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Blog

The World Has Changed: McDonald’s and the Oversight Duty of Officers-Part 2

This week, we are exploring a shift in the duties of care owed by corporate officers to the corporation. It is coming through the Chancery Court of Delaware in the case of McDonald’s Corporation and its former Executive Vice President and Global Chief People Officer of McDonald’s Corporation, David Fairhurst and his part in the creation of an absolute toxic atmosphere of sexual harassment at the very highest levels of the organization. It is styled In re McDonald’s Corporation Stockholder Derivative Litigation, and the court formally recognizes the oversight duties of officers of Delaware corporations. Today we consider the legal reasoning in the opinion.

Yesterday we began a discussion on the legal reasoning. Most compliance practitioners point to the 1996 Caremark decision as the one which set a Board’s duty around compliance. However, there has long been a duty of oversight in Delaware law, for Boards of Directors since at least the 1960s but for officers as well. In 1963, the Delaware Supreme Court established a Board duty when red flags are brought to its attention in the case of Graham v. Allis-Chalmers Manufacturing Co., which held that directors have an obligation to respond if information reached them, but created no affirmative duty to set up an information system to learn about issues within the company. A limited duty of oversight arose only if the directors had already learned enough to suspect that there were issues that needed overseeing. This was termed a “Red-Flags Claim” or a “Red-Flags Theory” of liability. This is also known as “Prong-One” Board liability.

Caremark created that affirmative duty for Board’s to engage in oversight. The Caremark court formulated a “more functional terminology, that species of claim can be called an “Information-Systems Claim” or an “Information- Systems Theory” of Board liability, also known as “Prong-Two” Board liability. In this type of case, a plaintiff typically pleads a prong-two Caremark claim by alleging that the board’s information systems generated red flags indicating wrongdoing and that the directors failed to respond. In McDonald’s Corp we now see both Prong-One and Prong-Two liability expanded to officers.

The Court of Chancery listed three key sources for expanding this duty from Boards to officers.

  1. Management runs a company. While Board’s oversee management, “most corporations are managed ‘under the direction of’ the board.” Moreover, “In the typical corporation, it is the officers who are charged with, and responsible for, running the business of the corporation.” Finally, “Because of this reality, “[m]onitoring and strategy are not exclusively the dominion of the board. Actually, nondirector officers may have a greater capacity to make oversight and strategic decisions on a day-to-day basis.”
  2. Boards depend on information from management. Here the court noted that “For relevant and timely information to reach the board, the officers who serve as the day-to-day managers of the entity must make a good faith effort to ensure that information systems are in place so that the officers receive relevant and timely information that they can provide to the directors.” From this, “it follows that officers must have a duty to make a good faith effort to establish an information system as a predicate to fulfilling their obligation to provide information to the board.”
  3. Compliance systems required under the USSG. The US Sentencing Guidelines (USSG) mandate that “[h]igh- level personnel of the organization shall ensure that the organization has an effective compliance and ethics program, as described in this guideline.” This requirement includes that “Specific individual(s) within high-level personnel shall be assigned overall responsibility for the compliance and ethics program.” The USSG goes on to define an organization’s “high-level personnel” as “individuals who have substantial control over the organization or who have a substantial role in the making of policy within the organization,” which includes “a director; an executive officer; an individual in charge of a major business or functional unit of the organization, such as sales, administration, or finance; and an individual with a substantial ownership interest.” This has the added benefit of putting compliance professionals directly in the path of liability created in this decision.

Interestingly since the Delaware courts had not explicitly expanded the duty of oversight to offices, the court looked at some bankruptcy court decisions for guidance. Here the Delaware court found, there were both Prong-One Red Flag claims and Prong-Two Information Systems claims available against officers under certain circumstances. The Delaware court concluded this section with the following “All of the foregoing authorities start from the premise that officers owe the same duties as directors. Because directors owe a duty of oversight, these authorities reason that officers owe a duty of oversight. That logic is sound.”

In a section I found very interesting, the Delaware court noted that officers have fiduciary duties to the corporation akin to those duties agents owe their principals. Here the court pointed to a prior Delaware decision, which “recognized a standard of conduct at the officer level that included a duty to act carefully, loyally, and in good faith to gather and provide information, with the standard of liability for the care dimension of the duty measured by gross negligence. By recognizing the duty to provide information, Hampshire lays the foundation for an officer-level duty consistent with an Information-Systems Theory.” The Court also found there is officer accountability to the Board which supports this extension of the duty of oversight to officer.

With this legal underpinning in place, please join me tomorrow to explore how this decision will impact Chief Compliance Officers.

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Daily Compliance News

January 30, 2023 – The Robbing Ohio Blind Edition

Welcome to the Daily Compliance News. Each day, Tom Fox, the Voice of Compliance, brings you compliance-related stories to start your day. Sit back, enjoy a cup of morning coffee and listen to the Daily Compliance News. All from the Compliance Podcast Network. Each day we consider four stories from the business world, compliance, ethics, risk management, leadership, or general interest for the compliance professional.

