The Cost of Director Inattentiveness

by Michael W. Peregrine, McDermott Will & Emery LLP

The personal cost of director inattentiveness is made painfully clear in an important federal appeals court decision. The decision, in re Lemington Homes, was decided on January 26, 2015 by the U.S. Court of Appeals for the Third Circuit.

Arising from the health care sector, the decision applies both traditional liability standards and controversial concepts of “deepening insolvency” to a board’s oversight of management and financial affairs during a period of great organizational stress. It also addresses the appropriateness of punitive damages against officers and directors.  In particular, the decision’s critical evaluation of director performance provides board members across industry sectors with a stark reminder that their conduct   may be actionable by third parties. As such, the decision offers a particularly valuable – and practical – board education opportunity.

Fundamentally, the liability awards in this case were based on a determination that the directors failed to exercise reasonable diligence and prudence in their oversight of the institution and its poorly performing management team. The duty of care/inattentiveness breaches arose from a series of board failings, including hiring inexperienced and under qualified executives; lack of responsiveness to serious quality of care deficiencies of which the board was made aware; allowing the CEO to work on what was essentially a part time basis; and failing to terminate the senior executives despite knowledge of their mismanagement.  The court determined that the directors were aware of the mismanagement yet took no action, despite clear evidence of deficient care to the institution’s residents. For this breach of care, $2,250,000  in joint and several compensatory damages were awarded against fifteen of the seventeen directors.

The liability awards were also based on a determination that the directors’ actions/inactions served to deepen the institution’s insolvency. “Deepening insolvency” is a controversial tort liability theory that presumes that certain kinds of fraudulent actions by fiduciaries of an insolvent corporation may serve to damage the remaining value of corporate assets. In this case, the problematic actions included allowing the institution’s resident census (and its ability to generate revenue) to be depleted before filing for bankruptcy, and its general mismanagement of the bankruptcy process—including the failure to establish a sale process despite advice of counsel to do so.

It is important to note that the liability findings in this case arose despite an unusually sympathetic set of individual defendants—volunteer directors of one the oldest, nonprofit nursing homes serving a predominantly minority constituency. One of the director defendants was a minister. It is also important to note that this case was instituted by the Official Committee of Unsecured Creditors. In an insolvency/bankruptcy proceeding, unsecured creditors can often prove relentless in their scrutiny of director conduct. The only good news for the directors is that the appeals court concluded that their otherwise problematic director conduct was neither “egregious” nor “outrageous” conduct (e.g., intentional, reckless or malicious) and thus were insufficient to support a trial award of punitive damages against five of the director defendants.

To be sure, these difficult facts arose from a small, nonprofit organization—a far cry from a Fortune 1000 corporation. Yet the standard of director conduct applied by the appeals court is quite similar to that which might be applied to a traditional corporate board. The message of this new decision is that directors will expose themselves to the risk of personal liability when they fail to respond to clear indications of executive incompetence or mismanagement. The ability of directors, in the exercise of their fiduciary obligations, to rely on the advice of the senior leadership team will likely be lost when the facts suggest they were aware of reasons (e.g., incompetence) that would have made such reliance unreasonable.

This new decision need not make the board/management dynamic more complex or contentious. It does not serve to hold directors to an unusually high standard of oversight of senior leadership. But it does serve as a very practical “real life” example that there are personal liability risks associated with inaction given evidence of executive mismanagement. “Sticking your head in the sand” in the face of management red flags is a recipe for personal exposure in any boardroom, in any type or size of corporation.

Michael W. Peregrine, a partner in McDermott Will & Emery, advises corporations, officers and directors on matters relating to corporate governance, fiduciary duties and officer/director liability issues. His views do not necessarily reflect the views of McDermott Will & Emery or its clients.