Duty of Care: Passive

Sleeping Sentry and agency costs

• Gagliardi analysis doesn’t apply because supposedly risk aversion doesn’t apply to omissions

• Monitoring is costly; absent gains (as with Sentencing Guidelines), requirement of monitoring system imposes costs without readily knowable gains.

Francis v. United Jersey Bank

Pritchard & Baird is a closely-held reinsurance firms with four directors: Charles Pritchard Sr. (founder), Mrs. Pritchard, and two sons Charles Jr. and William.

How it works: Primary insurer writes the policy to the insured, and then gets reinsurer to take on some portion of the risk, e.g., primary insurer takes the first $X in liability, and then the reinsurer takes the rest. Reinsurance brokers like P&B move premium payments and loss payments from primary insurers to reinsurers and back.

Charles Sr. starts the practice of co-mingling accounts and making “shareholder loans” which he pays back; after he dies, Charles Jr. and William run the business, continue the practice of “shareholder loans,” but don’t pay the money back.

Firm goes bankrupt; trustees in bankruptcy bring suit against Mrs. Pritchard (and eventually her estate) for negligence in the conduct of her duties as a director of the corporation.

Graham v. Allis Chalmers Mfg.

Allis-Chalmers is a very large, decentralized public corporation that makes electrical equipment.

In 1937, it entered into a consent degree with the FTC to stop fixing prices on condensers and turbine generators.

In late 1950s, Allis-Chalmers and four mid-level managers plead guilty to price-fixing charges, pay big fines.

Shareholder brings derivative suit against directors and top officers to recover on behalf of corporation.

Since defendant directors had no knowledge of anti-trust violations, the theory is they breached their duty of care.

Chancellor Corp. acquired MRB in 1999 but CEO and other officers forged documents showing the transaction taking place in August 1998 in order to consolidate MRB earnings a year earlier.

Audit committee members Marchese and Peselman received a report from outside auditor challenging 1998 acquisition date but did not follow up.

New auditors sign-off on 1998 acquisition date.

Marchese certifies 1998 10-KSB, but resigns from the board in 1999 and expresses concerns to the SEC.

Marchese agreed to undisclosed settlement for “recklessly ignor[ing] signs pointing to improper accounting treatment.”

In re Michael Marchese

U.S. Sentencing Guidelines for Organizations (last revised Nov. 2004): An effective compliance and ethics program (ECEP) can provide the basis for a downward adjustment in the ultimate punishment for corporate wrong-doing (though recent U.S. Supreme Court decisions make the Guidelines advisory rather than mandatory.

DOJ Policy on Charging Organizations (a.k.a. “Thompson Memo”) (2003): Government prosecutors will look at the depth and quality of a company’s compliance program in connection with charging decisions.

SOX § 404: requires CEO & CFO to certify that they have evaluated the effectiveness of the company’s disclosure controls and procedures, and identified to the outside auditors any material weaknesses in the company’s internal controls.

Federal Overlay on Monitoring Responsibility

In re Caremark

Caremark is a publicly traded health care provider -- provides a lot of specialized patient care, treatment for conditions ranging from AIDS to hemophilia.

Caremark is subject to the complex provisions of Anti-Referral Payments Law: basically, you’re not supposed to pay MDs to refer patients whose treatment is paid for by Medicare or Medicaid.

Caremark had always had an ethics guidebook, an internal audit plan, and a toll-free confidential ethics hotline. Price Waterhouse gave control system a clean bill of health. But despite it all, lower-level officers apparently engaged in enough misconduct to cost $250 million.

Shareholders file derivative suit seeking recovery from the board of directors, claiming breach of the duty of care.

Case is before Chancellor Allen to approve a settlement in which the Caremark directors promised only to implement relatively insignificant additional safeguards to increase Caremark’s ability to comply with the ARPL in the future.

In re Caremark

• “Breach of the duty of care or attention…”

• “Loss eventuates not from a decision but, from unconsidered inaction.”

“What is the board’s responsibility with respect to the organization and monitoring of the enterprise to assure that the corporation functions within the law to achieve its purposes?”

• The Graham Court held: “[A]bsent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.”

• What does this mean?• “The case can be more narrowly interpreted as

standing for the proposition that, absent grounds to suspect deception, neither corporate boards nor senior officers can be charged with wrongdoing simply for assuming the integrity of employees and the honesty of their dealings on the company's behalf.”

