Delaware Corporate and Commercial Litigation Blog : Delaware Litigation Lawyer & Attorney : Francis G. X. Pileggi : Corporate, Business, Commercial, Delaware Chancery Court

In Re The Dow Chemical Company Derivative Litigation, Cons. No. 4339, (Del. Ch., Jan. 11, 2010), read opinion here.

Kevin Brady and Ryan Newell of the Connolly Bove firm prepared this synopsis.

On January 11, 2010, a year after a major corporate battle between the Dow Chemical Company (“Dow”) and Rohm & Haas Company (“ROH”) regarding a $19 billion merger, Chancellor Chandler dismissed derivative claims including Caremark-type allegations against Dow’s current directors and officers for failure to adequately plead demand futility under Court of Chancery Rule 23.1.

Anatomy of the Deal -- “Ticking” Fee but No “Financing Out” or MAE Clause

In December 2007, Dow entered into a memorandum of understanding with Kuwait’s Petrochemicals Industries Company (“PIC”) for a joint venture referred to as “K-Dow.” Dow was to receive $9 billion in cash following the transfer of 50% interest in five Dow commodities chemical businesses. In July 2008, Dow entered into an $18.8 billion merger agreement wherein it would acquire all of ROH at $78 per share. The closing was scheduled to occur within 2 business days of receiving regulatory approval. Because Dow recognized that “uncertainty” regarding any aspect of the deal would be a death knell for the deal, Dow did not condition the closing on a financing or any other traditional “outs.” Dow assumed the risk of a material adverse effect in the chemical industry and financial markets. The merger agreement, however, did contain traditional penalties for delay or failure to close including specific performance and substantial “ticking” fees (interest on the cash portion of the deal which was estimated to be approximately $3.3 million per day).

As for financing, Dow had $9 billion from PIC, $4 billion from Berkshire Hathaway Inc. and the Kuwait Investment Authority, and a $13 billion bridge loan (available to be drawn upon if the ROH merger closed before K-Dow closed even though Dow’s position publicly was that the ROH merger was not contingent upon the closing of K-Dow).

Tightening of Credit Markets -- Dow’s Picture Worsens

In July 2008, Dow’s earnings were strong, however, by 2009 Dow’s outlook and the economy in general took a downward turn. Dow’s credit ratings nearly fell to junk bond levels, which possibly meant that either Dow did not have the necessary cash reserves for the ROH deal or, if it closed, Dow would be insolvent following several credit defaults. Dow nonetheless proceeded with pre-closing plans for both K-Dow and ROH.

In late November 2008, Dow received approval for K-Dow from Kuwait’s Supreme Petroleum Council (the “SPC”) to close, which was slated for January 2, 2009. That approval was later rescinded by the SPC (without giving any reason) in late December 2008 – which prompted Dow to quickly issue a press release stating that the ROH closing was not contingent upon K-Dow. (Allegedly, behind the SPC’s rescission were inferences of “external interference,” “politicizing” of the oil industry, and other suspicions that suggested bribery on Dow’s behalf.)

Dow Tries to Extend the Closing

As of January 9, 2009, the only remaining regulatory approval needed was that of the FTC. According to the Plaintiffs, Dow lobbied the FTC to delay approval and also asked ROH to extend the closing deadline. Neither request succeeded. The FTC granted final antitrust clearance for the transaction on January 23, 2009, which triggered a closing no later than January 27, 2009. Two days before closing, Dow refused to close citing two reasons: (i) a change in the economic climate; and (ii) the likelihood that the combined Dow-ROH entity would fail. ROH sued Dow on January 26, 2009 for specific performance. That litigation settled before as trial was about to start and the merger closed on April 1, 2009 “on substantially altered financial terms.”

