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Horman v. Abney

Court of Chancery of Delaware

January 19, 2017

JOSEPH HORMAN and STEVEN GREEN, Derivatively for the Benefit of and on Behalf of Nominal Defendant, UNITED PARCEL SERVICE, INC., Plaintiffs,

          Date Submitted: October 19, 2016

          Peter B. Andrews, Esquire, Craig J. Springer, Esquire, and David M. Sborz, Esquire of Andrews & Springer LLC, Wilmington, Delaware; Judith S. Scolnick, Esquire, Thomas L. Laughlin, Esquire, and Scott R. Jacobsen, Esquire, of Scott Scott Attorneys At Law, LLP, New York, New York; and Jesse Strauss, Esquire of Strauss Law P.L.L.C., New York, New York, Attorneys for Plaintiffs.

          Kenneth J. Nachbar, Esquire, John P. DiTomo, Esquire, and Richard Li, Esquire of Morris, Nichols, Arsht & Tunnell LLP, Wilmington, Delaware; Jamie A. Levitt, Esquire and Steven T. Rappoport, Esquire of Morrison & Foerster LLP, New York, New York; and Philip T. Besirof, Esquire of Morrison & Foerster LLP, San Francisco, California, Attorneys for Defendants and Nominal Defendant.


          SLIGHTS, Vice Chancellor

         Stockholders of United Parcel Service, Inc. ("UPS" or the "Company") have brought this derivative action on behalf of the Company against members of its Board of Directors (the "Board") alleging that they breached their fiduciary duty of loyalty by consciously failing to monitor and manage UPS's compliance with state and federal laws governing the transportation and delivery of cigarettes. Plaintiffs seek to recover for the Company losses it has or will sustain as a result of a pending enforcement action against the Company in federal court for illegally shipping untaxed cigarettes in which the government seeks approximately $180 million in damages and penalties.

         After receiving UPS's response to their demand for books and records under 8 Del. C. § 220, Plaintiffs filed their Verified Stockholder Derivative Complaint (the "Complaint") in which they set forth a single count-breach of fiduciary duty arising from a failure of oversight, well known in Delaware corporate law as a Caremark claim.[1] They allege the directors either failed to implement a reporting and monitoring system with respect to the shipment of illegal cigarettes or, having implemented a system, they ignored red flags that UPS had abandoned its compliance with that system. The failure of oversight is all the more troubling, according to Plaintiffs, because it occurred in the wake of a prior government investigation of UPS's illegal cigarette shipments that was resolved in 2005 by way of an Assurance of Discontinuance Agreement ("AOD") in which UPS committed to comply with applicable laws and to establish effective monitoring systems going forward. The AOD also provided that UPS could be subject to a penalty of up to $1000 per violation of the AOD as well as exposure to further liability under state and federal law. Plaintiffs allege that UPS and its Board consciously ignored the requirements of the AOD from 2010 through 2014 and have thereby exposed the Company to substantial liability.

         Plaintiffs did not make a demand on the Board to pursue these claims before filing suit. They maintain that any such demand would have been futile since each member of the Board faces a substantial likelihood of personal liability. The Defendants disagree and have moved to dismiss the Complaint under Court of Chancery Rule 23.1 for failure properly to plead demand futility and under Rule 12(b)(6) for failure to state a viable breach of fiduciary duty claim. After carefully reviewing the Complaint and its incorporated documents, and carefully considering the parties' arguments on the motion to dismiss, I conclude that Plaintiffs have failed to plead facts from which it may reasonably be inferred that the Defendants consciously failed to oversee UPS's compliance with its obligations to engage in proper shipping methods or its compliance with the AOD in a manner that would constitute bad faith. Because they have failed to plead with particularity that Defendants face a substantial likelihood of personal liability in this action, Plaintiffs have failed adequately to plead demand futility and their Complaint must be dismissed with prejudice under Court of Chancery Rule 23.1. Having so concluded, I need not reach Defendants' arguments under Court of Chancery Rule 12(b)(6).

         I. BACKGROUND

         The facts are drawn from allegations in the Complaint, documents integral to the Complaint and matters of which the Court may take judicial notice.[2] As it must at this stage of the proceedings, the Court assumes as true all well-pled facts in the Complaint.

