Chancery Court Accepts ‘Novel Theory’ of Board’s Failure of Oversight Claim

Shareholder Advocate Summer 2022

July 27, 2022

Delaware Chancery Court Vice Chancellor Travis Laster broke new ground recently by ruling that a board of directors’ failure to address an obvious “red flag” constituted a sufficient breach of fiduciary duty of oversight under the court’s Caremark1 standard to overcome a motion to dismiss, even though the board learned about it through a litigation demand.

The alleged misconduct in Garfield v. Allen2 involved a violation of an equity compensation plan approved by the ODP Corporation Board of Directors. Although Vice Chancellor Laster accepted “with trepidation” the “novel theory” of a Caremark claim advanced by plaintiff, he found that “the logic of the … theory is sound.” Vice Chancellor Laster noted that “from an analytical perspective … the source of the directors’ knowledge should not make a difference.” In short, a litigation demand by itself can now serve as a “red flag” triggering a potential Caremark claim. What remains to be seen is whether this new theory of liability becomes a viable approach to challenging a board’s breach of its fiduciary duty of oversight beyond the factual circumstances of this case.

The Garfield case arose in the context of the grant of equity awards by the directors of ODP under an existing executive compensation plan previously approved by its stockholders. The plan contained a limit on the number of shares that could be awarded to an individual in any given year. Plaintiff challenged the award granted to ODP’s CEO, claiming that the board had violated the plan by awarding him an excessive number of shares. Plaintiff made a demand on the ODP board to amend the award to comply with the terms of the plan.

In response to the demand, the board’s compensation committee chose to interpret the plan differently and applied another limitation found in the plan—one that was higher and ostensibly permitted the award to stand. Because the board denied the stockholder’s demand without taking any action, plaintiff brought a direct claim for a breach of contract based on the terms of the plan and a derivative claim for breach of fiduciary duties. Defendants moved to dismiss the claims relying on their different interpretation of the plan as the basis for not taking the action plaintiff demanded.

In denying the motion to dismiss, Vice Chancellor Laster ruled that the directors on the compensation committee breached the contractual terms of the plan and their fiduciary duties by approving the award, that the CEO breached his fiduciary duties by accepting the award, and that all the directors breached their fiduciary duty by not fixing the awards after receiving notice of the violation in the demand.

The underlying theory on the board’s failure to amend the award after receiving notice of the violation was premised on a Caremark type claim and rests on the notion that directors can be held liable for consciously not addressing “red flags” brought to their attention. Vice Chancellor Laster ruled that just because a “red flag” is raised in a litigation demand, it does not absolve directors from potential liability. Thus, the ODP directors who approved an improper award in the face of a “plain and unambiguous” contractual restriction in the plan face liability both for approving the improper award and for failing to address the issue once they were advised of the problem by a stockholder demand. Significantly, here all directors breached their fiduciary duties by failing to amend the award after being put on notice of the violation when they received plaintiff’s demand. As Vice Chancellor Laster noted: “[w]hen directors grant awards that exceed an express limitation in an equity compensation plan, the allegations support an inference that the directors acted knowingly and intentionally,” supporting a claim for breach of “fiduciary duty of loyalty by failing to act in good faith.”

Recognizing that this approach to Caremark claims was novel and without precedent, Vice Chancellor Laster cautioned against how this doctrine should be applied in future cases. His concern centered on other plaintiffs who might attempt to manufacture whistleblower-type claims as a basis for a demand and then sue directors who failed to act “because the directors did not respond to the whistle.” While this might be a concern, however, there now appears to be a pathway for stockholders to assert a Caremark claim where directors are advised of an otherwise unknown serious problem or “red flag” and fail to address the issue when given notice through a litigation demand.

1. In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 971 (Del. Ch. 1996) (Allen, C.)

2. Garfield v. Allen, et al., C.A. No. 2021-0420-JTL (Del. Ch. May 24, 2022)