I. Caremark : Dangerous at Any Speed
Chancellor Allen took advantage of the procedural posture of the Caremark case to write an opinion comprised almost entirely of dicta—in effect, a glorified law review article—on director duties. Despite that suspect origin, the Caremark dicta—at least at first blush—strikes many as a sensible rule. After all, directors long had had “a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them.” Courts outside of Delaware long had required “directors to keep themselves informed about the conduct of the business.” Accordingly, directors could not “shut their eyes to corporate misconduct and then claim that . . . they did not have a duty to look.”
Some argue that all Chancellor Allen did was to extend that existing obligation to include a more proactive duty of oversight of the corporation’s compliance with pertinent laws and regulations. Chancellor Allen began by distinguishing between cases in which a shareholder challenges a board decision and those in which a shareholder alleges “an unconsidered failure of the board to act.” If the necessary preconditions are satisfied, the former typically will be protected by the business judgment rule. The business judgment rule, however, does not apply to cases involving lapses of oversight by the board or other cases involving board inaction.
Allen thus concluded that boards have “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.” He conceded that the design of the necessary system “is a question of business judgment,” which presumably meant Allen expected board decisions about designing such systems would be protected by the business judgment rule. He further conceded that not even the best such system could ensure 100 percent compliance, so that directors would not be liable simply because the corporation violated the law. Even with those caveats, however, Chancellor Allen concluded that directors must ensure “that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation's compliance with law and its business performance.”
Chancellor Allen justified his conclusion by pointing to three policy considerations. First, many recent Delaware decisions laid renewed emphasis on the importance of the board’s corporate governance role. Second, boards have an oversight function that requires access to relevant information. Third, the federal sentencing guidelines provided significant sentence reductions for companies that had effective law compliance programs in place.
Chancellor Allen, however, cited no directly pertinent precedent supporting his asserted duty. This failure is not particularly surprising, because the law in Delaware at the time was clearly to the contrary. The key precedent was Graham v. Allis-Chalmers Manufacturing Co. In 1937, Allis-Chalmers entered into two consent decrees with the FTC in connection with alleged antitrust violations. In 1959, a federal investigation began into alleged illegal price fixing by mid-level employees. The incumbent directors were cleared of any involvement. Nevertheless, a shareholder sued the board of directors for having failed to install a law compliance program to prevent antitrust violations. Because plaintiff ’s claim was based on an alleged failure to act, the business judgment rule did not apply, and the Delaware Supreme Court proceeded to determine whether the directors had satisfied their duty of care.
Plaintiffs alleged that the defendant directors should be held personally liable to the corporation for the criminal fines paid by Allis-Chalmers, potential judgments in civil suits brought by allegedly injured private parties, and general harm to the company’s business reputation. On appeal from the Chancery Court’s dismissal of the complaint, plaintiffs argued that Allis-Chalmers’ board members were “liable as a matter of law by reason of their failure to take action designed to learn of and prevent anti-trust activity on the part of any employees of Allis-Chalmers.” The Delaware Supreme Court rejected that argument, holding that:
The precise charge made against these director defendants is that, even though they had no knowledge of any suspicion of wrongdoing on the part of the company's employees, they still should have put into effect a system of watchfulness which would have brought such misconduct to their attention in ample time to have brought it to an end. However, . . . it appears that directors are entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on suspicion that something is wrong. If such occurs and goes unheeded, then liability of the directors might well follow, but absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.
The court further opined that “we know of no rule of law which requires a corporate director to assume, with no justification whatsoever, that all corporate employees are incipient law violators who, but for a tight checkrein, will give free vent to their unlawful propensities.”
In light of Graham, Caremark should have been a very easy case. There was no evidence that Caremark’s directors knew about alleged violations and, moreover, the board had undertaken reasonable—albeit allegedly unsuccessful—efforts to ensure that the company complied with the relevant laws and regulations. Allen’s goal was not to apply existing law, however; it was to use the unique opportunity presented by the factual posture of the case “to expand directors' oversight duties beyond the limits of the Delaware Supreme Court's opinion in Allis-Chalmers.” In effect, Allen intended to de facto overrule Graham.
