On October 1, 2019, in In re Clovis Oncology Inc. Derivative Litig., a Delaware Chancery Court denied a motion to dismiss the plaintiffs’ Caremark claim alleging that individual directors should be held financially liable for failing to monitor the development of the biotech firm’s only promising experimental drug and for allowing the firm to publish inflated performance results. Clovis is significant because it marks the second opinion issued by the Delaware courts in recent months that allowed a Caremark claim to withstand a motion to dismiss, even though a Caremark claim is one of the most difficult to plead and prove.

Under the doctrine established by Caremark and its progeny, directors can face personal liability for knowingly not fulfilling their fiduciary duties by (1) failing to implement a board reporting or information system or (2) having established the system or controls, failing to monitor its operations, which prevented the directors’ awareness of risks and problems. Simply put, “‘to satisfy their duty of loyalty, directors must make a good faith effort to implement an oversight system and then monitor it.’” In addition, Delaware courts have stated that when the board oversight involves the monitoring of compliance with positive law, including regulatory mandates, the board’s oversight failure is more likely to give rise to liability.

Clovis is another reminder that directors should take care to fulfill their fiduciary duties, particularly for monitoring business operations in regulated areas, such as those where human health and welfare are at stake.

Key Facts:

The company, Clovis Oncology, Inc. (Clovis or the Company) had no drugs in the market and was developing a lung cancer drug that constituted the Company’s single promising drug. The Company’s clinical trial protocol incorporated a well-known, industry-wide clinical trial protocol that included a specific metric that indicated the drug’s efficacy. A standardized calculation method of the efficacy metric facilitates the comparison of competing drugs. Before the clinical trial commenced, the Company secured the approval of its clinical trial protocol from the Food and Drug Administration (FDA).

During the course of the clinical trial, the Company deviated from the protocol by improperly calculating the efficacy metric. The Company repeatedly published inflated performance results, including in connection with raising capital in the private and public securities markets. The company also failed to properly disclose the drug’s side effects.

While the board’s Nominating and Corporate Governance Committee was formally charged with developing and overseeing the effectiveness of the Company’s legal, ethical and regulatory compliance matters, the entire board received reports on the experimental drug that included “red flags” showing that the efficacy metric was being improperly calculated. The board took no corrective action. Eventually, when the drug’s properly calculated efficacy metric became public, the stock plummeted 70%.

Plaintiffs instituted suit, including Caremark claims against all the directors. Plaintiffs essentially alleged that the director defendants (i) failed to institute an oversight system for the clinical trial or (ii) consciously disregarded a series of red flags related to the clinical trial.

Key Analysis and Holding:

For a Caremark claim to withstand a motion to dismiss under Rule 12(b)(6), the complaint “must allege particularized facts that either (i) ‘the directors completely fail[ed] to implement any reporting or information system or controls, or . . . [(ii)] having implemented such a system or controls, consciously fail[ed] to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.’”

The court noted that Marchand v. Barnhill “makes clear, [that] when a company operates in an environment where externally imposed regulations govern its ‘mission critical’ operations, the board’s oversight function must be more rigorously exercised.” In Marchand, which we previously discussed, the defendants were accused of failing to properly oversee a regulatory compliance risk that led to the company, Blue Bell Creameries, distributing listeria-tainted ice cream. The Delaware Supreme Court denied the defendants’ motion to dismiss on the grounds that the plaintiffs had sufficiently pled that the board failed to meet the first prong of Caremark by not establishing a board reporting and information system. In comparison, in Clovis, the court found that the first Caremark prong was satisfied.

In making its determination, the Clovis court highlighted several points:

“Mission Critical” Product and Issues Existed Based on the facts pled, the Clovis court found that the experimental lung cancer drug constituted a “mission critical” product. Also, the efficacy metric and related FDA regulations governing the study were “mission critical regulatory issues.”

“Red Flags”–Second Caremark Prong The court turned most of its attention to the second Caremark prong, which focuses on the use of the board reporting system to monitor company activities. The court noted that “red flags” existed such as the board’s receiving reports showing that management was improperly calculating the efficacy metric. Moreover, the board knew that the Company was using the inflated performance numbers in communications outside the Company such as with investors and the FDA.

Scienter Was Inferred Because Defendants Were Experts Who Understood What Was at Risk and Failed to Act The Clovis court explained that to be held accountable for oversight liability, the directors must have “acted with scienter, which ‘requires proof that a director acted inconsistent with his fiduciary duties and, most importantly, that the director knew he was so acting.’” The Clovis court inferred that the board “consciously ignored red flags that revealed a mission critical failure to comply with the [specified] protocol and associated FDA regulations.” The directors either knew or should have known they were not discharging their duty. The board was composed of experts, and Clovis’ clinical trial protocol incorporated a protocol well known in the pharmaceutical industry. The court observed that neither the criteria of the well-known protocol nor the FDA requirements were nuanced. Clovis’ internal documents confirmed that the board spent hours at meetings discussing the experimental drug and its potential competitor.

The directors knew the efficacy metric was critical. Not only was it needed for FDA approval, but also would eventually be relied upon by prescribing physicians. Moreover, the board was aware the Company had used the metric to raise capital. Despite knowing all of this, the board took no action. The court described the directors who signed the Clovis Annual Report as acting “[w]ith hands on their ears to muffle the alarms.”

Heightened Liability Exposure for Directors When Positive Law and Consumer Health Involved While the Clovis court acknowledged that business-decision makers need latitude in order to take profitable business risks, the court drew a distinction by iterating that “‘Delaware Courts are more inclined to find Caremark oversight liability at the board level when the company operates in the midst of obligations imposed upon it by positive law yet fails to monitor existing compliance systems, such that a violation of law, and resulting liability, occurs.’” The Clovis court noted that when externally imposed regulations govern a company’s mission critical operations, the board must exercise a good faith effort to implement an oversight system, which “entails a sensitivity to ‘compliance issues[s] intrinsically critical’ to the company.”

Both in Clovis and Marchand, the courts denied a motion to dismiss, and the business activities in question were subject to compliance with FDA regulations.

What’s next?

In light of the Clovis decision, there are now two Caremark claims that recently withstood motions to dismiss within a short time span. It’s not clear whether this occurred because each had a well-pled complaint relating to a unique set of facts or whether more is at hand.

As Vice Chancellor Slights in Clovis observed, granting the motion to dismiss has limited predictive value on whether the claim, in light of evidence produced through discovery, will withstand a summary judgment motion or prevail at trial. For purposes of a motion to dismiss, the court is procedurally required to accept the allegations of the complaint as true and draw all reasonable inferences in the plaintiff’s favor. While the court may consider documents incorporated by reference, the consideration is generally limited to ensuring that plaintiffs’ representations of the documents are accurate and plaintiffs’ assertions are reasonably drawn.

The Vice Chancellor predicted that the Clovis plaintiffs will have difficulty proving causation. Although the court could not factor their arguments into his decision, the court mentioned that the defendants rigorously challenged plaintiffs’ assertions on a number of fronts.