Derivative Claims

Plaintiffs brought a litany of claims including breaches of fiduciary duties by the Directors for: “(a) approving the [ROH] Transaction, (b) misrepresenting the relationship between the [ROH] and K-Dow transactions, (c) failing to detect and prevent alleged bribery in connection with the K-Dow transaction, (d) failing to detect and prevent the alleged misrepresentations, (e) failing to detect and prevent insider trading, and (f) failing to prevent the payment of allegedly excessive and wasteful compensation.”

Demand Excusal

Plaintiffs, in bringing a derivative action, must satisfy Court of Chancery Rule 23.1 by either making a pre-suit demand or alleging demand futility. The Court stated that the purpose of the demand requirement “is not to insulate [directors] from liability; rather … to preserve the primacy of board decisionmaking regarding legal claims belonging to the corporation.” Demand is futile and therefore excused “only if a majority of the directors have such a personal stake in the matter at issue or the proposed litigation that they would not be able to make a proper business judgment in response to a demand.”

The Court also noted that while the procedural posture was a motion to dismiss, the more liberal standard of Rule 12(b)(6) did not apply. Because the claims were derivative, the motion must be considered under Rule 23.1: “demand futility under Rule 23.1 is ‘logically the first issue [for all derivative claims] and if plaintiffs cannot succeed under the heightened pleading requirements of Rule 23.1 . . . there is no need to proceed to an analysis of the merits of the claim’ under Rule 12(b)(6).” Moreover, two different demand standards applied to Plaintiffs’ claims. For the claims regarding a board action -- the Directors’ approval of the ROH merger -- the Court applied the Aronson test. For claims regarding board inaction (Caremark claims), the Court applied the Rales test.

Approval of the ROH Merger

Under Aronson, Plaintiffs were required to “plead particularized facts that raise a reasonable doubt either (i) that a majority of the directors who approved the transaction in question were disinterested and independent, or (ii) that the transaction was the product of the board’s good faith, informed business judgment.”

First Prong of Aronson

Plaintiffs allege that demand was excused as futile because half of the board failed the test of being disinterested or independent because of their relationships with director Liveris – yet they did not allege that Liveris was interested in the transaction. Plaintiffs pointed to Liveris’ role as a director at Citigroup – which was the named bank among many that were to provide the bridge loan if needed. Under this theory, the Court noted that Liveris potentially had a conflict of interest if ROH had forced Dow to draw upon the bridge loan to close and had Dow consequently gone into bankruptcy. However, this was merely a potential conflict and does not reasonably lead to the conclusion that a conflict existed. With no conflict of interest, there was no interested director and “without an interested director, the Court stated that the independence of the remaining directors need not be examined. Plainly put, the beholdenness or dominance of any director is irrelevant because there is no fear that the dominating director, without a personal or adverse interest, will do anything contrary to the best interest of the company and its stockholders.” With Plaintiffs failing to meet the burden under Rule 23.1, the Court held that the majority of the Directors were disinterested and independent.

Second Prong of Aronson

The Court held that the complaint failed to indicate that the Directors were not adequately informed. To survive the second prong of Aronson, the “‘plaintiffs must plead particularized facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision.’”

The Court found that “[n]othing in the complaint indicates the Dow board was not adequately informed about the transaction with [ROH].” Taking into consideration the economic times, the Court noted that “[e]ven accepting all the well-pled allegations as true, plaintiffs do not rebut or address the accepted facts that the board was negotiating in a seller’s market and [ROH] demanded certain deal protections.” The Directors made a decision to enter the merger agreement without a financing contingency because they did not want ROH to seek another partner. The Plaintiffs focused on the “substantive content of the directors’ decision” as opposed to the process. As Chancellor Chandler stated in Citigroup, “substantive second-guessing of the merits of a business decision . . . is precisely the kind of inquiry that the business judgment rule prohibits.”

The Court stated:

“To show that a disinterested and independent board acted outside the bounds of business judgment, plaintiffs must show that directors acted in bad faith. Recently, the Supreme Court clarified the concept of bad faith in Lyondell Chemical Co. v. Ryan, noting that ‘[i]n the transactional context, [an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties.’ Plaintiffs must show that defendants completely and ‘utterly failed’ to even attempt to meet their duties.”

