[Shareholder Oppression] Pleading of Demand Futility on a Claim of Failure to...
Eric Fryar
In re Citigroup Inc. Shareholder Derivative Litigation, 964 A.2d 106 (Del. Ch. February 24, 2009) [Read Opinion]
This derivative action was brought by shareholders against the current and former directors of Citigroup seeking to recover for the company its losses arising from exposure to the subprime lending market, on the theory that the officers and directors breached their fiduciary duties by failing to monitor and manage the company's risks and failing to properly disclose the company's exposure. Defendants moved to dismiss for failure to plead demand futility sufficiently.
The plaintiffs did not make a demand on the Citigroup Board prior to filing their derivative suit; therefore the lawsuit was subject to dismissal unless the plaintiffs' pleadings sufficiently demonstrated that demand would be futile. Ch. Ct. Rule 23.1 Pleading of futility is required to be done with particularity and is characterized as a "strict" rule. Therefore, although the court does take the plaintiff's well-pleaded factual allegations as true, Brehm v. Eisner, 746 A.2d 244, 253-54 (Del. 2000), the court's analysis much more resembles a decision on the merits than a review of sufficiency of the pleadings as the court applies "stringent requirements of factual particularity" requiring the plaintiffs to set forth "particularized factual statements that are essential to the claim." Under the test set forth in Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984), to show demand futility, plaintiffs must provide particularized factual allegations that raise a reasonable doubt that "(1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment." Where, however, plaintiffs complain of board inaction and do not challenge a specific decision of the board, there is no "challenged transaction," and the ordinary Aronson analysis does not apply. Rales v. Blasband, 634 A.2d 927, 933-34 (Del.1993). Instead, to show demand futility where the subject of the derivative suit is not a business decision of the board, a plaintiff must allege particularized facts that "create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand." Id. at 934. Such "reasonable doubt" is not created by the mere fact that the directors are deciding whether to sue themselves. Rather, demand will be excused based on a possibility of personal director liability only in the rare case when a plaintiff is able to show director conduct that is "so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists." Aronson, 473 A.2d at 815.
The plaintiff's principal claims were based on the board's failure to monitor the risks of the subprime market. Delaware courts recognized that such a failure can constitute a breach of the fiduciary duty of care in In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959 (Del.Ch.1996). Delaware law distinguishes between (1) "a board decision that results in a loss because that decision was ill advised or 'negligent'" and (2) "an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss." Caremark, 698 A.2d at 967. In the former class of cases, director action is analyzed under the business judgment rule, which prevents judicial second guessing of the decision if the directors employed a rational process and considered all material information reasonably available—a standard measured by concepts of gross negligence. Id. at 967. In the latter, directors could be liable for a failure to monitor, but only on a showing of bad faith: "[O]nly 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—will establish the lack of good faith that is a necessary condition to liability." Id. at 971. In Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006), the Delaware Supreme Court approved the Caremark standard for director oversight liability and made clear that liability was based on the concept of good faith, which the Stone Court held was embedded in the fiduciary duty of loyalty and did not constitute a freestanding fiduciary duty that could independently give rise to liability. Based on these authorities, the court in Citigroup held: "to establish oversight liability a plaintiff must show that the directors knew they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities such as by failing to act in the face of a known duty to act." 964 A.2d at 123.
The plaintiffs in Citigroup argued that the directors were liable for failure to "make a good faith attempt" to monitor the business risks associated with the subprime market based on their ignoring numerous "red flags" that signaled the approaching crash. The court noted that this is a very different kind of claim than the lack of oversight claims in Caremark and Stone, which involved the board's failure to oversee the conduct of employees who were violating the law. The business judgment rule "is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." Aronson, 473 A.2d at 812. The burden is on plaintiffs, the party challenging the directors' decision, to rebut this presumption. Thus, absent an allegation of interestedness or disloyalty to the corporation, the business judgment rule prevents a judge or jury from second guessing director decisions if they were the product of a rational process and the directors availed themselves of all material and reasonably available information. See id. Additionally, Citigroup's certificate of incorporation exculpated board members from personal liability except for acts or omissions not in good faith. Under Delaware law, "bad faith" conduct may be found where a director "intentionally acts with a purpose other than that of advancing the best interests of the corporation, ... acts with the intent to violate applicable positive law, or ... intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties." In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 67 (Del. 2006). More recently, the Delaware Supreme Court has held that when a plaintiff seeks to show that demand is excused because directors face a substantial likelihood of liability where "directors are exculpated from liability except for claims based on 'fraudulent,' 'illegal' or 'bad faith' conduct, a plaintiff must also plead particularized facts that demonstrate that the directors acted with scienter, i.e., that they had 'actual or constructive knowledge' that their conduct was legally improper." Wood v. Baum, 953 A.2d 136, 141 (Del. 2008). Therefore, the Citigroup court held: "A plaintiff can thus plead bad faith by alleging with particularity that a director knowingly violated a fiduciary duty or failed to act in violation of a known duty to act, demonstrating a conscious disregard for her duties." 964 A.2d at 125. Furthermore, the court was extremely troubled by the necessary result of the plaintiffs' theories of liability that would require the court to decide whether the board had made the "right business decision" based on the benefit of hindsight. Such an exercise is absolutely forbidden by the business judgment rule. See id. at 126, 130.
The court held that the plaintiffs' complaint did not adequately allege futility for the claim of failure to monitor because the plaintiffs conceded that the Citigroup had in place procedures and controls to monitor the risk, and the court believed that the complaint did nothing more than make conclusory allegations to the effect that the board failed to prevent the company from suffering losses. Id. at 127. The court held that the allegations that the board failed to heed numerous red flags was not evidence of a conscious disregard of duties, but merely of bad business decisions. Id. at 128.
The court also dismissed the plaintiffs' claim for failure to disclose the risks to the shareholders. The Delaware common law duty of disclosure is based on shareholders' entitlement to "honest communication from directors, given with complete candor and in good faith," even in the absence of a request for shareholder action. In re InfoUSA, Inc. Shareholders Litig., 953 A.2d 963, 990 (Del. Ch. 2007). When there is no request for shareholder action, a shareholder plaintiff can demonstrate a breach of fiduciary duty by showing that the directors "deliberately misinform[ed] shareholders about the business of the corporation, either directly or by a public statement." Malone v. Brincat, 722 A.2d 5, 14 (Del. 1998). The court held that the complaint did not demonstrate a reasonable doubt that the director defendants faced a substantial likelihood of personal liability for three reasons: First, mere nondisclosure is insufficient. The claim must be based a communication that is false or misleading or that is made misleading because of a material omission. Id. at 132-33. Second, the complaint did not sufficiently allege participation by the director defendants in the preparation of the disclosures that plaintiffs claimed were inadequate. Id. at 134. Third, the complaint did not sufficiently allege that the defendants were personally aware that any disclosures were false or misleading or that they acted in bad faith in not adequately informing themselves. Id. at 134-45.
Finally, the complaint alleged a claim for corporate waste in the board's approval of a letter agreement providing a $68 million golden parachute for the CEO. The court noted that the standard of liability for waste is extremely high: "an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade." Id. at 138 (quoting Brehm, 746 A.2d at 263). Based on the face of the pleadings, the court held that the plaintiffs had raised a reasonable doubt as to the substantial likelihood of personal liability for waste. Id. The court also held that the waste claim survived a motion to dismiss for failure to state a claim under Rule 12(b)(6), as the issues are the same as in demand futility but the standard is lower. Id. at 139.
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Posted By Eric Fryar to Shareholder Oppression at 3/21/2009 12:32:00 PM