Willful Blindness as Boardroom “Bad Faith”

peregrine

The recent increase in the frequency and success with which “willful blindness” theories have been asserted in litigation may have long term implications for the corporate director’s liability profile.

Willful blindness is an aggressive liability theory that seeks to expand the definition of “knowledge” to include situations in which institutions or individuals “turn a blind eye” when there is a high probability that a particular, troubling, fact or circumstance exists.  Assessing   willful blindness involves a highly subjective analysis, and can be especially troublesome for defendants in cases where bad facts, and real harm, may be present.  As such, it is a seductive theory of liability that is particularly appealing to a “pitchfork” perspective of individual accountability.  It has been applied most recently in a diverse set of high profile criminal, regulatory and civil actions and investigations.

The potential governance risk arises from the similarities between the traditional elements of a willful blindness cause of action, and those of director “bad faith” (i.e., the “conscious disregard” element).  Allegations supporting a traditional willful blindness claim can sound remarkably similar to those alleging a more traditional breach of the duty of care.  This may prove tempting for those who seek an “end run” around the standards for Caremark oversight liability claims, or a means for overcoming the barrier of exculpatory charter or bylaw provisions.  The board is thus well advised to discuss with its general counsel ways in which it can reduce its exposure to allegations premised on willful blindness.

Willful blindness is grounded in case law.  It has traditionally been applied in the context of a wide range of criminal statutes, but has increasingly been applied in civil litigation as well.  For example, the Supreme Court’s 2011 decision in Global Tech Appliances, Inc. v SEB S.A. applied a willful blindness theory to confirm liability for actively inducing patent infringement, in the context of federal patent law. While recognizing the different approaches applied by the Courts of Appeals to defining willful blindness, the Supreme Court described its two basic requirements as:  the defendant must (i) subjectively believe that there is a high probability that a fact exists; and (ii) take deliberate actions to avoid learning of that fact.  According to the Court, this two-pronged definition gives willful blindness “an appropriately limited scope that surpasses recklessness and negligence”.  Thus, in the context of fiduciary liability, we’re talking “bad faith”.

Another example of the non-criminal law application of willful blindness theories has been in the context of bankruptcy court litigation, particularly that instituted by Irving Picard, the trustee for liquidation of Bernard L. Madoff Investment Securities LLC (BLMIS).  In several prominent circumstances—one involving the owners of the New York Mets, and more recently one involving a major U.S. financial services company—the trustee sought to recover funds from Madoff clients and bankers alleged by the trustee to have been “willfully blind” to the Madoff fraud and thus complicit.  The Mets’ owners settled their case for $162 million and, in return, secured a pledge that the trustee would drop his claims that they were “willfully blind” to signs that Mr. Madoff was perpetrating a fraud.  Along the same lines, it is possible to see strains of the willful blindness theory in recent regulatory enforcement actions by the SEC and the CFTC applying “failure to supervise”-based laws against executives in the commodities and hedge fund sectors (i.e., that the ‘failure to supervise’ actions included ‘turning a blind eye” to alleged illegal activity).

The concern arising from this trend is that it may lead to mischief; i.e. more aggressive application of willful blindness theories, possibly to the area of corporate governance in general and the director’s compliance oversight responsibilities in particular.  The Delaware courts have described breach of the duty of oversight as ‘possibly the most difficult theory in corporation law oversight liability upon which a plaintiff may hope to win judgment’.  This suggests that establishing the lack of good faith (e.g., “conscious disregard”) that is a necessary condition to liability can be daunting.  But it does not mean that the risk does not exist, or that it is not increasing.

Are we talking more style than substance?  Perhaps.  Yet, there is something innately “human” about the willful blindness theory. Who among us has not at some point “turned a blind eye” to something they were relatively certain was a real and pressing problem, in the hope that it might simply go away?  Allegations that a board, or individual directors, knowingly took affirmative steps to keep “red flags” at a safe distance from the boardroom may be more persuasive as bad faith when painted with a willful blindness hue. Such claims prompt the iconic image of the television character “Sergeant Schultz” (“I know nothing”).  This attitude is easy to relate to; it may give judges and juries a ready, and highly personal reference point from which to sympathize with allegations based on a “head in the sand” boardroom culture.  All this, in an environment in which “finger-pointing”, and attempts to assert individual accountability for corporate harm/wrongdoing, are increasingly the order of the day.

Boards may help protect themselves by implementing checks and balances designed to assure that potential “red flags” get in front – and stay in front – of the board, until resolved.  These checks and balances might include:  First, assuring that the flow of compliance and risk information from senior management is timely, complete and in a context readily understandable by board and committee members.  Second, and related, reaching an unequivocal understanding with executive leadership of the types of developments of which the board must be immediately informed.  Third, requiring absolute clarity on the division of authority between the board and management on issues that merit action.  Fourth, confirming that the general counsel is expected to attend all meetings of the board and of its key committees.  Fifth, establishing a clear board-level “tone at the top” that supports the role of the general counsel as it relates to corporate governance, and acknowledges the professional responsibilities of the general counsel—especially with respect to “reporting up” and “reporting out” circumstances.

Perhaps the most significant—and explicit—protection might arise from board action that specifically confronts the “red flag” or other concern. With the assistance of the general counsel, the “red flag” should be formally placed on the board agenda—at either a regular meeting, or special meeting called for this particular purpose. The agenda item would be supported by an explanation from the chair, with the concurrence of the general counsel, that the ensuing discussion is specifically intended to help assure that the Board is addressing its related duty of care obligations, and to avoid any allegations of willful blindness. As the Supreme Court has made clear, willful blindness liability requires evidence of deliberate action to avoid confirming a high probability of wrongdoing. The board may reduce its exposure to willful blindness through explicit board evaluation and action, that is incorporated in the minutes. While the board’s ultimate decisions may in hindsight prove wrong or ineffective, its action will nevertheless create a record of attentiveness to the “red flag”, rather than turning a blind eye to its existence.

By strengthening governance processes, board/management checks and balances and the power and authority of “corporate guardians”, the risk is reduced that the board could be perceived as “closing its eyes” to obvious warning signs.

Michael W. Peregrine, a partner in the law firm of McDermott Will & Emery, advises corporations, officers, and directors on matters relating to corporate governance, fiduciary duties, and officer-director liability issues. His views do not necessarily reflect the views of McDermott Will & Emery or its clients. Mr. Peregrine would like to thank his partners, Thomas J. Murphy and William P. Schuman, for their assistance in the preparation of this comment.

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