Directors Beware! Caremark to Centro

Co-author: Ashok K. Gupta

Index

1. Introduction
2. Business Judgement Rule
3. One and a Half Cases
   • Caremark
   • Facts
   • Analysis
   • Marchand
   • Facts
   • Analysis
   • Boeing
4. Centro
   • Facts
   • Analysis
5. Situation in India
6. Best Practices
7. References

Introduction

When is it possible to investigate whether the directors of a company have done their job properly or not? Only when the wheels have fallen off the cart.

Things can go wrong for a company in two ways which we’ll call Type I and II situations for simplicity:

• Type I – it is uncovered that the company has done something criminal such as fraud
• Type II – in the ordinary course of business, poor decision-making has led to loss

In India, there is a long history of directors being pulled up in Type I situations [1][2][3]. This is not the focus of this article. What is not common in India or in the world is directors being held accountable when in the ordinary course of business, the company heads for disaster under their watch i.e. Type II situations.

Despite any belligerent nationalism to the contrary, our regulators and courts watch developments in the world with keen eyes. Sooner or later the regulatory and legal framework in India evolves to match the rest of the common-law world.

In this article, we will discuss 3 ½ cases from the USA and Australia which show that Indian directors need to re-evaluate what it means to ‘do their job properly.’

Business Judgement Rule

Business leadership is neither an easy nor a certain task. Directors are in a difficult position. On the one hand they must guide the company to the best outcomes for shareholders while on the other they are responsible for maintaining the health of the company. As directors must walk a tightrope in their roles, courts world-over have tended to grant them a strong measure of protection for any of their ‘good-faith’ decisions which go wrong. In the USA this protection is called the ‘business judgement rule’ [4]. As the terms suggests it protects a director from liability for the negative outcomes of any decisions, he took in his best business judgement.

The same rule exists in all common-law countries albeit with different nomenclature often including the phrases, ‘actions taken in good faith’ or ‘with bona fide intentions.’

One and a Half Cases

Caremark

The West is protective of its Industry. In the US especially, walls around directors were historically set very high. The Business Judgement rule was historically taken very seriously.

‘In re Caremark International inc.’ [5] was a landmark legal opinion that changed the way US courts approached litigations against directors.

Facts

Analysis

As we discussed in a previous article, in the US most civil suits are settled out of court. Such was the case in Re Caremark as well. What we do have is the opinion of a judge as to what his judgement would have been had the case gone to trial. This opinion also carries his thoughts on the suitability of the settlement amount. The judge’s analysis discloses certain important points for director liability:

1. Prior to the proposed settlement, the Board of Caremark did not have a Compliance and Ethics Committee. This was proposed to be established as part of the settlement terms. In India, guidelines under the Companies Act and from SEBI ensure that public companies mandatorily have several committees such as the Risk Management Committee and Stakeholder Relationship Committee which serve a similar purpose. The danger with statutorily mandated committees is that the working of these committees can become ‘tick box’ exercises.
2. Director’s liability for breach of duty can be through (1) a loss because of an ill-conceived action (2) loss due to an ‘unconsidered’ failure to act in a situation which warrants action.
3. A director’s action that leads to a loss is protected by the business judgement rule. A court cannot evaluate the content of the action as it is ill-equipped to do so. What it can evaluate is the appropriateness of the process that led to the action.
4. If shareholders believe that directors should have had better judgement and taken better action, then the shareholders should have appointed more skilled directors.
5. The Court noted that the plaintiff’s contention in this case was ‘possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment. The good policy reasons why it is so difficult to charge directors with responsibility for corporate losses for an alleged breach of care, where there is no conflict of interest or no facts suggesting suspect motivation involved.’
6. Directors are not the same as management. There are only certain matters which are directly within the purview of directors such as M&A, changes in capital structure etc. All other matters are handled by management and directors simply exercise oversight.

The last observation led to what is known as the Caremark Test. With respect to directors’ responsibility of oversight over management:  

1. Have the directors set up a reasoned and considered information reporting system that gives them information critical to the stewardship of the company?
2. Have the directors failed, on a ‘sustained and systematic basis,’ to monitor the information system thereby overlooking information vital to the company’s business?

In the Caremark opinion, the judge decided that the directors had not been guilty of failing the Caremark Test.

Marchand

The Caremark opinion was dated 1996 – many years later in 2018, the Marchand case [6] changed the Caremark test from an impossibly high hurdle to a reasonable test of the Board’s performance.

Facts

Analysis

The Marchand case did not overrule Caremark but it reframed how courts would look at such issues from then on. No longer would director liability be ‘the most difficult theory.’

