On September 25, 2021, the Caremark decision turned 25 years old. Caremark is a landmark decision from the Chancery Court of Delaware which transformed the duty of loyalty by placing within it the new duty of oversight, making it more than merely an elevated level of attention to business as the duties of care and good faith require. However, of the seventeen Caremark claims that have been brought in Delaware since it was decided, only five have survived a motion to dismiss: Marchand v. Barnhill, In re Clovis, Teamsters Local 443 Health Services & Insurance Plan v. Chou, Hughes v. Hu, and In re Boeing Co. Derivative Litig. Thus, a motion to dismiss is usually the first and greatest obstacle to such derivative shareholder claims.
Under Caremark, a court initially asks “whether there was [a] good faith effort to be informed and exercise judgment.” Plaintiffs will survive a motion to dismiss and directors can be held liable for a breach of duty if a plaintiff can show the directors acted in bad faith by (1) failing to implement monitoring systems in contravention of their duty of care or regulatory requirements, or (2) failing to use the monitoring systems in place, demonstrating a “conscious disregard for one’s responsibilities” by “non-compliance with applicable legal standards.” Plaintiffs in each of the five successful cases survived a motion to dismiss because they were able to leverage federal and state agency fact-finding regarding agency imposition of fines and penalties, investigations, or enforcement actions, and final rules or adjudications to support their state law fiduciary duty claims. This means plaintiffs who can rely on proven violations of federal regulatory and oversight requirements could use those violations to show bad faith per se to automatically establish a prima facie claim under either Caremark prong to overcome the dreaded motion to dismiss.
In a recent article, Federalizing Caremark, UCLA Law Review (forthcoming 2023), my co-author Carliss Chatman and I propose that Delaware formally adopt this approach to Caremark claims to effectively federalize Caremark. Government already tries to protect shareholders from being taken advantage of by passing laws and regulations about standards, disclosures, and duties and by forming agencies to enforce them. Formalizing plaintiffs’ ability to rely on known violations to bolster Caremark claims and recover for breaches of duty logically extends and supplements government efforts to protect and enforce by empowering those harmed to recover from the very actors who prompted government protection and enforcement in the first place. This approach would go a long way in remedying failed government attempts at ensuring corporate oversight through market-based compliance schemes by giving shareholder litigation the teeth needed for such schemes to be effective. However, our proposal is not without criticism. The first main critique questions whether our proposal violates basic principles of federalism by conflating federal and state roles in regulating business. A second critique questions whether violations result in any actual harm to the company that commits them. A third critique questions whether our proposal would discourage quality directors from serving on boards.
Under our system of federalism, federal and state governments have differing, but symbiotic, roles and powers. It would be inappropriate, if not outright unconstitutional, to propose conflating those roles, and we have taken care to avoid doing so. Our proposal to federalize Caremark strengthens our system of federalism by identifying and addressing harmful governance gaps, not overlaps, that developed over time as federal and state authorities tried to address various social and economic pressures.
The federal role in corporate governance and regulation is limited by Congress’ ability to only pass statutes allowed by its enumerated powers. Nevertheless, bills seeking to create federal charters or establish federal governance norms occurred as early as 1903, and Senator Elizabeth Warren introduced legislation to that effect as recently as 2018, but none ever became law. States, on the other hand, have authority over the formation and structure of corporations within their borders, and, under the internal affairs doctrine, have the power to regulate almost anything about them, including determining the fiduciary duties of corporate directors. Accordingly, state courts handle claims against directors, while federal claims are brought against the company itself.
Congress will probably not take over corporate governance wholesale, but it remains ready and able to influence it when emergencies prompt it to. This influence usually manifests as regulatory disclosure or oversight requirements. For example, the Great Depression prompted the passage of the two landmark acts, the Securities Act of 1933 and the Security Exchange Act of 1934, which required disclosures as part of an effort to tackle corporate fraud and manipulation. The Enron and Worldcom scandals and the 2008 housing crash, which prompted the Sarbanes-Oxley and Dodd-Frank Acts, respectively, further illustrate the permanence of corporate malfeasance, market disasters, and reactive, ineffective federal legislation.
