A recent landmark case in the US shows the importance of directors overseeing core safety controls instead of leaving it all to management.

    Companies in industries where public safety is an issue must have adequate controls to monitor for, avoid and remediate breaches of applicable rules and standards. The complexity and opacity of some modern regulatory regimes can make this seem a Sisyphean task. But when those controls fail, the consequences can be disastrous for customers. The damage then flows on the company itself through ensuing private and regulatory litigation, and a loss of trust, business reputation and community standing. In these situations, shareholders may look to individual directors for recourse on the basis they failed in their duty to adopt and oversee adequate controls.

    A recent decision on directors’ liability in the US illustrates how controls can fail when boards do not take an active role in monitoring compliance. In Marchand v Barnhill 212 A.3d 805 (2019) the Delaware Supreme Court overturned the decision of a lower court and allowed a claim against directors in these circumstances to proceed to trial at the instigation of shareholders.

    The Marchand case arose out a catastrophic listeria outbreak in 2015 at Blue Bell Creameries USA Inc, one of the largest ice-cream manufacturers in the US. The outbreak resulted in a complete product recall and led the company to shut down production at all its factories and lay off more than one third of its workforce. Three people died. As Chief Justice Leo Strine of the Delaware court explained, “Less consequentially, but nonetheless important for this litigation, stockholders also suffered losses because, after the operational shutdown, Blue Bell suffered a liquidity crisis that forced it to accept a dilutive private equity investment.”

    In Delaware, as in Australia, shareholders cannot sue directors for breach of their duties, which are owed to the company itself. The claim belongs to the company. However, company law in both jurisdictions allows for shareholders to bring what is known as a derivative action, through which the company’s right to recover against a defaulting director can be activated. The conditions under which that can occur differ between the two jurisdictions, but the principle is the same.

    In Marchand, the Delaware court was faced with two legal questions to resolve. The first — essentially procedural — was whether the Blue Bell shareholders met the threshold conditions allowing them to commence derivative proceedings under Delaware law. The second was whether there was an arguable case that the directors and executives of Blue Bell had breached their duty of loyalty by failing to adopt and oversee adequate controls to ensure the company could meet the stringent food safety standards that governed its US manufacturing operations.

    "Caremark ‘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 risks’.

    As Chief Justice Strine pointed out, Blue Bell was a monoline business. As a single-product food company, food safety was of obvious importance. The plaintiff alleged that despite the critical nature of food safety for Blue Bell’s continued success, “management turned a blind eye to red and yellow flags that were waved in front of it by regulators and its own tests, and the board — by failing to implement any system to monitor the company’s food safety compliance programs — was unaware of any problems until it was too late”.

    Unlike Australian directors, Delaware directors typically cannot be sued for negligence. However, they can be sued for breach of their duty of loyalty under a principle explained in In re Caremark International Inc Derivative Litigation, 698 A.2d 959 (Del. Ch.1996). Caremark established that a Delaware director must make a good faith effort to oversee the company’s operations — and that failing to make that good faith effort breaches the duty of loyalty and can expose a director to liability.

    Bad faith is established, under Caremark, when directors completely fail “to implement any reporting or information system or controls” or “having implemented such a system or controls, consciously fail to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention”. Thus, under Delaware law, to satisfy their duty of loyalty, directors must make a good faith effort to implement an oversight system and then monitor it.

    In defending this case, the directors argued that, by law, Blue Bell had to meet federal and state regulatory requirements for food safety, and that the company had in place safety manuals for employees and commissioned audits from time to time. They emphasised that the government regularly inspected Blue Bell’s facilities and Blue Bell management got the results.

    The plaintiff argued there was no evidence the board implemented a system to monitor food safety at the board level. The company’s records indicated “no board committee that addressed food safety existed; no regular process or protocols that required management to keep the board apprised of food safety compliance practices, risks, or reports existed; no schedule for the board to consider on a regular basis, such as quarterly or biannually, any key food safety risks existed; during a key period leading up to the deaths of three customers, management received reports that contained what could be considered red, or at least yellow, flags, and the board minutes of the relevant period revealed no evidence these were disclosed to the board; the board was given certain favourable information about food safety by management, but was not given important reports that presented a much different picture; and the board meetings are devoid of any suggestion that there was any regular discussion of food safety issues”.

    The Caremark principle has been criticised as too lenient. Certainly, the threshold for director liability is higher in Delaware than it is in Australia. But the Delaware court emphasised Caremark “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 risks. In Blue Bell’s case, food safety was essential and mission-critical.

    The complaint pled facts supporting a fair inference that no board-level system of monitoring or reporting on food safety existed”.

    So where did the Blue Bell board fall short? The court concluded the plaintiff’s pleadings “supporting a fair inference that no reasonable compliance system and protocols were established as to the obviously most central consumer safety and legal compliance issue facing the company, that the board’s lack of efforts resulted in it not receiving official notices of food safety deficiencies for several years, and that, as a failure to take remedial action, the company exposed consumers to listeria-infected ice-cream, resulting in the death and injury of company customers”.

    It is a timely reminder for all boards about the need for real vigilance around public safety.

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