The Management Friendly Nature of Delaware Courts: Of Boards, Ostriches, and the Absence of a Duty to Create a “Better” Reporting System (Part 1)
The Delaware courts sometimes assert that they do not tolerate an "ostrich" approach to fiduciary obligations. See White v. Panic, 793 A.2d 256 (Del. Ch. 2000) (noting that “Director Defendants are not alleged to have ‘hidden their heads in the sand’ instead of addressing a source of potential liability”). In other words, directors cannot escape liability by deliberately remaining uninformed.
Yet protestations to the contrary notwithstanding, the Delaware courts have in fact created a standard that encourages exactly this kind of behavior. See In re Walt Disney Co. Deriv. Litig., 825 A.2d 275 (Del. Ch. 2003) (“The new complaint, fairly read, also charges the New Board with a similar ostrich-like approach regarding Ovitz's non-fault termination.”).
Since the days of Caremark, 698 A.2d 959 (Del. Ch. 1996), it has been black letter law in Delaware that corporations need to have a system for keeping the board of directors informed. Liability could arise where through “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”. This could occur where “directors utterly failed to implement any reporting or information system or controls”. Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)(footnotes omitted).
Of course, the decision was no progressive beacon in the development of director duties. Boards already routinely put these systems in place whether because of the sentencing guidelines or SEC requirements. Indeed, if anything, it was late in the game – 1996 – that Delaware courts finally recognized these duties.
Reporting systems had the capacity to significantly increase the legal exposure of directors. Once a matter of importance was reported to the board, directors could be liable to the extent consciously disregarding the concerns. Thus, directors had an incentive to address what was reported but otherwise not request additional information, particularly on matters that could require them to act.
Although boards had a fiduciary obligation to put in place a reporting system, the court left open the requirements of any such system. The parameters of any reporting system depended upon the business judgment of the board. Nonetheless, as a practical matter, the obligation was to have a reporting system. The actual mechanics hardly mattered. Arguments that the reporting system should have been “better” were summarily dismissed.
The result was that boards had an incentive to put in place a reporting system but had no incentive to ensure that the system was robust. Said another way, directors had no incentive to improve the quality of the system to ensure that they received the information needed to address ongoing problems or concerns within the company. This was brought home with considerable clarity in In re General Motors Co. Derivative Litigation.