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The recent Enron, WorldCom, Adelphia and other corporate crises have led to widespread concern over the adequacy of corporate governance practices of many companies. The focus of much of this scrutiny has centered on the business practices, financial disclosure, audit committee and board independence requirements of public companies. Accordingly, boards of directors are seeking increased guidance regarding the proper discharge of their responsibilities to supervise and monitor the corporation’s management and affairs. Background The Board of Directors is generally charged with carrying out two principal functions: decision making and oversight. Much has been written about the board of directors’ duty of care in the decision making context, which requires directors to perform their duties in good faith and with the degree of care that an ordinary person would use under similar circumstances. Most directors are similarly aware of the protections afforded by the business judgment rule – courts will not second guess directors’ business decisions if the directors act on an informed basis and in good faith. In the oversight context, however, directors are not protected by the business judgment rule if they fail to take action when apprised of corporate impropriety. Many directors are unfamiliar with this less-defined and stricter component of the duty of care. Part I of this Alert defines the duty of oversight and distinguishes it from the board’s responsibilities in the decision making context. Part II will define the standard of care applicable to oversight, identify typical applications of the duty, and explore whether corporations may limit director liability under the duty of oversight. Defining the Duty of Oversight Liability under the duty of oversight arises from an unconsidered failure of the board to act in circumstances in which due attention would have prevented corporate misconduct, violations of law or a corporate loss. To prevail on a lack of oversight claim, a plaintiff must show that the directors knew or should have known that violations of law or improper conduct were occurring, that the directors took no steps to prevent or remedy the misconduct, and that their failure proximately caused the losses. Breaches of the duty of oversight typically occur when: directors abdicate their fundamental functions, e.g., when directors fail to supervise and monitor management and fail to be informed of the corporation’s business, affairs and activities. directors are informed of employee wrongdoing or of potential violations of law and fail to make an inquiry into and respond to the situation. directors delegate corporate managerial responsibility to an untrustworthy officer or employee and fail to monitor such officer or employee. Decisions Under the Business Judgment Rule v. Inaction Under the Duty of Oversight The law draws a distinction between two scenarios: deciding there is no problem versus ignoring a problem. In the first case, when a board considers a situation and makes a decision that results in a loss, the business judgment rule will protect a board’s decision if the board acted in good faith and properly informed itself in the process. The protection of the business judgment rule is not determined by the results of the decision, but by the quality of the process employed. For example, when a board conducts a proper internal investigation into a matter and either takes action or consciously decides that action is not necessary, that decision, even if wrong, will be protected by the business judgment rule. By contrast, when a loss originates from the board's failure to consider a problem, there has been no process, there is no decision to protect, and the business judgment rule does not apply. Instead, directors may face liability for breach of the duty of oversight. Rather than having a court defer to the directors' business judgment, the directors will likely be required to defend a negligence claim. Thus, when directors are aware, or should be aware, of material improper conduct, violations of law or other action that could result in material harm to the organization, the duty of oversight demands that directors investigate the matter and decide whether or not corrective action is needed. If the board fails to consider the situation, the board will be criticized for failure to supervise and may face liability under the duty of oversight. The Board may not take action in either case, but the results in the two cases are dramatically different. Therefore, the duty of oversight creates an incentive for boards to respond to potential indications of wrongdoing in order to gain the benefit of the business judgment rule. Boards can be held liable under the duty of oversight for failing to act when they know, or should know of wrongdoing. Boards may have difficulty determining whether warning signs are sufficiently strong to warrant their attention. However, Boards should expect that these situations will be viewed in hindsight, i.e., that the information in question will gain significance after the calamity has occurred. Thus, the impetus to investigate, supervise employees and evaluate warning signs is strong.

 

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