United States: Another Caremark Case Survives A Challenge

In In re The Boeing Company Derivative Litigation, Vice Chancellor Morgan Zurn of the Delaware Court of Chancery opened her opinion this way:

Do the directors bear any responsibility for these losses? The question before the Court in this derivative litigation was whether the plaintiff stockholders-New York and Colorado public pension funds-had adequately alleged, under In re Caremark International Inc. Derivative Litigation and Marchand v. Barnhill, that, as a result of the directors' "complete failure to establish a reporting system for airplane safety," or "their turning a blind eye to a red flag representing airplane safety problems," the board faced a "substantial likelihood of liability for Boeing's losses." In a 103-page opinion, the Court concluded that the answer was yes-on both bases. (Other claims regarding the company's officers and the board's handling of the CEO's retirement and compensation were dismissed.)  It's worth noting that this case is one of several Caremark claims in recent years to survive dismissal (see, e.g., this PubCo post). In Marchand, then-Chief Justice Strine remarked that Caremark presents a very high hurdle, observing that "Caremark claims are difficult to plead and ultimately to prove out," and constitute "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment." (See this PubCo post.) In light of this series of decisions, you have to wonder-at least with regard to matters that involve "essential and mission-critical" risk and safety issues-if that's still the case.

Background

As described by the Court, based on the complaint, following two crashes involving Boeing's 737 MAX airplanes in 2018 (the "Lion Air Crash") and 2019 (the "Ethiopian Airlines Crash") that involved tragic loss of life, the company suffered serious reputational harm and a significant drop in revenue. The crashes followed a shift at Boeing from a culture that prized engineering and safety to one that, after Boeing's acquisition of McDonnell Douglas, emphasized profits, rapid production and cost-cutting. Boeing also began to see a "sharp rise" in safety violations: between 2000 and 2020, the "FAA flagged twenty airplane safety violations for poor quality control, poor maintenance, and noncompliant parts, as well as the Company's failure to provide its airline clients with crucial safety information," resulting in fines of up to $13 million.

In "contrast to many other companies in the aviation space," the Court maintained, Boeing did "not implement or prioritize safety oversight at the highest level of the corporate pyramid. None of Boeing's Board committees were specifically tasked with overseeing airplane safety, and every committee charter was silent as to airplane safety." The audit committee was charged generally with oversight of risk and compliance, although "it did not take on airplane safety specifically" and did not "address product safety issues related to the design, development, or production of the 737 MAX, or ask for presentations on the topic." Rather, the committee addressed primarily financial risks and oversaw an "enterprise risk visibility" process, but this process did not emphasize airplane safety. Nor was airplane safety "a regular set agenda item or topic at Board meetings." Management did not periodically report to the board about airplane safety, nor did the board receive internal whistleblower complaints about airplane safety.

Notwithstanding its history of safety incidents, "Boeing continued to push production and forego implementing meaningful systems to monitor airplane safety," focusing its efforts principally on production of its 737 MAX, which was a redesign of an older model. According to the opinion, "no Board member asked about the safety implications of reconfiguring the [older model] with larger engines. Rather,.the Board's primary concern was 'how quickly and inexpensively the Company could develop the 737 MAX model to compete with Airbus's A320neo.'"

Because, in the redesign, its larger engines had to be situated differently on the airplane's wings, the 737 MAX tended to "pitch up" in flight, leading the company to develop new software, MCAS, that caused the airplane's tail to move up and its nose down.  However, it was widely known that the sole activating sensor for MCAS was "highly vulnerable to false readings or failure for numerous reasons," and there was no compensating alternative sensor.

According to the Court, Boeing's safety analyses and disclosures to the FAA underestimated the lethality of a failure with the MCAS software. As the Court phrased it, Boeing's safety assessment "did not consider the possibility that MCAS could trigger repeatedly, effectively giving the software unlimited authority over the plane."  Boeing also delayed forwarding to the FAA an employee's text messages "admitting he had lied to the FAA" and "bragging that his 'jedi mind tricks' had worked on the FAA." In addition, the training materials for U.S.-based airlines lacked specific information about the software, which senior FAA officials, testifying before Congress after the Lion Air and Ethiopian Airlines Crashes, said "should have been explained in those manuals."  

By the end of 2016, the Court continued, the 737 MAX had become the fastest-selling airplane in Boeing's history, and by 2018, "Boeing's profits from the 737 MAX skyrocketed," accounting for approximately 60% of Boeing's record $101.1 billion in annual revenue and 80% of net earnings, as well as over $400 billion in backlog. With the increase in sales, however, some Boeing employees expressed concerns about the airplane's safety, indicating "unrelenting and dangerous economic pressure from senior management to produce the 737 MAX rapidly and cheaply." Although senior management was aware of some of these "whistleblower" complaints, the board heard none of them.

