Caremark Liability Following The SEC's New ESG Reporting Requirements

• Jurisdiction: United States,Federal,Delaware
• Law Firm: Mintz
• Subject Matter: Corporate/Commercial Law, Environment, Corporate and Company Law, Corporate Governance, Environmental Law, Securities, Shareholders
• Author: Jacob Hupart, Douglas P. Baumstein, Jonathan Kravetz, Ellen Shapiro and Will G. McKitterick
• Published date: 13 January 2023

Recent developments in the Court of Chancery concerning a corporate board's duty to monitor and provide oversight over a corporation's operations, so-called Caremark claims, are likely to intersect with the SEC's proposed new ESG disclosure obligations to create a new category of corporate risk. Over the next several years, corporations are likely to face litigation focused on their climate-related actions and reporting surrounding them. In this article, we discuss recent trends in Delaware law that have led to a revitalization of Caremark claims (Part I), the SEC's current proposals for enhanced ESG disclosure (Part II), the likely intersection of these two trends, which can be expected to result in litigation and other corporate risk (Part III), and some commonsense steps corporations can take to mitigate this potential new category of risk (Part IV).

1. The Re-emergence of Caremark Claims

One of the more notable developments in Delaware case law in recent years has been the revitalization of "Caremark duty" claims. The Court of Chancery first annunciated that corporate directors have an affirmative duty of oversight to monitor so called "mission-critical" aspects of their business in In re Caremark Int'l Inc. Deriv. Litig., 698 A.2d 959, 970 (Del. Ch. 1996). Caremark actions were once notoriously difficult to plead-in explaining the doctrine, the Chancery Court famously called it "the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment." Id. at 967. As a result, Caremark claims frequently resulted in early dismissals. In recent years, however, the Delaware courts have breathed new life into the Caremark doctrine by allowing these types of claims to proceed to discovery. See, e.g., In re Boeing Co. Deriv. Litig., 2021 Del. Ch. LEXIS 197, at *1-*3 (Del. Ch. Sept. 7, 2021).

Caremark itself concerned the board of a health care company accused of violating certain federal and state laws and regulations that bar healthcare providers from paying referral fees for Medicare and Medicaid patients. Id. at 961-62. As a result of this alleged misconduct, Caremark and various Caremark officers faced multiple criminal indictments and five separate derivative actions for breaches of the duty of care. Id. at 964. After resolving the criminal indictments via a negotiated guilty plea, the company agreed to settle the derivative actions, and the court approved the parties' proposed settlement as "fair and reasonable." Id. at 970.

In its opinion approving the settlement, the Court of Chancery articulated the oversight and monitoring responsibilities of a corporation's board of directors under Delaware law. The duty of oversight, a subsidiary of the duty of loyalty, requires that a board "exercise a good faith judgment that the corporation's information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations." Id. at 970. According to Chancellor Allen, most corporate decisions do not need director supervision. Id. at 968 ("Legally, the board itself will be required only to authorize the most significant corporate acts or transactions: mergers, changes in capital structure, fundamental changes in business, appointment and compensation of the CEO, etc."). There are instances, however, where a board may be liable for "a sustained or systematic failure . . . to exercise oversight-such as an utter failure to attempt to assure a reasonable information and reporting system exists." Id. at 971.

Since Caremark, "duty to monitor" claims have typically involved allegations of some form of illegal activity on the part of employees concerning a "mission critical" aspect of a company's business, and a claim by plaintiff that the alleged unlawful conduct would not have occurred had directors properly exercised oversight. While no court has explicitly defined "mission critical," case law suggests that the term refers to core aspects of a corporation's operations that are essential to the success of the company.¹ Furthermore, the Delaware courts have distinguished between two distinct types of Caremark claims. The first type of claims concern a board's failure to implement a system of controls to prevent some unlawful misconduct that occurred. A plaintiff must plead the "directors utterly failed to implement any reporting or information system or controls." Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006). The second type of claims concern a failure to monitor by the directors. A plaintiff must plead the board "consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention." Id.

Caremark claims are notoriously difficult to plead in large part due to Caremark's stringent pleading standard with regard to demand futility requiring that a plaintiff "plead with particularity that the board cannot be entrusted with the claim because a majority of the directors may be liable for oversight failures," which is "extremely difficult to do." In re Boeing Co. Deriv. Litig., 2021 Del. Ch. LEXIS 197, at *2. In turn, Caremark claims historically were seldom brought. When plaintiffs did file, they rarely succeeded. In fact, for nearly two decades after Chancellor Allen's opinion in Caremark, there appear to be only six claims that ever survived a motion to dismiss.²

Nevertheless, the Caremark doctrine was returned to potency in 2019 following the Delaware Supreme Court's decision in Marchand v. Barnhill, 212 A.3d 805 (Del. 2019). That case arose from a listeria outbreak at a Blue Bell ice-cream manufacturing plant that killed three consumers and sickened many others. The outbreak forced the company to recall its products, shutter its plants, and accept a dilutive private equity deal. In response, a plaintiff-stockholder brought a derivative Caremark suit against Blue Bell's directors for failing to oversee and monitor the company's food safety operations.

The Delaware Supreme Court ultimately overturned the Court of Chancery's dismissal of the action and held that "[u]nder Caremark, 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.'" Id. at 822. To be sure, the company did have safety practices in place, commissioned audits from time to time, and government inspectors reviewed Blue Bell's facilities. Id. at 823. But the Delaware Supreme Court held these efforts did "not imply that the board implemented a system to monitor food safety at the board level." Id. The board...