Caremark and Proxy Fraud Liability for Material Deficiencies in the Board’s Oversight of Management and Internal Controls

A problem from Advanced Corporation Law

In my Advanced Corporation Law class, we discussed a problem from my Advanced Corporation Law casebook, which pulls together state law Caremark claims and federal proxy fraud claims. I had a lot of fun with this one, so I’m passing it along.

Mega Bank Holding Co., Inc., a large and diversified financial services corporation providing, among other things, investment banking services, recently announced that it had reached a settlement with the U.S. Department of Justice and several other federal agencies of criminal and civil claims.¹ The Department of Justice claimed that Mega had committed securities fraud and violated certain banking regulations in connection with Mega’s “packaging, marketing, sale, and issuance of residential mortgage-backed securities (RMBS).” In the settlement, Mega admitted having committed the alleged violations and further admitted that “in certain instances, loans that did not comply with underwriting guidelines were included in the RMBS sold and marketed to investors, but Mega did not disclose this to those investors.” Mega paid the government $1.7 billion to settle those claims.

Mega is a Delaware corporation. Its common stock is listed for trading on the NYSE. Its common stock and several classes of debt securities are registered with the SEC under § 12 of the Exchange Act. Mega is therefore a reporting company and at all relevant times was current in its reporting obligations.

Shareholders brought a number of derivative and class actions suits against Mega and its directors, which were combined for trial before Judge Helen Watkins of the U.S. District Court for the Southern District of New York. Among the many claims in the lawsuit is an allegation that the directors of Mega should be liable for violating Securities Exchange Act § 14(a) and SEC Rule 14a–9 thereunder because Mega’s proxy statements for the last two years were “materially false and misleading because they falsely stated that the Company’s Board of Directors maintained adequate and effective risk oversight over management and failed to disclose to the Company’s shareholders material deficiencies in the Board’s oversight of management and internal controls.”

1. If it were true that Mega’s board of directors failed to maintain “adequate and effective risk oversight over management,” would Mega’s shareholders have a state law claim against the directors? What would plaintiffs need to prove in order to prevail on such a claim, if any?

2. Mega’s directors have moved to dismissed the § 14(a) cause of action for failure to state a claim, citing Gaines v. Haughton.² How should Judge Watkins rule?

3. Would your answer to Question 2 change if the directors’ fees paid to Mega’s board members varied with Mega’s stock price, so that higher profits and a resulting higher stock price meant the directors received higher compensation?