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Are Directors Liable for Unforeseen Calamities?

The answer to the question posed in the title to this article may seem devious to you. After all, the answer must be “no” if we want anyone to serve on a corporate board of directors. Yet this question continues to pop up as discussed in the recent decision of the Delaware Court of Chancery in Marchand v. Barnhill, C.A. No. 2017-0586-JRS (Sept. 27, 2018).

The Marchand decision is primarily known because it is the first case to invoke a “super power” director with five votes while the other directors have just one vote each. The court held that in considering if a demand on the board to pursue litigation was excused because a majority of the board was sufficiently disinterested that those five votes counted toward a disinterested majority of the board. But Marchand is more important than that probably unique holding. Here is why.

Marchand arose out of the disastrous outbreak in 2014 of contamination at several facilities of Blue Bell, the famous ice cream maker. Plant shutdowns, employee layoffs and financial crises shortly followed in early 2015. The complaint alleged that unsanitary conditions at Blue Bell were reported “dating back to 2009” and provided considerable detail about health inspection reports of those conditions over the ensuing years, culminating in the 2015 shutdowns.  However, those reports did not apparently find their way to the Blue Bell’s controlling board of directors (at a parent of the operating entity) until 2015. In any case, the contamination clearly violated state and federal laws.

The Marchand court focused on whether the Blue Bell board was on notice that Blue Bell was violating the law. First, it noted that Blue Bell had apparently implemented mandated monitoring and reporting systems for contamination. Second, the board had received reports on Blue Bell’s operations, including from a third-party food safety auditor, that did not raise any health concerns. Thus, the complaint did not allege an utter failure to adopt reporting and compliance systems.

Second, the court found that the complaint failed to allege that the board knew of the misconduct involved in the contamination. There were no “red flags.” Thus, the complaint did not properly support any claim the board had acted in bad faith. As a result, the complaint was dismissed.

What then is the lesson of Marchand? So long as a corporation has some arguably reasonable system in place to monitor corporate conduct that includes reports to a board of directors, the board will not be held responsible for misconduct absent proof its members actually knew of that misconduct and failed to correct it. It does not matter that the monitoring system could have been better or that the board might have been more inquisitive. The board is simply not liable for failing to detect misconduct under these circumstances.

Marchand is not unusual in reaching that decision. The Delaware Federal District Court recently reached a similar result in Burtoin v. Blount, D. Del. C.A. 15-283-LPS (Sept. 30, 2018). So too have other Delaware decisions cited in Marchand. But what does make Marchandsomewhat stand out is the extreme set of facts, with apparently widespread contamination going unreported to the board of directors. At some point we will see such serious corporate misconduct that even exculpatory reports to a board will not be enough to shield it from potential liability. We are not there yet. But newspaper reports and other evidence of actual knowledge may be enough to convince a court that the board must have known of problems, despite reports to the board that assure it that all is well.

Finally, Marchand is also noteworthy because its result is at odds with the result decided by the same court in Wenske v. Blue Bell Creameries (Del. Ch. July 6, 2018). Wenske upheld a complaint against the same Blue Bell directors based on their alleged failure to comply with the contractual duties imposed on them by a limited partnership agreement. If both Marchand and Wenske alleged the same wrongful conduct, why was one complaint dismissed and the other upheld?

As the Marchand opinion explains, the different results turn on different standards of conduct. The LLP agreement at issue in Wenske imposed a contractual duty greater than the fiduciary duty at issue in Marchand. Thus, once again, the lesson is to carefully draft LLP agreements for you will be held to their terms.

Delaware Business Court Insider, October 24, 2018