Delaware Supreme Court Rules on Directors’ Standard of Oversight

November 8, 2006

Decision has significant implications for option backdating litigation

In a significant decision issued on November 6, 2006, the Delaware Supreme Court ruled on the standard to be applied under Delaware law when assessing the personal liability of corporate directors for failing to adequately oversee the corporation. In an era of option backdating scandals, the Supreme Court’s clear and timely statement on the standard for assessing directors’ oversight responsibilities strongly suggests that a similar (if not identical) standard will be applied to claims of director liability for failing to exercise proper oversight in awarding backdated options. Also of interest, the Supreme Court attempted to resolve the confusion around whether there is a separate fiduciary duty of good faith under Delaware law in addition to the fiduciary duties of care and loyalty. 

These issues came before the Court in a case involving AmSouth Bancorporation (AmSouth).1  In AmSouth, the Delaware Supreme Court affirmed the Court of Chancery’s decision to apply the so-called Caremark standard2 for assessing a director’s potential personal liability for failing to act in good faith in discharging his or her oversight responsibilities. As the standard is described by the Supreme Court, directors can be held liable based on alleged failures to satisfy their oversight responsibility only if:

(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. In either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.

Before applying the Caremark standard to the facts, the Supreme Court noted that because most of the decisions that a corporation makes (through its human agents) are not the subject of director attention, "a claim that directors are subject 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."

In AmSouth, the company was subjected to $50 million in fines and civil penalties for allegedly failing to fulfill its disclosure and reporting obligations under the Bank Secrecy Act and anti-money laundering rules with respect to activities of certain bank customers that were engaged in a "Ponzi" scheme that took place over the course of nearly two years. Nonetheless, because AmSouth had systems in place meant to deter and detect such suspicious activity, the Supreme Court declined plaintiffs’ invitation "to equate a bad outcome with bad faith," and concluded that the Court of Chancery was correct in dismissing plaintiffs’ claims.

While the standard adopted by AmSouth to judge directorial oversight liability will most likely be invoked in the near future in the context of stock option backdating, its lessons are more universal. Although good faith exercise of oversight responsibility may not invariably prevent corporation employees from violating criminal laws, or from causing the corporation to incur significant liability, directors should take a significant amount of comfort in knowing that Delaware law imposes a heavy burden on plaintiffs seeking to impose personal liability on corporate directors in such circumstances. As AmSouth dictates, "in the absence of red flags, good faith in the context of oversight must be measured by the directors’ actions to assure a reasonable information and reporting system exists and not by second-guessing after the occurrence of employee conduct that results in an unintended adverse outcome."

Finally, on a tangential note that will likely provide fodder for law review articles to come, the Delaware Supreme Court attempted to resolve confusion created by earlier Delaware decisions (and left unresolved in the Disney opinion decided earlier this year)3 about whether Delaware law imposes a separate fiduciary duty of "good faith" in addition to the more well known fiduciary duties of care and loyalty. The AmSouth Court stated that although the duty to act in good faith could be described colloquially as part of a "triad" of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty. However, a showing of bad faith conduct can still result indirectly in liability because a director’s failure to act in good faith is a breach of the director’s duty of loyalty. The practical effects of recategorizing the duty of good faith as a component of the duty of loyalty were not addressed by the Delaware Supreme Court, and it remains to be seen whether good faith-loyalty claims will be treated differently from classic conflict-loyalty cases.

1Stone v. Ritter, No. 93, 2006 (Del. 2006).

2.  698 A.2d 959 (Del. Ch. 1996).

3In re Walt Disney Co. Deriv. Litig., 906 A.2d 27 (Del. 2006).

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work or Jonathan K. Layne (310-552-8641; [email protected]) or Benyamin S. Ross (213-229-7048; [email protected]) in Los Angeles, Scott A. Kislin (212-351-4078; [email protected]) in New York, or Ronald O. Mueller (202-955-8671; [email protected]) in Washington, D.C.  

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.