“[W]e must not let our desire to blame someone for our losses make us lose sight of the purpose of our law.” – Chancellor William B. Chandler III, Delaware Court of Chancery1

On February 24, 2009, the Delaware Court of Chancery issued an opinion in In Re Citigroup Inc. Shareholder Derivative Litigation, a consolidated stockholders’ derivative action brought against current and former directors and officers of Citigroup.2 While the Citigroup opinion does not establish any significant new law, the court’s affirmation and application of existing Delaware law is notable for two reasons which are particularly poignant in the current economic downturn:  

  • First, the court signaled that large executive compensation packages paid by corporations that lose money may not survive corporate waste analysis
  • Second, 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  

Basic Requirements of a Derivative Suit – Futility of Demand

It is a “cardinal precept” of Delaware law that directors, rather than shareholders, manage the corporation.3 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.4  

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.5  

In considering the defendants’ Motion to Dismiss, Chancellor William B. Chandler III applied the well established analysis under Delaware law for assessing demand futility.6 When a derivative plaintiff complains of affirmative board action, he must plead particularized facts that (1) raise a reasonable doubt as to whether the directors were disinterested and independent, or (2) raise a reasonable doubt as to whether the challenged action was the product of a valid exercise of business judgment.7  

By contrast, if a derivative plaintiff complains of board inaction, he must plead particularized facts that raise a reasonable doubt that the board could have exercised independent and disinterested business judgment in responding to a pre-suit demand.8  

The Citigroup plaintiffs’ claims centered on the directors’ alleged breaches of the fiduciary duty of care and waste of corporate assets.9 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.10 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.11  

Since the plaintiffs’ breach of fiduciary duty claims challenged board inaction, they were required to plead facts proving that a majority of the Citigroup directors faced a substantial likelihood of personal liability, therefore raising a reasonable doubt as to whether the board could exercise disinterested business judgment in evaluating a pre-suit demand.12 In regard to the waste claims, which challenged board action, Rule 23.1 required the plaintiffs to plead facts establishing a reasonable doubt that the approval of the challenged transactions was a valid exercise of business judgment.13  

Dismissal of Claims Based on Losses from Subprime Operations

Except for the plaintiffs’ corporate waste claim challenging the former CEO’s retirement package, all of 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  

Application of the Caremark Standards

The Delaware “duty to monitor” standard was first enunciated by the Court of Chancery in the 1996 opinion In Re Caremark International Inc. Derivative Litigation. 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 only to 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 have further 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  

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 a likelihood that plaintiffs could rebut the presumption of the business judgment rule.19 The court observed that plaintiffs’ allegations could be characterized as simply 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 International Group, Inc. Consolidated Derivative Litigation (“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 were also involved in much of the wrongdoing, survived a motion to dismiss.26 By contrast, Chancellor Chandler noted that “there are significant differences between failing to oversee employee fraudulent or criminal conduct and failing to recognize the extent of a Company’s business risk.”27  

Disposition of Corporate Waste Claims

Under Delaware law, a plaintiff asserting a claim for corporate waste must show that fiduciaries “authorized an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.”28 Generally, establishing a waste claim is difficult for any plaintiff because the plaintiff must overcome the “general presumption of good faith by showing that the board’s decision was so egregious or irrational that it could not have been based on a valid assessment of the corporation’s best interests.”29  

The Citigroup court dismissed the plaintiffs’ waste claims arising from subprime asset purchases and investments in special investment vehicles because the plaintiffs failed to allege that such transactions resulted from bad faith conduct by the defendants.30 The court also dismissed the waste claims regarding the stock repurchase program, finding that all repurchases were at market price, i.e., “the price at which presumably ordinary and rational businesspeople were trading the stock.”31  

Survival of the Excessive Compensation Claim

Plaintiffs’ waste claims based on the former CEO’s multi-million-dollar retirement package, however, survived the defendants’ motion to dismiss. Specifically, the court found that plaintiffs had complied with Rule 23.1 by raising a reasonable doubt that approval of the retirement package was the product of a valid exercise of business judgment.32  

In doing so, the court noted that directors of Delaware corporations generally have “the authority and broad discretion to make executive compensation decisions.”33 However, the court cautioned, “the discretion of directors in setting executive compensation is not unlimited.”34 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.”35  

Ultimately, the court concluded that plaintiffs’ allegations that the multi-million-dollar retirement package was paid to a retiring CEO who was “allegedly responsible, in part, for billions of dollars of losses at Citigroup”36 raised a reasonable question as to whether it was “so one sided” that it met the test for corporate waste.37  

* * * * *  

The Citigroup opinion represents an interesting milestone in the current economic downturn. The decision makes clear that disaffected shareholders may have difficulty convincing the Delaware Court of Chancery to extend established doctrines of fiduciary duty in the face of economic crises and mounting losses, but nonetheless signals that extra care must be taken with respect to executive compensation packages coinciding with decreasing corporate success.