Chapter 16 The Duty of Care of Corporate Directors
Outline
(last update 1 Nov 06)
Chapter 16 The Duty of Care of Corporate Directors
A. Overview of the Standards of Care
B. Duty of Oversight
i. Supervision of ongoing business
o Francis v. United Jersey Bank
o Relation of monitoring duty to
§ business judgment rule
§ MBCA § 8.30(a)
ii. Monitoring of legal compliance and controls
o In re Caremark International Inc. Derivative Litigation
o Duty to supervise / monitorillegality
§ duty to investigate? only when "on notice"? create monitoring devices?
§ reaction to danger signs / correct behavior / liability for failure not to respond
o Relation of monitoring duty to
§ business judgment rule
§ MBCA § 8.30(a)
3. Director’s criminal liability
C. Business Judgment Rule
i. Scope of the Business Judgment Rule
o Shlensky v. Wrigley
o presumption of informed, good faith judgment
o burden on challenger to overcome
o exceptions / rebut presumption
(1) fraud; (2) conflicting personal interest;(3)illegality;(4) lack of attention
2. Business Judgment Rule and directorial negligence
D. Duty to Become Informed
1. The Trans Union Case: Smith v. Van Gorkom
· Trans Union decision-making
o nature of board omissions / oversights
o gross negligence?
o reliance corollary to BJR?
· Standards of review
o procedural -- gross negligence
§ importance of posturing
§ procedure assures substance?
o substantive -- waste
o causation
§ inattention related to loss?
§ who bears burden?
· Delaware's real agenda
o require "fairness" opinion / boardroom procedure
o reassert state fiduciary law
o suspicion of Van Gorkom's "fast shuffle"
o defense against "bear-hug" mergers
2. Due care and the Business Judgment Rule
3. Reliance
4. Lack of objectivity
5. Causation
6. Rebutting the presumption of the Business Judgment Rule
E. Avoidance of Liability
1. Protections against directorial liability
2. Statutory exculpation of directors
· Charter exculpation (opt-out)
o statutory authorization
§ Del. GCL § 102(b)(7)
§ MBCA § 2.02(b)(4)
o insulation: damages, not injunctive relief
o limits on coverage --
§ "breach ... duty of loyalty"
§ "not in good faith"
§ “improper personal benefit"
3. Indemnification
o mandatory indemnification
§ successful defense
§ whole or partial success?
o permissive indemnification
§ standard of conduct
§ determination
o derivative litigation?
o non-statutory indemnification
4. Directors’ and officers’ insurance
o coverage of corporate indemnification
o coverage of D&O losses
Class Notes
B. Duty of Oversight
1. Supervising of ongoing businessFrancis v. United Jersey Bank
(NJ 1981)
Pritchard & Baird Corp is in the reinsurance brokerage business -- and the company handles a lot of money. Assume you are a director of the company. What are your responsibilities -
· under state corporate statutes - any mention of fiduciary duties?
· under business understandings of the role of a director
How much do you have to know about the business? Do you have to learn financial statements? Must you become as familiar with the business as the company's executives? / NC Bus Corp Act § 55-8-30 General standards for directors.
(a) A director shall discharge his duties as a director ... :
(1) In good faith;
(2) With the care an ordinarily prudent person in a like position would exercise under similar circumstances; and
(3) In a manner he reasonably believes to be in the best interests of the corporation.
Director responsibilities - See ABA Section of Business Law "Corporate Director's Guidebook"
· Set corporate policy / strategies
· Ensure policy / strategies carried out
o attend meetings
o keep informed about company's business
o regularly review financial status
· Hire / fire / compensating executive officers
· Monitor for illegality / misconduct
o monitor management performance
o not shut eyes to bad acts
o object to illegality / misconduct
· Manage business in crisis
William Pritchard Sr. founded the company, but after he dies his two sons (William and Charles) run the business into the ground. They steal $10 million of clients' money, covering up their defalcations as "loans" in the company's financial statements.
Balance Sheet
Assets
Cash
Sh loans
Total / Liabilities
Clients
Equity
Shareholders
Total
Who was the plaintiff? What did Francis allege? Mrs. Pritchard became a director after Mr. Pritchard's death. What must a director do in carrying out her responsibilities? To whom do directors owe these duties?
