Investor lawsuits seeking to hold directors liable for failures in their oversight duties were bolstered in June by a case involving Blue Bell Creameries. Marchand v. Barnhill did not signal a change in law, but it did affirm a legal standard that boards that fail to make a good faith effort to oversee a material risk area breach their “duty of loyalty.”
Legalese aside, the Blue Bell case provides a compelling example for directors to examine. While legal standards set a high bar, Marchand demonstrates that, in certain circumstances, ignorance about poor risk management is not a defense against board liability.
The details around the lawsuit are well-established. A 2015 listeria outbreak linked to three deaths caused Blue Bell Creameries to shut down production, recall all products, and later reduce its workforce by more than one-third. An investor suit alleged senior management disregarded warnings about contamination risks and kept the board in the dark about the issue.
From 2009 through 2014, regulators identified numerous health safety compliance failures. Yet, even though several positive tests showed the presence of listeria, including one test from an independent lab, board minutes reflected “no board-level discussion of listeria.”
Despite what would appear to be a glaring lack of board oversight, the Delaware Court of Chancery dismissed the case in fall 2018, ruling the plaintiff failed to show that directors had breached their “Caremark duties.”
What Are Caremark Duties?
Caremark duties are the result of a 1996 Delaware Chancery Court decision in the derivative action case brought by shareholders of Caremark International Inc., alleging the board of directors breached its duty of care by failing to put in place adequate internal control systems. The Caremark Rule that came from the case, and set a precedent for future director liability claims, states, “a director’s obligations includes a duty to attempt in good faith to assure that a corporate compliance information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by noncompliance with applicable legal standards.”
Cutting through the legalese again, Caremark establishes an obligation for directors to at least try to make sure “a reasonable board-level system of monitoring and compliance” is in place. Failing to do so could make directors liable for losses relating to compliance failures.
In Marchand, the Delaware Supreme Court overturned the lower court’s dismissal, concluding “the complaint supports an inference that no system of board level compliance monitoring and reporting existed at Blue Bell.” The court noted the board failed to establish a committee to monitor food safety or devote time in meetings to discuss food safety compliance. Of significance is the court’s opinion that “... food safety was essential and mission critical.”
Protecting Against Caremark Failures
Reasonable and informed directors typically should not have to worry about Caremark failures. As the Delaware Supreme Court made clear, boards get into trouble when they ignore their oversight responsibilities.
There are valuable lessons in the court’s findings in Marchand that can help protect boards and head off behaviors that make them vulnerable to successful Caremark claims. It is important to note that the court’s findings that follow center on the Blue Bell board’s failure to understand its “mission-critical” risk: food safety.
Blue Bell had no board committee that addressed food safety. Boards must understand what is mission critical for their organization, whether it’s food safety at Blue Bell or data protection at Facebook, and assure that it has systems in place to monitor compliance with mission-critical regulations.
Blue Bell management was not required to keep the board informed about food safety compliance practices. Boards cannot assume management will bring all problems to their attention, and, therefore, must be proactive in seeking out information about compliance with mission-critical risks.
Blue Bell had no regularly scheduled discussions about food safety. Mission-critical risks must be discussed and assessed on a routine basis by the board.
Blue Bell’s board received favorable information about food safety but negative information was not shared. Boards cannot assume that management will willingly present the bad along with the good. It must establish processes to discover all relevant information from management and seek additional reliable sources of information, including turning to internal audit to provide independent assurance on the accuracy, completeness, and timeliness of the information the board receives, particularly around mission-critical risks.
Blue Bell board minutes reflect meetings were “devoid of any suggestion that there was any regular discussion of food safety issues.” Traditional approaches to protecting the board include limiting details in minutes, which often only reflect official board actions. In Blue Bell’s case, this strategy backfired in that the official account of business reflected that no time was spent discussing mission-critical issues.
The Marchand case and its relevant Caremark implications are but one of a growing number of pressure points on boards relating to oversight duties. As the list of governance failures and scandals grows, regulators, investors, and the general public are demanding more oversight and more accountability.
A February article in Business Law Today eloquently articulates the need for a fundamental change in how board directors approach their jobs:
“A substantive checks and balances approach addresses the roles, responsibilities, and relationships among the key elements and players in a firm’s governance, controls, and oversight system. Institutional investors, individual investors, and other market and regulatory interests increasingly demand that those involved in corporate governance recognize their responsibilities and are held accountable in addressing these responsibilities. An additional emerging expectation is that senior leaders in an organization, both board and management, recognize that a leader’s role is one of service rather than entitlement.”
The article goes on to say that governing structures that consolidate power and authority into fewer hands often fail if individuals in power feel entitled to do as they please. It adds that boards must be involved in formulating checks and balances and take active roles in executing them. “Carrying out these active roles will necessarily lead to regular interaction with the CEO and others in senior management as well as with a company’s internal and external auditors,” the authors write. “While tone at the top may sometimes remain only as words that do not actually affect behavior, the institution of checks and balances can exert considerable influence.”
These fundamental changes won’t happen overnight, especially in organizations with entrenched systems and practices. But clearly the era of boards providing obsequious approval to management is over. To continue to do so is not just counter to prevailing investor sentiment, it also makes boards increasingly susceptible, as demonstrated in Marchand.
Such a transition cannot happen without a system of effective checks and balances, as described in the Business Law Today article. Given this current environment of increased exposure, boards would do well to seek internal audit’s independent assurance and advice on critical issues.