In Stone v. Ritter,[1] shareholders of AmSouth Bancorporation brought a derivative suit against AmSouth’s directors alleging a “classic Caremark claim.” In 2004, AmSouth had paid $50 million in fines and penalties to the federal government to settle criminal and civil charges that the bank had failed to file reports of suspicious activity required by the federal anti-money-laundering regulations. The plaintiffs thereafter brought a derivative claim, seeking to recover the $50 million from the directors. Plaintiffs alleged that “defendants had utterly failed to implement any sort of statutorily required monitoring, reporting or information controls that would have enabled them to learn of problems requiring their attention.”
In Stone, the Delaware supreme court confirmed that “Caremark articulates the necessary conditions for assessing director oversight liability.” In doing so, however, the court described Caremark as a case in which the operative standards are good faith and loyalty rather than care, stating that:
[T]he Caremark standard for so-called “oversight” liability draws heavily upon the concept of director failure to act in good faith. That is consistent with the definition(s) of bad faith recently approved by this Court in its recent Disney decision, where we held that a failure to act in good faith requires conduct that is qualitatively different from, and more culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e., gross negligence). In Disney, we identified the following examples of conduct that would establish a failure to act in good faith: . . . where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.
Stone further held that “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.”
Liability will arise only where there are alleged “red flags” that are “either waved in one’s face or displayed so that they are visible to the careful observer.” Rattner v. Bidzos, 2003 WL 22284323 at 13 (Del. Ch. 2003), quoting In re Citigroup Inc. S’holders Litig., 2003 WL 21384599, at *2 (Del. Ch. 2003).
Which raises the question: What's the difference between a red flag that can result in liability if ignored and a yellow flag that cannot?
Friend of the blog prominent Delaware corporate lawyer Francis Pileggi recently posted an essay, Court Explains Directors Fiduciary Duty of Oversight, which discusses a recent Delaware Chancery Court case, Reiter v. Fairbank, and provides a valuable overview of the law in this area.
Pileggi explains:
In Reiter v. Fairbank, the Delaware Court of Chancery reasoned that there was no key event or document that constituted a red flag to the board. At most, there were a number of yellow flags that the board adequately addressed.
He goes on to discuss the yellow flags and why they were yellow rather than red.
[1] 911 A.2d 362 (Del.2006).
