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Board Members Should Take Note — Delaware Supreme Court Issues Important Decision on Caremark Compliance Standard

I have long predicted that corporate board members are in for a rude awakening. (See posts here and here and ebook here) Corporate boards have to improve their ability and knowledge surrounding supervision and monitoring of a company’s ethics and compliance program.  Most corporate boards have little to no knowledge about what compliance is, how it works, and what their precise obligations are as part of their corporate duties.

You can always tell how important compliance is by basic questions – how often does a CCO report to the Audit Committee and the full Board?  How much time are they given?  Do they have an executive session?  And, finally, when is the compliance meeting scheduled – at the end of the board meeting when board members are anxiously awaiting drinks and dinner?

If you detect a bit of sarcasm, I admit it.  I am cynical and nothing will change in board performance unless and until two things occur – courts hold board member responsible for oversight and compliance failures, and/or boards begin to appoint at least one member who has compliance expertise, preferably a former CCO at a major company.  At the heart of numerous compliance breakdowns is the failure of corporate boards to exercise proper and continuing oversight and direction of a company’s ethical culture and compliance program. 

Two cases have long protected board members: In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch.1996)(HERE); and Stone v. Ritter, 911 A.2d 362 (Del. 2006)(HERE).

In Caremark and Stone v. Ritter, the Delaware Supreme Court held that directors have a duty “to exercise oversight” and to monitor the corporation’s operational viability, legal compliance and financial performance.  A board’s “utter failure to attempt to assure a reasonable information and reporting system exists” is an act of bad faith and a breach of its duty of loyalty.  In other words, a board is impervious to challenge if it establishes a reporting and compliance system without regard to whether the system is actually working.  It is – and has been – a fairly easy standard for boards to meet.

The Delaware Supreme Court returned to this issue in a recent case – Marchand v. Barnhill et al, HERE, a case involving Blue Bell Creameries  and a listeria outbreak.  The facts, while compelling, involve a serious health and safety issue but nonetheless has significant implications for overall ethics and compliance functions. 

In 2015, Blue Bell, a large ice cream manufacturer, experienced a listeria outbreak, which caused the death of three individuals.  Blue Bell had to recall its products and shut down production.  Shortly after that, Blue Bell suffered a “liquidity crisis,” and the company was forced to secure financing that caused a fall in its stock price.  A stockholder brought a derivative suit alleging that the directors breached their fiduciary duty of loyalty under Caremark.  The trial court granted defendants’ motion to dismiss finding that plaintiffs did not plead any facts to support the claim that the board “utterly failed to adopt or implement any reporting and compliance systems.”

The Delaware Supreme Court reversed.  The Supreme Court cited several significant facts.  Blue Bell, as an ice cream maker, knew that food safety was essential and mission critical.  The company was regulated by three states and the FDA.  During the period 2009 to 2014, regulators identified a number of compliance failures and health safety risks.  Incredibly, although there were a number of positive tests for the presence of listeria, the relevant board minutes reflected “no board-level discussion of listeria.”  Moreover, the complaint alleged that the board was not informed about listeria or food safety issues generally, even as the problem grew.  It was not until the food recall was forced that the board was informed about food safety issues.

The Court also cited the fact that, once the board was forced to recall Blue Bell’s ice cream products, the board did not schedule any additional emergency board meetings to receive updates and left the matter in management’s hands.  Eventually, the CDC became involved and after several deaths issued a recall and warning to grocers and consumers.  FDA inspections of the plants revealed “major deficiencies” and little progress in remedying the problem despite growing listeria outbreaks and positive tests.  News reports described how management was ignoring the problem of plant conditions.  Blue Bell was forced to shut down all production and lay off one-third of its employees.

The Delaware Supreme Court reversed the trial court’s dismissal of the complaint and explained that “directors have great discretion to design context- and industry-specific approaches tailored to their companies’ business and resources, Caremark does have a bottom-line requirement that is important – the board must make a good faith effort – i.e., try to put in place a reasonable board-level system of monitoring and reporting.  In this regard, the Court cited several factors, including the failure of the board to establish a board committee to monitor food safety or to periodically devote a portion of its meetings to food safety compliance.  According to the board minutes, the board did not any discussion of food safety red flags.  Importantly, the board did not proactively require management to regularly provide information about mission-critical risks. The board had no protocol or expectation that management would deliver key food safety compliance reports or summaries of these reports to the board on a consistent and mandatory basis.   As a result, the board did not require the company to take action to rectify the systemic deficiencies identified by the FDA at Blue Bell’s manufacturing plants.

The Delaware Supreme Court’s decision is an important indication that even under Caremark, there are situations where boards have a greater responsibility to act.  While the facts are compelling involving a serious food safety risk and the death of consumers, the Court’s analysis can apply to other situations when boards fail to act involving other risks such as bribery, sanctions or other misconduct. 

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