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Directors’ fiduciary duty of loyalty to the company and its stockholders includes a duty to oversee the company’s operations. That, in turn, includes an obligation to take reasonable measures to implement and oversee risk management and compliance controls. Where a board fails to do this, directors may be vulnerable to lawsuits by stockholders. In Delaware, whose law governs most large American corporations, these are known as Caremark claims.

Historically, these kinds of suits have been very difficult to maintain because they require that plaintiffs show bad faith on the board’s part. And a bad outcome does not suffice to show bad faith.

Nonetheless, over the past several years, Delaware courts have allowed an increasing number of Caremark claims to survive a motion to dismiss and proceed to discovery. In these cases, the stockholder plaintiff adequately alleged a lack of corporate control systems or the existence of “red flags” suggesting improper oversight. As a recent decision put it, Caremark claims, “once rarities … have in recent years bloomed like dandelions after a warm spring rain.”

Boards need to take these recent rulings into account in considering how to oversee their companies’ risk management and compliance.

What the Duty of Oversight Entails

The 1996 Caremark case that gave its name to these claims held that a director’s duty of loyalty requires directors to implement and monitor risk oversight processes. To prevail in a suit against directors for breach of this duty, a plaintiff must prove that directors were not just negligent, but acted in bad faith — that they either (a) “utterly failed to implement any reporting or information system or controls” (the “first prong”) 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” (the “second prong”).

Bad faith requires that directors intended to do harm, consciously disregarded their responsibilities or failed to act in the face of a known duty to do so.

That is a high hurdle for plaintiffs, and no Caremark claim has ever even gone to trial. But in recent years stockholders have utilized their rights to inspect corporate books and records more frequently, and in a growing number of Caremark cases, they have drawn on that internal information to allege bad faith with enough detail to survive a motion to dismiss.

Delegate Responsibility to Management But Exercise Oversight

Delaware law recognizes that directors are not involved in the day-to-day management of their companies and protects them when they rely in good faith on information provided by officers and employees, among others. However, the board still has to be involved, and must take reasonable steps to establish a compliance system (the first prong of Caremark) and then must monitor that system (the second prong). “Caremark envisions some degree of board-level monitoring system, not blind deference to and complete dependence on management,” as one Delaware decision put it recently.

Just where to draw that line is the issue at the core of recent Caremark cases, as we will explain.

Inadequate Control Systems (First Prong)

In several recent suits, the stockholder plaintiff was allowed to proceed with its claims where it alleged in some detail that a board acted in bad faith and violated its duty of oversight by failing to establish a committee or other system to monitor “mission critical” risks at the board level in monoline companies. For example:

By contrast, cases have been dismissed where there was a record of conscientious board oversight:

Again, a bad outcome does not demonstrate bad faith. Delaware courts have acknowledged that “the directors' good faith exercise of oversight responsibility may not invariably prevent employees from violating criminal laws, or from causing the corporation to incur significant financial liability, or both.” Instead, the legal question is “whether the board made a good faith effort to put in place a reasonable board-level system.”

“Red Flags” (Second Prong)

The second way that a plaintiff can adequately plead a Caremark claim is to allege that a company’s board ignored specific “red flags” that suggested misconduct or malfeasance at the company.

Other examples of “red flags” have included lawsuits alleging illegal corporate conduct, known compliance issues regarding regulations or internal protocols, and employee reports suggestive of risks or deficiencies inherent to the company’s operations. In one recent case, the Court of Chancery suggested that the board should also monitor and consider “red flags” from sources outside the company, such as a stockholder’s litigation demand letter.

Even with some evidence of “red flags” that were not identified as such, it can be an uphill struggle for plaintiffs. The board must have “consciously overlooked or failed to address them.” And not every indication of a potential problem is a “red flag” worthy of a board-level reaction.

Fulfilling the Board’s Oversight Obligations

It is hard to draw clear-cut rules based on the litigation to date. But they point to steps boards can take to reduce the risk of a Caremark claim, or at least to be positioned to knock out a complaint on a motion to dismiss instead of being subjected to the time-consuming and expensive process of discovery and trial.

This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.

This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.

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