In Louisiana Municipal Police Employees’ Retirement System et al. v. David Pyott, et al., 2012 WL 2087205 (Del. Ch. June 11, 2012), the Delaware Court of Chancery found that allegations in a complaint alleging a Caremark claim against the directors of Allergan, Inc. (Allergan) were sufficient to survive a motion to dismiss.
In the United States, physicians may prescribe a pharmaceutical product for uses approved by the Food and Drug Administration (FDA), known as “on-label” uses, as well as for uses that have not been approved by the FDA, known as “off-label” uses. While a pharmaceutical company may sell products knowing that these products are being prescribed for off-label uses, a pharmaceutical manufacturer is not permitted to market or promote a drug for off-label uses. On September 1, 2010, after a three-year joint investigation by the Federal Bureau of Investigation (FBI), the FDA and the Department of Health and Human Services (DHHS) into alleged off-label marketing practices by Allergan, the company that manufactures Botox, Allergan pled guilty to criminal misdemeanor misbranding in connection with its alleged promotion of Botox for off-label uses. The company paid a total of $600 million in civil and criminal fines.
Soon after the settlement was announced, shareholders filed derivative actions against members of the Allergan Board of Directors in Federal Court in California and in the Delaware Chancery Court. The California Federal Court dismissed the complaint, ruling that the plaintiffs failed to plead “demand futility” under Rule 23.1. The defendants then moved to dismiss the Delaware case, arguing that (1) the California judgment required a dismissal pursuant to the doctrine of collateral estoppel, (2) the complaint failed adequately to plead “demand futility” under Rule 23.1, and (3) the complaint failed to state a claim under Rule 12(b)(6). However, Vice Chancellor Laster of the Delaware Court of Chancery disagreed and allowed the case to advance.
Allergan’s Alleged Promotion of Off-Label Uses
Allergan‟s plea followed allegations that it had implemented a series of initiatives to promote the sale of Botox for off-label uses. The company sponsored seminars and presentations at which speakers allegedly advocated off-label uses, founded and financed organizations that allegedly advocated off-label uses, provided support services for physicians seeking healthcare reimbursement for off-label uses, and lobbied government healthcare programs to expand reimbursement for off-label uses. Like many companies, Allergan cultivated its relationship with doctors by funding continuing education programs, seminars and promotional dinners, which are not in and of themselves unlawful. Allergan instituted a Physician Partnership Program in which the company allegedly paid selected physicians to promote off-label Botox use among their peers, and it funded physician “preceptorships,” in which company personnel shadowed participating physicians. The company also assisted doctors in receiving reimbursement from insurance companies through Provider Reimbursement Account Managers, who audited physician billing records and provided advice on maximizing reimbursement, including, allegedly, reimbursement for off-label uses. Allergan allegedly also provided direct financial incentives to physicians who wrote off-label prescriptions through a Temporary Price Allowance Program. Allergan also allegedly financed a number of organizations that distributed literature with dosing guidelines for off-label uses and maintained a website that provided information about off-label uses, while promoting themselves as “independent sources of information.” A third organization allegedly funded by Allergan was created to reduce coverage barriers to reimbursement for off-label uses.
On August 22, 2001, Allergan received a warning letter from the FDA asserting that Allergan‟s promotional activities and materials were “misleading and lacking in fair balance.” In June 2003, Allergan received another warning letter from the FDA asserting that the company‟s advertising for Botox was misleading. In September 2006, the FDA sent another a letter to Allergan concerning a presentation led by an Allergan-sponsored speaker at a dinner program that the company funded.
On October 24, 2006, the company‟s general counsel informed the Board that the Allergan-sponsored speaker at the program had presented a deck of slides that had not been approved by Allergan, but which included a large volume of information relating to an off-label use. In addition, the general counsel reported that an internal investigation revealed that the unapproved slides, or similar ones, had been presented at eight dinner meetings over the prior year. The general counsel further reported that the investigation also revealed weaknesses in the company‟s internal controls, as it appeared that both the sales representative and sales manager knew or should have known that unapproved slides were being used, but neither believed that they were responsible for reporting or correcting the issue.
The company‟s general counsel, in advising the Board of the 2006 FDA letter, noted, “[T]his is a potentially serious matter and in the current environment, the chance of receiving Agency action ... on this matter is ... very high.” Pyott, 2012 WL 2087205 at *10. This prediction proved to be true, as it preceded a three-year investigation, followed by a guilty plea and settlement.
Elements of a Caremark Claim
Vice Chancellor Laster quotes Chancellor Allen‟s observation that the Caremark theory “is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”1 As Vice Chancellor Laster explains, “[A] Caremark claim contends that the directors set in motion or allowed a situation to develop and continue that 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 *23. He notes that the list of corporate traumas for which “stockholders theoretically could seek to hold directors accountable is long and ever expanding: regulatory sanctions, criminal or civil fines, environmental disasters, accounting restatements, misconduct by officers or employees, massive business losses, and innumerable other calamities.” Id. However, Vice Chancellor Laster also notes that the directors‟ “good faith exercise of oversight responsibility may not invariably prevent employees from violating criminal laws or from causing the corporation to incur significant financial liability or both,” citing Stone v. Ritter, 911 A.2d 362, 373 (Del. 2006). Id.
