In June of last year, the Delaware Chancery Court (per VC Glasscock) dismissed a derivative suit brought by GM shareholders against GM directors, alleging that the GM board breached their duty of loyalty by failing to oversee operations of corporation in connection with the ignition switch scandal.
The case was dismissed in pre-trial motions for failure to comply with the basic procedural requirements associated with derivative litigation:
When a plaintiff seeks derivatively to pursue litigation arising from board action, without having made demand as required by Court of Chancery Rule 23.1, the plaintiff must allege with particularity facts that raise a reasonable doubt either that the directors are disinterested and independent or that the challenged action was otherwise the product of a valid exercise of business judgment. Where board inaction is the subject of such derivative litigation, the plaintiff must plead particularized facts raising a reasonable doubt that, at the time the complaint was filed, the board could have properly exercised independent and disinterested business judgment in responding to a demand.
.In this case, in which the board's principal alleged failing was a lack of oversight, the plaintiff must plead particularized facts raising a reasonable doubt that the board acted in good faith. For critical discussion of the bad faith standard in the oversight context, see my article The Convergence of Good Faith and Oversight:
In Stone v. Ritter, 911 A.2d 362 (Del. 2006), two important strands of Delaware corporate law converged; namely, the concept of good faith and the duty of directors to monitor the corporation's employees for law compliance. As to the former, Stone puts to rest any remaining question as to whether acting in bad faith is an independent basis of liability under Delaware corporate law, stating that although good faith may 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. Only the latter two duties, where violated, may directly result in liability, whereas a failure to act in good faith may do so, but indirectly. 911 A.2d at 370. Nevertheless, this holding may not matter much, because the Stone court makes clear that acts taken in bad faith breach the duty of loyalty. As a result, instead of being split out as a separate fiduciary duty, good faith has been subsumed by loyalty. In this sense, Stone looks like a compromise between those scholars and jurists who wanted to elevate good faith to being part of a triad of fiduciary duties and those who did not, with the former losing as a matter of form, and the latter losing as a matter of substance.
As to the duty of oversight, Stone confirmed former Chancellor William Allen's dicta in Caremark Int'l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996), that the fiduciary duty of care of corporate directors includes an obligation for directors to take some affirmative law compliance measures. In Stone, the Delaware Supreme Court confirmed that Caremark articulates the necessary conditions for assessing director oversight liability. Stone, 911 A.2d at 365.
This article argues that the convergence of good faith and oversight is one of those unfortunate marriages that leaves both sides worse off. New and unnecessary doctrinal uncertainties have been created. This article identifies those uncertainties and suggests how they should be resolved.
Bainbridge, Stephen M. and Lopez, Star and Oklan, Benjamin, The Convergence of Good Faith and Oversight. UCLA School of Law, Law-Econ Research Paper No. 07-09. Available at SSRN: http://ssrn.com/abstract=1006097.
Delaware precedents make clear that proving director liability for lack of oversight under the bad faith standard is one of the hardest claims for a plaintiff to make in corporate law. As I explain in my article Caremark and Enterprise Risk Management:
The financial crisis of 2008 revealed serious and widespread risk management failures throughout the business community. Shareholder losses attributable to absent or poorly implemented risk management programs are enormous.
Efforts to hold corporate boards of directors accountable for these failures likely will focus on so-called Caremarkclaims. The Caremark decision asserted that a board of directors has a duty to ensure that appropriate "information and reporting systems" are in place to provide the board and top management with "timely and accurate information." Although post-Caremark opinions and commentary have focused on law compliance programs, risk management programs do not differ in kind from the types of conduct that traditionally have been at issue in Caremark-type litigation.
Risk management failures do differ in degree from law violations or accounting irregularities. In particular, risk taking and risk management are inextricably intertwined. Efforts to hold directors accountable for risk management failures thus threaten to morph into holding directors liable for bad business outcomes. Caremark claims premised on risk management failures thus uniquely implicate the concerns that animate the business judgment rule's prohibition of judicial review of business decisions. As Caremark is the most difficult theory of liability in corporate law, risk management is the most difficult variant of Caremark claims.
