Caremark--The Failed Revolution (pt. 3)

  Caremark–The Failed Revolution (Pt. 3)

    I had originally hoped to wrap up my series on Caremark in this third part.  However, based partly on some reactions to my earlier posts, I’ve decided that the issue of what a director’s Caremark duties should be and how important they are deserves a post of its own.  

    Whether Caremark is truly a failed revolution is inextricably tied to one’s view on what a director’s Caremark duties should be and how important it is to impose those duties on directors.  Professors Hill and McDonnell argue that such duties are of middling importance.  As Professor McDonnell put it:

•     [F]ailure to monitor cases don't involve structural problems where there is strong reason to suspect that directors will be unlikely to pursue the best interests of shareholders.  We should have courts more closely scrutinize director action or inaction only where their self-interest, or the interest of others who may unduly influence them, is likely to distort their motivation.  There is no particular reason to expect strong problems along those lines in the decision concerning whether and how to monitor the behavior of corporate employees for possible illegality.

Professor McDonnell goes on to say that “there may be just enough of a threat of bad director motivation in these cases to give directors a whiff of potential liability and try to change norms, as Caremark does.”

    Whether the “whiff” of potential liability provided by Caremark is strong enough to really change directorial norms is, as Professor McDonnell noted, an empirical question which is difficult to answer.  On the other hand, one can criticize Professors Hill and McDonnell’s formulation for underestimating the importance of director monitoring of corporate employees for possible illegal activity, and the potential causes of directorial failures to do so.

    Caremark duties are grounded in the widely accepted norm that a board of directors of a corporation should, at a minimum, actively monitor the performance and behavior of the top managers of a corporation.  As the New Jersey Supreme Court stated more than 25 years ago in Francis v. United Jersey Bank,

    Directors are under a continuing obligation to keep informed about the activities of the corporation. Otherwise, they may not be able to participate in the overall management of corporate affairs...Directors may not shut their eyes to corporate misconduct and then claim that because they did not see the misconduct, they did not have a duty to look. The sentinel asleep at his post contributes nothing to the enterprise he is charged to protect.....Directorial management does not require a detailed inspection of day-to-day activities, but rather a general monitoring of corporate affairs and policies.

    The appropriateness and efficacy of a monitoring board of directors in furthering the interests of the owners of the corporation, the shareholders,  has been the subject of a vigorous extensive, and sometimes contentious discussion.  That discussion is far beyond the scope of this post.  However, when it comes to directorial monitoring of corporate management for violations of positive law, the shareholders, or even other corporate constituencies are no longer the only interested parties.  The general public becomes an interested party.

    Of course, devotees of strong versions of public choice theory will argue that no general public interest exists in most statutes and regulations.  For them, what follows should be irrelevant.  However, for the rest of us, the choice by a legislature or administrative body to proscribe certain forms of behavior and subject persons who engage in those behaviors to punishment or civil sanctions should have special significance.  That choice normally indicates that the public has an interest in stopping the behavior which goes beyond the interest of those who might be directly injured by it.  In corporate law, this is reflected in the rule that a decision by a board of directors to engage in an illegal act is not protected by the business judgment rule, even if the decision maximizes the profits of shareholders.  Some of the reasons for this rule are set forth in Professors Hill and McDonnell’s article referenced above.

    Thus, when directors monitor managers for violations of positive criminal and civil law, they are not only protecting the interests of the usual “suspects,” i.e., corporate constituencies such as shareholders, employees, creditors, suppliers, customers, etc., but also the interest of the general public.  The breadth of the interests served by directorial monitoring of managers for criminal and civil law violations makes the duty to engage in such monitoring perhaps the most important monitoring duty imposed upon directors.  Enforcement of the duty is important enough to require more than a mere “whiff” of potential liability.

            The earlier quote from Professor McDonnell also suggests that close scrutiny of directorial monitoring for illegal acts by employees is unwarranted because a failure to do so is unlikely to be motivated by their own self interest or the interests of others.  Of course, Professors McDonnell and Hill do recognize that a failure to monitor may be motivated by a desire to shirk ones responsibilities, but express the belief suits for breach of fiduciary duties are overkill when it comes to deterring shirking behavior.

    I am willing to concede that the vast majority of directors’ failures to monitor employees for illegal acts are not motivated by their own self interest or the interests of others.  I will even, for the sake of argument, concede that the costs of suits for breach of fiduciary conduct outweigh their usefulness as tools for controlling shirking behavior. The problem with failures to monitor is that they can, and in many cases probably are, motivated by things other than pursuit of self interest (or the interests of others) or a desire not to work hard.

    A director’s failure to monitor employees for illegal activities can stem from a variety of causes such as misplaced trust, overconfidence in ones ability to detect wrongdoing, cognitive biases, inappropriate heuristics, or even human empathy. While liability for breach of fiduciary duty may arguably be overkill for the number of failures caused by “shirking,” is it really overkill for monitoring failures caused by all these other factors?

    The bottom line is that directorial failures to monitor corporate employees for violations of positive criminal or civil law are important enough and likely to arise enough to deserve more than a “whiff” of potential liability.  A decent argument could be made that the standard for directors should be the traditional one encompassed by the “duty of care.”  Did the director set up a reasonable system for uncovering and reporting managerial wrongdoing and did the director act as the reasonable and prudent director would under the same or similar circumstances in utilizing the system?  The “business judgment rule” would not dilute application of this standard because that doctrine protects only decisions made by a board of directors (even decisions not to decide), but not unconsidered inaction by boards.  Failures to monitor for illegal activities usually fall into the latter category rather than the former.

    On the other hand, a straight “duty of care”/negligence standard might deter outside directors from being willing to serve on a board, and encourage non meritorious and wasteful strike suits against directors.  These concerns can be somewhat alleviated by adopting a “gross negligence” standard for directorial monitoring of managers for unlawful acts.  Thus, a director would be liable for failing to implement or utilize a system for detecting and reporting violations of positive law by corporate employees only if the directors behavior constituted a gross deviation from the behavior of the reasonable and prudent director.

    The preceding suggestion, is, of course, inconsistent with current Delaware corporate law.  The changes in Delaware which would have to be made, and whether changing it really matters in light of the federal Sarbanes Oxley Act will be discussed in the fourth, and definitely concluding portion of this series.