Brief Fact Summary.
Shareholders (Plaintiff) brought a derivative action against AmSouth Bancorporation (AmSouth) directors (Defendant) contending that demand was excused because the Defendant breached their oversight duty.Â Allegedly, the breach caused approximately $50 million in penalties the corporation was required to pay as a consequence of its employees’ failure to file specific reports required by federal banking regulations.
Synopsis of Rule of Law.
When specified facts do not create a reasonable doubt that the directors of a corporation acted in good faith in exercising their oversight responsibilities, a derivative suit will be dismissed for failure to make demand.
AmSouth Bancorporation (AmSouth) and a subsidiary paid $40 million in fines and $10 million in civil penalties, which arose from bank employees’ failure to file particular reports required by the federal Bank Secrecy Act (BSA) and other federal anti-money-laundering (AML) regulations.Â Evidence was shown that the corporation dedicated considerable resources to its BSA/AML compliance program, put various procedures and systems in place and in an effort to ensure compliance, and that these procedures and systems permitted the Defendant to regularly monitor the corporation’s compliance with BSA/AML regulations and requirements.Â On a regular basis the board (Defendant) received reports and training in these BSA/AML compliance systems and enacted written policies and procedures to ensure BSA/AML compliance.Â The shareholders (Plaintiff) of AmSouth brought a derivative action against the corporation’s directors (Defendant) based on these events, claiming they breached their oversight duties, before making demand on the board.Â They contended that demand was excused because the Defendant faced a good chance of liability of personal liability that would render them incapable of exercising independent and disinterested judgment in response to a demand request.Â AmSouth’s certificate of incorporation contained a provision that would exculpate its directors for breaches of their duty of care, provided they acted in good faith.Â The Chancery Court held that the Plaintiff failed to sufficiently plead that demand would have been futile, finding that the Defendant had not been alerted by any â€œred flagsâ€ that violations of law were occurring.Â Review was granted by the state’s highest court.
When specified facts do not create a reasonable doubt that the directors of a corporation acted in good faith in exercising their oversight responsibilities, will a derivative suit be dismissed for failure to make demand?
(Holland, J.)Â Yes.Â When specified facts do not create a reasonable doubt that the directors of a corporation acted in good faith in exercising their oversight responsibilities, a derivative suit will be dismissed for failure to make demand.Â Where a business decision was not involved, as in this case, the standard to determine demand futility is whether the particularized factual allegations create a reasonable doubt that, as of the time the complaint was filed, the directors could have exercised their independent and disinterested business judgment in response to a demand.Â The Plaintiffs’ attempt to satisfy this standard by claiming that the Defendant faces a substantial likelihood of personal liability, and therefore causes them to be interested in the outcome.Â This argument, however, must take into account the certificate of incorporation’s exculpatory clause, which can exculpate Defendant from a breach of the duty of care, but not a breach of their duty of loyalty or a breach that is not in good faith.Â The failure to act in good faith is a condition to finding a breach of the fiduciary duty of loyalty and imposing fiduciary liability.Â â€œ[A] failure to act in good faith is not conduct that results, ipso facto, in the direct imposition of fiduciary liability.â€Â Failing to act in good faith may result in liability because the requirement to act in good faith is a condition of the duty of loyalty.Â Therefore, because a showing of bad faith conduct is required to establish director oversight liability, the fiduciary duty violated by that conduct is the duty of loyalty.Â Second, and as a corollary, the duty to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duty of care and loyalty.Â Failure to act in good faith only indirectly gives rise to liability.Â Also, as a corollary, the fiduciary duty of loyalty is not limited to financial or similar conflicts of interest, but also includes cases where a director has failed to act in good faith.Â Oversight liability itself is determined by the standards articulated in the Caremark case (In re Caremark Int’l Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996)).Â The bases to oversight liability occurs where (1) the directors utterly fail to implement any reporting or information system or controls, or (2) having put in place such a system or controls, consciously fail to monitor or oversee its operations, thereby disabling themselves from being informed of risks or problems requiring their attention.Â In either case, liability requires a showing that the directors knew that they were not carrying out their fiduciary obligations.Â When these standards are applied to the facts pleaded by Plaintiff, it becomes clear that Defendant did not fail to act in good faith.Â The facts reveal that Defendant had established a reasonable information and reporting system and had set up various departments and committees to oversee AmSouth’s compliance with federal banking regulations.Â This system also enabled the board to periodically monitor such compliance.Â While it is clear with hindsight that the organization’s internal controls were inadequate there were also no â€œred flagsâ€ to notify the board of any wrongdoing.Â Defendant took the steps they needed to ensure that a reasonable information and reporting system was in place.Â Therefore, although there ultimately may have been failures by employees to report deficiencies to the board, there is no basis for an oversight claim seeking to hold the directors personally liable for such failures by the employees.
This case clarifies that Delaware directors do not have a fiduciary duty of good faith that is separate from other fiduciary duties.Â Rather, as explained by the court, the duty of good faith is a component of the duty of loyalty.Â The case also teaches that in the context of breach of oversight claims, a negative (and very costly) outcome does not per se equate to bad faith.