While the Plaintiffs claimed that the directors misrepresented the connection between ROH and the K-Dow deals, the Court found no misrepresentation of the relationship. Thus, having failed to show reasonable doubt that the Directors did not exercise valid business judgment, the Court held that Plaintiffs failed to satisfy the second prong of Aronson. Coupled with the failure to prove either interestedness or lack of independence, the Court dismissed with prejudice the claim for breach of fiduciary duties regarding the ROH merger.

Caremark Failure to Supervise

Demand futility for the Caremark monitoring claims was governed by Rales wherein:

[D]efendant directors who face a “substantial likelihood of personal liability” are deemed interested in the transaction and thus cannot make an impartial decision. But “[d]emand is not excused solely because the directors would be deciding to sue themselves.” Rather, “demand will be excused based on a possibility of personal director
liability only in the rare case when a plaintiff is able to show director conduct that is ‘so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.’”

The core of Plaintiffs’ Caremark claims was that the failure to monitor subjected Dow to be exposed to liability for 1) bribery allegations in K-Dow; 2) misrepresentations regarding the need for K-Dow to close to provide financing for ROH; and 3) insider trading and waste allegations.

To prevail on their claim for oversight liability, Plaintiffs

must show that the directors knew they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities such as by failing to act in the face of a known duty to act.” Furthermore, the test is “rooted in concepts of bad faith; indeed, a showing of bad faith is a necessary condition to director oversight liability.” Only an “utter failure” will satisfy a showing of bad faith. Moreover, because Dow has adopted a Section 102(b)(7) provision in its charter, plaintiffs must plead particularized facts showing bad faith in order to establish a substantial likelihood of personal directorial liability.

K-Dow Bribery Allegations

Plaintiffs claimed that the Directors failed to detect and prevent bribery related to K-Dow was “supported” by an unsubstantiated charge made by a Kuwaiti Parliament member. Nonetheless, at the motion to dismiss stage the complaint contained facts that allowed the Court to infer that bribery may have occurred. However, Plaintiffs failed to plead the “red flags” that would give the Directors a basis for suspicion. Plaintiffs argued that because members of Dow’s management may have been involved with bribery issues in the past (Dow paid a fine to the SEC in January 2008), the Board should have suspected similar behavior here. However, the Court rejected that argument because it was found that the prior infractions involved different members of management, a different country, and a different transaction.

Lacking both the knowledge of and reason to suspect bribery, the Directors could not have consciously disregarded their duty to supervise. Nor did Plaintiffs plead facts to suggest an “utter failure” to supervise insiders or that any director acted with anything but good faith. Accordingly, Plaintiffs failed to “allege facts that establish a substantial likelihood of director liability due to oversight liability under Citigroup . . . .” The bribery claim was dismissed with prejudice.

Interestingly, in footnote 85, the Court noted that Dow had set up policies to prevent improper dealings with third parties in its Code of Ethics which expressly prohibited unethical payments to third parties. Plaintiffs also made allegations that defendants permitted their corporate governance policies to be compromised. The Court said in essence that you can’t have it both ways – “Plaintiffs cannot simultaneously argue that the Dow board ‘utterly failed’ to meet its oversight duties yet had “corporate governance procedures” in place without alleging that the board deliberately failed to monitor its ethics policy or its internal procedures.”

Director(s) Domination or Control of Board

Finally, Plaintiffs argued that nonetheless Liveris faced a substantial likelihood for failing to supervise and that he dominated and controlled a majority of the Directors. Without reiterating its reasons, the Court held that Plaintiffs had not pled facts sufficient to show that Liveris, like the other directors, was subject to a substantial liability of interest. Having no conflict, it was irrelevant whether he dominated and controlled a majority of the Directors.