         A. The Parties

         Plaintiffs, Joseph Horman and Steven Green, were stockholders of UPS at the time of the alleged wrongdoing and have continuously been stockholders since that time. They seek to bring this action derivatively on behalf of UPS.

         Defendants, David P. Abney, D. Scott Davis, Rodney C. Adkins, Michael J. Burns, William R. Johnson, Dr. Candace Kendle, Ann M. Livermore, Rudy H.P. Markham, Clark T. Randt, Jr., Carol Tomé, and Kevin M. Warsh (the "Director Defendants"), are eleven members of the twelve-member UPS Board. Abney has served as UPS's CEO and as a director since September 2014. Davis has served as a director since 2006 and as Chairman of the Board since 2008. He previously served as UPS's CEO from 2008 to September 2014.

         Nominal Defendant, UPS, is a Delaware corporation with its principal place of business in Atlanta, Georgia. UPS is the world's largest package delivery company and a major provider of logistics and distribution services. According to its 2015 Form 10-K, UPS makes more than 18.3 million package deliveries per day.

         B. The Regulatory Environment Related to the Shipment of Tobacco Products

         UPS is subject to a variety of regulatory regimes including federal, state and local laws that regulate its shipment and delivery of cigarettes and other tobacco products. Among these regulations are various special excise taxing initiatives that have the effect of raising the cost of producing and buying tobacco products. These increased costs, it is hoped, will decrease demand for tobacco products and thereby directly create a public health benefit. The initiatives also raise revenues that can be deployed to educate the public on the harmful effects of tobacco products. By regulating shipping companies, such as UPS, governmental entities attempt to prevent unauthorized and illegal shipments of tobacco that undermine these taxing regimes.

         The City and State of New York have adopted a cigarette taxing structure which imposes an excise tax on packs of cigarettes that are possessed for sale within their respective jurisdictions. "Stamping agents, " licensed wholesale cigarette dealers, play a key role in the taxing regime by pre-paying the excise taxes, affixing tax stamps to each pack of cigarettes and then setting in motion the process whereby each subsequent purchaser in the distribution chain, ending with the consumer, will bear the tax burden. The stamping agents are the only legal entry point for cigarettes into the streams of commerce of the City and State of New York.

         According to regulators, cigarette bootlegging is alive and well in New York. It is estimated that the State of New York loses up to $610 million annually in revenue due to tax evasion schemes. In one such scheme, consumers buy their cigarettes from retailers on Native American reservations. Several sovereign Native American groups in the State of New York dispute the right of the State to require tax stamps on packs of cigarettes sold exclusively at tribal retailers. These sales include both in-person sales and those made by mail order, phone, fax, or online. Through remote means, retailers within Native American reservations can fill orders and ship cigarettes, without excise tax stamps, to non-tribal customers throughout the United States, including in the City and State of New York.

         To combat such practices, the State of New York enacted N.Y. Public Health Law ("N.Y. PHL") § 1399-ll which, inter alia, prohibits common carries, like UPS, from knowingly delivering cigarettes to any person in New York reasonably believed to be a person who is not authorized to receive cigarettes. N.Y. Exec. L. § 63(12) allows the New York Attorney General ("NYAG") to seek various equitable and legal remedies against any person or entity that has engaged in repeated fraudulent or illegal acts in the conduct of business. The violation of a state law or regulation, such as N.Y. PHL § 1399-ll, constitutes an "illegal act" under N.Y. Exec. L. § 63(12).

         UPS is also subject to federal laws that regulate cigarette and tobacco shipments and delivery, including: (1) the Contraband Cigarette Trafficking Act ("CCTA"), 18 U.S.C. § 2341, et seq., which makes it "unlawful to knowingly ship, transport, receive, possess, sell, distribute, or purchase" a quantity of more than 10, 000 cigarettes which lack tax stamps and are found in a jurisdiction which requires tax stamps; and (2) the Prevent All Cigarette Trafficking Act ("PACT"), 15 U.S.C. § 375, et seq. and 18 U.S.C. § 2341, et seq., which requires, inter alia, that all packages containing cigarettes include a notice that federal law requires the payment of cigarette excise taxes, and prohibits any shipper from delivering packages on behalf of any person whose name appears on a list of unregistered or noncompliant sellers maintained by the United States Attorney General.

