Tag: Caremark Doctrine

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Impact of the Federal Sentencing Guidelines at 30

The Federal Sentencing Guidelines for Organizations (FSGO) by the US Sentencing Commission (USSC) turn 30 this year. For compliance officers, this was perhaps the most significant government release. It did not create the compliance profession, but it certainly put compliance professionals in the forefront of the design, creation and implementation of corporate compliance programs. The FSGO also laid out for the first time, the government’s expectations of what a well-designed compliance program should look like in practice. This led to a dramatic increase in compliance professionals. Earnie Broughton, writing in the ECI blog, said, “In many ways the promulgation of the guidelines was a defining moment in our collective journey in understanding and realizing the benefits of good corporate character.”

In 2021, the Bureau of Labor Statistics reported 291,000 compliance officers in the US. But more than driving the compliance profession and a concomitant increase in compliance professionals the FSGO has in many ways shaped the structure of the 21st century corporation and dramatically improved corporate governance. In these ways, it laid the environmental, social and governance (ESG) foundations. Last month the US Sentencing Commission (USSC) released a summary of the FSGO and how it helped drives these changes, “The Organizational Sentencing Guidelines: Thirty Years of Innovation” (the History).

Regarding the FSGO themselves, they take a “carrot and stick” approach to the sentencing scheme that bases the fine range on the culpability of the organization. The guidelines instruct courts to determine culpability by considering six factors. The four aggravating factors, “that increase the ultimate punishment of an organization are: (i) the involvement in or tolerance of criminal activity; (ii) the prior history of the organization; (iii) the violation of an order; and (iv) the obstruction of justice.” The two mitigating factors are: “(i) the existence of an effective compliance and ethics program; and (ii) self-reporting, cooperation, or acceptance of responsibility.” Rather amazingly, the History reported that only 1.5% overall of all organizations sentenced “received the five-point culpability score reduction for disclosing the offense to appropriate authorities prior to a government investigation in addition to their  full cooperation and acceptance of responsibility.” Obviously, there is still room for improvement.

Rather unsurprisingly, the Department of Justice (DOJ) drew heavily on the FSGO for two key documents which laid out the foundations of an effective compliance program. The first was the 2012 FCPA Resource Guide (developed and released jointly with the Securities and Exchange Commission (SEC)) and its update, the 2021 FCPA Resource Guide, 2nd edition. The second was the Evaluation of Corporate Compliance Programs, initially released in 2019, and the 2020 Update to the Evaluation of Corporate Compliance Programs. The History noted that the Evaluation and its update, “was first developed in 2017 under the leadership of the DOJ’s first “corporate compliance expert”” and “provides greater clarity on some key issues prosecutors consider when assessing the adequacy of corporate compliance programs during charging and settlement decisions, by laying out “fundamental questions” that prosecutors should ask about compliance programs:

  • Is the corporation’s compliance program well designed. There were three key questions for consideration:
  • Is the program being applied earnestly and in good faith?
  • In other words, is the program being implemented effectively?
  • Does the corporation’s compliance program work in practice?

The Evaluation and its Update then proceed to describe “in detail the topics that prosecutors should consider when answering those questions.”Demonstrating its influence far beyond the DOJ, SEC and other government agencies, the Delaware court decision in Caremark demonstrates a key effect in the transformation of compliance programs, policies and procedures in the corporate world. The Caremark decision was a departure from prior Delaware case law which said that a board did not have to look for wrongdoing but only had to investigate if informed about it. That was from an old 1963 decision and the Court relied on the 1992 US Sentencing Guidelines to note how such views were no longer accepted. Board obligations had changed by 1996 with the following, “obligation to be reasonably informed concerning the corporation, without assuring themselves that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with law and its business performance.”

Caremark considered the proposed settlement of a derivative suit seeking to impose personal liability on members of the board of directors. The History noted, “the court considered whether director liability could stem from unconsidered action by the board. After observing that “[t]he Guidelines offer powerful incentives for corporations today to have in place compliance programs to detect violations of law, promptly to report violations to appropriate public officials when discovered, and to take prompt, voluntary remedial efforts,” the court concluded that “[a]ny rational person attempting in good faith to meet an organizational governance responsibility would be bound to take into account [the organizational guidelines].”

This meant that a director has a good faith duty to see that the organization establishes adequate information and reporting systems. i.e., a compliance program. No doubt due to the significance of the Delaware courts, “following the Caremark decision, federal and state courts recognized the importance of compliance programs in the context of shareholder derivative suits.” Caremark  and its progeny are now the law of the land regarding corporate governance and compliance across most states in the US.

All of these changes and much more point to the far- and wide-ranging impact of the FSGO.  “What began as an “experiment” to encourage legal compliance and foster more ethical business practices is now widely accepted as a success.” Moreover, “evidence suggests that compliance and ethics programs implemented using the guideline criteria produce positive effects on an organization’s behavior” and that the FSGO has had a significant impact on public and private sector actors.” Finally, the History concludes that the influence of FSGO “is now spreading around the globe, suggesting that the hallmarks of an effective compliance and ethics program have universal appeal.”

