Oversight and The Duty of Loyalty

Exam 1

Duty of Oversight (as part of loyalty)

• Directors must understand and monitor “Critical” parts of a company’s operations.

• This is part of the duty of loyalty; its considered “Bad faith,” or not loyal, to fail to exercise a director’s duty of care.

• Often, this duty requires directors to form committees meant to monitor “Mission critical” operations.

• The duty arose in delaware from in re caremark (“Caremark duties”)

  • In caremark (1996)

  • There, caremark failed to put in place ways of monitoring and avoid criminal activities.

  • The case cited Smith v. Van gorkom that directors must be minimally informed on key issues.

• Notably, directors are rarely active on a day-to-day level. They’re often directors of many large corporations. They use officers to conduct day-to-day affairs.

Marchand v. Barnhill - Facts and Issue

• Facts: Blue Bell “suffered a listeria outbreak in early 2015, causing the company to recall all of its products, shut down production at all of its plants, and lay off over a third of its workforce. Three people died as a result of the listeria outbreak. Less consequentially, but nonetheless important for this litigation, stockholders also suffered losses because, the operational shutdown "

• Issue: Breach of duty of loyalty?

Marchand v. Barnhill - Debate and Rule

• Debate: Directors can rarely be informed on all aspects of business. They depend on officers. So it’s difficult to hold directors liable for a failure to know what’s occurring in factories in other states. But, the duty of care must mean something.

• Rule: A board's “Utter failure to attempt to assure a reasonable information and reporting system exists… thus disabling themselves from being informed of risks or problems requiring their attention” is an act of bad faith in breach of the duty of loyalty

Marchand v. Barnhill - Key Facts

• Blue Bell makes one thing, which is ice cream. Food safety should thus be the highest importance of the corporation.

• “Blue bell's board had no committee overseeing food safety, no full board-level process to address food safety issues, and no protocol by which the board was expected to be advised of food safety reports and developments.”

• “Yellow” and “Red” flags were present about food safety and specifically, Listeria

• Despite reports [by sc and tx] to management, blue bell's board was not informed by management about the severe problem. The board met on February 19, 2015, following blue bell's annual stockholders meeting, but there was no listeria discussion

• The FDA discovered systematic deficiencies in all of blue bell's plants, e.G., constructed ‘in such a manner as to [not] prevent drip and condensate from contaminating food, food-contact surfaces, and foodpacking material”—that might have been rectified had any reasonable reporting system that required management to relay food safety information to the board on an ongoing basis been in place.

Marchand v. Barnhill - The Board’s Failure

• 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 that these were disclosed to the board;

• The board was given certain favorable 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.

Marchand v. Barnhill - Ruling and Holding

• Ruling:

  • Directors breached the duty of loyalty by failing to install monitoring processes for “Critical” aspects of the corporation’s function: I.E., making ice cream.

  • Under caremark, the shareholder showed that the directors’ breached their duty of loyalty by not acting in good faith

• Holding: breach of the duty of loyalty due to the directors’ lack of monitoring and failure to implement methods of collecting information about critical aspects of the corporation.

In Re Boeing - Facts and Issue

• Facts: a lion air (Indonesia) flight crashed using a Boeing supermax plane. A half-year later, another 737 supermax, flown by Ethiopian air, crashed. After the second crash, the aviation authorities of most countries grounded the plane. The problem turned out to be the mcas system.

• Issue: did the directors violate their duty of loyalty under caremark?

• “The narrow question before this court today is whether Boeing's stockholders have alleged that a majority of the company's directors face a substantial likelihood of liability for Boeing's losses?”

In Re Boeing - Key Facts

• Caremark liability: directors may liable for Boeing’s losses; “This may be based on the directors’ complete failure to establish a reporting system for airplane safety, or on their turning a blind eye to a red flag representing airplane safety problems.”

• Key facts:

  • The board didn’t meet until their pre-scheduled annual meeting. At the meeting, the topic of safety wasn’t prioritized or even discussed much (about 5 minutes).

  • The board declined to investigate after the initial crash

  • Boeing over $2 billion dollars, including a criminal penalty, for delaying and obscuring information suggesting its liability.

  • The board lacked a committee on plane safety

  • The board was unconcerned with plane safety

  • After the first crash, the board’s phone call was optional. And it emphasized ”returning to profitability” rather than safety.

  • “The next board meeting, in February 2019, addressed factory production recovery and a rate increase, but not product safety or mcas. At that meeting, the board affirmativelydecided to delay its investigation into the 737 Max, notwithstanding publicly reported concerns about the airplane's safety. Weeks later, after the Ethiopian airlines crash, the board still did not consider the 737 Max's safety. It was not until April 2019—after the FAA grounded the 737 Max fleet—that the board built in time to address airplane safety.”

  • ”Management's ad hoc reports were also one-sided at best and false at worst, conveying only favorable and optimistic safety updates and assurances that the quality of Boeing's aircraft would drive production and revenue… because the board did not have any formal procedures in place to monitor the safety of Boeing's airplanes, the board was not privy to the truth about mcas”

  • Management saw “Yellow and red flags” which were never reported to the board by the management who had received information from employees about the sensor’s malfunctions—no reporting system

• Shareholders: the first crash was a red flag that the board failed to act upon. And this LED to the second crash. No protocols were put in place for the board to learn more.

In Re Boeing - Court

• “Like food safety in marchand, airplane safety “Was essential and mission critical” to Boeing's business.”

• “The board and management's passive invocations of quality and safety, and use of safety taglines, fall short of the rigorous oversight marchand contemplates.”

• “As marchand made plain, the fact that the company's product facially satisfies regulatory requirements does not mean that the board has fulfilled its oversight obligations to prevent corporate trauma.”

• “The board did not simply fail to assess safety itself; it also failed to expect or demand that management would deliver safety reports or summaries to the board on a consistent and mandatory basis.”

• The board was entirely concerned about rectifying its public image instead of safety

• “Plaintiffs have pled facts that allowing a reasonable inference that the directors breached their duties of oversight with scienter: not only did the director defendants act inconsistently with their fiduciary duties, but they also knew of their shortcomings.”

• That the board knowingly fell short is also evident in the board's public crowing about taking specific actions to monitor safety that it did not actually perform.

• He falsely touted that the board was immediately contacted and met “Very, very quickly” after the lion air crash … considered grounding the 737 Max after the lion air crash… met within twenty-four hours of that crash to consider grounding; and recommended grounding. Each of calhoun's public representations was knowingly false. They evidence that at least calhoun knew what the board should have been doing all along.

In Re Boeing - Holding

The court held the directors personally liable to the sahreholders for failing to inform themselves of safety issues, failure to act on red flags, and failures to implement reporting mechanisms under caremark.