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Home , Business judgment rule, Duty, Duty of care, Duty of loyalty, Fiduciary

www. NYLJ.com monday, november 28, 2011 Monitoring the to Monitor

statements. As a result, the prices of Chinese by an actual intent to do harm” or an “intentional By Louis J. Bevilacqua listed have collapsed. Do directors dereliction of duty, [and] a conscious disregard have a duty to monitor and react to trends that for one’s responsibilities.”9 Examples of conduct HE SIGNIFICANT LOSSES suffered by inves- raise obvious concerns that are industry “red amounting to bad faith include “where the fidu- tors during the recent financial crisis have flags,” but not specific to the individual ? ciary intentionally acts with a purpose other than again left many shareholders clamoring to T And if so, what is the appropriate penalty for the that of advancing the best interests of the corpo- find someone responsible. Where were the direc- board’s failure to act? “Sine poena nulla lex.” (“No ration, where the acts with the intent tors who were supposed to be watching over the without punishment.”).3 to violate applicable positive law, or where the company? What did they know? What should they fiduciary intentionally fails to act in the face of have known? Fiduciary Generally a known duty to act, demonstrating a conscious Obviously, directors should not be liable for The duty to monitor arose out of the general disregard for his duties.”10 losses resulting from changes in general economic fiduciary duties of directors. Under Delaware law, Absent a , claims of breaches conditions, but what about the boards of mort- directors have fiduciary duties to the of by a board are subject to the judicial gage companies and financial institutions that and its stockholders that include the duty of care review standard known as the “ had a tied to market risk. Most and the .4 The duty of care requires rule.”11 The provides “a individuals that invest in the U.S. capital markets directors to act with the care that a person in a presumption that in making a business decision would likely be surprised to hear that the board’s similar position would reasonably believe appro- the directors of a corporation acted on an informed duty to monitor may not include monitoring such priate when making decisions or acting on behalf basis, in faith and in the honest that risk. In fact, just last month the Delaware of of the corporation under similar circumstances. the action taken was in the best interests of the Chancery would go no further than to say “this This duty requires directors to inform themselves company.”12 The focus of the judicial inquiry is Court has not definitively stated whether a Board’s “of all material reasonably available to on the process rather than the substance of the Caremark [oversight] duties include a duty to them”5 before they make a business decision. board’s decision-making. The protection provided monitor business risk.”1 The duty of loyalty requires directors to act in by the business judgment rule was designed to This article explores whether the directors’ good faith for the benefit of the corporation and its allow directors to pursue transactions, including fiduciary duty of oversight is robust enough to pro- stockholders, rather than for their own interest. risky transactions, without the specter of being vide with any level of assurance worth Earlier discussed a separate “duty second-guessed by others who have the benefit relying on, whether market trends or industry of good faith” requiring directors to act honestly, of hindsight bias or being held personally liable “red flags” ever create an on the part in the best interest of the corporation, and in a if those decisions turn out poorly. of directors to take action or whether the only manner that is not knowingly unlawful or contrary Furthermore, most Delaware have remedy available to investors in these situations to public policy. The , in In adopted a provision in their certificates of incor- is to replace the board. re The Walt Disney Company Derivative Litigation,6 poration pursuant to §102(b)(7) of the Delaware If the mortgage crisis is behind us, plenty of described the requisite conduct for establishing a General Corporation Law (DGCL)13 that allows for potential red flags remain out there for direc- breach of the duty of good faith as “qualitatively exculpation of directors from personal liability for tors to trip over. For example, it has been widely more culpable than gross ,”7 but did violations of fiduciary duty, except for, among oth- reported that the SEC and the U.S. Department not decide whether such duty was a duty inde- er things, breaches of the duty of loyalty, actions of are investigating and misleading pendent of the duties of care and loyalty. Five or omissions not in good faith14 or actions involv- financial statements in Chinese companies listed months later, in Stone v. Ritter, the same court ing internal misconduct or knowing violations of on U.S. exchanges, with particular emphasis on rejected the notion of a separate duty and found law. The combination of the deferential business companies that have gone public through reverse the duty of good faith to be a subsidiary element judgment rule and §102(b)(7) provisions makes mergers.2 One estimate is that more than one-third of the duty of loyalty.8 it extremely