Delaware Court Says Board Must Properly Monitor ‘Mission Critical’ Compliance Risk

Shareholder Advocate Fall 2020

October 15, 2020

By Amy Miller

Investors seeking to hold corporate boards liable for failing to properly oversee “mission critical” operations in highly regulated companies should be encouraged by a recent decision allowing shareholders of a pharmaceutical company to proceed with their derivative lawsuit.

On August 24, 2020, in Teamsters Local 443 Health Services & Insurance Plan v. Chou, No. 2019-0816-SG, 2020 WL 5028065 (Del. Ch. Aug. 24, 2020), the Delaware Court of Chancery continued a recent trend in the Delaware courts by upholding stockholder derivative claims against a board of directors for its alleged failure to comply with its oversight duty under In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996). The court held that stockholder-plaintiffs sufficiently pled that a majority of the directors of AmerisourceBergen Corp. (“ABC”) (the “Board”) faced a substantial likelihood of liability.

Specifically, plaintiffs alleged that ABC’s wholly owned subsidiary, Pharmacy, “was run like a criminal organization.” Pharmacy operated in a way to appear as if it were a state-licensed pharmacy, which it was not, to purposely avoid the Food and Drug Administration’s (“FDA”) oversight. Pharmacy’s business was to buy single-dose sterile vials of oncology drugs, put those drugs into syringes, and sell them for injection into a cancer patient’s body. Pharmacy bought the single-dose vials knowing that they were intentionally overfilled by the manufacturer. Instead of discarding this overfill, which was not intended for patient use, Pharmacy illegally “pooled” the overfill and used it to fill additional syringes. This process was unsterile and led to contamination of the pooled drugs.

ABC both pocketed the extra revenue and undercut the competition by providing kickbacks to buyers to increase its market share through its “extra” product. Ultimately, the criminal activities at Pharmacy and other associated subsidiaries were uncovered, leading to significant corporate criminal and civil penalties of approximately $885 million.

Plaintiffs alleged the Board failed to exercise its oversight responsibilities in good faith as required by Caremark and its progeny because criminal activities occurred at ABC’s subsidiaries, causing them to incur $885 million in fines. The court agreed, relying on Marchand v. Barnhill, 212 A.3d 805 (Del. 2019), where the Delaware Supreme Court explained a board’s duty to monitor a company’s “mission critical regulatory issues” and held that directors cannot ignore red flags indicating misconduct in defiance of their oversight duty under Caremark when the company’s core business operation is tied to complying with laws and a comprehensive regulatory regime. Similarly, here the Court of Chancery found that plaintiffs pled facts from which can be reasonably inferred that the Board consciously ignored red flags that its subsidiaries were defying important FDA regulations that were “mission critical” to ABC’s business operation.

The court found three categories of red flags relevant to its determination that the Board allegedly failed in its oversight duties. First, the court relied on allegations concerning a report prepared by the Company’s outside counsel, indicating that ABC had: (a) no centralized compliance and reporting structure, (b) inadequate documentation and tracking of compliance and ethics processes, and (c) inadequate accountability for compliance violations. Plaintiffs further alleged that the Audit Committee and the Board failed to take any steps to remedy the issues identified in the report. The court found this report qualified as a red flag and that the Board failed to respond to it.

Next, the court recognized another category of red flags based on the allegations in a qui tam (whistleblower) suit brought by a former employee. Plaintiffs alleged that the Board members had signed Form 10-Ks disclosing the qui tam complaint, which addressed the problematic use of overfill occurring at ABC’s subsidiaries but took no action in response to this red flag. The court also acknowledged a third and final category of red flags, embodied in a 2012 Department of Justice subpoena and an FDA search warrant. Although both documents were publicly disclosed, the ABC Board again took no corrective actions in response to them.

Based on these red flags, the court held that the Board consciously ignored facts warning of ABC’s subsidiaries’ illegal overfill business, along with its attendant mission critical compliance risks. The court further held that the Board faced a substantial likelihood of liability because a majority of the Board knew of the evidence of corporate misconduct—yet acted in bad faith by consciously disregarding its duty to address that misconduct in the Company’s subsidiary.

Ultimately, the court denied defendants’ motion to dismiss on all counts, continuing a string of decisions over the past year of upholding claims against directors who fail to properly oversee the mission critical operations of highly regulated companies. This recent trend in Delaware provides encouragement to stockholders to assert similar claims based on oversight failures under Caremark, especially where a board had a duty to monitor a company’s “mission critical regulatory issues” and has failed in those efforts.