D&O Liability

Delaware courts have recently issued decisions that may impact the number and types of claims brought by shareholders of Delaware companies seeking to hold directors and officers personally liable under various claims, in particular in connection with the current economic crisis. Plaintiffs in these cases have invoked novel theories in an attempt to extend the boundaries of an existing corporate law doctrine, the fiduciary duty of corporate oversight. Plaintiffs have also attempted to energize another doctrine that has had limited, if any, viability until recently, namely the doctrine of corporate waste. Under both approaches, plaintiffs have achieved some success. In addition, plaintiffs have succeeded in obtaining a clear declaration from Delaware courts that officers do, in fact, have the same fiduciary duties as directors, which is likely to open new avenues for potential claims by shareholders.

Fiduciary Duties

In Gantler v. Stephens, 2009 Del. LEXIS 33 (Jan. 27, 2009), the Delaware Supreme Court addressed whether corporate officers have fiduciary duties, an issue which has long been assumed to be the case but which has not previously been established clearly by Delaware courts. The plaintiffs' claims related to decisions and actions of the company's directors and officers in connection with the potential sale of the company. The plaintiffs alleged that the directors and officers rejected or failed to take seriously bids from several prospective purchasers and favored alternate plans that would preserve their positions with the company. Significantly, the plaintiffs alleged that the officers sabotaged the due diligence process as to two of the bidders by their delay and non-responsiveness to requests for information, and thereby scuttled the two offers. In finding that the plaintiffs had alleged sufficient facts to support a claim against the officers for violations of their fiduciary duties, the Gantler court held, without qualification, that “the fiduciary duties of officers are the same as those of directors.” The court further noted that, although the fiduciary duties of care and loyalty of directors and officers may be the same, the effect of a breach of a fiduciary duty may have a disproportionate effect on an officer as compared to a director, because corporations are not authorized under Delaware statutory law to include in its certificate of incorporation a provision exculpating officers from monetary liability for breaches of their duty of care, whereas directors may be so exculpated.

Commentators appear to be in two camps regarding the impact of the Gantler court's declaration of the fiduciary duties of officers. Some believe that the holding does not mark a significant event in Delaware law; that the decision merely confirms what was already presumed based on earlier decisions by Delaware courts. Other commentators believe that the decision will have a significant impact on future cases. Even if the former is correct and the declaration is not a significant event from an academic perspective, as a practical matter, the decision is nonetheless likely to significantly increase the number of new claims brought against officers for breaches of their fiduciary duties. To date, relatively few cases have involved claims of breaches of officer fiduciary duties. By declaring with finality that officers do in fact have fiduciary duties of care and loyalty to their corporation and shareholders, the Delaware Supreme Court at least partially filled the void of uncertainty, thereby eliminating a barrier that potential claimants might have had to bringing such claims. Accordingly, it would not be unexpected for courts to see an increase in the number of claims brought on theories based in violations of fiduciary duties of officers.

Duty of Oversight

In two recent cases, American International Group, Inc. Consolidated Derivative Litigation, 2009 Del. Ch. LEXIS 15 (Feb. 10, 2009), and In re Citigroup Shareholder Derivative Litigation, 2009 Del. Ch. LEXIS 25 (Feb. 24, 2009), the plaintiffs' claims included alleged violations of the defendant directors' fiduciary duty of oversight under In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). The Caremark analysis, as explained by the Chancery Court in the Citigroup case, provides that a finding of a violation of the duty of oversight requires the directors to have either “(a) ' 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.” Thus, to establish oversight liability, plaintiffs must further 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.” The court stated that the test is rooted in concepts of bad faith: “a showing of bad faith is a necessary condition to director oversight liability.” In the AIG case, the court concluded that there was sufficient evidence that the defendants violated their duty of oversight in the face of “widespread illegal misconduct,” whereas in the Citigroup case, the court found insufficient evidence of a violation of their duty of oversight where the defendants allegedly failed to monitor and manage the company's subprime market risk exposure in the face of publicly available warning signs.

