Caremark Compliance for the Next Twenty-Five Years

Courtesy of Robert Bird

One of the most influential cases in corporate governance isIn re Caremark Inc. Derivative Litigation (Caremark).[1] In 1996, Caremark imposed a novel duty on boards of directors to make a good faith attempt to implement and exercise oversight over obligations leading to liability. In my manuscript titled, “Caremark Compliance for the Next Twenty-Five Years,” I explore recent subtle changes in Caremark liability and explore how boards can be best prepared for the compliance challenges of the next quarter-century.

Traditionally, boards did not have to do very much to withstand Caremark claims. Only “a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exits” would potentially expose the board to liability.[2] Breach of this minimal duty has been difficult for plaintiffs to plead and prove, and the caselaw shows a number of Caremark lawsuits that did not surmount the high proof requirements.

As Caremark approaches its twenty-fifth year, much change has taken place in corporate governance and society. When Caremark was decided, the internet was a new technology, extensive compliance demands tied to the behemoth health care law known as HIPAA had just been enacted, and the influential United States Sentencing Guidelines specifically targeted to organizations were less than five years old. Other major developments such as the financial crisis of 2007-09, the Dodd-Frank Act of 2010, and innumerable other compliance-related developments, had yet to transpire. The legal, ethical, social, and technological environments in which Caremark was decided are substantially different than today. The governance climate of 1996 is significantly different than the climate of 2020.

Marchand and Clovis

There is a sign that Caremark duties may be evolving. Two recent cases, Marchand v. Barnhill [3] and In re Clovis Oncology, Inc. Derivative Litigation,[4] merit close examination. In Marchand, lax food safety standards caused an outbreak of listeria in the ice cream facilities of Blue Bell Creameries. Three consumers died from eating tainted ice cream and more were hospitalized. The plaintiff alleged that Blue Bell’s board lacked a meaningful system of compliance to prevent key compliance risks from reaching the board of directors. In Clovis, a biopharmaceutical company inflated clinical trial test results to investors and regulators related to a promising and potentially lucrative drug therapy for treating lung cancer. Shareholders alleged that the board failed to properly oversee the clinical trial and let the company mislead the market about the drug’s effectiveness.

In both cases, the courts took the rare step of allowing Caremark claims to survive motions to dismiss. These decisions signaled a subtle relaxation of Caremark standards of liability. They showed a new understanding of Caremark that obligates boards to not merely attempt oversight, but to proactively ensure that such oversight is effective. This is a subtle but noteworthy change in board duties, and one to which the academic literature should respond. The Marchand and Clovis cases should prompt governance scholars to take a closer look at how Caremark will be interpreted today, tomorrow, and for the next twenty-five years.

Practitioners React to Marchand and Clovis

The manuscript upon which this blog post is based first examines the reaction of practitioners to Caremark after the Marchand and Clovis decisions. Practitioners, most commonly law firms and other professional firms, write public letters or advisories that inform their clients and the public about current legal issues. Client letters were gathered by conducting Google searches for publicly-available advisories that either interpreted Marchand alone or in conjunction with the Clovis decision. The results found that professional firms ably commented on the two cases from a variety of perspectives. Some firms reemphasized the need for changes in board composition in order to improve the management of compliance risks, such as by augmenting board member subject matter expertise and forming a separate subcommittee to deal with compliance issues. Ohers suggested changes to board practices, such as implementation of a robust reporting system or taking more detailed minutes of board meetings. Finally, a few firms recommended changes in how boards engage with management, such as setting explicit expectations for management and management processes regarding compliance matters. The results showed that, while professional firms are well-suited to offer tactical advice to respond to the immediate implications of court cases, professional firms are only somewhat willing to offer operational advice directed at the organization. Further, they generally do not offer long-term strategic analyses of boards future obligations to stakeholders.

This leaves open the question of how can boards of directors manage their Caremark compliance obligations for the long-term. Although Marchand and Clovis guide Caremark compliance today, firms must prepare for the Caremark compliance of tomorrow. The Caremark standard will most likely evolve as courts expect more and better oversight from boards on compliance, risk, and related issues. Decisions in the present may be reviewed by a court years later, when the legal, compliance, and risk management expectations of boards have changed.

Building a Culture of Compliance

One of the best ways that boards can reliably prepare for their long-term future of governance is through fostering a culture of integrity throughout the organization. Culture is not only an important organizational force, but is having an increasingly important influence on the legal obligations of companies. For example, the United States Sentencing Guidelines explicitly incorporates the presence of an ethical organizational culture into a firm’s culpability score in sentencing. A culture of integrity exists when all stakeholders in the organization are intrinsically motivated to govern themselves by voluntarily choosing legal, ethical, and compliance-focused behavior because they believe it is the best way to act for themselves and the organization. A culture of integrity embraces an adherence to both the letter and spirit of rules, and the incorporation of ethical standards beyond what is legally required.

Building a culture of integrity is no easy task. Any culture change, and especially one that aspires to integrity-based principles, cannot happen merely through a board mandate. Rather, the first place that boards must look to in order to establish a culture of integrity is in the mirror. This does not necessarily mean that boards lack integrity. Rather, it means that the dynamics of board interaction can raise invisible barriers that defeat an effort to make culture change work.

The next step a board must take is to promote a culture of integrity to others. Building a culture of integrity requires, first and foremost, an unwavering tone at the top. All C-suite executives, including the general counsel, chief compliance officer, chief executive officer, and of course the board of directors, must be committed to building a new culture. Such leaders must clearly express their values and commitments over the long-term and adhere to them even when they are personally or financially inconvenient.

Finally, boards must empower leaders to sustain these principles of integrity. This begins by ensuring employees are knowledgeable about the compliance processes and obligations to which they are directly accountable. Once employees begin to own their accountability, managers must enable employees to act upon this new value system and make independent decisions without prior approvals. As a culture of integrity takes root, employees should feel further empowered to challenge practices that contradict best in class compliance practices without fear of retribution. Through this ownership and engagement, a culture of integrity evolves from an abstract concept into a concrete practice of values-driven management that permeates the organization and fosters a best in class compliance program. Sustaining these principles, and allowing a culture of integrity to take root in the organization, will not only help boards protect themselves from Caremark claims, but also allow them to have a long-lasting and positive influence over their organizations.

 

Link to the manuscript: https://ssrn.com/abstract=3566279

 

[1] In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996), https://law.justia.com/cases/delaware/court-of-chancery/1996/13670-3.html

[2] Id. at 971.

[3] Marchand v. Barnhill, 212 A.3d 805 (Del. 2019), https://law.justia.com/cases/delaware/supreme-court/2019/533-2018.html

[4] In re Clovis Oncological Derivative Litigation, C.A. No. 2017-0222-JRS (Del. Ch. Oct. 1, 2019), https://law.justia.com/cases/delaware/court-of-chancery/2019/ca-2017-0222-jrs.html

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