In re Caremark International Inc. Derivative Litigation
698 A.2d 959 (1996)
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Rule of Law:
A board of directors has a fiduciary duty to attempt in good faith to ensure that a corporate information and reporting system exists, and that failure to do so may, under some circumstances, render a director liable for losses caused by non-compliance with applicable legal standards.
Facts:
- Caremark International, Inc., a healthcare provider, derived substantial revenue from Medicare and Medicaid, making it subject to the Anti-Referral Payments Law (ARPL), which prohibits paying for patient referrals.
- Caremark had various contracts with physicians for services like consultation and research grants, some of whom also referred patients to Caremark, raising concerns about illegal 'kickbacks' under the ARPL.
- As early as 1989, Caremark's predecessor created an internal 'Guide to Contractual Relationships' and regularly consulted lawyers to ensure its practices were lawful.
- In 1991, the U.S. Department of Health and Human Services (HHS) began investigating Caremark for potential ARPL violations.
- In response to the investigation, Caremark's board and management took several compliance-focused steps, including revising its guide, instituting new contract approval policies, creating an Ethics Committee, and hiring an outside auditor (Price Waterhouse) which found no material weaknesses.
- Despite these compliance efforts, federal grand juries indicted Caremark in 1994, alleging that employees had made illegal payments to physicians for patient referrals.
- Caremark ultimately pleaded guilty to one count of mail fraud and paid approximately $250 million in criminal and civil fines to settle the government investigations and related private-payor claims.
Procedural Posture:
- Shareholders filed a consolidated derivative action in the Delaware Court of Chancery against the members of Caremark's board of directors.
- The complaint alleged the directors breached their fiduciary duty of care by failing to adequately supervise the conduct of Caremark employees, which exposed the company to significant liability.
- The complaint was amended three times to add allegations related to new indictments and financial losses.
- The director-defendants filed motions to dismiss the complaints.
- Before the court ruled on the dismissal motions, the parties negotiated a settlement agreement.
- The parties subsequently filed a joint motion requesting the court to approve the proposed settlement as fair and reasonable.
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Issue:
Does a board of directors breach its fiduciary duty of care by failing to prevent corporate losses from employee misconduct where the board has made a good faith effort to implement a corporate information and reporting system?
Opinions:
Majority - Chancellor Allen
No. A board of directors does not breach its duty of care for a failure to monitor where it has made a good faith attempt to ensure a reasonable corporate information and reporting system exists. The court updated the standard from Graham v. Allis-Chalmers, which held that directors have no duty to install a system of 'espionage' absent cause for suspicion. In the modern regulatory environment, particularly with the advent of the Federal Organizational Sentencing Guidelines, a board has an affirmative obligation to attempt in good faith to assure that an adequate information and reporting system is in place. Liability for a breach of this duty of oversight attaches only for 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.' In this case, the record shows that the Caremark board had established compliance mechanisms, including an ethics guide, an ethics committee, and outside auditors. These actions constitute a good faith attempt to be informed, and there is no evidence that the directors consciously permitted a known violation of law to occur or failed to exercise their oversight function. Therefore, the claims against the directors are extremely weak, and the proposed settlement is fair.
Analysis:
This case is a landmark in corporate governance, establishing the modern standard for a board's duty of oversight, often called 'Caremark duties.' It shifted the legal expectation from a passive, 'red flag' model under Graham v. Allis-Chalmers to an affirmative duty to implement compliance and monitoring systems. The decision sets a very high bar for finding directors personally liable for corporate non-compliance, requiring proof of a 'sustained or systematic failure' that demonstrates a lack of good faith. The ruling has profoundly influenced corporate behavior, prompting companies to invest heavily in robust internal compliance programs to protect directors from potential liability.
