From Director Liability to Officer Liability to Esg Caremark Claims: a Natural Evolution?

• Publication year: 2023

From Director Liability to Officer Liability to ESG Caremark Claims: A Natural Evolution?

Gareth McHugh

FROM DIRECTOR LIABILITY TO OFFICER LIABILITY TO ESG CAREMARK CLAIMS: A NATURAL EVOLUTION?

Abstract

With the McDonald's decision, officers and directors could face Caremark liability for the first time, and this decision could also lead to an influx of ESG-based Caremark claims in Delaware Courts. This Comment explains that, while ESG Caremark claims would force corporations to adopt ESG oversight systems to avoid liability, the very political, social, and legal environment that created a growing call for ESG Caremark claims presents a beneficial opportunity for corporations to appeal to consumers and investors by proactively adopting ESG oversight systems. Corporations are at a nexus where they can either willingly adopt ESG oversight systems and reap the benefits or wait until the courts or the government force their hand, miss the opportunity, and simultaneously face fines.

Table of Contents

Introduction..........................................................................................250

I. The Public and Governmental ESG Atmosphere...................253
II. Pre-Marchand: the Difficulty in Proving a Caremark Claim............................................................................................258

A. Unsuccessful Caremark Claims............................................... 258
B. What Constitutes a Proper Overwatch System? ....................... 265

III. Post-Marchand: The Rise of Caremark Liability Claims.......268
IV. The Financial Repercussions of ESG Caremark Liability......274

A. The Ideal Overwatch System ................................................... 275
B. Mitigation of ESG Caremark Oversight System Costs ............. 275

Conclusion.............................................................................................278

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Introduction

The potential personal liability that corporate directors and officers face for a failure to oversee the corporation expands greater than ever, so it is only fair that corporate opportunity expand with it. Caremark claims, which originate from In re Caremark International Inc. Derivative Litigation,¹ establish a cause of action for shareholder derivative suits that allows the board of directors' liability for a failure to oversee the corporation based on a director's duties of care and loyalty.² As the Delaware Court of Chancery in In re Caremark explained:

[A] director's obligation includes a duty to attempt in good faith to assure that a corporate 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 non-compliance with applicable legal standards.³

Modern Caremark liability cases have established a two-prong test for Caremark claims. Corporate directors can be found liable if they either "utterly failed to implement any reporting or information system or controls" or, "having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention" can prove liability.⁴ In re McDonald's Corp. seemingly adapted this two-prong test to apply to corporate officers.⁵ Corporate boards implemented oversight, or overwatch, systems to protect themselves from Caremark liability.⁶ In the Caremark context, oversight systems monitor a corporation's regulatory compliance risks and involve reporting and addressing these risks at the board or executive management level.⁷

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In recent years, there was an increase of Caremark claims in Delaware courts. These claims normally focus on regulatory aspects and a failure to monitor corporate compliance with state and federal law, especially financial and product liability focused regulations.⁸ However, Caremark claims' rise coincided with a growing call for companies to focus on environmental, social, and corporate governance ("ESG") issues.⁹ In fact, "83% of consumers think companies should be actively shaping ESG best practices."¹⁰ ESG is a broad area, and issues under its umbrella include environmental sustainability, climate change, resource scarcity, labor practices, talent, product safety, data privacy, diversity, inclusion, sexual discrimination and relationships in its local communities, executive and board compensation, internal audits and controls, anti-corruption, and shareholder rights.¹¹ That some ESG aspects remain unregulated and voluntary rather than mandatory furthers this complexity. For instance, while the Clean Air and Water Acts heavily regulate environmental protection, diversity and inclusion initiatives remain mostly voluntary for corporations, with some efforts even encountering litigation.¹² Thus, corporations must determine the value of adopting those still unregulated ESG aspects. Corporations that impose voluntary ESG requirements perhaps agree with Merrick Dodd's argument that corporations are not just vehicles for