Mrs. Pritchard "became incapacitated and was bedridden [and] became listless and ... started to drink rather heavily." She did not attend meetings of the board of directors "never knew what her sons were doing ..."What could Mrs. Pritchard have done? What would you, as corporate counsel, advise that she do? Would it have stopped her sons' thefts? / NC Bus Corp Act § 55-8-30 General standards for directors.
(a) A director shall discharge his duties as a director ... :
(1) In good faith;
(2) With the care an ordinarily prudent person in a like position would exercise under similar circumstances; and
(3) In a manner he reasonably believes to be in the best interests of the corporation.
NJ Supreme Court:
"Her neglect of duty contributed to the climate of corruption; her failure to act contributed to the continuation of that corruption. Consequently, her conduct was a substantial factor contributing to the loss.
"Sometimes ... a director may have a duty to take reasonable means to prevent illegal conduct by co-directors; in an appropriate case, this may include threat of suit."
Hypothetical
You are outside counsel to Pritchard and Baird. Lillian Pritchard asks you to advise her on what to do as director. You give her the "Corporate Director's Guidebook" and tell her to read it. She does and concludes she is in over her head. She asks you to become director in her place? What should you say? She stays on as director and asks for you to counsel her on action she should take regarding suspicions of her sons. Should you counsel her? / See Rules of Professional Responsibility.
Hypothetical
William Jr. and Charles, rather than evil, are just witless -- a case of "good genes gone bad." They make foolish decisions and run the business into the ground through sheer incompetence. Mrs. Pritchard, absent and intoxicated, fails in her directorial responsibilities. Is she liable for her utter lack of care? Would witless William and Charles be? What could Mrs. Pritchard have done? / NC Bus Corp Act § 55-8-30 General standards for directors.
(a) A director shall discharge his duties as a director ... :
(1) In good faith;
(2) With the care an ordinarily prudent person in a like position would exercise under similar circumstances; and
(3) In a manner he reasonably believes to be in the best interests of the corporation.
Hypothetical
Mrs. Pritchard, worried about her directorial responsibilities, asks for your advice. She suspects William and Charles are taking more money from the business than they should. She says that at the next meeting she worries they will propose loans for themselves. What should she do? / NC Bus Corp Act § 55-8-24 Quorum and voting.
(d) A director who is present at a meeting of the board of directors ... when corporate action is taken is deemed to have assented to the action taken unless:
(1) He objects at the beginning of the meeting ... to holding it ...
(2) His dissent or abstention from the action taken is entered in the minutes of the meeting; or
(3) He files written notice of his dissent or abstention with the presiding officer of the meeting before its adjournment or with the corporation immediately after adjournment ... The right of dissent or abstention is not available to a director who votes in favor of the action taken.
2. Monitoring of legal compliance and controls
Graham v. Allis-Chalmers Manuf Co
(Del. 1963)
Back when US industry ruled the world, corporations had wondrous multi-tiered bureaucracies. Allis-Chalmers, an electrical equipment manufacturer, had two main groups, of which one (the Industrial Group) had five divisions, of which one (Power Equipment Division) had ten departments.
You are a director of Allis-Chalmers. What are your responsibilities? See "Corporate Director's Guidebook." The laws forbid US manufacturers from doing many things. They are good laws. What must you do to ensure Allis-Chalmers is a good corporate citizen? What if you don't do it right?
There's a problem down in Power Equipment. The boys have been maximizing shareholder gain by fixing prices. Too bad it's illegal! The company has to ante up to the feds and pay antitrust penalties. What does shareholder Graham claim? What should the directors have done? What does the Delaware court say? / Delaware Supreme Court:
"... we think knowledge ... that in 1937 the company had consented to the entry of [antitrust] decrees ... did not put the Board on notice of the possibility of future illegal price fixing ..."
"Plaintiffs have wholly failed to establish either actual notice or imputed notice to the Board ... of facts which should have put them on guard, and have caused them to take steps to prevent the future possibility of illegal price fixing and big rigging."
