Summary of Stone v. Ritter
Citation: 911 A.2d 362 (Del. 2006)
Relevant Facts: Plaintiff William Stone, together with his wife Barbara, brought this stockholder derivative suit against C. Dowd Ritter and other current and former executives of AmSouth Bancorporation. The Stones alleged in their complaint that the director defendants were liable for corporate losses, and resulting stock losses, as a result of management failure to prevent employee misconduct. AmSouth Bank, a wholly owned subsidiary of AmSouth, paid $40 million in fines and an additional $10 million in civil penalties arising from a government investigation primarily related to employee failure to file suspicious activity reports (“SAR"’s) relating to an investment fraud, Ponzi-style scheme. The government investigated the conduct of Louis D. Hamric, II and Victor G. Nance, who operated the scheme by making false promises and using AmSouth to establish investor custodial accounts, with those accounts used to deposit funds Hamric and Nance claimed were interest payments from the investment operation. AmSouth employees distributed funds following instructions from Hamric and Nance to the accounts on behalf of investors. The illegal scheme was discovered when the interest payments were discontinued. In the resulting investigation, the government determined that at least one AmSouth Bank suspected the illegal conduct and failed to file the required SAR. AmSouth neither admitted nor denied wrongdoing. As to the derivative complaint, the Stones did not make a pre-filing demand on the defendants, nor did they allege that any defendant director had knowledge of the wrongful conduct. At trial, the Stone’s complaint against Ritter and the other defendants was dismissed, with that Court concluded they failed to adequately plead the futility of a pre-filing demand. The Stones appealed.
Issue: Was the plaintiffs’ complaint fatally defective for failing to adequately excuse their refusal to make a pre-filing demand on the directors in the absence of a legitimate, statutory exception? Can a stockholder derivative suit against corporate directors proceed in the absence of a claim of actual knowledge regarding the wrongdoing or systemic failure to maintain oversight?
Holding: Yes, the complaint was defective as the futility of a pre-filing demand depends on the probability of establishing director liability, which the Court determined was lacking. No, a derivative suit against directors requires more than failure to uncover wrongdoing.
Reasoning: Justice Holland delivered the opinion of the Court. First, the Court considered the Chancery Court’s determination that plaintiffs failed to excuse their obligation to make a pre-filing demand on the directors. The Stones allege that any such claim would have been futile, and they were accordingly excused from attempting to make such a demand, as the directors would be personally liable in this suit and had a personal interest in denying the claim. Thus, the necessity of making a pre-filing demand turns on the question of ultimate liability for losses as a result of employee misconduct; to wit, if the directors were liable, they had an interest in declining the demand, conversely, if they are not liable, then the pre-filing demand is not excused. The Court reiterated the Delaware standard for director liability where the directors do not have actual knowledge of the conduct that gave rise to corporate losses (in this case fines as a result of wrongdoing). Citing and reaffirming prior cases, the Court explained that directors are not liable for assuming the honesty and integrity of employees in their corporate behavior, absent grounds to suspect deception. While directors are required to both be reasonably informed and institute policies to keep them so informed, they are not required to uncover detailed information about every aspect of corporate operations. Director liability for losses predicated on ignorance of the wrongdoing, then, requires systemic failure in the oversight role of directors, sufficient to establish a lack of good faith as a necessary precondition for liability. In other words, directors must establish reasonable oversight procedures, comply with those procedures, stay informed, and act in good faith. Directors must intentionally violate their obligations by failing to act in the presence of a duty to act. In this case, the Court said directors had no “red flags" to alert them to wrongdoing, and had established a reasonable system to stay well-informed. The failings were those of employees in their conduct and failure to report problems up the chain of command. The Court made clear that bad outcomes do not create an inference of bad faith on the part of directors. Accordingly, the Court affirmed the Chancery Court’s dismissal.
Conclusion: Under Delaware law, the standard for director liability for employee misconduct requires bad faith or systemic oversight failure. Directors are not liable for misconduct that they were ignorant of, assuming that they established sufficient monitoring protocols to effectively manage corporate operations.