Environmental, Social & Governance Briefs

On Governance: Caremark Decision and Reputational Risk Through #MeToo Glasses

May 15, 2018

On Governance is a series of guest blog posts from corporate governance thought leaders. The series, which is curated by the Governance Center research team, is meant to serve as a way to spark discussion on some of the most important corporate governance issues.

Public and private businesses today face many decisions that do not arise from, and have consequences far beyond, solely financial performance. Rather, these decisions are primarily driven by, and implicate, important social, cultural and political concerns. They include harassment, pay equity and other issues raised by the #MeToo movement (See The Conference Board’s webcast) ; immigration and labor markets; trade policy; sustainability and climate change; the manufacture, distribution and financing of guns and opioids; corporate money in politics; privacy regulation in social media; cybersecurity; advertising, boycotts and free speech; race relations issues raised by the pledge of allegiance controversy; the financing of healthcare; the tension between religious freedom and discrimination laws; and the impact of executive pay on income inequality, among others.

If the nature of the issues is not unprecedented, the number, diversity and polarization seem to be. 

Delaware courts and shareholders currently assess decisions made by boards of directors primarily under the business judgement rule and the 1996 Caremark standard.  Many other states have similar schemes for evaluating director decisions or follow Delaware precedent.  Generally, Caremark addresses the legal standard of culpability when directors are alleged to have failed to address a risk, while the business judgment rule provides a framework for assessing affirmative board decisions unless a more substantive review is warranted. 

Companies and boards have traditionally viewed the risk of liability under Caremark as being primarily a compliance issue; a well-designed and administered compliance function should bubble up to directors the issues and information that require their attention, satisfying the Caremark duty of attention.  A long series of Delaware decisions describe a Caremark-based derivative challenge as “possibly the most difficult theory in corporation law on which a plaintiff might hope to win a judgment.”

This blog post explores the potential for change in the Caremark standard in light of the current intersection of business and social, political and cultural issues.

The Caremark Standard

The Caremark decision arose from a failure of the Caremark International Inc. to comply with laws concerning inducements to prescribe drugs.  The plaintiffs alleged that Caremark’s directors breached their duty of care. Chancellor William Allen of the Delaware Court of Chancery stated that “evaluation of the central claim made entails consideration of the legal standard governing a board of directors’ obligation to supervise or monitor corporate performance.”  He determined that “where a director in fact exercises a good faith effort to be informed and to exercise appropriate judgment, he or she should be deemed to satisfy fully the duty of attention”.  Decisions subsequent to Caremark have drawn a distinction between, on the one hand, inadequate or flawed efforts by directors and, on the other hand, a conscious disregard for fulfilling fiduciary obligations.  “The decision to act and the conscious decision not to act are thus equally subject to review under traditional fiduciary duty principles.”[1] 

Reasons for Revisiting the Caremark Standard in the Current Environment

As stated above, some of the most challenging issues facing business today have substantial components that are not traditional business issues.  In a way, Chancellor Allen anticipates today’s business challenge for directors by expressly premising his holding on moral considerations: “one wonders on what moral basis might shareholders attack a good faith business decision of a director as ‘unreasonable’ or ‘irrational’” (emphasis added).  That is not to say that the Caremark opinion suggests that moral failures should be a basis for director liability.  Rather, the Caremark opinion suggests that the standard for director liability should in some way reflect the moral issues at stake: asking whether there is a moral basis for the courts to hold directors liable for not ferreting out an obscure compliance failure that results in a modest financial penalty is also by implication asking whether there is a moral basis for the courts to not hold directors liable for turning a blind eye to issues of great political, social or cultural consequence.

Chancellor Allen’s “duty of attention” is an important focus for today’s issues because directors may be inclined to think that addressing the fraught political, social and cultural aspects of today’s issues is beyond their purview, because they are not primarily business issues.  However, precisely for that reason, the moral basis for judging directors based on how they deal with today’s issues may have evolved.