Bainbridge, Stephen M., Caremark and Enterprise Risk Management (March, 18 2009). UCLA School of Law, Law-Econ Research Paper No. 09-08. Available at SSRN: http://ssrn.com/abstract=1364500
Unfortunately for the GM shareholders, their claim basically alleged that the board had failed to properly manage and oversee the risks related to the ignition switch issues:
In an attempt to show bad faith here, the Plaintiffs allege that the transfer of risk management responsibilities was made despite an already poorly-functioning risk management system, creating an even worse system. The Plaintiffs also allege that the Audit Committee was overburdened with issues relating to GM's bankruptcy, and thus, the decision to transfer more responsibility could not have been made in good faith. The Plaintiffs also allege that the transfer of responsibilities was incomplete: that the Audit Committee Charter did not adopt the entirety of the Finance and Risk Committee's responsibilities.Importantly, as will be discussed in greater detail below, there is no sufficiently pled allegation that the Board was aware that its risk management system was not functioning as it should—i.e., there were no “red flags” or other bases from which I can infer knowledge on the part of the Board that its system was inadequate. Thus, the decision to make changes to that system—a type of decision that is squarely within the realm of director decision-making—cannot be said to be in bad faith, made with conscious disregard of the Board's duties to GM.
The court's conclusion makes clear that doing a bad job of risk management is not the equivalent of bad faith, just as Delaware law has consistently held in prior cases:
Pleadings, even specific pleadings, indicating that directors did a poor job of overseeing risk in a poorly-managed corporation do not imply director bad faith. This case presents a classic example of the difference between allegations of a breach of the duty of care (involving gross negligence) as opposed to the duty of loyalty (involving allegations of a bad-faith conscious disregard of fiduciary duties). The conduct at issue here, as pled, falls short of an utter failure to attempt to establish information or reporting systems, a conscious failure to monitor existing systems, or conduct otherwise taken in bad faith. Accordingly, I find that there is not a substantial likelihood of personal liability on the part of a majority of the Board, excusing demand, and the Motion to Dismiss should be granted for failure to comply with Rule 23.1.
In re Gen. Motors Company Derivative Litig., No. CV 9627-VCG, 2015 WL 3958724, at *17 (Del. Ch. June 26, 2015)
Legal blogger Frank Reynolds reports on the recent Supreme Court hearing of the GM shareholders appeal:
Delaware law experts agreed that the GM plaintiff shareholders had a tough row to hoe in trying to convince the state high court that the reporting system the board implemented was so “utterly useless” that relying on it constituted gross misconduct.
Widener professor Paul Regan, who took his corporate law classes to Wednesday’s oral argument, said the odds do not appear to be in the plaintiffs’ favor.
Even if they proved the directors made bad or negligent decisions about the defect reporting system’s setup and operation, he said, it won’t be enough to revive their suit because “the standard of bad faith regarding the duty of care is very tough to meet.”Regan noted that the justices closely questioned plaintiffs’ attorney David A. Jenkins of Smith Katzenstein & Jenkins in Wilmington, on his attempt to prove that the directors exhibited bad faith — rather than mere negligence — in using a reporting system that failed to get them the information they needed on a spate of disastrous ignition switch lockups.
The justices had no questions for defense attorney Robert J. Kopecky of Kirkland & Ellis in Chicago, who recited a litany of the directors’ well-intentioned attempts to ensure that they were getting up-to-date information on defects after GM emerged from bankruptcy protection in 2009, Regan said.
(HT: Francis Pileggi) Personally, I don't see how the Delaware Supreme Court could possibly hold for plaintiffs without tossing most of its Caremark jurisprudence out the window. In order for their to be liability under Stone v Ritter, there must be a showing that "(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."
Based on VC Glasscock's factual summary: (1) the GM board did have a reporting system; (2) the GM board did not intentionally ignore red flags or similar alerts. Indeed, it looks like the plaintiffs' claim should fail for the same reasons that the plaintiffs' claims failed in Stone:
With the benefit of hindsight, the plaintiffs’ complaint seeks to equate a bad outcome with bad faith. The lacuna in the plaintiffs’ argument is a failure to recognize that the directors’ good faith exercise of oversight responsibility may not invariably prevent employees from violating criminal laws, or from causing the corporation to incur significant financial liability, or both ....
GM doubtless suffered a significant loss. But as long as a bad outcome does not constitute bad faith per se, these sort of claims will remain almost impossible for plaintiffs to win.
