Corporate Governance WWW. NYLJ.COM MONDAY, NOVEMBER 28, 2011 Monitoring the Duty to Monitor statements. As a result, the stock prices of Chinese by an actual intent to do harm” or an “intentional BY LOUIS J. BEVILACQUA listed companies 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 company? 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 fiduciary acts with the intent tors who were supposed to be watching over the law 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 Duties 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 conflict of interest, claims of breaches conditions, but what about the boards of mort- directors have fiduciary duties to the corporation of duty of care 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 “business judgment had a business model tied to market risk. Most and the duty of loyalty.4 The duty of care requires rule.”11 The business judgment rule 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 good faith and in the honest belief that risk. In fact, just last month the Delaware Court 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 information 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 investors with any level of assurance worth Earlier jurisprudence 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 obligation 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 corporations have remedy available to investors in these situations to public policy. The Delaware Supreme Court, 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 negligence,”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 Justice are investigating fraud 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, courts 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 evidence 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 judiciary 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.