Amidst a spirited debate around the duties of directors in relation to environmental, social, and governance (ESG) risks, two recent decisions from Delaware courts provide clarifying contours. The decisions are particularly significant since Delaware is the leading state for corporate law and the most popular jurisdiction of incorporation for publicly traded companies. Both decisions construe the scope of a board’s responsibility to monitor and oversee corporate risk under the standards set forth in In re Caremark Int’l, Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), and its progeny.
Caremark and Fiduciary Duty
Mission-Critical Compliance and Director Liability
The first case, Marchand v. Barnhill, 212 A.2d 805 (Del. 2019), involved Blue Bell Creameries, one of the nation’s largest ice cream makers. A listeria outbreak in early 2015 resulted in consumer deaths, serious injuries, a recall of all of Blue Bell’s products, a closure of its plants, and layoffs of one-third of its workers. A shareholder sued two executives and the board under Caremark, claiming they breached their fiduciary duties. The Delaware Court of Chancery granted the defendants’ motion to dismiss. On appeal, the Delaware Supreme Court reversed, noting that the plaintiffs had pled a valid claim that the board had “undertaken no efforts to make sure it [was] informed of a compliance issue intrinsically critical to the company’s business operation.” For Blue Bell, “food safety was essential and mission critical” and thus a “central compliance issue.” The plaintiffs reasonably claimed that the company had no board committee overseeing food safety, no board-level process to address food safety issues, and “no protocol by which the board was expected to be advised of food safety reports and developments.” It was not sufficient for Blue Bell to show that management was aware of the issues or that executives discussed “general operations” with the board. Good faith in this context required a monitoring system at board level for the specific mission-critical food safety risks.
The second case, In re Clovis, 2019 WL4850188 (Del. Ch. 2019), involved allegations of material misrepresentation regarding the success of clinical trials of a new cancer drug (Roci) by Clovis Oncology, a biotechnology company. Unlike in Marchand, two board committees were overseeing drug’s testing protocols and its public disclosures. The critical issue was whether, having established oversight, the board properly exercised its monitoring responsibilities. The Delaware Court of Chancery relied on Marchand in noting that boards must be attuned to “compliance issues intrinsically critical to the company.” In this case, “Roci was Clovis’ mission critical product.” Its success was central to the company’s valuation and capital raising. The board could thus reasonably be expected to understand the testing protocols and regulatory disclosure expectations related to the drug—and that management was misrepresenting the success of the clinical trials by relying on an incorrect application of the protocols. After FDA inquiries, Clovis publicly reported a much lower effectiveness rate under the proper protocol, and its stock plummeted. While the board thus had reporting systems in place, the court held that the complaint adequately pled a violation of Caremark’s second prong: a board must not ignore a “red flag” that is either “waived (sic) in [its] face” or “displayed” in a way “visible to the careful observer,” namely, “one whose gaze is fixed on the company’s mission critical regulatory issues.”
Mission-Critical ESG Issues and Director Liability
Marchand and Clovis help lay the foundation for claims against directors for oversight failures related to ESG and related risks. Both cases turn on “mission critical” regulatory compliance risks tied to core business pursuits. Importantly, while the decisions implicate “G” issues, the core business pursuits in both cases concern “S” risks related to public health. For global companies across sectors, a growing array of ESG issues increasingly play a similar role and are increasingly being regulated as such. The Sustainable Accounting Standards Board (SASB) framework—the ESG-materiality benchmark for conventional and responsible investors—identifies a wide range of ESG issues that “are likely to affect the financial condition or operating performance of companies within an industry.” Many of these arguably are, or will soon become, mission critical in the same way that food safety was to Blue Bell and testing protocols were to Clovis. For resource companies, human rights & community relations and ecological impacts are the heart of legal compliance and viable resource extraction. For technology and communications companies, privacy and data security are central to both regulatory compliance and brand value. For consumer goods, supply chain management plays a similar role, particularly given the lasting harm that civil society campaigns can inflict on shareholder value. And, with the tightening web of mandatory due diligence and disclosure regulation across jurisdictions, we are likely to see modern slavery and climate risk management become mission critical to a broad array of industries.
Marchand and Clovis represent a clarification rather than a fundamental reshaping of directors’ duties of loyalty. Boards are not expected to be omniscient, let alone omnipotent. But here are five steps that can help protect against claims of bad faith:
- Assess Key Risks. It is important for boards to understand the company’s material and mission critical ESG and compliance risks, not just its operations and business risks. Not all ESG risks will be material to most companies. Assessment is essential to develop efficient and effective monitoring systems. Generally, these risks exist throughout the sector, and further company-specific risks can be learned from non-financial audits, risk and impact assessments, and enterprise risk reports from management.
- Institute Systems. Boards should gain comfort that there is appropriate coverage, at the full board or committee level, of the critical ESG risks facing the company. That may mean reviewing board charters to confirm the mission critical ESG risks are adequately covered. Wherever responsibility is assigned on a board level, there should be systems in place so that management is regularly reporting on those critical risks.
- Include Expertise. Consistent with the admonishment in Clovis that board members are expected to respond to “red flags” that are “visible to the careful observer,” and that the board should be able to “infer” certain critical deviations, it is likely a good idea to include on the board at least one member with sufficient knowledge of the critical risk area to enable them to spot and comprehend its significance even without management explanations. Robust board training on the underlying risk and the potential red flags that warrant most attention can also be helpful.
- Act When Appropriate. When red flags or potential red flags arise—including possible material misrepresentation risks—they should be identified and addressed. Upon being informed of risks or problems related to the area of critical risk, consider whether to implement a heightened system of monitoring, such as setting additional meetings, requiring additional reports from management, or seeking independent expert advice. Leaving the response entirely to management is inviting a Clovis
- Document What You’ve Done. Document that critical risks and red flags have been discussed, mindful of potential litigation risk. Minutes from board meetings, and board materials, should not just reflect positive information or operational matters. They should demonstrate that the board received appropriate information about the critical ESG risks facing the company, and that the board spent time discussing those specific issues and challenges. The goal should be to create a record demonstrating oversight by the board, mindful that materials may be disclosable in future litigation.
It can be expected that Marchand and Clovis will spur additional challenges under Caremark, seeking to apply the rulings to other compliance and non-operational business risks. While the potential success of those claims remains hard to gauge, it is difficult to dispute that ESG risks are becoming increasingly material and more carefully regulated in general. Moreover, given the increased ESG focus of a broad array of investors—from pension funds to world-leading asset managers—additional board-level attention to critical ESG risks is going to be time well spent.
Jonathan Drimmer is a partner in the investigations and white collar defense practice at Paul Hastings, where he focuses on issues related to anti-corruption, complex multi-jurisdictional investigations, and environmental, social, and governance risks and disputes. He is a recognized international expert on anti-corruption and business and human rights, and is a frequent speaker, author and commentator on issues related to both topics.
Yousuf Aftab of Enodo Rights & Atelier Aftab is a sustainability lawyer and strategist with extensive experience helping Fortune 100 companies navigate ESG risks and crises. He is also the co-author of Business & Human Rights as Law (LexisNexis 2019).