difficult to hold directors liable for of these companies may have misleading financial Typically, absent a transaction involving finan- a breach of fiduciary duty absent a showing of cial self-interest, are reluctant to probe the self-dealing. subjective state of mind of directors, i.e., their Without the protection generally provided “good faith,” and have been reluctant to find by the business judgment rule and §102(b)(7), Louis J. Bevilacqua is a partner at Cadwalader, Wick- that a director has breached the duty of loyalty. it would be difficult to find quality directors to ersham & Taft, where he co-chairs the corporate depart- ment. Associates Jeffrey Weissmann and Nicole Bernier Finding bad faith is a rarely met threshold that serve on public boards and, if found, such direc- assisted in the preparation of this article. requires proof of “fiduciary conduct motivated tors would need to be paid substantially higher monday, november 28, 2011 amounts to compensate them for their increased monitoring system is in place, Stone indicates tor internal employee misconduct or violations of risk.15 However, the broad exculpation provided that a director’s oversight liability can be estab- law, rather than business risk. Here, however, the by §102(b)(7) also calls into question whether lished by that the directors deliberately most that the plaintiffs had demonstrated was fiduciary duties provide meaningful oversight ignored “red flags” as to potential issues. Unlike that directors made bad business decisions; but protection for investors, given directors’ lack of Caremark, Stone construed the duty to monitor such decisions were protected by the business personal liability. as part of the duty of loyalty rather than the duty judgment rule. The restrictiveness of the court’s Duty of Oversight of care, thus removing monitoring failures from language implies that the Delaware is §102(b)(7) exculpation. However, by effectively likely to limit the finding of oversight liability to In its 1996 decision,16 In re Caremark Interna- adding an element of scienter as a requirement the most extreme instances of bad faith. One can tional Inc. Derivative Litigation,17 the Delaware to establish a breach of the duty of loyalty, Stone question whether the same outcome would have Court of Chancery held that losses allegedly made it virtually impossible for plaintiffs to show been reached if the duty of care (instead of just resulting not from board decisions (which are that directors breached their duty. loyalty) had been part of the analysis. subject to the business judgment rule), but instead Following Stone, Delaware courts continued AIG and Countrywide from unconsidered inaction, could trigger director to tighten the standard upon which directors liability for a failure to monitor. could be held liable for oversight claims. Red Despite cases where the plaintiffs’ pleading was The underlying wrong in Caremark was the flags recognized by Delaware courts to poten- held sufficient to implicate the board’s duty of company’s payment of illegal kickbacks. The case tially impose director liability have been found oversight, the sphere of facts that establish liabil- emphasized that timely information about poten- only in cases involving illegal company activity, ity has been limited to the point that a board need tial issues or “red flags” was essential in order for extreme instances of employee fraud, or other have little or no concern, or at least no financial the board to perform its supervisory and moni- violations of law. Red flags related to business concern, about its duty to monitor the company’s toring role.18 The court held that the duty of care risks or market trends, no matter how damaging performance, except in a case that involved actual required corporate directors to “exercise a good they may be to the company, have never been or constructive fraud or other illegal activity. faith judgment that the corporation’s information found by a published Delaware court opinion to Meanwhile, reputational risk alone has proven and reporting system is in concept and design implicate a director’s duty of oversight. Some of to be no real deterrent. In American International adequate to assure the board that appropriate the recent cases addressing oversight claims, Group v. Greenberg, et al.,25 the Delaware Court information will come to its attention in a timely many of which arose out of the mortgage crisis, of Chancery found that two of the director defen- manner.”19 Such a system would presumably allow are discussed briefly below. dants knowingly tolerated inadequate controls and the board to react so as to protect the interests knowingly failed to monitor their subordinates’ of the corporation and shareholders. However, compliance with the law. In this case, the directors the court limited the duty by holding that “only The business judgment rule had direct control over the corporate operations a sustained or systematic failure of the Board provides “a presumption that in involved in the commission of illegal acts. The to exercise oversight—such as an utter failure making a business decision the defendants involved were not only directors, but to attempt to ensure a reasonable information also senior officers of the corporation, and the and reporting system exists—will establish the directors of a corporation acted corporate divisions involved