The Lion Air Crash occurred in October 2018. Satellite data from the crash showed the plane "rising and falling repeatedly," as MCAS was activated to force the airplane's nose downwards. Risk assessments by Boeing and the FAA showed "an unacceptably high risk of catastrophic failure if MCAS was not changed." Subsequently, the WSJ published an article reporting that Boeing withheld information from airline managers and pilots about MCAS, leaving pilots unprepared to deal with the possible risks, and did not highlight information about the flight control systems in the training manuals.

According to the opinion, when, a week after the crash, management alerted the board, it did not mention MCAS, the absence of a redundant activating sensor or other factors, concluding that management believed the "737 MAX fleet is safe." Later, in the face of strong negative press, the CEO told the board that the WSJ article was "categorically false," instead blaming the flight crew for the crash. On an "optional" board call in November, almost a month after the crash and the first board call post-crash, management explained that erroneous sensor date contributed to the crash, that "the Lion Air repair shop may not have followed the approved repair process on the sensor," and denied that information was withheld. There were no minutes of the meeting.

The board did not reconvene until its regular meeting in December. The minutes indicated that the board's "primary focus relating to the 737 MAX and Lion Air Crash was on restoring profitability and efficiency in light of longstanding supply chain issues," although the crash was apparently addressed in executive session. Nor, according to the Court, did the audit committee appear to focus on 737 MAX safety at that time. An addendum to board minutes in February stated that the board "decided to delay any investigation until the conclusion of the regulatory investigations or until such time as the Board determines that an internal investigation would be appropriate."

The Ethiopian Airlines Crash occurred in March, less than a month after the board decision to delay an internal investigation.  In the crash, the "pilots followed Boeing's recommended emergency procedures, but could not regain control of the plane because MCAS repeatedly activated."  After investigation, the FAA grounded the 737 MAX. Only after the second crash did management formally implement, at the initiative of the CEO, safety reporting to the board. Nevertheless, the CEO's communications to the Board "focused on restoring Boeing's reputation and returning the 737 MAX to service."

Five days after the Ethiopian Airlines Crash, one of the directors specifically called for a meeting devoted to airplane safety because "[i]n addition to providing necessary information for the Board, this type of agenda would underscore the board's (and management's) unwavering commitment to quality and safety above all other performance criteria." In late April, following up on that recommendation, the board devoted over two hours to product safety, critically assessing "MCAS, the FAA certification process and pilot training requirements."  Notably, the Court also quoted at length from some communications between two directors who both sat on a different board together: at the other company, one of the directors said, "'each board meeting, executive committee meeting, and operating review [began] with a review of product quality/safety-before any discussion of financial performance, market share/competitive activities, new product development timetables, and certainly stock price.' He stressed that people 'paid close attention to the priorities of senior management, and everyone in the corporation understood that nothing was more important to the CEO and the board than quality/safety,' and that '[i]t's hard to quantify the impact of this approach, but it certainly was important.'"

In addition, the board established an airplane committee, although the "fact-finding sessions intended to inform the Committee's conclusions and recommendations were sparsely attended..On May 6, for the first time, the Airplane Committee formally requested information about the cause of the crashes." The committee chair proposed that product safety reports should go to the audit committee and the board as a whole.  Two new committees devoted to safety and whistleblower reports were established. In December, the audit committee received a compliance risk management report that, for the first time, included a category for "Safety." Eventually, the CEO "acknowledged that access to better information would have supported grounding the 737 MAX fleet shortly after the Lion Air Crash."

The Court also asserted that the "Board publicly lied about if and how it monitored the 737 MAX's safety," with the lead director making "false" representations in newspaper interviews designed to "'[p]osition the Boeing Board of Directors as an independent body that has exercised appropriate oversight.'"  After the CEO came under fire from the FAA, he was terminated, although allowed to retain over $38 million in unvested equity awards.

The 737 MAX fleet was grounded for twenty months.  Boeing suffered damage to its "profitability, credibility, reputation, and business prospects," including an estimate for 2020 of non-litigation costs of $20 billion and litigation-related costs in excess of $2.5 billion. In January 2021, "Boeing consented to the filing of a criminal information charging the Company with conspiracy to defraud the United States and thereby incurring billions of dollars in penalties."

