Delaware Affirms Key Oversight Function of Directors in Highly Regulated Industries

In an opinion issued this summer, the Delaware Supreme Court recently affirmed that corporate directors in highly-regulated industries must exercise adequate oversight over safety and compliance matters as part of their fiduciary duties of care and loyalty. 

The decision presents an opportunity for food and drug makers and others whose products raise safety concerns to review their corporate governance practices to improve oversight, enhance safety, and protect management from legal exposure. 

Background of the Case

The case, Marchand v. Barnhill, involved shareholders’ claims against Blue Bell, the fourth-largest ice cream maker in the country, whose products were contaminated by a listeria outbreak in 2015, causing  three deaths and a massive product recall. 

As a result of the outbreak, Blue Bell laid off one-third of its workforce and was forced to accept a highly-dilutive capital infusion to keep operations going. 

The court’s legal opinion focused on two issues: first, whether directors holding a majority of the board’s votes could impartially consider the shareholder’s claims that management breached its duties in connection with the outbreak; and second, whether the board of directors breached its fiduciary duties by failing to adequately oversee the safety of Blue Bell’s food-making operations.

As the court noted in its opinion, Blue Bell operated as a single-product food manufacturer, and “food safety was essential and mission critical.” The company was “required to comply with regulations and establish controls to monitor for, avoid and remediate contamination and conditions that expose the Company and its products to the risk of contamination.” Yes according to the complaint:

1. No board committee existed to address food safety;

2. The company had no regular process or protocol that required management to keep the board informed of food safety matters;

3. The company did not have a schedule for the board to consider food safety on a regular basis; and

4. While management received reports with compliance red flags, no evidence existed to suggest these were disclosed to the board. 

Summary of Key Holdings

The Marchand decision had two principal holdings.

Directors Must Exercise Informed Oversight of Safety and Compliance

The Court held that because “no system of board-level compliance monitoring and reporting existed at Blue Bell,” directors breached their duties under the court’s precedent, which required them to make a good faith effort to oversee company operations.

Key to the court’s determination were the facts that the Blue Bell board did not put in place “a reasonable system of monitoring and reporting about the corporation’s central compliance risks.” According to the Court, the board’s lack of effort resulted in it not receiving official notices of food safety deficiencies for several years until the outbreak in 2015.

Crucially, while the company management had systems in place to ensure compliance with regulations, the court emphasized this does not absolve a board of directors from its independent obligation to exercise oversight of those efforts.

Director Independence

The court also found that a director’s deep and longstanding relationship with Blue Bell’s founding managers was sufficient to call into question that director’s ability to impartially assess the shareholder’s claims. 

According to the Court, the lack of director independence turns on whether a director may feel “subject to [an] interested party’s domination or beholden to the interested party.”  

While monetary considerations are important to this analysis, the “law cannot ignore social nature of humans.” Because of the deep business and personal relationship between the director and management, the Court held that reasonable doubt existed as to whether the director could “impartially or objectively assess whether to bring a lawsuit.”

Evaluating Next Actions 

For companies in highly regulated industry like food and drug manufacturing, Marchand is a call to action to ensure board-level oversight of safety and compliance functions. What’s critical in this regard is that the board is regularly apprised of material information relating to safety and compliance and that the Board actively review that information and respond to it with appropriate oversight.    

While every company and board must determine for itself what constitutes appropriate oversight, examples of governance practices to this effect might include the following:

1.     Establish a board committee responsible for regulatory and compliance risks;

2.     Create processes and protocols requiring company management to inform the board of safety compliance developments, practices and risks;

3.     Maintain a quarterly schedule for the board to review and discuss regulatory and compliance risks; and

4.     Keep detailed minutes of board discussions regarding regulatory and compliance matters.

The Marchand opinion also underscores the value of independent directors to effective corporate governance.  As company operations mature, it’s important that its board include perspectives that are independent of incumbent management to better enable healthy and impartial oversight.