         C. The Assurance of Discontinuance Agreement

         In 2004, as part of an effort by the NYAG to combat cigarette tax evasion in the State of New York, the NYAG began investigating residential cigarette deliveries by UPS and other shipping companies. As a result of its investigation, the NYAG concluded that UPS had violated N.Y. PHL § 1399-ll by delivering unstamped and untaxed cigarettes to New York residential customers. The investigation revealed that the deliveries, which had been made to residences throughout the State of New York, had originated principally from retailers located on Native American reservations to fill orders accepted over the internet or by telephone. Following the investigation, in order to avoid a civil enforcement action, UPS entered into the AOD on October 21, 2005.[3] The AOD placed affirmative obligations on UPS to set up policies, programs, and procedures to ensure compliance with N.Y. PHL § 1399-ll. These measures included investigating shippers, creating a database of tobacco shippers and sharing that list with the State of New York, auditing the shippers, refusing to ship untaxed cigarettes and imposing progressive discipline against non-compliant shipping customers up to and including a ban on those customers from using any UPS service. UPS was also required to maintain a "UPS Cigarette Policy, " regularly train its employees on how to ensure enforcement of the policy, conduct compliance audits and maintain associated records. It agreed to a stipulated damages penalty of $1, 000 for each violation of the AOD.

         The AOD was an evergreen commitment that was binding upon UPS, its employees and its Board:

This Assurance of Discontinuance shall be binding on and apply to UPS, its officers, directors, employees, affiliates, assignees and any individual, corporation, subsidiary or division through which UPS may now or hereinafter act, as well as any successors in interest.[4]

UPS designated Norman Brothers, its Vice President of the Legal Department, as the point of contact for all notifications from the State of New York concerning enforcement of the AOD.[5]

          D. UPS Initially Complies with the AOD and Then Allegedly Falters

         Plaintiffs acknowledge that UPS initially complied with its obligations under the AOD.[6] In December 2005, UPS filed a compliance report with the NYAG, as required under the AOD. In this report, UPS confirmed that it no longer shipped illegal cigarettes to consumers, only delivered tobacco products from licensed entities, and had issued instructions to its employees to monitor packages for evidence of shipments to unauthorized persons and to report any instances of non-compliance to management. Approximately two years later, in February 2008, UPS acknowledged that it was not diminishing its commitment to the post-AOD compliance policies even though the United States Supreme Court had issued a decision striking down a portion of Maine's cigarette regulatory regime which was similar in structure to New York's regime. Later in 2008, Norman Brothers publicly stated that "[w]e have a policy that's been in effect for almost three years now and has been effective, and we see no reason to change it."[7]

         According to Plaintiffs, this period of compliance lasted until no later than 2010, when the Director Defendants began to ignore their oversight responsibilities and UPS began to operate in violation of the AOD and applicable state and federal laws governing the shipment of cigarettes. During this time period, in which it is alleged that UPS delivered thousands of cartons of unstamped cigarettes from manufacturers to cigarette dealers on Native American reservations in New York and then directly to consumers' residences throughout New York and other states, there are no Board-level documents that mention much less directly address UPS's compliance with the AOD or applicable cigarette and tobacco laws. In November 2010, however, Norman Brothers and other members of the Legal Department did make a presentation to the Audit Committee, including Defendants Tome', Burns, Johnson, Markham, Davis and Abney, in which Brothers and his team outlined "significant matters and trends." The minutes of this meeting do not reflect that compliance with the AOD was discussed, although it is alleged that Brothers, as the designated contact for compliance, would have known that UPS was non-compliant and would have reported this to the Audit Committee. The following year, in September, 2011, an internal UPS business development memorandum from "BD Memo"[8] reflects that UPS, at some level, was aware that an investigation had been conducted by the New York State Department of Taxation and Finance ("NYTF") and the federal Alcohol, Tobacco, and Firearms Bureau ("ATF"), and that these regulators were alleging that UPS was in violation of the AOD.

