Delaware Court Of Chancery Dismisses Derivative Suit For Failure To Allege Substantial Likelihood Of Liability Sufficient To Excuse Pre-Suit Demand
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  • Delaware Court Of Chancery Dismisses Derivative Suit For Failure To Allege Substantial Likelihood Of Liability Sufficient To Excuse Pre-Suit Demand

    On June 30, 2022, Chancellor Kathaleen St. J. McCormick of the Delaware Court of Chancery granted a motion to dismiss derivative claims for breach of fiduciary duty brought by a stockholder of an energy company (the “Company”) against its directors following an incident involving explosions in the pipeline system of one of its natural gas distribution subsidiaries. City of Detroit Police and Fire Retirement System v. Hamrock, C.A. No. 2021-0370-KSJM (Del. Ch. June 30, 2022).  Plaintiff claimed that the board breached its oversight obligations under Caremark by allegedly failing to implement a reporting and monitoring system relating to pipeline safety and ignoring “red flags.”  The Court held that pre-suit demand under Court of Chancery Rule 23.1 was not excused because the complaint did not adequately plead that the directors faced a substantial likelihood of liability.

    The incident allegedly occurred when a construction crew attempted to replace a pipe without first relocating pressure regulator-sensing lines.  System over-pressurization allegedly resulted in fires and explosions that caused a fatality and multiple injuries, as well as structural damage in the area.  Several criminal and regulatory consequences for the Company purportedly followed, including a $56 million settlement with the office of the Massachusetts Attorney General, a deferred prosecution agreement with the U.S. Department of Justice, and an agreement by the subsidiary to plead guilty and pay a $53 million fine with respect to federal claims.

    Plaintiff asserted three theories of oversight-related liability under In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).  The Court, however, dismissed the complaint, finding that the allegations were insufficient to demonstrate the requisite substantial likelihood of liability to plead demand futility.

    First, plaintiff alleged that the board “utterly fail[ed] to implement any reporting or monitoring system to oversee pipeline safety, which was ‘mission critical’ for [the Company’s] gas businesses.”  The Court, however, found that plaintiff’s “own allegations” demonstrated the inadequacy of that claim.  For instance, the complaint and the documents incorporated therein revealed that the board had a specific committee “tasked with overseeing safety issues, which did, in fact, monitor and report on pipeline safety compliance.”  The Court explained that, although a board “must make a good faith effort” to implement a “reasonable board-level system of monitoring and reporting,” it has “great latitude in crafting and implementing” that system.

    Second, plaintiff alleged that the board made “repeated business decisions to allow [the Company’s] Gas Subsidiaries to operate in violation of pipeline safety laws, rather than expend the necessary funds to ensure that these subsidiaries complied with those laws.”  But the Court held that plaintiff did not adequately allege a “degree of lawlessness” sufficient to plead an oversight claim against the board.  The Court noted that “the big picture” is that the board had “committees dedicated to compliance risk and voluntarily took several concrete steps” to improve safety.

    Third, plaintiff alleged that the directors ignored safety-related “red flags.”  For example, the complaint alleged that the board was “repeatedly informed” that deficient recordkeeping practices “posed a significant risk” and that the board was “made aware of serious issues concerning violations of specific recordkeeping requirements” at its natural gas subsidiaries.  The Court, however, held that the relationship between the “corporate trauma” and the alleged red flags was “too attenuated.”  The Court found that plaintiff did not adequately allege that defendants had knowledge that should have alerted them to the risk of the explosions that ultimately occurred at the relevant subsidiary.  The Court explained that “the red flag must be sufficiently connected to the corporate trauma at issue to elevate the board’s inaction in the face of the red flag to the level of bad faith.”