In re General Motors: Product Defects, Negligent Controls, Apathetic Culture Insufficient to Establish Bad Faith

Practical Law Legal Update w-000-4525 (Approx. 8 pages)

In re General Motors: Product Defects, Negligent Controls, Apathetic Culture Insufficient to Establish Bad Faith

by Practical Law Corporate & Securities

Background

The case stems from the 2014 General Motors recall following the malfunctioning of ignition switches in several GM car models. Beginning in February 2014, GM issued the first of what would be 45 recalls, covering a total of 28 million vehicles. Approximately 13 million vehicles were recalled due to a malfunction with the ignition switch that would cause the vehicle's engine and electrical system to shut off and prevent the vehicle's airbag from inflating in a crash. The recalls resulted in charges of approximately $1.5 billion against GM's earnings through the first and second quarters of 2014. GM also set up an uncapped fund to compensate victims of accidents caused by the faulty ignition switches. At the time of the plaintiffs' complaint, the fund had approved 23 death claims and 16 injury claims, and had received 1,130 total claims.

After the recall was announced, GM disclosed that certain of its employees had known about the defect years beforehand. As a result of the defect and ensuing revelation, GM is now the subject of several products liability and personal injury lawsuits, two Congressional investigations and a criminal investigation by the Department of Justice. GM has also paid $35 million to the government in fines for its violation of the National Traffic and Motor Vehicle Safety Act of 1996.

As the court repeatedly emphasized in its opinion, at issue in the derivative litigation was not GM's civil and criminal liability. Rather, the court's objective was to determine whether the corporation itself could recoup damages from its directors for the benefit of its stockholders and, in turn, whether GM's directors had a disabling self-interest that would render them incapable of exercising the business judgment necessary to decide whether to pursue that claim on GM's behalf.

The plaintiffs, GM stockholders, filed a derivative suit seeking to hold GM's board of directors personally liable to the company. The plaintiffs alleged that the board breached its duty of loyalty by failing to oversee the operations of the company, causing it to be unaware until February 2014 of defects and safety risks known to the company's employees. Alleged deficiencies in board oversight highlighted by the plaintiffs included:

In the 2010-2011 period, sluggishness by the board to address what it knew were management's lack of knowledge and skill sets to perform risk assessments and develop risk-mitigation strategies.
The transfer of risk-management duties from the company's Chief Risk Officer (CRO), one year after his appointment, to the General Auditor, who maintained all of his other duties. This may have caused a conflict of interest, as the General Auditor was tasked with objectively reviewing the company's risk management.
The dissolution of the Finance and Risk Committee after its formation only two years earlier, and transfer of some, but not all, of its risk-management-oversight duties to the Audit Committee. The plaintiffs contended that GM had already concluded that placing risk-management oversight on the Audit Committee was not considered best practices. The plaintiffs also noted that responsibility for reviewing internal systems of communication, which included escalation of information to management and to the committee and the board as needed, had belonged to the Finance and Risk Committee, but had not been added to the Audit Committee's charter. As a result, no single committee of the board was responsible for all vehicle safety-related issues, which in turn may have fostered a culture in which employees did not elevate safety concerns to upper management.
Deficiencies in the database that GM maintained to store data required to be reported under the Transportation Recall Enhancement, Accountability and Documentation (TREAD) Act, with several problems apparent before the defect issue arose. The deficiencies created insufficient reporting mechanisms or procedures for informing the board of any inquiries from the National Highway Traffic Safety Administration (NHTSA) and the company's responses thereto. As a result, the board was not informed of any problem posed by ignition switches, or of the NHTSA's inquiries, until February 2014.
A tiered approval system by the legal department that only required settlements of $5 million or more to be escalated to GM's general counsel, regardless of whether the settlement involved injury or fatality.
A lack of procedures in the legal department to require that the general counsel or the board be informed of potential punitive damages in pending litigation.
An institutional lack of urgency and avoidance of responsibility. The plaintiffs heavily emphasized metaphorical gestures known at the company as the "GM Nod," in which everyone nods in agreement to a plan of action with no intent of following through, and the "GM Salute," in which crossed arms pointing outward at others indicates that responsibility lies elsewhere. In the plaintiffs' view, these gestures embodied the culture at GM and the board; that culture, in turn, supplied the inference that the board consciously failed to act in the company's interest.

