“A consolidated derivative action on behalf of Caremark International, Inc. (“Caremark”) involving claims that the members of Caremark’s board of directors breached their fiduciary duty of care to Caremark in connection with alleged violations by Caremark employees of federal and state laws and regulations applicable to health care providers. The non-compliance resulted in punitive fines totalling approx. $250 million.

“Recall for example the displacement of senior management and much of the board of Salomon, Inc.; the replacement of senior management of Kidder, Peabody following the discovery of large trading losses resulting from phantom trades by a highly compensated trader;  or the extensive financial loss and reputational injury suffered by Prudential Insurance as a result its junior officers misrepresentations in connection with the distribution of limited partnership interests. Financial and organizational disasters such as these raise the question, what is the board’s responsibility with respect to the organization and monitoring of the enterprise to assure that the corporation functions within the law to achieve its purposes?

“In 1963, the Delaware Supreme Court in Graham v. Allis-Chalmers Mfg. Co., addressed the question of potential liability of board members for losses experienced by the corporation as a result of the corporation having violated the anti-trust laws of the United States. There was no claim in that case that the directors knew about the behavior of subordinate employees of the corporation that had resulted in the liability. Rather, as in this case, the claim asserted was that the directors ought to have known of it and if they had known they would have been under a duty to bring the corporation into compliance with the law and thus save the corporation from the loss. The Delaware Supreme Court concluded that, under the facts as they appeared, there was no basis to find that the directors had breached a duty to be informed of the ongoing operations of the firm. In notably colorful terms, the court stated that “absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.” The Court found that there were no grounds for suspicion in that case and, thus, concluded that the directors were blamelessly unaware of the conduct leading to the corporate liability.

Graham v. Allis-Chalmers does not mean that a corporate board has no responsibility to assure that appropriate information and reporting systems are established by management. “[I]n recent years the Delaware Supreme Court has made it clear-especially in its jurisprudence concerning takeovers, from Smith v. Van Gorkom through Paramount Communications v. QVC -the seriousness with which the corporation law views the role of the corporate board. [R]elevant and timely information is an essential predicate for satisfaction of the board’s supervisory and monitoring role under Section 141 of the Delaware General Corporation Law.

“Failure to monitor: Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability-creating activities within the corporation, as in Graham or in this case . . . 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 exists-will establish the lack of good faith that is a necessary condition to liability. Such a test of liability-lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight-is quite high.”