In re Caremark International Inc. Derivative Litigation
(Del. Ch. 1996 - Ch. Allen)
Federal and state regulators investigated Caremark, a health-care provider, for referral kickbacks -- payments by Caremark to doctors conditioned on the doctors sending business to Caremark. These payments are illegal under Medicare and Medicaid. Eventually, the regulators and other private payors settled with Caremark. The terms: Caremark agrees to new compliance measures and pays $98.5 million.
Shareholders of Caremark bring a derivative suit. On what grounds? Caremark settles the derivative claims. On what terms? What is the issue for the court? Was there a legal basis for the settlement? Why did the plaintiffs’ attorneys receive a fee of $816,000 for a weak case? /
Ch. Allen:
“The complaint charges the director defendants with breach of their duty of attention or care in connection with the on-going operation of the corporation’s business. The claim is that the directors allowed a situation to develop and continue which exposed the corporation to enormous legal liability and that is no doing they violated a duty to be active monitors of corporate performance. --- the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”
Settlement with derivative plaintiffs:
· Caremark (and employees) won’t engage in illegal referrals or fee splitting
· Board will discuss matter semi-annually and establish Compliance and Ethics Committee
· Caremark will remove employees whose job is to make referral payments
· Caremark will disclose to patients company’s relationship with health care providers
Is this settlement proper? Was there a basis for the plaintiff's claims that the directors' had violated their fiduciary duties? What are the directors' duties in this area? / Ch. Allen:
“... corporate boards may satisfy their obligation to be reasonably informed concerning the corporation [by] assuring themselves that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and the board itself timely, accurate information sufficient to allow management and the board .... to reach informed judgment concerning both the corporation’s compliance with law and its business performance.
Advise your corporate client [who is this, by the way?] on how to minimize exposure to corporate monitoring liability? / Ch. Allen:
“Plaintiffs would have to show either
· that the directors knew or
· should have known that violations of law were occurring and
· in either event,
o that the directors took no steps in good faith effort to prevent or remedy that situation
o that [defendants do not establish affirmative defense] that such failure [did not] proximately result in the losses complained of ...
Some hypothetical
You are a director of FlyAway, an airline company. The company competes in markets where price-fixing has occurred in the past and is widely considered to be common. In fact, FlyAway in the past has entered into consent decrees with the government. The company is in full compliance with these decrees. As a matter of corporate law, must the board have an antitrust compliance program? / What is the holding of Caremark?
FlyAway's board receives the following report from Legal Division:
"We continue to monitor the company's compliance with ir safety laws. Nothing new to report."
The next week FlyAway is cited the next week for 47 FHA rule violations -- some really serious. The board had not set a compliance plan for the company. Should shareholders be able to sue the directors? / NC Bus Corp Act § 55-8-30 General standards for directors.
(b) In discharging his duties a director is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by:
(1) One or more officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the matters presented;
(2) Legal counsel, public accountants, or other ... professional or expert competence; or
(3) A committee of the board of directors of which he is not a member if the director reasonably believes the committee merits confidence.
In the more competitive world of the 2000s, the Fly Away board decrees the following:
"The company's employees will work aggressively to keep down the costs of cost-ineffective safety compliance and, when push comes to shove, will err on the side of violating the law -- so long as the penalties are less than cost of compliance."
FlyAway is cited for 47 FHA rule violations -- some really serious. What if the air-safety statutes do not have any penalty provisions that apply to the directors' behavior? Should shareholders be able to sue the directors? Should corporate law serve as a supplemental enforcement device for non-corporate regulatory schemes? / What is the corporation? A social institution or a profit-making business structure?
C. Business Judgment Rule
Shlensky v. Wrigley(Ill. App. 1968)
The Chicago Cubs play only day baseball. Philip K. Wrigley, the team's president and 80% shareholder, says this is because baseball is a "daytime sport." Shlensky is a baseball fan, a minority shareholder, and a statistician. How profitable is day baseball? See Cubs web page! Dream up a litigation strategy for Mr. Shlensky? (1) procedure? (2) substantive theory? (3) remedy? / Philip Wrigley's idea of baseball