20138 Advanced Company & Business Law

Class 13

In re Caremark International Inc. Derivative

Litigation*
Delaware Court of Chancery, 1996
698 A2.d 959

Caremark is a healthcare provider. A substantial part of the revenues generated by the

company’s business is derived from Medicare and Medicaid – two government-run
reimbursement programs designed to help low-income people with their medical expenses.
The case originates from a federal investigation of illegal payments made by Caremark
employees to physicians in exchange for patient referrals – that is, for prescribing special
treatments provided by Caremark. Subsequently, five stockholder derivative actions were
filed in the Delaware Court of Chancery alleging that Caremark’s directors breached their
duty of care by failing to adequately supervise the conduct of Caremark employees, thereby
exposing Caremark to fines, liability, legal fees and further economic loss. Once the
government entities involved had agreed to negotiate a settlement that would permit
Caremark to continue participating in Medicare and Medicaid programs, the parties to
this case managed to negotiate a settlement. The Court is now required to exercise an
informed judgment whether the proposed settlement is fair and reasonable in the light of
all relevant factors. On an application of this kind, the Court attempts to protect the best
interests of the corporation and its absent shareholders all of whom will be barred from
future litigation on these claims if the settlement is approved.

Allen, Chancellor
Pending is a motion […] to approve as fair and reasonable a proposed settlement
of a consolidated derivative action on behalf of Caremark International, Inc. (“Caremark”).
The suit involves claims that the members of Caremark’s board of directors (the “Board”)
breached their fiduciary duty of care to Caremark in connection with alleged violations by
Caremark employees of federal and state laws and regulations applicable to health care
providers. As a result of the alleged violations, Caremark was subject to an extensive four
year investigation by the United States Department of Health and Human Services and the
Department of Justice. In 1994 Caremark was charged in an indictment with multiple
felonies. It thereafter entered into a number of agreements with the Department of Justice
and others. Those agreements included a plea agreement in which Caremark pleaded guilty
to a single felony of mail fraud and agreed to pay civil and criminal fines. Subsequently,
Caremark agreed to make reimbursements to various private and public parties. In all, the
payments that Caremark has been required to make total approximately $ 250 million.

*
Footnotes omitted.

Università Bocconi Spring 2021

1
 20138 Advanced Company & Business Law
Class 13

This suit was filed in 1994, purporting to seek on behalf of the company recovery
of these losses from the individual defendants who constitute the board of directors of
Caremark. The parties now propose that it be settled […].
Legally, evaluation of the central claim made entails consideration of the legal
standard governing a board of directors’ obligation to supervise or monitor corporate
performance. For the reasons set forth below I conclude, in light of the discovery record,
that there is a very low probability that it would be determined that the directors of
Caremark breached any duty to appropriately monitor and supervise the enterprise. Indeed
the record tends to show an active consideration by Caremark management and its Board
of the Caremark structures and programs that ultimately led to the company’s indictment
and to the large financial losses incurred in the settlement of those claims. It does not tend
to show knowing or intentional violation of law. Neither the fact that the Board, although
advised by lawyers and accountants, did not accurately predict the severe consequences to
the company that would ultimately follow from the deployment by the company of the
strategies and practices that ultimately led to this liability, nor the scale of the liability,
gives rise to an inference of breach of any duty imposed by corporation law upon the
directors of Caremark. […]

II. LEGAL PRINCIPLES

[…]
B. Directors’ Duties To Monitor Corporate Operations
The complaint charges the director defendants with breach of their duty of attention
or care in connection with the on-going operation of the corporation’s business. The claim
is that the directors allowed a situation to develop and continue which exposed the
corporation to enormous legal liability and that in so doing they violated a duty to be active
monitors of corporate performance. The complaint thus does not charge either director self-
dealing or the more difficult loyalty-type problems arising from cases of suspect director
motivation, such as entrenchment or sale of control contexts. The theory here advanced is
possibly the most difficult theory in corporation law upon which a plaintiff might hope to
win a judgment. The good policy reasons why it is so difficult to charge directors with
responsibility for corporate losses for an alleged breach of care, where there is no conflict
of interest or no facts suggesting suspect motivation involved, [are described hereafter].
1. Potential liability for directorial decisions: Director liability for a breach of the
duty to exercise appropriate attention may, in theory, arise in two distinct contexts. First,
such liability may be said to follow from a board decision that results in a loss because that
decision was ill advised or "negligent". Second, liability to the corporation for a loss may
be said to arise from an unconsidered failure of the board to act in circumstances in which
due attention would, arguably, have prevented the loss. […] The first class of cases will
typically be subject to review under the director-protective business judgment rule,
assuming the decision made was the product of a process that was either deliberately
considered in good faith or was otherwise rational. […] What should be understood […] is