         At a meeting of the Audit Committee in February, 2014, the committee members were advised that the State of New York and City of New York had already initiated civil litigation against FedEx in New York for violations of cigarette regulations and that "New York City has approached UPS with similar issues."[9] The Audit Committee received similar reports of possible non-compliance in May and August 2014. Although it is alleged that these reports alerted the Director Defendants to potential compliance issues, they came too late to allow them to do anything about the problem.

         E. The Federal Case Against UPS

         In February 2015, the City and State of New York filed suit against UPS in the United States District Court for the Southern District of New York alleging that UPS has violated the AOD and state and federal law on numerous occasions over a period of several years. The suit seeks injunctive relief, compensatory damages under federal law, civil penalties under state and federal law, treble damages under the Racketeer Influenced and Corrupt Organizations Act ("RICO"), an award of the stipulated damages penalty of $1, 000 for each violation under the AOD and the appointment of a court-appointed Special Master to monitor UPS's tobacco deliveries and its compliance with tobacco trafficking laws going forward. In total, the damages and penalties sought amount to at least $180 million.

         F. Procedural History

         Plaintiffs filed their Complaint on May 2, 2016, after obtaining books and records from the Company under 8 Del. C. § 220. The Complaint asserts one derivate claim on behalf of UPS for breach of the fiduciary duty of loyalty against the Director Defendants arising from their failure to comply with their oversight responsibilities. On June 15, 2016, Defendants filed a motion to dismiss the Complaint under Court of Chancery Rule 23.1 for failure to make a pre-suit demand and under Court of Chancery Rule 12(b)(6) for failure to state a claim upon which relief can be granted (the "Motion").


         Caremark claims inevitably arise in the midst of or directly following "corporate trauma" of some sort or another.[10] In this derivative action, Plaintiffs seek to hold the Director Defendants personally liable to UPS for breaching their fiduciary duties in bad faith in a manner that caused the corporate trauma. After carefully reviewing the Complaint, however, I am satisfied that Plaintiffs have "conflate[d] concededly bad outcomes from the point of view of the Company with bad faith on the part of the Board."[11] Because I have concluded that demand is not excused under Rule 23.1, I will not reach the Director Defendants' arguments under Rule 12(b)(6). The analysis begins and ends with demand futility.

         A. Legal Standards - Rule 23.1 Demand Futility

         "[A] cardinal precept of the General Corporation Law of the State of Delaware is that directors, rather than shareholders, manage the business and affairs of the corporation."[12] Plaintiffs' claim against the Director Defendants for breach of fiduciary duty alleges harm suffered by UPS. The claim, therefore, belongs to the Company and the decision whether or not to pursue it typically would rest with the Board.[13] A board of directors does not stand alone, however, in its authority to initiate litigation on behalf of the corporation. In certain circumstances, stockholders may pursue litigation derivatively on behalf of the corporation as a matter of equity to "redress the conduct of a torpid or unfaithful management . . . where those in control of the company refused to assert a claim belonging to it."[14]

         Because stockholder derivative suits "by [their] very nature . . . impinge on the managerial freedom of directors, "[15] our law requires that a stockholder satisfy the threshold demand requirements of Court of Chancery Rule 23.1 before he is permitted to assume control of a claim belonging to the corporation. To do so, 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.[16] When a derivative plaintiff elects not to make a demand upon the board, Rule 23.1 places a heightened pleading burden on that plaintiff to meet "stringent requirements of factual particularity that differ substantially from the permissive notice pleadings" embodied in Court of Chancery Rule 8 and that animate Court of Chancery Rule 12(b)(6).[17]

         This Court employs one of two tests when determining whether demand upon the board would be futile. The first applies when a plaintiff challenges a decision of the board of directors to take affirmative action.[18] The second, established in Rales v. Blasband[19] and applicable here, applies when a plaintiff challenges board inaction such as when a board is alleged to have consciously disregarded its oversight duties.[20] Under the Rales test, the court "must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand."[21] Particularized facts create a reasonable doubt of the board's independence and disinterestedness when the demand would reveal board inaction of a nature that would expose the board to "a substantial likelihood" of personal liability.[22] "The mere threat of personal liability . . . is insufficient."[23]

