Court Explains Rigorous 'Caremark' Pleading Requirements
A recent opinion containing the report and recommendation of the magistrate judge in the U.S. District Court for the District of Delaware, In re Chemed Shareholder Derivative Litigation, C.A. No. 13-1854-LPS-CJB (D.Del. Dec. 23, 2015), well illustrates the accepted wisdom that a Caremark claim is "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment, as in In re Caremark International Derivative Litigation, 698 A.2d 959 (Del.Ch. 1996). As the Chemed case demonstrates, it is exceptionally difficult to even plead such a claim. In recommending that dismissal be granted on Rule 23.1 grounds (with leave to amend), the court carefully analyzed Delaware law and the requisite specificity necessary for a plaintiff to plead that directors "consciously failed to act after learning about evidence of illegality [such as becoming aware of] the proverbial 'red flag.'"
A Caremark claim typically arises after a corporation suffers a major corporate trauma and resulting loss or harm. The question that frequently ensues is where was the board of directors and how did it allow this trauma to occur? Under Delaware law, the board of directors carries responsibility for the management of the corporation's affairs, but the board may, and typically does, delegate the day-to-day management to officers and other full-time employees. With most corporations having corporate charter provisions exculpating the directors from monetary liability for violations of the duty of care, directors receive protection from personal liability for negligent oversight and management of the corporation's affairs, as in 8 Del. C. Section 102(b)(7). Directors may be liable, however, for breach of the duty of loyalty for a Caremark claim if they fail to act when they otherwise should have done so. One way to satisfy the Caremark burden is to demonstrate the directors consciously failed to act after learning about evidence of corporate illegality. To establish a breach of the fiduciary duty of loyalty in a Caremark context requires a showing that the directors knew they were not discharging their fiduciary obligations or that they demonstrated a conscious disregard for their duties through a systematic and continuous failure to oversee and monitor over a period of time. Caremark claims asserted by shareholders against the directors are derivative in nature because they seek to vindicate harm to the corporation. The plaintiff therefore must satisfy rigorous Rule 23.1 pleading standards. These require the plaintiff to plead with specificity facts showing that at least half the board cannot disinterestedly exercise business judgment in responding to a demand to sue the board members. A mere threat of personal liability is not enough to disable a director from disinterestedly considering a demand. Plaintiffs are entitled to an inference of director interestedness only where the facts pleaded show the directors face a substantial likelihood of liability. The Chemed case demonstrates the difficulty of pleading facts that permit an inference of directorial knowledge sufficient to show the directors face a substantial likelihood of Caremark liability.
Chemed Corp. is a publicly traded company that through its Vitas-affiliated subsidiaries provided end-of-life hospice care through 52 programs in 18 different states. It had a board composed of 10 directors, two of whom were part of management. The shareholder derivative complaint contained allegations of Vitas' broad and longstanding failures to comply with the eligibility and billing requirements for Medicare and Medicaid. The complaint alleged that since at least 2004 and through at least 2013, Chemed through Vitas submitted fraudulent claims to Medicare and Medicaid in violation of state and federal law and that such misconduct was at the core of Chemed's business strategy and embedded in its regular practices. To support these allegations, the complaint drew on allegations made in four qui tam lawsuits filed in 2007, 2008, 2009 and 2012 alleging Vitas liability under the federal False Claims Act (FCA) for conduct dating to 2001. The complaint also referenced two other lawsuits: a 2012 securities fraud lawsuit alleging concealment by senior management of a fraudulent billing scheme related to Medicare hospice reimbursement that was settled for $6 million, and a 2013 U.S. Department of Justice suit brought under the FCA and alleging false claims to Medicare for hospice care. The derivative complaint also referenced various state and federal investigations into improper hospice care billing by Vitas and a statistical analysis showing that Vitas patients received more expensive care more often and remained in hospice care longer than the national average. Finally, the complaint made allegations about Chemed's internal audit function to monitor compliance at the corporate level, and report its work to the Chemed board.
The plaintiffs alleged that these facts demonstrated the board faced a substantial likelihood of liability because they permit a reasonable inference that the board either actually knew of Vitas' misconduct, ignored red flags putting it on notice of misconduct that it failed to stop, or the audit committee members knew of misconduct and failed to discharge their oversight duties.
Despite the specific allegations and detail in the complaint, the court determined the allegations failed to show that the information of pervasive misconduct actually reached the board's attention. Likewise, the court was unwilling to infer the board's bad-faith intent or knowledge of misconduct from the existence of the foregoing statistical and lawsuit allegations in the absence of particularized allegations showing how often the board met to discuss facts asserted to have led to its knowledge of fraud; how those specific facts came to the board's attention; or whether any board members initiated investigations to learn more about such facts.
With respect to the numerous subpoenas and investigations commenced against Vitas, the court noted they were reported in the Form 10-K and that it was a fair inference that more than half of the directors were aware of them. But it was not sufficient to infer from this that the board had actual knowledge of misconduct or that failure to take action would be a breach of the board's fiduciary duties. Regarding the four qui tam lawsuits, the court noted the failure to plead facts showing any of the directors knew of the complaints until at least 2011 or later. The court did not infer board knowledge of the complaint's contents, except for one director who signed 10-Qs referencing receipt of the complaints.
Similarly, with respect to the DOJ complaint and the DOJ's intervention in three of the qui tam actions, the court noted that knowledge of this and the additional allegations would have been significant and disconcerting to the Chemed directors. But because these filings occurred only six months before the derivative complaint and there were no allegations showing the directors' knowledge of the DOJ actions or the board's response thereto, no basis existed to infer that the board must have known of the underlying acts referenced and now faced substantial liability. Whether considered individually or collectively, the court found that the plaintiffs' allegations failed to support a reasonable inference that the board disregarded actual knowledge about improper Vitas billing or knew that a failure to respond would be a breach of fiduciary duty.
Having found the allegations of actual knowledge lacking, the court had little trouble dismissing the "red flag/should have known" argument. The court found the allegations did not permit a reasonable inference that the board was aware of red flags that should have put it on notice of misconduct. Similarly, for the audit committee, allegations that the misconduct fell within the delegated authority of the committee did not support the inference that the committee knew and consciously disregarded the problem.
To sustain a Caremark claim, this case illustrates the importance of linking to the particular director defendant's knowledge of the misconduct giving rise to the corporate trauma. In the absence of allegations of the directors' direct knowledge of misconduct or red flags and subsequent response, the court will be reluctant to infer Caremark liability. Resorting to a Section 220 books-and-records demand to obtain minutes, reports and other materials reflecting director knowledge of the misconduct would have enhanced the plaintiffs' ability to plead facts showing what information actually reached the board and what the directors then did or did not do in response. Such additional information also would have permitted the plaintiffs to consider and plead an alternative Caremark theory based on the board's failure to implement controls and reporting mechanisms sufficient to ensure it would receive adequate information to reveal the type of misconduct allegedly taking place in this case.