Stories we are following in today’s edition of Daily Compliance News:

  • Is corruption robbing Ohio blind? (Ohio Capital-Journal)
  • Shareholders can sue execs for ‘failure of oversight.’ (Reuters)
  • Is SBF contacting witnesses edition? (WSJ)
  • The court hearing on a monitor for Boeing. (Law360)
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Blog

A Caremark Retrospective: Part I – Background

It is often instructive to look back at old cases which have become so well known for a doctrine that the underlying facts are often forgotten. I did so recently in reading the original Caremark and Stone v. Ritterdecisions. The former decision was released in 1996 and the latter, some ten years later in 2006. They both made interesting reading and the underlying facts could well be drawn from the headlines of anti-corruption and anti-money laundering (AML) enforcement actions today. 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 originalCaremark decision. Today, in Part 1, we review the underlying facts of the Caremark decision and in Part II, the legal reasoning.

Underlying Facts

In Caremark, the decision 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 try and 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.

Multiple federal investigations found that from the mid-1980s until the early 1990s, Caremark paid out millions to doctors in forms disguised to evade ARPL liability. Caremark claimed that its payments for consultation, teaching, research grants and other similar evasions did not violate the law. Further, it relied on an audit by Price Waterhouse (PwC) which concluded that there were no material weaknesses in Caremark’s control structure.

In 1993, Caremark formally changed its compliance manual to prohibit such payments, announced this change internally and put on training for this new set of policies. However, there were no attendant controls, monitoring or follow up noted. Indeed, it is not clear if much if anything changed at Caremark, given the decentralized nature of its business model.

Criminal and Civil Charges

In August 1994, Caremark was hit with a 47-page indictment alleging criminal violations of ARPL, specifically including making payments to induce physicians to refer patients to Caremark services and products. The indictment alleged that payments were “in the guise of research grants and others were consulting agreements.” Moreover, the Indictment went on to allege that such payments were made where no consulting services or research performed. (Very 2022 FCPA-ish) One doctor was alleged to have direct payments from Caremark for staff and offices expenses. Multiple shareholder suits were filed against the Board in Delaware and another federal Indictment was handled in Ohio. In addition to the claims in Ohio, new allegations of over billing and inappropriate referral payments made in Georgia and “reported that federal investigators were expanding their inquiry to look at Caremark’s referral practices in Michigan as well as allegations of fraudulent billing of insurers.” Rather amazingly, the company management, when reporting the Indictment to the Board of Directors, maintained the company had done nothing wrong.

Settlements

Of course, the Caremark senior management was not correct, and Caremark was required to pay millions to resolve enforcement actions. An agreement, with the Department of Justice (DOJ), Office of Inspector General (OIG), US Veterans Administration, US Federal Employee Health Benefits Program, federal Civilian Health and Medical Program of the Uniformed Services, and related state agencies in all fifty states and the District of Columbia required a Caremark subsidiary to enter a guilty plea to two counts of mail fraud, and required Caremark to pay $29 million in criminal fines, $129.9 million relating to civil claims concerning payment practices, $3.5 million for alleged violations of the Controlled Substances Act, and $2 million, in the form of a donation, to a grant program set up by the Ryan White Comprehensive AIDS Resources Emergency Act. Caremark also agreed to enter into a compliance agreement with the Department of Health and Human Services (HHS).

In addition to all these entities, Caremark was also sued by several private insurance company payors (“Private Payors”), who alleged that Caremark was liable for damages to them for allegedly improper business practices related to those at issue in the OIG investigation. As a result of negotiations with the Private Payors the Caremark Board of Directors approved a $98.5 million settlement agreement with the Private Payors in 1996.

In addition to the financial penalties, Caremark finally agreed to institute a full compliance program. It created the position of Chief Compliance Officer (CCO) and created a Board level Compliance and Ethics Committee who, with the assistance of outside counsel, was tasked with reviewing existing contracts and advanced approval of any new contract forms.

Join us for our next piece where we consider the court holdings and rationales in Caremark and Stone v. Ritter.

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The Woody Report

Twitter v. Elon Musk

Welcome to The Woody Report, where Washington & Lee School of Law Associate Professor Karen Woody and host Tom Fox discuss issues on white collar crime, compliance issues, international corruption, securities and accounting fraud, and internal corporate investigations. From current events to topical issues to academic research and thought leadership, Karen Woody helps lead the discussion of these issues on the new and exciting podcast. In this episode, Tom and Karen explore the Twitter lawsuit against Elon Musk for failing to follow through on his agreement to purchase Twitter. Some of the issues we explore include:

  1. Twitter Complaint
  2. What is specific performance?
  3. What is an equitable remedy?
  4. Why is this matter in Delaware?
  5. The judge and her role.
  6. The discovery to date.

Resources

Karen Woody on LinkedIn

Karen Woody at Washington & Lee, School of Law