On September 25, 2012, the Delaware Chancery Court held that “a plaintiff who files a Caremark claim hastily and without … [first] conducting a meaningful investigation” is presumed to have “acted disloyally to the corporation.” South v. Baker, 2012 WL 4372538, at *16 (Del. Ch. Sept. 25, 2012) (Laster, V.C.). Applying this presumption, the court held that the with-prejudice dismissal of hastily-filed Caremark claims against the directors of Hecla Mining Company would “not have preclusive effect on the efforts of more diligent stockholders to investigate potential claims and, if warranted, file suit.” South, 2012 WL 4372538, at *1.
“During 2011, Hecla experienced a series of incidents at the Lucky Friday mine,” including a rock fall in April 2011 and a rock burst in December 2011. Id. at *3, *4. On January 25, 2012, the United States Mine Safety and Health Administration (“MSHA”) “issued a press release noting that Hecla had been cited for numerous safety violations.” Id. at *1, *6. A week later, “the first of two securities class actions was filed.” Id. at *6. “Seven stockholder derivative actions [soon] followed.” Id.
On March 1, 2012, Steven and Linda South (“the Souths”) filed the instant derivative action, asserting Caremark claims against Hecla’s directors. Id. “A Caremark claim contends that the directors set in motion or ‘allowed a situation to develop and continue which exposed the corporation to enormous legal liability and that in doing so they violated a duty to be active monitors of corporate performance.’” Id. at *8 (quoting In re Caremark Int’l Inc. Der. Litig., 698 A.2d 959, 967 (Del. Ch. 1996) (Allen, C.)). “Because a plaintiff asserting a Caremark claim must plead facts sufficient to establish board involvement in conscious wrongdoing,” the Delaware Supreme Court “has admonished stockholders repeatedly to use Section 220 of the General Corporation Law, 8 Del. C. § 220, to obtain books and records and investigate their claims before filing suit.” Id. at *1. However, the Souths neither filed a Section 220 request nor made any demand on the Board prior to bringing suit. Id. at *7-8.
The defendants moved to dismiss the Souths’ complaint “pursuant to [Chancery Court] Rule 23.1 for failure to make demand or adequately plead demand futility.” Id. at *1.
The Chancery Court Dismisses the Souths’ Complaint with Prejudice for Failure to Plead a Connection Between the Board’s Actions and the Lucky Mine Incidents
“To plead demand futility” in a Caremark case, “a stockholder plaintiff must plead facts establishing a sufficient connection between the corporate trauma and the board such that at least half of the directors face ‘a substantial likelihood of personal liability.’” Id. at *9. “Without a connection to the board, a corporate trauma will not lead to director liability.” Id.
“A plaintiff can plead the necessary connection by alleging with particularity actual director involvement in a decision or series of decisions that violated positive law.” Id. “A plaintiff who cannot point to facts supporting such a decision can plead that the board consciously failed to act after learning about evidence of illegality—the proverbial ‘red flag.’” Id. However, in most cases:
[T]he plaintiff must fall back to the final means of connecting the directors to illegality: the board’s obligation to adopt internal information and reporting systems that are “reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with law and its business performance.”
Here, the Souths did “not cite any statute, regulation, or other provision of positive law that the [Hecla] Board allegedly decided consciously to violate, nor facts from which such a decision could be inferred.” Id. at *10. The Chancery Court noted that “[t]he plaintiffs might have looked for evidence of such a decision by using Section 220 to obtain minutes and related materials from Board and Safety Committee meetings.” Id. Instead, the plaintiffs relied on the January 2012 MSHA press release and a report issued by the MSHA in November 2011. Id. The court found that neither of these documents “supports a reasonable inference that the Board consciously decided to violate positive law.” Id.
The Souths’ “central argument” was that “the unfortunate incidents at the Lucky Friday mine amounted to ‘red flags’ sufficient to put the Board ‘on notice’ of safety issues.” Id. at *11. “Although the complaint asserts that the directors knew of and ignored the 2011 safety incidents, the complaint nowhere alleges … that the directors were told about the incidents, what the Board’s response was, or even that the incidents were connected in any way.” Id. “Here again,” the court found that “the Souths might have used Section 220 to investigate what the directors knew and did, evaluate their theories of liability, and make an informed decision about whether or not to sue.”8 Id.
Finally, the Chancery Court found that “the Souths’ complaint does not contain allegations from which a court could infer ‘a sustained or systemic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists.’” Id. at *12. “The complaint instead pleads affirmatively that the Board established a Safety Committee” comprised of “the four outside directors with the most mining industry experience.” Id.