The plaintiffs asserted that a demand on the board would be futile because a majority of the directors would face a substantial likelihood of personal liability in connection with the alleged breach of the directors' duty of loyalty. The defendants (11 current board members and five former board members) filed a motion to dismiss.

Outcome

The court analyzed whether demand on the board would be futile under two standards of review:

The two-pronged Aronson v. Lewis test, regarding the board's inadequate transfers of risk-management duties.
The Rales v. Blasband test, regarding the board's failure to implement or monitor an adequate reporting system, under a Caremark theory of failure of oversight.

The court granted the defendants' motion to dismiss, finding that the plaintiffs had not pleaded sufficient facts to excuse demand under the Aronson and Rales tests. The court found that the plaintiffs had not shown that the board had disregarded its duty of loyalty and that, consequently, a majority of the board did not face a substantial likelihood of personal liability.

Plaintiffs Did Not Satisfy Aronson Regarding the Challenged Board Actions

In a derivative action against a company's directors arising from board action (as opposed to inaction), the Aronson test requires that a plaintiff plead facts, with particularity, that either raise reasonable doubt that the directors were disinterested and independent or that the challenged action was a valid exercise of business judgment (Aronson v. Lewis, 473 A.2d 805 (Del. 2000); for detailed discussion, see Practice Note, Shareholder Derivative Litigation: When Demand Requirement Is Excused). To show that there was not a valid exercise of business judgment where a corporation has a Section 102(b)(7) exculpatory clause in its charter (which GM had), a plaintiff must show that the directors acted in bad faith and consequently violated their duty of loyalty. Bad faith requires a showing of an absence of a good-faith pursuit of the best interests of the company. This is typically established if a director either:

Intentionally acted with a purpose other than that of advancing the best interests of the corporation.
Acted with the intent to violate applicable positive law.
Failed to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.

(In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 67 (Del. 2006).)

The plaintiffs did not attempt to question the board's disinterest or independence. Rather, they asserted under the second prong of the Aronson test that the board's decision to transfer risk management from the CRO and the Finance and Risk Committee to the General Auditor and Audit Committee, respectively, could not have been made in good faith, because:

The board knew that the risk-management system was not functioning properly.
The Audit Committee was already overburdened with issues following GM's recent bankruptcy.
Not all of the Finance and Risk Committee's duties were transferred to the Audit Committee.

The plaintiffs argued that these factors, taken together, showed that the board not only made the risk-management system worse, but did so with conscious disregard for its duties to GM.

The court, in disagreeing with the plaintiffs' inferences, emphasized that decisions regarding a company's risk-management system fall squarely within the board's decision-making realm. To find that those decisions were made in bad faith, the court explained that it would need "red flags" or other bases from which to infer knowledge on the part of the board that its system was inadequate. Contrary to that standard, the court held that there was an absence of red flags. It found instead that:

None of the evidence provided by the plaintiffs indicated that the board had actual or constructive knowledge that the risk-management system was not functioning properly or that it was inadequate.
The General Auditor continued to make presentations to the Finance and Risk Committee and, after its dissolution, to the Audit Committee in a similar manner as the CRO had done. This indicated both that:
- neither the General Auditor nor the Audit Committee were too overburdened; and
- even if express provisions were not expressly added to the Audit Committee's charter, the General Auditor continued to operate as if all of the duties of the Finance and Risk Committee had also been transferred.
The allegations that a transfer of duties to the General Auditor was self-evidently improper were merely conclusory.

Therefore, even if the board's decisions were not advisable in hindsight, they did not amount to a bad faith, conscious disregard of the board's duties.

Plaintiffs Did Not Satisfy Rales Regarding the Challenged Board Inactions

Under Rales v. Blasband, demand will be excused as futile if the plaintiff pleads particularized facts that create a reasonable doubt that the board could exercise its independent and disinterested business judgment in responding to a demand (634 A.2d 927 (Del. 1993)). The plaintiffs here argued that a majority of the board was not disinterested because it would face a substantial likelihood of personal liability as a result of the conduct alleged in the plaintiffs' complaint. The personal liability for the directors, in turn, would result from their failure of oversight, a basis for liability first set forth in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). In relevant part, Caremark established that director liability arises where the directors either:

Utterly failed to implement ay reporting or information system or controls.
Consciously failed to monitor or oversee the operation of a system or control implemented by the board, thereby disabling themselves from being informed.