Complaint

The plaintiffs filed a derivative action against the board claiming conscious breach of fiduciary duty and violation of corporate responsibilities by "(1) before the Lion Air Crash, failing to implement any reasonable information and reporting system to monitor and oversee the safety of Boeing's airplanes; (2) after the Lion Air Crash, despite being made aware of red flags concerning the operation, development, and nondisclosure of MCAS, consciously disregarding their duty to investigate and to remedy any misconduct uncovered; and (3) after the Ethiopian Airlines Crash, falsely assuring the public about the safety of the 737 MAX and MCAS and deciding to cash out [the CEO's] unvested equity-based compensation." The complaint also included a derivative claim for breach of fiduciary duty against certain officers.

Court's analysis

The case came before the Court in the context of demand futility. The plaintiffs alleged that demand on the board was futile because a majority of the board "faced a substantial likelihood of liability for failing to make any good faith effort to implement and oversee a board-level system to monitor and report on safety," that is, "failure to fulfill their oversight duties under the standards set forth in Caremark, as applied by the Delaware Supreme Court in Marchand." The Court concluded that, as to the directors, the allegations were sufficient to render demand futile (except for the claim related to CEO compensation), but not adequate as to the officers. At this stage, where the Court assumes the truth of the allegations, the plaintiff "must allege particularized facts that satisfy one of the necessary conditions for director oversight liability articulated in Caremark: either that (1) 'the directors utterly failed to implement any reporting or information system or controls'; or (2) 'having implemented such a system or controls, [the directors] consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.'" According to the Court, "a showing of bad faith is a necessary condition to director oversight liability." The allegations must "allow a reasonable inference the directors acted with scienter which in turn 'requires [not only] proof that a director acted inconsistent[ly] with his fiduciary duties,' but also 'most importantly, that the director knew he was so acting.'"

The Court agreed that the plaintiffs had stated a claim under the first prong of Caremark, which requires that the board must "make a good faith effort-i.e., try-to put in place a reasonable board-level system of monitoring and reporting."  Comparing the specific  "failings" of the Boeing board to those of the board in Marchand-also a case involving "'essential and mission critical' regulatory compliance risk"-the Court concluded that the burden had been met. The Board, the Court said citing Marchand, has a "rigorous oversight obligation where safety is mission critical." The Court was careful to state that the deficiencies identified in Marchand (see this PubCo post) were not necessarily "prescriptive"-directors "have great discretion to design context- and industry-specific approaches tailored to their companies' businesses and resources''-but rather that Marchand was "dispositive in view of Plaintiffs' remarkably similar factual allegations." As such, the Court then marched through the specific failures in Marchand as applied to the Boeing board.

No board committee addressing airplane safety. The plaintiffs alleged that, as in Marchand, Boeing had "no committee charged with direct responsibility to monitor airplane safety," and the audit committee's focus was primarily financial; the board "did not specifically charge the Audit Committee with monitoring airplane safety," and the committee did not address the safety of the 737 MAX. The various airplane safety committees were not established until after the crashes.  In addition, there was no internal reporting system to bring whistleblower safety concerns to the board.

No regular schedule for the board as a whole to consider airplane safety. What's more, plaintiffs alleged, the board as a whole "did not formally address or monitor safety," such as by regularly allocating meeting time to safety discussions. The Court pointed to several of the board meetings after the first crash, during which the board addressed "restoration of profitability and efficiency, but not product safety, MCAS, or the [activating] sensor."  In addition, the Court noted that the board had "affirmatively decided to delay its investigation into the 737 MAX, notwithstanding publicly reported concerns about the airplane's safety." The first real safety discussion, the complaint alleged, occurred only after the 737 Max was grounded by the FAA. Although there were various "nods" to safety, they occurred in the context of business objectives such as assessing "production timelines and revenue expectations," as well as FAA relationships; they fell "short of the rigorous oversight Marchand contemplates." Parroting Marchand (changing the company name and product), the Court stated that "'[T]he fact that [Boeing] nominally complied with F[A]A regulations does not imply that the board implemented a system to monitor [airplane] safety at the board level.'. As Marchand made plain, the fact that the company's product facially satisfies regulatory requirements does not mean that the board has fulfilled its oversight obligations to prevent corporate trauma." Ultimately, the failure of the board to put formal procedures in place to monitor safety meant that "the Board was not privy to the truth about MCAS, [activating] sensor vulnerabilities, or how those issues were handled in FAA certification and pilot training." 

