A NEW CAREMARK ERA: CAUSES AND CONSEQUENCES.

• Author: Shapira, Roy
• Position: Corporate director oversight duties

ABSTRACT

What role does corporate law play in holding directors accountable for compliance failures? Until recently, the answer has been "very little." The prevalent standard for director oversight duties ("Caremark duties) was set high, effectively demanding that plaintiffs show scienter without having access to discovery. As a result, derivative actions over directors 'failure of oversight were routinely dismissed at the pleading stage, and many commentators considered Caremark duties largely irrelevant. Yet starting in June 2019, a string of successful Caremark cases have signaled a new era of enhanced oversight duties. This Article contributes to our understanding of the new Caremark era along three dimensions. First, the Article delineates the contours of the shift in Delaware courts' approach to oversight duties. The courts now increasingly apply the "mission critical compliance" exception to justify enhanced duties, and lower the threshold for receiving information in order to investigate potential failure-of-oversight claims. Second, the Article identifies the drivers of this "new Caremark era," with special emphasis on the role of a seemingly disparate development in shareholders' right to information from the company. Shareholders now enjoy much better pre-filing discovery powers, which they can utilize to plead with particularity facts about how the board never even discussed a critical compliance issue, or how they knew about critical problems but chose to ignore them. Armed with these newfound pre-filing investigatory tools, shareholders can overcome what once seemed insuperable pleading hurdles. Finally, the Article evaluates the desirability of the new Caremark era, spotlighting its likely positive effects on information flows inside companies and the ability of the market to discipline corporate misbehavior (better reputational discipline), as well as the ways in which it nicely compensates for the blind spots of other enforcement mechanisms.

TABLE OF CONTENTS INTRODUCTION I. NEW TRENDS IN OVERSIGHT LIABILITY II. CAUSES: THE RISE OF SHAREHOLDER INSPECTION RIGHTS A. Corporate Law Puts a Premium on Pre-Filing Investigations B. Pre-Filing Investigations Determine the Fate of Caremark Claims C. What Changed? The Liberation of Section 220 1. Proper Purpose 2. Permissible Scope D. Other Causes besides The Rise of Shareholder Inspection Rights III. CONSEQUENCES: FACILITATING BETTER INTERNAL AND EXTERNAL ENFORCEMENT A. Facilitating Better Paper Trails B. Facilitating Reputational Discipline 1. Reputation through Litigation: A Short Primer 2. Reputation through Caremark Litigation C. Balancing the Flaws of Regulatory Enforcement and Internal Compliance 1. Problems with Regulatory Enforcement and Compliance 2. How the New Caremark Era Can Mitigate These Problems CONCLUSION INTRODUCTION

Compliance has become a key corporate governance issue across the globe. (1) Companies pour hundreds of billions of dollars into internal compliance programs meant to prevent and detect wrongdoing by their employees. (2) Regulators are constantly attempting to gauge the effectiveness of such internal compliance programs. Yet until recently, corporate law played a seemingly very limited role. The prevalent standard for director oversight duties (Caremark duties (3)) was set high, effectively demanding that plaintiffs show scienter without having access to discovery. As a result, derivative actions over directors' failure of oversight were routinely dismissed at the pleading stage, and many commentators considered Caremark duties largely irrelevant.

Against this background, it was noteworthy when, within thirteen months in 2019-2020, four Caremark claims succeeded in surviving the motion to dismiss (Marchand, Clovis, Hughes, and Chou). Practitioners immediately took notice, and started debating the meaning of the string of successful cases. Does it signify a meaningful trend of a "stricter Caremark era," (4) or is it merely a rare coincidence of cases with extremely egregious facts? (5) And if there is, indeed, a resurgence in director oversight duties, why now? What changed around 2019 that sparked the resurgence?

