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Delaware Chancery Court Applies Business Judgment Rule to Dismiss “Business Risk” Oversight Claim, But Allows Claim for Corporate “Waste” Based on Former CEO’s Exit Package
In one of the early decisions to analyze potential officer/director liability arising from losses stemming from exposure to subprime debt, on February 24, 2009, the Delaware Chancery Court in In re Citigroup Inc. Shareholder Derivative Litigation1 dismissed shareholders’ “failure to monitor” claims against the current and former officers and directors of Citigroup, yet left alive a claim for corporate waste for approving a $68 million departure package for the former CEO. Perhaps reflecting the zeitgeist embodied in the recent wave of shareholder proxy proposals and federal legislative proposals, the Court concluded that the claim as pled at least raised reasonable doubt as to whether the deal was “so one-sided that no reasonable person could conclude that the corporation has received adequate consideration,” and therefore did not require prior demand on the board.
The Citigroup Decision:
Shareholders brought a derivative action on behalf of Citigroup against the company’s current and former officers and directors, alleging that they breached their fiduciary duties by 1) failing to monitor and manage the risks associated with the subprime lending market, and 2) engaging in a variety of activities resulting in corporate waste. Defendants sought to dismiss the complaint on grounds that the shareholders had failed to make a prior demand on the board, and that plaintiffs had failed, as is required under Rales v. Blasband,2 to justify their failure to do so by creating a reasonable doubt that the board “could have properly exercised its independent and disinterested business judgment in responding to the demand.”
In an attempt to assert liability under a Caremark3 “duty of oversight” analysis, plaintiffs claimed the Citigroup board failed to properly monitor and manage the company’s risk associated with subprime lending market, by ignoring “red flags” that allegedly should have alerted the board to such risks. Plaintiffs claimed these “red flags” included a series of news articles, bankruptcy filings, and other publicly available information since 2005 reflecting the worsening conditions of the financial markets, including the subprime and credit markets, and large losses by the company’s peers such as Bear Stearns and Merrill Lynch due to such conditions. Plaintiffs pointed to the fact that a majority of the Citigroup directors were “financial experts,” who they allege should have been “especially sensitive to the red flags in the marketplace” and the dangers of structured investment vehicles (SIVs) in light of the company’s previous involvement with (and liability for) Enron SIVs.
The Court rejected the legal contention that the claims should be analyzed under a Caremark analysis — which is typically applied to the failure to detect and prevent employees’ fraudulent or criminal conduct — and concluded that the failure to recognize the extent of the business risks involved with the company’s subprime market exposure fell squarely within the business judgment rule.4 Calling plaintiffs’ theory under Caremark “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment,”5 the Court concluded:
Although these claims are framed by plaintiffs as Caremark claims, plaintiffs’ theory essentially amounts to a claim that the director defendants should be personally liable to the Company because they failed to fully recognize the risk posed by subprime securities. . . [T]he mere fact that a company takes on business risk and suffers losses — even catastrophic losses — does not evidence misconduct, and without more, is not a basis for personal director liability. . . Oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk.6
The shareholders also alleged the board members committed corporate waste by 1) allowing the company to purchase $2.7 billion in subprime loans; 2) authorizing and not suspending the company’s repurchase program, leading to the repurchase of approximately $645 million of the company’s own stocks at allegedly artificially inflated prices; 3) allowing the company to invest at least $7.9 billion in SIVs that were unable to pay off maturing debt; and 4) approving a multimillion-dollar payment and benefit package for the departing Chief Executive Officer.
The Court quickly dismissed most of plaintiffs’ claims of corporate waste. However, it concluded that plaintiffs’ claims surrounding the departure package for the former CEO — which included $68 million in salary, bonus, and accumulated stockholdings, plus an administrative assistant, car, and driver for up to five years — could, if proved, create a reasonable doubt that the agreement was “so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.”7
Practical Implications:
1. Survival of the Business Judgment Rule
In their complaint, plaintiffs strove heartily to fit what would ordinarily be an exercise of business judgment — i.e., the evaluation of the business risks associated with an investment in certain market sectors — into a Caremark “duty of oversight” claim. Plaintiffs claimed, for example, that there were extensive “red flags” starting in May 2005 that should have put defendants on notice about problems brewing in the real estate and credit markets. As such, plaintiffs claimed the defendants failed under Caremark to monitor the company’s “business risk” specifically with respect to its exposure to the subprime market.