The difficulty, of course, is that “a foundational principle of the American judicial system,” the binding precedent rule, holds that “when a higher court has already decided an issue, a lower court has no discretion to ignore that precedent.” Allen therefore had to reinterpret Graham. He asserted Graham could be “narrowly interpreted as standing for the proposition that, absent grounds to suspect deception, neither corporate boards nor senior officers can be charged with wrongdoing simply for assuming the integrity of employees and the honesty of their dealings on the company's behalf.” But that interpretation cannot be reconciled with Graham’s clear statement that, “absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.”
Allen’s other move was to claim that the Delaware “Supreme Court's statement in Graham concerning ‘espionage’” needed to be rethought in light of the various subsequent legal developments enhancing the board’s duty to be informed. There are three problems with that move. First, there is no doubt that Allen’s opinion departed “from the usual trend in the court of chancery of affording substantial deference to corporate directors.” In doing so, Allen “stretched directors' obligations under the duty of care” significantly beyond that duty’s existing bounds. The result was “a significant expansion of directors' duties.”
Second, courts had applied Graham routinely as recently as the year prior to Caremark, suggesting that time had not eroded Graham’s standing. In 1995, for example, Delaware Vice Chancellor Balick had dismissed a plaintiff ’s complaint because the plaintiff ’s claims were “inconsistent with Graham.” In 1993, the U.S. District Court for the Southern District of Texas cited Graham for the law governing the directors’ duty of oversight.
Third, and most important, Allen ignored the policy concerns that justified the Graham standard. In earlier work coauthored with UCLA School of Law alumni Star Lopez and Benjamin Oklan, I pointed out the “interesting analogy between Graham and the well-known aphorism ‘every dog gets one bite.’” At common law, a dog owner could only be held liable to someone the dog had bitten if the owner was aware that the dog had vicious propensities. In general, the rule required either that the dog previously had bitten someone (the proverbial first free bite) or the owner was otherwise on notice of the dog’s vicious disposition.
The analogy to cases like Graham should be readily apparent. Just as a dog's master is not liable unless the master knew ex ante that the dog has a propensity to bite, directors are liable under Graham only if they are on notice that firm employees have a propensity for misconduct. Just as a prior bite puts a dog's master on such notice, prior criminal violations or breaches of fiduciary duty can put directors on notice. Just as masters have an affirmative duty to control dogs of an inherently vicious breed, moreover, directors will be held liable when they recklessly fail to monitor an obviously untrustworthy employee.
The rationale behind the one free bite rule was that a rule imposing liability regardless of whether the owner was on notice of the dog’s propensity to bite would require the owner to take costly precautions in the form of fencing, insurance, and other interventions.
As with the dog bite rule, there is a strong cost-benefit justification for Graham. Compliance programs are expensive. Programs with real teeth require substantial high-level commitment and review, frequent and meaningful communication to employees, serious monitoring and auditing, and appropriate discipline when violations are discovered. By analogy to the one-bite rule, one thus would expect a firm to take such precautions only when the board of directors is on notice of a past violation.
Allen simply ignored these countervailing considerations, as have Caremark’s progeny, even though those considerations call into question the entire project. Because a board's exercise of its oversight function so often falls outside the business judgment rule, most of what directors actually do potentially became subject to second-guessing by courts. By raising the costs mandated by Caremark, extending that duty to ESG factors would significantly compound that original error.
II. Guttman and Stone Compound the Error
The Caremark plaintiffs framed their claims as sounding in the defendants’ duty of care. Chancellor Allen’s observation that “questions of waiver of liability under certificate provisions authorized by 8 Del. C. § 102(b)(7) may also be faced” confirms that the duty in question was the duty of care, because duty of loyalty claims are not exculpable under section 102(b)(7). Not surprisingly, contemporaneous commentators understood Caremark to be a care case.