Despite these examples, Congress does not always influence corporate governance through disclosure or oversight requirements, and it is often quite unsympathetic to shareholders in general. Congress passed the Private Securities Litigation Reform Act of 1995 (PSLRA) in response to corporate complaints about attorneys bringing frivolous suits attempting to recover for negative shifts in stock prices. Attorneys did not care about proving fraud or manipulation or obtaining remedies for investors because the goal was to obtain attorney’s fees by taking advantage of the will to settle. Subsequent PSLRA reforms required heightened pleading standards, allegations which supported strong inferences of fraudulent intent, an automatic stay of discovery upon the filing of a motion to dismiss, lead plaintiff provisions, and a statutory safe harbor for forward-looking statements.
All of these federal legislative efforts have resulted in a lot of regulations and mountains of disclosure information but impotent shareholders. Shareholders could be harmed by conflicts of interest and self-dealing, but if the misconduct does not amount to insider trading, then they must try their luck in state courts. The same is true with malfeasance. The conduct could be a breach of state law fiduciary duties, but if it does not meet the heightened standards for misrepresentation or other securities violations then the shareholder must go to state court. Assuming shareholders actually pursue their claim in the Chancery Court of Delaware, they still have to overcome Caremark.
Federalizing Caremark can resolve all of these issues. No new law needs to be passed because as long as plaintiffs rely on agency-generated evidence showing the corporation has knowingly violated laws and regulations about oversight and disclosures, then they would be relying on the sort of negative information corporations cannot hide. No new agency needs to be formed because the agencies that already exist already generate the evidence plaintiffs ought to rely on by performing their normal investigatory and enforcement functions. No new right of action has to be recognized because state courts already recognize that directors should be liable if they breach their fiduciary duties. Law-abiding companies need not fear frivolous lawsuits because the Caremark standard and all the controlling laws can remain unchanged. But empowering shareholders to bring meritorious claims against breaches of duty goes further than correcting a deficiency in the justice system, it takes steps toward eliminating market inefficiencies caused by the governance gap.
Shareholder derivative suits function in the interstice between market mechanisms and social goals. As the number of federal or state regulations increase, the cost of ensuring compliance also goes up. The corporation is not going to pay for the price increase because it must maximize its shareholders’ profits, so the cost is often passed on to consumers. Over time, legal compliance becomes a simple cost-benefit analysis—if it is cheaper to break the law than to obey it, then businesses will break the law to either keep prices low to attract consumers or to maximize profits for its shareholders. Thus, the bureaucratic-market spiral begins: more regulations inevitably lead to more violations, which lead to more enforcement actions and penalties, which then raises the cost of compliance, which incentivizes yet more violations. Furthermore, if a corporation is breaking the law, then neither the director nor the corporation has a strong incentive to say so to shareholders. But federal and state governments, by and through agencies and courts, do have the power to discover violations pursuant to their enforcement and investigative powers.
Thus, federalizing Caremark has the potential to improve market efficiency by decreasing the amount of government regulation and enforcement necessary by removing the profit benefit of breaking laws. If shareholders who have the greatest incentive for both profit and compliance, rather than governmental entities, are empowered and incentivized to enforce regulatory compliance, then corporations have no incentive to break the law, and the cycle can be broken. Agency actions already create agency records; all shareholders would need to do is append those records to their Caremark suits when they file them in state courts.
The second critique of our proposal questions these assertions about improved market efficiency by asking whether the shareholders of corporations which violate federal law actually suffer any harm. After all, if the company did indeed profit from breaking the law or violations were perpetrated by directors trying to increase profits, then even if they broke the law, directors could not have breached any fiduciary duty to shareholders and should not be subject to Caremark claims. How can shareholders successfully allege a harm if the illegal conduct at issue benefitted their bottom line?
However, simple legal obedience is the cornerstone of all corporate law, and any legal arguments about the profitability of breaking laws should be dismissed as an untenable contradiction of terms. Section 101(b) of the Delaware General Corporation Law states: “A corporation may be incorporated or organized under this chapter to conduct or promote any lawful businesses or purposes, except as may otherwise be provided by the Constitution or the law of this State.” Furthermore, “a fiduciary may not choose to manage an entity in an illegal fashion, even if the fiduciary believes that the illegal activity will result in profits for the entity.” Federalizing Caremark would fully conform with these basic legal principles.
Assuming, arguendo, that fiduciaries could permissibly profit from breaking the law, this argument would be almost entirely restricted to the sort of frivolous or conclusory shareholder claims that would not be able to rely on the substantiating agency evidence our proposal emphasizes. Such allegations are specious not because some unknowable wrongful behavior may have benefited the corporation at some point, but because there would be no evidence of financial loss due to agencies inflicting financial penalties or fines on the corporation for known violations. If they are to succeed in the current environment, derivative Caremark claims should be brought only after investigations are completed or fines and penalties have been levied.