What plaintiffs did not — and really could not — do was to plead with adequate specificity that the Citigroup board, at bottom, did more than engage in a business strategy that produced large revenues at the time but later did not. Caremark itself distinguishes between board decisions resulting in a loss because they were ill-advised or negligent (i.e., a product of business judgment) on the one hand, and those that are the product of “a sustained or systemic failure of the board to exercise oversight — such as an utter failure to attempt to assure a reasonable information and reporting system exists,” on the other. While the plaintiffs’ pleading efforts demonstrate the wisdom of directors continuing to identify business risks affecting other similarly situated companies and assessing whether those same risks might also affect their company, the Chancery Court decision affirms that, in the absence of losses stemming from employee misconduct or violations of the law, this assessment continues to fall within the ambit of the business judgment rule.
2. Role of a Robust Audit Committee and Charter
The Citigroup decision also reaffirms the importance of having an active audit committee with a robust charter populated by directors with appropriate expertise. The Chancery Court placed particular importance on the qualifications of Citigroup’s Audit and Risk Management Committee (which plaintiffs themselves touted) and the extensiveness of its charter and operations. After quoting extensively from the Committee charter to support its observations regarding the Committee’s broad authority to monitor the risks plaintiffs complained of, the Court also noted the frequency of the ARM Committee meetings: 11 in 2006 and 12 in 2007.8
While in the aftermath of the Delaware Chancery Court’s 2004 decision in Emerging Communications9 many observers questioned the degree to which the Delaware courts would hold financial experts to a higher standard than others on the board, the Citigroup court veered away from that path. The Court instead focused on plaintiffs’ failure to connect in any meaningful way the company’s prior involvement with SIVs at Enron to the SIVs it established to invest in home equity loans and other mortgage-backed securities. As such, plaintiffs failed to show how the Citigroup directors should have been on “heightened notice” in light of their expertise and prior experience in this area.
3. Continued Focus on Executive Compensation
As the Chancery Court acknowledged (and the recent decision in the Disney litigation10 demonstrated), it is ordinarily quite difficult for plaintiffs to adequately plead, let alone succeed, on a corporate waste claim based on excessive compensation plans. Thus, the Court had no qualms summarily dispatching plaintiffs’ claims for corporate waste for the purchase of $2.7 billion in subprime loans, the repurchase of $645 million in company stock at allegedly inflated prices, and the investment by the company of at least $7.9 billion in SIVs11 — each of which was of a decidedly greater magnitude than the former CEO’s exit package and post-exit perquisites. The Court’s decision nonetheless to allow plaintiffs’ corporate waste claim to proceed based upon the payment package is perhaps a sign of how “loaded” such payments have become, especially at companies suffering particularly steep losses in shareholder value or otherwise.
This alert was authored by Beth I.Z. Boland and Angela Lin with comments from Dale E. Barnes, Stephen D. Alexander and Michael P. O'Brien. For assistance, please contact the following lawyers:
Dale E. Barnes, Co-chair, Securities Litigation
dale.barnes@bingham.com, 415.393.2522
Jordan D. Hershman, Co-chair, Securities Litigation
jordan.hershman@bingham.com, 617.951.8455
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Securities Area
roger.joseph@bingham.com, 617.951.8247
Neal E. Sullivan, Practice Group Leader, Broker-Dealer; Co-chair, Securities Area
neal.sullivan@bingham.com, 202.373.6159
1 964 A.2d 106 (Del. Ch. Feb. 24, 2009).
2 634 A.2d 927 (Del. 1993).
3 In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).
4 In doing so, the Court highlighted the “stark contrast” between plaintiffs’ allegations and those in other recent derivative litigation involving losses sustained from investments in subprime mortgages, A.I.G., Inc. Consolidated Derivative Litigation, 2009 WL 366613 (Del. Ch., Feb. 10, 2009), in which plaintiffs made well-pled allegations that the board failed to exercise reasonable oversight of “pervasive fraudulent and criminal conduct” at the highest levels of the company. The Court concluded: “[t]here are significant differences between failing to oversee employee fraudulent or criminal conduct and failing to recognize the extent of a Company’s business risk.” Citigroup, 964 A.2d at 131 (emphasis in original).
5 Id. at 125.
6 Id. at 124, 130, 131 (emphasis in original).
7 Id. at 136-39. In return for this exit package, the company received from the CEO a non-compete agreement, a non-disparagement agreement, a non-solicitation agreement, and a release.
8 Id. at 127.
9 In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. June 4, 2004).
10 In re The Walt Disney Company Derivative Litigation, 906 A.2d 27 (Del. 2006).
11 Citigroup, at 135-37 and n. 96.
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