The answers, this Article suggests, are (1) "yes," and (2) "section 220." Yes, there is a trend of revamped director oversight duties. And this trend is here to stay, partly because it is driven by a seemingly disparate development in shareholders' rights to information from the company, nestled in D.G.C.L. [section] 220. (6)

Section 220 grants shareholders a qualified right to inspect the company's books and records. In recent years Delaware courts have liberalized their interpretation of section 220 requirements: both in terms of whether to provide internal documents (the "proper purpose" requirement), and in terms of what internal documents to provide (the "permissible scope" requirement). The courts now order provision of not just formal documents such as board minutes, but also informal electronic communications such as private emails or LinkedIn messages between directors. Armed with such newfound pre-filing discovery powers, shareholders and their attorneys can use the internal documents to plead with particularity facts that implicate directors' mental state and awareness, thereby overcoming the once-insuperable Caremark pleading hurdle. Plaintiffs can now more easily show that the board never even discussed a critical compliance issue, or knew about critical problems but chose to ignore them.

Indeed, section 220 actions--that is, litigation over what documents shareholders can get in order to investigate potential failure of oversight--should be considered themselves a part of the new Caremark era. Within the past year, plaintiffs have succeeded in getting internal documents, including sometimes emails, to investigate failures of oversight on the part of Facebook's directors in the Cambridge Analytica scandal, or AmerisourceBergen's directors in the opioid crisis, to name two examples. In other words, the trend is bigger than the Marchand-Clovis-Hughes-Chou quadfecta.

What changed is therefore not necessarily the standard for oversight liability, which is still a high bar, (7) but rather shareholders' ability to establish the facts and hold directors accountable. In a separate project I show how the expansion of section 220 has revamped judicial oversight of deal negotiations; (8) here I focus on how it has revamped director oversight duties as well. To be sure, there exist other factors contributing to the new Caremark era, beyond the increased emphasis on pre-filing investigations. Notably, Delaware courts have been carving a constantly-growing exception to the deferential standard, in the form of "mission critical compliance": in situations where meeting certain regulatory demands is critical to the firm's success, directors should be especially alert to yellow and red flags, and proactively monitor compliance. The combination of the courts' increased willingness to scrutinize directors' conduct in this context and plaintiffs' increased ability to document directors' conduct is likely to continue generating successful Caremark claims going forward.

Yet it is one thing to say that plaintiffs are now more likely to succeed in failure-of-oversight claims, and another to say that the new turn in Caremark litigation is desirable from a societal perspective. For one, the expansion of pre-filing discovery comes with its own set of costs, such as potentially bringing back the dreaded fishing expeditions through the backdoor. (9) And, critics may claim, thus far it has produced no meaningful benefits: success in section 220 actions or the motion to dismiss does not mean that these cases will ultimately be decided in favor of the plaintiffs. We therefore cannot conclude that the new Caremark era will generate more compensation for shareholders or better deterrence, the argument goes. In fact, such an objection misconstrues how Delaware corporate law works (deters). In corporate law, in general, corporate decision-makers practically never pay out of pocket for their misbehavior. (10) Yet deterrence cannot be measured solely on the basis of sanctions imposed in verdicts coming after a full trial.

Corporate law's impact on oversight rather comes from paying settlements ex post and, pertinently, planning how to avoid the risks and costs of litigation ex ante. Part of the law's effect on behavior comes from the memos that legal advisors send their clients, explaining how they should behave going forward. As this Article details, the new Caremark cases created a wave of law firm memos calling on boards to place compliance issues on the agenda and make sure deliberations are being properly recorded. Another part of the law's effect on behavior comes from imposing (uninsurable) non-legal costs, such as emotional costs (stress, embarrassment) and reputational costs (having details about your misbehavior dug out and made public for all other market participants to see). This Article illustrates how the expansion of section 220 has dramatically increased these non-legal costs for failure of oversight, thereby ramping up deterrence. In all, while it is still too early to empirically assess the costs and benefits of the new mode of Caremark litigation, this Article provides several indications that suggest it will, indeed, prove desirable.

The Article proceeds in three parts. Part I sets the stage by delineating the ebbs and flows of director oversight standards over the years, culminating in their recent resurgence. Part II explains why two important new developments in Delaware law, namely, director oversight duties and shareholder information rights, are intertwined. The resurgence of inspection rights led to a resurgence of oversight duties. Part III evaluates some of the consequences of the section 220 turn in Caremark litigation, such as an increased emphasis on documentation and upward flows of...