Graham v. Allis-Chalmers Manufacturing Company

Supreme Court of Delaware
188 A.2d 125 (1963)

ELI5:

Rule of Law:

Corporate directors are not liable for losses resulting from employee misconduct that they were unaware of, as they have no duty to install a corporate system of espionage to ferret out wrongdoing absent any cause for suspicion or 'red flags' that would put a prudent person on notice.

Facts:

Allis-Chalmers Manufacturing Company was a large, decentralized corporation with over 31,000 employees and numerous plants and offices.
In 1937, the company entered into two consent decrees with the Federal Trade Commission (FTC) related to price-fixing, though none of the current directors were in leadership positions at that time.
Only three of the fourteen current directors were aware of the 1937 decrees, and they had each satisfied themselves that the company had not engaged in the prohibited practices and had only consented to the decrees to avoid litigation costs.
Starting in 1956, several mid-level employees of Allis-Chalmers, without the knowledge of the board of directors, participated in a conspiracy with competitors to fix prices and rig bids.
The board of directors first learned of potential anti-trust violations in the summer of 1959 from newspaper reports, after which they initiated an internal investigation.
No evidence was produced to show that any director had actual knowledge of the anti-trust activity or was aware of any facts that should have put them on notice of the illegal conduct prior to the 1959 reports.

Procedural Posture:

Allis-Chalmers Manufacturing Company and four of its non-director employees were indicted for violating federal anti-trust laws.
The company and the employees entered pleas of guilty to the indictments.
Shareholders John P. Graham and Yvonne M. Graham filed a shareholder derivative action in the Delaware Court of Chancery against the directors of Allis-Chalmers.
The Vice Chancellor of the Court of Chancery ruled in favor of the director defendants, finding them not liable for the losses sustained by the corporation.
The plaintiffs, Graham, appealed the Vice Chancellor's decision to the Supreme Court of Delaware.

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Issue:

Does a corporate director's duty of care require the implementation of a system of internal controls to detect employee misconduct when the director has no knowledge of or reason to suspect any wrongdoing?

Opinions:

Majority - Justice Wolcott

No. A corporate director's duty of care does not require the implementation of a system to detect employee misconduct absent any reason for suspicion. Directors are entitled to rely on the honesty and integrity of their subordinates until something occurs to put them on suspicion that something is wrong. The mere fact that the company had entered into consent decrees over two decades prior, of which most of the board was unaware, did not constitute a 'red flag' sufficient to put the board on notice of potential future wrongdoing. Given the size and complexity of Allis-Chalmers, the directors were justified in confining their oversight to broad policy decisions and relying on corporate reports. Absent cause for suspicion, there is no duty upon directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.

Analysis:

This case established a significant, though now largely superseded, precedent for the duty of oversight. The court's holding created what is often called the 'Graham' or 'red flag' standard, suggesting that director liability for failure to monitor only attaches when they consciously disregard warning signs of misconduct. This decision set a very low bar for director oversight, effectively requiring no proactive monitoring system. This standard was later revisited and substantially modified by the Delaware Court of Chancery in In re Caremark International Inc. Derivative Litigation, which established that directors do have an affirmative duty to ensure that information and reporting systems exist within the corporation.

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