Caremark–The Failed Revolution

When Chancellor Allen put out his decision in In Re Caremark International, Inc. Litigation in 1996 many scholars and other commentators regarded it as revolutionary. Unfortunately, if the decision was meant to be revolutionary, the revolution it began was largely a failed one. Indeed, the failure of that revolution may, in part, be responsible for some of the federal intervention into state corporate law wrought by the Sarbanes Oxley Act.

The old "conventional wisdom" had been that, under the 1963 Delaware Supreme Court decision in Graham v. Allis-Chalmers, directors who failed to set up a system designed to detect fraudulent, illegal or criminal activities of corporate managers, were not liable for damages suffered by the corporation unless the directors had reason to believe that such wrongdoing was actually occurring. In Caremark, Chancellor Allen suggested that directors who failed to set up a reasonable system for the detection and reporting of corporate wrongdoing or to utilize a system which had been set up could be liable for breach of the duty of care they owed to the corporation.

Unfortunately, the duties imposed upon directors by Caremark were more like a Potemkin village than a revolution. First, the standard established in Caremark was demanding only when compared to the rule of virtual non liability announced in Allis-Chalmers. Chancellor Allen did write that:

-"a director's obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards."

However, in applying his standard to the proposed settlement in front of the court he also opined that:

-"where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation,...only a sustained or systematic failure of the board to exercise oversight-such as an utter failure to attempt to assure a reasonable information and reporting system exists-will establish the lack of good faith that is a necessary condition to liability. Such a test of liability-lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight- is quite high."

Thus, even a theoretical possibility of directorial liability would require a showing of some extreme directorial misconduct when it came to monitoring the activities of subordinates.

Second, and perhaps even more important, Caremark duties were, as a practical matter, dead upon enunciation. The fatal flaw in the Caremark scheme was tying the duty to erect systems to detect corporate wrongdoing to the duty of care. In Delaware, and many other jurisdictions, the duty of care has been effectively eviscerated by §102(b)(7) of the Delaware General Corporation Law, and its counterparts in other jurisdictions. That section allowed a corporation to place in its certificate of incorporation a provision protecting directors from suits seeking monetary damages for breaches of their duty of care, even if those breaches amounted to gross negligence. Section 102(b)(7) was enacted in 1986. By the time Caremark came around in 1996, an overwhelming majority of Delaware publicly held corporations had "opted in" to the protections of 102(b)(7). Today the percentage of corporations giving their directors the protection of 102(b)(7) is even larger. Given the "high test" for liability in Caremark itself, and the widespread adoption of 102(b)(7) exculpatory provisions, it should not be surprising that in the ten years after that decision, not a single reported decision in Delaware held a director liable for a breach of her Caremark duties.

In 2006 in Stone v. Ritter the Delaware Supreme Court finally rendered a decision in a Caremark duty case. The impact of Stone v. Ritter on Caremark will be discussed in the next post in this series.

Comments

[Francis Pileggi]

At least one corporate law professor might disagree with your statement that there have been no reported Delaware cases finding liability based on Caremark. Here is a link to a post by Prof. Gordon Smith who analyzes the Delaware Chancery Court decision in Araneta as finding liability based on Caremark principles: http://www.theconglomerate.org/2007/01/more_on_caremar.html
I also refer to the case more cursorily, and provide a link to the whole decision at the following link:
http://www.delawarelitigation.com/2006/12/articles/chancery-court-updates/directors-found-liable-for-not-stopping-majority-shareholders-conduct/

[Francis Pileggi]

As a supplement to my prior comment (of yesterday), below is a link to a post in which I collected the analysis of a few other professors related to their views on Caremark in the context of Stone v. Ritter and the Chancery Court's decision in the Araneta case (that I linked to yesterday).
http://www.delawarelitigation.com/2008/02/articles/commentary/are-caremark-duties-of-directors-real/

[Harry Gerla]

Part one of my series was meant to describe the fate of Caremark up to Stone v. Ritter. Subsequent developments, including Araneta, will be discussed in part II forthcoming later this week.