Case Study: The Caremark Decision

While specific case law regarding an "effective company compliance program" is scarce, the Delaware Court of Chancery addressed the issue in the 1996 decision In re Caremark International, Inc. In its decision, the Chancery Court warned that directors failing to assure that an organization takes adequate compliance measures could be held personally liable for subordinate wrongdoing.

In leading up to the Delaware Court's decision, Caremark had been the subject of a four-year government investigation for violating federal and state regulations prohibiting health-care providers from paying kickbacks in exchange for patient referrals. The investigation resulted in felony indictments, a guilty plea and the payment of fines and reimbursements totaling $250 million.

Following the government prosecution, Caremark's shareholders brought derivative suits against the company seeking recovery from directors for failure to detect illegal employee activities through adequate supervision and monitoring systems. The suit led to a settlement agreement under which Caremark paid the plaintiffs' legal fees and expenses and the board adopted certain remedial measures aimed at improving compliance in the future.

In approving the settlement agreement, the Court said that under Delaware law directors are not required to "operate a corporate system of espionage" to uncover employee wrongdoing they have no reason to suspect. However, the Court noted that the ongoing duty of care required directors to assure that information and reporting systems exist and are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board to reach informed judgments concerning both the corporation's compliance with the law and its business performance.

In reaching this decision, the Court based its conclusion on past Delaware court opinions and the 1991 Federal Organizational Sentencing Guidelines calling them, "powerful incentives for corporations today to have in place compliance programs to detect violations of law promptly, to report violations to appropriate public officials when discovered, and to take prompt, voluntary remedial efforts." Continuing, the Court added, "The Guidelines create such strong incentives for corporations to establish compliance programs that any rational person attempting in good faith to meet an organizational governance responsibility would be bound to take into account this development…and the opportunities for reduced sanctions that it offers."

The Court noted, "In order to show that the Caremark directors breached their duty of care by failing adequately to control Caremark's employees, plaintiffs would have to show either (1) that the directors knew or (2) should have known that violations of law were occurring and, in either event, (3) that the directors took no steps in a good faith effort to prevent or remedy that situation, and (4) that such failure proximately resulted in the losses complained of…"

Concluding, the Court wrote, "The record supplies essentially no evidence that the director defendants were guilty of a sustained failure to exercise their oversight function. To the contrary, insofar as I am able to tell on this record, the corporation's information systems appear to have represented a good faith attempt to be informed of relevant facts. If the directors did not know the specifics of the activities that lead to the indictments, they cannot be faulted…The record at this stage does not support the conclusion that the defendants either lacked good faith in the exercise of their monitoring responsibilities or conscientiously permitted a known violation of law by the corporation to occur."

So what does the Chancery Court's decision mean? According to U.S. Sentencing Commissioner John Steer, the Delaware Court, in its Caremark decision, was essentially saying, "Compliance programs are a good idea." Continuing, Steer said, "The case is a good example that shows the potential dangers of not having a compliance program in place."

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