The AIG case involved claims brought by shareholders of AIG alleging that an “Inner Circle” of AIG executives and employees caused the company to engage in “widespread illegal misconduct.” Such conduct included misstating the company's financial performance to deceive investors; creating sham transactions and subsidiaries to improve the appearance of the company's balance sheet and to hide losses; engaging in tax avoidance schemes and promoting such schemes to clients; and conspiring with other companies to manipulate derivatives and insurance markets. The AIG court determined that “the pled facts support an inference that [the defendants] were conscious of the fact that they were not doing their jobs,” thereby satisfying the knowledge element required to maintain a Caremark claim. The court concluded that the AIG directors' failure to act satisfied the Caremark bad faith criterion, noting that “[t]he diversity, pervasiveness, and materiality of the alleged financial wrongdoing at AIG is [sic] extraordinary.”

The Citigroup case involved a claim alleging the defendant directors and officers had breached their fiduciary duties for failing to properly monitor and manage the company's risk exposure in the subprime mortgage market in the face of public information indicating worsening conditions in the subprime and credit markets, which ultimately subjected the company to massive losses. Identifying this public information as “red flags,” the plaintiffs claimed that the “red flags” should have put defendants on notice of the problems with the company's subprime investments.

The Citigroup court characterized the plaintiffs' theory as “a bit of a twist on the traditional Caremark claim.” Whereas a typical Caremark case involves liability for damages arising from a failure to properly monitor or oversee employee misconduct or violations of law, as in the AIG case, the Citigroup plaintiffs proposed to extend Caremark to reach directors' alleged failure to properly monitor the company's business risk. The Citigroup court explained that it saw the plaintiffs' claims instead as an attempt to hold the defendants liable for making business decisions that, in hindsight, turned out poorly for the company. The Citigroup court explained that it was “almost impossible for a court, in hindsight, to determine whether the directors of a company properly evaluated risk and thus made the 'right' business decision” due to, in part, “the tendency for people with knowledge of an outcome to exaggerate the extent to which they believe that outcome could have been predicted,” which the court described as “hindsight bias.” The Business Judgment Rule, the court asserted, avoids hindsight bias by focusing on the decision-making process rather than the merits of the decision itself.

Ultimately, the Citigroup court considered principles of both the Business Judgment Rule and Caremark, noting that, where there is a fiduciary duty exculpatory provision and no evidence of self-dealing, a common and necessary element in both analyses is bad faith. Accordingly, proof of bad faith would both establish a violation of the duty of oversight and overcome the business judgment presumption. In order to prove bad faith, a plaintiff is required “to plead particularized facts that demonstrate that the directors acted with scienter,” that is, with knowledge that their conduct was legally improper. For example, a plaintiff could allege “particularized facts that show that a director consciously disregarded an obligation to be reasonably informed about the business and its risks or consciously disregarded the duty to monitor and oversee the business.” However, the court noted, the plaintiffs faced an extremely high burden to state a claim for personal director liability for a failure to see the extent of a company's business risk, as “the burden for a plaintiff to rebut the presumption of the Business Judgment Rule by showing gross negligence is a difficult one, and the burden to show bad faith is even higher.”

The Citigroup court ultimately concluded that the plaintiffs' factual allegations were insufficient to demonstrate bad faith by the defendants, determining that: 1) the warning signs alleged by the plaintiffs were “nothing more than signs of continuing deterioration in the subprime mortgage market” and, at best, evidence that the directors made bad business decisions; 2) at no point did the plaintiffs allege how the defendants' oversight mechanisms were inadequate or how the defendants knew of these inadequacies and consciously ignored them; 3) at no point did the plaintiffs explain what the defendants did or failed to do that would give rise to a violation of their fiduciary duties; and 4) the plaintiffs' allegations that the defendants must have seen and consciously ignored the warning signs or knowingly failed to monitor the company's risk in accordance with their fiduciary duties were nothing more than “conclusory allegations.”

