3.5.4 Special aspects of enterprise risk management, standards of supervision and care

Bater v. Dresser (1920)

Coleman, the bookkeeper of a small bank in Cambridge, defrauded the bank. Semi-annual examinations had not revealed any wrong doing. A claim for damages was filed against the directors. The US Supreme Court made a distinction between Dresser, the president, and the other directors. As Dresser was at the bank for many hours every day and had received several hints and wamings, he was held liable. The other directors, who were outsiders and had been persuaded by the president and the semi-annual examinations that nothing was wrong, were held not to have been negligent. This case is important because it makes clear that the US courts distinguish between insider directors and outsider directors in liability cases.16

Graham (1963)

Graham, the plaintiff, alleged that the directors of Allis-Chalmers had knowledge of anti-trust price-fixing arrangements, although the corporation had agreed to a consent order 20 years earlier not to violate antitrust laws. Allis-Chalmers manufactured a variety of electrical equipment and had 31,000 employees, 24 plants and annual sales of $ 500 million. Its policy was to decentralise management and to have prices set by particular department managers. The 14-strong board, which consisted of 4 executive and 10 non-executive directors, met once a month and was supplied with financial and operating data. They made all decisions on general business policy. In this case some of the company's employees were suspended, interrogated and indicted. The board members were not. Graham wished to sue the board members for damages on the grounds that they knew of the anti-trust activities. The Chancellor and the Delaware Supreme Court ruled that the individual directors were not liable because they had not known of the activities. Some employees of Allis-Chalmers had violated the anti-trust laws and thus subjected the corporation to a loss. There was no duty upon the directors to install a corporate system of espionage if they had no reason to suspect wrongdoing. They were entitled to rely on the honesty and integrity of the employees. This was especially true given the large size of the organization. In short, there were no red flags. Directors are liable for mistakes of employees only if they have recklessly reposed confidence in an obviously untrustworthy employee.

The modem view is that directors should implement procedures and programmes to assist them in their monitoring role.17 Federal sentencing guidelines have provided for lesser sentences to corporations that have implemented compliance programmes.

Caremark (1994)

This case recognized the trend and interpreted the Graham standard more narrowly. The directors of Caremark Int. Inc. were successful in their motion to dismiss the case against them. The plaintiffs had claimed that Caremark directors should have known that officers and employees of Caremark were involved in violations of the federal Anti-Referral Payments Law. That law prohibits health care providers from paying any sum of money to induce referral of Medicare or Medicaid patients. The Court held that "It is important to be reasonably informed that the board exercises good faith (under loyal) judgment that the corporation's information and reporting system is adequate to assure the board has appropriate information in a timely manner as a matter of ordinary operations. However, directors cannot be required to possess detailed information about all aspects of the enterprise. Only a sustained or systematic failure of the board to exercise oversight, such as an utter failure to attempt to assure a reasonable information and reporting system, will establish the lack of good faith (under the duty of loyalty) as a necessary condition for liability". Boards have the duty (a) to institute a system of supervision and (b) to record and monitor that the system functions, but do not have the duty to possess detailed information about the activities of all employees. Some form of monitoring system must therefore be in place.

Stone v. Ritter (2006)

Stone was shareholder in AmSouth. In 2004 AmSouth Bank paid $40 million in fines and $10 million in civil penalties arising from violations of anti-money laundering regulations, alleged to be the largest ever of its kind. KPMG confirmed that AmSouth had a longstanding compliance programme. There were many AmSouth employees involved: BSA officer, BSA/ AML Compliance Department, Corporate Security Department and Suspicions Activity Oversight Committee. The BSA officer trained the board of directors annually. The board at various times enacted written policies, e.g. a board-wide policy directing all AmSouth employees to immediately report suspicious transactions. The claim that directors are liable for employees' failures is "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment" [...] "Only a sustained or systematic failure of the board to exercise oversight [...] will establish the lack of good faith (under the duty of loyalty) that is a necessary condition to liability." "In the absence of red flags, good faith in the context of oversight must be measured by the directors' actions to assure a reasonable information and reporting system exists," as noted in the Caremark decision. The Chancery Court and the Supreme Court dismissed the case. The directors are therefore only liable for failure to implement a reporting system or, if there is a system, for consciously failing to monitor the system.

AIG (February 2009)

A motion by AIG directors Maurice R. (Hank) Greenberg and Smith to dismiss the complaint filed by the plaintiffs was not accepted by Vice-Chancellor Strine in a 108-page opinion. In this case a litigation committee of independent directors had been appointed. This committee had decided to institute the litigation initiated by plaintiffs against Greenberg and Smith and the "inner circle".

AIG had invested hundreds of millions in offshore subsidiaries and then entered into worthless reinsurance contracts with them. Also, AIG invested in buying up for itself elderly people's existing insurance policies while telling the public it was issuing new insurance policies. Greenberg and his inner circle inspired and oversaw a business strategy premised in substantial part on the use of improper accounting and other techniques designed to make AIG appear more prosperous than it in fact was. Each of the inner circle had been awarded an enormous amount of stock by Greenberg; they had supervisory authority over AIG's investments and served on AIG's finance and executive committees. In some of the wrongdoings Matthews, one of Greenberg's top managers, was kept in the dank by Greenberg and his inner circle. Here Greenberg and Smith and the "inner circle" were likely to be liable because they had acted in this way without informing the other directors. The motion to dismiss was not accepted and the case will go on to trial.

Citigroup (September 2009)

Citigroup suffered huge losses because of direct and indirect investments in subprime markets. These investments turned out very poorly. However, risk management systems were in place and there was an audit and risk management committee that had the duty to assist the board in monitoring the risk analysis. This committee met about 11 times a year. The Chancery Court considered that the board knew of the deterioration of the subprime market and of the possibility of further deterioration. The plaintiffs in this shareholder derivative suit did not even specify how the monitoring system was inadequate. The Court held that the "red flags" mentioned by the plaintiffs were only general market circumstances and therefore more a sign of poor decision making than of acting in breach of fiduciary duties. The plaintiffs were denied the right to start litigation and the motion to dismiss was accepted. Again, if there are risk management systems in place and there were no specific red flags, the directors are not liable.