Are Directors Vulnerable for Lack of Oversight When a Natural Disaster Strikes?
Edward M. McNally
This article was originally published in the Delaware Business Court Insider | April 06, 2011
The recent events in Japan prompt the question of whether the members of a corporation’s board of directors have any exposure to liability when a natural disaster strikes their company. The potential claim would be that as part of their duty to oversee the company’s risk management, they should have better protected their company from the losses resulting from a natural disaster.
Of course, most people view such national disasters as "black swans," or events no one anticipates will happen.
Surely directors are not responsible for future events no one anticipates.
Or are they?
The analysis of this issue begins with a review of the directors’ duty to oversee their corporation’s activities to proactively prevent losses. In Delaware, this duty is often referred to as a "Caremark" duty, after the decision that proposed such a duty exists. Delaware courts have repeatedly described a Caremark claim as possibly the most difficult claim to win under Delaware corporate law. Yet, Caremark claims continue to be filed, albeit less frequently than other types of claims against directors.
A Caremark claim is particularly dangerous to directors. The Delaware Supreme Court has characterized some Caremark claims as breaches of the duty of loyalty that all directors and officers owe to their corporations. While that may not seem too different from a claim based on lack of care, the difference is significant.
The Delaware statute permitting a corporation to immunize directors from damages does not apply to breach of loyalty claims. Thus, director liability under a Caremark claim may have serious consequences if D&O coverage is not sufficient.
Regardless of whether the plaintiff characterizes the claims as a breach of the duty of loyalty or care, the claims will have one common characteristic. Typically, Caremark plaintiffs allege that the directors failed to take affirmative steps in some way that would have prevented damage to the corporation. That failure cannot be just simple negligence because under Delaware law, simple negligence is insufficient to constitute a breach of a director’s duty. Rather, at least gross negligence must be alleged to state a claim.
Thus, to state a Caremark claim the complaint usually alleges that the directors were aware of their duty to take action and that their failure to do so was grossly negligent. That awareness usually depends on "red flags" -- warnings the directors received before they failed to act. If the directors receive enough red flags and ignore them, then it may be said they were grossly negligent, and a Caremark claim exists.
However, the courts have also permitted a Caremark claim even without any red flags. When directors have utterly failed to do any monitoring of corporate affairs or put in place some system of supervision over corporate activities, a Caremark claim may be brought when damages occur because of bad conduct by employees. Directors just cannot simply sit back and do nothing, even in the absence of a warning that things are amiss.
Does it not follow that almost by definition a natural disaster is not anticipated because it is out of the ordinary and no red flags went up? That does not necessarily follow when you think about it. For example, it is reported that Japan had at least one prior earthquake that seriously affected a nuclear power plant. Japan has building codes that require earthquake protection. Does it follow that the past damage to a nuclear plant and the building codes generally together constituted red flags that directors of Japanese companies in the nuclear power business could not safely ignore? What do directors need to do to avoid liability for natural disasters?
In the final analysis, the answer to this question will depend upon what was reasonable under the circumstances. A large corporation may receive literally thousands of complaints each year from customers, employees or regulators. It is not reasonable to ask a board of directors to consider each of those complaints as red flags requiring their inquiry. The board would do nothing else if it had to look into a thousand complaints. Instead, what the board should do is have in place some process that is designed to catch wrongdoing, filter complaints and send to the board only those few that warrant further action by the board of directors.
That same analysis applies to the board’s duties concerning potential natural disasters. It is to be expected that some level of natural events may occur and lead to damages to a corporation’s infrastructure. Storms are even classified by how often they are expected to occur, with a "10 years storm" expected at least once a decade. The board should have in place insurance and other measures that it has been advised by experts are sufficient to protect their corporation from natural disasters that are reasonably likely to occur.
The board should periodically review the company’s insurance and disaster avoidance plans, at least to be satisfied that appropriate steps have been taken by management to address that threat to the company.
Not every potential disaster needs to be planned for, just those that are actual threats. If these basic steps are taken, directors should not be held liable if a natural disaster causes an anticipated harm to their company. We have not yet reached the point where the courts will expect directors to foresee black swans. Some risk is necessary for success. A properly functioning board is entitled -- and indeed expected -- by its investors to take such risks.
Edward M. McNally (email@example.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Superior Court and Court of Chancery handling disputes involving contracts, business torts and managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm’s clients.