Claim of failure by directors to monitor risk at Citigroup fails under Delaware law

By Cydney Posner

A new Delaware case, In re Citigroup Inc., decided in late February, reaffirms how high a threshold the business judgment rule imposes to protect the decisions and judgments made by directors of Delaware companies. The case may be a harbinger of cases to come in the context of the current economic turmoil.

The case was a shareholder derivative action brought on behalf of Citigroup Inc. against current and former officers and directors, seeking to recover the company's losses arising out of its exposure to the subprime lending market. The plaintiffs alleged that the defendants breached their fiduciary duties by, among other things, failing to adequately oversee and manage Citigroup’s exposure to the problems in the subprime mortgage market, even in the face of alleged "red flags." The plaintiffs claimed that the defendants ignored extensive red flags that should have given them notice of the potential problems, instead pursuing short-term profits at the expense of the company’s long-term viability. The court characterizes these red flags as "generally statements from public documents that reflect worsening conditions in the financial markets, including the subprime and credit markets, and the effects those worsening conditions had on market participants, including Citigroup’s peers."

Plaintiffs further alleged liability based on corporate waste including, among other things, approval of a multi-million dollar severance payment and benefit package for defendant and former CEO Charles Prince. The case was decided on a motion to dismiss, primarily in the context of a plea of demand futility.

While, based on what we read in the press, these allegations all might sound about right, the only claim that survived was the single claim of corporate waste in connection with the Prince severance agreement. As the court concluded, in light of the staggering losses suffered by Citigroup investors, it "is understandable that investors, and others, want to find someone to hold responsible for these losses, and it is often difficult to distinguish between a desire to blame someone and a desire to force those responsible to account for their wrongdoing. Our law, fortunately, provides guidance for precisely these situations in the form of doctrines governing the duties owed by officers and directors of Delaware corporations. This law has been refined over hundreds of years, which no doubt included many crises, and we must not let our desire to blame someone for our losses make us lose sight of the purpose of our law. Ultimately, 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 held personally liable if the company experiences losses. This doctrine also means, however, that when the company suffers losses, shareholders may not be able to hold the directors personally liable."

The plaintiffs framed the issue as a failure of the duty to monitor liability-creating activities, a standard articulated in In re Caremark. In that case, the court distinguished between ill-advised board decisions, which are analyzed under the business judgment rule and measured by concepts of gross negligence, and "an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss." In the former line of cases, the presumption of the business judgment rule will prevent "judicial second guessing" of the decision if the directors "employed a rational process and considered all material information reasonably available," even if a board's decision is considered, in hindsight, "stupid," "egregious" or "irrational." In a failure to monitor case, a lack of good faith can be established "only [by] 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…" As a result, the court concludes, oversight liability requires a showing that the directors "knew they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities."

While a typical Caremark case would involve allegations of a failure to monitor employee misconduct or violations of law, this case alleged a failure to monitor Citigroup's business risk exposure, in effect a kind of conflation of a failure to monitor case with a regular business judgment case. As the court notes, when "one looks past the lofty allegations of duties of oversight and red flags used to dress up these claims, what is left appears to be plaintiff shareholders attempting to hold the director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company. Delaware Courts have faced these types of claims many times and have developed doctrines to deal with them—the fiduciary duty of care and the business judgment rule."

Moreover, to circumvent the 102(b)(7) exculpation clause in the company's charter, the plaintiffs "root their theory of director personal liability in bad faith," a standard that the court views as similar to that applied when assessing oversight liability. In either case, bad faith can be establish by showing "that a director consciously disregarded an obligation to be reasonably informed about the business and its risks or consciously disregarded the duty to monitor and oversee the business." Although directors do have responsibilities to monitor, "this obligation does not eviscerate the core protections of the business judgment rule—protections designed to allow corporate managers and directors to pursue risky transactions without the specter of being held personally liable if those decisions turn out poorly. Accordingly, the burden required for a plaintiff to rebut the presumption of the business judgment rule by showing gross negligence is a difficult one, and the burden to show bad faith is even higher."

Here, there was no question that Citigroup had procedures and controls in place that were designed to monitor risk, including a risk management committee that held numerous meetings. However, plaintiffs contended that the directors breached their duty either because the oversight mechanisms were inadequate or because they did not make a good faith effort to comply with the established oversight procedures in light of the red flags that should have put them on notice of the impending problems. The court founds that these warning signs were "not evidence that the directors consciously disregarded their duties or otherwise acted in bad faith"; rather, they were, at most; "evidence that the directors made bad business decisions." By contrast, the court compared the failure to monitor case that survived challenge in the recent AIG case, where the defendants were alleged to have failed to exercise reasonable oversight over pervasive fraudulent and criminal conduct. With a company like Citigroup that was "in the business of taking on and managing investment and other business risks," the plaintiffs did not show that the directors failure to see the extent of Citigroup's business risk met the "extremely high" burden: "To impose oversight liability on directors for failure to monitor 'excessive' risk would involve courts in conducting hindsight evaluations of decisions at the heart of the business judgment of directors. 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."

The only claim that survived the motion was the claim for corporate waste in connection with the $68 million Prince severance package. At that stage of the litigation, a successful claim for waste requires "an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration." The requirements for waste claims are stringent: 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." Nevertheless, there is an "outer limit" to the board’s discretion to set executive compensation. Without more information regarding the value of Prince's various promises in exchange for his severance package, there was a reasonable doubt about whether the severance exceeded that outer limit at the pleading stage.

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