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A Caremark Retrospective: Part III – Lessons for Today

Over this short blog post series I have been exploring the original Caremark and Stone v. Ritter decisions from the Delaware Supreme Court. The former decision was released in 1996 and the latter, some ten years later in 2006. The original Caremark decision laid the foundation for the modern obligations of Boards of Directors in oversight of compliance in general and a company’s risk management profile in particular. Stone v. Ritter confirmed the ongoing vitality of the original Caremark decision. In Part 1, we reviewed the underlying facts of the Caremark decision and in Part II, we considered the court holdings and rationales in Caremark and Stone v. Ritter. Today, I want to review what those decisions mean for today’s Board of Directors, Chief Compliance Officer (CCO) and compliance professional.

Bribery, Fraud and Corruption

One of the things that struck me about both decisions was how timely the underlying facts were. In Caremark, a 1996 decision with the corruption going back into the 1980s, the case involved a company which provided patient care and managed care services and a substantial part of the revenues generated by the company was derived through third party payments, insurers, and Medicare and Medicaid reimbursement programs. Medicare and Medicaid payments were governed under the Anti-Referral Payments Law (“ARPL”) which prohibited health care providers (HCPs) from paying any form of remuneration (i.e., kickbacks) to physicians to induce them to refer Medicare or Medicaid patients to Caremark products or services.

To get around this prescription, Caremark entered various contracts for services (e.g., consultation agreements and research grants) with physicians at least some of whom prescribed or recommended services or products that Caremark provided to Medicare recipients and other patients. Moreover, Caremark had a decentralized governance and operational structure which allowed wide latitude to the business units to enter into such agreements without corporate or any centralized compliance or legal oversight. The results were about what you would expect.

In Stone v. Ritter, the AmSouth bank was induced to open a custodial account for two investment advisers who induced some 40 investors into a fraudulent investment, involving the construction of medical clinics overseas, by misrepresenting the nature and the risk of that investment. The bank provided custodial accounts for the investors and to distribute monthly interest payments to each account upon receipt of a check from the investment advisors. The scheme went on for about two years before the sapped investors stopped getting paid and began to contact the bank.

Federal bank examiners examined AmSouth’s compliance with its reporting and other obligations under the Bank Secrecy Act (BSA). AmSouth “entered into a Deferred Prosecution Agreement (“DPA”) in which AmSouth agreed: first, to the filing by USAO of a one-count Information in the United States District Court for the Southern District of Mississippi, charging AmSouth with failing to file SARs; and second, to pay a $40 million fine. In conjunction with the DPA, the USAO issued a “Statement of Facts,” which noted that although in 2000 “at least one” AmSouth employee suspected that Hamric was involved in a possibly illegal scheme, AmSouth failed to file SARs in a timely manner.” From my reading of these facts, it appears that there was ample evidence an illegal scheme was ongoing, and a Suspicious Activity Report (SAR) should have been filed. As with the underlying facts of Caremark, the underlying facts of Stone v. Ritter are still the basis for enforcement actions today.

Caremark – The Evolution of Board Duties

To create the modern Caremark Doctrine the Delaware Supreme Court had to overcome prior existing Delaware law regarding the board’s obligations. That decision from 1963, is known as  Allis-Chalmers, addressed the question of potential liability of board members for losses experienced by the corporation as a result of the corporation having violated US antitrust laws. 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,  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 save the corporation from the loss. In Allis-Chalmers the Court found “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.” As there were no grounds for suspicion in by the board, the directors were blamelessly unaware of the conduct leading to the corporate liability.

The Court found that the obligations for a board had evolved significantly from 1963, most notably in three areas. First, in the area of corporate takeovers, the court viewed “the seriousness with which the corporation law views the role of the corporate board.” The second area was the recognition as an “essential predicate for satisfaction of the board’s supervisory and monitoring role under Section 141 of the Delaware General Corporation Law.” The third and final change was the 1992 US Sentencing Guides and the “potential impact of the federal organizational sentencing guidelines on any business organization. Any rational person attempting in good faith to meet an organizational governance responsibility would be bound to take into account this development and the enhanced penalties and the opportunities for reduced sanctions that it offers.”

To effectuate this change, the court stated “I am of the view that a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.” Moreover, “it is important that the board exercise a good faith judgment that the corporation’s information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations, so that it may satisfy its responsibility.”

Conclusion

It is this final language which forms the basis of the modern Caremark Doctrine. There has been expansion of the Doctrine from this basic language over the past 25 years. Hopefully every board is aware of their obligations and are actually meeting them. However, every CCO and compliance professional needs to make the board aware of its Caremark obligations and then educate them on how to fulfill those obligations.

