In re Citigroup Inc. Shareholder Derivative Litigation: Delaware Court of Chancery Confirms Existing Principles of Delaware Law Despite Financial Climate
In a decision that affirms existing Delaware law, the Delaware Court of Chancery in In re Citigroup Inc. Shareholder Derivative Litigation, No. 3338-CC, 2009 WL 481906 (Del. Ch. Feb. 24, 2009), upheld the business judgment rule and its protection of directors' business decisions in the face of worldwide economic losses. The court dismissed all but one facet of the case, which alleged Caremark violations against Citigroup directors due to Citigroup's losses in the subprime lending market. The court found that directors' oversight responsibilities are not intended to allow for personal liability based on an inability to predict the future and an incorrect evaluation of business risk. Risk is inherent in maximizing shareholder value, and the court found that losses, in and of themselves, are not reason enough to hold directors personally liable for taking risks that lead to those losses.
This Update provides a summary of key points of the Citigroup decision and offers practical advice.
Case Facts: Citigroup Sustains Losses in the Subprime Mortgage Market
In late 2005, housing prices, driven up by speculation and easily accessible credit, started to decline. At the same time, as adjustable rate mortgages were resetting to higher interest rates, homeowners faced increased monthly mortgage payments. By mid-2007, this combination of events led many subprime mortgage lenders to file for bankruptcy, subprime mortgage package securities to suffer from delinquency, and rating agencies to downgrade bonds that were backed by subprime mortgages. Citigroup had significant exposure to the subprime market through securities linked to subprime loans as well as through the issuance of collateralized debt obligations, many of which had options for their purchasers to sell them back to Citigroup at original cost. Citigroup's losses were apparent by late 2007, as illustrated by numerous announcements and disclosures by the company.
A shareholder derivative action brought in New York and Delaware sought recovery from current and former directors and officers of Citigroup based on the company's losses in the subprime market. Shareholders claimed that the directors breached their fiduciary duties by not properly monitoring and managing the risks associated with problems in the subprime market, not disclosing Citigroup's exposure to subprime assets, and ignoring "red flags" in the real estate and credit markets in favor of short term profits, to the detriment of long-term viability.
The plaintiffs also brought claims of corporate waste against the defendant directors and officers, asserting that they allowed Citigroup to buy $2.7 billion in subprime loans, authorized a share repurchase program that resulted in Citigroup buying its own shares at "artificially inflated prices," approved a multimillion dollar retirement package for former Chief Executive Officer Charles Prince (despite his alleged culpability for Citigroup's financial woes), and authorized investment in structured investment vehicles focusing on riskier assets.
Chancellor William B. Chandler III, in a broad and sweeping decision, dismissed all claims, except the claim for corporate waste regarding the multimillion-dollar retirement package for the former chief executive officer.
Caremark Revisited: Only Sustained or Systematic Failure Will Establish Lack of Good Faith
The court affirmed principles of Delaware law pertaining to director liability, as articulated in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). The court in Caremark distinguished the content of a board's decision from the good faith employed in the decision-making process, holding that "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 a necessary condition to liability." The Caremark court clarified that "the business judgment rule is process oriented and informed by a deep respect for all good faith board decisions." The Delaware Supreme Court applied the Caremark standard to director oversight liability in Stone v. Ritter, 911 A.2d 362 (Del. 2006). Plaintiffs thus have a very high burden when claiming personal liability for directors' failure to monitor business risk.
Business Risk Resulting in Losses Does Not Automatically Result In Liability
In Citigroup, Chancellor Chandler drew a careful distinction between liability based on monitoring illegal activity and liability based on monitoring business risk. In contrast to previous cases, such as Caremark, where boards failed to monitor employee actions resulting in violations of law, defendants in Citigroup were accused of failing to monitor business risk. In Citigroup, the plaintiffs alleged that because Citigroup's losses were not prevented, the defendants must have ignored supposed "red flags." The court dismissed the claim for personal liability of the defendants, likening this failure to recognize the risk of the subprime markets to a business decision that turned out poorly. The Chancellor emphasized that "[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." In fact, Citigroup was in the business of taking on and managing business risk. The Chancellor stated that Delaware law is not intended to subject directors to personal liability because of their inability to properly predict the future and evaluate business risk. Chancellor Chandler, drawing on Caremark and Stone, stated that to establish oversight liability, a plaintiff must demonstrate 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."
The Citigroup court confirmed that, absent an allegation that the directors were personally interested or disloyal to the company, the business judgment rule prevents a judge or jury from second-guessing the decisions of a board of directors if the decisions resulted from a rational process and the directors utilized all available information. Chancellor Chandler held that finding directors liable for failing to monitor business risk itself "risks undermining the well settled policy of Delaware law by inviting Courts to perform a hindsight evaluation of the reasonableness or prudence of directors' business decisions."
Business thrives on risk, and inherent in risk is the possibility of an unexpected outcome. The Chancellor, therefore, concluded that it is almost impossible for a court to accurately judge an evaluation of risk. Imposing liability in this context would "cripple [decision-makers'] ability to earn returns for investors by taking business risks."
Directors Are Not Held to a Higher Standard of Care Given Special Expertise
The court also made clear that a director with special expertise will not be "held to a higher standard of care in the oversight context." Most of the directors named in the complaints served on Citigroup's audit and risk management committee and were characterized as "audit committee financial experts" in Citigroup's public filings. Although sitting on an oversight committee entails additional risk-monitoring responsibility, the court held that "such responsibility does not change the standard of director liability under Caremark and its progeny, which requires a showing of bad faith." The court stated that even directors who are considered experts are protected against "judicial second guessing" based on the business judgment rule.
Knowledge of General Economic Environment Is Not Enough to Trigger Personal Liability
The court noted that the "red flags" presented by the plaintiffs amounted to nothing more than public documents reflecting a worsening economy and subprime mortgage market. This generalized information, including the decline of the housing market, a rise in foreclosure rates, bankruptcy filings for subprime lenders, and reported losses by Citigroup's peers, was not enough to support a claim that the directors knew of any wrongdoing at Citigroup or that they "consciously [disregarded] a duty somehow to prevent Citigroup from suffering losses."
Claim for Waste Based on Retirement Package Is Allowed to Proceed
Delaware law provides that to overcome the presumption of good faith, a board's decision must be "so egregious or irrational that it could not have been based on a valid assessment of the corporation's best interests." In response to the claim for corporate waste in approving the former chief executive officer's $68 million compensation package, the court noted that a board does not have unlimited discretion in setting executive compensation. Where the compensation is "so disproportionately large as to be unconscionable," it may constitute waste. The court concluded that reasonable doubt exists as to whether such compensation is beyond the outer limit of the board's discretion and allowed this waste claim to proceed.
- Directors Should Exercise Special Care in Approving Compensation Packages. It is too early to know whether Delaware courts will be more willing to entertain corporate waste claims based on executive compensation, but given the Chancellor's statements in this context, it is likely that more waste claims will be brought by shareholder plaintiffs. Notwithstanding the deference that the Delaware courts continue to provide to most board decisions, directors should exercise special care when determining compensation packages for executives.
This Update is only intended to provide a general summary of the Delaware Court of Chancery's decision in Citigroup. Read the full text of the Citigroup decision online. You can find discussions of other recent cases, laws, regulations and rule proposals of interest to public companies on our website.