Delaware Supreme Court Confirms Extremely Heavy Burden to Hold Directors Liable for Oversight Failures

November 13, 2006

In a recent decision, the Delaware Supreme Court made it extremely clear that claims against directors for failing to provide adequate oversight (so called Caremark claims) are subject to a heavy burden on plaintiffs.

In Stone v. Ritter (Del. Supr. No. 93,206, Nov. 6, 2006) (copy attached), the Court recognized that good faith exercise of oversight responsibility will not always prevent employees from violating criminal laws or from causing substantial financial liability. “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.” The Court held that directors will not be subject to potential oversight liability unless either (a) they “utterly failed to implement any reporting or information system or controls” or (b) having implemented such a system, they “consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.” And, in “either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.” This clearly places a very heavy burden on plaintiff shareholders in seeking to hold directors liable, as it should. Of course, this does not mean that directors should not seek to follow “best practices.” But as the recent Disney decision reiterated, the standard to avoid liability is not “best practices.”

The Supreme Court also clarified that under Disney, “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” and thus a failure to act in good faith does not directly result in liability. Instead, the obligation to act in good faith is “a condition of the fundamental duty of loyalty.” The Court also noted that the duty of loyalty is not limited to cases involving a conflict of interest – financial or otherwise. This is because “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 interests.”

The Supreme Court’s opinion was issued in the context of affirming the dismissal of a shareholder derivative action against the directors of AmSouth Bancorporation. AmSouth had agreed to pay $50 million in fines and civil penalties to resolve governmental investigations relating to the failure of bank employees to file Suspicious Activity Reports as required by the Bank Secrecy Act (“BSA”) and anti-money-laundering (“AML”) regulations. In connection with the settlement, AmSouth also agreed to a Cease and Desist Order requiring it to improve its BSA/AML program. Also in connection with the settlement, FinCen (the Treasury Department’s Financial Crimes Enforcement Network) concluded that AmSouth’s AML Compliance Program “lacked adequate board and management oversight.” Nevertheless, because the plaintiff did not allege particularized facts that created reasons to doubt whether the directors had acted in good faith in exercising their oversight responsibilities, the Court affirmed the dismissal of the derivative claim for failure of the plaintiff to demand that the Board itself decide whether to bring suit.

For further information on this subject, please contact Victor I. Lewkow, any of your regular contacts at the firm, or any of our partners or counsel listed under “Corporate Governance” in the Our Practice section of our website.