In my most recent column for the publication of the National Association of Corporate Directors, I discussed a recent Delaware Court of Chancery decision that addressed the fiduciary duty of directors to provide oversight, and what must be alleged with particularity in order to survive a motion to dismiss. Members of the Delaware bench have described a claim for violation of this duty, sometimes referred to as the Caremark duty, to be one of the most challenging claims in Delaware corporate litigation to prevail on. The name of the case is Reiter v. Fairbank, and it was previously highlighted on these pages.

Supplement: Prof. Stephen Bainbridge, venerable corporate law scholar and friend of the blog, quotes from my article in the context of his larger discussion about what qualifies as a “red flag” for purposes of the Caremark oversight duties of a board.

The Delaware Court of Chancery recently provided an exemplary explanation of Delaware law on the requirements that must be met before directors can be found liable for breaching their duty of oversight. Reiter v. Fairbank, C.A. No. 11693-CB (Del. Ch. Oct. 18, 2016).

Key Background Facts: This case involved a claim that the board of directors of Capital One Financial Corporation breached its fiduciary duties of oversight in connection with its alleged failure to adequately monitor the bank’s activities in connection with check cashing services, and in particular, allegedly failed to monitor compliance with the federal laws and regulations regarding money laundering.

Key Legal Principles Addressed: The Court of Chancery found that the standard under Delaware law for imposing oversight liability, sometimes referred to as Caremark liability, requires evidence of bad faith, meaning that “the directors knew that they were not discharging their fiduciary obligations.”

The court reasoned that this type of claim, often described as one of the most difficult to prevail upon in corporate litigation, failed to allege facts from which it reasonably may be inferred that the defendant directors consciously allowed Capital One to violate the federal requirements so as to demonstrate that they acted in bad faith.  Specifically, the plaintiff failed to plead with particularity that a majority of the directors of Capital One faced a substantial likelihood of liability.

It would take more space than typically allocated for a blog post to recite the excellent recitations of the law by the court regarding the nuances and prerequisites of both: (1) the duties of oversight of the board of directors, which is part of the duty of loyalty, a subset of which is the duty of good faith; and (2) the prerequisites for a plaintiff to successfully allege a breach of the duty of oversight such that it will survive a motion to dismiss under either Rule 23.1 or 12(b)(6).

Several gems can be found on pages 14 and 15 of the slip opinion, in which the court explains that the Rales test applies in this context as opposed to the Aronson because in connection with a Caremark claim, it is the lack of action by a board or an alleged violation of the board’s oversight duties that must be examined as opposed to an allegedly improper decision.

In addition, the prerequisites that must be satisfied by a plaintiff alleging a Caremark claim are usefully enunciated in page 17 through 20 of the slip opinion.

I will provide a few selected excerpts, but those needing to know the nuances of Delaware law on this topic need to read the whole opinion.The court explained that in order to establish a breach by the directors of their fiduciary duty by failing to adequately implement controls and monitoring procedures, plaintiffs would need to show either:

“(1)  That the directors knew, or (2) should have known that violations of law were occurring and, in either event, (3) that the directors took no steps in a good faith effort to prevent or remedy that situation, and (4) that such failure approximately resulted in the losses complained of.”

The opinion referred to the Delaware Supreme Court’s reinforcement of the Caremark framework for director oversight liability by clarifying that:  “To impose personal liability on a director for failure of oversight requires evidence that the directors ‘knew that they were not discharging their fiduciary obligations.’”  See footnote 48 and accompanying text.