Caremark: Standard of Conduct

“[I]t is important that the board exercise a good faith judgment that the corporation's information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations, so that it may satisfy its responsibility.”

Caremark: Standard of Liability

“[I]n my opinion only a sustained or systematic failure of the board to exercise oversight – such as an utter failure to attempt to assure a reasonable information and reporting system exits – will establish the lack of good faith that is a necessary condition to liability.”

Duty of Care – post Caremark

• Is this a case about decision-making (van Gorkom) or oversight (Caremark)?

• Disney and Stone v. Ritter

Disney: Decision-Making?

• Hiring: Disney board approves Ovitz’s employment agreementFive yearsSalary ($1 million)Bonus (“discretionary” … $7.5 million?)Options (two tranches)

• Firing: Eisner approves Ovitz’s “Non-fault Termination”Cash payments ($38 million)Options (3 million ≈ $100 million)

Disney: Round 1

•Chancellor Chandler (1998)–Care–Waste Dismissed!

Replead!

Justice Veasey (2000)“A prolix complaint larded with conclusory

language”Emphasizes good faith

Why bad faith?• DGCL § 102(b)(7)

– (b) In addition to the matters required to be set forth in the certificate of incorporation by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters:

– (7) A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law …

What is “bad faith”?• Traditional corporate law

– Illegal– Fraudulent– Ultra vires

• Bad faith as “substantive due care”– Allen: “theoretical” possibility of liability for

“egregious”decisions– Veasey: “Due care in the decisionmaking context is

process due care only”• Bad faith as “irrationality”

– Veasey: “Irrationality may … tend to show that the decision is not made in good faith”

Disney: Round 2•Chancellor Chandler (2003)

– Bad faith– Motion to dismiss under Rule 23.1

• the directors are disinterested and independent, or• the challenged transaction was otherwise the product of a

valid exercise of business judgment

Motion Denied!

Chandler:“The facts alleged in the new complaint suggest that the defendant directors consciously and intentionally disregarded their responsibilities, adopting a ‘we don't care about the risks’ attitude concerning a material corporate decision. Knowing or deliberate indifference by a director to his or her duty to act faithfully and with appropriate care is conduct, in my opinion, that may not have been taken honestly and in good faith to advance the best interests of the company”

Disney: Round 3

•Chancellor Chandler (2005)–Post-trial opinion–No bad faith

Dismissed!

Chandler“Upon long and careful consideration, I am of the opinion that the concept of intentional dereliction of duty, a conscious disregard for one’s responsibilities, is an appropriate (although not the only) standard for determining whether fiduciaries have acted in good faith. Deliberate indifference and inaction in the face of a duty to act is, in my mind, conduct that is clearly disloyal to the corporation. It is the epitome of faithless conduct....”

Rebutting the BJR• Before Trial:

– Allege facts sufficient to support a finding that the board of directors violated the duty of care, the duty of loyalty, or the duty of good faith• But: the Delaware Supreme Court has held that where a corporation

has an exculpatory provision and the plaintiffs file a complaint that contains only a duty of care claim, the court will dismiss the compaint because the plaintiffs cannot recover monetary damages from the defendants. Or, stated another way, to survive a motion to dismiss, a complaint must allege a breach of the duty of loyalty or the duty of good faith.

• At Trial:– Prove facts sufficient to support a finding that the board of directors

violated the duty of care, the duty of loyalty, or the duty of good faith• Emerald Partners: "If a shareholder plaintiff fails to meet this

evidentiary burden, the business judgment rule operates to provide substantive protection for the directors and for the decisions that they have made."

If the BJR is Rebutted• Before Trial: complaint withstands a motion to dismiss• At Trial:

– Burden shifts to the defendants to show that the challenged transaction was entirely fair

– What if plaintiff's case rested solely on a breach of the duty of care and corporation has an exculpatory provision?• “When entire fairness is the applicable standard of judicial review, this

Court has held that injury or damages becomes a proper focus only after a transaction is determined not to be entirely fair. A fortiori, the exculpatory effect of a Section 102(b)(7) provision only becomes a proper focus of judicial scrutiny after the directors' potential personal liability for the payment of monetary damages has been established. Accordingly, although a Section 102(b)(7) charter provision may provide exculpation for directors against the payment of monetary damages that is attributed exclusively to violating the duty of care, even in a transaction that requires the entire fairness review standard ab initio, it cannot eliminate an entire fairness analysis by the Court of Chancery.”

