Delaware Supreme Court Adopts the Caremark Standard for Oversight Liability
As had been widely expected, the Delaware Supreme Court recently adopted the standard for director “oversight” liability of In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996). The decision should provide comfort to directors of Delaware corporations concerned about the risk of liability for corporate wrongdoing about which they had no knowledge but which happened under their watch.
In Stone v. Ritter __ A.2d __ (Del. Nov. 6, 2006), the Supreme Court held 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 of these two “necessary conditions” for liability, an utter failure to implement a reporting system or a conscious failure to oversee or monitor such a system where it does exist, the Court found that any imposition of liability “requires a showing that the directors know they were not discharging their fiduciary obligations.”
Importantly, the Court established that the sort of bad faith conduct at issue in a Caremark violation, a director’s conscious disregard for his or her responsibilities, stems not from a violation of an independent “good faith” duty, on an equal footing with the duty of care and the duty of loyalty. Instead, clarifying a long-running doctrinal controversy in Delaware corporate jurisprudence, the Court characterized the duty of good faith as a “subsidiary element” of the duty of loyalty.
The impact of viewing an oversight failure within the rubric of the duty of loyalty may be significant. In the Caremark decision itself, the plaintiffs were alleging that the oversight failure was a duty of care failure. Stone recasts a director’s oversight failure as falling within the duty of loyalty, which seems to confirm that the standard for liability is now so high that the dereliction of monitoring obligations must be intentional. A careless director might mistakenly believe that his or her monitoring efforts are sufficient, but a disloyal director has to know that his or her actions are not in the best interests of the corporation.
As one commentator, Law Professor Eric Chiappinelli has noted on his web log, Stone may have the effect of removing oversight failure claims from the protections of section 102(b)(7), because loyalty claims are not claims that directors can be protected against under that statute. However, even without the protection of section 102(b)(7), Stone’s holding that the dereliction of a monitoring obligation must be intentional, and thus in bad faith, before any liability will be imposed, offers significant protection to directors. So long as adequate reporting and control systems are in place, and so long as directors do not consciously fail to monitor and oversee such systems, they should not be subject to “oversight” liability.