The Caremark Context

In his Caremark opinion, Chancellor Allen tightens the standard that was adopted in Graham v. Allis-Chalmers Mfg. Co. about 30 years earlier.  The Allis-Chalmers court held, in a claim against directors arising in the context of anti-trust violations, that there was no basis to find the directors liable for breaching a duty to be informed of the corporation’s operations, famously stating that “absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.”

Chancellor Allen found at least a broad reading of the Allis-Chalmers standard to be insufficient, stating that “modernly this question has been given special importance by an increasing tendency, especially under federal law, to employ the criminal law to assure corporate compliance with external legal requirements, including environmental, financial, employee and product safety as well as assorted other health and safety regulations.”

He held, to the contrary, that a board must assure itself “that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation's compliance with law and its business performance.”  Chancellor Allen focused on the obligation of directors to collect the facts necessary to reach informed judgment and concluded that turning a blind eye was not an appropriate alternative.

In the same year that he wrote his Caremark opinion, Chancellor Allen also wrote the opinion in Gagliardi v. TriFoods, which he cited in Caremark.  Gagliardi provides examples of the kinds of decisions that Chancellor Allen likely had in mind when he decided Caremark: (1) TriFoods’ former president causing the corporation to pay $125,000 to a consultant for the design of a new logo and packaging; (2) directors acquiescing in a “reckless” commission structure in order to build sales volume; (3) directors tolerating duplicate product research facilities; (4) directors overpaying in a corporate acquisition; and (5) directors failing to pre-empt harm to customer relations arising from delivery of poor product, and to supplier relations from poor payment practices.

Compare that list to the kinds of potential claims that could arise from the difficult issues of today:

(1) failure to prevent a corporation from employing large numbers of undocumented illegal aliens, one of whom gets into a fatal car accident on the way home from work;

(2) failure to oversee compliance with environmental standards, resulting in unacceptable levels of toxins in the drinking water of a poor urban neighborhood;

(3) failure to terminate the employment of the CEO, a sexual predator;

(4) failure to adopt best practices for background checks in connection with the sale of assault rifles, one of which is used in a school shooting;

(5) failure to appropriately monitor or react to corporate compliance with political contribution rules, or to protect customer data, likely affecting the results of elections; or

(6) failure to ensure an appropriate response to consumer boycott threats arising from advertising support on controversial media outlets.

This is a nightmare list of potential claims, to be sure (albeit only a partial one), but is it clear that the standard applied to director conduct in these situations would, taking into account Chancellor Allen’s moral basis test, be consistent with our current understanding of the relatively forgiving Caremark standard?

Whose Responsibility?

One line of thought suggests that responsibility for these new and difficult issues lies primarily with management, and not with directors.  A few considerations seem particularly relevant to this question.

First, management, and not directors, are usually the driving force for company action.  While the board oversees the company and sets strategy, management implements that strategy and generally has broad discretion afforded to it through board delegation under state law.  As we have noted, directors may be sued directly for their or company actions, or inactions, but the system provides a relatively broad shield that insulates their decisions from being second-guessed by the judiciary.  Management, tasked with the responsibility of running the day-to-day operations, is subject to more uncertain standards.

In 2009 in Gantler v. Stephens, Delaware made it clear that corporate officers owe the same fiduciary duties as directors.  However, Gantler stopped short of reviewing officer conduct under any standard (and therefore did not apply the business judgment rule) and there have been limited overtures regarding the applicable standard of review for officers’ conduct in cases since then.[2]  In addition, the court in Gantler asserted that the consequences of a breach of fiduciary duties would not necessarily be the same as a director’s breach.  It remains unclear how an officer’s fiduciary duties are to be measured; despite the assertion in Gantler that officers owe fiduciary duties, there is no mechanism to enforce or assess the fulfillment of those duties. [3]

