The Delaware Court of Chancery recently held that large executive compensation packages paid by corporations that lose money may not survive corporate waste analysis. See In Re Citigroup Inc. Shareholder Derivative Litigation, Civil Action No. 3338-CC (Del. Ch. Feb. 24, 2009).
The decision, issued in a consolidated stockholders’ derivative action brought against current and former directors and officers of Citigroup,1 did provide some solace for corporate executives amid the current economic downturn. The court refused to hold directors and officers personally liable for breach of fiduciary duty based on taking business risks that resulted in substantial losses for the corporation.
The Citigroup plaintiffs’ claims centered on the directors’ alleged breaches of the fiduciary duty of care and waste of corporate assets.2 Specifically, plaintiffs alleged that Citigroup’s directors breached their duty of care by failing to adequately oversee, manage and disclose the company’s exposure to massive losses the company ultimately suffered in the subprime mortgage market.3 The plaintiffs’ corporate-waste claims sought to recoup from the directors a $68 million severance and benefit package paid to Citigroup’s former CEO upon his retirement; $2.7 billion spent to acquire subprime loans; funds paid through a share repurchase program at allegedly inflated prices; and investments in failing special investment vehicles.4
It is a “cardinal precept” of Delaware law that directors, rather than shareholders, manage the corporation.5 Therefore, under Court of Chancery Rule 23.1, stockholder plaintiffs alleging derivative claims must either: (1) plead that they made a pre-suit demand on the corporation’s board to take remedial action and that the board wrongfully refused to bring suit on behalf of the corporation; or (2) plead facts showing that such a demand on the board would have been futile.6
Since the plaintiffs in Citigroup did not make a pre-suit demand on the company’s board, the defendants moved to dismiss the complaint on the grounds that the plaintiffs failed to meet the more stringent pleading requirements under Rule 23.1, and plead with particularity facts showing demand futility.7
Excessive Compensation Claim
The plaintiffs’ waste claims based on the former CEO’s multimillion-dollar retirement package survived the defendants’ motion to dismiss.
For their waste claims to survive dismissal, under Rule 23.1 the plaintiffs had to plead facts establishing a reasonable doubt that the approval of the challenged transactions was a valid exercise of business judgment.8
The court found that plaintiffs had complied with Rule 23.1. In so doing, the court noted that directors of Delaware corporations generally have “the authority and broad discretion to make executive compensation decisions.”9 The court cautioned, however, “the discretion of directors in setting executive compensation is not unlimited.”10 Instead, Delaware case law makes clear that “there is an outer limit” to a board’s discretion to set executive compensation that is reached when “executive compensation is so disproportionately large as to be unconscionable and constitute waste.”11
Ultimately, the court concluded that plaintiffs’ allegations that the multimilliondollar retirement package was paid to a retiring CEO who was “allegedly responsible, in part, for billions of dollars of losses at Citigroup”12 raised a reasonable question as to whether it was “so one sided” that it met the test for corporate waste.13
‘Duty to Monitor’
The rest of the plaintiffs’ fiduciary duty and waste claims were dismissed under Rule 23.1.
In particular, the court held that “[u]ltimately, 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 personally liable if the company experiences losses.”14
The plaintiffs’ main fiduciary-duty claim was based on a subset of the duty of care—the “duty to monitor” first enunciated in the Caremark case.15 The Delaware “duty to monitor” standard first was enunciated by the Court of Chancery in the 1996 opinion In re Caremark Int’l Inc. Derivative Litig. Claims based on an alleged breach of the so-called “duty of oversight” are “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”16 Although Delaware courts recognize that fiduciaries of Delaware corporations have certain responsibilities to implement and monitor a system of oversight, Caremark limits liability for failing to do so to only those rare situations in which a “sustained or systematic failure of the board to exercise oversight” exists, as in situations of an “utter failure to attempt to assure a reasonable information and reporting system exists” or of consciously failing to monitor such a system after it is implemented.17
Even if such a situation exists, Delaware courts further have limited liability for failure to monitor to situations where directors and officers failed to implement proper systems in bad faith—i.e., the defendants knew they were not discharging their fiduciary obligations or they demonstrated a conscious disregard for such obligations.18
Subprime Mortgage Losses
Applying these standards, the Citigroup court dismissed the plaintiffs’ “duty to monitor” claims on three grounds.
First, the court found that plaintiffs’ allegations were insufficient to show likelihood that plaintiffs could rebut the presumption of the business judgment rule.19 The court observed that plaintiffs’ allegations could be characterized simply as attempting to hold the directors liable for “business decisions that, in hindsight, turned out poorly for the Company.”20
Second, the court addressed the merits of plaintiffs’ “duty to monitor” claims. The plaintiffs asserted that the Citigroup board failed to adequately consider alleged “red flags” from 2006 - 2008 relating to the decline in the subprime mortgage market.21 The court, however, found that pleading the mere existence of such “red flags” and Citigroup’s losses from the subprime crisis was insufficient to prove a knowing or conscious disregard by the board for its fiduciary obligations.
Plaintiffs therefore failed to plead with particularity a substantial likelihood of personal liability sufficient to excuse demand.22
Third, and most notably, the court refused to extend the “duty to monitor” standard of Caremark and its progeny to the directors’ alleged failure to properly monitor and oversee business risks.23 Instead, the court held that “the 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.”24
The court further distinguished the case before it from its recent decision in American Int’l Group, Inc. Consol. Derivative Litig. (“AIG”).25 In AIG, the plaintiffs’ derivative complaint alleged financial fraud involving managers at the highest levels of the corporation and, based on allegations that certain AIG insiders not only knew of the alleged fraud, but also were involved in much of the wrongdoing, survived a motion to dismiss.26