The important points that emerged from the judgement were:

• The Blue Bell Board had utterly failed to set up an effective information system to receive reports on food safety. As a monoline company that manufactured and sold food, the Board should have treated food safety as a top priority.
• In Caremark the claimants had to prove that the directors had completely failed to either set up an information reporting system or failed to monitor it. However, Marchand shifted the goal post and stated that directors had a duty to make a ‘good faith’ effort to set up and monitor the information reporting system.
  • The difference between Caremark and Marchand is a subtle one. As an example, in Marchand the judge noted that Blue Bell had always been nominally compliant with the FDA regulation checklist. However, these regulation checklists were intended to check compliance at the company-level and not at the Board level.In Marchand, the Court seemed to allow the idea of res ipsa facto (“the thing speaks for itself”) as evidence of the Board’s lack of effort. Indeed, in the years leading up to 2015, the Board had only once briefly discussed food safety as recorded in meeting minutes. Its response to yellow and red flags was also severely lacking. This was a marked change from Caremark, where it appeared that a litigant would have to dig through Board decisions or lack thereof and piece-by-piece build up a case of negligence.
  • Res ipsa facto is a doctrine that is often applied in cases of negligence. If you are walking along a road and a traffic signal falls on you, you would not need to actively prove that the Municipal Corporation was negligent. In the normal state of affairs a traffic signal should not fall and the Municipal Corporation is the only entity that can and should maintain traffic signals. Hence the Corporation is presumed negligent. In other words, the effect indicates the cause.  
• The directors in Marchand contended that Management had discussed operational issues with the Board regularly and thus the directors had met the Caremark criteria of monitoring the information reporting system. The judge in Marchand rejected this contention as it could then be used as a defence no matter how egregious the negligence, simply because the directors obliquely discussed general operational matters. Therefore, specificity of discussions was ruled an important factor to claim the defence of the second part of the Caremark test.

Boeing

The Marchand interpretation of Caremark was not a one-off. It was applied again 2019 when Boeing’s directors [7] sought to settle a suit against them. It had been discovered that the airline manufacturer had outright lied to the Federal Aviation Authority (“FAA”) about the viability of a new navigation system it had developed for its 737 Max jet. Many facts in the Boeing case are remarkably like the Marchand case. However, while in Marchand three lives were lost, in Boeing hundreds of lives were lost.

Many of the observations from the Boeing opinion are like those in Marchand. However, a few new points are:

• From the 2000s onwards, the Boeing Board and senior management became obsessively and solely focused on profit maximization. Board discussions were wholly concentrated on different aspects of the business. Even discussions about safety and risk only considered those aspects from the business angle. In fact, after the Lion Air crash of 2018 which killed all 189 passengers and crew, the Board dedicated itself to damage control to the extent that it blamed the tragedy on the poor skills of the deceased pilots of the ill-fated Lion Air flight.
• Just as the Blue Bell Board did not receive any information on food safety nor discussed it any substantial capacity, the Boeing Board did not receive any significant information on aircraft safety or engineering issues, nor did it seem inclined to discuss those issues.

Centro

It isn’t just the US which is becoming more proactive on the issue of director liability but Australia as well. In fact, as we will see from the infamous Centro case [8] the Australian judiciary has taken an even harder stance on directors’ duty of care than the American judiciary.

The Centro case has been quite contentious since Justice Middleton issued his judgement in 2011. The judgement elevated what was expected of directors considerably.

Facts

Analysis

The judge made some important widely applicable observations in his judgement:

• Directors are required to sign off on financial statements because of the statements’ fundamental importance to the business of the company.
• ‘The higher the office that is held by a person, the greater the responsibility that falls upon him or her.’ With this statement the judge seems to have suggested that directors of a company have a duty of extraordinary care.
• Directors must have acquired a rudimentary understanding of the business, familiarity with the financial status of the company, understanding of financial statements (accounting principles) and must possess a questioning mind.
• Directors have a greater responsibility than simply representing a particular field of expertise.
• The impugned directors contended that if none of the specialist external auditors (Big 4), specialist accountants in the management team, Audit Committee had discovered the irregularity in the financial statements then how could they be expected to.
  • The judge rejected this contention. Directors ought to seek help from other sources but cannot be overly reliant on them. Directors are required to affirm that the financial statements to which they are affixing their signatures give a ‘fair representation’ of the financial health of the company. This is not a tick-box exercise and directors are obligated to apply their own minds and exercise due care and diligence before forming any opinion.
• The directors also contended that the volume of documents presented to them prior to any Board or committee meetings was so large that it would be impossible for them to discover specific mistakes.
  • The judge rejected this assertion. The Board is responsible for discussing and directing what a typical ‘board pack’ should contain. Therefore, it is the Board’s duty to condense the information into useful, manageable chunks.  

Situation in India

If we take the director liability in Type II situations on a spectrum with one end representing Caremark and the other end Centro, India will fall somewhere in the middle. Statutorily we are closer to Australia than to the laissez-faire corporate approach of America. However, in practice one of the issues that courts in India would likely worry about, before adopting Centro, would be the knock-on effect on the supply of independent directors in India.

