April 30, 2011

Director Liability, the Duty of Oversight, and the Need to Investigate

Jeremy S. Piccini

To satisfy a corporate board's duty to investigate, utilizing outside counsel may be the best option.

In today's turbulent economy, corporations are faced with a number of challenges beyond the threat of decreased stock value and the inability to cover monthly expenses. Recent corporate scandals, affecting the likes of Enron and Goldman Sachs, demonstrate that companies are often tempted to misrepresent and deceive in order to stay profitable. Acknowledging the trend of corporate fraud, Congress approved of the Sarbanes-Oxley Act of 2002 (SOX) and recently began to enact other regulatory schemes to prohibit such corporate fraud and provide for greater oversight. After SOX, however, the financial crisis beginning in 2007 further revealed the need for improved corporate regulations. Most recently, on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act came into effect in the United States. One of its main objectives is to increase transparency and improve accountability in the corporate financial world. Aimed at preventing a repeat of the financial crisis and its various causes, the Dodd-Frank Act again demonstrates the need for corporate monitoring. Although many laws and regulations pertaining to oversight only apply to publicly held companies, such changes highlight Congressional and public awareness of the increasing potential for corporate fraud, the need for an independent counsel, and the importance of the corporate duty of oversight.

In reaction to such corporate scandals and regulatory actions, corporate boards are being held accountable for the failure to adequately oversee an institution's compliance function. For background purposes, a corporate board of directors is primarily responsible for overseeing the company, and in exercising these responsibilities, directors are charged with the fiduciary duties of care and loyalty. The duty of care mandates that a director act in good faith and use the degree of care that an ordinary person would exercise in a similar situation. The business judgment rule protects directors' decisions as long as the decision is informed, made in good faith, and with the honest belief that the action taken is in the company's best interest.

Director Oversight Liability

Director oversight liability is based on the concept of good faith. As a general matter, "a director's obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances, may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards." In re Caremark International, Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). Put differently, directors may be at "risk if they fail to reasonably oversee the organization's compliance program or act as mere passive recipients of information." (See The Office of Inspector General of the U.S. Department of Health and Human Services and the American Health Lawyers Association, Corporate Responsibility and Corporate Compliance: A Resource for Healthcare Board of Directors.) "A director has a duty to attempt in good faith to assure that (1) a corporate information and reporting system exists, and (2) this reporting system is adequate to assure the board that appropriate information as to compliance with applicable laws will come to its attention in a timely manner as a matter of ordinary operations." When a red flag or warning sign appears, this duty of care requires reasonable investigation and diligence. Accordingly, the board should be trained so that it is equipped to identify red flags and actively oversee the compliance program.

Thus, a corporate director is subject to liability when he (1) utterly fails to implement any reporting or information system or controls, or (2) having implemented such a system or controls, the director consciously fails to monitor or oversee its operations, rendering the corporation unable to recognize and address risks or problems. These bases of director liability are addressed in recent cases on the topic.

Case Law

Two Delaware Supreme Court decisions provide the necessary steps a corporation should take in order to avoid director oversight liability. In re Caremark International, Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), established the need for a corporate program identifying potential wrongdoings in order to exercise the director's duty of oversight. Under the court's ruling, a corporate board cannot escape liability for monitoring issues if they have not implemented a program to detect violations, meaning that directors should not only have procedures to address possible or actual problems that may arise but to identify them as well. This safeguard would ensure that the potential issue is halted or ameliorated, and should also prevent a reoccurrence.

Stone v. Ritter , 911 A.2d 362 (Del. 2006), confirms the oversight standard of Caremark, adding that directors must exercise "good faith" in dealing with potential or actual violations of the law or corporate policy. At a minimum, when directors have actual knowledge of illegal or improper conduct or have knowledge of facts that should put the director on notice of such conduct, the directors must take good faith steps to remedy the problem. This includes measures aimed at preventing reoccurrence, as well as steps to stop the problem from materializing or progressing. Directors should also consider modifying their oversight programs to better address and enforce compliance issues such as those mentioned in this article and in the relevant cases.

There are various ways for a director to be considered on notice of possible wrongdoing. Whistle-blower calls, letters or public notice, public suspicion, consumer complaints, numerous and related civil litigation claims, and red flags discovered by a compliance program all adequately alert directors that something may be awry within the company. When there is actual knowledge, or there are blatant signs of wrongdoing, a director will be held liable for willfully ignoring or otherwise failing to investigate. Inaction, and failure to address such signs in good faith, may constitute grounds for director oversight liability.

In summary, a director may breach the duty of oversight by failing to implement a monitoring or compliance program, failing to oversee the program's operation and periodically reassess its effectiveness, or failing to investigate possible violations once the director is on notice.