The Citigroup court distinguished its holding from the holding in the AIG case, explaining that failing to predict business risk is fundamentally different from failing to oversee employee fraudulent or criminal conduct (as in AIG): “oversight duties ' are not designed to subject directors ' to personal liability for failure to predict the future and to properly evaluate business risk.” The court queried:

If directors are going to be held liable for losses for failing to accurately predict market events, then why not hold them liable for failing to profit by predicting market events that, in hindsight, the director should have seen because of certain red (or green?) flags?

What remains unclear about the holding in the Citigroup case is whether the theory of oversight liability will be available in cases not involving internal fraudulent and criminal action. At times, the Citigroup court indicated disfavor with extending the analysis to situations involving other aspects of director oversight, although the court suggested that there could be a set of facts under which liability could be found.

Corporate Waste

The Citigroup case involved additional substantive claims, including that various actions by the defendants constituted corporate waste, in particular their approval of a multimillion-dollar severance package for the company's departing CEO. The Citigroup court explained that to overcome the Business Judgment Rule in the context of a claim of corporate waste, the court would analyze whether the “defendants authorized an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.” The court explained that, although directors have broad discretion to make executive compensation decisions, “there is an outer limit to the board's discretion to set executive compensation, at which point a decision of the directors on executive compensation is so disproportionately large as to be unconscionable and constitute waste.” Applying this analysis, the Citigroup court allowed the claim relating to the severance package to proceed to trial.

Impact

Fiduciary Duties of Officers

Unfortunately, under the Gantler decision, it is unclear whether every aspect of the fiduciary duties of directors have been incorporated to apply to officers, including the various analyses formulated by Delaware courts to test for violations of fiduciary duties of directors. For example, does the same Business Judgment Rule analysis apply to both officers and directors? Do officers have the same Caremark duties of oversight as directors and, if so, does the same analysis apply to a related claim for breach of the duty? Does corporate waste as a ground for liability apply to officers as well? Presumably, there will be some concepts and rules that are not directly transferable to officers due to the different roles that officers and directors serve within the corporate context. Therefore, this is likely to be an area of Delaware corporate law that will continue to increase in significance. Companies may want to review the protections available to their officers in indemnification agreements and insurance policies, for example, to ensure that the relevant documents provide the desired level of protection for claims of violations of their fiduciary duty of care. Failure to do so could expose officers to unexpected personal liability.

Oversight Liability

The AIG case establishes that, even though a claim based on the duty of oversight is extremely difficult to withstand judicial scrutiny, such claims remain viable in the face of fraudulent and criminal activity. Even though the defendants in Citigroup were found not liable for failure to monitor the business risk of the company, directors and management nonetheless may want to ensure that their oversight procedures and controls monitor not only fraudulent and criminal activity, but also activity that may result in major losses for the company, whether such activity is internal or external to the company. Moreover, directors must be vigilant. If effective oversight controls are in place and the directors reasonably monitor these controls systems and respond accordingly, it is unlikely that they will be held liable on a theory of oversight liability.

Corporate Waste

Directors may want to consider the Citigroup holding relating to corporate waste and accordingly should have a heightened sensitivity to matters of executive compensation and to awarding what may be perceived as excessive executive compensation, particularly in the context of the current economic climate. Even though the standard of proof remains very high, the Citigroup decision is likely to leave open a window of opportunity for shareholders to bring claims relating to executive compensation under the doctrine of corporate waste. Directors may want to keep themselves apprised of developments in future cases, as an increase in compensation-related claims is likely to follow.

Laurence S. Lese is a partner in Duane Morris LLP and practices in the firm's Washington, D.C., office. Richard I. Olszewski is an associate at Duane Morris in its Philadelphia office.

