• Court Dismisses Derivative Claim for Alleged Breach of Oversight Duty
  • January 26, 2017 | Author: Lewis H. Lazarus
  • Law Firm: Morris James LLP - Wilmington Office
  • The Delaware courts encourage plaintiffs who bring derivative claims in Delaware without making demand on the board of directors to seek books and records under Section 220 of the Delaware General Corporation Law so as to be able to plead facts sufficient to demonstrate that demand is excused. Many claims have been dismissed under Delaware Court of Chancery Rule 23.1 because a plaintiff failed to utilize the "tools at hand" to obtain relevant books and records. When a plaintiff grounds its claim on directors' alleged failure to exercise oversight, however, even receipt of books and records may not enable a plaintiff to plead facts sufficient to demonstrate that the directors knowingly ignored their duties so as to have acted in bad faith. That high standard as articulated by the Delaware Supreme Court in Stone v. Ritter makes a Caremark claim for breach of directors' oversight duties as among the most difficult in corporate law. The Court of Chancery's recent decision in Reiter v. Fairbank, C.A. No. 11693-CB (Del. Ch. Oct. 18), demonstrates that, regardless of the injury allegedly sustained by the subject company, a pleading based on books and records obtained from the company that at best reflects awareness of "yellow flags" is not sufficient to call into question the directors' good faith and hence to excuse demand, thus requiring dismissal of the plaintiff's derivative claim.

    Background Facts

    Capital One Financial Corp.'s business included check cashing. It was subject to certain statutory requirements under the Bank Secrecy Act and anti-money laundering laws (BSA/AML). Following investigations by state and federal agencies, Capital One entered into a consent order on July 10, 2015, in which the company agreed with the Office of the Comptroller of the Currency, without admitting to any wrongdoing, that it had "failed to adopt and implement a compliance program that adequately covers the required BSA/AML program elements due to an inadequate system of internal controls and ineffective independent testing." It also agreed to certain remedial actions. On Nov. 10, 2015, after obtaining books and records, the plaintiff filed its complaint alleging breach of the duty of loyalty by all director defendants and seeking monetary damages based on unjust enrichment for their receipt of compensation and directors' fees. The plaintiff alleged that the defendants "purposefully, knowingly or recklessly" failed to comply with the BSA/AML. The defendants moved to dismiss for failure to state a claim and for failure to comply with Rule 23.1 and also to stay pending completion of other ongoing regulatory investigations. As explained below, the court dismissed the complaint for failure to make demand and to allege with particularity that a majority of the board faced a substantial threat of personal liability such that they could not impartially consider a demand.

    Court of Chancery's Findings

    The court's analysis focused on five reports which plaintiff alleged demonstrated purposeful ignoring of red flags that the company was engaging in criminal or fraudulent misconduct. The court examined the documents incorporated by reference in the complaint to understand the state of mind of the directors in terms of the information that was presented to them (as opposed to for the truth of the matters asserted). Based on that careful review the court found that the reports presented to the directors did not show or permit the inference that the company's BSA/AML controls or procedures violated statutory requirements or that anyone at the company had engaged in criminal or fraudulent conduct. The court emphasized that directors of Delaware corporations generally do not breach their oversight duties by having inadequate procedures for managing business risk, as opposed to inadequate procedures to detect illegal or fraudulent activity. Applying that standard, the court held that "the complaint's allegations evidence that Capital One's management made efforts to cope with tightening regulations and more aggressive AML enforcement actions, and regularly kept the directors informed of those efforts along the way." Therefore, the plaintiff failed to plead facts sufficient to permit the inference that a majority of the Capitol One board faced a substantial risk of personal liability so as to be disqualified from considering a demand in an impartial and disinterested way.

    Lessons Learned

    This case illustrates that it remains difficult to plead a successful claim for breach of the directors' duty of oversight. Here, the plaintiff utilized the tools at hand to obtain information to attempt to overcome its pleading burden but the reports upon which it relied neither demonstrated nor permitted the inference that the board knew of criminal or fraudulent conduct or that the Capital One board "embraced a strategy to pursue profits by employing illegal means." The case re-affirms that the bar remains high to hold directors personally liable for breach of the duty of loyalty for failing to exercise appropriate oversight. Thus, the plaintiff here could not state a claim even though the company had agreed with a federal agency, without admitting wrongdoing or liability, that its internal controls were insufficiently robust. Unless a plaintiff can plead facts with particularity showing that directors consciously ignored red flags of criminal or fraudulent conduct, a plaintiff will not be able to go forward on a claim that the directors of a Delaware corporation should be personally liable for failing properly to oversee the company's business activities.