Red Flags in the Morning, Directors Take Warning...

• Author: Paul Graf
• Position: Assistant Professor in the Finance Department of the College of Business of San Diego State University
• Pages: 19-27

B u s i n e s s L a w B r i e f | S p r i n g / S u m m e r 2 0 1 0 1 9

In In re Walt Disney Company Derivative Litigation (Disney)

the Delaware Supreme Court held that directors have a non-

indemnifiable and non-exculpatory duty to act in good faith.1

Although this duty of good faith is linked to the duty of care and

the duty of loyalty, it is separate and distinct.2 The Disney court

distinguished the duty of care from the duty of good faith by

noting that Section 102(b)(7) (exculpation provision in articles

of incorporation) of the Delaware Code would be rendered

meaningless if the court held that grossly negligent conduct,

which is covered by the duty of care, was also a breach of the

duty of good faith.3 The court reasoned that Section 102(b)(7)

allows exculpation for gross negligence, but specifically disallows

exculpation for the breach of the duty of good faith; therefore, it

was inappropriate to conflate the two.4 In comparing the duty of

care to the duty of good faith, the court held that breaches of the

duty of good faith were “qualitatively more culpable than gross

negligence [duty of care], and should be proscribed.”5

The decision is noteworthy because it confirmed that direc-

tors are not insulated from monetar y liability through exculpa-

tion or indemnification for breaches of the duty of good faith.

In Stone ex rel. AmSouth v. Ritter (Stone), the Delaware Supreme

Court held that Chancellor Allen’s opinion in In re Caremark

International Inc. Derivative Litigation (Caremark), articulated

the necessary conditions predicate for director oversight liability;

namely, failure to implement any reporting system, or, having

implemented a system of controls, consciously failing to moni-

tor or oversee operations.

6

It is the conscious, knowing failure to

monitor that transforms a breach of the directors’ duty of care

into a breach of the duty of good faith.

7

In Stone, the Delaware Supreme Court was careful to point

out, however, that the duty to monitor does not make directors

insurers of corporate wellness.

8

Even though the duty of good

faith requires boards to establish a reasonable, workable system

to monitor corporate behavior, the court did not conclude that

all failures to capture misconduct in the monitoring nets, or

flawed decisions about monitoring data, would render the direc-

tors monetarily liable.

9

Nor is it expected that even the best

monitoring system will prevent all wrongful acts. In Caremark,

Chancellor Allen observed that most decisions do not come to

the attention of the board.

10

Furthermore, absent suspicion,

directors are justified in assuming the integrity of company

employees.

11

However, if the directors know or suspect that there is a

problem requiring oversight, the duty of good faith is implicated.

Peter D. Bordonaro points out that this scienter requirement in

Stone relieves directors from liability for breaches of the duty of

good faith if they failed to act, but did not do so knowingly.

12

This paper will explore and explicate those circumstances where

a director will be deemed to ignore a known duty to act. The

knowledge requirement hinges on what information or signals,

“red flags,” come to the board’s attention that should prompt the

board to take action.

In Section One, the paper will explore the types of events,

circumstances or facts that should be regarded by a court as a red

flag for purposes of determining director liability under theories

of good faith. Section Two will discuss the challenges of proving

a lack of good faith through inference. Section Three will exam-

ine strategies to negate inferences of bad faith. In Section Four,

the interplay between red flags and theories of good faith will be

analyzed. Finally, in Section Five the paper will address practical

concerns regarding the duty of good faith and red flags.

I. ARE YOU SEEING RED?

A. Identifying Red Flag Issues

A red flag is something that draws the attention of the casual

observer—it demands attention. A red flag stands out because it

is unusual or unexpected. It causes observers to do a double take.

Not all flags are red – some are orange or yellow to suggest a less

obvious problem. What distinguishes a red flag from the others?

Considering the severe consequences of ignoring a red

flag, it is important to search for guidelines. In Graham v.

Allis-Chalmers Manufacturing Company, the Delaware Supreme

Court analyzed whether the board of Allis-Chalmers should have

known of anti-competitive activities perpetrated by certain of the

company’s employees.

13

Plaintiffs argued that a 1937 consent

decree put directors on notice that they needed to take steps to

Red Flags in the Morning, Directors Take

Warning…

By: Paul Graf †

Not all flags are red – some are orange

or yellow to suggest a less obvious problem.

What distinguishes a red flag from

the others?