In his 2003 Guttman v. Huang opinion, however, then Vice Chancellor Leo Strine asserted that by “its plain and intentional terms, the [Caremark] opinion . . . requires a showing that the directors breached their duty of loyalty by failing to attend to their duties in good faith.” As we have seen, the Caremark decision did no such thing and Strine failed to cite any other authority supporting situating Caremark in the duty of loyalty. Accordingly, Guttman aptly has been described as “a dramatic departure from precedent.”
Some might argue that by situating the Caremark duty within the good-faith obligation rather than the duty of care Strine insulated directors from liability. Instead of facing liability merely for being grossly negligent (the due care standard), directors would only face liability if they acted with the intentionality required by the good-faith obligation. As Strine himself argued:
For reasons Caremark well-explained, to hold directors liable for a failure in monitoring, the directors have to have acted with a state of mind consistent with a conscious decision to breach their duty of care. Caremark itself encouraged directors to act with reasonable diligence, but plainly held that director liability for failure to monitor required a finding that the directors acted with the state of mind traditionally used to define the mindset of a disloyal director—bad faith—because their indolence was so persistent that it could not be ascribed to anything other than a knowing decision not to even try to make sure the corporation's officers had developed and were implementing a prudent approach to ensuring law compliance.
In addition, recharacterizing the Caremark standard as good faith rather than care effectively precluded boards from engaging in cost-benefit analyses.
In Stone v. Ritter, the Delaware Supreme Court nevertheless cited Guttman approvingly while holding that Caremark liability arises under the duty of loyalty. The court explained that directors can be held liable when they “utterly failed to implement any reporting or information system or controls” or, having created such a system, they “consciously failed” to exercise oversight through that system. Both prongs thus adopt “a scienter-based standard.” Accordingly, “to establish oversight liability a plaintiff must show that the directors knew they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities such as by failing to act in the face of a known duty to act.”
Although the Stone court endorsed Chancellor Allen’s prediction that Caremark is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment,” the court’s recharacterization of the pertinent fiduciary duty exacerbated the original Caremark error in several unfortunate ways. First, it confirmed that Caremark claims are non-exculpable, eliminating an important protection for directors. Second, it also meant that Caremark claims are non-indemnifiable. Third, loyalty claims are concerned with issues of fairness, but oversight failures are about errors of judgment. Likewise, the remedies associated with loyalty are designed to ensure that the disloyal fiduciary retains neither their ill-gotten gains nor the tainted fruits thereof, but oversight cases do not involve the sort of ill-gotten gains one finds in, for example, conflicted interest transactions or corporate opportunities. Finally, Stone created a risk that directors can be held liable for conduct falling short of what previously had been regarded as aspirational best practice rather than legal mandates. This concern is particularly pertinent for present purposes, because ESG issues at present are mostly aspirational.
III. “Once Is Happenstance. Twice Is Coincidence. The Third Time It’s Enemy Action”
There was considerable debate as to whether Stone expanded or contracted the risk of director liability for oversight failures. In the last few years, there has been a series of cases that are generally agreed to have significantly increased that risk. In particular, although Delaware courts in the past “routinely dismissed Caremark claims at the motion to dismiss stage, even in the face of substantial ‘corporate traumas,’” a significant number of recent cases have survived the pleading stage.
The trend began in Marchand v. Barnhill. Shareholders of Blue Bell Creameries USA, Inc., a major ice cream manufacturer, brought Caremark claims against Blue Bell’s board after listeria—a bacterium capable of causing a potentially fatal food borne illness—contaminated the company’s manufacturing facilities and, as a result, its products. Three people died from eating contaminated ice cream and many were struck ill. The Delaware Supreme Court held that “the complaint alleges particularized facts that support a reasonable inference that the Blue Bell board failed to implement any system to monitor Blue Bell’s food safety performance or compliance.” Accordingly, the court reversed the Court of Chancery’s decision to dismiss the suit for failure to plead demand futility.
