A recent decision by the Delaware Chancery Court that exempted corporate directors from liability in the current financial mess could prove helpful to other directors facing similar sub-prime and credit crisis-related derivative claims.
In a 58-page decision that provided some of the court’s most expansive comment ever on the subject, the Chancery Court ruled Feb. 24 that the business judgment rule protects the directors of Citigroup from shareholder lawsuits over how the bank managed—or more accurately, mismanaged—the risks involved in the sub-prime mortgage market.
Unhappy investors, who have seen their Citi stock plummet from $25 one year ago to less than $2 last week, had sought to sue current and former Citi directors for failing to properly monitor, manage, and disclose Citigroup’s risks in the sub-prime lending market. The court, however, refused to “second guess” the soundness of Citi’s decisions. It wrote that the 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.”
The decision is bound to be cited in the future, as other investors try to sue the leadership at other financial institutions pummeled by the financial crisis.
LaCroix
“The court’s holding confirms that, even though we’re in an unprecedented financial crisis, ordinary principles of law are going to govern the board of directors’ liability,” says Kevin LaCroix, a director with OakBridge Insurance Services and author of a blog on director and officer liability issues.
“This decision is good news for directors,” says James Bowers of the law firm Day Pitney, because it affirms their role as overseers. As long as directors have the information they need from management to make decisions and act in good faith, “I find it hard to believe that a court is going to second-guess their judgment—even if their judgment proves not to have been the correct judgment.”
The Citi decision is also newsworthy for what it didn’t toss out: a claim of “corporate waste” pertaining to the board’s approval of a $68 million severance package for former CEO Charles Prince. On that point, Bowers says, the court will consider whether Prince’s pay package “is so disproportionately large that it might be unconscionable and might constitute corporate waste.”
Waste claims are difficult to prove, and rarely make much headway in court. Travis Laster, a partner with the law firm Abrams & Laster, quips that such claims are like the Loch Ness monster: “some mythical being believed to exist, but has never been spotted.”
“The court’s holding confirms that, even though we’re in an unprecedented financial crisis, ordinary principles of law are going to govern the board of directors’ liability.”
— Kevin LaCroix,
Director,
OakBridge Insurance Services
“It’s the first case that I know of in a long, long time that has gone forward on a waste theory on compensation,” he says.
Bowers
Bowers believes the court’s decision means that executive compensation “remains a vulnerable area” for shareholder litigation, even though board oversight has received a big boost.
The court did, however, stress the difference between lawsuits against directors who tried their best and still made a mess of things (like Citi), and those against directors who didn’t exercise reasonable oversight at all. It cited another recent decision to let a lawsuit proceed against directors of AIG—the insurance giant that lurched into government receivership last year and has needed four bailouts since September—because in that case, the AIG directors “allegedly failed to exercise reasonable oversight over pervasive fraudulent and criminal conduct.”
Laster says there is a “huge distinction” between the two cases.
“The whole idea behind Delaware law is not, ‘Hey, let’s protect directors just because we like directors,’ or ‘Hey, let’s protect management just because we like management,’” he says. Rather, the business judgment rule is intended to protect directors who have done the best job they can, he says.
Similar Cases
The court also stressed in the Citi decision that Delaware law places an “extremely high burden” on plaintiffs to demonstrate a director’s personal liability for failing to see the extent of a company’s risk. Indeed, the Citi decision is only the latest in a string of Chancery Court decisions favoring directors at Delaware corporations.
CITIGROUP DECISION
The following order was rendered in the case of In Re Citigroup, Inc. Shareholder Derivative Litigation:
Citigroup has suffered staggering losses, in part, as a result of the recent
problems in the United States economy, particularly those in the subprime
mortgage market. It is understandable that investors, and others, want to find
someone to hold responsible for these losses, and it is often difficult to distinguish
between a desire to blame someone and a desire to force those responsible to
account for their wrongdoing. Our law, fortunately, provides guidance for
precisely these situations in the form of doctrines governing the duties owed by
officers and directors of Delaware corporations. This law has been refined over
hundreds of years, which no doubt included many crises, and we must not let our
desire to blame someone for our losses make us lose sight of the purpose of our
law. Ultimately, the discretion granted directors and managers allows them to
maximize shareholder value in the long term by taking risks without the
debilitating fear that they will be held personally liable if the company experiences
losses. This doctrine also means, however, that when the company suffers losses,
shareholders may not be able to hold the directors personally liable.
For the foregoing reasons, the motion to dismiss or stay in favor of the New
York Action is denied. Defendants’ motion to dismiss is denied as to the claim in
Count III of the Complaint for waste for approval of the November 4, 2007 Prince
letter agreement. All other claims in the complaint are dismissed for failure to
adequately plead demand futility pursuant to Court of Chancery Rule 23.1.
An Order has been entered consistent with this Opinion.
Source
In re Citigroup Inc. Shareholder Litigation (Feb. 24, 2009).
“This is the third in a trilogy of cases that examined the board’s management of the oversight of the corporation,” Bowers says.
In the 1996 decision Re Caremark Derivative Litigation (which the Chancery Court based its Citigroup decision upon), directors of Caremark were sued by shareholders for oversight failures after Caremark was found to have illegally paid physicians for patient referrals. But the court said that the implementation of a compliance program, which included an information and reporting system, protected the directors from liability.
In Stone v. Ritter in 2006, the Delaware Supreme Court affirmed the Caremark standard of director oversight liability, saying that plaintiffs had to demonstrate “a sustained or systematic failure of the board to exercise oversight” to establish the lack of good faith necessary to assign personal liability to directors.
In total, Bowers says, the three cases offer a framework of duties and responsibilities that companies and directors must execute if they are to do their job well and without fear of liability. “Make sure the process of decision making in the boardroom is not flawed,” he says.
Bowers specifically recommends three criteria for directors:
Exercise diligence in seeking information central to the risks of the business. If directors have any doubts over having insufficient information from management, “they need to raise their hand and take corrective steps to do something about it.”
Exercise independence. Boards should bring in consultants if they have difficulty understanding complex business plans, and management hasn’t provided them with the information they need.
Ask tough questions and approach management with a healthy degree of skepticism. “Be aggressive and stern in terms of how the business is run.”
Adds Bowers: As much as boards can demonstrate they have established a strong internal system of controls to manage risks and they are acting in good faith, “there’s very little chance that they’re going to be held liable.”
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