In conclusion, having failed to establish that even one director faced a substantial likelihood of liability, Plaintiffs were unable to show that the board was dominated, controlled, and improperly influenced. Thus, under Rales, Plaintiffs failed to establish that demand was excused so the claims were dismissed.

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Lyondell Chemical Co. v. Ryan, Del. Supr. (March 25, 2009), read opinion here.  See revised opinion of  April 16, 2009 here. The Delaware Supreme Court rendered this unanimous en banc decision last evening. It was much anticipated in the corporate law world and in the few hours since its release it has already generated substantial commentary among corporate law professors and similar commentators.

Kevin Brady, a highly respected Delaware litigator, has provided us with the following review of the opinion:

In its decision on an interlocutory appeal, Delaware's High Court reversed the Court of Chancery’s July 29, 2008 decision denying summary judgment for the directors of Lyondell Chemical Company (“Lyondell”) as to the “Revlon” and “deal protection” claims and whether the directors of Lyondell acted in good faith in conducting the $13 billion sale of Lyondell.

The class action complaint alleged that the Lyondell directors breached their fiduciary duties of care, loyalty and candor and put their personal interests ahead of the interests of the Lyondell shareholders. In particular, the complaint alleged that: (i) the merger price was grossly insufficient; (ii) the directors were motivated by self-interest; (iii) the process by which the merger was negotiated was flawed; (iv) the directors agreed to unreasonable deal protection provisions and (v) the preliminary proxy statement omitted numerous material facts. By way of background, the merger price represented a substantial premium over the market price and the merger was approved not only by a disinterested board but also by more than 99% of the voted shares.

Lyondell’s charter contained an exculpatory provision pursuant to 8 Del. C. § 102(b)(7), protecting the directors from personal liability for breaches of the duty of care, so the case turned on whether there were any shortcomings on the part of the directors to implicate their duty of loyalty, a breach of which is not exculpated. Because the Court of Chancery had found that the board was independent and was not motivated by self-interest or ill will, the focus became whether the directors were entitled to summary judgment on the claim that they breached their duty of loyalty by failing to act in good faith.

Court of Chancery Focuses on Process and Deal Protection Provisions

The Court of Chancery rejected all of the plaintiffs’ claims except those directed at the process by which the directors sold the company and the deal protection provisions in the merger agreement. In particular, whether under Revlon v. MacAndrews & Forbes Holdings, Inc. (506 A. 2d 173, 182 (Del. 1986)), the directors failed to obtain the best available price in selling the company. The Court of Chancery decided that “unexplained inaction” by the Lyondell directors for two months permitted a reasonable inference that the directors may have consciously disregarded their fiduciary duties. The Supreme Court disagreed finding that there was no evidence from which to infer that the directors knowingly ignored their responsibilities, thereby breaching their duty of loyalty.

Justice Carolyn Berger writing for the Court examined the concepts of “bad faith” and “failure to act in good faith” as well as the range of conduct that might be classified as such in light of existing Delaware case law. See, In re Walt Disney Co. Deriv. Litig. (906 A. 2d 27 (Del. 2006)), Stone v. Ritter, (911 A. 2d 362 (Del. 2006) and In re Caremark Int’l Deriv. Litig. (698 A. 2d 959 (Del. Ch. 1996). While the Court of Chancery had denied summary judgment in order to obtain a more complete record before deciding whether the directors had acted in bad faith, the Supreme Court determined that the trial court “reviewed the existing record under a mistaken view of the applicable law.” The Supreme Court went on to note that there were three factors that contributed to that mistake: (i) the Court of Chancery imposed Revlon duties on the directors before they either decided to sell, or before the sale had become inevitable; (ii) the Court of Chancery read Revlon and its progeny as creating a set of requirements that must be satisfied during the sale process; and (iii) the Court of Chancery “equated an arguably imperfect attempt to carry out Revlon duties with a knowing disregard of one’s duties that constitutes bad faith.”

