the most difficult theory in corporation law upon which a plaintiff may hope to win a judgment." The court in Marchand, however, distinguished the plaintiffs' claims stemming from deadly, listeria-tainted ice cream from the traditional financial harms alleged in In re Caremark International, such as general financial wrongdoing and accounting fraud. It determined certain categories of alleged wrongdoing, such as those involving food safety, to be "essential and mission critical" to the company's business, and oversight must therefore be "more rigorously exercised." Ultimately, the Marchand court concluded that the board had failed to make a good faith effort to put into place on oversight and monitoring system.

In re Boeing builds off the Marchand decision, finding that, like food safety in Marchand, airplane safety is essential and mission critical to Boeing's business. Accordingly, the court found that airplane safety must be specifically provided for in oversight protocols; broad language common to many audit committee charters relating to monitoring risk generally was insufficient. Although Boeing's audit committee was charged with general "risk oversight," the court noted that aircraft safety was not listed in the charter and the audit committee did not regularly receive briefings or reports on aircraft safety, Federal Aviation Administration regulatory complaints or employee concerns regarding safety. Instead, the court concluded that the audit committee was primarily geared toward monitoring Boeing's financial risk; the yearly report reviewed by the audit committee on the company's risk management process did not address airplane safety risks, including the issues ultimately responsible for the two 737 MAX crashes, or any other manufacturing defect issues, focusing instead on the impact of manufacturing issues on aircraft delivery. The court also noted that Boeing lacked an internal reporting system, which "compounded" the existing deficiencies of board-level safety monitoring that could alert the board or audit committee to issues as they arose, and relied instead on management to curate any complaints. The result was that missional critical safety issues were not reported to the board.

In addition to prospective risk oversight failures, the court turned its analysis to the Boeing board's response and investigation into the causes of the two crashes. "[T]he Board treated the [first] crash as an 'anomaly,' a public relations problem, and a litigation risk, rather than investigating the safety of the aircraft and the adequacy of the flight certification process." The board's declination to test reported information calling the 737 MAX's safety into question did not indicate a mere "failed attempt" to address a red flag, and it "was aware or should have been aware that its response to the [crash] fell short." In addition, the court found the board delayed any review and relied passively on management until a second plane crashed. In making this determination, the court relied upon records produced in accordance with a stockholder demand under Del. Code Ann. tit. 8, § 220, which allows stockholders to inspect a corporation's books and records. This highlights the importance of corporate mindfulness when creating documents that may paint the company as deflecting or minimizing the issues, as Section 220 records are often wielded by stockholders pursuing derivative litigation claims. The In re Boeing decision serves as a warning to corporate boards nationwide to take organized and deliberate steps to structure company risk oversight processes or risk litigating costly derivative suits.

Conclusion

The key lesson from the In re Boeing decision is that boards should work with management and the board's advisers to identify critical potential risks inherent in the company's business model before they manifest. The board must then ensure that those risks are delegated to a proper board committee and flagged in its charter. Boards should also document that the board or a relevant committee regularly considers and received reports related to those issues, and when a problem occurs, ensure a robust crisis response that treats the matter as more than a public relations issue, and does not abdicate responsibility to management. Moreover, the risk oversight imperatives of In re Boeing (and its antecedents) amplify guidance and commentary by the U.S. Securities and Exchange Commission regarding the responsibilities of boards of directors to monitor (and ensure adequate disclosure) of material risk, just one more reason for corporate boards to take risk seriously.

Notes

1 2021 WL 4059934 (Del. Ch. Sept. 7, 2021)

2 698 A.2d 959 (Del. Ch. 1996)

3 212 A.3d 805 (Del. 2019)


Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.


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