When It Comes To A Lack Of Ethics, Ignorance Is No Defense

Last fall, you could almost feel the shudder passing through corporate boardrooms. A federal judge in California refused to dismiss lawsuits against 15 present and former directors of Wells Fargo & Co. over the massive fake-account scandal that publicly erupted in 2016.

In an Oct. 4 ruling, U.S. District Judge Jon Tigar said it was hard to believe directors didn’t know about the high-pressure sales culture that drove Wells Fargo employees to open thousands of fraudulent accounts in their customers’ names. “It is implausible the Director Defendants were unaware of the account-creation scheme given the extent of the alleged fraud and the number of red flags,” the judge wrote.

Tigar’s decision to allow plaintiffs to sue Wells Fargo’s directors personally was a chilling reminder that executives aren’t the only ones who can be held accountable for corporate misconduct. In rare circumstances—which may become less rare if the Wells Fargo ruling stands—directors can be found liable for failing to heed obvious signs of trouble occurring on their watch.

For more than two decades, directors took comfort in a Delaware Supreme Court decision involving a bribery scandal that struck the prescription-benefit company Caremark in the early 1990s. As with Wells Fargo, shareholders hit Caremark with a so-called derivative lawsuit on behalf of the corporation itself, seeking damages from officers and directors.

“Caremark changed the law in a subtle but important way: Now they have to make sure the internal detectives are on the beat. And if they don’t hear anything, Then they need to ask again.”

The Caremark decision did leave a narrow opening for lawyers to sue directors directly over corporate misconduct. If the board failed to make sure the company’s reporting systems were sufficient to detect serious misconduct, then maybe, just maybe, they could be liable for the resulting damages.

“If you’re really that insidiously cavalier and willfully ignorant about what you’re supposed to be doing, yeah, it can be a breach of duty,” said Lawrence Hamermesh, professor of corporate law at Widener University’s Delaware Law School.

Directors of the coal-mining company Massey Energy learned this in 2011 when Delaware Judge Leo Strine said that they may have violated their duty of loyalty to shareholders by overlooking the company’s long record of safety violations and Chief Executive Don Massey’s very public taunts of the Obama administration’s mining-safety regulators. Massey pled guilty to criminal violations of safety laws in a 2006 fire that killed two miners and established a board-level safety committee to settle a derivative suit in 2008. Yet the company racked up a record 10.653 citations in 2009 and in April 2010 a massive explosion at Massey’s Upper Big Branch mine killed 29.

“Delaware law does not charter law breakers,” Strine wrote in a decision which, for other technical reasons, let directors largely off the hook. “As a result, a fiduciary of a Delaware corporation cannot be loyal to a Delaware corporation by knowingly causing it to seek profit by violating the law.”

Where does Wells Fargo fall between Caremark and Massey Energy?

“It’s all about red flags,” Hamermesh said. “What kind of notice is enough to persuade a court a director could be held liable in retrospect?”

The plaintiffs in Wells Fargo point to plenty of flags, including whistleblower complaints and a December 2013 article in The Los Angeles Times that basically outlined the fraudulent scheme that would erupt in full public view a couple of years later. Directors will point to an independent investigation by lawyers at Shearman & Sterling that concluded the board was misled by managers about how many employees were engaged in wrongdoing and responded forcefully once they discovered the magnitude of the problem in late 2015.

Under the old rules before Caremark, courts generally held directors had “no duty to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.” Caremark changed that in a subtle but important way: Now they have to make sure the internal detectives are on the beat. And if they don’t hear anything? Then they need to ask again.