Corporate Governance

Delaware Courts and Exonerating the Board from Supervising Risk: In re Citigroup Derivative Litigation (The Refusal to Impose Meaningful Standards for Reporting Standards)

By J. Robert Brown

We are discussing In re Citigroup.  Today is our final post, for now. 

The case didn't involve the traditional Caremark allegations. Caremark, as repeated in Stone v. Ritter, analyzed the possibility of liability for a breach of the duty to monitor under two prongs:

• (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.

The two prongs completely ignore the efficacy of the reporting system.  Its enough, apparently, to have one, no matter how good or bad (the only standard is that it can't result in "a sustained or systematic failure of the board to exercise oversight."  That standard is ridiculously high, effectively a waste standard for the duty to monitor.  Once a company has a reporting system in place, a board can only be liable for failing to react to react to the information that it receives under the entirely inadequate reporting system.

Shareholders in this case tried to focus the court's attention on the reporting system.  Citigroup's board had a risk assessment committee.  The committee, however, apparently did not react to the extraordinary amount of risk that resulted in the staggering losses. Either the board didn't know or did know but didn't act.  Either way, the case presented an opportunity to help define the types of information that needed to be presented to the board.

The Chancery Court, however, treated the case as simply sour grapes based on an after the fact dissatisfaction with the company's business decisions. "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."

Even more surprisingly, the Chancery Court took the position that it would be a mistake to impose on directors the possibility of liability for failing to adequately assess risks within the company.

• To the extent the Court allows shareholder plaintiffs to succeed on a theory that a director is liable for a failure to monitor business risk, the Court risks undermining the well settled policy of Delaware law by inviting Courts to perform a hindsight evaluation of the reasonableness or prudence of directors' business decisions. Risk has been defined as the chance that a return on an investment will be different that expected. The essence of the business judgment of managers and directors is deciding how the company will evaluate the trade-off between risk and return. Businesses—and particularly financial institutions—make returns by taking on risk; a company or investor that is willing to take on more risk can earn a higher return. Thus, in almost any business transaction, the parties go into the deal with the knowledge that, even if they have evaluated the situation correctly, the return could be different than they expected.

In other words, the Chancery Court characterized the subprime mess and the near nationalization of Citigroup as an ordinary risk taking transaction that did not require oversight by the board of directors.  When it comes to examining the standards set by the Delaware courts for directors (or lack of standards), this case typifies the wrong headed approach of the courts.  Even in the middle of the worst financial crisis since the Great Depression, the Delaware courts cannot bring themselves to entertain even the possibility that the board might have had a role in supervising the excessive risk taking by Citigroup.

The answer?  Sarbanes-Oxley II and federal requirements that define the standards for directors in overseeing substantial risk taking.  Preemption in a word. 

As usual, we have posted primary materials on the DU Corporate Governance web site.  

Full post as published by The Race to the Bottom on March 17, 2009 (boomark / email).