In Belmont v. MB Investment Partners, Inc., No. 12-1580, 2013 WL 646344 (3d Cir. Feb. 22, 2013), the United States Court of Appeals for the Third Circuit held that a mere failure by corporate directors to oversee enforcement of compliance protocols which, if properly enforced, might have led to the directors’ knowledge of securities fraud by a corporate employee does not establish the directors’ “culpable participation” in the employee’s misconduct sufficient to support controlling person liability under Section 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”), 15 U.S.C. § 78t(a). Third Circuit held additionally that corporate directors may not be held personally liable for misconduct of corporate employers under a theory of negligent supervision. These rulings reinforce protections for directors from personal exposure to damages caused to third parties by harmful acts of employees, even where better corporate oversight might have been able to prevent the harm caused by the employees.

Belmont arose from a Ponzi scheme. Mark Bloom, an employee and officer at defendant MB Investment Partners, Inc. (“MB”), also was the sole manager of a hedge fund called North Hills, L.P. (“North Hills”), unaffiliated with and outside the scope of his employment and responsibilities with MB. Bloom nevertheless marketed North Hills to several of MB’s clients.

North Hills turned out to be a Ponzi scheme. After it collapsed, Bloom was arrested, charged and pled guilty to all charges levied against him arising from the Ponzi scheme.

After Bloom’s guilty plea, plaintiffs (who had invested in North Hills and lost over $4 million in its collapse) filed suit against MB, certain MB officers and directors and one MB employee, alleging (1) controlling person liability under Section 20(a) of the Exchange Act; (2) negligent supervision; (3) violations Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), and Securities & Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder; (4) violations of the Pennsylvania Unfair Trade Practice and Consumer Protection Law, 73 Pa. Cons. Stat. Ann. § 201-1 et seq.; and (5) breach of fiduciary duty. Plaintiffs alleged that MB’s directors knew Bloom was operating North Hills, but did not know the fund was a Ponzi scheme.

Defendants moved to dismiss. The United States District Court for the Eastern District of Pennsylvania granted the motion in part, dismissing all claims against the MB employee. Following discovery, the remaining defendants filed motions for summary judgment. The district court granted that motion in its entirety. Plaintiffs appealed.

The Third Circuit affirmed nearly all of the district court’s decision, vacating and remanding for trial only the grant of summary judgment for MB Investment on the claims for violation of Section 10(b) and Rule 10b-5. In doing so, the Court made noteworthy rulings relating to Section 20(a) of the Exchange Act and negligent supervision that provide insight into the limits of liability of a corporation’s directors for misconduct of employees.

In their Section 20(a) claim, plaintiffs alleged that MB’s directors were controlling persons jointly and severally liable for the actions of Bloom, a person allegedly under their control. Plaintiffs argued that the directors recklessly failed to monitor Bloom and were therefore culpable participants in his fraud, making them secondarily liable for his actions under Section 20(a). Plaintiffs alleged no acts by the directors in furtherance of the fraud. Instead, they proceeded on a theory of inaction, arguing that because the liability being sought was secondary, they needed only to show recklessness, not knowing misconduct by the directors. According to plaintiffs, the directors’ alleged failure to enforce compliance protocols and investigate red flags relating to Bloom’s activities demonstrated recklessness adequate to make them liable for his misdeeds.

The Third Circuit explained that to prevail on a theory of inaction, plaintiffs must prove that the directors’ inaction was undertaken intentionally to further the fraud and intentionally to prevent its discovery. In other words, the directors must have had knowledge of the fraud in order to intentionally fail to act to prevent it — a fact the plaintiffs conceded was not true when they alleged the directors did not properly monitor Bloom. Further, the Court reiterated the principle that secondary liability requires a more culpable state of mind (intent), not a lesser one (recklessness). The Court concluded that sloppy compliance practices which result in a lack of knowledge of an employee’s harmful activities was insufficient to establish culpable participation for the purposes of Section 20(a) liability.

The Court also held that directors are not liable as employers under a theory of negligent supervision. Plaintiffs alleged that the directors, since they are vested by state corporate law with supervisory responsibilities for the corporation, are subject to liability for negligent supervision of the corporation’s employees. Plaintiffs also argued that Bloom’s misconduct was foreseeable by the directors as a matter of law because the MB directors knew Bloom managed a separate hedge fund, but failed to monitor his operation.

The Court explained that while negligent supervision requires the elements of common law negligence (duty, breach, causation and damages), the tort is specifically predicated on the duties of an employer to responsibly monitor its employees and to refrain from placing an employee in a situation where the employee will harm a third party. The Court observed that the question of whether a director of an employer corporation, rather than or in addition to the employer corporation itself, can be liable for negligent supervision is determined by asking whether a director owes a duty to third parties to supervise a corporation’s employees.

The Third Circuit held that directors do not owe a duty to third parties to supervise employees. The Court noted that while a director’s fiduciary duty of loyalty to act in good faith for the benefit of the corporation has been held to include some duty of oversight, that duty has never been understood to include responsibility for day-to-day supervision of employees. The Court noted that those types of day-to-day supervision duties are the responsibility of officer or employee-supervisors and are expressly not the duty of directors. The Court further concluded that there is no agency relationship between the director and employee. Instead, the corporation itself is the employer of the culpable employee and potentially liable for his or her tortious acts. Therefore, directors are not liable under a theory of negligent supervision.

The rulings issued by the Third Circuit confirm the limits to directors’ exposure for damage caused by actions of unscrupulous employees, and in particular preserve those limits even where arguably poor oversight prevented the directors from discovering the employees’ harmful acts.

For more information, please contact John Stigi at (310) 228-3717.