This is “Legal Issues Regarding Oversight”, section 6.3 from the book Governing Corporations (v. 1.0).
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Much has been written about the board of directors’ Duty of Care in the decision-making context, which requires directors to perform their duties in good faith and with the degree of care that an ordinary person would use under similar circumstances. Most directors are similarly aware of the protections afforded by the Business Judgment Rule—courts will not second guess directors’ business decisions if the directors act on an informed basis and in good faith. By contrast, the oversight role of the board is less well defined from a legal perspective. The reason is that, in an oversight context, directors are not protected by the Business Judgment Rule if they fail to take action when they become aware of corporate impropriety. Many directors are unfamiliar with this less defined and stricter component of the Duty of Care.This section is based on Kleinman and Thompson (2002).
In adjudicating claims, the law distinguishes between two scenarios: deciding there is no problem and ignoring a problem. When a board considers a situation and makes a decision that results in a loss, the Business Judgment Rule will protect a board’s decision if the board acted in good faith and properly informed itself in the process. The protection of the Business Judgment Rule is not determined by the results of the decision but by the quality of the process employed. For example, when a board conducts a proper investigation and either takes action or consciously decides that action is not necessary, that decision, even if wrong, will be protected by the Business Judgment Rule.
By contrast, when a loss occurs because of a board’s failure to consider a problem, there has been no process, there is no decision to protect, and the Business Judgment Rule does not apply. Instead, directors may face liability for breach of the Duty of Oversight. Rather than having a court defer to the directors’ business judgment, the directors will likely be required to defend a negligence claim. Thus, when directors are aware, or should be aware, of material improper conduct, violations of law or other action that could result in material harm to the organization, the Duty of Oversight demands that directors investigate the matter and decide whether or not corrective action is needed. If the board fails to consider the situation, the board will be criticized for failure to supervise and may face liability under the Duty of Oversight. Specifically, boards can be held liable under the Duty of Oversight for failing to act when they know or should know of wrongdoing.The leading Delaware cases addressing the duty of oversight and related issues are Graham v. Allis-Chalmers Mfg. Co. (1963); In re Caremark International Derivative Litigation (1996); Aronson v. Lewis (1984); Boeing Co. v. Shrontz (1992); and In re Dataproducts Corp. Shareholders Litigation (1991). See also Hansen (1993).
Note that although the board may not take action in either case, the results in the two cases are dramatically different. The Duty of Oversight, therefore, creates an incentive for boards to respond to potential indications of wrongdoing in order to gain the benefit of the Business Judgment Rule.
How can a board protect itself? The law demands that directors investigate when there are red flags. If a director has actual knowledge of a material problem, he or she would be well advised not to wait for management to bring the topic before the board. Proper board action will always be the best defense to a Duty of Oversight claim.
Delaware law allows a corporation, in its certificate of incorporation, to eliminate or reduce the personal liability of directors for breaches of fiduciary duty, including the Duty of Care. Although the Duty of Oversight is considered a component of the Duty of Care, Delaware courts have not specifically held that such a charter provision would bar a Duty of Oversight claim.