When Exactly Do Revlon Duties Arise?

In analyzing Revlon and its progeny, the Court of Chancery determined that the directors must actively engage in the sale process, and confirm that they have obtained the best available price either by conducting an auction, a market check or demonstrating “an impeccable knowledge of the market.” The Court of Chancery concluded that because the Revlon sale process must follow one of the these courses of conduct identified above and that the Lyondell directors had not followed any of the standards that the Court of Chancery extracted from Revlon and its progeny, the directors were unable to meet their burden under Revlon.

The Supreme Court disagreed noting that the problem with the Court of Chancery’s analysis was that Revlon duties arise not because a company is “in play” (such as in this case where there was a Schedule 13D filing) but rather when the company “embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change of control.” In this case, that was when the Lyondell directors began negotiating the sale of Lyondell. The Supreme Court further noted that “there is no legally prescribed steps that directors must follow to satisfy their Revlon duties” and that the Lyondell directors failure to take any specific steps during the sale process could not have demonstrated a “conscious disregard of their duties.”

The Supreme Court concluded that the Court of Chancery “approached the record from the wrong perspective. Instead of questioning whether disinterested, independent directors did everything that they (arguably) should have done to obtain the best sale price, the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price.” Finding that the record clearly established that the Lyondell directors did not breach their duty of loyalty by failing to act in good faith, the Supreme Court reversed the decision of the Court of Chancery and remanded the matter for entry of judgment in favor of the Lyondell directors.

SUPPLEMENT: Professor Stephen Bainbridge provides a scholarly analysis here. Dean and Professor Eric Chiappinelli provides his learned overview of the case here. Professor Gordon Smith gives us the benefit of his professorial insights here. Attorney  Bernard Sharfman of the Cohen Milstein firm has written a thoughtful article that includes a discussion of this case here.

Some of the extensive commentary on the trial court's opinion is collected here.

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Professor Bainbridge provides scholarly commentary here on the recent Chancery Court decision in Citigroup, including a rebuttal to Professor Jay Brown and an analysis of Caremark duties, as well as a discussion of the theoretical and practical underpinning of the Business Judgment Rule.

My prior highlighting of the Citigroup case and a link to the actual opinion is here.

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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.

Disclosure Claims

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.

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American International Group, Inc., Consolidated Derivative Litigation; AIG, Inc. v. Greenberg, et al., 2009 Del. Ch. LEXIS 15 (Feb. 10, 2009)("AIG I") 965 A.2d 763 (Del. Ch. 2009), read opinion here.

This Chancery Court decision denied a Motion to Dismiss breach of fiduciary duty claims against former AIG Chairman Maurice "Hank" Greenberg and other AIG directors in connection with the long list of claims relating to AIG's need to restate years of  financial statements, and related losses of billions of dollars in stockholder value. The opinion is 104-pages long in the original slip op.  format  and could easily be the subject of a law review article, but pressing client matters allow me only to identify the decision at this time and add a few highlights.

Notably, the  defendant officers were dismissed on jurisdictional grounds in large part because the claims originated before the Delaware statute was changed to allow jurisdiction in Delaware to be more easily imposed against officers. Also, the auditor, PricewaterhouseCoopers, was dismissed based on the application of New York law (in light of the substantial relationship test for choice of law), and New York law apparently required dismissal of the claims against them.

The best way to highlight a few aspects of a voluminous opinion like this on a blog is via bullet-points.

• The court found that the complaint stated breach of loyalty claims against directors for "knowingly tolerating inadequate internal controls and knowingly failing to monitor their subordinates' compliance with legal duties." [Caremark claim] See footnotes 123 and 124.
   
