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Delaware Court of Chancery Dismisses Derivative Action Against Board of Directors of UPS for Failure to Monitor

The Court of Chancery granted a motion to dismiss a shareholder derivative action brought against the board of directors of UPS for breach of their fiduciary duty of loyalty in which it was alleged that the board failed to monitor UPS’s compliance with laws governing the transportation and delivery of cigarettes, resulting in the government seeking approximately $180 million in a pending enforcement action against UPS. In ruling on the motion, the Court held that the plaintiffs did not adequately plead facts to support their contention that making a demand on the board of directors to take corrective action or pursue the claim would be futile, which is a prerequisite to a shareholder derivative action.

Joseph Horman and Steven Green v. David P. Abney, et al. and United Parcel Service, Inc involved a derivative action asserted on behalf of UPS for breach of the fiduciary duty of loyalty. The plaintiffs’ claim was based on the alleged failure by the Board of Directors (the “Defendants”) of United Parcel Service, Inc. (“UPS”) to comply with their oversight obligations with regard to UPS’s compliance with laws governing the transportation and delivery of cigarettes.  This type of failure to monitor claim is referred to under Delaware case law as a Caremark claim.  The Defendants moved to dismiss the plaintiffs’ claim based on the failure to make a pre-suit demand on the Directors.

UPS, the world’s largest package delivery company, is subject to various regulatory restrictions governing the shipment and delivery of cigarettes. In 2004, the New York Attorney General investigated UPS’s compliance with these restrictions and concluded that UPS had violated certain prohibitions on the delivery of untaxed cigarettes to New York residents.  To resolve the investigation, UPS entered into an Assurance of Discontinuance Agreement (the “AOD”) in 2005, which required UPS to institute policies, programs, and procedures to ensure compliance with New York law regarding shipment and delivery of cigarettes. The AOD also provided for a stipulated penalty of $1,000 per violation of the AOD, in addition to other potential liability under state and federal law.  Although UPS initially complied with the AOD, in February 2015, the City and State of New York filed suit in federal court against UPS based on alleged violations of the AOD and other applicable state and federal laws over a period of several years preceding the suit.  The suit seeks penalties and damages of at least $180 million.  The plaintiffs in Horman alleged that the Defendants’ failure to oversee the corporation’s compliance obligations led to the alleged violations that are the subject of the federal suit.

The Court of Chancery reviewed the Defendants’ motion to dismiss the derivative action on the basis that prior to commencing a shareholder derivative suit on behalf of a corporation, the plaintiff must either demand that the board of directors take corrective measures or pursue the claim or, alternatively, demonstrate that a demand on the board would be futile such that the demand requirement should be excused. The Court of Chancery applied the Rales test, which applies when a board is alleged to have disregarded its duty and requires the plaintiff to show reasonable doubt that the board “could have properly exercised its independent and disinterested business judgment in responding to a demand.” Under Rales, reasonable doubt of board independence and disinterestedness exists when the demand would reveal board inaction that would expose the board to a substantial likelihood of personal liability.

The Court of Chancery determined that the plaintiffs did not adequately plead facts to excuse demand with respect to their Caremark claim.  The Caremark standard requires that in order for directors to be exposed to personal liability for a failure of oversight, the plaintiffs must show that the directors knew that they were not discharging their fiduciary obligations.  In order to do so, the plaintiffs must allege facts that demonstrate one of the necessary conditions for director oversight liability, namely: (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 [the corporation’s] operations thus disabling themselves from being informed of risks or problems requiring their attention.”

With respect to the first prong of the Caremark standard, the Court of Chancery explained that UPS implemented corporate governance changes required by the AOD and plaintiffs admitted that UPS did so.  Thus, the plaintiffs did not plead facts supporting a reasonable inference that the Defendants face a substantial likelihood of liability for utterly failing to create and implement a system of internal controls.  With respect to the second prong of the Caremark standard, the Court of Chancery stated that the plaintiffs did not adequately plead facts to support the claim that the Defendants acted in bad faith by ignoring “red flags” indicating corporate misconduct.  The Court of Chancery reviewed each of the “red flags” that the plaintiffs presented and explained that, in certain cases, the plaintiff did not plead sufficient facts to indicate that anyone had actually called the Defendants’ attention to the so-called “red flags,” and in other cases, the Defendants responded to address the red flags when they were presented.  Thus, the Defendants did not face a substantial likelihood of personal liability for ignoring the red flags in a manner that demonstrated conscious failure to monitor.  Therefore, the Court held that under Caremark, based on the facts pled by the plaintiffs, demand could not be excused as futile on either basis.

Finally, in addressing the plaintiffs’ alternative theory of a knowing, conscious failure to monitor–that the magnitude and duration of UPS’ alleged misconduct supports a reasonable inference that the Defendants were aware of the wrongdoing–the Court of Chancery held that the plaintiffs did not allege any facts that enabled the Court to consider the magnitude of the illegal shipments in the context of UPS’s overall operations.

The Court of Chancery dismissed the plaintiffs’ claims with prejudice for failure to plead particularized facts showing that demand on the Defendants would have been futile.

Horman v. Abney (UPS) memorandum opinion 170119

Copyright 2017 K & L Gates

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Michelle R. Repp, KL Gates, acquisitions transactions lawyer, private equity investments attorney
Partner

Ms. Repp concentrates her practice primarily on corporate, transactional and securities matters. Ms. Repp has experience in representing publicly-traded and privately-held clients in mergers and acquisitions transactions, private equity investments and secured credit facilities, as well as providing general corporate advice. Ms. Repp’s practice also includes public and private securities offerings and securities compliance matters.

412-355-8317
Joshua A. Haft, KL Gates, venture capital financings lawyer, mergers and acquisitions attorney
Associate

Joshua A. Haft is an associate in the firm’s Pittsburgh office. He focuses his practice on emerging growth companies and venture capital financings, mergers and acquisitions, and general corporate matters.

412-355-7487