Any fears that the Delaware Supreme Court might be backing off its traditional protection of corporate directors were categorically put to rest earlier this month by a decision reinforcing the high standard that must be met to sue directors for failing to exercise sufficient oversight.
According to experts, the ruling in the case—Stone v. Ritter—is likely to have implications for litigation over stock option backdating, as well as other types of shareholder and derivative litigation. And some say the court’s conclusions will not necessarily warm the hearts of governance advocates.
Fisch
Jill Fisch, a business law professor at Fordham University, says there has been speculation about whether the Delaware court, “in light of things like Enron, are really going to hold directors’ feet to the fire. This decision says they’re not.”
Mary Ann Jorgenson, a partner with the law firm Squire Sanders & Dempsey, calls the Stone ruling a “good and pragmatic decision” that has made clear that Delaware is sticking by a principle the Chancery Court had articulated many years ago (but never formally adopted by the Supreme Court) that directors are not liable unless “there is a sustained or systematic failure of the board to exercise oversight.”
Jorgenson
Not only must directors not be doing something they should be doing, Jorgensen says, but “they’ve got to know that they’re not doing it: They have to have knowledge that they’re supposed to be doing something and consciously are not doing it.”
Bank Hit With $50M Fine
The Stone case involved AmSouth Bancorp., a regional bank in the southeast United States that had been hit with $50 million in fines and civil penalties due to its alleged failure to meet reporting obligations under the Bank Secrecy Act and anti-money laundering rules. The bank found itself in trouble due to the actions of customers who participated in a Ponzi scheme over a two-year period.
Two shareholders of AmSouth brought suit on behalf of the corporation against the directors for their failure to prevent the violations. The suit didn’t claim that any of the directors actually knew of the conduct of bank employees that resulted in the liability, but instead alleged that they should have known about it.
A Chancery Court judge dismissed the suit and the Delaware Supreme Court affirmed, for the first time expressly adopting the reasoning of a Chancery Court decision from the 1996 case In re Caremark International Inc. Derivative Litigation.
RULING
An excerpt follows from Stone v. Ritter, in which the court discusses the deliberate use of certain language to describe a “lack of good faith” in the earlier decided case of Caremark.
It is important, in this context, to clarify a doctrinal issue that is
critical to understanding fiduciary liability under Caremark as we construe that case. The phraseology used in Caremark and that we employ here—describing the lack of good faith as a “necessary condition to liability”—is deliberate. The purpose of that formulation is to communicate that a failure to act in good faith is not conduct that results, ipso facto, in the direct imposition of fiduciary liability. The failure to act in good faith may result in liability because the requirement to act in good faith “is a subsidiary element[,]” i.e., a condition, “of the fundamental duty of loyalty.” It follows that because a showing of bad faith conduct, in the sense described in Disney and Caremark, is essential to establish director oversight liability, the fiduciary duty violated by that conduct is the duty of loyalty.
This view of a failure to act in good faith results in two additional doctrinal consequences. First, although good faith may be described colloquially as part of a “triad” of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty. Only the latter two duties, where violated, may directly
result in liability, whereas a failure to act in good faith may do so, but indirectly. The second doctrinal consequence is that the fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it in Guttman, “[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.”
We hold that Caremark articulates the necessary conditions predicate
for director oversight liability: (a) the directors utterly failed to implement
any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. In either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge
that fiduciary obligation in good faith.
Source
Stone v. Ritter (Court of Chancery of the State of Delaware, New Castle County, C.A. No. 1570; Nov. 6, 2006)
As in Caremark, the plaintiffs in the AmSouth case were trying to hold directors liable for negligent oversight, not conscious neglect.
In response, the Supreme Court cited two conditions necessary to hold the directors liable: that the directors “utterly failed” to implement any reporting or information system or controls; or, if the directors had implemented those systems, “consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention,” the court wrote. “In either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.”
The plaintiffs were seeking “to equate a bad outcome with bad faith,” the court concluded. “In the absence of red flags, good faith in the context of oversight must be measured by the directors’ actions ‘to assure a reasonable information and reporting system exists’ and not by second-guessing after the occurrence of employee conduct that results in an unintended adverse outcome.”
‘Rogue’ Employees
Olinsky
Mark Olinsky, a corporate litigator with the law firm Sills Cummis Epstein & Gross, says the “overall headline” from the AmSouth ruling is: “Good News for Corporate Directors.”
Although the decision “doesn’t change what people should be doing, directors can take comfort that if they put a system in place and make sure they’re monitoring it and not looking away, they won’t be blamed—or shouldn’t be blamed—for acting in bad faith by not being perfect,” Olinsky says.
Peter Ladig, of the Bayard law firm, agrees that the decision in Stone “doesn’t ultimately change any advice lawyers would be giving to directors. There’s an obligation to monitor what’s going on and you have to have an adequate reporting system. Once you have that in place, you can’t put your head in the sand if you find something has gone wrong.”
Ladig
But Ladig says the Delaware court seems to be making clear that, “even in the post-Enron, post-WorldCom world, they don’t see anything wrong with the way Delaware monitors and enforces fiduciary duties.”
Separate Duty Of ‘Good Faith’
In addition to embracing the Caremark standard for liability, the court that decided the AmSouth case also clarified an issue from a case that left open the question of whether Delaware law imposes an independent duty of “good faith” on corporate directors, in addition to the traditional duties of care and loyalty, when it was decided earlier this year.
In Stone v. Webster, which involved Walt Disney, the court emphatically said no such separate duty of good faith exists; rather, it is part of the duty of loyalty.
Hamermesh
Lawrence Hamermesh, a law professor at Widener Law School, says that while this aspect of the decision is mostly interesting to academics, it means that “lawyers defending directors, and directors themselves, have one less thing to worry about.”
Stigi
The court essentially issued a rebuke to commentators who read the Disney decision as creating an additional independent duty for directors, according to John Stigi, a partner with the law firm Sheppard Mullin Richter & Hampton. “In some respects it doesn’t matter, but to the extent that a plaintiff could come up with a theory under which the director was acting in bad faith—but did not breach the duty of care or loyalty—Stone says there’s no claim.”
Ladig says it’s also significant that the court placed the duty of good faith under the duty of loyalty. Historically, he says, a director could not violate the duty of loyalty unless he or she had some financial interest in the transaction. “Now, for the first time, the court has recognized that you can.”
Placing the duty of good faith under the duty of loyalty may mean that some kinds of lawsuits may not be dismissed so easily, according to Ladig. But, he adds, “It’s still the hardest claim to make in Delaware corporate law.”
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