Delaware Courts Confirm High Standard For Breach Of Oversight Duty Applies Equally To Officers And Directors

Overview

In the United States, corporate directors and, as confirmed by the Delaware Court in McDonald's Corp. Stockholder Derivative Litigation (McDonald)¹, corporate officers owe, as a subset of their duty of loyalty, a duty to monitor and oversee the operations of a company. This duty of oversight is often referred to as the "Caremark" duty, named after the 1996 case establishing its parameters.² A party seeking to bring a Caremark claim against a director and/or officer "must allege sufficient facts to support a reasonable inference that the fiduciary acted in bad faith."³

Recently, in Segway Inc. v Cai,⁴ the Delaware Court of Chancery released an important decision clarifying that McDonald did not create a lower standard for Caremark claims brought against corporate officers of Delaware corporations. Rather, the high pleading standard is confirmed to apply equally to both U.S. directors and officers.

Currently, directors and officers of Canadian corporations do not owe a specific duty of oversight. In a previous blog, Delaware Court Extends a Director's Duty of Oversight to Officers—What Could This Mean for Canadian Directors and Officers?, we wrote that Canadian courts may look to this string of recent decisions from Delaware as guidance in understanding director and officer liability in Canada. It remains to be seen whether, in light of this further case law, it will influence Canadian consideration of this issue.

Facts

Segway Inc. brought a claim against its former President, Judy Cai, for a breach of her duty of loyalty to the company—specifically, the duty of oversight. The singular allegation was that Cai breached her fiduciary duty of loyalty as an officer of the corporation by "consciously disregarding certain financial discrepancies." Segway alleged that Cai made egregious discrepancies in reporting Segway's financial information, including providing numbers that did not match the company's records. Segway also alleged that Cai ignored customer issues which caused the accounts receivable to increase and had failed to take action and advise the board of these issues.

Cai moved to dismiss the claim on the basis that Segway failed to state a claim upon which relief can be granted.⁵

The Decision

The Court granted Cai's motion, holding that such allegations are an ill fit for a Caremark claim.

While the Court reaffirmed its decision in McDonald that the oversight duty extends to corporate officers, it clarified that it had not in fact created a lower standard for oversight claims brought against officers. The Court rejected Segway's interpretation of McDonald implying a lower standard for officers as compared to directors. Rather, the Court clarified that a Caremark claim against a corporate officer is not easier to plead than one against a director—the high standard applies to both directors and officers. In addition, it should be noted that in order for an officer to be liable for breach of their duty of oversight that the applicable bad faith needs to be with respect to "matters within the officer's remit".

The Court proceeded to analyze whether Segway adequately pleaded that Cai had acted in bad faith, which was required to support its claim that Cai had breached her duty of oversight. A fiduciary is said to act in "bad faith" where they: (1) "utterly fail to implement any reporting or information system or controls; or (2) "having implemented such a system or controls, consciously fail to monitor or oversee its operations", disabling them "from being informed or risks or problems."

The Court noted that oversight duties under Delaware law are not "designed to subject [fiduciaries] to personal liability for failure to predict the future and to properly evaluate business risk" and that "Bad [sic] things can happen to corporations despite fiduciaries exercising the utmost good faith."

The Court concluded that the allegations against Cai did not satisfy the high threshold of wrongdoing necessary to establish bad faith but also specifically noted that Segway did not allege any potential wrongdoings by Cai. Specifically, the Court held that the allegations made did not amount to the red flags required to trigger Caremark liability. Furthermore, in finding that there was no evidence under the second prong of the test that Cai acted in bad faith, the Court affirmed that "the Caremark doctrine is not a tool to hold fiduciaries liable for everyday business problems" but rather intended to "address the extraordinary case where fiduciaries' "utter failure" to implement "an effective compliance system or 'conscious disregard' of the law gives rise to a corporate trauma." Therefore, the motion by Cai to dismiss was granted.

Takeaways for Canadian Corporate Law

As we highlighted in a previous blog, Delaware Court Extends a Director's Duty of Oversight to Officers—What Could This Mean for Canadian Directors and Officers?, while there is presently no duty of oversight in Canadian corporate law, directors and officers must act honestly and in good faith with a view to the best interests of the corporation. On this basis, we expressed that it is foreseeable that a Caremark-style claim may be brought in Canada against directors and officers of Canadian corporations. While this new decision confirms the high standard for which a party seeking to bring a Caremark claim against a director or officer must satisfy, it remains to be seen whether it will influence further consideration on the issue.

In any event, it is well known that Canadian corporate law often looks to Delaware law, and this latest installment of Delaware cases involving claims brought against directors and officers of a corporation for alleged failures to oversee decisions and monitor red flags, may prove influential in Canada.

For more information about directors' and officers' duties in the context of your organization, please do not hesitate to contact the authors or a member of the Bennett Jones Corporate Governance group.

Footnotes

1. C.A. No. 2021-0324-JTL (Del. Ch. Jan. 25, 2023).

2. In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).

3. Segway Inc v Cai, C.A. No. 2022-1110-LWW (Del. Ch. Dec. 14, 2023).

4. C.A. No. 2022-1110-LWW (Del. Ch. Dec. 14, 2023).

5. Court of Chancery Rule 12(b)(6).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Ms Denise D. Bright
Bennett Jones LLP
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