In India, statutes already clearly spell out directors’ criminal liability. In most of the significant acts promulgated by the Union Government there is a section towards the end, which has clearly been copy-pasted across statutes. This boilerplate section is entitled ‘Offences by Companies.’ It is an interesting section for several reasons, some which are beyond the scope of this article. However, for directors of companies it is important for the following reasons (paraphrased and simplified):

• If a company commits an offence, then any person in an overall leadership role at the company (i.e., directors) is deemed guilty of the same offence simply by virtue of his leadership position.
• The director is allowed to try and prove his innocence either by claiming ignorance of the commission of the offence or by showing that he ‘exercised all due diligence’ to prevent its commission.
• However, ignorance cannot be a defence if it is proved that the director’s negligence contributed to the commission of the offence.

While the ‘Offences by Companies’ section deals with criminal liability, one can reasonably expect that even civil liability would follow a similar pattern. In fact, it is commonly known that the threshold of proof in criminal law is ‘beyond reasonable doubt’. However, in civil law the threshold is usually lower and the claim must just meet the ‘preponderance of probabilities’ threshold.

As we mentioned in the first paragraph of this article, courts have mostly held directors liable for Type I cases in India, specifically when a fraud has been uncovered.

Best Practices

Just because Type II situations haven’t been litigated seriously in India until now doesn’t mean they will not be in the future.

From the 3 ½ cases discussed in this article, certain best practices emerge which Indian directors should proactively start adopting rather than waiting for a cataclysmic Indian judgement to derail the train.

1. Anything that directors are statutorily required to verify, sign off on or formally represent should be treated as a critically important duty. For such a duty:
   • directors should not delegate the duty beyond seeking expert advice.
   • directors must go through all the necessary related information themselves
   • directors are presumed to have sufficient knowledge about what they’re representing. In case of any knowledge gaps, for example in accounting principles, directors must proactively seek to deepen their understanding.
2. Information is king. The Board must:
   • decide which subjects are critical for the Board to directly track.
   • discuss and direct the setting up of a resilient information reporting system which has some level of protection from any management manipulation.
   • direct the nature and volume of board packs such that each director is able read such a pack with attention, focus and critical thinking.
   • directors must insist that minutes of meetings record substantive discussions in more detail. It should not be enough for the minutes to just record the topic, approving directors, dissenting directors and the resolution. Minutes have served as vital evidence of directors’ negligence in all the cases discussed in the article. The converse can also be true. It is the best chance for directors to show that they have acted in ‘good faith.’
3. Directors must be wary of:
   • trusting management reassurances implicitly. As the cliched aphorism, doubtfully credited to Ronald Reagan, goes – ‘trust but verify.’
   • allowing financial objectives to overrule all other considerations. As behavioral economics has shown us, for humans, loss aversion is a stronger force than risk aversion. This is true of shareholders and the State as well.
4. Every company and industry has certain core issues that the Board must regularly discuss in detail while employing critical analysis. A representative list of such core issues for various industries is provided below:

Industry	Critical Business Component
Pharmaceuticals	1.Drug safety/toxicity (think of the recent cough syrup deaths) 2. Intellectual property
Infrastructure	1.Worker safety 2.Environment
Paints & Chemicals	1.Chemical toxicity 2.Environment 3.Safe storage
Electric & Electronics	1. Consumer safety 2. Environment
Travel & Hotels	1.Consumer data 2.Customer experience (refer recent airline incidents)
Information Technology & Communications	1. Intellectual Property 2. Data Protection 3. Platform abuse
Entertainment	1. Intellectual Property 2. Data Protection 3. Platform abuse
Banking & Financial Services	1. Data Protection 2. Process leakages
Retail & E-commerce	1.Consumer data 2.Customer experience (refer recent airline incidents) 3. Worker protection
Defence	1. Worker safety 2. Intellectual property 3. Espionage 4. Confidentiality processes
FMCG	1. Consumer safety 2. Environment
Fashion	1. Consumer experience 2. Environment
Services (e.g. HR)	1. Working conditions 2. Compliance
Food & Beverages	1. Food safety 2. Environment
Oil, Gas and Petroleum	1.Worker safety 2.Environment
Fertilisers & Insecticides	1.Product safety 2. Environment 3. Use/abuse of subsidies

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References

1. 2017 SCC OnLine Cal 8423 [Dr. Mani Kumar Chhetri v. State of West Bengal]
2. (1973) 1 SCC 602 [Official Liquidator, Supreme Bank Ltd. v. P.A. Tendolkar (late) & Ors.]
3. 2005 SCC OnLine Bom 1507 [Official Liquidator of John Galt Laboratories Ltd. v. R.B. Sangare and Others]
4. Lyon, Greg. “Director’s Duty of Care and the Business Judgement Rule.” Australasian Legal Information Institute, Oct. 1998, www.austlii.edu.au/au/journals/LawIJV/1998/326.pdf. Accessed 10 Jan. 2023.
5. 698 A.2d 959 (1996) [In re Caremark Intern, Inc. Derivative Litigation]
6. 212 A. 3d 805 (Del. 2019) [Marchand v. Barnhill & Ors.]
7.  C. A. 2019-0907-MTZ (Del. Ch. Sep. 7, 2021) [In Re: The Boeing Company Derivative Litigation]
8. [2001] FCA 717 [ASIC v Healey & Ors.]

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