Court Imposes Caremark Fiduciary Duty on Corporate Officer (as compared to Director)
In Miller v. McDonald, et al., ( D. Del., Bankr., April 9, 2008), read opinion here, the Bankruptcy Court for the District of Delaware decided an issue of great importance to those who follow corporate governance issues related to the fiduciary duties of officers and directors. In this opinion on a motion to dismiss claims against an officer of a company, the Bankruptcy Court relied on decisions of the Delaware Chancery Court and the Delaware Supreme Court to deny a motion to dismiss in the course of ruling that Caremark duties would be imposed on an officer (who was not a director), that was on the management team when the President of the company committed fraud and other actions and omissions that ultimately led to the bankruptcy filing of the company. This is notable in part because there are not as many decisions that address the fiduciary duties of officers, as opposed to directors of a corporation.
Here is a summary on this blog of a Delaware Chancery Court decision of a few weeks ago that also imposed fiduciary duties on a corporate officer, (with a link to other similar cases and to a recent article on the topic by Professor Lyman Johnson).
No, this is not a “deepening insolvency case”. This case involves a fiduciary duty claim that alleged that even if the defendant did not commit any of the fraud and other abuses that led to the downfall of the company, he breached his fiduciary duty to make an effort to put monitoring systems in place that would have increased the likelihood that the fraud perpetrated by the company President could have been detected sooner and/or could have been prevented sooner. (see page 29 of opinion linked above). Here is a key quote from the opinion:
To date, the fiduciary duties of officers have been assumed to be identical to those of directors. With respect to directors, those duties include the duty of
care and the duty of loyalty. There has also been much discussion regarding a duty of good faith, which may or may not be subsumed under the duty of loyalty. Ovitz became an officer of Disney on October 1, 1995 when he
became President of the corporation, and he became a director on January 22, 1996. Therefore, upon becoming an officer on October 1, 1995, Ovitz owed fiduciary duties to Disney and its shareholders.
In re Walt Disney Co. Derivative Litigation, No.15452, 2004 WL 2050138, at *3 (Del. Ch. Sept. 10, 2004), (internal citation omitted).
Other courts have also applied the Delaware law and recognized that officers owe fiduciary duties to the corporation. In Stanziale v. Nachtomi (In re Tower Air, Inc.), the Third Circuit Court of Appeals upheld the bankruptcy trustee’s claims against
Tower Air’s directors and officers. Count two alleged that Tower Air’s officers breached their fiduciary duty to act in good faith, inter alia, by failing to tell the directors about maintenance problems, and by failing to address the maintenance problems. 416 F.3d 229, 234 (3d Cir. 2005). The Third Circuit held that “[t]he
officers’ passivity in the face of negative maintenance reports seems so far beyond the bounds of reasonable business judgement that its only explanation is bad faith.” See id. at 234, 239.
The same part of the above 2004 Disney decision was relied on for a similar reason in a 2007 Chancery Court decision. See Ryan v. Gifford, 935 A.2d 258, 269 [n.27] (Del. Ch.2007).
Also notable about this case is that the Bankruptcy Court relied on Section 307 of the Sarbanes Oxley Act because this was a publicly-held company–and because that section applies to lawyers such as the officer in this case. The background (at pages 24 to 26) in the opinion, to the above quote from the 2004 Disney case, is important enough to provide below verbatim:
The basis for the Trustee’s claim is that [defendant officer] breached his duty of care by failing to implement an adequate monitoring system and/or the failure to utilize such system to safeguard against corporate wrongdoing. See In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959, 967-71 (Del. Ch. 1996); Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006). Even though Florida law governs this claim, Delaware law is still relevant because “[t]he Florida courts have relied upon Delaware corporate law to establish their own corporate doctrines.” Connolly v. Agostino’s Ristorante, Inc., 775 So.2d 387, 388 n.1 (Fla. Dist. Ct. App. 2000) (citing Int’l Ins. Co. v. Johns, 874 F.2d 1447, 1459 n.22 (11th Cir. 1989)).
The Trustee relies on ATR-Kim Eng Fin. Corp. v. Araneta, No. 489-N, 2006 WL 3783520 (Del. Ch., Dec. 21, 2006) for his position. In Araneta, the court found two defendants who were directors and officers of the company liable for not stopping the company’s majority shareholders and fellow director from transferring the company’s assets to members of his family, a violation of his fiduciary duties. See id. at *1, 19, 23-25. The court cited the Delaware Supreme Court’s Stone decision for directors’ liability:
Caremark articulates the necessary conditions predicated for director oversight liability: (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or control, consciously failed monitor or oversee its operation thus disabling themselves from being informed of risks or problems requiring their attention.
Id. at *24 (citing Stone, 911 A.2d at 370).
The court reasoned that:
One of the most important duties of a corporate director is to monitor the potential that others within the organization will violate their duties. Thus, a “director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board considers to be adequate, exists.” Obviously, such a reporting system will not remove the possibility of illegal or improper acts, but it is the directors’ charge to “exercise a good faith judgement that the corporation’s information and reporting system is in concept and design adequate to assure the board that appropriate information will come
to its attention in a timely manner as a matter of ordinary questions, so that it may satisfy its responsibility.”
Id. at * 23-24 (quoting Caremark, 698 A.2d at 970).
The Trustee alleges that as the vice president of operation and in-house general counsel to World Health, [defendant officer] was responsible for failing to implement any internal monitoring system and/or failing to utilize such system as is required by Caremark and Araneta. The material misrepresentations contained in World Health’s SEC filings are examples of such failure. Since the SEC adopted a final rule pursuant to § 307 of the Sarbanes-Oxley Act, effective August 5, 2003, a general counsel has an affirmative duty to inspect the truthfulness of the SEC filings. 17 C.F.R. Part 205 (Jan. 29, 2007).
Section 307 addresses the professional responsibilities of attorneys. It directs the SEC to issue rules that “set forth minimum standards of professional conduct for
attorneys appearing and practicing before the Commission in any way in the representation of issuers.” Sarbanes-Oxley Act § 307, 15 U.S.C. § 7245 (2005). The standards must contain a rule requiring “an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the issuer up-the-ladder within the company.” Id. Therefore, the Trustee appropriately asserts that [defendant officer] as the in-house general counsel and the only lawyer in top management of World Health during the relevant period, had a duty to know or should have known of these corporate wrong doings and reported such
breaches of fiduciary duties by the management.
UPDATE: Here is a discussion of the case (and more) from Steve Jakubowski, Chicago’s preeminent bankruptcy lawyer, the Justice Cardozo of the blogosphere, and a paradigm of a good man, on his Bankruptcy Litigation Blog. He also amazingly catalogued, with links, the last 27 or so cases that I have summarized on this blog with bankruptcy related issues. I am humbled by the kind words in his post.
UPDATE III: Here is a post by Professor Bainbridge, who also adds relevant commentary from his book on the Sarbanes Oxley Act.
UPDATE IV: Here on The Harvard Corporate Governance Blog is another version of my post on this case.