• Delaware Supreme Court Reaffirms the Limits on Director Liability for Alleged "Oversight Failures"
  • November 29, 2006 | Authors: David Clarke; Gerard A. Trippitelli
  • Law Firms: DLA Piper - Washington Office ; DLA Piper - San Diego Office
  • Over the past several years, rulings by non-Delaware courts and some significant settlements paid by directors have raised uncertainty for outside directors about the scope of their duty to oversee a company’s management and operations and their potential personal liability for accounting or other management improprieties in which the directors were not personally involved. A decision issued recently by the Delaware Supreme Court addresses this uncertainty and should provide some comfort to directors of Delaware corporations.

    In Stone v. Ritter, — A.2d — (Del. 2006), the court reaffirmed Delaware law (articulated in the earlier Caremark decision) that directors can be subjected to "oversight liability" only in the rare instance where "(a) the directors utterly failed to implement any reporting or information systems or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling them from being informed of risks or problems requiring their attention." The court confirmed earlier rulings that without proof directors deliberately disregarded "red flags"—i.e., tangible indications that internal systems or controls were not functioning properly—the sole relevant inquiry in evaluating a duty of oversight claim is whether the directors acted "to assure a reasonable information and reporting system exists…" Because of this highly deferential standard, the Stone court reiterated, a claim seeking to subject directors "to personal liability for employee failures is ‘possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.’"

    The Standard for Proving Director Oversight Liability Remains High

    Stone was a stockholder derivative action filed on behalf of AmSouth Bancorporation, a Delaware corporation, against fifteen of its present and former directors. The claims arose after AmSouth paid $50 million in fines and civil penalties—allegedly the largest ever of their kind—to resolve government and regulatory investigations into failures by bank employees to file "Suspicious Activity Reports" concerning customer activities, as required by federal law. The plaintiffs acknowledged that AmSouth’s directors "neither ‘knew [n]or should have known that violations of law were occurring." Nevertheless, they asserted claims against the directors for failing to implement policies and procedures to ensure compliance by bank employees with the applicable regulations.

    In affirming the Court of Chancery’s dismissal of the lawsuit, the Delaware Supreme Court reviewed Delaware law regarding oversight liability as it had existed before the many high-profile corporate scandals of recent years. The court held that the pre-existing Caremark standard still applied in evaluating stockholder claims predicated on directors’ alleged oversight failures. Examining the allegations in the case before it, the court concluded that the plaintiffs did not allege a failure of oversight claim because, among other things, they had acknowledged that the AmSouth board had established reasonable reporting systems to supervise compliance with the relevant laws, even though those systems had failed to prevent the improprieties that led to the government penalties at issue.

    Stone Court Reaffirms Deference to Directors But Emphasizes Need for Effective Controls

    The Stone decision can be viewed as a companion to the Delaware Supreme Court’s recent decision in Disney. There, the court reaffirmed the deference granted to directors’ decisions under Delaware’s business judgment rule. In both decisions, the court has signaled that managerial error or misconduct, standing alone, is not sufficient to hold corporate directors personally liable to the corporation or its stockholders, a standard that remains unaltered by the notable corporate scandals of the recent past.

    Nevertheless, the decision is a reminder that in carrying out their oversight duties, directors should be focused on the adequacy of internal controls and management systems and whether those systems permit the board of directors to receive timely and accurate information about the corporation’s financial results and operations.