Pomerantz LLP

Recent Derivative Actions Highlight Directors' Obligation To Monitor And Prevent Employee Misconduct

Attorney: Veronica V. Montenegro
Pomerantz Monitor January/February 2018

A pair of recent noteworthy derivative actions highlight directors’ potential liability for failure to prevent miscon­duct by employees. In In re Wells Fargo & Company Shareholder Derivative Litigation, plaintiffs brought a derivative action alleging that the company’s officers and directors “[f]rom at least January 1, 2011 … knew or consciously disregarded that Wells Fargo employees were illicitly creating millions of deposit accounts and credit card accounts for their customers, without those customers’ knowledge of consent.” In a 189-page com­plaint, filed in the Northern District of California, plaintiffs allege that cross-selling, the sale of new products and services to existing customers, was paramount to Wells Fargo’s financial success. Various Wells Fargo annual reports during the time period explained that the com­pany’s strategy was to increase the cross-sell business model and touted Wells Fargo as the “king of cross sell.” In order to fulfill its cross-selling plan, Wells Fargo implemented what was known as the “Gr-Eight Initiative,” which set a strict quota of eight products per household that bankers had to sell. Plaintiffs allege that the setting of these types of quotas translated into pressure on bankers to open numerous accounts per customer.

Like many companies, Wells Fargo’s articles of association include a so-called “raincoat” provision that protects directors from personal financial liability for breach­es of fiduciary duty that do not involve self-dealing or conscious misconduct amounting to bad faith.Such pro­visions have, in the past, made it extremely difficult to prosecute misconduct claims against directors for failing to prevent misconduct by employees. Yet here the court held that the alleged misconduct, as pleaded in the action, could be sufficient to meet the bad faith threshold.

Specifically, here Wells Fargo’s directors and senior management received numerous “red flag” warnings that the quota system was leading to widespread misconduct. For example, in September 2007, Wells Fargo directors received letters from employees discussing how the Gr-Eight Initiative created high-pressure sales conduct that resulted in unethical and illegal activity. Also, in 2008, Wells Fargo began tracking employee complaints regarding unethical sales practices, and between 2008 and 2013, several lawsuits against the company involved allegations of unauthorized account creation. In 2011, two branch managers emailed Wells Fargo CEO John Stumpf warning him that employees were creating fake accounts to meet the company’s sales quotas, and they were fired in retaliation. A December 2013 Los Angeles Times article reported that, based on a review of internal bank documents and courts records and interviews with almost 30 former and current Wells Fargo employees, they had determined that Wells Fargo employees had engaged in fraudulent account opening tactics fomented by the relentless pressure to sell. In September 2016, Stumpf testified before the Senate Banking Committee that he had discussed the article with the board. On April 3, 2015, a former Wells Fargo banker both mailed and emailed a letter to Stumpf and the board advising them of unethical practices in sales due to continuous management pressure, and during the next several months continued to email Wells Fargo representatives, copying the board and asking for updates. Additionally, in May 2015, a consumer class action challenging the illicit account creation scheme was filed against Wells Fargo. In 2014, the Office of the Comptroller specifically identified the need to assess cross-selling and sales practices as part of its upcoming examination of the company’s governance process, and in 2015 it issued several Supervisory Letters highlighting the lack of an appropriate control or oversight structure given corporate emphasis on product sales and cross-selling. In September 2016, Stumpf testified before the Senate Banking Committee that he learned of the fraud in 2013 and that the board learned of it later in 2013 and 2014. In response to written questions, he confirmed that at least from 2011 forward, the board’s Audit and Examinations Committee received periodic reports of Wells Fargo’s Internal Investigations Group, which investi-gates issues involving team members, as well as information on suspicious activity reporting.

In a decision last year, the court refused to dismiss the complaint, explaining that under the standard for director oversight liability and the standard for breach of the duty of care when the company has adopted an exculpa­tory provision protecting directors from financial liability, plaintiffs “must allege particularized fact that show that a director consciously disregarded an obligation to be reasonably informed about the business and its risks or consciously disregarded the duty to monitor and oversee the business.” In denying defendants’ motion to dismiss, the court held that “the extensive and detailed allegations in the complaint plausibly suggest that a majority of the Director Defendants did precisely that.” The court pointed to the numerous “red flag” allegations in the complaint and ruled that when viewed together, these allegations bolstered the conclusion that the director defendants consciously disregarded their fiduciary duties to the company. Additionally, the court rejected defendants’ ar­guments that the termination of 5,300 employees over a period of five years demonstrated that the company’s oversight systems and controls were working, hold­ing that the allegations, taken as a whole, support an inference that director defendants knew that the unauthorized creation practices were not isolated, but rather a systemic issue that was rampant and that the company’s oversight systems and controls for sales integrity issues were inadequate.

Similar issues were presented in a case involving Twenty- First Century Fox (“Fox News”). It started as a request for inspection of corporate books and records under Section 220 of the Delaware Corporations Code, made when a stockholder of record, the City of Monroe Employ­ees’ Retirement System, submitted a production request. The request came soon after the July 2016 complaint filed by former Fox News reporter, Gretchen Carlson, against the company for sexual harassment and wrong­ful termination. Carlson alleged that Fox News CEO Roger Ailes had harassed and retaliated against her. The company opened a full-fledged investigation which led to Ailes’ ouster as well as allegations against Bill O’Reilly and others. In the summer of 2017, Fox News and the City of Monroe Employees’ Retirement System entered into a mediation agreement and the Stipulation of Settlement of the books and records case, filed concur­rently with a verified derivative complaint in the Delaware Court of Chancery, on November 20, 2017. The complaint, filed against CEO Rupert Murdoch, his two sons, the com­pany’s other directors and the Roger Ailes estate, alleges that Fox News had a systemic, decades-long culture of sexual harassment, racial discrimination and retaliation that led to a hostile work environment. It further alleges that the company did not take steps to address work-place issues such as sexual harassment and racial discrimination and that it failed to implement controls sufficient to prevent the creation and maintenance of a hostile work environment. The revelations not only led to numerous sexual harassment settlements and racial discrimination lawsuits, but to departures of talent and damage to the company’s good will and reputation, as well as significant financial harm.

The complaint pointed to numerous past sexual harass­ment allegations against Roger Ailes and Bill O’Reilly, as well as an EEOC settled charge against a mid-level Fox News Executive, as red flags showing that the company was aware of employee misconduct and was still not prompted to open a formal inquiry. Not only was no inquiry conducted until after Carlson’s lawsuit, but the company and the board failed to implement sufficient oversight over the workplace to prevent massive damage to the company. The complaint also detailed that the company has had to pay over $55 million in settlements over the unaddressed misconduct. The settlement provided for $90 million, as well as the implementation of governance and compliance enhance-ments at the company. In their brief filed in support of their motion for court approval of the settlement, plaintiffs’ counsel stated that a corporate board can­not pretend that such repeated conduct is isolated nor that it does not and will not pose a grave risk to companies and their shareholders.

While the Wells Fargo and Fox News cases have various differences, their shared similarity is worth highlighting: turning a blind eye to employee misconduct by failing to investigate red flags and establish strong monitoring controls runs the risk of companies’ executives being held accountable regardless of their lack of participation. Neither of the cases alleged that the company’s directors or executives engaged in the wrongdoing, but rather, that they breached their fiduciary duties because they knew of or consciously disregarded the alleged misconduct and failed to stop or prevent it.