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Caremark Standard Set in Stone

When public companies get into trouble with the government, shareholder lawsuits often follow. And in the era of Sarbanes-Oxley and corporate governance scandals, shareholder lawsuits increasingly are targeting corporate directors.

Shareholders often use the courts to attempt to hold directors personally responsible for all kinds of corporate problems, from dwindling sales to accounting fraud. And historically, the limits of director liability haven’t been clearly defined. Instead, courts and litigants have relied on a de-facto standard established by a Delaware Chancery Court in 1996 in In re Caremark International Inc. Deriv. Ligit. (698 A.2d 959, 971).

Now, however, director-liability standards are becoming clearer, most notably with the Delaware Supreme Court’s December 2006 decision in Stone v. Ritter, 911 A.2d 362 (Del. 2006), a shareholder-derivative lawsuit seeking to hold corporate directors personally responsible for alleged oversight failures.

“Stone is a classic oversight case,” says Melissa C. Brown, of counsel in Dykema’s Grand Rapids, Mich., office. “And the Delaware Supreme Court seems to have been waiting for just the right set of facts to adopt the Caremark standard.”

In Caremark, a Delaware Chancery Court said plaintiffs must prove a “sustained and systemic failure” to exercise oversight in order to show a lack of good faith and hold directors liable for wrongdoing that occurs on their watch. As Brown told InsideCounsel magazine in a Dykema on Demand Podcast, the Stone decision formalizes the Caremark standard in a way that will influence shareholder-derivative lawsuits filed in Delaware – as well as courts across the country, which look to Delaware for corporate-law principles.

“The Delaware Supreme Court has now announced a standard for oversight cases,” Brown says. “Lack of good faith is a necessary condition to liability.”

Affirmative Duty
In the Stone case, the Delaware Supreme Court affirmed a Chancery Court judgment dismissing a shareholder-derivative lawsuit against directors of AmSouth Bancorporation, a commercial bank with branches in six states. The court rejected the plaintiffs’ charge that AmSouth’s directors should be held accountable for losses arising from money-laundering activity that occurred on their watch, but without their knowledge.

The case arose from a Ponzi scheme perpetrated by certain AmSouth account holders. No bank employees were involved in the scheme, but some suspected wrongdoing and failed to file the suspicious activity reports required by regulators. As a result, banking authorities levied $50 million in fines and penalties against the bank – sparking shareholders’ ire.

“In plaintiffs’ view, the directors didn’t have information and reporting systems that would have brought such problems to their attention, thus directors must have breached their duty to shareholders and to the corporation,” Brown says. “In other words, the plaintiffs argued that directors failed to exercise adequate oversight of the company’s operations.”

Stone and SOX
The facts and allegations in Stone gave the Delaware court an appropriate opportunity for application of the Caremark standard, clarifying the limits of director responsibility. The Chancery Court in Caremark relied on an earlier case, Graham v. Allis-Chalmers Mfg. Co. (188 A.2d 125 (Del. 1963), to show that directors may not have the duty to “ferret out” wrongdoing, and the Delaware Supreme Court agreed in Stone. But the decision doesn’t absolve corporate directors of responsibility for adequate oversight.

“Nothing in Stone protects directors who are willfully ignorant, or who act in bad faith,” Brown says. “But it does protect directors from personal liability where plaintiffs look at a bad outcome, and use the outcome itself as their evidence of bad faith.”

At the same time, the Stone decision, in combination with other recent cases (See “From Graham to Stone: The Evolution of Director Liability”), further establishes the requirement that directors make a good-faith effort to obtain appropriate information as a matter of ordinary operations. Under Stone, directors can fulfill their duties by ensuring the company has adequate systems for keeping directors and officers informed. Moreover, federal statutes and sentencing guidelines impose the same duties established by the Delaware courts.

“Stone’s emphasis on good reporting systems and sound corporate controls is completely harmonious with Sarbanes-Oxley Section 404,” Brown says. “If directors ensure well-designed and well-implemented systems are in place, and monitor the information produced by those systems in a timely and effective fashion, then they’ll be acting in a manner consistent with the intent of both Sarbanes-Oxley and Stone.”

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Featured Articles :

• Caremark Standard Set in Stone
  Shareholders often use the courts to attempt to hold directors personally responsible for all kinds of corporate problems.

• From Graham to Stone: The Evolution of Director Liability
  A series of cases beginning in 1963 have been refining the basic premise that directors have an affirmative duty to exercise good faith in overseeing corporate operations.

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