Under the first basis for a Caremark claim, the plaintiffs alleged that the board utterly failed to implement a reporting system, as demonstrated by the following deficiencies:

GM's database, designed to comply with the TREAD Act, was only available to federal investigators and a limited internal team who managed the database.
Quarterly reports were sent to the NHTSA, but the database did not include certain categories, including ignition switch defects and reports from outside counsel regarding potential punitive damages, which meant that those issues were not tracked by the database.
GM did not have a reporting process that would inform the general counsel and the board of any serious defects, potential for punitive damages or settlement amounts below $5 million.

However, as the court explained, even these allegations, taken as true, did not amount to a complaint that the GM board had not established any reporting system. Rather, the allegation was only that in the plaintiffs' view, the reporting system could have been better. The court refused to accept the plaintiffs' argument that these deficiencies amounted to a knowing failure by the board to monitor or oversee the company, even if the existing systems represented "an overly bureaucratic system of 'information silos.'" The court noted that:

GM had a system in place to collect safety and risk data, as required by TREAD.
GM had a system in place for approving settlement amounts at varying levels. The fact that the system did not include certain metrics or that the general counsel was not informed of all litigation risks did not mean that the board had failed to implement a risk-management system.
The board delegated review of GM's risk-management structure to the Finance and Risk Committee, and later, the Audit Committee, who presented on safety and quality issues to the board. This meant that the board did have a review system in place, even if the board's oversight of the committees did not satisfy the plaintiffs in hindsight.

To the second basis for a Caremark claim, a conscious failure to oversee a system that has been implemented, the plaintiffs relied heavily on a theory that the culture at GM provided the basis to infer that the GM board had consciously failed to exercise oversight. In particular, the plaintiffs highlighted the "GM Nod" and "GM Salute" as indicators that management's, and presumably then the board's, default mode was to avoid responsibility.

The court rejected this theory as well. The court held that the plaintiffs had not presented particularized facts to show that the culture at the management level also existed at the board level. The court also emphasized that liability under the second basis for a Caremark claim has been held to require pleading with particularity that there were red flags that put the directors on notice of problems with their systems, but which were consciously disregarded. As it had already discussed in its ruling on the Aronson test, the court found no such red flags here.

The court concluded that all of the plaintiffs' pleaded facts, even when considered together, still did not imply bad faith. Although the facts may have been sufficient to raise question of negligence on the part of the board, that finding would be insufficient to conclude that demand would be futile, because even gross negligence (the standard for breach of the duty of care) would not cause personal liability for the GM directors.

Practical Implications

The General Motors decision is a strong example of the difficulty of establishing a Caremark claim, demonstrating the shortcomings a board of directors can suffer before a Delaware court will find a complete failure of oversight on its part. Here, the court acknowledged the "unsettling" context of the case and therefore explained at some length that its role in the case was only to decide on the issue of derivative claims and disabling conflicts of interest, while leaving other legal avenues for establishing civil, criminal and administrative liability. The court also added a "concluding thoughts" section to again highlight the difference between allegations of a breach of the duty of care (which turns on gross negligence) and allegations of a breach of the duty of loyalty (which turns on a bad-faith conscious disregard of fiduciary duties). To demonstrate demand futility, both Aronson and Rales require more than a finding in hindsight that the board made poor decisions or even acted negligently. Bad outcomes from the point of view of the company cannot be conflated with bad faith on the part of the board.

At a more general level, the decision reminds that the outcome of fiduciary duty cases often turns on the standard of review. While the GM board's conduct might have risen to the level of bad faith in an ordinary sense, at the heart of the decision is the missing component of scienter on the part of the board that is necessary for a finding of conscious disregard of fiduciary duties. As long as the board did not ignore red flags or utterly fail to implement any system at all for reporting or controls, the courts will be hard-pressed to find bad faith.

In re General Motors: Product Defects, Negligent Controls, Apathetic Culture Insufficient to Establish Bad Faith | Practical Law