Why it matters: On June 16, 2017, the Delaware Court of Chancery in the case of In re Qualcomm Inc. FCPA Stockholder Derivative Litigation dismissed a shareholders’ derivative lawsuit that had been brought against the board of directors of Qualcomm Inc. The complaint included a Caremark claim alleging that the Qualcomm board’s “conscious disregard for red flags” resulted in a “princelings” investigation by the Securities and Exchange Commission (SEC) and a March 2016 settlement pursuant to which Qualcomm paid the SEC a $7.5 million civil penalty to resolve Foreign Corrupt Practices Act (FCPA) violations. In dismissing the lawsuit, the court ruled that the complaint failed to adequately plead demand futility or bad faith on the part of Qualcomm’s board, finding among other things that the plaintiff shareholders “simply seek to second-guess the timing and manner of the board’s response to the red flags, which fails to state a Caremark claim.”

Detailed discussion: On June 16, 2017, the Delaware Court of Chancery in the case of In re Qualcomm Inc. FCPA Stockholder Derivative Litigation dismissed a shareholders’ derivative lawsuit that had been brought against the board of directors of Qualcomm Inc. The complaint included a Caremark claim alleging that the Qualcomm board’s “conscious disregard for red flags” led to a “princelings” investigation by the SEC and a March 2016 settlement (including a cease-and-desist order) pursuant to which Qualcomm paid the SEC a $7.5 million civil penalty to resolve alleged violations of the internal controls provisions of the FCPA. In dismissing the lawsuit, the court ruled that the complaint failed to adequately plead demand futility or bad faith on the part of Qualcomm’s board, finding among other things that the plaintiff shareholders “simply seek to second-guess the timing and manner of the board’s response to the red flags, which fails to state a Caremark claim.”

The court’s opinion details the SEC’s findings and cease-and-desist order in connection with the FCPA settlement at the heart of the shareholder derivative lawsuit. To briefly summarize, on March 1, 2016, the SEC announced that Qualcomm agreed to pay $7.5 million to settle charges that it and its Chinese subsidiary violated the internal controls provisions of the FCPA by hiring relatives of Chinese government officials who had decision-making power over “whether to select the company’s mobile technology products amid increasing competition in the international telecommunications market.” The SEC’s investigation further found that Qualcomm and its Chinese subsidiary “provided gifts, travel, and entertainment to try to influence officials at government-owned telecom companies in China.” In addition to paying the $7.5 million civil penalty, Qualcomm agreed to self-report and certify to the SEC for a two-year period about its FCPA compliance efforts (for more on the SEC’s FCPA settlement with Qualcomm and the SEC’s “princelings” investigations generally, see our March 2016 newsletter under “FCPA Focus on China, Princelings and the First SEC FCPA DPA with an Individual: Qualcomm and PTC”).

Following the SEC settlement, a shareholders’ derivative complaint (Complaint) was filed in the Delaware Court of Chancery against the Qualcomm board of directors that asserted as the first of three counts (the others being waste and unjust enrichment) a Caremark claim for breach of fiduciary duty based on improper board oversight (the claim name derives from the 1996 Delaware Court of Chancery case of In re Caremark International Inc. Derivative Litigation, which first established the test—discussed below—for board liability in an oversight context). We focus only on the Caremark claim here.

Qualcomm subsequently moved to dismiss the Complaint under Delaware Court of Chancery Rule 23.1 for, among other things, failure to adequately allege demand futility, which the court granted as to all three counts after first reviewing the standards that must be met to prove demand futility under Delaware law (“to excuse demand, the alleged derivative claims against the board must be sufficiently strong such that a majority of the members of the board face a ‘substantial likelihood’ of personal liability”).

The court began its analysis of the Caremark count by reiterating the two bases on which directors may be held liable for a Caremark claim under Delaware law: “(a) the directors utterly failed to implement any reporting or information system or controls; or (b) 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 noted that the plaintiffs in this case were relying on the second prong of the Caremark test, and thus their Complaint “must allege ‘(1) that the directors knew or should have known that the corporation was violating the law, (2) that the directors acted in bad faith by failing to prevent or remedy those violations, and (3) that such failure resulted in damage to the corporation.’” Further, because the plaintiffs were not alleging that the Qualcomm board intentionally caused Qualcomm to violate the law, the court said that in order to adequately plead bad faith the plaintiffs “must plead particularized facts from which it is reasonably inferable that the [b]oard consciously disregarded its duties by ‘intentionally fail[ing] to act in the face of a known duty to act.’” In this regard, the court said, “[s]imply alleging that a board incorrectly exercised its business judgment and made a ‘wrong’ decision in response to red flags . . . is insufficient to plead bad faith.”

Applying these principles to the case before it, the court found that the Complaint “fails to allege particularized facts giving rise to an inference that a majority of the board faces a substantial likelihood of liability on the Caremark claim alleged” and thus failed to adequately plead demand futility.

The court said that, at the outset, it “need not address whether the alleged red flags actually constitute red flags or whether the board’s response to the alleged red flags caused damage to Qualcomm because the Complaint fails to plead facts giving rise to an inference that the board acted in bad faith.” For example, the court said that even “[a]ssuming for purposes of this analysis that the various reports to the Audit Committee and the board [cited by the plaintiffs] constituted red flags, the Complaint does not allege that the board consciously disregarded the red flags.” In fact, the court noted that “[m]any of the documents the Complaint cites as red flags also include planned remedial actions.”

The court then went through some of the Qualcomm board’s responses to the alleged “red flags” cited by the shareholders as proof of bad faith or conscious disregard on the part of the board, and concluded as follows:

“These responses to the red flags show that the board did not act in bad faith. There is no indication that the board believed Qualcomm could continue to violate the FCPA without consequences. And no allegations suggest that the Qualcomm board consciously disregarded the red flags. The allegations in the Complaint do not adequately plead ‘an intentional dereliction of duty’ after the board was aware of the risk of future FCPA violations through the red flags. In fact, Plaintiffs point to only two factual allegations as evidence of a failure to respond to the red flags: a December 31, 2013 target date for the translation of its FCPA compliance materials into Chinese (which Plaintiffs allege was too late) and the company’s plan to formulate a long-range FCPA plan (which Plaintiffs again contend was too late because it remained outstanding as of January 27, 2014). These board decisions do not rise to the level of bad faith. Instead, Plaintiffs here simply seek to second-guess the timing and manner of the board’s response to the red flags, which fails to state a Caremark claim.”

Finally, the court also rejected the plaintiffs’ argument that the SEC’s findings in the 2016 cease-and-desist order regarding Qualcomm’s violation of the FCPA were proof positive of dereliction of duty in bad faith by the Qualcomm board, stating:

“A corporation’s violation of the FCPA alone is not enough for director liability under Caremark. Delaware courts routinely reject the conclusory allegation that because illegal behavior occurred, internal controls must have been deficient, and the board must have known so. Delaware law, not the FCPA, establishes the standard for director liability, and under Delaware law, Plaintiffs’ Complaint does not allege bad faith.”