Università Bocconi Spring 2021

2
 20138 Advanced Company & Business Law
Class 13

that compliance with a director’s duty of care can never appropriately be judicially
determined by reference to the content of the board decision that leads to a corporate loss,
apart from consideration of the good faith or rationality of the process employed. That is,
whether a judge or jury considering the matter after the fact, believes a decision
substantively wrong, or degrees of wrong extending through “stupid” to “egregious” or
“irrational”, provides no ground for director liability, so long as the court determines that
the process employed was either rational or employed in a good faith effort to advance
corporate interests. To employ a different rule -- one that permitted an “objective”
evaluation of the decision -- would expose directors to substantive second guessing by ill-
equipped judges or juries, which would, in the long-run, be injurious to investor interests.
Thus, the business judgment rule is process oriented and informed by a deep respect for all
good faith board decisions.
Indeed, one wonders on what moral basis might shareholders attack a good faith
business decision of a director as “unreasonable” or “irrational”. Where a director in fact
exercises a good faith effort to be informed and to exercise appropriate judgment, he or
she should be deemed to satisfy fully the duty of attention. If the shareholders thought
themselves entitled to some other quality of judgment than such a director produces in the
good faith exercise of the powers of office, then the shareholders should have elected other
directors. […]
2. Liability for failure to monitor: The second class of cases in which director
liability for inattention is theoretically possible entail circumstances in which a loss
eventuates not from a decision but, from unconsidered inaction. Most of the decisions that
a corporation, acting through its human agents, makes are, of course, not the subject of
director attention. Legally, the board itself will be required only to authorize the most
significant corporate acts or transactions: mergers, changes in capital structure,
fundamental changes in business, appointment and compensation of the CEO, etc. As the
facts of this case graphically demonstrate, ordinary business decisions that are made by
officers and employees deeper in the interior of the organization can, however, vitally
affect the welfare of the corporation and its ability to achieve its various strategic and
financial goals. [Recent financial scandals] raise the question, what is the board’s
responsibility with respect to the organization and monitoring of the enterprise to assure
that the corporation functions within the law to achieve its purposes?
Modernly this question has been given special importance by an increasing
tendency, especially under federal law, to employ the criminal law to assure corporate
compliance with external legal requirements, including environmental, financial, employee
and product safety as well as assorted other health and safety regulations. [Violations of
such requirements are sentenced with heavy penalties that are deemed to] offer powerful
incentives for corporations today to have in place compliance programs to detect violations
of law, promptly to report violations to appropriate public officials when discovered, and
to take prompt, voluntary remedial efforts.
In 1963, the Delaware Supreme Court in Graham v. Allis-Chalmers Mfg. Co.,
addressed the question of potential liability of board members for losses experienced by

Università Bocconi Spring 2021

3
 20138 Advanced Company & Business Law
Class 13

the corporation as a result of the corporation having violated the anti-trust laws of the
United States. There was no claim in that case that the directors knew about the behavior
of subordinate employees of the corporation that had resulted in the liability. Rather, as in
this case, the claim asserted was that the directors ought to have known of it and if they had
known they would have been under a duty to bring the corporation into compliance with
the law and thus save the corporation from the loss. The Delaware Supreme Court
concluded that […] “absent cause for suspicion there is no duty upon the directors to install
and operate a corporate system of espionage to ferret out wrongdoing which they have no
reason to suspect exists.” The Court found that there were no grounds for suspicion in that
case and, thus, concluded that the directors were blamelessly unaware of the conduct
leading to the corporate liability.
How does one generalize this holding today? Can it be said today, absent some
ground giving rise to suspicion of violation of law, that corporate directors have no duty to
assure that a corporate information gathering and reporting systems exists which represents
a good faith attempt to provide senior management and the Board with information
respecting […] compliance with applicable statutes and regulations? I certainly do not
believe so. […]
In stating the basis for this view, I start with the recognition that in recent years the
Delaware Supreme Court has made it clear […] the seriousness with which the corporation
law views the role of the corporate board. Secondly, I note the elementary fact that relevant
and timely information is an essential predicate for satisfaction of the board’s supervisory
and monitoring role under Section 141 of the Delaware General Corporation Law. Thirdly,
I note the potential impact of [federal sanctions] on any business organization. […]
[I]t would […] be a mistake to conclude that […] corporate boards may satisfy their
obligation to be reasonably informed concerning the corporation, without assuring
themselves that information and reporting systems exist in the organization that are
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.
Obviously the level of detail that is appropriate for such an information system is a
question of business judgment. And obviously too, no rationally designed information and
reporting system will remove the possibility that the corporation will violate laws or
regulations, or that senior officers or directors may nevertheless sometimes be misled or
otherwise fail reasonably to detect acts material to the corporation’s compliance with the
law. But it is important that the board exercise a good faith judgment that the corporation’s
information and reporting system is in concept and design adequate to assure the board that
appropriate information will come to its attention in a timely manner as a matter of ordinary
operations, so that it may satisfy its responsibility.
Thus, I am of the view that a director’s obligation includes a duty to attempt in good
faith to assure that a corporate information and reporting system, which the board