• The court emphasized that the Caremark claim was not based on one instance of fraud, but rather on such a pervasive scheme that the court actually uses the term "criminal organization" to describe the extraordinary wrongdoing alleged in the complaint.  See LEXIS format at *78.
• Acknowledging the difficulty of pleading a breach of loyalty claim under Caremark based on a duty to monitor, even under Rule 12(b)(6),  the court found that the complaint did  so.  FN 125
• Key quotes from the opinion about Caremark claims include:

• "Our Supreme Court has recognized that directors can be liable where they 'consciously failed to monitor or oversee [the company's internal controls] thus disabling themselves from being informed of risks or problems requiring their attention.'" FN 126.  And although satisfaction of this standard requires scienter, the pled facts support an inference that Matthews and Tizzio were 'conscious of the fact that they were not doing their jobs.'" FN 127

• Caremark claims against Greenberg were upheld because the complaint adequately pled that the AIG internal controls were broken and Greenberg knew they were broken (and could get around them), but failed to do anything to fix the internal controls.

• Breach of fiduciary duty claims were also upheld against directors alleged to have used insider information to profit at the expense of innocent buyers of stock (i.e., they allegedly sold their stock based on material non-public information about the pervasive fraud.) See FNs 128 to 131

• arguments were rejected that involved attempts to dismiss contribution and indemnity claims based on ripeness and related theories. See FNs 143 to 145 and Section 6302(c) of Title 10 of the Delaware Code (regarding joint tortfeasor partial settlements).

• When a "Special Litigation Committee" decides to "take no position" on a derivative suit, that is tantamount to "allowing it to proceed", and also supports demand futility.

• Equitable tolling may, in some situations, extend the three-year statute of limitations for fiduciary duty claims (FNs 181 to183) such as when a fiduciary uses his fraud to conceal his wrongdoing to prevent others from discovering the liability.

• Quote: "Many of the worst acts of fiduciary misconduct have involved frauds that personally benefited insiders as an indirect effect of directly inflating the corporation's stock price by the artificial means of cooking the books." See  LEXIS format of opinion at *122.

UPDATE: Professor Larry Ribstein comments here on this case and the recent Citigroup decision also highlighted on these pages here, which should be read together with this case. Here is another analysis by Professor Ribstein about this case and the Citigroup case on the Harvard  Law School Corporate Governance Forum. Prof. Lawrence Cunningham provides insightful commentary here.

UPDATE II:  In a June 17, 2009 decision in this case,  American International Group, Inc. v. Greenberg, No. 729-VCS (June 17, 2009),  read opinion here, the Chancery Court summarized the above decision from February thusly:

 In an earlier opinion in this action, this court addressed the motions to dismiss brought by PricewaterhouseCoopers and several former-AIG officers and employers.5

In that previous decision, this court held that the Complaint survived dismissal as against challenge by insider defendants Hank Greenberg, Edward Matthews, and Thomas Tizzio and that the Complaint stated well-pled claims of breach of fiduciary duty against those defendants.6  The Complaint also adequately alleged fraud and conspiracy claims against Tizzio. 7

By contrast, this court held that New York law governed the claims against AIG’s auditor, PricewaterhouseCoopers, and that New York law’s approach to the doctrine of in pari delicto barred AIG from recovering against PricewaterhouseCoopers. That holding was driven by the court’s choice of law analysis and did not reflect whether AIG could have maintained such a suit under Delaware law.

Finally, in that decision, this court held that it did not have personal jurisdiction over certain AIG officers and employees who had allegedly engaged in improper behavior before 10 Del. C. § 3114 was broadened to cover certain corporate officers.
Because none of the acts relevant to the illegal conduct pled in the Complaint occurred in Delaware and none of those defendants was a Delaware resident, this court could not exercise jurisdiction over them.

I now address the motions to dismiss brought by the third parties who allegedly conspired with AIG to commit illegal acts. The relevant allegations in the Complaint center on two separate courses of illegal conduct: the Fake Reinsurance Conspiracy and the Bid-Rigging Conspiracy.

5 See generally AIG I, 965 A.2d 763.
6 Id. at 799.
7 Id. at 807
 

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