Seyfarth Synopsis: The Delaware Chancery Court’s October 1 In re Clovis decision1 marks the second time in 2019 that a Delaware court has permitted a Caremark duty-to-monitor derivative claim against directors—considered “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment”2—to survive a motion to dismiss. While the Clovis Court did not purport to create a sea-change in Caremark jurisprudence, and emphasized the difficulty of pleading such a claim, the decision highlights that directors should take care to monitor compliance issues, especially in heavily regulated industries.
On October 1, 2019, Vice Chancellor Slights held in his fifty-page In re Clovis Oncology Inc. Derivative Litigation opinion that plaintiffs adequately pleaded a derivative claim against the company’s directors for failure to monitor the board’s compliance and reporting system.3 Specifically, plaintiffs alleged that the directors “ignored red flags” that Clovis was reporting the wrong metric from clinical trials of one of the company’s only potential products, a lung cancer drug.4
Named after the seminal 1996 In re Caremark decision, a claim that directors either fail to implement or to monitor a compliance system is notoriously difficult to plead.5 Clovis follows the Delaware Supreme Court’s Marchand decision in June as the second Caremark claim this year to survive a motion to dismiss.6 Both Clovis and Marchand involved fairly extreme circumstances, in which the directors’ alleged failure involved a mission critical product in a highly regulated industry. Both decisions are also carefully worded to highlight the high bar to stating a Caremark claim. These two decisions appear to signify that Caremark claims are viable, but only where the facts indicate a strong likelihood of knowledge that the directors are not doing their duty.
Clovis Factual Background
Clovis is an oncology drug company which allegedly had no products on the market and was resting much of its prospects on the potential success of a single developmental lung cancer drug.7 In testing the drug, the company used an industry-standard testing protocol which required each instance of tumor shrinkage to be “confirmed” (by observing it in a subsequent scan) before that instance could be included in the calculation of the trial’s success-defining metric, the objective response rate (“ORR”).8 But plaintiffs alleged that the Board regularly received reports indicating that Clovis was inflating the ORR by basing its calculation in part on unconfirmed responses, and did nothing despite Clovis continuously reporting this inflated ORR to the public and the FDA.9 Even though the directors allegedly knew of the inflated ORR as early as June 12, 2014,10 it was not until November 16, 2015 that Clovis issued a press release clarifying that the “confirmed” ORR was significantly lower.11 Once the confirmed ORR was revealed, Clovis’s stock price dropped 70%,12 prompting a series of securities fraud lawsuits (one of which settled for $142 million), an SEC complaint (leading to the entry of an “onerous” consent decree requiring Clovis to pay $20 million), and the launch of an FDA investigation.13
A Compliance System Alone is Not Enough: Caremark provides two separate “prongs” of potential director liability: (i) when directors “completely fail to implement any reporting or information system or controls” or (ii) when, “having implemented such a system or controls, [directors] consciously fail to monitor or oversee its operations . . .”14 Unlike the Delaware Supreme Court’s recent Marchand decision, which reversed dismissal on first-prong allegations that directors failed to implement a board-level compliance monitoring system,15 Clovis instead found second-prong allegations that the board implemented, but failed to monitor, such a system to be well-pled.16 Clovis should serve as a reminder that Boards cannot rest on the existence of a compliance system, and should instead maintain oversight of the system on an ongoing basis.
The High Bar to Pleading Caremark Claims Remains: Clovis involved well-pled allegations that directors “consciously ignored red flags that revealed a mission critical failure,”17 leaving the door open for future defendants to distinguish a case with less extreme allegations. The Court identified a “high bar” to pleading Caremark claims, which “require well-pled allegations of bad faith to survive dismissal—i.e., allegations ‘the directors knew that they were not discharging their fiduciary obligations,’ a standard of wrongdoing ‘qualitatively different from, and more culpable than . . . gross negligence.’”18 The Court was careful to note that Caremark “does not demand omniscience” on the part of directors.19 Rather, a plaintiff who wishes to state a claim under Caremark’s second prong must “well-plead that a ‘red flag’ of non-compliance waived before the Board Defendants but they chose to ignore it.”20
The Risk of Caremark Liability Increases For Instances of Heavily Regulated Industries, “Mission Critical” Operations, or Board Expertise: Like Marchand before it, Clovis highlights that “when a company operates in an environment where externally imposed regulations govern its ‘mission critical’ operations, the board’s oversight function must be more rigorously exercised.”21 The Clovis Court also emphasized allegations that the Board was “comprised of experts” and that it was reasonable to infer that the directors “would have understood” and “appreciated the distinction” between the reporting methods at issue.22 Thus, Caremark shows the increased liability risk for directors monitoring compliance in heavily regulated industries (e.g. pharmaceutical, food, telecommunications, and financial services), dealing with a mission critical issue (such as “monoline” companies relying on one product or service) or who have industry expertise.,
Plaintiffs continue to face an uphill battle when alleging Caremark claims. But Clovis, like Marchand, reinforces that directors must still take care to implement and monitor compliance systems—or they risk liability.
1. No. CV 2017-0222-JRS, 2019 WL 4850188, 2019 Del. Ch. LEXIS 1293 (Del. Ch. Oct. 1, 2019), available here.
2. Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362, 372 (Del. 2006) (quoting In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959, 967 (Del. Ch. 1996)).
3. Clovis, No. CV 2017-0222-JRS at 1-2.
4. Id. at 2.
5. Caremark. 698 A.2d at 967.
6. Marchand v. Barhill, 212 A.3d 805, 822 (Del. 2019) (reversing the dismissal of a Caremark claim alleging failure to implement any board-level compliance system).
7. Clovis, No. CV 2017-0222-JRS at 10.
8. Id. at 12, n. 68.
9. Id. at 14-19. The Court disregarded defendants’ argument that the FDA “blessed Clovis’ plan to report unconfirmed responses for ‘interim’ results because [the drug] was on an accelerated approval track” as outside the allegations in the Complaint, noting that whether Plaintiffs’ allegations “hold up during discovery, at summary judgment or at trial remains to be seen.” Id. at 41-42.
10. Id. at 14
11. Id. at 21.
12. Id. In addition, the Board was allegedly advised that the drug had “serious, undisclosed side effects” but “sat idle” while the Company misled the public and regulators about these side effects. Id. at 22-25.
13. Id. at 26-27.
14. Id. at 33 (internal brackets omitted) (quoting Marchand, 212 A.3d at 821).
15. Marchand, 212 A.3d at 822.
16. Clovis, No. CV 2017-0222-JRS at 38-42.
17. Id. at 42.
18. Id. at 33 (quoting Stone, 911 A.2d at 369–70).
19. Id. at 36.
20. Id. at 37.
21. Id. at 36 (citing Marchand, 212 A.3d at 824).
22. Id. at 39-40.
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