Audit Committee Not Liable for Earnings Release
Stockholders of Zimmer Biomet Holdings, Inc., brought a derivative law suit. Zimmer is a company that manufactures and markets various products in the highly regulated medical device industry. The plaintiffs’ claims stemmed from a September 12, 2016 “for cause” inspection of Zimmer’s North Campus site in Warsaw, Indiana by the U.S. Food & Drug Administration. The compliance problems identified during that inspection resulted in Zimmer issuing a blanket hold on shipments of products processed at the North Campus facility. Zimmer subsequently reported disappointing financial results for the third quarter of 2016, reduced its fourth quarter guidance, and saw its stock price fall 14%.
As with many derivative actions, a threshold issue was whether the plaintiffs’ failure to make a pre-suit demand on the Zimmer board was excused. Of the eleven-member board in place when this lawsuit was filed, the plaintiffs acknowledge that eight directors were independent. However, plaintiffs argued that making a demand would nonetheless have been futile because a majority of those directors face a substantial likelihood of liability.
However, the plaintiffs did not allege particularized facts to support that argument that directors faced a substantial likelihood of liability. Zimmer had an exculpation provision in its charter, meaning that the plaintiffs were required to plead facts suggesting a fair inference that the directors breached their duty of loyalty.
According to the Court, the only challenged disclosure that came close to directly implicating any of the Board members is the third quarter earnings release that was reviewed and approved by the Audit Committee.
On October 24, 2016, the Audit Committee—along with Zimmer’s officers, its counsel, and its external auditor—met to review the Company’s draft earnings release for the third quarter of 2016 and were given an “update on the ongoing FDA inspection” of the North Campus. After discussion, the Audit Committee members “expressed no objections” to the contents of the draft release.
Citing well accepted law, the Court noted that whenever directors communicate publicly or directly with shareholders about the corporation’s affairs, with or without a request for shareholder action, directors have a fiduciary duty to shareholders to exercise due care, good faith and loyalty.” The duty of disclosure “is not an independent duty, but derives from the duties of care and loyalty.” The contours of that duty and what it requires of fiduciaries are context specific. Where (like here) the disclosures at issue did not concern a request for stockholder action, Malone v. Brincat requires that a plaintiff demonstrate scienter—i.e., that the directors “deliberately misinform[ed] shareholders about the business of the corporation, either directly or by a public statement.” Because Zimmer’s certificate of incorporation included an exculpatory provision under Section 102(b)(7), the plaintiffs “must plead particularized factual allegations that ‘support the inference that the disclosure violation was made in bad faith, knowingly or intentionally’” to establish demand futility.
According to the Court, Delaware courts may infer scienter for Malone claims where certain types of specific factual allegations are made. A plaintiff must plead with particularly that directors “had knowledge that any disclosures or omissions were false or misleading or . . . acted in bad faith in not adequately informing themselves.” A plaintiff also must allege “sufficient board involvement in the preparation of the disclosures” to “connect the board to the challenged statements.”
The third quarter earnings release covered the period ending September 30, 2016—just one day after the first ship hold went into effect. It was uncertain how much, if at all, the ship hold affected Zimmer’s third quarter results (or what the Audit Committee knew about potential effects). But based on the Complaint, there was reason to infer that the Audit Committee members knew that the FDA inspection of the North Campus would have an effect on Zimmer’s revenue guidance when they approved the earnings release. As the Complaint points out, the Audit Committee was given an update “on the ongoing FDA inspection of [North] Campus” during its October 24, 2016 meeting. “At the conclusion of [that] discussion, the Committee members expressed no objections to the contents of the draft earnings release.”
The plaintiffs argued that the earning release was an attempt to “hide and obscure” information from the public because the release “contained no disclosure of the FDA inspection or manufacturing shutdown.” In other words, plaintiffs argued the Audit Committee did not ensure that Zimmer adequately disclosed a potential reason for its reduced guidance. According to the Court, that assertion might call into question the Audit Committee members’ “‘erroneous judgment’ concerning the proper scope and content of the disclosure.” But that would, at best, support an exculpated claim for breach of the directors’ duty of care according to the Court. An inference cannot be drawn, from the limited allegations in the Complaint, that the Audit Committee approved an earnings release reducing revenue guidance while intentionally omitting material information about a possible underlying cause. The plaintiffs did not ascribe any bad faith actions or motives to the Audit Committee members that would demonstrate otherwise.
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