United States: Yellow Flags Are Not Red Flags: Delaware Court Of Chancery Rejects Caremark Claim In Reiter V. Fairbank

Last Updated: March 14 2017
Article by Joseph W. Swanson

In October 2016, the Delaware Court of Chancery rejected a shareholder derivative lawsuit premised on an alleged lack of oversight by the directors of Capital One Financial Corp., Reiter v. Fairbank, C.A. No. 11693-CB, 2016 WL 6081823 (Del. Ch. Oct. 18, 2016). In so doing, the court not only provided a helpful summary of the law governing fiduciary duty claims grounded on a lack of oversight but also made clear the obstacles plaintiffs must overcome to succeed on those claims.

Caremark, Stone, and the Oversight Claim under Delaware Law

The oversight claim has become a preferred tool of plaintiffs' counsel seeking to hold directors responsible for misfortune that befalls a company. In In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), the seminal decision outlining that claim, the Court of Chancery explained that directors must attempt "in good faith" to ensure that a "corporate information and reporting system" exists to enable the directors to provide adequate oversight of the company's compliance with applicable laws and regulations. The court added in Caremark that this claim was "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."

Ten years after Caremark, the Delaware Supreme Court explained that, for an oversight claim to succeed, at least one of the following must be present:

the directors utterly failed to implement any reporting Web or information system or controls [or] 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.

Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006).

For liability in either scenario, there must be a showing that "the directors knew that they were not discharging their fiduciary obligations." (Emphasis added.)

Despite these exacting standards, shareholders have persisted in asserting oversight claims against directors. This has likely been driven, at least in part, by the fact that the duty to oversee a company's compliance in good faith is part of the duty of loyalty, a point made in Stone. As a result, corporate fiduciaries facing an oversight claim are not protected by any exculpatory provision contained in the articles of incorporation. Accordingly, an oversight claim might assist a plaintiff in demonstrating demand futility in a derivative suit against the board. See Rates v. 8/asband, 634 A.2d 927, 936 (Del. 1993).

Reiter v. Fairbank

It was against this backdrop that the plaintiff shareholder in Reiter v. Fairbank brought a derivative action against Capital One's directors. The plaintiff maintained that the directors breached their duty of loyalty in failing to oversee the company's compliance with the Bank Secrecy Act (BSA) and other anti-money-laundering laws (AMLs). According to the plaintiff, the directors disregarded red flags that Capital One's BSA/AML compliance program did not fulfill legal requirements governing the company's check-cashing business. The plaintiff asserted that this lack of oversight ultimately resulted in the company becoming subject to various investigations and entering into a consent order with the Office of the Comptroller of Currency. The plaintiff did not make a pre-suit demand on the board because the plaintiff believed such demand would have been futile.

The defendants moved to dismiss, among other reasons, because of the plaintiff's failure to make a demand on the board. The Court of Chancery agreed and dismissed the suit. In its opinion, the court found that a demand would not have been futile. Specifically, the court determined that the plaintiff had not alleged facts from which it could be inferred that the directors "consciously allowed Capital One to violate BSA/AML statutory requirements so as to demonstrate that they acted in bad faith." Thus, there was not a reasonable doubt under the Ra/es test that the directors could have exercised their independent and disinterested business judgment-a demand in this case would not have exposed a majority of the board to "a substantial likelihood" of personal liability.

In reaching that decision, the court reviewed Caremark and its progeny, with a particular focus on the state of mind required under those cases. The court noted that directors' good-faith discharge of their oversight responsibility may not always prevent employees' violations of the law, and, therefore, a plaintiff must plead with particularity a connection between the directors' action or inaction and the injury suffered by the corporation. One way to demonstrate that connection would be for the plaintiff to plead that the directors "consciously disregard[ed]" corporate misconduct-i.e., the "proverbial 'red flag."'

In this case, the plaintiff alleged that the board ignored a litany of red flags-in the form of at least 25 reports to the directors over a multiyear period-showing that Capital One's BSA/AML controls and procedures were inadequate. To assess the claims, the court focused on the handful of reports that served as the plaintiff's most compelling "red flags." In the court's view, however, those reports were no more than "yellow flags" that showed Capital One's increasing compliance risk as well as added regulatory interest in AML compliance. None of those reports indicated that any employee had engaged in fraudulent or criminal conduct. Rather, those reports showed that management had been engaged in an effort to address these issues and reduce the company's risk profile, and had gone so far as to exit the check-cashing business, a prominent focus of BSA/AML compliance. These factual allegations enabled the court to distinguish this case from cases in which boards knowingly tolerated-if not participated in-illegal conduct. In reaching its conclusion to dismiss the case, the court cited Stone for the proposition that an oversight claim has merit only when "the directors knew that they were not discharging their fiduciary obligations."

The Significance of Reiter v. Fairbank

Reiter is important for its thorough review of the law in Delaware attendant to an oversight claim, especially the reminder that the "core inquiry" in any such claim is whether the directors "intentionally disregarded their fiduciary duties in bad faith." Toward the conclusion of the opinion, the court emphasized a principle that runs throughout Caremark and its progeny-namely, that "[g]ood faith, not a good result, is what is required of the board."

In that regard, directors, and those who advise them, would be well served to remember that perfection need not be the enemy of the good when it comes to fulfilling their oversight obligation. A board that institutes and then monitors a reasonable reporting system tailored to the company's compliance risks should be insulated from Caremark liability, even if that system fails to prevent those risks from being realized. This has proven to be the case, for example, in the cybersecurity arena, where shareholders have experienced a string of defeats in derivative litigation that followed data breaches at Wyndham, Target, and Home Depot.  Like Reiter, those cases teach generally that a board's good-faith attention to a company's most pressing compliance risks should help the directors avoid personal liability if a shareholder later seeks to hold them responsible for corporate harm.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions