In Re Citigroup Inc. Shareholder Derivative Litigation, (Del. Ch., Feb. 24, 2009), read opinion here.
This Delaware Chancery Court opinion should be of widespread interest because it is the first detailed analysis of potential liability of directors under Delaware law for claims relating to a company suffering major losses resulting from substantial exposure to subprime debt.
Kevin Brady, a highly respected Delaware litigator, has graciously collaborated with me to prepare the following detailed review of the case. Readers will recognize Kevin as a regular recent contributor on this blog. This is the first decision, however, where we both collaborated on a summary of the same case. Due to the length of this decision, he focused on the first (and most important) part and I covered the second half of the 58-page opinion beginning with the reference to Chancery’s recent AIG ruling (summarized here, which allowed claims to proceed to trial against AIG directors, and is a decision that should be read together with this case.)
This case involves derivative claims brought by shareholders of Citigroup. Chancellor Chandler dismissed all but one of the plaintiffs claims based on a failure to adequately plead demand futility; however plaintiffs’ claim for waste with respect to a November, 2007 letter agreement concerning a payment and benefits package for Citigroup’s CEO survived the motion to dismiss. The Court also denied defendants’ Motion to Stay or Dismiss in favor of a New York action.
This action was brought by plaintiff shareholders against current and former directors:
(i) alleging breach of fiduciary duties for failing to properly monitor and manage the risks that Citigroup faced concerning problems in the subprime lending market; and
(ii) for failing to properly disclose the Company’s exposure with respect to its subprime assets.
Plaintiffs claimed that there were extensive “red flags” starting in May, 2005 that should have put defendants on notice about problems “that were brewing in the real estate and credit markets.” Defendants allegedly ignored the warnings and sacrificed the long term viability of Citigroup for short term profits. The plaintiffs also claimed that the director defendants and certain other defendants were liable for waste for: (i) allowing Citigroup to purchase $2.7 billion in subprime loans in 2007; (ii) authorizing and not suspending the Company’s share repurchase program in 2007 which allegedly resulted in the Company buying its own shares at “artificially inflated prices; (iii) approving a multi-million dollar payment and benefit package in November 2007 for Citigroup’s CEO; and (iv) allowing the Company to invest in “structured investment vehicles” (“SIVs”) that were unable to pay off maturing debt.
Motion to Dismiss or Stay Denied
A related action was filed in the U.S. District Court for the Southern District of New York on November 6, 2007. Four more shareholder lawsuits were filed in New York and all of them were consolidated on August 22, 2008. In the consolidated New York action, plaintiffs alleged: (i) violations of the Securities Act of 1934 §10b-5 and Rule 10b-5; (ii) breaches of fiduciary duties; (iii) waste; and (iv) unjust enrichment. An action was filed in Delaware on November 9, 2007, three days after the first New York action was filed. Ultimately three other actions were filed in Delaware and on April 21, 2008, the four pending Delaware actions were consolidated.
The defendants in the New York case moved to dismiss the consolidated action. The defendants in the consolidated Delaware action moved to dismiss or to stay the Delaware action in favor of the New York action. After the Court reviewed the legal standard set out in McWane Cast Iron Pipe Corp. v. McDowell-Wellman Eng’g Co., 263 A. 2d 281 (Del. 1970) for staying an action where there is a prior action pending elsewhere and the traditional forum non conveniens analysis, Chancellor Chandler concluded that defendants had failed to meet their burden of showing a hardship that would entitle them to a stay or dismissal of the Delaware action in favor of the New York action. As part of his forum non conveniens analysis, the Court specifically referenced the “important and atypical practical considerations” described by Vice Chancellor Parsons in In Re The Bear Stearns Cos. S’holder Litig., C.A. No-3643-VCP 2008 WL 959992 (Del. Ch. Apr. 9, 2008) as sui generis in that action where, the Court granted a motion to stay in favor of a New York action because “the [Bear Stearns] Court was faced with a case involving the Federal Reserve Bank and the Department of Treasury in which inconsistent rulings could ‘negatively impact not only the parties involved but also the U.S. financial markets and the national economy.” The Chancellor found that those factors were not present here.
Failure to Adequately Plead Demand Futility
Chancellor Chandler started his analysis by referring to the familiar Aronson test for demand futility where plaintiffs must provide particularized factual allegations that raise a reasonable doubt that the directors are disinterested and that the challenged transaction was otherwise the product of a valid exercise of business judgment. However, the Court changed direction when it noted that the plaintiffs here were complaining about board “inaction” and as a result, the Aronson test did not apply. Instead, in order to show demand futility in this situation, the Court turned to the standard set in Rales v. Blasband, 634 A. 2d 927 (Del. 1993) which mandates that a plaintiff must allege particularized facts that “create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to the demand.”
In analyzing the plaintiffs’ theory of director liability for failure with respect to the duty to monitor, the Court reviewed the decisions of In re Caremark Int’l Inc. Derivative Litig., 698 A. 2d 959 (Del. Ch. 1996) and Graham v. Allis-Chalmers Manufacturing Company, 188 A. 2d 125 (Del. 1963).
With regard to director liability standards, the Caremark Court distinguished between (1) “a board decision that results in a loss because that decision was ill advised or ‘negligent’” and (2) “an unconsidered failure of the board to act in circumstances in which due attention would arguably, have prevented the loss.” In the first instance, the director’s actions are measured against the business judgment rule. In the second instance, “only a sustained or systematic failure of the board to exercise oversight – such as an utter failure to attempt to assure a reasonable information and reporting system exists – will establish the lack of good faith that is necessary condition for liability.”
Chancellor Chandler then turned to Stone v. Ritter, where he noted that the Delaware Supreme Court approved the Caremark standard of director oversight liability making it clear that liability was based on the concept of good faith which was embedded in the duty of loyalty and did not constitute a freestanding fiduciary duty. Thus, Chancellor Chandler noted that “to establish oversight liability a plaintiff must show that the directors knew that they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities such as failing to act in the face of a known duty to act.” In addition, in order for the plaintiffs to succeed, “a showing of bad faith is a necessary condition to director oversight liability.”
In this case, the Chancellor characterized the plaintiffs’ claims as “a bit of a twist on the traditional Caremark claim” because they alleged that the defendants failed to monitor the Company’s “business risk” specifically with respect to Citigroup’s exposure to the subprime mortgage market. The plaintiffs supported their claim by arguing that the board should have been especially conscious of the “red flags” because a majority of the Citigroup directors served on the board during the Enron crisis and were members of the Audit and Risk Management (“ARM”) Committee and therefore considered “financial experts.” The Chancellor viewed the claims differently. “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. When one looks past the lofty allegations of duties of oversight and red flags used to dress up these claims, what is left appears to be plaintiff shareholders attempting to hold director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company.”
The Court went on to note that the doctrines of the fiduciary duty of care and the business judgment rule have been developed to address those situations. And as a result, the burden was on the plaintiffs not only to show gross negligence but to rebut the presumption that the directors acted in an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the company. In addition, Citigroup had adopted a provision in its certificate of incorporation pursuant to 8 Del. C. § 102(b)(7) that exculpates directors from personal liability for violations of breaches of fiduciary duty, except for, among other things, breaches of the duty of loyalty or actions or omissions not in good faith or that involve intentional misconduct or knowing violation of law. In this action, while the plaintiffs had not alleged that the directors were interested in the transaction, they did allege that the directors acted in bad faith.
The Court concluded that “[a] plaintiff can thus plead bad faith by alleging with particularity that a director knowingly violated a fiduciary duty or failed to act in violation of a known duty to act, demonstrating a conscious disregard for her duties.” Did the director consciously disregard an obligation to be reasonably informed about the business and the risks or consciously disregard the duty to monitor and oversee the business? “The presumption of the business judgment rule, the protection of an exculpatory § 102(b)(7) provision, and the difficulty of proving a Caremark claim together function to place an extremely high burden on a plaintiff to state a claim for personal director liability for failure to see the extent of a company’s business risk.”