The court emphasized several factors that distinguished Marchand from the run of the mill Caremark case. Blue Bell was a monoline company, which made it especially vulnerable to product safety concerns. Food safety is a heavily regulated industry, which made compliance “essential and mission critical.” But the board “had no committee overseeing food safety, no full board-level process to address food safety issues, and no protocol by which the board was expected to be advised of food safety reports and developments.”
Marchand was the opening act in a trilogy of 2019 cases that collectively “heighten[ed] directors’ compliance oversight duties,” at least “where regulatory compliance relates to core features of the company’s business.” In Hughes v. Hu, the Chancery Court held that demand should be excused because the directors faced a substantial risk of personal liability for alleged Caremark violations. The company had publicly acknowledged persistent problems with its internal controls, but “the Audit Committee met sporadically, devoted inadequate time to its work, had clear notice of irregularities, and consciously turned a blind eye to their continuation.” Although the corporation “had the trappings of oversight, including an Audit Committee, a Chief Financial Officer, an internal audit department, a code of ethics, and an independent auditor,” the pleadings suggested that the board had never established any board-level monitoring and reporting systems. The court thus echoed Marchand in mandating active oversight at the board level.
Marchand’s emphasis on board oversight of mission critical business lines was highlighted in the other case of the trilogy, In re Clovis Oncology, Inc. Derivative Litigation. Clovis was a monoline biopharmaceutical company whose prospects rested mainly on the fortunes of one anti-cancer drug, which was then undergoing FDA-regulated clinical trials. Citing Marchand’s highlighting of “the importance of the board's oversight function when the company is operating in the midst of ‘mission critical’ regulatory compliance risk,” the court concluded that while the board had established monitoring and reporting systems the board had failed adequately to supervise them.”
Various explanations have been offered for these cases. All of the cases involved effective use of shareholder inspection rights under DGCL section 220 to develop the sort of detailed allegations necessary for a complaint to survive a motion to dismiss. Most involved failures of board oversight of mission critical risks in areas that posed significant risk of harm to the public, such as food and drug safety. As such, some commentators contend it is too soon to tell whether Marchand and its progeny mark a change in the law or simply reflected unusually egregious facts in unique settings. Nevertheless, as Goldfinger advised James Bond, when the same thing happens at least three times, it raises suspicions that one is observing a trend. Not surprisingly, cautious commentators are encouraging boards to respond to the trilogy by taking additional precautions to ensure they are fully Caremark compliant.
At a minimum, the recent Caremark duty decisions represent developments about which boards must be aware and that boards must consider in shaping both their agendas and their processes. Not only must boards establish monitoring mechanisms, particularly with respect to mission critical operations, but they must also be able to show that they were monitoring the mechanisms and responding to red flags and other alerts. All of these new points of emphasis carry their own need for improved documentation. The overall indication is toward a more active and attentive board.
IV. Caremark and Social Justice Make Odd Bedfellows
As a vehicle for achieving social justice, Caremark is an odd and almost wholly unsuitable choice. Caremark claims almost universally must be brought derivatively. In successful derivative suits, any recovery goes to the corporate treasury rather than into the shareholders’ pockets. As a result, the same directors whose oversight errors gave rise to liability in the first instance may well end up deciding how to spend that recovery, minus legal fees and other transaction costs. Because of directors’ indemnification rights and insurance, moreover, monetary judgments and settlements are often paid by the corporation itself.
The problem is compounded by the inherently dysfunctional nature of derivative litigation. In derivative suits, the real party in interest is neither the nominal named shareholder nor the shareholders in general, but rather the plaintiff ’s counsel. Counsel’s interests often will be inconsistent with those of the company’s shareholders (and, for that matter, stakeholders). For example, “lawyers may find it in their interest to assert frivolous claims entirely for their settlement value (the familiar ‘strike suit’).” Conversely, both plaintiff counsel and defendants have incentives to settle meritorious litigation too cheaply. In Caremark itself, for example, Chancellor Allen concluded that the agreed settlement provided the corporations and its shareholders with “very modest benefits.” Given this reality, it is difficult to imagine that extending Caremark to oversight of ESG risks would result in significant corporate action on issues such as climate change or workforce diversity.
