While Washington and the media continue to criticize and analyze the make-up of the boards of those corporations at the heart of the financial crisis and the apparent lack of oversight, the Delaware Chancery Court has taken a step in the other direction.

In Re Citigroup, Inc., Shareholder Derivative Litigation, No. 3338-CC (Feb. 24, 2009), the plaintiffs brought suit essentially alleging that the directors had breached their fiduciary duties by failing to properly monitor and manage the business risks that Citigroup faced from the sub-prime crisis and by ignoring “red flags” appearing in press reports and news events of the worsening conditions in the sub-prime markets and credit markets.

In its first detailed analysis of potential liability of directors under Delaware law for claims relating to a company’s losses resulting from a substantial exposure to sub-prime debt, the Court dismissed the claims on the grounds of failure to adequately plead demand futility. In doing so, the Court stated, “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.” And that “[t]o impose liability on directors for ‘making’ business decisions would cripple their ability to earn returns for investors by taking business risks. Indeed, this kind of judicial second guessing is what the business judgment rule was designed to prevent, and even if a complaint is framed under a . . . [duty of oversight] theory, this Court will not abandon such bedrock principles of Delaware fiduciary duty law.”

The decision reaffirmed and clarified several key protections for directors established by the Caremark decision, with respect to oversight responsibilities.

  1. Plaintiff’s face “an extremely high burden” in bringing a claim for personal director liability for a failure to monitor business risk;
  2. While directors could be liable for a failure of board oversight, “only a sustained 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;” and
  3. Bad business decisions, absent fraud or illegality, are not evidence of the bad faith necessary to establish oversight liability. But there is an important distinction between oversight liability with respect to business risk and oversight responsibility with respect to illegal conduct.

The Chancery Court has clarified that for directors to be personally liable for a failure in oversight the failure must be more than a failure to correctly predict the future failure or evaluate business risk. “To establish oversight liability a plaintiff must show 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.” And Catastrophic business losses do not amount to bad faith—at least not according to the Chancery Court in this case.