Law is a reflection of society, and corporate law is no exception. As we wrestle with broader questions around social justice, (very real) environmental risks, and the proper balancing of our long term societal goals, the proverbial corporate pendulum continues swinging away from the shareholder primacy model and towards a more holistic approach of the role of the corporation in society. In this context, so called ESG issues – an acronym for environmental, social, and governance – have taken center stage in the corporate debate. Although still amorphous and evolving, the term ESG now generally stands for the proposition that there are certain factors measuring the long term sustainability and ethical impact of a company that should be considered by the markets in addition to the more traditional metrics centered on short term economic value creation for the direct equity owners of the enterprise.
As ESG priorities continue to expand, the laws of corporations – both federal and state statutory and common law – will likely evolve to keep up with, if not become active participants in, the collective societal discourse on the topic. At the federal level, there is an ongoing debate as to the need to require companies to make or otherwise standardize ESG disclosures as part of the mandatory disclosure requirements of the Securities Exchange Act of 1934. More dramatic recent initiatives have included United Stated Senator Elizabeth Warren’s introduction of the Accountable Capitalism Act, which would mandate very large corporations to obtain a federal charter and obligate company directors to consider the interests of all corporate stakeholders, including employees and customers.
At the state law level, the debate has been equally intense among members of the academy, jurists, and practitioners, though concrete proposals are still modest. Many states’ corporations have for decades enjoyed the benefits of so-called “other constituencies” statutes, which allow corporate boards to consider – for the most part on a discretionary basis – the impact of board decisions on constituencies other than shareholders. Delaware, the leading state in the area of corporate law and by far the most popular jurisdiction for the incorporation of publicly traded companies, does not have an “other constituencies” statute in its corporate code, and directors’ guiding principle is to promote the value of the corporation for the benefit of its stockholders. In Delaware, directors may take into account the welfare of other constituencies, such as customers, employees, and the communities in which the corporation operates, but only if that consideration provides rationally related benefits accruing to the stockholders.
The precise scope of Delaware directors’ flexibility – or obligations – to take into account the welfare of other constituencies may become a fertile area for the development of Delaware case law in the coming years, as ESG issues continue to dominate the public discourse. A reminder as to how some of this debate might come into play in the courtroom, and how it might shape directors’ actions, comes in the form of the recent Delaware Supreme Court decision of Marchand v. Barnhill et al., No. 533, 2018 (Del. June 19, 2019). In Marchand, the Delaware Supreme Court reversed the Court of Chancery’s dismissal of a complaint against the board of directors of ice cream manufacturer Blue Bell Creameries, arising from their alleged failure to discharge their duty “to exercise oversight” by failing to implement any system to monitor Blue Bell’s food safety performance or compliance. Such failure resulted in a listeria outbreak in 2015 that caused the death of three people. Beyond the tragic loss of life, the outbreak caused the company to recall all of its products, shut down production at all of its plants, and lay off over a third of the workforce.
In In re Caremark Int’l, Inc. Derivative Litigation, 698 A.2d 959 (Del.Ch. 1996), and its progeny, Delaware courts articulated the scope of a board’s duty to monitor and oversee corporate risk. Importantly, liability for failure to monitor risk can only be imputed to individual board members where: “(a) the directors utterly failed to implement any reporting or information system or controls; or (b) 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. In either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.” Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006) (citing In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996)). But importantly, a breach of the board’s duty to exercise oversight is an act of bad faith in breach of the duty of loyalty, such that directors will generally not be exculpated from personal liability.
Since Caremark, the good faith duty to monitor risk has been addressed in hundreds of cases. Charles R. Ragan, Information Governance: It’s a Duty and It’s Smart Business, 19 Rich. J.L. & Tech. 12, 17 n.28 (2013). While courts have considered potential liability for failure to monitor risks, Delaware courts have been careful not to allow plaintiffs to use the duty to monitor as a vehicle to second-guess a well-informed board’s business decisions, including well-informed decisions regarding risk-taking. Notably, in In re Citigroup Inc. Shareholder Litigation, 964 A.2d 106 (Del. Ch. 2009), Chancellor Chandler rejected the plaintiffs’ claims that Citigroup board members breached their fiduciary duty by failing to prevent the losses incurred by Citigroup as a result of its substantial exposure to the subprime mortgage market. The Court held that the alleged warning signs cited by the plaintiffs were insufficient to imply knowledge of the need to oversee subprime mortgage investment decisions. The court reiterated its well established principle that “the mere fact that a company takes on business risk and suffers losses—even catastrophic losses—does not evidence misconduct and without more, is not a basis for personal director liability.”
In Marchand, the Court noted that one of the most central issues at Blue Bell Creameries was “whether it is ensuring that the only product it makes—ice cream—is safe to eat.” In that regard, the Court opined that the complaint against the board fairly alleged that before the listeria outbreak engulfed the company, (1) no board committee that addressed food safety existed, (2) no regular process or protocols that required management to keep the board apprised of food safety compliance practices, risks, or reports existed, and (3) the board meetings were devoid of any suggestion that there was any regular discussion of food safety issues. In sum, the Court noted that the complaint pled facts supporting a fair inference that no board-level system of monitoring or reporting of food safety existed. It went on to state: “Although Caremark may not require as much as some commentators wish, it does require that a board make a good faith effort to put in place a reasonable system of monitoring and reporting about the corporation’s central compliance risk. In Blue Bell’s case, food safety was essential and mission critical.”
It would be misplaced to characterize Marchand as an ESG case. After all, the Court noted the significant negative impact that the listeria outbreak had on shareholder value, as it led to a liquidity crisis that forced the company to accept a dilutive private equity investment. However, as ESG issues continue to be front and center in the national corporate debate, the case serves as a reminder of how these issues intersect with traditional analyses of fiduciary duties and the role of the board of directors.
As boards actively assess their role in the evolving corporate landscape, Marchand offers a reminder of the oversight obligations that Delaware courts have long imposed on directors under Caremark. Further, given societal concerns around ESG matters, Caremark might come to play a more prominent role in gently guiding boards and corporations towards more actively incorporating these concerns in their decision-making process.
With the above in mind the following are selected recommendations for boards to ensure that they properly comply with its risk management obligations:
- Actively identify mission critical risk areas for the corporation, and confirm that the full board or a duly appointed committee addresses and monitors these areas;
- Seek to implement a regular process or protocol that requires management to keep the board apprised of relevant developments;
- Schedule for the board to consider on a regular basis any key issues that are identified;
- Carefully preserve in board minutes or other contemporaneous records an accurate description of the role played by the board in identifying and monitoring high risk areas; and
- Cultivate a culture that encourages management to accurately elevate to the board a full realistic view of risk management and compliance.
This post comes to us from Eduardo Gallardo, a partner in the New York office of Gibson Dunn & Crutcher, who specializes in mergers & acquisitions and corporate governance. The opinions in this piece are solely his and do not necessarily represent the views or opinions of Gibson Dunn or any other partner of the firm.