Delaware Court Increases Scrutiny of Corporate Board Oversight and Monitoring of Compliance Programs
On October 1, 2019, in In re Clovis Oncology, Inc. Derivative Litigation (here), a Delaware Chancery Court denied a motion to dismiss the plaintiffs’ claims under the Caremark decision against individual directors for failing to monitor the development of the biotech firm’s experimental drug and allowing it to permit inflated performance results. The Court’s decision was the second opinion issued by the Delaware courts in recent months allowing plaintiff claims under Caremark to proceed to trial.
Under the Caremark standard, directors can face personal liability for violating their fiduciary duties if they: (fail to implement a board reporting system or (2) fail to monitor the reporting system’s operations which would have made the board aware of potential risks. Under prior decisions, the Court has dismissed most Caremark claims given the difficulty of pleading and satisfying the Caremark standard.
This trend, however, appears to be changing. The Court has made it clear that a director’s duty of loyalty is satisfied when a director makes a good faith effort to implement an oversight system and then monitor it. To the extent that a company operates in a regulated market, the Delaware Courts have suggested that oversight and monitoring are important requirements to exercising good faith.
The Clovis case is another case in line with recent cases concerning board member responsibility, particularly in regulated areas. See prior posting concerning Blue Bell Ice Cream. Clovis had no drugs to market and was developing a lung cancer drug that was its most promising drug. Clovis’ clinical trial incorporated a well-known protocol that included a specific metric for indicating the drug’s efficacy.
During the trial, Clovis deviated from the protocol by improperly calculating the efficacy measurement. As a result, Clovis published inflated performance results, and included this information in raising capital in the private and public securities markets. Clovis also failed to properly disclose the drug’s side effects.
While the board’s nominating and corporate governance committees were responsible for developing and overseeing the effectiveness of Clovis’ legal, ethics and regulatory compliance, the full board received reports on the drug that indicated “red flags” as to the accuracy of the efficacy metric’s calculation. The board took corrective action and Clovis’ stock plummeted 70 percent.
The Court cited a prior case, Marchand v. Barnhill (here), involving Blue Bell ice cream, that the case “makes clear, [that] when a company operates in an environment where externally imposed regulations govern its ‘mission critical’ operations, the board’s oversight function must be more rigorously exercised.” In the Blue Bell Ice Cream case, the Board failed to properly oversee a regulatory compliance risk that led to the distribution of listeria-tainted ice cream.
In Clovis, the Court found that the experimental lung cancer drug constituted a “mission critical” product, and that FDA regulations governing the study were “mission critical regulatory issues.” In addition, the Court noted that “red flags” existed such as the board’s receiving reports showing that management was improperly calculating the efficacy metric. Moreover, the board knew that the Company was using the inflated performance numbers in communications outside the Company such as with investors and the FDA.
The Clovis Court explained the directors must have “acted with scienter, which ‘requires proof that a director acted inconsistent with his fiduciary duties and, most importantly, that the director knew he was so acting.’” The Clovis court inferred that the board “consciously ignored red flags that revealed a mission critical failure to comply with the [specified] protocol and associated FDA regulations.” The directors either knew or should have known they were not discharging their duty. The board was composed of experts, and Clovis’ clinical trial protocol incorporated a protocol well known in the pharmaceutical industry. The court observed that neither the criteria of the well-known protocol nor the FDA requirements were nuanced. Clovis’ internal documents confirmed that the board spent hours at meetings discussing the experimental drug and its potential competitor. Despite knowing all of this, the board took no action. The court described the directors who signed the Clovis Annual Report as acting “[w]ith hands on their ears to muffle the alarms.”
The Clovis Court explained that “‘Delaware Courts are more inclined to find Caremark oversight liability at the board level when the company operates in the midst of obligations imposed upon it by positive law yet fails to monitor existing compliance systems, such that a violation of law, and resulting liability, occurs.’”
The Clovis Court noted that when externally imposed regulations govern a company’s mission critical operations, the board must exercise a good faith effort to implement an oversight system, which “entails a sensitivity to ‘compliance issues[s] intrinsically critical’ to the company.”