In light of the “extremely high burden” placed on plaintiffs, the Court concluded that plaintiffs’ conclusory allegations (and thus their failure to plead particularized facts) were insufficient to state a Caremark claim thereby excusing demand. To the contrary, Citigroup had procedures and controls in place that were designed to monitor risk and the plaintiffs did not contest these standards. Citigroup also had an ARM Committee to assist the board in fulfilling its oversight responsibility regarding risk assessment and risk management. And even if there were warning signs, they are not evidence that the directors consciously disregarded their duties or otherwise acted in bad faith but may only be evidence that the directors made bad business decisions.
The Court also found that the plaintiffs had failed in their attempt to show how the existence of the Enron scandal somehow put the Citigroup directors on “heightened alert” to problems years later with the subprime mortgage crisis. Moreover, the Court found that the use of SIVs in the Enron related conduct would not serve to put the director defendants on any type of heightened notice to the unrelated use of SIVs in structuring transactions involving subprime securities.” “That there were signs in the market that reflected worsening conditions and suggested that conditions may deteriorate even further is not an invitation for the Court to disregard the presumptions of the business judgment rule and conclude that the directors are liable because they did not properly evaluate business risk.”
Recent Chancery Decision in AIG case Distinguished
The court disagreed with the plaintiffs’ characterization of their claims as "failure to monitor" (Caremark) claims, but nonetheless, the court distinguished a recent Chancery Court decision that did allow a Caremark "failure to monitor" claim to survive a motion to dismiss (under a more plaintiff-friendly Rule 12(b)(6) standard.) See American International Group, Inc. Consolidated Derivative Litigation, 2009 WL 366613 (Del. Ch., Feb. 10, 2009) ("AIG case"). Cursory highlights on this blog of the 100-plus page decision in the AIG case by the Delaware Chancery Court that allowed Caremark claims to survive beyond a motion to dismiss can be found here.
The AIG case was distinguishable from this Citigroup case, the court observed, in part because unlike the allegations against Citigroup, the defendant directors in the AIG case: "allegedly failed to exercise reasonable oversight over pervasive fraudulent and criminal conduct. Indeed, the court in AIG even stated that the complaint there supported the assertion that top AIG officials were leading a "criminal organization" and that the ‘diversity, pervasiveness, and materiality of the alleged financial wrongdoing at AIG is extraordinary.’" (emphasis in original).
Contrariwise, the claims against the Citigroup directors involved allegedly failing to recognize the extent of a company’s business risk–as opposed to allegedly failing to oversee employee fraudulent or criminal conduct. Caremark-type duties were not designed to impose oversight liability for business risk.
Money quote: "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." (emphasis in original)
The reasoning for the foregoing statement of Delaware law was explained by means of a query by the court in footnote 78 that deserves quoting verbatim:
… Query: if the Court were to adopt plaintiffs’ theory of the case—that the defendants are personally liable for their failure to see the problems in the subprime mortgage market and Citigroup’s exposure to them—then could not a plaintiff succeed on a theory that a director was personally liable for failure to predict the extent of the subprime mortgage crisis and profit from it, even if the company was not exposed to losses from the subprime mortgage market? If directors are going to be held liable
for losses for failing to accurately predict market events, then why not hold them liable for failing to profit by predicting market events that, in hindsight, the director should have seen because of certain red (or green?) flags? If one expects director prescience in one direction, why not the other?
The court observed that the plaintiffs were asking it to engage in the exact kind of judicial second guessing that the business judgment rule proscribes. Especially in a case with staggering losses, it would be tempting to examine why the decision was wrong, but the presumption of the BJR against an objective review of business decisions by judges is no less applicable when losses to the company are large.
Plaintiffs argued demand futility regarding their disclosure claims based on the "substantial likelihood of liability" standard which would, they argued, prevent the defendant directors from exercising independent and disinterested business judgment in reviewing a demand. Due to the Section 102(b)(7) provision in Citigroup’s charter, such disclosure violations would need to have been done in bad faith, knowingly or intentionally. The court reviewed these claims and found them wanting in the particularity required by Rule 23.1 For example, it was not demonstrated that the directors knew that there were misstatements or omissions in the financial statements, or that they acted in bad faith by not informing themselves adequately. (See footnotes 83 to 87 and 92 to 93 for supporting cases relating to disclosure obligations and detail needed in disclosure violation claims.)
