Dismissed Shareholder Lawsuit Against Capital One in Delaware Is a Reminder to Pay Close Attention to AML Compliance

In a recently decided case, Reiter v. Fairbank (Del Ch. October 18, 2016), the Delaware Chancery Court dismissed shareholder allegations that the directors of Capital One Financial Corporation had breached their fiduciary duty of loyalty by failing to oversee Capital One’s compliance with the Bank Secrecy Act and other anti-money laundering laws (BSA/AML). In July 2015, Capital One consented to the entry of an order issued by the Office of the Comptroller of the Currency in which the OCC found that Capital One had “failed to adopt and implement a compliance program that adequately covers the required BSA/AML program elements due to an inadequate system of internal controls and ineffective independent testing.” Capital One remains subject to ongoing investigation on this score by the New York Attorney General, the Department of Justice and the Financial Crimes Enforcement Network. The Capital One board escaped trial on the allegations of their own malfeasance because of the very high pleading standards in Delaware for failure of oversight claims against directors. The case is nonetheless a reminder of the close attention that should be paid by directors to compliance with anti-money laundering laws.

Background

Capital One is a Virginia-based financial institution incorporated in Delaware, with both banking and non-banking subsidiaries. The facts of the case begin with Capital One’s acquisition in 2006 of North Fork Bancorporation, Inc., as a result of which Capital One began providing banking services to check cashing and related money service businesses in New York and New Jersey. Unsurprisingly, check cashing businesses are a significant focus of anti-money laundering laws and regulations, since they often service metropolitan neighborhoods subject to high drug trafficking activity. While Capital One would have preferred to exit its servicing of these businesses following the North Fork acquisition, it was persuaded not to do so by the New York Department of Financial Services. Capital One finally exited the check cashing services business in 2014.

Through a books and records search conducted in accordance with Delaware law, the plaintiff shareholder identified at least twenty-five reports delivered to the audit and risk committee, and successor committees, of the Capital One board over a three-and-a-half-year period, which detailed the corporation’s BSA/AML compliance risk. According to these reports, the risk escalated from “low” in early 2011 to “high” in early 2013, where it remained in 2014, apparently leading to the ongoing regulatory enforcement action against Capital One.

The shareholder plaintiff relied on these documents as evidence, at the pleading stage, for its allegations that the board of Capital One was liable for a failure of oversight. In Delaware, this is known as a Caremark claim after the Delaware Chancery Court decision by that name (In re Caremark Int’l Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996)). According to the complaint, which was filed by the shareholder in a derivative capacity, the reports to the audit and risk committee indicated that the directors consciously disregarded their responsibility to oversee compliance by Capital One with BSA/AML. Were the plaintiff to have succeeded in the case, the directors would have been liable in monetary damages to the corporation.

The Decision

The Chancery Court dismissed the complaint with prejudice on the technical grounds that the plaintiff had failed without justification to make a demand on the board to bring the action on behalf of the corporation. Essentially, however, the decision constituted a holding that, as a matter of law, the directors were not subject to Caremark liability under the facts of the case.

The court found that the allegations amounted at worst to “yellow flags of caution” related to the compliance risks, which came at a time of increased regulatory scrutiny of AML compliance in the financial services industry from early 2011 to early 2013. More importantly, the reports “simultaneously explained to the directors in considerable detail on a regular basis the initiatives management was taking to address those problems and to ameliorate the AML compliance risk.”

This was sufficient for the directors to defeat a failure of oversight claim, which the court, citing Caremark, characterized as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” Caremark “requires a showing that the directors knew that they were not discharging their fiduciary obligations,” and that proved to be an impossibly high burden for the plaintiff. As the court observed, the very allegations of the complaint evidenced the efforts of Capital One’s management to deal with “tightening regulations and more aggressive AML enforcement actions,” and to keep the directors informed of those efforts. The remedial efforts included “designation of a new Chief AML Officer, monthly training, quarterly internal audits, other initiatives taken in response to the changing regulatory landscape, and ultimately, the decision to exit altogether the check cashing business that presented the most acute BSA/AML challenges.”

Observations

The board in Reiter v. Fairbank dodged the bullet of a protracted litigation, and possible liability, for lapses in BSA/AML compliance, but those lapses were hardly cost-free to Capital One. Aside from the various ongoing enforcement actions, the corporation incurred the expense and distraction, over the course of a year or so, of a books and records request and the litigation itself. The decision, while favorable to the directors from a liability standpoint, portrays a passive board that wholly relied on management programs that were ineffective to prevent regulatory scrutiny and sanction. It is hardly a model for active oversight of a troubled BSA/AML compliance program. The case may therefore serve as a lesson to boards operating in environments where BSA/ABL compliance is likely to be an issue—including funds raising money domestically and internationally—that active attention to compliance issues may avoid considerable cost and aggravation down the road.