08/27/2013 09:31 am ET Updated Oct 27, 2013

Directors Must Remedy Known Regulatory Violations or Face Personal Liability

The business judgment rule insulates corporate directors from personal liability for mistaken decisions made with adequate information and in good faith. However, the protection granted by the business judgment rule has limitations as an Aug. 16, 2013, decision by the U.S. Court of Appeals for the Seventh Circuit illustrates (Westmoreland County Retirement System v. Parkinson). Shareholders sued Baxter International, Inc. directors for failing to comply with a 2006 consent decree entered into with the Food and Drug Administration (FDA) involving infusion pumps. In 2010 the FDA mandated a recall of the pumps producing a $588 million pre-tax charge to Baxter. The Seventh Circuit allowed the shareholders' suit to proceed without requiring the shareholders to first demand action by the board of directors.

Between 2006 and 2010 the directors discussed the pumps at least 28 times and recorded charges in excess of $300 million related to the problem but each fix created more issues causing the FDA to mandate clinical trials. From 2008 until 2010, Baxter failed to set up the trials, ultimately resulting in the recall. While these events were unfolding Baxter told investors that it hoped to launch a "next generation platform" "in the not-too-distant future." Baxter's CEO stated that the current pump was an "old device" lacking the technology of newer devices. A shareholder derivative suit against the directors and other company officials followed the FDA recall order and financial loss.

The Seventh Circuit applied Delaware state law in reviewing the business judgment rule. The directors' breach of the duty of loyalty may involve more than finances or conflicts of interest. Failing to act in the face of a known duty to act demonstrates a conscious disregard for the directors' responsibilities and a failure to act in good faith. The shareholders' suit asserted that in 2008 the directors ceased work on the old pump, essentially walking away from it in the hope of getting a new device to market. This occurred despite the risk to patients using the old pump and in violation of the FDA consent decree. Consequently, the suit alleged bad faith by the directors after 2008 in spite of their earlier efforts. The Seventh Circuit reversed the trial court's dismissal of the shareholder derivative suit.

This decision illustrates the ongoing obligations imposed upon directors by consent decrees entered into with regulatory agencies. It further demonstrates that directors who fail to meet these obligations face personal financial liability for corporates losses created by the agency's response. More broadly, failing to conclusively address known regulatory requirements is not simply a matter of business judgment. Legal compliance is a fundamental obligation of directors that cannot be escaped.