Thus, Vice Chancellor Laster explains that to state a Caremark claim, a plaintiff must plead a sufficient connection between “the corporate trauma and the board.” Id. According to Vice Chancellor Laster, a plaintiff must allege (1) that “actual board involvement in a decision violated positive law,” i.e., permitting an inference that the “directors knowingly violated positive law,” (2) that “the board consciously failed to act after learning about evidence of illegality,” i.e., the board ignored “red flags” “indicating misconduct at the company,” (3) that “the board is dominated or controlled by key members of management, who the rest of the board unknowingly allowed to engage in self-dealing transactions,” or (4), most typically, that the board failed in its obligation to adopt internal information and reporting systems that are “reasonably designed to provide to senior management and to the board timely and accurate information sufficient to allow management and the board ... to reach informed judgments concerning both the corporation‟s compliance with law and its business performance. [footnote omitted.]” Id. at *23-24. Where liability is asserted due to a failure to adopt or maintain reporting systems, “only a sustained or systematic failure of the board to exercise oversight—such as the utter failure to attempt to assure a reasonable information and reporting system—will establish the lack of good faith that is a necessary condition to liability.” Id. at *24.
Denial of Motion to Dismiss Caremark Claim against Allergan Directors
On September 3, 2010, the stockholder plaintiffs filed a lawsuit against the Allergan directors in Delaware Chancery Court. In concluding that the complaint survived a motion to dismiss, the Vice Chancellor initially explains that the plaintiffs were not seeking to impose liability on the Allergan directors for “making a „wrong‟ business decision or taking imprudent business risk,” id. at 30, thus distinguishing recent cases like In re Citigroup Inc. S’holder Deriv. Litigation, 964 A.2d 106, 126 (Del. 2009) and In re Goldman Sachs Gp., Inc. S’holder Litigation, 2011 WL 4826104 (Del. Ch. 2011). He fully supports those decisions, noting, “that type of judicial second-guessing is what the business judgment rule was designed to prevent.” Id.
The Vice Chancellor then explains, “Corporate misconduct involving fraud or illegality presents a different situation.” Id. He notes, “Delaware law allows corporations to pursue diverse means to make a profit, subject to a critical statutory floor, which is the requirement that Delaware corporations only pursue „lawful business‟ by „lawful acts.‟ Under Delaware law a fiduciary may not choose to manage an entity in an illegal fashion, even if the fiduciary believes that the illegal activities will result in profit for the entity. [citation omitted]” Id. at 31. In summary, “a fiduciary of a Delaware corporation cannot be loyal to a Delaware corporation by knowingly causing it to seek profits by violating the law,” citing In re Massey Energy Co., 2011 WL 2176479, at *20 (Del. Ch. 2011). Id. Indeed, in a footnote the Vice Chancellor comments, “Delaware law explicitly rejects the notion that a board of directors can act loyally by consciously deciding to violate positive law,” citing a recent law review article by Chancellor Leo Strine.2 2012 WL 2087205 at FN 33.
The Vice Chancellor explains that the plaintiffs “alleged a direct connection between the Board and a business plan premised on illegal activity.” Id. at *31. The Vice Chancellor notes specific allegations as to the Allergan Board‟s review of annual business plans that contemplated the dramatic expansion of Botox sales in the US, including the marketing and promotion of off-label applications of Botox. Allegedly, the Board closely monitored the dramatically increasing sales of Botox, which were far in excess of what the market for existing on-label uses could support or which could be generated by serendipitous off-label prescriptions by physicians. The plaintiffs alleged that the Board kept the business plan in place even after FDA inquiries in 2006 would have illustrated Allergan‟s “regulatory exposure.” The Vice Chancellor notes that one could reasonably infer “that the Board knew Allergan per-sonnel were engaging in or turning a blind-eye toward illegal off-label marketing and promotion and that the Board nevertheless decided to continue Allergan‟s existing business practices in pursuit of greater sales.” Id. at *33. The Vice Chancellor therefore explains that “from these allegations, one can reasonably infer that the Board knowingly approved and monitored a business plan that contemplated illegality.” Id. at *31. The Vice
Chancellor notes approvingly that the complaint references various Board presentations that the plaintiffs obtained using a “books and records” request under Section 220. The Vice Chancellor explains:
It is not unreasonable to infer that the Board and the CEO saw the distinction between off-label selling and off-label marketing as a source of legal risk to be managed, rather than a boundary to be avoided. [footnote omitted] Based on this premise, the CEO and his management team devised and the Board approved, a business plan that relied on off-label-use-promoting activities, confident that the risk of regulatory detection was low, that most regulatory problems could be solved, and that dealing with regulatory risk was a cost of doing business ... The appearance of formal compliance cloaked the reality of non-compliance, and directors who understood the difference between legal off-label sales and illegal off-label marketing continued to approve and oversee business plans that depended on illegal activity. Id. at *34.
