Monday, July 12, 2021

Chancery extinguishes case against FedEx board for illegal cigarette shipments

By Anne Sherry, J.D.

The Delaware Court of Chancery dismissed, with prejudice, a would-be derivative complaint brought on behalf of FedEx against its board of directors. The plaintiff alleged that demand on the board would have been futile because the directors abdicated their Caremark duties to detect and remediate illegal cigarette shipments, resulting in fines and settlements with regulators. But the complaint’s own allegations demonstrated that the board kept apprised of the issues with cigarette shipments and implemented measures to remedy the problems (Pettry v. Smith, June 28, 2021, Slights, J.).

FedEx is subject to several federal and state laws restricting the shipment of cigarettes. In 2004, the New York Attorney General opened an investigation into the company’s shipment of cigarettes to individual consumers and residence. FedEx settled the investigation in 2006 by entering into an Assurance of Compliance (AOC) agreement under which it agreed to comply going forward or pay $1,000 for each violation. Despite this, customers continued to ship unstamped cigarettes using FedEx, and further regulatory lawsuits followed in 2013 and 2017. In 2018, FedEx settled all pending enforcement actions for $35.3 million and agreed to implement training and employ an independent consultant.

According to the complaint, in 2012 the company’s general counsel updated the board on the status of the enforcement actions, including the report that FedEx’s outside counsel issued after an internal investigation. In 2014 the FedEx board created a committee to consider a stockholder’s demand that the company bring claims against directors and officers regarding the unlawful cigarette shipping practices. The committee released a report in 2019 detailing its findings and conclusion that it was not in FedEx’s best interests to bring the lawsuit.

Caremark allegations. The plaintiff obtained books and records from FedEx and filed a complaint in 2019 asserting one derivative claim for breach of the duty of loyalty. The complaint alleged that the board was alerted to illegal cigarette shipments in 2012 but did nothing to remediate the shipments, which continued to occur until 2016, when FedEx ceased delivering cigarettes nearly entirely. The plaintiff declined to make a litigation demand on the board, instead arguing that the board was incapable of investigating and prosecuting the breach-of-duty claims because a majority of the board faced a substantial likelihood of personal liability.

To demonstrate demand futility, the plaintiff was required to allege particularized facts under one of the two prongs of Caremark: either the directors utterly failed to implement any reporting or information system or controls—the plaintiff conceded that this was not the case—or consciously failed to monitor such a system or oversee its operations. The court determined that the plaintiff’s conclusory allegation that the board failed to take action to address the unlawful cigarette shipping practices ignored other facts acknowledged in the complaint.

Board responded to red flags. The complaint noted that the board was updated as to the cigarette shipment issues on 11 occasions during 2014 and 2015, while the audit committee was apprised of the status of the litigation against FedEx at least six times. The board also formed the committee in 2014 to consider the litigation demand it had received, and a report from its outside counsel found that the company should not bring the requested litigation. The existence of this report alone refutes a reasonable inference that the board sat by ignoring red flags, the court wrote.

Furthermore, several company personnel were reprimanded for the way they handled the account of one of the cigarette vendors, as well as other issues, contradicting the assertions of a "do nothing" environment. And importantly, the complaint acknowledged that FedEx eventually banned nearly all tobacco shipments, introduced numerous training programs, and implemented measures to increase the detection of illegal cigarette shipments. The decision to stop shipping cigarettes predated any litigation filed by the New York state prosecutor concerning post-2012 conduct. The reasonable inference to be drawn from contemporaneous board minutes is that the board was engaged on the issue but allowed the New York litigation to play out before making decisions about remediation of the underlying conduct.

The case is No. 2019-0795-JRS.