Business Judgment Rule v. Duty of Oversight

It is important to reconcile the business judgment rule with the duty of oversight. The business judgment rule protects a director's informed and good faith decision. If directors are alerted to a potential violation of the law or corporate policy, and after proper internal investigation, the board determines in good faith that further action is not necessary, that decision is protected by the business judgment rule. In the above scenario there is an informed and conscious process, and as long as directors carry out the process in good faith, they likely have the protection of the business judgment rule. If, however, the board is alerted to a possible wrongdoing and fails to address the situation or consciously disregards it, there is no process and therefore the business judgment rule protection will not apply to protect the directors. The directors may instead face liability for failure to oversee and monitor. Accordingly, it appears that the duty of oversight may create a perceived incentive for directors to respond to potential indications of wrongdoing in order to gain the benefit of the business judgment rule.

The Investigation

Responses or investigations to these signs of possible violations can be carried out through in-house counsel or a company compliance department at the direction of the board or the board's independent audit committee or other investigative committee; however, such responses and investigations are best dealt with through consultation with independent, outside counsel. Internal employees are often ill-equipped to take on a crucial investigation because of time constraints and large work-loads. In-house counsel do not have unlimited time to devote to conducting investigations and instead are typically focused on managing transactions, litigation/pre-litigation matters, and managing the risks of the business while attempting to insert their own processes to streamline legal and business efficiencies. Due to these time constraints and lack of independence, it is possible that investigations may be compromised or not given the attention necessary for the directors to escape liability. However, if an investigation is determined to be for a claim relating to relatively small levels of liability or other minor compliance issues, it may be best conducted by in-house counsel for efficiency purposes, unless or until such matter unraveled into a more complex scenario.

The company and board of directors must balance benefits of control over the investigation with the need for the investigator to be independent in fact and appearance. While internal compliance or legal personnel may understand the business of the company better than outside counsel and may be more in-line with values and goals of the company executives or directors in charge of such investigation, utilizing internal employees may give the appearance that the investigation was conducted in a biased manner. Outside counsel would have a better chance of achieving a view of credibility and objectivity, would have fewer qualms with approaching management on an issue, and the matter would be perceived as taken more seriously by the company in the view of investors, government regulators or prosecutors, and the media. Furthermore, outside counsel may have more resources to devote to the investigation, the company would be better protected from potential wrong-doers being involved in the investigation, and outside counsel may better protect the attorney-client privilege by more aptly avoiding such advice or work-product being categorized as business advice (issues have arisen with the attorney-client privilege and work-product protection when investigations are conducted by in-house counsel or other employees of the subject company).

In addition, the company must also determine whether its regular outside counsel firm or special counsel should be utilized on such a matter. Regular counsel may be "tainted" in the sense that such a firm is closer to the business management team and may have more vested in the matter, whereas appointing special outside counsel would strengthen the credibility of the company while decreasing any appearance of a conflict of interest and providing a special level of expertise.

In situations where corporations have used internal in-house counsel or investigators, a court may look less favorably on the application of the business judgment rule and corporate settlements. An independent corporate investigation demonstrates that the company is taking the possible violation seriously, and also ensures that the subsequent report and findings will be unbiased and accurate. Company personnel can potentially compromise the legitimacy and validity of any investigation because they are employed by the corporation. A relatively small initial investment in outside counsel can prevent colossal damage to a company in the future.

Utilizing Outside Counsel

In looking to outside counsel, it is important to consider a firm that has experience in internal audits and investigations. In addition to conducting investigations, the firm should also be able to counsel a corporation if a problem has already materialized. In such a transition from pre-litigation to litigation, a company that has already conducted an independent investigation by outside counsel would be better prepared in assessing the risk and liability of such claims and would be able to build its defense at an early stage. This is imperative to limit further liability and to maintain the corporation's current value and public image.


Directors should always keep in mind the possibility of oversight liability. While it is certainly not expected or demanded that directors be able to predict the future, directors still must implement compliance and monitoring programs within the corporation. Moreover, once implemented, directors must oversee such programs and look into possible law or corporate policy violations to which they are alerted. In the event that there is an impending violation, directors must, reasonably and in good faith, stop the wrongdoing from progressing. If a violation has already occurred, directors must fix the wrongdoing and add preventative measures to avoid reoccurrence. Although these steps are seemingly simple, it can be quite easy for a director to slip up and subsequently face liability. By retaining an outside firm to serve as independent counsel to aide in investigating allegations of wrong-doing, implementation, or oversight of programs, as well as to assist in damage control following an apparent violation, a board of directors further limits potential oversight liability for themselves and greater liability for the company. In adhering to these guidelines, directors invest the time and money that ultimately benefit not only them individually, but the entire corporation.

By investigating potential claims of fraud or other liability, directors may be best served by utilizing outside counsel to investigate and document the process and findings.

Jeremy S. Piccini

Jeremy S. Piccini is a partner with Bertone Piccini LLP in Hasbrouck Heights, New Jersey.