- When D&O's Failure to Monitor Results in Breach of Fiduciary Duty, In-House Counsel Are Liable
- June 5, 2008 | Author: Thomas R. Califano
- Law Firm: DLA Piper - New York Office
The US Bankruptcy Court for the District of Delaware (the Court) recently handed down a decision (the World Health Decision) recognizing that liability may be imposed on in-house counsel in cases when poor oversight and monitoring allowed the corporation’s directors and officers to breach their fiduciary duty.
World Health Alternatives Inc. (the debtor), a nationwide provider of health care staffing services throughout the United States, became a publicly traded corporation in early 2003, with $245,000 in assets and negative equity of some $90,000. It had sustained a $400,000 loss in the previous quarter. During the next year, however, it raised approximately $40 million to buy eight different businesses in the health care staffing industry. On February 20, 2006 (the petition date) it filed its chapter 11 bankruptcy petition. The case was converted to a chapter 7 on October 31, 2006 and George Miller was appointed trustee.
In May 2007, the trustee brought a 13-count complaint (the complaint) against numerous defendants who were former executives of the debtor, charging that, during the years leading up to the petition date, the company engaged in a series of reporting, regulatory and financial “inconsistencies.”
The trustee filed papers charging that the debtor’s accounting systems were insufficient and, as a result, misrepresentations were made by the debtor’s directors. According to the trustee, certain SEC filings were fraudulent, the corporation’s directors and officers committed corporate waste and huge amounts of liabilities went unreported, including over $4 million to the IRS. The trustee claimed that these false and misleading reports were made to the SEC and shareholders because World Health lacked adequate internal controls and was, therefore, unable to ascertain its true financial condition.
Among the named defendants were the debtor’s current and previous officers and directors, among them Brian Licastro, the debtor’s alleged vice president of operations and in-house general counsel. Along with the misconduct alleged by the trustee, the complaint also charged that Licastro and other officers were aware or should have been aware of the malfeasance, misleading SEC filings and accounting discrepancies that led to significant harm to the debtors’ creditors. Licastro filed a motion to dismiss the complaint pursuant to Fed. R. Civ. P. 12(b)(6), Fed. R. Bankr. P. 7012 (the motion).
In a decision by the Honorable Peter J. Walsh, the court denied the motion in part and granted dismissal without prejudice on the remaining allegations against Licastro.1
World Health Significant for Three Reasons
The World Health decision is significant for three reasons. First, the decision explicitly extends the Caremark “directors’ oversight liability”2 to officers of a corporation, and in particular to the VP of operations and in-house general counsel. Licastro argued that these are proper obligations of directors but that he was not a director but only an officer. Judge Walsh, however, concluded, “[t]he Trustee appropriately asserts that Licastro as the in-house general counsel and the only lawyer in top management of World Health during the relevant period, had a duty to know or should have known of these corporate wrong doings and reported such breaches of fiduciary duties by the management.” Id. In doing so, the court noted that, under both Delaware and Florida law, both officers and directors owed fiduciary duties to the corporation. Further, the court made note of the fact that general counsel are, more often than not, corporate officers who owe a fiduciary duty of oversight and inspection with regard to SEC filings. Judge Walsh stated that “[Licastro] was an officer in two respects, vice president of operations and general counsel.” Memo. Op. at 27.
Second, although Licastro did not personally benefit from the alleged waste, the court sustained a corporate waste count against him, based on the allegation that he was "aware of the alleged corporate waste and took no action, as [a] fiduciary[y], to prevent such conduct." Memo Op. at 33.
Lastly, the court upheld a negligent misrepresentation count against Licastro, stating that "if [he] properly performed his duty as in-house counsel, these misrepresentation[s] [in public filings] would not have been made and the resulting harm [resulting in a $2.7 million payout in a shareholder class action] would have been avoided. Memo. Op. at 36-37.
In sum, the court determined that the trustee could pursue his actions against Licastro, as both vice president of operations and in-house counsel to the debtor, for failing to act or implement sufficient safeguards to prevent the alleged misconduct.
Decision Means In-House Counsel Must Be “Watchdog”
The implications for general counsel of distressed companies are both clear and ominous. The court in effect recognized a duty by in-house counsel to act as a “watchdog” to prevent misconduct by officers.
Thus, now more than ever, corporations should make it a priority to clearly define the responsibilities of in-house counsel, directors and officers with respect to internal financial oversight, reporting requirements and accounting procedures.
1 The trustee also alleged three counts of fraudulent transfers (counts IX, X, XI). These counts failed to satisfy Fed. R. Civ. P. 9(b). Also, allegations under an equitable subordination claim (count XII) were deemed too imprecise.
2 In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996) articulates the necessary conditions for imposing directors oversight liability: (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system of control, consciously failed to monitor or oversee its operation, thus disabling themselves from being informed of risks or problems requiring their attention. See Memo. Op. at 25; see also ATR-Kim Eng Fin. Corp. v. Arenta, No. 489-N, 2006 WL 3783520 (Del. Ch., Dec. 21, 2006) (citing Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006).