P. Clarkson Collins Jr. of Morris James.

Judges and commentators frequently characterize Caremark claims (claims seeking to hold directors liable for damages resulting from grossly inadequate reporting regimes or oversight) as the most difficult kind of breach of fiduciary claim to assert with success. In a recent Court of Chancery opinion in Shabbouei v. Laurent Potdevin and Lululemon Athletica, C.A. No. 2018-0847-JRS (Del. Ch. Apr. 2, 2020), Vice Chancellor Joseph Slights rejected the plaintiff's effort to recharacterize what was essentially an inadequate Caremark claim into a self-interested, unfair dealing claim against the board arising from its termination of a CEO accused of sexual misconduct. Dismissing the claim under a straight-forward Rule 23.1 analysis of demand futility, the court found the allegations did not support an inference that the board's decision to make a severance agreement rather than terminate the CEO for cause resulted from the board's desire to insulate itself from claims that it had exercised inadequate  oversight over the CEO's conduct.

Background

A Lululemon stockholder brought a derivative suit alleging that the board breached its fiduciary duties by rushing to pay an excessive severance fee of $5 million to facilitate the CEO's separation and cover up their slow response to his well-documented malfeasance. The CEO Potdevin had an employment agreement that permitted his termination "without cause" and "for cause," with the former affording significant severance payments. The company had a Global Code of Business Conduct and Ethics for its employees that prohibited "harassment or unlawful behavior of any kind, including derogatory comments based on race or ethnicity or unwelcome sexual advances." The company had an anonymous hotline to encourage reporting of violations, and it charged the board committees with overseeing compliance with the Ethics code. The complaint alleged that the CEO had an inappropriate relationship with an employee and had created a toxic culture of harassment and favoritism that led to the departure of high ranking employees and a number of complaints to the hotline.

In late November 2017, two incidents of "inappropriate conduct" by the CEO were brought to the board's attention. Thereafter, the board met five times between Nov. 29 and February 2018 to discuss how to deal with the CEO. They hired outside counsel to investigate and received an interim report from counsel Jan. 29, 2018. The board then authorized its chairman to negotiate a separation agreement and release in accordance with the board's direction. The subsequent negotiation resulted in a $5 million severance payment in exchange for a release from the CEO and his quiet departure pursuant to an agreement made Feb. 2, 2018. Following a Section 220 books-and-records demand from which this information was gleaned, the plaintiff filed suit in November 2018. The defendants moved to dismiss pursuant to Rule 23.1.

Discussion

The court employed a straight-forward Aronson demand futility analysis to determine the complaint's sufficiency. Under the first prong, it examined whether the majority of the board was independent and disinterested with respect to the challenged decision. In this case that involved an analysis of whether the separation agreement extinguished a substantial likelihood of board liability. This in turn necessarily required the court to undertake a Caremark analysis of the inadequate oversight allegations in the complaint. The court found them insufficient to expose the directors to a Caremark-type liability given the policies and oversight the board had implemented. The board's actual response to the threat posed by the CEO's inappropriate behavior, notwithstanding allegations that the response was not fast enough, was inconsistent with a liability theory premised on conscious indifference to red flags. Lacking allegations sufficient to create a substantial likelihood of board liability, the complaint failed to demonstrate the board was self-interested in the challenged decision.

The court similarly rejected the argument that the release given by the CEO in the separation agreement, in favor of the company and all of its representatives including the board, made the board self-interested. The court reasoned that releases are a common element of such agreements that benefit the company and that the release by the CEO in this case arguably would not even apply to the fiduciary duty claim at issue.

Similarly, the complaint's allegations were not sufficient to satisfy the second Aronson prong: that the board's decision to make the separation agreement was not the product of a valid business judgment. Here the court focused not on the decision's merits, which involved weighing a myriad of competing corporate considerations properly left to the board's business judgment. Instead, the court examined whether the allegations supported an inference that the board lacked sufficient information to act or that its decision was so egregious on its face that it supported an inference of bad faith. Noting that whether to settle with the CEO and the amount of information required by a board before making a decision are themselves business judgments, the court ruled the complaint failed to undermine the presumption that the board exercised its business judgment in good faith.

Takeaway

Efforts to plead around the difficult Rule 23.1 demand futility burden by alleging an otherwise disinterested board engaged in a self-interested attempt to coverup its oversight failings will not succeed in the absence of specific allegations supporting Caremark liability or an inference of bad faith. The Court of Chancery looks beyond conclusory allegations of interestedness or lack of independence to see if specific factual allegations permit an inference of wrongdoing that will overcome the presumptions of independence and good faith that accompany the board's decision-making.

P. Clarkson Collins Jr. ([email protected]) is a corporate governance and fiduciary litigation partner at Morris James in Wilmington.