Importantly, the court explained why the allegations against the audit committee were insufficiently detailed for claims involving allegedly faulty financial statements to survive: "Under our law, to establish liability for misstatements when the board is not seeking shareholder action, shareholder plaintiffs must show that the misstatement was made knowingly or in bad faith." In addition, even so-called financial experts on the audit committee are entitled to rely in good faith on reports and statements and opinions, pursuant to DGCL Section 141(e), from the corporation’s officers and employees who are responsible for preparing the company’s financial statements.
Waste Claims and Demand Futility
Plaintiffs argued that demand was futile for their waste claims under the second Aronson prong. That is, they do not argue a majority of the directors were not disinterested and independent. Rather, they argue that demand is excused because the "challenged transaction was other than the product of a valid exercise of business judgment". (Clearly, a high threshold.)
In addition to the difficulty of satisfying the second prong of Aronson, the claim of waste under Delaware law is extremely hard to establish. Namely, one must plead particularized facts that lead to the inference that the directors approved an "exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration." (footnotes 98 and 99).
The third high hurdle plaintiffs had to jump was that they were attacking a compensation decision. However, the court noted that there is "an outer limit" to the discretion of the board in setting compensation, at "which point a decision of the directors on executive compensation is so disproportionately large as to be unconscionable and constitute waste." (footnotes 105 and 106). If waste is found, it is a non-exculpated violation, as the Delaware Supreme Court has held that waste constitutes bad faith. The court’s explanation of the compensation package for the departing CEO, who allegedly was at least partially responsible for the staggering losses, and why this waste claim on compensation survived, is worth quoting verbatim:
According to plaintiffs’ allegations, the November 4, 2007 letter agreement provides that Prince will receive $68 million upon his departure from Citigroup, including bonus, salary, and accumulated stockholdings. Additionally, the letter agreement provides that Prince will receive from Citigroup an office, an administrative assistant, and a car and driver for the lesser of five years or until he commences full time employment with another employer. Plaintiffs allege that this compensation package constituted waste and met the “so one sided” standard because, in part, the Company paid the multi-million dollar compensation package to a departing CEO whose failures as CEO were allegedly responsible, in part, for billions of dollars of losses at Citigroup. In exchange for the multi-million dollar benefits and perquisites package provided for in the letter agreement, the letter agreement contemplated that Prince would sign a non-compete agreement, a non-disparagement agreement, a non-solicitation agreement, and a release of claims against the Company. Even considering the text of the letter agreement, I am left with very little information regarding (1) how much additional compensation Prince actually received as a result of the letter agreement and (2) the real value, if any, of the various promises given by Prince. Without more information and taking, as I am required, plaintiffs’ well pleaded allegations as true, there is a reasonable doubt as to whether the letter agreement meets the admittedly stringent “so one sided” standard or whether the letter agreement awarded compensation that is beyond the “outer limit” described by the Delaware Supreme Court. Accordingly, the Complaint has adequately alleged, pursuant to Rule 23.1, that demand is excused with regard to the waste claim based on the board’s approval of Prince’s compensation under the letter agreement. (footnotes omitted.)
This post is much longer than normal, but the gravity of this case warrants it. Moreover, I expect that others will be commenting on this opinion, and I will link to that commentary as I encounter it.
UPDATES: Prof. Larry Ribstein provides insightful commentary here about this case and also the recent AIG case highlighted on this blog. Here is another insightful analysis of this case and the AIG case by Professor Ribstein on the Harvard Law School Corporate Governance Forum. The AmLaw Daily linked this post here. Professor Lawrence Cunningham comments on the case here.
UPDATE II: Kevin LaCroix’s The D & O Diary here has a thoughtful post about this case. Kevin’s blog is must-reading for anyone interested in the latest developments on D and O liability and related issues.