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Caremark Imposed on Officers

From Delaware Business Litigation Report:

Delaware Bankruptcy Court Applies Caremark to Officers: Miller v. McDonald, C.A. 07-51350 (Bankr. Del. April 9, 2008)

In a case of apparent fist impression, a bankruptcy court in Delaware has held that Caremark duties apply to corporate officers as well as directors. Thus, corporate officers also have the duty to exercise reasonable care in oversight of corporate operations in their area of responsibility. This is hardly a surprise. However, given that the officer involved in this case was considered the company’s general counsel, this decision has some far-reaching implications.

Indeed.

Francis Pileggi has much more detail:

In this opinion on a motion to dismiss claims against an officer of a company, the Bankruptcy Court relied on decisions of the Delaware Chancery Court and the Delaware Supreme Court to deny a motion to dismiss in the course of ruling that Caremark duties would be imposed on an officer (who was not a director), that was on the management team when the President of the company committed fraud and other actions and omissions that ultimately led to the bankruptcy filing of the company.  This is notable in part because there are not as many decisions that address the fiduciary duties of officers, as opposed to directors of a corporation.

... No, this is not a “deepening insolvency case”. This case involves a fiduciary duty claim that alleged that even if the defendant did not commit any of the fraud and other abuses that led to the downfall of the company, he breached his fiduciary duty to make an effort to put monitoring systems in place that would have increased the likelihood that the fraud perpetrated by the company President could have been detected sooner and/or could have been prevented sooner. (see page 29 of opinion linked above).

Go read the whole thing for its valuable analysis and follow the links for even more analysis.

For the latest on Caremark as applied to boards, see my article The Convergence of Good Faith and Oversight. At least insofar as CEOs and CFOs of publicly traded companies are concerned, I doubt whether this matters too much. Whatever obligations state law may now impose presumably can be swept into the due diligence processes used to support the CEO and CFO certifications under Sarbanes-Oxley sections 302 and 906. As my book on Sox explains:

The CEO and CFO need not replicate the internal or external audit as part of the certification process, but some element of due diligence is necessary. As a matter of best practice, the CEO should receive what might be called “mini-302 certifications” from subordinates providing for their areas of responsibility the affirmations and certifications required by § 302. The certifying officer should meet with the outside auditor to confirm that it has had unrestricted access to conduct its audit and has met with the audit committee. Likewise, the certifying officer should meet with the audit committee to ensure that it has met with the outside auditor and to determine whether the committee knows of any material problems or deficiencies. Finally, the CEO and CFO should meet with the disclosure committee and the head of internal audit to ensure that the information necessary to prepare the corporation’s disclosure statements is properly flowing within the firm.

Because certification covers the MD&A disclosures, the certifying officers should meet with those responsible for drafting the MD&A. Even if the MD&A is drafted internally, it may be appropriate to have outside counsel review the disclosures.

I go on to explain that counsel (including the CLO) will be actively engaged in this process:

Indeed, counsel can be quite helpful throughout this process. Counsel can advise the CEO and CFO on conducting the requisite pre-certification assessment, memorialize the assessment process in an appropriate diligence report, and assist with identifying areas of particularly high risk. As for the cost, well, let’s be honest. If you could buy an insurance policy using somebody else’s money, doesn’t it make sense to do so? The CEO and CFO are putting their necks on the line here, but the company pays both the general counsel and outside lawyer. The temptation to spend the shareholders’ money on legal advice will prove irresistible. If you like, think of it as part of the CEO and CFO’s pay package.

The ramifications of extending affirmative oversight duties to the CLO, however, are potentially “far-reaching.”

Consider the following case:

• In August 2002, ESI’s CFO and Controller developed a scheme to fraudulently inflate ESI’s financial results. In one particular instance, the CFO and Controller reduced expenses and increased net income by $1 million by eliminating vested retirement and severance benefits for ESI’s Asian employees. By doing so, ESI reported a profit for the quarter ended August 31, 2002 consistent with analyst’s expectations rather than a loss.


• On September 17, 2002, Mr. Isselmann participated in an Audit Committee meeting during which ESI’s CFO told the committee that legal counsel had approved the elimination of the benefits. Mr. Isselmann had not reviewed or approved the decision to eliminate the benefits and had not sought advice from outside legal counsel, yet he did not question the CFO’s statements.


• Around the same time, Mr. Isselmann learned that ESI executives had provided the company’s auditors with a memorandum stating that ESI was under no legal obligation to pay the retirement and severance benefits.


• On October 3, 2002, Mr. Isselmann asked ESI’s legal counsel in Japan to advise him on the elimination of the retirement and severance benefits. Japanese counsel informed Mr. Isselmann that ESI could not unilaterally terminate the benefits without violating the law. Despite this opinion, Mr. Isselmann did not inform either the Audit Committee or the auditors.


• On October 7, 2002, during a Disclosure Committee meeting, Mr. Isselmann attempted to raise the issue of elimination of the retirement and severance benefits for Asian employees. However, the CFO objected to discussing the issue and Mr. Isselmann backed down.


• Prior to filing of the quarterly report, an Audit Committee member questioned Mr. Isselmann once again about the elimination of the benefits. Mr. Isselmann did not inform the Audit Committee member of the contrary advice received from Japanese legal counsel and the quarterly report was then filed.


• In March 2003, after learning that the CFO and Controller had eliminated the retirement and severance benefits upon discovering an accounting error that negatively impacted earnings, Mr. Isselmann reported what he knew about the elimination of the benefits to ESI’s outside legal counsel and Audit Committee.


• Following an internal investigation, ESI restated its financial results for the quarter ended August 31, 2002 from a net profit of $158,000 to a net loss of $3.4 million. Mr. Isselmann resigned from the company the same month.

Today, Isselmann presumably would face both Part 205 sanctions from the SEC but also be vulnerable to a Caremark claim under the new holding.

Importantly, because the Delaware Supreme Court in Stone v. Ritter recharacterized Caremark as a good faith case, expenses incurred in connection with a violation of one’s Caremark duties become non-indemnifiable.