February 27, 2009
On February 24, 2009 the Court of Chancery of the State of Delaware issued an important opinion dismissing all but one claim in a shareholder derivative action seeking to recover for Citigroup Inc. its losses arising from exposure to the subprime lending market.[1] The opinion sets an important precedent for companies and their boards whose actions (or inactions) may be the prime target of litigation by the plaintiff bar in light of the ongoing financial crisis. Most noteworthy, the opinion makes a clear statement that the business judgment rule continues to be the guiding standard by which to analyze the actions of boards and directors and that Delaware Courts recognize that to impose liability on directors for making a "wrong" business decision would cripple their ability to earn returns for investors by taking business risk.
Plaintiffs, shareholders of Citigroup, brought the action against current and former directors and officers of the company alleging, among other things, that the defendants breached their fiduciary duties by failing to properly monitor and manage the risks Citigroup faced from problems in the subprime lending market, even in the face of alleged "red flags". Plaintiffs’ fiduciary duty argument was based on a theory of director liability famously articulated in the 1996 In re Caremark decision.[2] In a typical Caremark action, plaintiffs argue that the defendants are liable for damages arising from a failure to properly monitor or oversee employee misconduct or violations of law. For example, in Caremark the board allegedly failed to monitor employee actions in violation of the federal Anti-Referral Payments Law. Director oversight liability under the Caremark standard is "rooted in concepts of bad faith; indeed, a showing of bad faith is a necessary condition to director oversight liability."[3] Such bad faith, deemed a breach of the duty of loyalty, could result in personal liability to the board members.
Significantly, the Court ruled that the actions of the Citigroup defendants were not properly viewed as Caremark-type failures of oversight but rather as activities protected by the business judgment rule. The Court noted that plaintiffs’ claims were based on defendants’ alleged failure to properly monitor Citigroup’s business risk, specifically its exposure to the subprime mortgage market, rather than, for example, an alleged oversight failure allowing widespread criminal activity. As the Court rightfully pointed out, plaintiffs were attempting to hold the director defendants personally liable for making business decisions that, in hindsight, turned out poorly for the company.
An endorsement by the Court of plaintiffs’ Caremark argument would have greatly expanded the potential of director liability. Plaintiffs’ view was summarily rejected by the Court. Instead the Court makes it clear that Caremark-type obligations to implement and monitor a system of oversight do not, absent extraordinary circumstances, eviscerate the core protections of the business judgment rule which are "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." As the Court further notes, Citigroup was in the business of taking on and managing investment and other business risk, and "[t]o 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 Citigroup decision reinforces the long-standing principle that, absent extraordinary circumstances, a Delaware Court will not second-guess the business decisions made by a well-informed board. No different standard will be, or need be, applied in light of current market conditions.
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or any of the following:
John F. Olson – Washington, D.C. (202-955-8522, [email protected])
Dennis J. Friedman – New York (212-351-3900, [email protected])
Jonathan K. Layne – Los Angeles (310-552-8641, [email protected])
Eduardo Gallardo – New York (212-351-3847, [email protected])
Adam H. Offenhartz – New York (212-351-3808, [email protected])
Aric H. Wu – New York (212-351-3820, [email protected])
Securities Litigation Group:
Wayne W. Smith (949-451-4108, [email protected]) in Orange County
Jonathan C. Dickey (212-351-2399, [email protected]) in New York
Robert F. Serio (212-351-3917, [email protected]) in New York
© 2009 Gibson, Dunn & Crutcher LLP
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