This critique also amounts to gambling with shareholder investments. Repeatedly breaking the law will, at some point, result in an investigation and enforcement actions. At that time, the company will be penalized as a repeat offender and the costs associated with those criminal acts will pile up. It is incumbent upon the fiduciary to maintain a level of transparency with the shareholder and that includes informing them of the risks being taken with their investments.
However, quality directors recognize the usefulness of monitoring systems, the insurance that regulations can provide, and the value of a good name. In the grand scheme of things, very few directors or companies are actively trying to break the law for profit. Minor violations routinely occur, are reported, and get investigated with little to no problem every day. Scandals like Enron, WorldCom, or even Theranos, while impactful when they occur, are rare. The contention that federalizing Caremark would discourage quality directors from serving on boards, impliedly leading to an increase of unscrupulous ones, is unrealistic.
Part of surviving a motion to dismiss involves rebutting the business judgment rule, which is the judicial presumption that directors act in compliance with their fiduciary duties when making business decisions. This rule emerged to alleviate the tension between observing the duty of care and assuming some risk to enable a corporation to make a profit. The business judgment rule prevents courts from holding directors liable merely because the directors made a decision the court would not have.
A plaintiff can rebut this presumption by presenting evidence that the directors were at least grossly negligent in not becoming adequately informed, were not acting in the best interest of the company, or were acting in bad faith. Delaware’s Section 102(b)(7) carves out liability for breaches of duty of care, as proven by gross negligence, therefore, in practice, plaintiffs must demonstrate bad faith by relying on breaches of duty of loyalty or good faith.
In In re the Walt Disney Company Derivative Litigation, the Chancery Court paused mid-decision to delineate three categories of action sometimes called “bad faith.” The first category, “subjective bad faith,” is “fiduciary conducted by an actual intent to do harm.” The second category involves gross negligence, related to the duty to take due care, which includes “a failure to inform one’s self of available facts.” According to the court, this did not constitute true bad faith, so long as gross negligence had no “malevolent intent.” The third category of bad faith, the one most relevant to our discussion, is the “intentional dereliction of duty, a conscious disregard for one’s responsibilities.”
The reason good, law-abiding directors need not fear our proposal, and why contentions to the contrary are without merit, is that they are still adequately protected by the business judgment rule. Caremark’s two prongs cannot be satisfied, plaintiffs cannot proceed, and directors cannot be held liable unless the business judgment is rebutted, and so long as directors do not take any actions which would be considered “bad faith” under category one or three, they have nothing to fear. Our proposal would not undermine the traditional understanding of the business judgment rule allowing businesses to take risks and make good faith decisions that ultimately lose their shareholders money. Therefore, our proposal only enables shareholders to recover from directors who act with “actual intent to do harm” or are intentionally disregard their duties (e.g., flouting the law for profit) at the expense of their shareholders. The business judgment rule would continue to afford directors acting in good faith the same amount of protection it always has.
Presently, a symbiotic relationship exists between Delaware and federal administrative agencies that, if acknowledged, could provide shareholders and stakeholders with the tools they need to address harms caused by corporate governance failures. Federalizing Caremark is one step towards strengthening this relationship. Providing adequate protection to shareholders, the capital markets, and all stakeholders requires action at both the state and federal level. Delaware should allow shareholders’ Caremark claims to survive a motion to dismiss any time there are facts from agency actions. And, if shareholders are relying on these findings, agencies must be given the tools they need to properly monitor the industries they oversee.
The mere existence of Caremark has already brought about changes in corporate behavior. Boards are now advised to avoid truncating the oversight process by merely listing risks, to delineate roles of the full board and standing committees, to allow time on the board agenda for risk oversight, to set risk escalation and monitoring protocols, to pay attention to company culture, and to maintain minutes concerning critical risk matters. As a first line of defense, we should work more towards normalizing good governance in these ways. In those instances where compliance fails, however, we should be prepared to let good shareholder derivative suits go forward.
Carliss Chatman is an Associate Professor of Law at the Washington and Lee University School of Law.
Tammi Etheridge is an Assistant Professor of Law at Elon University School of Law.
This post is adapted from her paper, “Federalizing Caremark,” available on SSRN.