Delaware Supreme Court Allows Caremark Breach of Loyalty Claim To Go Forward

On June 18, in Marchand v. Barnhill, the Delaware Supreme Court reversed a ruling by the Delaware Court of Chancery in a shareholder derivative suit alleging a breach of the duty of loyalty. While the standard for a director’s breach of the duty of loyalty remains a high bar to meet, cases such as Marchand illustrate that a complete failure on the part of a board of directors to create any processes that ensure the board will obtain adequate information on matters part and parcel of a company’s business may in fact satisfy this standard.

Under the duty of loyalty, as explained in In re Caremark International, Inc. Derivative Litigation,^[1] “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 in breach of the duty of loyalty.”^[2] In Marchand, the Delaware Supreme Court underscored that in the application of Caremark, it is the existence rather than the effectiveness of monitoring and reporting controls that is material to a breach of the duty of loyalty. In the event a court finds a breach of the duty of loyalty, its directors may face personal liability.           

The Marchand case centers on Blue Bell Creameries USA Inc. (Blue Bell), a large and prominent ice cream manufacturer. From 2009 to 2013, regulators found a series of troubling facts regarding Blue Bell’s food safety practices, including five positive tests for listeria, a type of bacteria found in contaminated food. The food safety issues culminated in 2015, when Blue Bell suffered a listeria outbreak, which led to financial hardship for the company and three deaths related to contaminated ice cream sold by Blue Bell. During this period, the Supreme Court found that the board had in place no mechanisms — such as a dedicated committee of the board to address food safety, a process or protocol to keep the board apprised of food safety compliance, or a regular schedule to review key food safety risks — to ensure directors would receive adequate information regarding food safety. Due to this failure, the board was not made aware of concerns raised on at least six separate occasions by the Food and Drug Administration and state regulators articulating the poor conditions in Blue Bell manufacturing facilities. Such concerns ranged from pipes leaking into open cartons waiting to be filled, spiderwebs near ingredients and standing water in manufacturing facilities. Although the management team consistently received reports of listeria in Blue Bell plants, the board did not receive any information or discuss food safety issues even as the conditions degraded. Blue Bell’s board was made aware of the food safety issues only when a limited recall of Blue Bell products took place in 2015. Yet when the board was finally informed, it simply delegated the company’s response to management, and adopted a resolution expressing support for the Blue Bell management team. In determining the complaint sufficiently alleged that the directors acted in bad faith, breaching their duty of loyalty to the company, the court focused on the board’s lack of oversight despite several reports from federal and state regulators regarding food safety.

Given the lack of oversight by the board in the realm of food safety, an area the court refers to as mission-critical to Blue Bell’s business, the Delaware Supreme Court held the facts in this case support finding of a breach of the duty of loyalty. In articulating their application of Caremark, the court noted that while applicable case law gives deference to boards to design contextually appropriate monitoring and reporting systems, a baseline good-faith effort must exist. Quoting Caremark, the Delaware Supreme Court underscored that proving a breach of the duty of loyalty “is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” In reaching its decision, the court emphasized the insufficiency of meeting regulatory standards as evidence of implementation of a system to monitor food safety at the board level, which would have been necessary to avoid a Caremark claim.

While this case doesn’t change Delaware law, it illustrates the possibility of meeting the often difficult Caremark standard. Going forward, this case underscores that the courts will consider the insufficiency of meeting regulatory standards as evidence of compliance with a director’s duty of loyalty. Every company needs to review its policies and procedures to ensure the adequate and timely flow of material information from management to the board of directors, including with respect to the monitoring and oversight of the principal risks the company faces.

^[1] In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch.1996)

^[2] Stone v. Ritter, 911 A.2d 362, 372 (Del. 2006)