Question
Over the past few years, the Delaware Courts have been wrestling with the duty of oversight as first set forth in the Caremark case. The exact parameters of that duty, when it is triggered, and what it entails remains somewhat uncertain.
Putting aside Delaware law for a moment, Do you think that good corporate governance requires a board to have a duty of oversight that is part of the duty of loyalty or duty of care? (If not, why not.)
Stephen, I know that you have been critical of Caremark and the Caremark line of cases. Do you think the duty of care or the duty of loyalty includes within it a duty of oversight at all or do you think it is unnecessary for effective governance.
Answer
First, Caremark was wrong from the outset. Caremark’s unique procedural posture, which precluded any appeal, gave Chancellor Allen an opportunity to write “an opinion filled almost entirely with dicta” that “drastically expanded directors’ oversight liability.” In doing so, Allen misinterpreted binding Delaware Supreme Court precedent and ignored the important policy justifications underlying that precedent.
Second, Caremark was further mangled by subsequent decisions. The underlying fiduciary duty was changed from care to loyalty, with multiple adverse effects. In recent years, moreover, there has been a steady expansion of Caremark liability. Even though the risk of actual liability probably remains low, there is substantial risk that changing perceptions of that risk induces directors to take excessive precautions.
I think we ought to revive Graham v. Allis-Chalmers Manufacturing Co., 188 A.2d 125, 130 (Del. 1963). Consider the old saying: “every dog gets one bite.” This saying was based on the common law principle that a dog’s master was only liable for bites if the master knew or had reason to know the dog had a propensity to bite. Such knowledge could be based either on the breed’s inherently violent propensities or a prior bite. The economic rationale for such a rule is simple—monitoring costs. Keeping an eye on your dog requires costly precautions, such as leashes, fences, and the like. Why require such expenditures if Fido is as gentle as a lamb?
The analogy to Graham should be self-evident, but let’s beat the dead horse anyway. Just as a dog owner does not have liability unless the owner knows the dog has a propensity to bite, directors are liable only if they are on notice that their employees have a propensity for crime. Just as a dog owner is put on such notice by a prior bite, prior criminal violations can put directors on notice. Just as owners have an affirmative duty to control dogs of an inherently vicious breed, directors may not recklessly fail to monitor an obviously untrustworthy employee.
As with the dog bite rule, Graham implicitly rests on a cost-benefit analysis. Law compliance programs are not free. At the very least, a law compliance program requires preparation of a company manual telling employees not to fix prices. It probably also requires training of employees. Beyond that, the firm probably should send lawyers out to do compliance audits from time to time. Programs with real teeth require substantial high-level commitment and review, frequent and meaningful communication to employees, serious monitoring and auditing, and appropriate discipline where violations are discovered. By analogy to the dog bite cases, one reasonably would expect a firm to go through all this only when on notice of a past violation.
Interestingly, the Model Business Corporation Act’s director liability provisions codify a standard closer to Graham than Caremark. Under MBCA § 8.31(a)(2)(iv), a director may be held liable for sustained inattention but only when “particular facts and circumstances materialize that” would put “a reasonably attentive director” on notice of the need for further inquiry. Under this provision, it would seem, proactive vigilance is not required.
Reading
Bainbridge, Stephen Mark, Don’t Compound the Caremark Mistake by Extending it to ESG Oversight (September 2021). Business Lawyer (September 2021), UCLA School of Law, Law-Econ Research Paper No. 21-10, Available at SSRN: https://ssrn.com/abstract=3899528
Bainbridge, Stephen Mark, Caremark and Enterprise Risk Management (March, 18 2009). UCLA School of Law, Law-Econ Research Paper No. 09-08, Available at SSRN: https://ssrn.com/abstract=1364500 or http://dx.doi.org/10.2139/ssrn.1364500
Bainbridge, Stephen Mark 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: https://ssrn.com/abstract=1006097 or http://dx.doi.org/10.2139/ssrn.1006097