         "On a motion to dismiss pursuant to Rule 23.1, the Court considers the same documents, similarly accepts well-pled allegations as true, and makes reasonable inferences in favor of the plaintiff-all as it does in considering a motion to dismiss under Rule 12(b)(6)."[24] Given the heightened pleading requirements of Rule 23.1, however, "conclusory allegations of fact or law not supported by allegations of specific fact may not be taken as true."[25] Because the Complaint cites documents that Plaintiffs obtained through their Section 220 demand, I may consider those documents under the incorporation-by-reference doctrine to determine whether the Complaint contains sufficient allegations to demonstrate demand futility.[26]

         B. Plaintiffs Have Not Adequately Pled that Demand is Excused With Respect to Their Caremark Claim

         Plaintiffs allege in a single count that the Director Defendants breached their duty of loyalty owed to UPS and its stockholders by "willfully, consciously recklessly, and intentionally failing to perform their duties of oversight to ensure the Company's compliance with positive law."[27] Plaintiffs assert that demand on the Board should be excused based on demand futility because all eleven of the Director Defendants, including nine directors whose independence is unquestioned, face a disqualifying interest in determining whether UPS should pursue the claim. The disqualifying interest, in this case, is self-preservation. Specifically, Plaintiffs allege that each of the Director Defendants "face a substantial likelihood of liability" for their breach of fiduciary duty as alleged in the Complaint.[28]

         1. The Caremark Liability Standard

         In Caremark, Chancellor Allen reviewed the state of director oversight law and described the circumstances under which stockholders could hold directors personally liable for harm caused to the corporation under the theory that the directors "violated a duty to be active monitors of corporate performance."[29] As Chancellor Allen first observed in Caremark, and has been oft-repeated by this court, proving liability for a failure to monitor corporate affairs is "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."[30] A decade later, our Supreme Court embraced the Caremark standard and clarified that in order to impose personal liability on directors for a failure of oversight there must be evidence that "the directors knew that they were not discharging their fiduciary obligations."[31] At the pleadings stage, a plaintiff must allege particularized facts that satisfy one of the necessary conditions for director oversight liability articulated in Caremark: either that (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 its operations thus disabling themselves from being informed of risks or problems requiring their attention."[32]

         This liability standard "draws heavily upon the concept of director failure to act in good faith."[33] As our Supreme Court explained in Disney, the "intentional dereliction of duty" or "conscious disregard for one's responsibilities, " which "is more culpable than simple inattention or failure to be informed of all facts material to the decision, " reflects that directors have acted in bad faith and cannot, by default, avail themselves of defenses grounded in a presumption of good faith.[34] In order to plead a claim under Caremark, therefore, a plaintiff must plead facts that allow a reasonable inference that the directors acted with scienter which, in turn, "requires [not only] proof that a director acted inconsistently with his fiduciary duties, " but also "most importantly, that the director knew he was so acting."[35]

         Our law recognizes that alleging directors failed to act in good faith is significantly different from alleging that corporate wrongdoing has occurred. This distinction takes into account that "directors' good faith exercise of oversight responsibility may not invariably prevent employees from violating criminal laws, or from causing the corporation to incur significant financial liability, or both."[36]Accordingly, "Delaware courts routinely reject the conclusory allegation that because illegal behavior occurred, internal controls must have been deficient, and the board must have known so."[37] Rather, a plaintiff must plead with particularity

          "a sufficient connection between the corporate trauma and the board."[38] One way to plead the requisite connection is to plead particularized facts which, if proven, would establish the first Caremark prong for imposing oversight liability-that the directors "utterly failed to implement any reporting or information system or controls."[39] A second, alternative, way "[t]o establish such a connection [is to] plead that the board knew of evidence of corporate misconduct-the proverbial 'red flag'-yet acted in bad faith by consciously disregarding its duty to address that misconduct."[40] Plaintiffs have attempted to plead both theories.

