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The Story of Allis-Chalmers, Caremark, and Stone: Directors' Evolving Duty to Monitor


Jennifer Arlen


New York University School of Law

November 19, 2008

NYU Law and Economics Research Paper No. 08-57

Abstract:     
This chapter explores the evolution in Delaware's approach to director oversight of legal compliance. The transformation of Delaware's duty to monitor is, in part, a story of how the dramatic increase in the scope and magnitude of federal corporate criminal liability pushed the Delaware state courts to treat compliance with federal criminal law as an important corporate governance issue. It also is the story of the struggle between the Delaware Chancery Court and the Delaware Supreme Court over the standard of conduct and standard of review to govern directors' oversight duties.

In the seminal opinion on this issue, In re Caremark International Inc. Derivative Litigation, Chancellor William T. Allen challenged two different facets of Delaware Supreme Court precedent. First, he in effect reversed Allis-Chalmers by holding that directors have a duty to ensure that the firm establishes an effective compliance program, where no duty previously existed. Second, he pushed back against Smith v. Van Gorkom by holding that (i) the proper standard of review to govern director liability for breach of this monitoring duty was good faith, not gross negligence (irrespective of 102(b)(7)), and (ii) that bad faith required a conscious neglect of duty, not merely objectively (excessively) unreasonable conduct. Chancellor Allen's approach in Caremark arises from his twin convictions that (1) directors will satisfy judicially imposed duties even without the threat of liability and (2) judges do not have the expertise to assess the objective reasonableness of directors' actions. Caremark succeeded in moving the Delaware Supreme Court to Chancellor Allen's approach, as evident from Stone v. Ritter. Yet, as became evident following WorldCom and Enron, Caremark did not induce directors to focus adequately on compliance. Caremark specifies a general oversight duty, without specific content. Directors have latitude to adopt a loose interpretation of their oversight duties, largely insulated from liability by the good faith standard of review. In response, federal authorities and the stock exchanges intervened with more precise rules relating to corporate oversight of compliance.

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Date posted: November 23, 2008  

Suggested Citation

Arlen, Jennifer, The Story of Allis-Chalmers, Caremark, and Stone: Directors' Evolving Duty to Monitor (November 19, 2008). NYU Law and Economics Research Paper No. 08-57. Available at SSRN: http://ssrn.com/abstract=1304272 or http://dx.doi.org/10.2139/ssrn.1304272

Contact Information

Jennifer Arlen (Contact Author)
New York University School of Law ( email )
40 Washington Square South
New York, NY 10012-1099
United States
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