Caremark: 10-K Disclosure Can Show Directors Ignored “Red Flags”
Last week, the Delaware Court of Chancery rejected a motion to dismiss in Teamsters Local 443 Health Services & Insurance Plan v. Chou — making it the latest in a string of Caremark claims that have made it past the pleadings stage. A blog from Ann Lipton explains the case — and notes that unlike other recent Caremark claims, VC Glasscock appeared to be much more cautious in finding a “failure to monitor.”
What tripped up the defendants in this case was the finding that the board had ignored red flags of illegal activity. The illegal activity involved a subsidiary that was pooling excess “overfill” medication from cancer vials into additional syringes, which led to contamination. A Troutman Pepper memo summarizes the three red flags that the plaintiffs adequately pled the board had ignored:
An outside law firm report had previously identified that Specialty, and by extension, Pharmacy, was not integrated into ABC’s compliance and reporting function, which according to the court, constituted a red flag that Specialty’s compliance mechanisms had substantial gaps that the audit committee had failed to follow-up on and rectify.
A former executive of Specialty had filed a complaint under seal in federal district court,alleging that Pharmacy’s business was essentially an illegal operation and, although ABC’s 2010 and 2011 Form 10-K disclosed the suit and was signed by ABC’s board of directors, the ABC board failed to take any remedial steps.
Specialty had received a subpoena from federal prosecutors which ABC believed, according to plaintiffs, related to the former Specialty executive’s action, which was subsequently disclosed in ABC’s 2012 Form 10-K, which was also signed by the ABC directors, and which was not referenced in the minutes of board or committee meetings.
The court found that it was conceivable that the board didn’t take any action to respond to the compliance report or either of the Form 10-K disclosures — therefore, the litigation is moving forward. This case highlights that directors who sign securities filings not only need to ensure that disclosure of legal proceedings and contingencies is accurate, but they also need to actually follow up on any concerning substance. As Troutman Pepper’s memo explains, those discussions should also be referenced in minutes:
Corporate fiduciaries and practitioners alike should be aware that corporate fiduciaries will be deemed to have knowledge of disclosures contained in filings and documents that they have executed (such as a Form 10-K). In this regard, it is especially important that directors are aware of, understand, and ask questions about what they are signing as a matter of compliance with their fiduciary duties.
In addition, Teamsters is evidence that minutes of board of directors and audit committee meetings will be heavily scrutinized in litigation. As applied in Teamsters, the absence of references to a red flag in minutes is equivalent to the board of directors or committee never having discussed the matter. Thus, counsel engaged in the representation of boards of directors and audit committees, as well as corporate officers, should be especially vigilant when drafting minutes in connection with the investigation and resolution of red flags.
Minutes should reflect that the risk or red flag was disclosed to the board or audit committee, that the board or audit committee followed-up on that risk and sought additional information, and ultimately, that the board either took at least some action to rectify that risk or red flag or determined that the risk or red flag was not necessary to further address.
-Liz Dunshee, TheCorporateCounsel.net September 2, 2020
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