         2. No Well-Pled Derivative Claim That the Board Utterly Failed to Implement Any Reporting or Information Systems or Controls

         Plaintiffs' argument that they have pled particularized facts that the Director Defendants utterly failed to adopt any reporting and compliance systems is perplexing. The Complaint and the documents it incorporates by reference acknowledge that UPS implemented the corporate governance changes required by the AOD.[41] Plaintiffs admitted as much more than once.[42] The Complaint also acknowledges that UPS has a Legal Department, an Internal Audit, Compliance & Ethics Department and an Audit Committee of the Board.[43] And, according to the Complaint, "[t]he [Director Defendants] . . . were provided updates about legal compliance through reports from the UPS Legal Department."[44] The Audit Committee's Charter, also referenced in the Complaint, establishes that the Audit Committee's general responsibility for oversight includes oversight of "the Company's compliance with legal and regulatory requirements. . . ."[45] Thus, the Complaint itself reveals that the Plaintiffs have not plead particularized facts that the Board "utterly" failed to adopt or implement any reporting and compliance systems.[46]

         Notwithstanding the allegations in their Complaint acknowledging the existence of reporting and compliance systems at UPS, Plaintiffs advance two arguments as to why the Complaint still adequately pleads factual bases upon which the Board faces a substantial likelihood of liability under the first prong of Caremark. First, they argue that documents produced in response to their Section 220 demand reveal an absence of any Board minutes or other Board materials relating to the monitoring of compliance with the AOD from January 1, 2010 to February 12, 2014. They contend this informational void supports a reasonable inference that the Director Defendants "did absolutely nothing to oversee UPS's compliance with the [AOD] or cigarette laws in any way."[47] According to Plaintiffs, this period of "deafening silence" at the Board level is a "clear indication of the Board's conscious disregard of its duties and utter lack of oversight over its known duties under the [AOD]."[48] Second, Plaintiffs contend that, regardless of the oversight mechanisms in place, the Director Defendants were "merely going through the motions"[49] in monitoring UPS's compliance obligations. In this regard, they note that "recent rulings make clear that merely going through the motions . . . is not sufficient oversight to satisfy a director's fiduciary duty of loyalty with regard to overseeing that the Company is adhering to its fundamental obligation to obey positive law."[50] Neither argument is convincing.

         Plaintiffs' positions rely upon the assumption that this board of directors of a large public company owed the Company and its stockholders a duty to take active steps affirmatively to "monitor the monitors" even after implementing a well-constituted monitoring and reporting system.[51] In this regard, Plaintiffs point to paragraph 53 of the AOD which they claim created a Board level obligation to ensure compliance with the AOD beyond ensuring that the Company implemented compliance systems.[52] Even in the absence of the AOD, the UPS Board owed a fiduciary duty to stockholders not to cause UPS to violate positive law and not to sit on its hands as it watched others within the Company do so.[53] The Director Defendants' duty to oversee compliance with these laws, therefore, was not created or somehow heightened by the existence of the AOD. It derives, instead, from the fiduciary duty of loyalty and the obligation to discharge that duty in good faith in the best interests of the corporation they serve.[54] The Board cannot be held liable for breaching this duty, under the first prong of Caremark, unless it can be proven that its members "utterly failed to implement any reporting or information systems or controls."[55] This is so even if the reporting systems they implemented and relied upon, without reason to suspect they were not working, did not ultimately detect corporate wrongdoing or bring it to their attention. "[G]ood faith, not a good result, is what is required of the board."[56] Indeed, "the one thing that is emphatically not a Caremark claim is the bald allegation that directors bear liability where a concededly well-constituted oversight mechanism, having received no specific indications of misconduct, failed to discover fraud."[57]

         To repeat, the Plaintiffs' own allegations acknowledge the creation and implementation of a system of internal controls following UPS's acceptance of the AOD. The system functioned well, at least for a time, after the AOD was finalized and the Complaint makes no particularized allegation that the system was intentionally disabled or diminished within UPS. That the Plaintiffs did not turn up any Board documents specifically referencing continued compliance with the AOD during a specific time period is not sufficient to allege that the system was not in place or that the Board was simply going through the motions when overseeing compliance.[58] At best, the Complaint might support an ...

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