V. Expanding Caremark to ESG Oversight Would Compound the Original Error
Caremark negatively impacted corporate governance in two major respects, both of which would be exacerbated if Caremark is extended to encompass ESG risks. First, it increased directors’ liability exposure. Second, Caremark limited board discretion by mandating oversight regardless of whether the benefits outweighed the costs. Yet another negative impact will result from mandating board oversight of ESG risks, because doing so would work a significant change in the Delaware law governing corporate purpose.
A. Increasing the Risk of Liability
Until recently, the actual risk of Caremark was slight. The risk as perceived by board members, however, was significant. While it remains debatable whether Marchand and its progeny have substantially increased the actual risk directors will face Caremark liability, there seems little doubt that they have substantially increased the perceived risk.
High levels of perceived risk on the part of current or potential board members have undesirable consequences. Among other things, it can reduce their willingness to serve or make them overly cautious and risk averse. Extending Caremark to ESG risk oversight would exacerbate these concerns.
A core problem is that ESG oversight is difficult and beyond the skill set of typical corporate boards. Directors must be knowledgeable about the corporation’s business. In light of Marchand, they now must be especially knowledgeable and actively engaged in supervising mission critical aspects of that business. Mandating that directors also take legal responsibility for oversight of ESG issues would require boards to develop expertise in such areas as cybersecurity, diversity, information technology, and even pandemic responses. It is difficult to imagine a manageably sized board that would have expertise in the full panoply of ESG issues.
Worse yet, a board often will be unable to predict what expertise it needs. In the case of regulatory compliance, there is an objective measure of what commands the firm must obey—only those commands promulgated by the appropriate government body are “law.” In the case of aspirational commands, there is no such objective standard to tell us which aspirations are the correct ones. While there may be general agreement on what constitutes an ESG risk, such as the impact of climate change, at the margins there is far less certainty. To paraphrase an observation by SEC Commissioner Hester Pierce about the difficulty of drafting ESG disclosure rules, “figuring out how to deal with ESG from a [Caremark] standpoint is complicated by the great and growing number of unrelated (and incommensurable) items it encompasses.” It is further complicated, “because people do not share uniform views of what good ESG practices are for issuers.” Suppose, for example, that Friends of the Earth and the NRDC have different opinions about which of two environmental hazards is greater. Which one should the board prioritize? How does the board decide?
Proponents of a broader understanding of Caremark that encompasses ESG issues might argue that boards are simply expected to supervise the company’s performance in these areas not to actually manage them. The difficulty with that argument is that exercising the power to review someone else’s decisions is the functional equivalent of making those decisions. As Nobel laureate economist Kenneth Arrow observed: “If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B . . . .” In that case, B needs much the same set of knowledge and skills as possessed by A. Not surprisingly, SEC Commissioner Lee has suggested that boards need additional expertise with respect to ESG risks.
Compounding the problem is the potential for extending Caremark to include oversight of ESG risks will clash not only with shareholder wealth maximization but also with the interests of stakeholders by bringing the latter into conflict with each other.
For example, employee constituents might prefer to focus on cleaner supply chains over moving toward renewable energy development, to avoid incurring substantial costs that might drive the company to liquidation, whereas the community constituents might prefer reducing greenhouse gas emissions for cleaner air. There might even be disagreement within certain constituent groups over what constitutes sustainability, such as individuals within the consumer class with distinct views whether sustainability should focus on environmental or social impact, not to mention the impact of political ideology on such views.
Boards would therefore need not only enhanced subject matter expertise, but also skills and training in resolving such conflicts.
