WSGR ALERT

Delaware Court of Chancery Highlights the Significance of Director Oversight of "Mission Critical" Operations

October 9, 2019

On October 1, 2019, Vice Chancellor Joseph Slights of the Delaware Court of Chancery issued an opinion in In re Clovis Oncology, Inc. Derivative Litigation, in which he found that stockholder plaintiffs had stated a claim against the board of directors based on allegations that they 1) repeatedly failed to monitor the accuracy of the company's clinical trial protocols and compliance with regulatory mandates, and 2) then allowed the company to mislead the market regarding the efficacy and likely FDA approval of one of the company's primary drugs under development.

Clovis marks the second case in recent months in which a Delaware court has allowed stockholder plaintiffs to proceed with a derivative breach of fiduciary duty action on the basis of an alleged failure of oversight, often referred to as a Caremark claim after a seminal Delaware decision in this area.

The Decision

Clovis is a biopharmaceutical firm that had one "especially promising" cancer drug (Rociletinib) under development, which the court described as Clovis's "mission critical product." The plaintiffs alleged that, in pursuing FDA approval for Rociletinib, Clovis adopted a well-known clinical trial protocol called RECIST, which incorporated a success-defining metric called objective response rate (ORR). The plaintiffs further alleged that the board knew that investors would not view an ORR incorporating unconfirmed (as opposed to clinically confirmed) responses as meaningful, nor would the FDA approve the drug based upon such results. Yet, despite such knowledge, the board, according to the plaintiffs, allowed the company to report an ORR of 60 percent, which was based in part upon unconfirmed responses, and which gave the market the impression that the drug was showing more promise than the "correct" ORR using only confirmed responses would have indicated. The board was also allegedly aware of other clinical trial violations and side effects, which indicated additional concerns with the drug, but did not ensure the company's announcements with the respect to the drug were tempered. When the "correct" ORR of 28-34 percent was disclosed to the market, Clovis's stock price dropped 70 percent, wiping out $1 billion in market value.

Plaintiffs brought derivative claims against the board of directors for breach of fiduciary duty for failing in their oversight obligations. In holding that all of the directors faced a substantial likelihood of liability under Caremark, the court looked to the Delaware Supreme Court's recent decision in Marchand v. Barnhill, 212 A.3d 805 (Del. 2019), which allowed fiduciary duty oversight claims against a board and senior members of management following the listeria outbreak at Blue Bell Creameries to go forward,1 and noted 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." Plaintiffs adequately alleged that the directors failed in this regard with allegations that the directors knew that 1) RECIST and FDA guidance required reporting ORR based only on confirmed responses, and 2) management was publicly reporting ORR based in part on unconfirmed responses in order to keep up with competitors' reported ORR, but the directors did nothing to address this fundamental departure from RECIST.

In reaching its conclusion, the court noted that the board consisted of directors who had extensive experience in the pharmaceutical industry. In looking to board decks and minutes the plaintiffs obtained through a books and records demand, the court went into detail about the way the board was allegedly "hyper-focused" on the drug's development and clinical trial, and thus, given their education and experience, the directors either knew—or should have known—that management was reporting incorrect ORR data, and the board did nothing to address it.

The defendants had vigorously protested the plaintiffs' allegations, including whether or not RECIST requires only confirmed responses be included in ORR, whether FDA guidance was clear, and whether the FDA had otherwise blessed Clovis's plan to report unconfirmed responses. The defendants also argued that certain of the board materials provided in response to the books and records demand contradicted the plaintiffs' allegations, and that the court should consider those materials under the parties' agreement that all such materials should be deemed incorporated into the complaint. The court refused to consider these arguments, however, finding that they were factual issues that would be explored in the discovery process and that one set of documents could not be used to contradict the plaintiffs' well-pled factual allegations based upon other documents produced in response to a books and records demand.2

Interestingly, the court noted that, although the plaintiffs' allegation that the board's failure of oversight caused harm to the company was sufficient to survive dismissal, plaintiffs' ability to show "causation will be challenging" because they "may have difficulty connecting the oversight failure(s) to the corporate trauma" due to the possibility that the drug may have failed with or without the board's alleged inaction.

At the same time, the court rejected plaintiffs' claims for breach of fiduciary duty under Brophy (for trading on the basis of alleged insider information) and unjust enrichment. Plaintiffs had pointed to stock sales made by four of the defendants in advance of the "corporate trauma soon to come." The court noted that the size of the trades relative to the defendants' overall stock holdings was an important consideration in analyzing the Brophy claims. Because these defendants sold only a "sliver" of their overall stake in Clovis (selling between $223,536 and $2,786,031 worth of stock in the trades in question, but retaining between 96 and 99.9 percent of their holdings), the court dismissed the claims.

Takeaways

  • While Caremark claims have been traditionally viewed as difficult for plaintiffs, Delaware courts have recently shown a willingness to allow such claims to proceed at the pleadings stage, particularly when they involve a failure of oversight with respect to regulatory and legal compliance as to a company's "critical product."
  • Pharmaceutical companies and their directors should pay close attention to disclosures regarding clinical studies and progression of any "mission critical" drugs.
  • Pharmaceutical companies should carefully consider their clinical trial protocols and director oversight thereof, including how such trials are described in company materials and communications with the FDA, given that such materials are often subject to stockholder books and records demands and can potentially be taken out of context.
  • More generally, as part of directors' fiduciary duty oversight obligations and given the recent Delaware Supreme Court guidance, boards should ensure that they regularly spend adequate time on regulatory and legal compliance issues, that there is a system in place for management to report any concerns up to the board, and that the board's processes are properly documented in board minutes.

For further information on this Delaware Court of Chancery decision, please contact Katherine Henderson, Amy Simmerman, Brad Sorrels, Ryan Greecher, or any other member of the corporate governance or corporate governance litigation practices.


2 The court specifically noted that "our courts must regulate how far down the road of incorporation by reference a defendant may go when plaintiff has well-pled something as fact (e.g. that the Board understood ORR), even if another document might suggest the facts are otherwise. Section 220 documents may or may not comprise the entirety of the evidence on a particular point. Until that is tested, Defendants cannot ask the court to accept their Section 220 documents as definitive fact and thereby turn pleading stage inferences on their head. That is not, and should not be, the state of our law."