Introduction

 Most directors and officers have heard about the serious threat facing the business community due to the Year 2000 problem. Most also have heard that the company's Year 2000 risks extend far beyond its internal systems to the key trading partners and service providers on which it depends for its day-to-day existence. Nevertheless, recent studies indicate that most companies have not yet completed assessing their Year 2000 risks, while others have not yet begun that process. Given these circumstances, directors and officers should recognize the risks they face from failing to address their company's Year 2000 issues immediately. This article explains how directors and officers can use the business judgment rule as a guide for actions they may take to minimize their corporation's year 2000 risks and to minimize their own exposure to liability for failing to discharge their duty of care regarding Year 2000 risks.

What are the Year 2000 risks for directors and officers?

 It is likely that directors' and officers' management of their corporation's Year 2000 risks will be attacked if their corporation suffers significant Year 2000-related losses. Shareholders in these circumstances may seek to hold the directors liable for failing to exercise prudent business judgment in handling the Year 2000 problem. As of mid-May, six Year 2000-related lawsuits have been filed, including five class actions. If remediation projects fail or the problem adversely affects stock values for other reasons, lawsuits could be filed against directors and officers alleging that they breached their duty of care to the corporation.

Fortunately, the "business judgment rule" can significantly reduce directors' and officers' exposure from such Year 2000 litigation. To demonstrate the appropriate diligence, directors and officers should understand the business judgment rule and how it may affect a court's evaluation of their performance in handling Year 2000 issues. Below, we examine the business judgment rule, as it has been interpreted in the recent Caremark decision (In re Caremark International Inc. Derivative Litigation, [1996] 698 A2d 959, 967-8 [applying Delaware law] [Chancellor Allen]), and then apply it to a hypothetical set of Year 2000 risks.

What diligence is required by the business judgment rule and the Caremark decision?

 Under the business judgment rule, directors and officers are bound by the fiduciary duties of loyalty and due care to ensure that the corporation is managed in the best interests of its shareholders. As codified in California, for instance, the business judgment rule requires that each director serve "in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders, and with such care, including reasonable inquiry, as an ordinary prudent person in a like position would use under similar circumstances." See, California Corporation Code Sec. 309(a). Although the rule ostensibly states an affirmative fiduciary duty, the body of law surrounding the business judgment rule provides one of the best defenses for directors and officers to claims that they should be held liable for corporate losses. The recent Caremark decision, which has been cited as the most comprehensive and authoritative statement of the current status of the director's duty of care under Delaware law, provides a good illustration of how reasonable decision making and information gathering procedures can shield directors from liability on claims that they breached their duty of care in ensuring company-wide compliance with appropriate standards. Caremark is instructive for directors regarding Year 2000 risks because managing those risks also involves implementing company-wide compliance programs.

In Caremark, the complaint alleged that Caremark's directors breached their duty of care when Caremark incurred approximately $250 million of losses from alleged violations of health care provider laws (including Medicare). As alleged, the directors initially misinterpreted the laws to permit Caremark to enter into certain contracts with patient referral sources, then inadequately supervised Caremark employees who illegally, and against Caremark policy, paid kickbacks for patient referrals. Despite these allegations and the large losses, the court found that there was no substantial evidence to support the claims against the directors. The court explained that director liability for a breach of the duty to exercise appropriate attention may arise in two distinct contexts: 1) "Liability for directorial decisions" -- that is, where directors make ill-advised or "negligent" decisions; and 2) "Liability for failure to monitor" -- that is, where directors fail to act because of inattention.

As to the first potential source of liability (negligent decision), the Caremark court explained that whether a court, after the fact, "believes a decision substantively wrong ... provides no ground for director liability, so long as the court determines that the process employed was rational or employed in a good faith effort to advance corporate interest." The evidence that the directors' decision violated this good faith requirement was extremely week because the Caremark board had been informed by experts that the company's practices were lawful. As to the second potential source of liability (inattention), the court explained that directors must "attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists." Again, the court determined that the evidence against the directors was weak because the company's information systems represented "a good faith effort to be informed of relevant facts." Significantly, Caremark's corporate information and reporting system utilized an internal audit plan to assure compliance with ethics policies, employed an outside auditor to evaluate its control structure, and informed the board about these and other efforts.

The business judgment rule and Caremark applied to Year 2000 risks

Put in the context of Year 2000 risks, the Caremark decision points to the need for directors and officers to establish: (1) an information gathering and reporting system that is reasonably calculated to bring important Year 2000 risks to the attention of the directors and officers in a timely manner; and (2) a Year 2000 decision making process (including appropriate expert consultation) that is reasonably calculated to lead to sound judgments regarding those risks. Because Year 2000 problems are pervasive and involve uniquely specialized and complex technological problems, many companies cannot rely on their regular information gathering and decision making processes, but must create special Year 2000-focused programs to ensure that no key risk is overlooked and that informed decisions are made.

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.