Disney• Before Trial

– Chandler: “I … conclude that plaintiffs' pleading is sufficient to withstand a motion to dismiss under Rule 12(b)(6). Specifically, plaintiffs' claims are based on an alleged knowing and deliberate indifference to a potential risk of harm to the corporation. Where a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director's actions are either ‘not in good faith’ or ‘involve intentional misconduct.’ Thus, plaintiffs' allegations support claims that fall outside the liability waiver provided under Disney's certificate of incorporation.”

Disney

•At Trial:–Chandler: “I conclude that the only

reasonable application of the law to the facts as I have found them, is that the defendants did not act in bad faith, and were at most ordinarily negligent, in connection with the hiring of Ovitz and the approval of the [Ovitz Employment Agreement.]”

Disney• On Appeal: attempting to rebut the BJR

– Breach of Care in Hiring Ovitz• The Compensation Committee did not follow “best practices,” but

they were sufficiently informed to meet their duty of care• The remaining Disney directors were aware of Ovitz’s skills,

reputation and experience, and they knew about the key terms of the OEA

– Breach of Good Faith in Hiring Ovitz• Disney directors acted in good faith in hiring Ovitz

– Breach of Duties in Firing Ovitz• Eisner had authority to fire Ovitz unilaterally (i.e., without board

consent)• Litvack and Eisner did not breach any duty by firing Ovitz without

cause• Remaining directors were justified in relying on Litvack and Eisner

What is “Bad Faith”?• Three candidates

– “Subjective bad faith” = “actual intent to do harm”• “That such conduct constitutes classic, quintessential bad

faith is a proposition so well accepted in the liturgy of fiduciary law that it borders on axiomatic.”

– “Lack of due care”• “The conduct that is the subject of due care may overlap with

the conduct that comes within the rubric of good faith in a psychological sense, but from a legal standpoint those duties are and must remain quite distinct.”

– “Intentional dereliction of duty, a conscious disregard for one's responsibilities”

• “Fiduciary conduct of this kind, which does not involve disloyalty (as traditionally defined) but is qualitatively more culpable than gross negligence, should be proscribed.”

• Section 102(b)(7) “distinguishes between ‘intentional misconduct’ and a ‘knowing violation of law’ (both examples of subjective bad faith) on the one hand, and ‘acts ... not in good faith,’ on the other. Because the statute exculpates directors only for conduct amounting to gross negligence, the statutory denial of exculpation for “acts ... not in good faith” must encompass the intermediate category of misconduct captured by the Chancellor's definition of bad faith.

Stone v. Ritter

•AmSouth failed to report suspicious account activity and did not comply with federal anti-money laundering requirements–“Classic Caremark claim”

•Delaware Supreme Court embraces Caremark and connects it to Disney

Stone v. Ritter• Key Disney passage on bad faith:

– “A failure to act in good faith may be shown … where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties”

• Holland:– This behavior is “fully consistent with, the lack of

good faith conduct that the Caremark court held was a ‘necessary condition’ for director oversight liability.”• ??? Caremark was supposed to be about

“unconsidered inaction”

Stone v. Ritter• Implications

– Good faith is a “subsidiary element” of the duty of loyalty

– “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.”

– “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.”

The New Caremark(?)– “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.”

Classic Duty of Loyalty – Self Dealing

• Self-dealing occurs when the corporation enters into a transaction with a director– Varied transactions ranging from sale of property to provision of

services– May be direct or indirect (indirect includes transactions with

relatives, other entities in which the director has a financial interest, and interlocking directorates)

– Includes cases where executive determines her own compensation

• Fundamental principle is that the decision making process is tainted

• Two possible solutions: cleanse the process or look at substance

DGCL § 144(a) No contract or transaction between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director's or officer's votes are counted for such purpose, if:

DGCL § 144

(1) The material facts as to the director's or officer's relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; or

(2) The material facts as to the director's or officer's relationship or interest and as to the contract or transaction are disclosed or are known to the shareholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by vote of the shareholders; or

(3) The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the shareholders.

All Corporate Transactions

Conflict-of-Interest Transactions

Conflict –of-interest

Transactions

“Bad” Transactio

nsHow do we find the bad

transactions?

Duty of Loyalty - Hollinger• Corporate Opportunity

– “The International board is empowered by Delaware law to dispose of [the Telegraph] without seeking stockholder assent. Black's asserted power (acting through Inc.) to remove the International board as a means of impeding the sale of the Telegraph does not change the fact that it is the prerogative of the members of the International board-whoever they are-to consider whether a sale of the Telegraph is in the interests of all International stockholders. Not only that, asset sales were one of the options the Strategic Process was specifically designed to consider. The opportunity to sell the Telegraph belonged to International.”

Hollinger’s Duty of Loyalty • What did Black do wrong?

– “Purposely denying the International board the right to consider fairly and responsibly a strategic opportunity within the scope of its Strategic Process and diverting that opportunity to himself”

– “Misleading his fellow directors about his conduct and failing to disclose his dealings with the Barclays, under circumstances in which full disclosure was obviously expected”

– “Improperly using confidential information belonging to International to advance his own personal interests and not those of International, without authorization from his fellow directors”

– “Urging the Barclays to pressure Lazard with improper inducements to get it to betray its client, International, in order to secure the board's assent to the Barclays Transaction”

Duty of Loyalty – Cure (Broz 1)• Allen:

“Both formality and the group dynamics of board action are important in corporate law. Formality in such circumstances is not ‘mere formality’, it is treated by courts as important because it tends to focus attention on the need for deliberation and the existence of accountability structures. With respect to group dynamics, it is an old rule that boards may act with legal effect only at duly convened meetings at which a quorum is present. Again functional reasons underlie the law's insistence on correct form.”

Duty of Loyalty – Cure (Broz 2)• Veasey:

“[P]resenting the opportunity to the board creates a kind of ‘safe harbor’ for the director, which removes the specter of a post hoc judicial determination that the director or officer has improperly usurped a corporate opportunity. Thus, presentation avoids the possibility that an error in the fiduciary's assessment of the situation will create future liability for breach of fiduciary duty. It is not the law of Delaware that presentation to the board is a necessary prerequisite to a finding that a corporate opportunity has not been usurped.”

Business Judgment Rule

Director Misconduct

Rebut thepresumption?

Plaintiffs WinMotion to Dismiss

Case DismissedNo

Allegations

ExculpatoryProvision

Allege more thanbreach of care?

Case DismissedNo

Yes

Yes

Pretrial:Exculpation

Director Misconduct

Disinteresteddirector approval?

Yes

No

Evidence

Pre-trial or Trial:Ratification

Business Judgment Rule

Defendants WinDisinterested

shareholder approval?

No

YesCare or Loyalty?

Loyalty

Care

Defendants Win

Entire Fairness Review

Business Judgment Rule

Defendants Win

Director or Controlling Shareholder?

Director

C. S.

“The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of when the

transaction was timed, how it was initiated, structured, negotiated,

disclosed to the directors, and how the approvals of the directors and the

stockholders were obtained. The latter aspect of fairness relates to the

economic and financial considerations of the proposed merger, including all

relevant factors: assets, market value, earnings, future prospects, and any

other elements that affect the intrinsic or inherent value of a company's stock.”

Trial

Rebut thepresumption?

Defendants Win

No DamagesNo

Fair?

Damages

No

Yes

Yes

Entire Fairness

Ratio decidendi?

ExculpatoryProvision

Loyalty

Care

Business Judgment Rule

Evidence

Trial:Entire

Fairness

1. Establish an appropriate supervisory and compliance structure.

2. Create a sophisticated inventory of regulatory and reputational risks faced by the firm’s businesses.

3. Establish an “early warning” system to identify emerging areas of regulatory focus.

4. Communicate the board’s and senior management’s compliance message throughout the organization.

5. Conduct specialized training for supervisors.

6. Ensure that information concerning regulatory and reputational risks and issues is promptly surfaced to senior management and compliance personnel.

7. Use internal discipline effectively to reinforce the compliance message when appropriate.

From: Mervis, Savarese & Miller, The New Regulatory and Enforcement Environment (2005)

Board Best Practices in the New Era of Corporate Monitoring