In the aftermath of Wal-Mart’s Foreign Corrupt Practices Act scrutiny, certain company shareholders (as is fairly typical in instances of FCPA scrutiny) filed derivative actions against various current or former Wal-Mart officers and directors alleging, among other things, breach of fiduciary duties.
By way of background as to derivative claims, the internal affairs of a corporation, such as the rights of corporate directors, are governed by state law. State law, including most prominently Delaware law, provides directors broad discretion to manage the corporation subject to their fiduciary duties to the corporation and its shareholders. A director’s fiduciary duties include the duty of care and the duty of loyalty, including its subsidiary component the duty of good faith.
A corporate director’s duty of good faith has evolved over time to include an obligation to attempt in good faith to assure that an adequate corporate information and reporting system exists. In the notable Caremark decision by the influential Delaware Court of Chancery, the court held that a director’s failure to do so, in certain circumstances, may give rise to individual director liability for breach of fiduciary duty.
In Stone v. Ritter, the Delaware Supreme Court provided the following necessary conditions for director oversight liability under the so-called Caremark standard: (i) a director utterly failed to implement any reporting or information system or controls; or (ii) having implemented such systems or controls, a director failed to monitor or oversee the corporation’s operations. The court held that both situations require a showing that a director knew that they were not discharging their fiduciary obligations and courts have widely recognize that a director’s good faith exercise of oversight responsibility may not necessarily prevent employees from violating criminal laws or from causing the corporation to incur significant financial liability or both.
Derivative claims, such as those filed against Wal-Mart’s current and former officers and directors, are subject to unique pleading requirements. Ordinarily, a company’s board of directors has the exclusive authority to institute corporate action such as filing a lawsuit on behalf of the corporation when it has been harmed. However, when the harm to the corporation is the result of an alleged breach of fiduciary duty by the directors, the law recognizes that the board of directors is unlikely to sue itself in such a situation. Thus, the law provides a mechanism for shareholders to bring a lawsuit, not in their individual capacity, but on behalf of the corporation to recover monetary damages for the corporation.
Because a derivative action usurps a traditional board of director function and can be subject to harassment and abuse, state law often requires shareholders to first make a demand on the corporation to file suit or to plead with particularity so-called demand futility, meaning that demand on the board would be futile because the board is incapable of making an independent judgment concerning the conduct at issue.
Most derivative actions, including those in the FCPA context, are brought as demand futility cases because if a shareholder makes a demand on the board of directors to bring the claim it will be assumed that the shareholder views the board of directors as sufficiently independent to analyze the claim and the board’s decision will be analyzed under the board-friendly business judgment rule. To survive a motion to dismiss, a shareholder pleading demand futility must allege more than conclusory allegations regarding a breach of fiduciary duty. Rather, the shareholder must allege with particularly facts suggesting that the majority of directors were interested; or that the directors failed to inform themselves; or that the directors failed to exercise due care as to the conduct at issue.
Those who predicted that the Wal-Mart derivative actions would set a new standard for director liability were once again proven wrong (see here for the prior post).
Earlier this week, in this order U.S. District Judge Susan Hickey (W.D. Ark.) dismissed eight Wal-Mart shareholder FCPA-related derivative claims that were consolidated into one action.
Judge Hickey summarized the shareholders allegations as follows.
“Plaintiffs allege that the Individual Defendants breached their fiduciary duties of loyalty and good faith by: (1) permitting violations of foreign and federal laws and Wal-Mart’s code of ethics; (2) permitting the obstruction of an adequate investigation of known potential (and/or actual) violations of foreign and federal laws; and (3) covering up (or attempting to cover up) known potential (and/or actual) violations of foreign and federal laws. Plaintiffs also allege that Individual Defendants violated Sections 14(a) and 29(b) of the Exchange Act by causing Wal-Mart to make false or misleading statements in its April 2010 and April 2011 proxy materials relating to annual director elections.”
After reviewing applicable Delaware law, Judge Hickey stated, in pertinent part, as follows.
“The Complaint consistently implies that Defendants should have or must have known about the alleged misconduct by virtue of their positions and the supposed reporting structure at Wal-Mart. According to Plaintiffs, “senior executives … knew about” the alleged misconduct, those “executives [were] required to regularly report to the Audit Committee of Wal-Mart’s Board,” and the Audit Committee, in turn, “was obligated to report on [this] to Wal-Mart’s full Board.” Plaintiffs allege that, given the “inference” that information concerning bribery was reported to Wal-Mart’s Board, Wal-Mart made a conscious decision not to act on this information.
Plaintiffs reference vague “decisions” made by Defendants but do not plead with particularity who made these decisions, how these decisions were made, or when the decisions were made. Plaintiffs generally allege that the Board made a decision not to act in response to evidence of criminal conduct. Missing from the Complaint are any particularized facts that link a majority of the Director Defendants to any actual decision. Plaintiffs point to no alleged meeting, discussion, or vote where the Board allegedly made one of these decisions. This lack of such particularized facts regarding a conscious decision about how or whether to respond to the alleged misconduct indicates that an analysis under Aronson is inappropriate.”
Elsewhere, Judge Hickey stated:
“According to Plaintiffs, nine Director Defendants knew about the wrongful conduct in 2005-2006 (the alleged bribery in Mexico and the internal investigation that allegedly concealed the wrongdoing) and either actively participated in it or acquiesced in it. Defendants argue that Plaintiffs have failed to sufficiently plead that a majority of the Board knew about or consciously ignored the alleged wrongful conduct in 2005-2006 and therefore cannot show that a majority of the Director Defendants face a substantial likelihood of personal liability. The Court agrees.
Nothing in the Complaint suggests any particularized basis to infer that a majority of the Board had actual or constructive knowledge of the alleged misconduct, let alone that they acted improperly with scienter. Plaintiffs’ allegations do not provide the particulars for what each Director Defendant knew, how he or she learned of the information, or when he or she learned of the information. Thus, as discussed below, Plaintiffs have failed to plead with particularity that at least eight Director Defendants face a substantial likelihood of personal liability so that their ability to consider a demand impartially would be compromised.”
“Courts may not impute knowledge of wrongdoing to directors simply because they serve on the board or because the corporate governance structure requires that notice of the wrongdoing reach the board.”
In a footnote, Judge Hickey’s order states: “The Foreign Corrupt Practices Act prohibits United States companies from bribing foreign officials to secure improper business advantage.”
This is an inaccurate statement of law.
Rather, the FCPA contains an “obtain or retain business” element that must be proved. Indeed, the DOJ’s position that the FCPA captures payments to “secure an improper business advantage” wholly apart from the “obtain or retain business” element has been specifically rejected by courts. (See here for the prior post).
The inaccurate statement of law in the order is perhaps not surprising given that the Judge referred to the FCPA as the “Federal Corrupt Practices Act.”
For additional coverage of Judge Hickey’s decision – as well as its potential impact on current Delaware court proceedings arising from the same alleged facts – see here form the D&O Blog.