Avoiding the Risk of Fiduciary Litigation as a Result of the Pandemic — Steps Directors Should Be Taking

A board’s Caremark duties — the directors’ obligations to make a good faith effort to implement an oversight system and then to monitor it — are likely to be the focus of fiduciary duty litigation arising from the COVID-19 pandemic. As corporations suffer losses and the market value of their securities swings wildly, stockholders and other potential plaintiffs (creditors in a bankruptcy, for example) may bring suit contending that such losses somehow stem from a board's failure to implement and oversee procedures to identify and mitigate significant operational or legal risks. While the notion that a board should have anticipated and identified the risks attendant to the present global pandemic seems farfetched, boards can and should take steps now to avoid such litigation, by first strengthening their processes and then appropriately documenting the steps they take.

As explained in In re Caremark International, Inc. Derivative Litigation,^[1] as part of their fiduciary duty of loyalty, “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.” In two recent cases, Marchand v. Barnhill^[2] and In re Clovis Oncology, Inc. Derivative Litigation,^[3] Delaware courts permitted derivative claims against directors personally to survive beyond the motion to dismiss stage, holding that plaintiffs had adequately pled that the director defendants had failed at least one prong of their Caremark duties. In Marchand, the plaintiffs alleged that the directors of Blue Bell Creameries, a prominent ice cream manufacturer that suffered a listeria outbreak, had not implemented any board-level mechanisms to ensure that directors would receive adequate information to monitor food safety issues. Clovis Oncology focused on allegations that the board had failed to monitor significant drug development and regulatory protocol issues, again key risks to the company. But the Delaware cases emphasize that Caremark liability should be exceedingly rare. Delaware fiduciary law tends to be process-oriented. It is not the effectiveness of the controls that makes for the alleged bad faith fiduciary breach, but whether there were processes in effect. What offends Caremark is a complete failure or abdication of the board’s obligation to monitor significant operational or legal risk. Quoting Caremark, the Delaware Supreme Court in Marchand reiterated that proving such 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.”

To reduce their exposure in future fiduciary duty litigation, directors should review their processes and then document effectively what they have done. Accordingly, most boards will want to reassess the key operational and legal risks facing the company. Topics for consideration may include liquidity and finance arrangements; outlook and contingency planning regarding operations and personnel matters; any impact of the pandemic on the availability of essential personnel; impacts on the supply chain, customers and distributors; and revenue and expense outlook and earnings guidance. Privacy and cybersecurity issues should also be at the top of the list. Similarly, the board will want to assess legal compliance and regulatory matters and what the company’s regulators expect of it in the current environment.

Procedurally, boards and committees should consider meeting more frequently. Risks to the company should be discussed and updated at such regular and special meetings. Equally important, the processes of the board and its committees should be adequately and timely documented in contemporaneous minutes to evidence the directors’ oversight and diligence. Fiduciary litigation in Delaware is frequently preceded by a books and records request under Section 220 of the Delaware General Corporation Law. A corporation’s minutes and related board materials form part of what have been referred to as Formal Board Materials. These Formal Board Materials are generally the first priority of a books and records request and the materials a court will most likely require a corporation to provide to a demanding stockholder. In those instances, potential plaintiffs will scour the Formal Board Materials and may reference them in any complaint. The Formal Board Materials may form part of the record on consideration of a motion to dismiss. To the extent the minutes and board materials reviewed at or in preparation for meetings appropriately document the directors’ processes and monitoring of the company’s operational risks and compliance with the law, they may go a long way toward defeating meritless derivative litigation at an early stage. The Delaware courts also sometimes look askance at minutes that are prepared many months after the events, particularly when litigation already exists or is imminent. It is therefore helpful that the minutes be drafted and approved in a timely fashion.

Taking these procedural steps now will help ensure that directors receive the protections of the business judgment rule they deserve during the ongoing emergency caused by COVID-19.

^{[1] 698 A.2d 959 (Del. Ch. 1996).}

^{[2] 212 A.3rd 805 (2019).}

^{[3] C.A. No. 2017-0222 (Del. Ch. Oct. 1, 2019).}