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A Caremark Retrospective: Part II – Holdings and Rationale

Today, I continue my exploration of two of the most significant cases regarding Boards of Directors and corporate compliance; the Caremark and Stone v. Ritter decisions. The former decision was released in 1996 and the latter, some ten years later in 2006. The original Caremark decision laid the foundation for the modern obligations of Boards of Directors in oversight of compliance in general and a company’s risk management profile in particular. Stone v. Ritter confirmed the ongoing vitality of the original Caremark decision. Yesterday, in Part 1, we reviewed the underlying facts of the Caremark decision. Today, in Part II, we consider the holdings and the legal reasoning. Perhaps the most interesting thing about both cases is that even though the Court in Caremark delineated the doctrine and in Stone v. Ritter confirmed it, both Courts ruled against the moving parties and for the defendant corporate Boards.

Caremark

In Caremark, the Court began by noting that director liability for a breach of the duty to exercise appropriate attention can come up in two distinct contexts. In the first, liability can occur from a board decision that results “in a loss because that decision was ill advised or “negligent””. In the second, board liability for a loss “may be said to arise from an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss.”

However, any decision is tempered by the following, what “may not widely be understood by courts or commentators who are not often required to face such questions, is that compliance with a director’s duty of care can never appropriately be judicially determined by reference to the content of the board decision that leads to a corporate loss, apart from consideration of the good faith or rationality of the process employed.” In other words, if there is a process or protocol in place a board cannot be said to have violated its duty, even with “degrees of wrong extending through “stupid” to “egregious” or “irrational”.” To do so would abrogate the Business Judgment Rule.

The Caremark court went so far as to cite Learned Hand for the following, “They are the general advisors of the business and if they faithfully give such ability as they have to their charge, it would not be lawful to hold them liable. Must a director guarantee that his judgment is good? Can a shareholder call him to account for deficiencies that their votes assured him did not disqualify him for his office? While he may not have been the Cromwell for that Civil War, Andrews did not engage to play any such role.”

However, there is a second type of liability which boards can run afoul of under Caremark, and it is the one which seems to the liability under which most boards are found wanting in successful Caremark claims. It is when “director liability for inattention is theoretically possible entail  circumstances in which a loss eventuates not from a decision but, from unconsidered inaction.” This was a departure from prior Delaware case law which said that a board did not have to look for wrongdoing but only had to investigate if informed about it. That was from an old 1963 decision and the Court relied on the 1992 US Sentencing Guidelines to note how such views were no longer accepted. Board obligations had changed by 1996 with the following, “obligation to be reasonably informed concerning the corporation, without assuring themselves that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with law and its business performance.”

Stone v. Ritter

This case involved money laundering and a bank’s failure to report suspicious activity which led to an employee running a Ponzi scheme. The bank in question was fined over $40 million. Once again, the plaintiffs were not successful in their claims. The Stone v. Ritter court approved the Caremark Doctrine and went on to further specify thatCaremark required a “lack of good faith as a “necessary condition to liability”.” It is because the Court was not focusing simply on the results but in the board’s overall conduct “of the fundamental duty of loyalty.” It follows that because a showing of bad faith conduct, “is essential to establish director oversight liability, the fiduciary duty violated by that conduct is the duty of loyalty.”

Interestingly, the Court added what it termed as “two additional doctrinal consequences.” First, although good faith is a “part of a “triad” of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty.” Violations of the duties of care and loyalty may result in direct liability, whereas a failure to act in good faith may do so, but it would only result in indirect liability. The second consequence is that the “duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it in Guttman, “[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.””

The Stone v. Ritter court ended by further refining the Caremark Doctrine to define the necessary conditions for director liability under Caremark. They are:

  1. Directors utterly failed to implement any reporting or information system or controls;
  2. If they have implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.

In either situation, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.

As usual, once I get started, I often cannot stop so in my next blog post (or two) I will consider how this has evolved.

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One Month to More Effective Internal Controls – Board of Directors’ oversight as an internal control

Is a Board of Directors a compliance internal control? The clear answer is yes. In the 2020 FCPA Resource Guide, Hallmarks of an Effective Compliance Program, there are two specific references to the obligations of a Board in a best practices compliance program. One states, “Within a business organization, compliance begins with the Board of Directors and senior executives setting the proper tone for the rest of the company.” The second is found under the Hallmark entitled “Oversight, Autonomy and Resources,” which says the CCO should have “direct access to an organization’s governing authority, such as the Board of Directors and committees of the Board of Directors (e.g., the audit committee).”

Further, under the U.S. Sentencing Guidelines, the Board must exercise reasonable oversight on the effectiveness of a company’s compliance program. The DOJ Prosecution Standards posed the following queries: Do the directors exercise independent review of a company’s compliance program, and are directors provided information sufficient to enable the exercise of independent judgment? The DOJ’s remarks drove home to me the absolute requirement for Board participation in any best practices or even effective anti-corruption compliance program.
Three key takeaways:

  1. Board oversight over the compliance function is a separate internal control so document it and use it.
  2. Board must perform oversight over your company’s internal controls.
  3. Does your Board use the five principles for involvement in compliance internal controls?

For more information on how to build out a best practices compliance program, including internal controls, check out The Compliance Handbook, 3rd edition.