Delaware Court of Chancery Permits Caremark Claim Alleging Directors’ Failure to Monitor Critical Company Business Operations
October 29, 2019
By Joseph G. Adams and Taryn J. Gallup
On October 1, 2019, the Delaware Court of Chancery issued its decision in In re Clovis Oncology, Inc. Derivative Litigation, C.A. No. 2017-0222-JRS (Del. Ch. Oct. 1, 2019), which addresses the duties of directors to oversee and monitor the controls in place at the corporations on whose board they serve. In Clovis, the Delaware Court of Chancery allowed a shareholder to proceed with claims against outside directors on the grounds that the directors allegedly consciously failed to monitor those internal systems and controls when they ignored “multiple warning signs” about clinical trials that were “intrinsically critical” to Clovis’s business operations.
Clovis is a biopharmaceutical company that was developing a purportedly promising lung cancer drug called Roci. A key metric in the Roci clinical trial protocol was “confirmed” objective response rates. Clovis and the directors were aware that the FDA would not accept “unconfirmed” objective response rates as evidence of Roci’s efficacy. Throughout the relevant period (i.e., February 26, 2014 through March 23, 2017), Clovis made statements in press releases, SEC filings, investor calls and medical journals indicating that Roci’s “confirmed” objective response rate was approximately 60 percent. Despite these public statements, the Clovis directors were on notice as early as June 2014 that Clovis was improperly calculating Roci’s objective response rate by impermissibly including “unconfirmed” objective response rates and that the true objective response rate was lower than 60 percent. That is, the Clovis directors received several reports over time showing that Clovis was calculating the objective response rate based, in part, on unconfirmed responses. In addition, the directors were also made aware of certain undisclosed serious adverse effects associated with Roci and various protocol violations that occurred during the Roci clinical trials.
On November 16, 2015, following a meeting with the FDA concerning Roci’s reported clinical trial results, Clovis publicly disclosed that Roci’s correct “confirmed” objective response rate was as low as 28-34 percent. This disclosure caused a substantial drop in Clovis’s stock price followed by an additional drop five months later when the FDA decided to delay action on the new drug application for Roci. On May 5, 2016, Clovis withdrew its new drug application for Roci and terminated all ongoing Roci trials. In connection with Clovis’s misstatements and the ensuing stock price decrease, certain directors were named as defendants in various securities fraud class actions, one of which settled for $142 million in cash and Clovis stock. In addition, the SEC commenced an enforcement action against Clovis and certain directors, which culminated in an “onerous consent decree” requiring the directors to pay hefty civil penalties. The FDA also began an investigation into Clovis as a result of the Roci clinical trial.
Based on the Clovis directors’ purported awareness and inaction, plaintiff stockholders brought a derivative action against all nine members of the Clovis board of directors, alleging that the director defendants breached their fiduciary duties by “failing to oversee the Roci clinical trial and then allowing [Clovis] to mislead the market regarding the drug’s efficacy.” Among other claims, plaintiffs alleged that the director defendants breached their fiduciary duty under Caremark through their alleged “actions and inactions” in connection with the Roci clinical trial. The director defendants moved to dismiss plaintiffs’ complaint for failure to make pre-suit demand and failure to adequately allege a Caremark claim. See In re Caremark Int’l Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).
In an opinion by Vice Chancellor Joseph R. Slights III, the Delaware Court of Chancery declined to dismiss plaintiffs’ Caremark claim against the director defendants. Before explaining its decision, the court reiterated the disjunctive two-prong Caremark standard, which requires a plaintiff to allege particularized facts that either (1) the directors completely failed to implement any reporting or information system or controls, or (2) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. The court first noted that plaintiffs’ allegations did not satisfy the first Caremark prong because the complaint acknowledged that Clovis’s Board Nominating and Corporate Governance Committee was “specifically charged” with general compliance oversight of FDA and federal health care program requirements and that the Clovis board reviewed detailed information concerning the Roci clinical trial at each board meeting. Rather, plaintiffs’ allegations concerned the second Caremark prong, which concerns allegations that a company “implemented an oversight system but the board failed to monitor it.” While the court acknowledged that a board can only ignore red flags that are “waived in one’s face or displayed so that they are visible to the careful observer,” the Delaware Supreme Court’s decision in Marchand v. Barnhill, 212 A.3d 805 (Del. 2019) made clear that “the careful observer is one whose gaze is fixed on the company’s mission critical regulatory issues.” Here, the court found that the Roci clinical trial was “mission critical” for Clovis and that plaintiffs adequately alleged that the directors “consciously ignored red flags that revealed a mission critical failure” to comply with the clinical trial protocol and FDA regulations.
While the Clovis opinion does not overturn any established precedent, it provides further insight into how courts evaluate claims against directors, particularly claims concerning whether directors, having implemented a reporting system or controls, consciously failed to monitor or oversee those controls thus disabling themselves from being informed of risks or problems requiring their attention. Although courts often remark that Caremark claims are among the hardest to plead and prove, Clovis demonstrates that courts are willing to permit Caremark claims where a board failed to monitor an existing oversight system designed to oversee “critical” company business operations.
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