To be sure, the merits of board decisions are beyond the scope of Caremark analysis, such that directors should not face liability for reaching the wrong balance of such concerns. Nevertheless, the concept and design of the required reporting systems is within the scope of Caremark analysis. Hence, if a court were to determine that the board’s systems and processes for managing conflicting ESG risks were inadequate, liability could follow.
Increasing the risk directors will face Caremark liability will have a number of additional adverse consequences. First, it may deter qualified individuals from being willing to serve on boards. Second, it will widen the scope of section 220 inspection requests, which may encourage fishing expeditions. Third, D&O liability insurance will become harder to get and more expensive when available. Finally, and perhaps most importantly, compliance with Caremark obligations as they already exist is costly and time consuming. This “focus on oversight and monitoring has taken attention away from strategy and risk optimization.” Extending Caremark to ESG factors would exacerbate the problem.
The net effect likely would be even greater tendencies for boards to overinvest in Caremark compliance. If directors are found liable for breaching their Caremark duties, the judgment will be paid out of their own pockets. If directors hire legal counsel and expert advisors to assist them with Caremark compliance, the company—and thus ultimately the shareholders—bear the expense. The more of the corporation’s money that directors spend on compliance, the less likely they are to face personal liability, which incentivizes directors to overinvest in lawyers and experts. Compounding the problem is that expanding Caremark duties to encompass ESG will require hiring a larger and broader set of lawyers and experts, because a larger and more disparate set of issues will be dragged into the Caremark net.
B. Undermining the Board Centric Nature of Delaware Law
Delaware corporate law is board centric. Hence, “[o]ne of the fundamental principles of the Delaware General Corporation Law statute is that the business affairs of a corporation are managed by or under the direction of its board of directors.” This focus has numerous doctrinal consequences, not the least of which is a high degree of judicial deference to board decisions. As the Delaware Supreme Court has explained, so long as directors act loyally and in good faith, “[c]ourts do not measure, weigh or quantify directors' judgments. We do not even decide if they are reasonable in this context.”
In its fully evolved form, Caremark poses a fundamental challenge to this board-centric philosophy. Suppose a board of directors carefully considered whether the company should adopt a law compliance program with respect to a specific set of issues. The board received detailed advice from outside experts and the company’s top management team. Based on that advice and after lengthy deliberation, the board reasonably and in good faith concluded that the costs of adopting such a program outweighed the benefits it would provide. Subsequently, company employees violated the relevant legal rules and the company was obliged to pay a substantial fine.
Unlike Caremark, where liability potentially arose from the board’s alleged failure to take action, in this hypothetical situation liability potentially arises out of a board decision. In Caremark itself, Chancellor Allen stated that, in such cases, the business judgment rule applies. Indeed, he made clear that what “may not widely be understood by courts or commentators who are not often required to face such questions, is that compliance with a director's duty of care can never appropriately be judicially determined by reference to the content of the board decision that leads to a corporate loss, apart from consideration of the good faith or rationality of the process employed.” One cannot but infer that Allen expected a good-faith, cost-benefit analysis that leads to a considered board decision not to adopt a law compliance program would be protected by the business judgment rule. After all, Caremark was driven by his longstanding concern “that directors had ‘become overly passive, lulled into complacency by both Delaware's strong business judgment rule and a business norm favoring directorial non-interference with the CEO.’” A board that actively engaged with the decision whether to adopt a law compliance program does not raise that concern even if they opt not to do so.
Once Guttman and Stone reclassified Caremark as a loyalty-based claim, however, the business judgment rule lost relevance. Whether directors acted loyally and in good faith is not determined by whether they conducted an adequate cost-benefit analysis. As a result, former Delaware Chief Justice Veasey and Justice Randy Holland correctly insisted that “the issue of whether or not to have and monitor in good faith an effective oversight protocol is a mandatory requirement. The business judgment rule would not protect the deliberate decision not to have and monitor the oversight requirement.”
Expanding Caremark to include oversight of ESG issues would compound that invasion of board prerogatives. As we have seen, ESG compliance today is mostly aspirational, which means that Delaware law does not require directors to adopt compliance programs in this area and imposes no liability for failure to do so.