As to the FDA inquiries in 2006, the Vice Chancellor commented that the “incident should have further illuminated the serious legal risks posed by Allergan‟s various programs ... and the existence of a culture of non-compliance at the Company. Despite being confronted with this red flag, the directors subsequently approved iterations of the business plan that further ramped up Allergan‟s support for off-label use.” Id. at *36.
The Vice Chancellor is quick to point out that these are not the only inferences that could be drawn from the facts. He notes that “alternatively, one could infer that the directors received advice from sophisticated counsel about the difference between legal off-label sales and illegal off-label marketing, understood where the boundary lay, and approved a business plan and management initiatives in the good faith belief that Allergan was remaining within the bounds of the law, although perhaps close to the edge ... [and] closely monitored Allergan‟s performance with this understanding. Unfortunately the directors‟ good faith belief proved incorrect.” Id. at *34. The Vice Chancellor confirms that “if this scenario proves true, then the directors will not have acted in bad faith and will not be liable to Allergan for any of the harm it suffered.” Id. At this stage of the case, however, the Vice Chancellor has held that “a reasonable inference can be drawn from the particularized allegations of the Complaint and the documents it incorporates by reference that the Board knowingly approved and subsequently oversaw a business plan that required illegal off-label marketing and support initiatives for Botox.” Id.
The Vice Chancellor reviews the California federal court‟s decision dismissing the same complaint, but refuses to follow that court‟s reasoning, noting that a plaintiff does not have to point to an actual confession of illegality to survive a motion to dismiss a Caremark case, but rather must simply allege sufficient facts to support a reasonable inference that the directors “in fact approved a business plan that contemplated illegal off-label marketing.” Id. at *35. In considering the California federal court‟s holding, the Vice Chancellor notes that a conclusion that the directors had engaged in “appropriate remedial action” was a factual issue capable of being disputed. In a footnote, the Vice Chancellor notes an earlier case against Massey Energy, where the court noted that “plaintiffs in turn point to evidence creating a plausible inference that the independent directors of Massy ... [went] through the motions—rather than make good faith efforts to ensure that Massey cleaned up its act.” Id. at *34.
Lessons from the Allergan Case
The Allergan case provides a helpful summary of the current state of the law regarding Caremark claims, and the key factors that provide a link between corporate trauma and board action. In particular, it is important to note that Vice Chancellor Laster distinguishes valid Caremark claims from those brought by plaintiffs seeking to impose liability on directors for making wrong business decisions or taking imprudent risks.
Vice Chancellor Laster also outlines key defenses for directors, including a lack of knowledge of illegality. He notes that ten of the twelve defendant directors who served on the Board were “fully conscious of the role of off-label marketing in Allergan‟s success.” Id. at *34. These directors would also have been aware of the FDA inquiries and the concerns regarding the company‟s internal controls expressed by the general counsel. He explains that the inference was more tenuous for two directors who joined later.
The Vice Chancellor also outlines a fact pattern that could demonstrate the directors‟ good faith belief that the company was acting within the bounds of the law. This good faith belief, in the Vice Chancellor‟s view, would stem from their receipt of “advice from sophisticated counsel about the difference between legal off-label sales and illegal off-label marketing,” and their authorization and monitoring of activities that they believed were legal. Even if their “good faith belief unfortunately proved incorrect,” they would not be held to have acted in bad faith. Id. at *34.
Further, the Vice Chancellor notes the California court‟s reliance on the defendants‟ motion claiming “appropriate remedial action.” While he does not dismiss on that basis because of the requirement that the court adopt plaintiff-friendly interpretations of allegations on a motion to dismiss, it seems clear that remedial action would be a defense. Indeed, once evidence of illegal activity or behavior that may give rise to significant liability is revealed to the Board, its duty is to proactively address the situation to protect the company from further liability. The Vice Chancellor cautions against directors going through the motions, with an appearance of formal compliance cloaking a reality of non-compliance. Instead, the defense would be required to show “good faith efforts that [the company] cleaned up its act.” Id. at *34.
The defenses that Vice Chancellor Laster outlines are likely to prove critical to avoiding director liability. Moreover, the Allergan decision makes clear that directors should be vigilant in assessing business plans to discern illegal activities, basing their assessment on advice from sophisticated counsel, and should understand and monitor the adequacy of a company‟s internal controls to maintain compliance with applicable laws. Just as importantly, the directors should monitor corporate culture and act swiftly to root out any whiff of a “culture of non-compliance.” Finally, the corporate minutes should reflect the directors‟ actions. In taking these actions, the board will have the greatest chance of defeating a complaint alleging that it acted in bad faith through its alleged involvement in an illegal scheme.