In response to the recent economic downturn, Congress, the Obama administration, and federal regulators have taken unprecedented steps to impose regulation on how public companies are governed and run. They have sought to alter the rules for, among other things, executive compensation, director elections, and regulation of the financial industry.
Given the federal response, the business law community was anxious to analyze the response of the Delaware Court of Chancery, the nation’s preeminent court for litigating business disputes. A review of the Court of Chancery’s recent decisions shows that it has not allowed the current political climate to influence its historically balanced approach. These decisions illustrate that the Court understands the role of corporate risk-taking with investment capital and will not automatically equate corporate losses with directorial or executive liability. At the same time, however, the Court will allow suits to proceed where plaintiffs plead factual allegations of corporate wrongdoing. Two recent decisions illustrate this balanced approach.
The first decision involved shareholder derivative litigation (filed on behalf of the company) against current and former directors of Citigroup, which received billions in government aid. In that case, the plaintiffs alleged that the directors breached their fiduciary duties by failing to properly: (1) monitor and manage risks associated with Citigroup’s exposure to the subprime lending market in the face of “red flags”; and (2) publicly disclose Citigroup’s exposure to subprime assets. Based on these allegations, the plaintiffs sought to hold the Citigroup directors personally liable for alleged shareholder losses.
Despite Citigroup’s substantial losses, the Court of Chancery dismissed almost all of the claims in the lawsuit at the pleading stage for failure to make a “demand” on the board prior to bringing suit. The Court refused to engage in a substantive hindsight review of the business judgment that gave rise to the losses because, as was alleged in the complaint, Citigroup had policies, procedures, and controls in place designed to monitor risk. As the Court stated: “Citigroup was in the business of taking on and managing investment and other business risks. To impose oversight liability on directors for failure to monitor ‘excessive’ risk would involve courts in conducting hindsight evaluations of directors 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.”
In the second decision, involving AIG, now largely owned by the federal government, the shareholder plaintiffs alleged that AIG management secretly used offshore subsidiaries to mask losses and misstated the company’s financial performance in order to convince investors that AIG was more financially secure than it actually was. In denying motions to dismiss the complaint, the Court of Chancery found that the plaintiffs had alleged facts that, if ultimately proven true, would show “pervasive, diverse, and substantial financial fraud” involving senior managers at AIG. Because the plaintiffs pled facts that would support a conclusion that the former CEO and CFO, among other former senior executives at AIG, had “personal knowledge” of the widespread financial corruption and “direct involvement in a variety of allegedly improper transactions,” the Court permitted the case to proceed to discovery.
While the boundaries between these two cases are extreme, it is easy to see some lines of demarcation. Where plaintiffs allege a lack of effective oversight and risk management by directors, Delaware courts will look to determine if any oversight processes are in place to monitor risk. If risk management processes exist, then Delaware courts will not typically subject business decisions to an unfair hindsight analysis colored by the passage of time and the outcome, regardless of the efficacy or effectiveness of those processes. That is in contrast to cases where executives are credibly alleged to have engaged in, or acquiesced to, financial fraud. This balanced approach should continue to encourage the corporate risk-taking necessary to help the economy recover from the recent downturn, while at the same time provide an effective deterrent to wrongdoing. It should also continue to make Delaware the preeminent forum for incorporation and choice of law clauses in contracts.
David Hennes is a litigation partner resident in Fried, Frank, Harris, Shriver & Jacobson LLP’s New York office. Michael Savicki, a litigation associate, assisted in the preparation of this article.