All good corporate governance practices include compliance with statutory law and case law establishing fiduciary duties. But the law of corporate fiduciary duties and remedies for violation of those duties are distinct from the aspirational goals of ideal corporate governance practices. Aspirational ideals of good corporate governance practices for boards of directors that go beyond the minimal legal requirements of the corporation law are highly desirable, often tend to benefit stockholders, sometimes reduce litigation and can usually help directors avoid liability. But they are not required by the corporation law and do not define standards of liability.
Extending Caremark into this area would eviscerate this important distinction. It would transform best practices into legal mandates, intruding significantly on the board’s authority. To paraphrase Chancellor William Chandler’s analysis of extending Caremark to oversight of business risks, once Delaware courts begin allowing “shareholder plaintiffs to succeed on a theory that a director is liable for a failure to monitor” ESG risks, they will undermine “the well settled policy of Delaware law by inviting Courts to perform a hindsight evaluation of the reasonableness or prudence of directors' business decisions.”
C. Undercutting Delaware’s Law of Corporate Purpose
An expanded Caremark doctrine requiring board oversight of ESG risks presumably would remain enforceable only by shareholders. Doing so would not necessarily create either de jure or de facto fiduciary duties running to stakeholders. At a minimum, however, extending Caremark to the ESG context would effectively create a legal mandate that directors try to balance profit against environmental and social issues. As such, it would work an important change in Delaware’s law of corporate purpose.
In Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., the Delaware Supreme Court held that while a board of directors “may have regard for various constituencies in discharging its responsibilities,” the board may do so only if “there are rationally related benefits accruing to the stockholders.” Progressive scholars advocating allowing or even requiring directors to take ESG factors into consideration have tried to dismiss Revlon as a sport with relevance, at most, to a limited set of cases involving a subset of board defenses against corporate takeovers. This effort encountered a serious obstacle in eBay Domestic Holdings, Inc. v. Newmark, which held that “directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders.” Accordingly, the court explained, directors of a Delaware corporation cannot validly adopt “a business strategy that openly eschews stockholder wealth maximization.” Again, however, progressive ESG advocates dismissed eBay as erroneous or limited in scope.
In 2012, however, Delaware Chief Justice Strine rejected those arguments. Strine endorsed Chancellor Chandler’s statement in eBay that directors “cannot deploy a rights plan to defend a business strategy that openly eschews stockholder wealth maximization—at least not consistently with the directors' fiduciary duty under Delaware law,” which Strine described as a “rather expected statement.” He went on to confirm that “corporate law requires directors, as a matter of their duty of loyalty, to pursue a good faith strategy to maximize profits for the stockholders,” while noting that the business judgment rule accords directors considerable discretion about how to do so.
In 2015, Chief Justice Strine again addressed claims by progressive corporate law academics “that directors may subordinate what they believe is best for stockholder welfare to other interests, such as those of the company's workers or society generally.” In assessing their claims, the Chief Justice was rather harsh. He described those commentators as arguing “that Delaware judges do not understand the very law they are applying, and the Delaware General Assembly does not understand the law it has created.” Most damningly, Chief Justice Strine essentially accused the commentators—whom he called out by name in lengthy string cites—of misrepresenting the law, arguing that they “pretend that directors do not have to make stockholder welfare the sole end of corporate governance, within the limits of their legal discretion, under the law of . . . Delaware.”
As originally conceived, Caremark was a non-trivial intrusion on the board’s obligation to maximize shareholder wealth. Stone and its progeny compounded the problem by making clear that a board decision causing the corporation to violate the law is a non-indemnifiable, non-exculpable violation of the duty of loyalty.
Because such a decision is one made in bad faith by definition, it now appears to be a per se violation of the duty of loyalty. In light of the remedial aspects of the good faith doctrine discussed above, moreover, liability will be imposed even in circumstances in which the corporation affirmatively benefited from the decision in question.
