Topics:   Business Ethics,Compliance,Featured,Regulations & Legislation,Risk Management

Topics:   Business Ethics,Compliance,Featured,Regulations & Legislation,Risk Management

August 6, 2019

The Caremark Standard: Tough, but Not Impregnable

August 6, 2019

The Caremark decision built a high wall for plaintiffs to scale in asserting a board’s failure to comply with duty of care and loyalty standards. A landmark case before the Delaware courts in 1996, the decision written by the Court of Chancery of Delaware for In re Caremark International Inc. clarifies the board’s duties in relation to its oversight activities. The court outlined what plaintiffs must prove when claiming that directors breached their duties, notably that:

  1. either the directors knew or should have known that violations of the law were occurring; and, in either event,
  2. the directors took no steps in good faith to prevent or remedy that situation; and
  3. such failure resulted in the losses alleged in the complaint.

Recently, the Delaware Supreme Court overturned and remanded a decision by the Chancery Court, ruling that a plaintiff had indeed scaled the Caremark standard in his complaint. The case, Marchand v. Barnhill, et. al, involved Blue Bell Creameries’ directors and officers. The company in 2015 recalled all of its ice cream products and shut down all production operations after the U.S. Food and Drug Administration and several state health agencies found evidence of listeria in its factories and products. The contamination resulted in the deaths of three people. As the company’s revenues dropped substantially, it fired or suspended more than half of its workforce and ceased paying distributions to its limited partners. Ultimately, it was fined by government authorities for poor safety policies and practices.

The plaintiffs in this case brought a complaint that the board breached its common law fiduciary duties. The court was compelled to decide in the plaintiff’s favor due to evidence of the simplicity of the company’s business model; the industry-specific risk of food safety; the lack of board oversight of food safety issues; and the absence of protocols by which the board expected to be advised of developments in this risk area.

It was concerning to the court that when “yellow and red flags about food safety were presented to management, there was no equivalent reporting to the board and the board was not presented with any material information about food safety” during the critical period leading up to the three deaths. In the court’s view, these facts created “a reasonable inference that the directors consciously failed to attempt to assure a reasonable information and reporting system exist[ed].”

The Caremark standard is burdensome for the plaintiffs’ bar to overcome. Indeed, it was stated in a footnote of the Marchand ruling that “[under Delaware] law, director liability based on the duty of oversight is possibly the most difficult theory… upon which a plaintiff might hope to win a judgment.

Whether this decision opens the door for Delaware case law to evolve remains to be seen. In the meantime, directors should consider the following advice:

Never truncate the oversight process by merely listing risks. Align the board’s oversight with the company’s most significant risks, given its strategy and business model. Listing the company’s risks from time to time and doing nothing else falls short of effective oversight. Prioritize the most critical risks and focus on them.

Allow time on the board agenda for risk oversight, and set risk escalation and monitoring protocols. Executives responsible for managing risk should be positioned to succeed with policies, processes, reporting, and systems appropriate to the industry. Risk management issues should be discussed regularly. In understanding who is responsible for the key risks, the broad strokes of the risk responses in place, and the nature of arising issues, the board should ask questions to satisfy itself that mission-critical matters are escalated in a timely manner to its attention, especially those related to compliance.

Pay attention to company culture. Organizational culture and performance incentives were highlighted in the case against Blue Bell because it was inexplicable to stakeholders that management did not inform the board of the matters in question. The board must have confidence that management will act promptly to inform it when mission-critical issues of any nature arise. Setting specific and clear expectations of management and risk owners who are tied to mission-critical risks, and including relevant topics at regularly scheduled meetings, would help the board attain that confidence and nurture a culture of trust and open, timely communication about emerging problems.

Delineate full board and standing committee roles. The complaint against Blue Bell Creameries alleges that, despite the importance of food safety, the board had no committee overseeing it, no full board-level process to address it, and no protocol by which the board expected to be advised of developments relating to it. When delegating responsibilities to its committees, the full board should ensure the key risks are covered by the appropriate committee—whether it currently exists or has to be created and newly chartered—and that information flows are sufficient to apprise the full board of critical matters.

Maintain minutes concerning critical risk matters. According to the court, “minutes from the board’s […] meetings are bereft of reports on the listeria issues […] [and] revealed no evidence that these were disclosed to the board.” The court’s findings suggest an expectation that management will escalate mission-critical matters to the board on a timely basis, that the board will set protocols for such escalation, and that there will be evidence in the minutes that such matters were discussed by the board. It was troubling to the court that the board left the company’s response to the listeria outbreak to management instead of holding more frequent emergency board meetings to receive ongoing updates.

The Blue Bell Creameries case is based on unique facts dealing with a food safety and compliance matter. Nonetheless, the court’s decision is a wake-up call for boards to ensure that their risk oversight processes meet or exceed fiduciary standards and take into account the unique regulatory demands of the industry.

Jim DeLoach is managing director at Protiviti.

Comments

Jim DeLoachAugust 17, 2019

Thank you, Mark, for commenting. I agree completely with you that the Board is not expected to manage risk but rather is expected to provide the oversight that gives it assurance that management is getting the job done. I also agree that the Marchand decision offered some clarity on the Caremark standard, particularly on the relationship between duty of care and duty of loyalty. An excerpt from the Marchand decision that I did not cite in my blog tells the story: "If Caremark means anything, it is that a corporate board must make a good faith effort to exercise its duty of care. A failure to make that effort constitutes a breach of the duty of loyalty." That is exactly what happened in the Blue Bell case, according to the court's ruling.

Mark FlynnAugust 14, 2019

The Blue Bell case, in my view, represents a continuing evolution of the Caremark standard. The Board’s oversight obligation is triggered by known risks and regulatory compliance obligations even in the absence of actual violations. However, it is not the Board’s responsibility to manage the risk but to assure itself that management has reasonably designed policies, procedures and practices in place to effectively mitigate known risks. This requires adequate education and understanding of the nature and severity of this risk as applicable to the specific enterprise and ongoing oversight.