“Because the complaint lacks particularized facts supporting a reasonable inference that a majority of the Board faces a substantial risk of liability,” the court determined that dismissal of the Souths’ suit was warranted under Rule 23.1. Id. at *13. The court found it significant that the Souths offered no “explanation as to why [they] did not use Section 220 before filing suit, as the Delaware Supreme Court has recommended repeatedly.” Id. at *14. Given the circumstances, the court held that “dismissal with prejudice as to the Souths [was] a fitting consequence that [did] not seem likely to work any prejudice on the corporation.”9 Id.
The Chancery Court Holds That the Dismissal of the Souths’ Complaint Does Not Preclude Caremark Claims Brought by Other Plaintiffs Because the Souths Did Not Adequately Represent Hecla
The Chancery Court next considered whether the “with-prejudice dismissal of [the Souths’] lawsuit could have preclusive effect on the litigation efforts of other stockholders.” Id. at *1. The court explained that “[t]here is a broad consensus” that “a with-prejudice dismissal does not have preclusive effect if the initial plaintiff failed to provide adequate representation for the corporation.” Id.
The court noted that recent Chancery Court decisions “have suggested a presumption that when a stockholder hastily files a Caremark claim after the public announcement of a corporate trauma, in an effort to shift the still-developing losses to the corporation’s fiduciaries, but without first conducting a meaningful investigation, the plaintiff has not adequately represented the corporation.”10 Id. at *7. This “presumption recognizes that when a plaintiff asserts a Caremark claim, the plaintiff must plead a connection between the underlying corporate trauma and the board.” Id. at *17. In “other types of derivative actions in which a plaintiff challenges a specific and identifiable board decision,” the court explained that “a plaintiff may well be able to plead particularized allegations without using Section 220 that are sufficient to survive a Rule 23.1 motion to dismiss.” Id. “For a Caremark claim, however, the connection to the board is neither readily apparent nor reasonably inferable from the occurrence of the corporate trauma.” Id.
This “presumption also recognizes that there usually will not be any need to rush when filing a Caremark claim” because Delaware courts routinely stay Caremark claims pending the resolution of direct suits and regulatory proceedings. Id. Moreover, since Caremark claims “are premised on corporate liability, pursuing a Caremark claim during the pendency of [an] underlying litigation or governmental investigation may well compromise the corporation’s position on the merits, thereby causing or exacerbating precisely the harm that the Caremark plaintiff ostensibly seeks to remedy.” Id. at *18. The court explained that “[a] plaintiff who hurries to file a Caremark claim after the announcement of a corporate trauma behaves contrary to the interests of the corporation but consistent with the desires of the filing law firm to gain control of (or a role in) the litigation.” Id. at *17.
The Chancery Court stated that a plaintiff could rebut the presumption of disloyalty by demonstrating that he “did not file hastily and conducted a meaningful and thorough investigation.” Id. “To be adequate, the investigation would have to address not only the merits of the corporation’s claim, but also the connection between the trauma and the board, the critical issue on which a Rule 23.1 motion to dismiss the Caremark claim will turn.” Id. “Alternatively, the plaintiff could rebut the inference itself by persuading the [c]ourt that filing the Caremark claim in that form and at that time, based on the investigation conducted, served the best interests of the corporation.” Id.
Here, the court determined that “[t]he circumstances surrounding the filing of this case gave rise to a presumption of disloyalty.” Id. at *18. “First, the plaintiffs filed [their Caremark claim] hastily,” even though “there was no reason to rush that would [have] further[ed] the interests of the corporation.” Id. Moreover, the plaintiffs “admittedly did not make use of Section 220,” nor did the complaint “suggest a meaningful investigation by the plaintiffs or their counsel into whether there was a connection between the incidents and action or conscious inaction by the Board.” Id. at *19. Finally, the plaintiffs “failed to produce any evidence, much less persuasive evidence, to rebut either the requisite facts giving rise to the presumption or the resulting inference.” Id. at *18. “To the contrary, the plaintiffs’ counsel confirmed that he filed when he did because of [first-to-file] pressures” and “the fear that plaintiffs who moved more quickly … might gain control of the suit.” Id.
Finding that “the Souths and their counsel failed to provide adequate representation for Hecla,” the Chancery Court held that “the dismissal of the Souths’ complaint should not have preclusive effect on the litigation efforts of more diligent stockholders.” Id. at *1, *20.