Delaware Chancery Court Dismisses Claims for Breach of Fiduciary Duty in Connection with Subprime Exposure in Citigroup Derivative Action
On February 24, 2009, the Delaware Chancery Court dismissed all but one derivative claim seeking to hold Citigroup directors personally liable for the company’s losses arising out of exposure to subprime mortgage debt on that basis that plaintiffs failed adequately to allege demand futility. See In re Citigroup Inc. Shareholder Derivative Litigation, No. 3338-CC (Feb. 24, 2009, Del. Chancery Court). The court allowed a single count alleging corporate waste in connection with the directors’ approval of the $68 million severance package for former Citigroup CEO Charles Prince to go forward. Summarizing the plaintiffs’ breach of fiduciary duty claims, Chancellor Chandler wrote: “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 director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company.”
The plaintiffs’ derivative action alleged that current and former Citigroup directors breached their fiduciary duties by failing to recognize and monitor the company’s risk related to subprime debt and by failing to disclose the company’s exposure to risky subprime assets. The plaintiffs also alleged that the directors were liable for corporate waste in connection with (i) allowing the company to purchase over $2.7 billion in subprime loans, (ii) approving the buyback of $645 million of the company’s shares at artificially-inflated prices, (iii) allowing the company to invest in special investment vehicles that were unable to pay off maturing debt, and (iv) approving the CEO’s multi-million dollar severance package upon his resignation in November 2007. The plaintiffs never made demand on the Citigroup board with respect to these claims, and the complaint alleged that demand on the board would have been futile because the directors faced personal liability for the claims.
The court analyzed the motion to dismiss pursuant to Delaware’s Rule 23.1 requirement that plaintiffs adequately plead demand futility. With respect to the claims for breach of fiduciary duty, the court held that the plaintiffs’ allegations failed to demonstrate the directors’ bad faith in carrying out their oversight or disclosure duties, which was the standard in order to properly plead demand futility. The court found that the plaintiffs’ conclusory allegations that because the directors failed to prevent subprime losses they must have consciously ignored “red flags” warning of subprime risk were insufficient to support a claim that the directors would be subject to personal liability. Chancellor Chandler further noted that the alleged “red flags” were simply public documents reflecting worsening economic conditions, and at most they were evidence that the directors made bad business decisions. The court’s analysis repeatedly emphasized that the business judgment rule prevented the court from engaging in judicial second-guessing of the directors’ decisions.
Turning to the plaintiffs’ allegations of waste, the court held that plaintiffs failed to plead adequately that the subprime loan purchases and SIV investments were the result of board action. With regard to the repurchase of Citigroup stock, the court found that plaintiffs widely missed the Delaware standard governing corporate waste, which requires establishing that a transaction was so one-sided that no ordinary businessperson of sound judgment could conclude that the company received adequate consideration. Finally, though, noting that the discretion of directors in setting executive compensation is not unlimited, the court found that the plaintiffs’ allegations were sufficient to create reasonable doubt as to whether the compensation package given to Mr. Prince was so one-sided that it constituted corporate waste and was beyond the “outer limit” of the directors’ discretion. Accepting the plaintiffs’ allegations as true for purposes of deciding the motion, the court held that the complaint adequately had alleged demand futility with respect to the waste claim based on the CEO’s severance package.