Second, senior management is accountable directly to the board, as the board has the power to select and fire those individuals.  Directors are accountable to shareholders who have the ability to vote them out as directors.  In the past few years, there has been a rapid and significant evolution in investor expectations and attitudes towards the companies in which they invest in regard to stewardship.  In addition, demand for socially responsible investing has grown, and traditional institutional investors, as well in some cases as activists, have focused their stewardship advocacy directly on boards (and in the creation of investment vehicles that invest only in companies that meet certain social or environmental criteria).  As investor expectations in this regard continue to evolve, investors are increasingly focused on power of their votes.  We have already begun to see a shift in voting behavior evidencing votes serving both a financial and social and political functions.  Thus far, however, institutional investors have been vocal about linking their views on social and political issues to the manner in which such decisions affect financial performance, or as a proxy for a board’s understanding and management of risk that in turn affects financial performance.  Whether significant numbers of investors will place a stronger emphasis in voting decisions on social and political views, such that elections are affected by issues that are not primarily financial issues, is an interesting and open question.

Third, there are typically minimal tangible repercussions under current law for a director who is found to have breached his or her fiduciary duties.  Broad indemnification laws and agreements mean that few directors have been personally liable for any portion of a monetary judgment.[4]  The specter of reputational harm is real, but does it justify the relatively director-friendly Caremark standard?  How should additional demands on, or expectations for, directors, if they seem to be appropriate, be balanced with the risk that the most-qualified individuals may refuse to serve because of the corresponding additional risks?  A year ago, few directors would have thought that the board’s attitude towards ferreting out sexual harassment would be material to their jobs as directors; today many more see that concern.  So, in a sense the change in expectations has already occurred without a change in law, but will a change in law follow?  Should it?

How Could Change Come About?

While it may not be obvious what set of facts could give rise to a claim arising from today’s issues, it is not a stretch to imagine that one would.  Director fiduciary claims have already been brought based on allegedly pervasive sexual harassment issues.  Are we at the beginning, middle or end of a period of unusual tension concerning today’s divisive issues?

Perspectives on the Caremark Standard

As stated above, the Caremark standard requires boards to stay informed about matters that could affect “judgments concerning both the corporation's compliance with law and its business performance.” What about corporate conduct that implicate today’s pressing political, cultural and social issues. For example, should boards be expected to stay informed of issues relating sexual harassment at their companies, or business practices that could implicate important religious freedom issues, even if they do not seem to implicate material financial or legal compliance concerns?

As also stated above, the Caremark standard applies to board inaction, whereas the actions of directors are subject to substantive review if not protected by the business judgment rule.  The business judgment rule protection requires independence, due care and good faith.  In the context of today’s highly visible and contentious issues, what justifies the different standards applicable to judicial review of board inaction, on the one hand, and board action, on the other?  Should corporate losses arising from these issues be presumed to be the result of a “conscious decision not to act”?

Take-Aways

For as long as Caremark continues to be the law, directors should ensure that they at least meet the Caremark standard in connection with the #MeToo movement and other issues relevant to their businesses, but they should not be too concerned about new liability risks, even in the current environment.  Meeting the Caremark standard includes periodically assuring that there is a system for information and problems to come to the board’s attention.  The application of the Caremark standard to today’s issues does not require novel efforts.

However, reputational risks for companies and directors, distinct from liability risks, deserve to be highlighted in the current environment.  The enterprise risk approach that many companies and boards take should be re-examined to ensure that they are designed so that reputational risk concerns will bubble up to the board.  In our experience this adjustment has already happened at many companies.

Finally, a move away from the Caremark standard in judging board conduct seems conceivable, but certainly not inevitable.  Any such change would likely be motivated by a different moral calculation than prevailed in the past, one that arises from the social, cultural and political nature and scope of the issues facing business today.  It might reflect political calculations related to today’s populist trends and a backlash against the corporate class.  The change could be ushered in by Delaware courts examining a controversy arising under the current legal framework, or by changes in law, for which there is precedent in Sarbanes-Oxley (arising from the Enron and WorldCom scandals) and Dodd-Frank (following the financial crisis).

The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board or the Governance Center.