This may seem a trivial complaint. Given the highly regulated nature of the U.S. economy and the growing use of criminal law to regulate corporate conduct, however, the adoption of a per se rule of liability lacking even an exception for de minimis violations of laws malum prohibitum in fact is a significant restriction on the discretionary powers of boards of directors.
In addition to being inconsistent with the shareholder wealth maximization norm, here is another way in which Caremark is inconsistent with the board centric thrust of Delaware law.
If it were clear that managing to maximize ESG outcomes was profit maximizing, incorporating ESG considerations into the Caremark duty would not exacerbate the existing conflict between Caremark and Delaware’s law of corporate purpose. It is true that maximizing ESG metrics will often also maximize shareholder wealth, of course, since a rising tide often lifts all boats. The evidence suggests, however, that this is not always the case.
A 2020 meta-analysis of studies of the impact of CSR on firm performance found it “is either statistically insignificant or marginally positive.” A 2020 literature review similarly concluded that the impact of CSR on firm financial performance remains uncertain.
If socially responsible firms are superior performers, one should see evidence that investment portfolios weighted toward such firms outperform the market on a risk-adjusted basis. Yet, there is little evidence that SRI investment funds outperform relevant market indices. To the contrary, there is some evidence that purportedly antisocial corporate conduct can result in superior stock market performance. In addition, the evidence suggests that stock market prices react to new information about a company’s ESG performance only where the information in question is material to the company’s financial prospects. This suggests that investors are not making purchase and sale decisions based on non-pecuniary factors. Instead, their decisions are driven by financial considerations.
In sum, incorporating ESG into Caremark duties would exacerbate the existing tension between Caremark and the directors’ duty to maximize shareholder wealth. Unlike Caremark, which can be justified by the need to ensure that the corporation complies with applicable laws, ESG compliance remains voluntary. Advocates of extending Caremark to encompass ESG compliance thus likely hope doing so will push companies to adopt what they regard as socially responsible policies but which they have not been able to mandate through the political process. Asking corporate executives to take on governmental functions not only asks them to undertake tasks for which they are untrained and for which their enterprise is unsuited, it also subverts the basis of a liberal democracy. Government efforts to solve social problems are inherently limited by the checks and balances baked into the American political system. Mandated board attention to ESG risks would erode those checks and balances by asking unelected executives to undertake solving social ills.
In sum, there is no justification for forcing boards into spending shareholder wealth on costly and controversial programs not required by law. Instead, “it is optimal for firms to make decisions that max shareholder wealth and let consumer-investors allocate the wealth to achieve optimal consumption and portfolio allocations, including ESG exposures.”
Conclusion
Caremark was a mistake. Its progeny compounded that initial error in multiple ways. In an ideal world, the Delaware Supreme Court would return us to the Graham rule. In the real world, however, the best we can hope for is to avoid further compounding the error.
If Caremark has any merit, it comes from helping to ensure that companies comply with the laws and regulations governing the mission critical aspect of their businesses. Society has deemed the conduct governed by those rules to be of sufficient import so as to merit penalties that can be extreme. Ensuring compliance thus presumably benefits society by reducing the risk of corporate violations, while also presumably benefiting shareholders by reducing the risk that companies will face potentially crippling fines. Or, at least, so Caremark proponents will argue.
In some areas, ESG risks have been addressed by statutes or rules. In those areas, Caremark applies. Critically, however, there are many areas in which ESG concerns remain aspirational. Corporate efforts to manage those risks are voluntary. Boards exercise the discretion with which corporate law has vested them to determine whether or not it is in the shareholders’ interest to address certain ESG risks.
Extending Caremark to encompass ESG would turn what is now voluntary into a mandate. It would intrude on the board’s primacy. It would raise costs and lower profits. It would encourage overinvestment in unnecessary precautions. In brief, it would flout all the reasons Graham and the one free bite rule made such considerable sense. And, for all that, it is unlikely to result in greater social justice.