No regular process requiring management to keep the board apprised of airplane safety issues. As alleged, the board also "had no regular process or protocols requiring management to apprise the Board of airplane safety; instead, the Board only received ad hoc management reports that conveyed only favorable or strategic information." As set forth in the complaint, the board received occasional, discretionary "management-initiated communications" that "were not safety-centric," and "when safety was mentioned to the Board, it did not press for further information, but rather passively accepted management's assurances and opinions." However, the Court affirmed, for "mission-critical safety," the board cannot leave "compliance with [airplane] safety mandates to management's discretion rather than implementing and then overseeing a more structured compliance system." In the absence of a safety mandate, the CEO's "self-directed communications to the Board focused on discrediting media reports faulting MCAS, and on blaming Lion Air repair shops and crew." And notes from the CEO indicated that "Boeing's management was taking charge while the Board remained a passive recipient of updates."

Some red flags were not relayed to the board. While the board surely learned of some red flags, such as the Lion Air Crash, management received whistleblower complaints and problematic internal safety analyses-which "could be considered red, or at least yellow, flags"-but these were not disclosed to the board.  Rather, management told the board that "the 737 MAX was safe."  The Court found that the failures to relay these complaints were also indicia of "the absence of a reporting system."

Some directors knew that better protocols should have been in place. In addition, the Court concluded, the board's own words supported an "explicit finding" of scienter. Here, the Court alluded to the director communications calling for the initial meeting dedicated to airplane safety and recollecting the more exemplary approach followed at another company where they had also served as directors.  These communications, the Court reasoned, "confirm that directors knew the Board should have had structures in place to receive and consider safety information." The Court also found director "knowledge" in the lead director's public representations "about taking specific actions to monitor safety that it did not actually perform."

The Court also found that the plaintiffs stated a claim under the second prong of Caremark, which requires that they plead "particularized facts that the board knew of evidence of corporate misconduct-the proverbial red flag-yet acted in bad faith by consciously disregarding its duty to address that misconduct."  In particular, the Court viewed the Lion Air Crash as "a red flag about MCAS that the Board should have heeded but instead ignored." Again, the opinion stated, when management said that the 737 MAX was safe, the board did not challenge management, nor did it challenge management after the WSJ article appeared. Rather, the board "treated the crash as an 'anomaly,' a public relations problem, and a litigation risk, rather than investigating the safety of the aircraft and the adequacy of the certification process." However, because of the viability of plaintiffs' claims under the first prong, the Court concluded that it did not need to decide whether the "prong two theory" was cognizable.

The Court did not find adequate the allegations in the third claim that the directors consciously breached their fiduciary duties by allowing the CEO to "retire" and receive unvested equity-based compensation. The Court held that the plaintiffs did not "meaningfully challenge the independence and disinterestedness" of the board in connection with the terms of the CEO's departure or adequately plead waste or bad faith.  Instead, according to the Court, they theorized that the board was essentially paying the CEO for his silence about the board's failures, but did not adequately plead supporting facts. The Court determined that it was reasonable to infer that the board was "validly exercising its business judgment" when it decided to allow the CEO to retire with compensation.

For Count II regarding certain officers of Boeing, the Court also dismissed that claim. According to the Court, the complaint's demand futility allegations did not address the officers, nor did the plaintiffs argue that any of the directors were "beholden to or dominated by the Boeing officers such that they would be unable to assess Count II regardless of the theory of liability."

What can we learn?

So what is the lesson here?  No doubt a Caremark claim is still a tough claim for a plaintiff to establish.  But, as Boeing shows, a board can make that claim much easier to establish if it leaves risk oversight to the discretion of management and fails to raise questions in the face of red flags. As the Court made clear, boards need to oversee compliance and monitor risks. Moreover, what Boeing, Marchand and other similar cases have underscored is the imperative of board engagement on risks that relate to mission-critical operations of the business-for example, product safety for product manufacturers or privacy or cybersecurity for companies holding large amounts of confidential customer data. To effectively carry out its responsibilities, Boeing suggests, the board needs to periodically identify key risks and challenges facing the company, especially mission-critical risks, and make a good faith effort to proactively establish reporting systems or other communication protocols that require management to report to the board on a regular basis about risk and compliance issues, especially those that are "essential and mission critical" to the company's business. Boeing showed that Board reporting systems and protocols should be sufficiently rigorous to put boards on notice promptly in the event any mission-critical risk begins to emerge so that directors can immediately assess and monitor the situation, including the need for further response. Whether responsibility is retained at the board level or delegated to a committee dedicated to oversight of mission-critical risk, appropriate time should be allocated to monitor, review and consider any risk-related information. Care should also be taken to document board and committee consideration of risk-related information.

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