Caremark–The Failed Revolution (part II)

As discussed inpart I of this series, the duty of a Board of Directors in Delaware to monitor for possible wrongdoing by corporate managers under the famous Caremark decision was more of an illusion than a reality. Two facts account for this result. First, the standard for liability announced in Caremark itself was extremely hard for plaintiffs to prove. Second, and more important, Caremark seemed to tie the monitoring duty it created to the directors’ duty of care, a duty which had been largely vitiated by Delaware §102(b)(7) and the exculpatory provisions that corporations adopted under the authority of that provision.

In November 2006, the Delaware Supreme Court handed down its decision in Stone v. Ritter. Stone v. Ritter has been extensively discussed in both the blogosphere and in written commentaries. As far as Caremark was concerned the court really did not change things. The court did officially give its imprimatur to Caremark, a result which had been long and widely anticipated. The court also characterized a breach of a director’s Caremark duties as a breach of the duty of loyalty. As a number of other bloggers and commentators have noted, this was probably something of a misreading of Caremark. While there is language in the Caremark about "good faith," the decision is pretty clearly premised on a breach of the duty of care. Indeed, Chancellor Allen, in the casebook on Corporation Law he later coauthored, placed Caremark in the section on "Duty of Care." Regardless of the accuracy of the Supreme Court’s reading of Caremark, the uncoupling of the duties announced in that case from the duty of care would seem to be a felicitous development for those who support the imposition of duties upon directors to monitor the activities of corporate managers for wrongdoing. The decision to move Caremark duties into the duty of loyalty category would seem to break them free from the stranglehold of 102(b)(7) exculpatory provisions. That newfound freedom for Carmark duties was, in fact, an illusion because the court adopted an extremely cramped view of those duties. In Stone v. Ritter the court held that in order to establish that a director was in breach of her Caremark duties, a plaintiff would have to prove that the director acted either with animus toward the corporation or consciously (i.e., subjectively) disregarded those duties.

As Professor Bainbridge haspointed out, this formulation excuses precisely those actions which present the "clearest case" for liability under Caremark--where there was an "unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss." As Professor Bainbridge further suggested, the Stone v. Ritter formulation seems to allow a "clueless board that just sort of drifted along for years with unconsidered inaction [to] escape liability" and to make "ignorance really bliss." Far from freeing Caremark from the shackles of 102(b)(7) exculpatory provisions, the court in Stone v. Ritter merely pointed to a narrow class of Caremark claims which could fit under §102(b)(7)’s exception for actions not in good faith, while simultaneously decreasing the usefulness of Caremark duties in the tiny group Delaware corporations which do not have 102(b)(7) type exculpatory provisions in their Certificates of Incorporation.

Less than seven weeks after Stone v. Ritter was handed down, the Delaware Chancery Court, in an opinion by VC Strine, actually found to directors to be liable for breach of their Caremark duties. ATR-Kim Eng Financial Corp. v. Araneta, 2006 WL 3783520. Francis G. X. Pileggi, in his Delaware Corporate and Commercial Litigation Blog, cites Araneta as evidence that Caremark duties are being taken seriously by Delaware courts. There is no doubt that in Araneta VC Strine did find two of the defendants liable for an utter failure to put into place a system to detect wrongdoing by their fellow director. However, given the particularly egregious facts of that case, it hardly represents a harbinger of meaningful enforcement of Caremark duties. Indeed, it would have been stunning if the defendants had not been found liable even under the broadest interpretation of Graham v. Allis Chalmers.

Araneta involved a corporation owned by two shareholders, a 90% shareholder and a 10% shareholder. The majority shareholder/director looted the corporation by transferring its assets to himself for no consideration. VC Strine, "applying" Caremark, found the other two directors liable for doing nothing to detect or stop the looting. Caremark was, however, besides the point given the facts of the case, among which were the following:

(1) The two directors admitted that they were placed on the Board by the controlling shareholder and were present on it merely to represent the interests of that shareholder. VC Strine characterized them as "paid stooges" of the controlling shareholder.

(2) The two directors admitted that they drew no distinction between the interest of the controlling shareholder and corporation itself.

(3) The two directors refused to do anything to recover the assets of the corporation even after discovering that they had been looted by the controlling shareholder.

Given these facts, one did not need Caremark to establish the liability of the two directors. They would have been liable even under Graham v. Allis Chalmers given that they had ample reason to know that the controlling shareholder was engaging in wrongdoing. Araneta, as Professor Gordon Smith points out, is something of a one and only.  As he put it "[t]his case was a first, and I think we will not have many more like it." The closest analogy I can think of is the classic 1919 Dodge v. Ford case which was just about the last case overturning a board’s decision not to declare dividends. In that case, as in Araneta, you had a combination of outrageous facts and a defendant director (Henry Ford himself) who was litigation wise disingenuous enough to openly admit what he was doing (not declaring dividends to benefit society rather than the corporation).

If Caremark duties in Delaware remain pretty much an empty shell, that still leaves the unanswered questions of (a) what should be the scope of a director’s duty to uncover wrongdoing by top corporate management, (b) can an appropriate solution be fashioned given the current state of Delaware law, and (3) does what Delaware does with respect to Caremark duties matter any more given the increased monitoring responsibilities of directors under the federal Sarbanes Oxley Act? These issues will be explored in the third and concluding part of this series.