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creating money but must also contribute to the community.¹³ Some scholars directly tied Caremark claims and ESG together and advocated for ESG-based Caremark claims.¹⁴

With the Delaware Court of Chancery's landmark ruling in In re McDonald's Corp. Derivative Litigation, corporate officers and directors can face Caremark liability for the first time since Caremark claims' creation nearly 30 years ago.¹⁵ The In re McDonald's decision carries the potential for a second transformation of Caremark claims. In In re McDonald's, a former vice president faced liability because he consciously ignored sexual harassment notices in the workplace and did not create an oversight system to monitor human resources.¹⁶ Instead of a failure to oversee finances or products, In re McDonald's directly addressed a corporation's failure to oversee the ESG issues of gender and sexual harassment. In re McDonald's could signal the welcome of more ESG-based Caremark claims in the Delaware legal system.

With ESG Caremark claims' potential expansion, corporate officers and directors may risk liability if they do not adopt ESG oversight systems. But, beyond avoiding liability for corporate officers and directors, corporations that implement ESG oversight systems can gain important benefits. In this comment, I analyze consumer trends, the political environment, case law, current monitoring systems, and potential costs to explain those benefits, and I advocate for corporations to voluntarily adopt ESG oversight systems.

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I. The Public and Governmental ESG Atmosphere

The McDonald's decision outwardly indicates the Delaware Court of Chancery's openness to ESG Caremark claims, and there is growing public and governmental support for ESG initiatives. According to PricewaterhouseCoopers, "well over half of all consumers (59%) say a company's purpose and values play an important role in their purchasing decisions," and "younger consumers (17-38 years) are almost twice as likely to consider ESG issues when making purchasing decisions than consumers over 38 years old."¹⁷ It is not just consumers that care about ESG. Corporate employees and investors push for ESG objectives.¹⁸ If corporations adapt this push, they can benefit from it too, as almost 25% of investment in the U.S. went toward ESG-oriented corporations in 2019.¹⁹ This, with consumers' increasing willingness to change their buying habits based on a corporation's perceived ESG attitude, creates an incentive for corporations to adopt ESG goals and objectives.²⁰

The growing call from the public for ESG focused corporations bleeds into inner corporate operations. Shareholder activist campaigns are increasingly common and increasingly hostile toward corporate boards.²¹ This results in votes against corporate directors.²² In fact, a shareholder activist campaign focused on environmental sustainability ousted two Exxon Mobil board members.²³ This atmosphere created a "race to the top, where the top corporations are trying to 'out green' one another" to appeal to shareholders, investors, and even employees.²⁴

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The federal government increased its emphasis on ESG-related issues as well, especially ESG reporting. Since the Biden administration encouraged environmental protection in its policy implementation, even federal bills not strictly focused on the environment contain terms aimed at helping the environment. For example, the Inflation Reduction Act provides for clean-energy tax credits, rebates for green vehicles, and rewards for oil and gas companies for cutting methane emission.²⁵ In total, the Biden administration added 57 environmental policies and overturned 83 of the Trump administration's less environmentally friendly policies.²⁶

The Biden administration's environmental protection laws and regulations add to an already extensive body of regulatory law, particularly the Clean Air and Water Acts. The Clean Air Act allows the EPA to set a standard for air quality and require that states adopt plans that meet this standard.²⁷ The Clean Water Act similarly allows the government to set water quality standards and controls companies' discharge in waterways.²⁸ The Clean Water and Air Acts stand out as some of the earliest ESG regulations, having passed in 1972 and 1970 respectively.²⁹ While the Biden administration's policies mostly relate to greater environmental regulation and protection, the Securities and Exchange Commission ("SEC") under the administration focuses broadly on ESG issues.

Several proposals from the SEC aim to require ESG disclosures in more situations. Foremost, an SEC proposal from May 2022 would require investment funds that consider ESG factors to make disclosures to the government regarding their strategies in fund prospectuses, annual reports, and adviser brochures.³⁰ The requirement would apply to the...