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BOARD MEMO 2021

'Caremark' and Section 220 requests

Mary
Eaton

Partner, New York

Meredith Kotler

Meredith
Kotler

Partner, New York

In last year’s board memo we discussed recent trends in Delaware litigation including the Marchand and Clovis decisions (which allowed Caremark failure of oversight claims to proceed past the pleading stage), and the continued use of Section 220 requests for books and records. Developments in 2020 show these trends will remain relevant to boards as we head into 2021.

Caremark litigation

The Delaware Supreme Court’s decision in Marchand v. Barnhill took many by surprise, given that Caremark claims are hard to plead and prove. In 2020, we saw three more Court of Chancery decisions upholding Caremark claims at the pleading stage: Inter-Marketing Group USA, Inc. v. Armstrong; Hughes v. Hu; and Teamsters Local 443 Health Services & Insurance Plan v. Chou.

In Inter-Marketing, the Court of Chancery permitted a Caremark claim to proceed in a derivative action alleging an utter failure to implement or properly oversee a pipeline integrity reporting system, which resulted in a pipeline rupturing and spilling 3,400 barrels of oil into an environmentally sensitive part of the West Coast. In permitting the claim to proceed, the court gave significant weight to trial testimony of the company’s CEO in California criminal proceedings in which he testified that pipeline integrity was “not discussed at the board level.” In Hughes, the court permitted a Caremark claim to proceed where the allegations supported an inference of a conscious failure to monitor or oversee operations in connection with the company’s financial reporting, which resulted in the restatement of three years of financial statements. In particular, the company’s audit committee was alleged to have met sporadically and only when required by the federal securities laws, and their “abbreviated meetings” suggested that they devoted inadequate time to their work, particularly given known internal controls issues. In addition, according to the allegations, the audit committee frequently acted through written consent, as opposed to addressing issues during live meetings, and the company’s outside auditor, which was later sanctioned, failed to adequately identify and report key issues relating to the company’s financial performance (and when it did, the audit committee failed to follow up or investigate). Similarly, in Teamsters, the court sustained another Caremark claim, finding sufficient for purposes of a motion to dismiss plaintiff’s allegations that the board consciously failed to monitor the company’s operations and ignored multiple red flags relating to the company’s manufacture and distribution of pre-filled syringes of oncology medications. Specifically, the board was alleged to have ignored a negative assessment from outside counsel regarding the company’s compliance program, a qui tam suit was presented to management but never reported to the board, and a DOJ subpoena and FDA search warrant were not discussed by the board.

When analyzed together with Marchand and Clovis, we can see some common themes continuing to develop. It is becoming clearer that the alleged failure of oversight relating to “mission critical” risks is what separates the successful Caremark claim from the unsuccessful one, at least for purposes of surviving a motion to dismiss. These recent cases make it all the more critical for board minutes and other corporate records to meticulously document each of the steps the board has taken in exercising its duty of oversight. Indeed, the post-Marchand cases have reaffirmed the importance of Section 220 requests in successfully pleading Caremark claims, and courts appear to be more willing to permit claims to pass the pleading stage where the board records do not clearly reflect a diligent board following up on red flags.

Section 220 Demands

It is thus not surprising that we continue to see a rise in the use of pre-litigation Section 220 demands. The scope of available documents varies by court, and Courts of Chancery continue to distinguish between formal board materials (e.g., minutes, other board-level documents that evidence deliberations and decisions) and informal board materials (e.g., emails, texts and other communications), with the former being routinely discoverable and the latter typically (though not always) available only upon a proper showing by the plaintiff.

In addition, several issues related to Section 220 demands that were raised in dicta in the Court of Chancery’s decision in Juul Labs, Inc. v. Grove could lead to additional litigation in the future. First, the court questioned whether the internal affairs doctrine would bar a stockholder from bringing an inspection action outside of Delaware, setting up the possibility that a stockholder could use the inspection statutes of a non-chartering jurisdiction to obtain books and records. Since many companies are chartered in Delaware but have their principal places of business elsewhere, this option could become a frequent tool of prospective plaintiffs seeking a more favorable forum. Second, the court noted that while Delaware courts have historically rejected companies’ efforts to limit or eliminate inspection rights, there were “strong countervailing considerations” in favor of allowing such waivers, “including Delaware’s broad recognition of parties’ ability to waive other important rights, whether constitutional or statutory”. The court suggested that one relevant factor in determining the viability of a waiver of inspection rights was whether it appeared in a unilateral or bilateral agreement, with the latter being more likely to survive scrutiny. As Juul Labs will not be the last word on either of these issues, further developments are expected.