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Questioning The Caremark Standard

caremark3The Justice Department’s aggressive enforcement program has had a profound impact on corporate governance. As a consequence, the last there has been a significant change in emphasis in the C-Suite, among general counsel and chief compliance officers.

The last bastion of clinging to the old ways has been the corporate boardroom. Change has been much slower.

Most people try to avoid change and cling to their old ways. Change can be uncomfortable. What most people forget is change can be good. Indeed, change can be much better.

Corporate boards have lots of ways to avoid change. One remnant of the past that needs to be reexamined is the Caremark court decision. In that case, the Delaware Chancery Court established the legal standard for evaluating a board of directors’ obligation to supervise or monitor corporate performance.

The facts underlying the case are instructive. In August 1991, the HHS Office of the Inspector General (“OIG”) initiated an investigation of Caremark’s predecessor for violation of anti-referral laws for payments to doctors for referrals of Medicare and Medicaid patients. These investigations eventually resulted in criminal indictments in Minnesota and Ohio.

Shareholder lawsuits were filed alleging improper oversight by Caremark’s board of directors of these activities. In defense, the board cited its efforts to oversee the centralization of Caremark’s operation. In addition, the board of directors was aware of an internal guide to Caremark contracts prohibiting payment of referral fees for Medicare and Medicaid patients. To ensure compliance with the guide, Caremark adopted a policy requiring regional officers to approve each contract.

The Caremark shareholders alleged that the board of directors breached its duty of attention or care in connection with the company’s ongoing operations.caremark

The Chancery Court analyzed relevant precedent to establish a standard for directors to be reasonably informed concerning the corporation through information and reporting systems “reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with law and its business performance.”

Thus, “a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.”

The Court’s decision in Caremark is out of step with current governance practices and requirements. As stated, the Caremark decision is focused more on creating appropriate “information” systems than applying “substantive” minimum ethics and compliance requirements.

caremark2The Caremark decision provides an unfair refuge for corporate boards that cling to form over substance – information over action. I am not suggesting that corporate boards be second-guessed on their compliance decisions but I am arguing for a greater scrutiny of corporate board exercise of discretion and actions taken.

The ethics and compliance field has been radically transformed with new tools, new research and new approaches. Additional resources have been allocated to the ethics and compliance function. Change has come in the form of new expectations and performance standards for everyone involved. It is now time for corporate boards to do the same, hold themselves to a higher standard and raise the level of corporate governance. To do that, Caremark has to be re-examined to take into account the new realities of ethics and compliance.

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