Saturday, August 29, 2020
When the Delaware Supreme Court decided Marchand v. Barnhill, a lot people wondered – including, ahem, me – whether it heralded a new approach to Caremark claims. Among other things, Caremark claims tend to be successful – if at all – upon a showing that the Board either participated in, or simply disregarded, illegality (in Elizabeth Pollman’s phrasing, were disobedient). Claims that the Board simply did not monitor sufficiently tend to be more of a theoretically possibility than a lived reality, or at least, that was the case until Marchand. Given the facts of Marchand, I speculated at the time that the choice to find potential liability on the basis of lack of monitoring was motivated by some desire to beef up the law in this area.
Which is why I found the decision in Teamsters Local 443 Health Services & Insurance Plan v. John G. Chou interesting, because to me, it reads like VC Glasscock, at least, plans to tread gingerly.
The plaintiffs alleged that AmerisourceBergen (“ABC”) violated the law in connection with its pharmaceutical business. For those keeping score, I must clarify that the allegations do not involve ABC’s violations of law in connection with the distribution of opioids – that case is pending before the Delaware Supreme Court with respect to a Section 220 dispute. Instead, this ABC case involves violations of law in connection with the distribution of cancer medication. Apparently, one of ABC ‘s subsidiaries had an entire business model of skimming the excess “overfill” medication off of cancer med vials, and then repackaging and selling it – lucrative for the subsidiary, but also extraordinarily dangerous and quite illegal because of the potential for contamination. Eventually, the whole thing ended in Specialty (one of ABC’s operating segments) pleading guilty to criminal charges and settling civil ones.
Glasscock began his analysis with a fun (for us law professors) summary of the theoretical issues surrounding Caremark claims:
The facts of Caremark claims ... often invoke judicial sympathies. Frequently, the facts of the case involve corporate misconduct that has led to material suffering among customers, or to the public at large. A judge in the Caremark context must be careful to remember the issues before her. At issue is not whether specific or society-wide victims may themselves receive a remedy for corporate misconduct. Instead, the issue is whether the corporation, whose directors have allegedly allowed it to commit bad acts, should itself recover damages that ultimately inure to the benefit of the corporate owners, its stockholders. This unusual posture raises the question of whether Caremark liability is merely a branch of fiduciary liability designed to make the beneficiaries of that duty whole for breach, or whether it should be seen also as a blunt but useful tool to encourage good corporate citizenship. That question is for academic discussion, not judicial resolution; again, a judge in equity must be mindful that it is the corporation, not that corporation’s victims, to whom any recovery will flow.
He then distinguished between the two flavors of Caremark: failure to monitor, and actively ignoring evidence of illegality:
Caremark claims can take two forms. A so-called “prong one” claim arises where “the directors utterly failed to implement any reporting or information system or controls.” Under “prong one,” “a director may be held liable if she acts in bad faith in the sense that she made no good faith effort to ensure that the company had in place any system of controls.” A “prong two” claim, on the other hand, arises where “having implemented such a system or controls, [the directors] consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.” To state a “prong two” Caremark claim, the Plaintiffs must “plead [particularized facts] that the board knew of evidence of corporate misconduct—the proverbial ‘red flag’—yet acted in bad faith by consciously disregarding its duty to address that misconduct.”
The Chou plaintiffs alleged both types of claims. With respect to failure to monitor, they claimed that Specialty was entire outside of ABC’s board-level compliance program, and ABC’s Audit Committee – which was responsible for compliance – was aware of that fact. Specifically, one of ABC’s officers commissioned a report from Davis Polk regarding ABC’s compliance, and Davis Polk reported its findings to the Audit Committee:
Important implications of Davis Polk’s findings were that Specialty was not integrated into ABC’s compliance and reporting function, and that oversight responsibilities were being left to officers and directors of the various ABC subsidiaries.
In the aftermath of the Davis Polk Report the Board and the Audit Committee did not follow through on Davis Polk’s recommendations. Indeed, [the relevant subsidiaries] were kept out of ABC’s compliance programs for the entire period of the [illegal program]....
This is the stuff that Marchand directly implicates, and therefore should be a slam dunk for liability, at least at the pleading stage, right?
Glasscock expressly declined to rule on whether the plaintiffs had stated a failure to monitor claim (though he did acknowledge a “lax approach (at best) to compliance,” slip op. at 70. Instead, he sustained the complaint solely on the ground that ABC had ignored red flags of illegal activity.
The Davis Polk report, he pointed out, was not simply evidence of failure to monitor; it was its own kind of red flag, at least when combined with other evidence. As he put it, the report put the Board on notice of “gaps in Specialty’s compliance, making the later red flags all the more consequential.” Slip op. at 57.
The other red flags? There was a qui tam lawsuit regarding the illegal conduct, which the Board necessarily knew about because it was disclosed in ABC’s 10-Ks, which the Board signed. The defendants claimed that the Board responded to those allegations – it did not consciously disregard them – but Glasscock concluded that the Board’s responses were in fact to a different qui tam case that potentially involved other drugs. Slip op. at 60-61. Board minutes showed some discussion of the relevant matter, but not necessarily any remedial action. Therefore, it was reasonably conceivable that the Board took no action in response to the suit.
And, there was a subpoena from federal prosecutors, which the Board necessarily knew about because it was also disclosed in the 10-Ks. And though the 10-Ks said the Board was responding to the subpoena, that didn’t necessarily mean the Board was investigating the underlying conduct. Slip op. at 67 (“[i]t is reasonably conceivable that ABC could respond to the subpoena, in the way of handing over the information requested, without taking any action with regard to the reason why the United States Attorney’s Office was asking for information…. I find that the absence of any discussion of the subpoena by the Board is sufficient to make reasonable the inference the Plaintiffs ask me to draw, that is, even after receiving the subpoena the Board did nothing to correct the underlying mission critical compliance shortcomings.”)
You know what was not a red flag though? The fact that the FDA received and executed a search warrant of the subsidiary’s operations in 2012. Why? Because there was no evidence the Board was aware of it. Unlike the other red flag allegations, the search was never mentioned in a 10-K. See slip op. at 66 (“It is not reasonable to infer that the Board consciously ignored a red flag with regard to the search warrant, because there is no well-pled allegation that the Board had knowledge of the search warrant or the raid, and hence the scienter required to adequately plead bad faith is absent.”).
In other words, just as Marchand seemed motivated to find potential Caremark liability based on a lack of monitoring, Glasscock seems pretty motivated to do the opposite. By sticking to the Board admissions of knowledge (while reading their actions extremely narrowly), Glasscock was able to cabin the case into well-trod Caremark ground, without the need to venture into the new territory explored in Marchand.
That said, Glasscock couldn’t quite escape one telling conclusion, which I imagine will be cited in many a future plaintiff’s brief going forward: “Calling attention to the hiring of law firms to review alleged illegality, without more, is insufficient to refute well-pled allegations that the Board failed to address mission critical compliance risks.” I.e., asking for a legal review? Does not satisfy Caremark.
And that’s where we are.