Università Bocconi Spring 2021

4
 20138 Advanced Company & Business Law
Class 13

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. I now turn to an analysis of the claims asserted with this concept of the
directors duty of care, as a duty satisfied in part by assurance of adequate information flows
to the board, in mind.
In order to show that the Caremark directors breached their duty of care by failing
adequately to control Caremark’s employees, plaintiffs would have to show either (1) that
the directors knew or (2) should have known that violations of law were occurring and, in
either event, (3) that the directors took no steps in a good faith effort to prevent or remedy
that situation, and (4) that such failure proximately resulted in the losses complained […].

III. ANALYSIS OF THIRD AMENDED COMPLAINT AND SETTLEMENT

[…] 1. Knowing violation for statute: Concerning the possibility that the Caremark
directors knew of violations of law, none of the documents submitted for review, nor any
of the deposition transcripts appear to provide evidence of it. Certainly the Board
understood that the company had entered into a variety of contracts with physicians,
researchers, and health care providers and it was understood that some of these contracts
were with persons who had prescribed treatments that Caremark participated in providing.
The board was informed that the company’s reimbursement for patient care was frequently
from government funded sources and that such services were subject to the Anti-Referral
Payments Law [including criminal sanctions]. But the Board appears to have been
informed by experts that the company’s practices while contestable, were lawful. There is
no evidence that reliance on such reports was not reasonable. […] [T]he duty to act in good
faith to be informed cannot be thought to require directors to possess detailed information
about all aspects of the operation of the enterprise. Such a requirement would simple be
inconsistent with the scale and scope of efficient organization size in this technological
age.
2. Failure to monitor: Since it does appear that the Board was to some extent
unaware of the activities that led to liability, I turn to a consideration of the other potential
avenue to director liability […]: director inattention or “negligence”. Generally where a
claim of directorial liability for corporate loss is predicated upon ignorance of liability
creating activities within the corporation, […] only a sustained or systematic failure of the
board to exercise oversight -- such as an utter failure to attempt to assure a reasonable
information and reporting system exists -- will establish the lack of good faith that is a
necessary condition to liability. Such a test of liability -- lack of good faith as evidenced
by sustained or systematic failure of a director to exercise reasonable oversight -- is quite
high. But, a demanding test of liability in the oversight context is probably beneficial to
corporate shareholders as a class, as it is in the board decision context, since it makes board
service by qualified persons more likely, while continuing to act as a stimulus to good faith
performance of duty by such directors.
Here the record supplies essentially no evidence that the director defendants were

Università Bocconi Spring 2021

5
 20138 Advanced Company & Business Law
Class 13

guilty of a sustained failure to exercise their oversight function. To the contrary, insofar as
I am able to tell on this record, the corporation’s information systems appear to have
represented a good faith attempt to be informed of relevant facts. If the directors did not
know the specifics of the activities that lead to the indictments, they cannot be faulted.
The liability that eventuated in this instance was huge. But the fact that it resulted
from a violation of criminal law alone does not create a breach of fiduciary duty by
directors. The record […] does not support the conclusion that the defendants either lacked
good faith in the exercise of their monitoring responsibilities or conscientiously permitted
a known violation of law by the corporation to occur. […]

Università Bocconi Spring 2021

6