were under their lack of good faith that is a necessary condition on an informed basis, in good supervision. The facts in this case prompted the to liability.”20 faith and in the honest belief that court to describe the defendants as having led This limited duty to monitor was confirmed the action taken was in the best a “criminal .” This court’s holding, by the Delaware Supreme Court 10 years later in however, offers little hope for future plaintiffs, Stone v. Ritter.21 The action against the directors interests of the company.” since the alleged wrongdoing was so widespread was based on their failure to adequately monitor and egregious and involved violations of law, the corporation’s compliance with federal bank- In a 2009 Delaware Court of Chancery case effectively implying scienter on the part of the ing and . The complaint was styled as a Caremark claim, In re Citigroup implicated directors. dismissed since the court found that the plain- Shareholder Derivative Litigation,23 the plaintiffs In In re Countrywide Financial Corporation tiffs failed to allege facts that demonstrated that claimed that the public reports and statements Derivative Litigation,26 the U.S. District Court for the directors were aware that the corporation’s reflecting worsening conditions in the financial the Central District of , in considering controls were inadequate but chose to do noth- markets, in particular with respect to subprime a motion to dismiss, found that allegations of ing about these deficiencies. The court out mortgages, should have served as “red flags” to Countrywide’s rampant disregard of underwrit- the necessary conditions for director oversight the Citigroup directors who breached their duty ing standards and the directors’ failure to take any liability as follows: to properly monitor the business risks involved. action in the face of company-specific red flags (a) the directors utterly failed to implement The court rejected the plaintiffs’ claims and could potentially establish the requisite inference any reporting or information system or con- pointed out that the alleged “red flags” were of scienter or at least deliberate recklessness. The trols; or “little more than portions of public documents court determined that directors who served on (b) having implemented such a system or con- that reflected the worsening conditions in the key board committees charged with overseeing trols, consciously failed to monitor or oversee subprime mortgage market and in the economy Countrywide’s risk exposures, investment port- its operations thus disabling themselves from generally”; they were “not evidence that direc- folios, and loan loss reserves, “were in a position being informed of risks or problems requiring tors consciously disregarded their duties”24 as to recognize the significance of these red flags, their attention.22 required by Stone. and, accordingly, investigate the extent to which Imposing liability under Stone requires a The court distinguished its holding from that underwriting standards had been abandoned.”27 showing that the directors knew they were not of Caremark and Stone by highlighting how those As the court in Staehr v. Mack later explained,28 discharging their fiduciary . Once a two cases involved the alleged failure to moni- the red flags identified in Countrywide were “of monday, november 28, 2011

such prominence that individual defendants dent audit committees, more squarely in the area 4. See In re Walt Disney Co. Derivative Litigation, 907 A.2d must necessarily have examined and considered where courts will reach to find scienter given the 693, 795 (Del. Ch. 2005). them in the course of their committee oversight audit committees specific charge to monitor the 5. Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985) (quot- duties.” Because loan origination was at the core financial reporting of these companies? ing Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)). of Countrywide’s business, and because the com- The SEC’s investigation of these compa- 6. 906 A.2d 27 (Del. 2006). pany’s culture encouraged unchecked deviation nies involves in financial state- 7. Id. at 66. from underwriting standards, this case turned in ments that could involve fraudulent or criminal 8. Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006). a direction contrary to that of Citigroup. misconduct. Such areas have been found to be 9. Disney, 906 A.2d 27 at 66. Although the plaintiffs’ claims in Countrywide within even the most restrictive view of oversight 10. Id. at 67. were dismissed due to loss of standing, the analy- liability. As the Citigroup court noted, the failure 11. See Disney, 907 A.2d at 747. sis of the district court suggests that future plain- to monitor fraudulent or criminal misconduct 12. In re Citigroup Inc. Shareholder Derivative Litigation, 964 tiffs may find some success in oversight claims within the company is different from the failure A.2d 106, 125 (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. involving a failure to supervise normal business to monitor business risk. 1984)). activity without alleging a failure of oversight relat- Although Caremark and its progeny, particularly 13. Section 102(b)(7) was enacted in response to the 1985 ing to employees committing illegal acts. Notably, Citigroup, indicate that external market-based risks Delaware Supreme Court decision in