Vocal criticism of large exit-compensation packages, especially in light of the massive losses reported by many financial services companies, continues to crescendo among investors and now has spread to the general public. A recent decision by the Delaware Court of Chancery suggests that compensation packages may become a new source of liability for directors, adding the plaintiffs’ bar to the cacophony.

The plaintiffs in In Re Citigroup Inc. Shareholder Derivative Litigation, No. 3338-CC, alleged that Citigroup’s directors had breached their fiduciary duties by failing to monitor and manage the risk Citigroup faced from subprime-backed collateralized debt obligations and by failing to adequately disclose the extent of Citigroup’s exposure to those assets. In addition, the plaintiffs alleged that Citigroup’s directors were liable for committing corporate waste by authorizing investments in subprime assets while the subprime market was failing, not suspending Citigroup’s share repurchase program, and approving a payment and benefit package for retiring CEO Charles Prince that the plaintiffs estimated at approximately $68 million.

In response to the plaintiffs’ argument that demand upon the Citigroup board to bring suit was futile, and to the directors’ motion to dismiss, Chancellor Chandler, writing for the court, dismissed the plaintiffs’ claims that Citigroup’s board had failed to adequately monitor risks. The court also dismissed the waste claims stemming from Citigroup’s additional investments in subprime assets and continuing its share repurchase program. The court, however, excused plaintiffs’ failure to demand and refused to dismiss the claim alleging corporate waste resulting from Prince’s retirement package.

The Letter Agreement and Plaintiffs’ Arguments

Under a Letter Agreement dated November 4, 2007, Prince resigned as chairman and CEO of Citigroup and agreed to retire from the company at the end of the year. Under the terms of the Letter Agreement, Prince was entitled to receive his salary through the effective date of his retirement; medical and related benefits following retirement; vesting of all stock options, deferred stock awards and restricted stock awards; a prorated cash incentive award; and tax gross-ups. In addition, Prince received office space, an assistant, and a car and driver for the lesser of five years or until he found permanent employment.

According to Citigroup’s proxy statement, Prince received:

  • the remaining two months of his $1 million annual salary;
  • his vested deferred stock, valued at approximately $12.5 million;
  • his vested restricted stock, valued at approximately $9.7 million;
  • vesting of outstanding stock options which were underwater and had no value;
  • a cash incentive award of $10.4 million, prorated for 10 months of service and decreased by a factor based on the annual shareholder return (43.3 percent);
  • a car, driver, assistant and office space worth $1.5 million annually; and
  • vested deferred and non-deferred retirement balances having a value of approximately $1.8 million.

In exchange for the retirement package, Prince agreed to not solicit Citigroup managers or clients and not to compete with Citigroup for five years following his retirement. Prince also agreed to non-disparagement and non-disclosure restrictions and a general release of claims against Citigroup.

Citigroup, in a level of detail unusual for a proxy statement, described the board’s discussion of Prince’s resignation and the proposed terms of the Letter Agreement. The board considered Prince’s years of service, the various senior positions he held, the value of the compensation he was to receive, and Citigroup’s performance during his tenure, including its performance in the current economic and regulatory climate, and concluded that the terms of the Letter Agreement were appropriate.

The Citigroup plaintiffs disagreed. The plaintiffs alleged that the board’s approval of the Letter Agreement constituted corporate waste and that demanding the directors to take action would be futile. The plaintiffs argued that demand was excused because there existed a reasonable doubt as to whether approval of the Letter Agreement was the product of a valid exercise of business judgment.

The Chancery Court’s Opinion

Directors of Delaware corporations are granted the authority and broad discretion to determine executive compensation. There is an “outer limit,” however. If the directors’ broad discretion creates an executive compensation package that is unconscionable to the point that a reasonable business person would be unwilling to pay corporate assets for such a disproportionately small return, the compensation package can be considered corporate waste.

The plaintiffs’ burden was to plead, with particularized factual allegations, that upon Prince’s retirement Citigroup would receive so little in return for the pay package set forth in the Letter Agreement that the result would be the type of unconscionable exchange a reasonable person would never consider. To support their allegations, the plaintiffs argued that: (i) Prince was receiving millions of dollars in salary, bonus, accumulated stock and ancillary benefits; (ii) Prince was at Citigroup’s helm when the bank recorded billions of dollars in losses; and (iii) all that Citigroup received in exchange for the pay package were promises not to compete, not to disparage Citigroup, not to solicit employees or clients and to release Citigroup from any claims. The plaintiffs contended that this arrangement was “so one sided” that no ordinary business person of sound judgment could conclude that Citibank had received adequate consideration in return and the pay package therefore constituted corporate waste.

Based only on the text of the Letter Agreement and the plaintiffs’ allegations, the court could not accurately assign values to Prince’s actual compensation or his various noncompete promises. While the court concluded that there was a reasonable doubt whether the Letter Agreement was “so one sided” towards Prince that it crossed the “outer limit” of the board’s discretion to set executive compensation, the court took plaintiffs’ allegations as true and excused the demand requirement. The court could not conclude with reasonable certainty that the plaintiffs would not prevail on the corporate waste claim and, therefore, Citigroup’s motion to dismiss was denied.

Significance to Directors

It is too early to know how Citigroup will impact derivative actions specifically and director liability in general, but it is safe to assume that corporate waste claims will become en vogue, especially against struggling companies rewarding departing executives with large severance packages. Three points made by Chancellor Chandler highlight areas where boards may want to reevaluate their compensation procedures. The first is Chancellor Chandler’s comment that the Letter Agreement did not enumerate the additional compensation Prince actually received. According to the plaintiffs, Prince received $68 million in total compensation. According to Citigroup’s proxy, Prince received approximately $42 million, including the value of the office space, car, and support personnel if used for the entire five-year term. The value of the compensation package assigned by plaintiffs and Citigroup, respectively, differs by more than a third, and may be an important factor in determining if the compensation Citigroup paid was commensurate with the value of Prince’s covenants.

The second point Chancellor Chandler made is that the real value of Prince’s noncompete, non-solicit, and other promises was not known. At the time of his retirement, Prince was almost 58 years old, and could presumably still offer considerable value to another company in need of an executive. Had Prince been older, and possibly considered as less capable of leading another company, the value of the non-compete clause could be in question. In addition, given his almost 30-year career with Citigroup and its predecessors, the business relationships he developed both within Citigroup and with its clients, and the clout his negative comments could carry, both the non-compete and nondisparagement covenants could have significant value.

Third, Chancellor Chandler noted in a footnote, but did not further elaborate, that he was not convinced that the board would be absolved of liability for corporate waste under the exculpation provision of Citigroup’s certificate of incorporation. Under In re Walt Disney Co. Derivative Litigation, committing corporate waste is an act of bad faith and bad faith acts cannot be exculpated under Delaware law.

Directors should consider Chancellor Chandler’s first two points together when making compensation decisions. To avoid allegations of corporate waste, the value of the package given to a departing executive should be balanced against the value of the covenants or other consideration the executive is giving to the company. Included in this equation should be the total economic value to the departing executive, including all equity awards. If the bargain is so one sided towards the executive that a court could conclude that an ordinary business person of sound judgment would reject the deal for inadequate consideration, the board may be opening itself up to allegations of corporate waste, and the certificate of incorporation may not provide adequate protection against liability.