Smith v. Van Gorkom, the standard of scienter applied by the district do not give rise to red flags sufficient to impose which found directors personally liable for a breach of the court included deliberate recklessness. Such a oversight liability, the external events in such cases duty of care based on their . standard is recognized under federal securities related solely to business risk. In contrast, the red 14. The inclusion in §102(b)(7) of “actions or omissions not litigation under §10(b), but it is broader than the flags raised by the investigation of Chinese com- in good faith” as a separate item from the “duty of loyalty” generally recognized standard under Delaware law panies involve potential fraud and illegal deviation does raise a question as to Stone’s finding that the duty of good in oversight claims. from standards. Following the direction faith is a subsidiary element of the duty of loyalty. Delaware court decisions to date suggest that of the Countrywide court in broadening the scope of 15. See generally Martin Petrin, “Assessing Delaware’s Over- directors’ requirement to take action is triggered the duty to monitor, it remains possible that given sight Jurisprudence: A Policy and Theory Perspective,” 5 Va. only in instances where the company’s internal the right set of facts, a court may find that evidence L. & Bus. Rev. 433 (2011). The fear of chilling service of quality operations raise red flags, and generally only in of systemic fraud and illegal activity in various Chi- directors begs the question of whether due to the tremendous instances where the failure to investigate involves nese companies has created a market-based red flag losses suffered, shareholders might be better off increasing di- red flags that concern fraudulent or criminal con- for directors of other similarly situated companies. rector compensation and not adopting §102(b)(7) exculpation duct rather than business risk. Delaware courts Given the widespread nature of the trend, a duty to provisions in . have declined to find that general external , act may be created, and ignoring such a duty may 16. The Caremark decision, in part, was interpreting the such as those in the global marketplace, consti- be found to constitute a failure to monitor. 1963 Delaware Supreme Court case Graham v. Allis-Chalmers tute the kind of red flags that establish proof of Accordingly, prudence mandates that directors Mfg. Co., 188 A.2d 125 (Del. Supr. 1963). an intentional failure to act in the face of a known of similarly situated companies consider that these 17. 698 A.2d 959 (Del. Ch. 1996). duty to act. Given the in Delaware, prac- trends could be “red flags” that should require 18. See Id. at 970. titioners have questioned whether the Chancery directors to take appropriate action. Such actions 19. Id. at 970. Court would have come to a different conclusion, could include reviewing the effectiveness of infor- 20. Id. at 971. even in the context of a motion to dismiss, in mation and reporting systems and, if necessary, 21. 911 A.2d 362 (Del. 2006). considering the Countrywide facts.29 increasing monitoring to provide more robust early 22. Id. at 370. The SEC’s Investigation warning systems, as well as considering whether 23. In re Citigroup Inc. Shareholder Derivative Litigation, 964 conducting a targeted internal investigation into A.2d 106 (2009). Has the SEC’s announced investigation of numer- particular areas may be warranted to ensure that 24. Id. at 128. ous Chinese companies created a red flag? Does the shareholders’ interests are protected. 25. 965 A.2d 763 (Del. Ch. 2009). the duty of oversight require action by indepen- Although the duty to monitor may provide far 26. 554 F. Supp. 2d 1044 (C.D. Cal. 2008). dent directors of other Chinese companies who are less protection than investors may have expect- 27. Id. at 1060. not currently under investigation by the SEC? ed, the potential remains for this duty to expand 28. 2011 WL 1330856 (S.D.N.Y.) at 8. This question is dependent on three others: (both in the areas of business risk and in the area 29. See Eric J. Pan, “The Duty to Monitor Under Delaware (1) Is the Delaware standard universally of market-based illegal activity trends), especially Law: From Caremark to Citigroup,” The Conference Board (Feb- accepted or are other states going to be more if a court is presented a set of facts such as the ruary 2010). aggressive in protecting shareholders rather than widespread illegal activities like those currently directors? being investigated by the SEC. (2) Has the duty of oversight law in Delaware settled in the right place, or does Countrywide ••••••••••••••••••••••••••••• indicate that the pendulum has started to swing 1. In re The Goldman Sachs Group. Inc. Shareholder Litiga- toward “more shareholder protection”? tion, C.A. No. 5215-VCG at 60 (Del. Ch. Oct. 12, 2011). (3) Given the types of alleged activity being 2. Speech of Commissioner Aguilar, April 4, 2011. Reprinted with permission from the November 28, 2011 edition of the NEW YORK LAW investigated by the SEC, are the boards of Chinese 3. Since ancient Roman times it has been recognized that a JOURNAL © 2011 ALM Media Properties, LLC. All reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382 or reprints@alm. companies, and more particularly the indepen- law without a meaningful penalty would just be ignored. com. # 070-11-11-36