Delaware courts have recently issued decisions that may impact the number and types of claims brought by shareholders of Delaware companies seeking to hold directors and officers personally liable under various claims, in particular in connection with the current economic crisis. Plaintiffs in these cases have invoked novel theories in an attempt to extend the boundaries of an existing corporate law doctrine, the fiduciary duty of corporate oversight. Plaintiffs have also attempted to energize another doctrine that has had limited, if any, viability until recently, namely the doctrine of corporate waste. Under both approaches, plaintiffs have achieved some success. In addition, plaintiffs have succeeded in obtaining a clear declaration from Delaware courts that officers do, in fact, have the same fiduciary duties as directors, which is likely to open new avenues for potential claims by shareholders.

Fiduciary Duties

In Gantler v. Stephens, 2009 Del. LEXIS 33 (Jan. 27, 2009), the Delaware Supreme Court addressed whether corporate officers have fiduciary duties, an issue which has long been assumed to be the case but which has not previously been established clearly by Delaware courts. The plaintiffs' claims related to decisions and actions of the company's directors and officers in connection with the potential sale of the company. The plaintiffs alleged that the directors and officers rejected or failed to take seriously bids from several prospective purchasers and favored alternate plans that would preserve their positions with the company. Significantly, the plaintiffs alleged that the officers sabotaged the due diligence process as to two of the bidders by their delay and non-responsiveness to requests for information, and thereby scuttled the two offers. In finding that the plaintiffs had alleged sufficient facts to support a claim against the officers for violations of their fiduciary duties, the Gantler court held, without qualification, that “the fiduciary duties of officers are the same as those of directors.” The court further noted that, although the fiduciary duties of care and loyalty of directors and officers may be the same, the effect of a breach of a fiduciary duty may have a disproportionate effect on an officer as compared to a director, because corporations are not authorized under Delaware statutory law to include in its certificate of incorporation a provision exculpating officers from monetary liability for breaches of their duty of care, whereas directors may be so exculpated.

Commentators appear to be in two camps regarding the impact of the Gantler court's declaration of the fiduciary duties of officers. Some believe that the holding does not mark a significant event in Delaware law; that the decision merely confirms what was already presumed based on earlier decisions by Delaware courts. Other commentators believe that the decision will have a significant impact on future cases. Even if the former is correct and the declaration is not a significant event from an academic perspective, as a practical matter, the decision is nonetheless likely to significantly increase the number of new claims brought against officers for breaches of their fiduciary duties. To date, relatively few cases have involved claims of breaches of officer fiduciary duties. By declaring with finality that officers do in fact have fiduciary duties of care and loyalty to their corporation and shareholders, the Delaware Supreme Court at least partially filled the void of uncertainty, thereby eliminating a barrier that potential claimants might have had to bringing such claims. Accordingly, it would not be unexpected for courts to see an increase in the number of claims brought on theories based in violations of fiduciary duties of officers.

Duty of Oversight

In two recent cases, American International Group, Inc. Consolidated Derivative Litigation, 2009 Del. Ch. LEXIS 15 (Feb. 10, 2009), and In re Citigroup Shareholder Derivative Litigation, 2009 Del. Ch. LEXIS 25 (Feb. 24, 2009), the plaintiffs' claims included alleged violations of the defendant directors' fiduciary duty of oversight under In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). The Caremark analysis, as explained by the Chancery Court in the Citigroup case, provides that a finding of a violation of the duty of oversight requires the directors to have either “(a) ' 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.” Thus, to establish oversight liability, plaintiffs must further 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.” The court stated that the test is rooted in concepts of bad faith: “a showing of bad faith is a necessary condition to director oversight liability.” In the AIG case, the court concluded that there was sufficient evidence that the defendants violated their duty of oversight in the face of “widespread illegal misconduct,” whereas in the Citigroup case, the court found insufficient evidence of a violation of their duty of oversight where the defendants allegedly failed to monitor and manage the company's subprime market risk exposure in the face of publicly available warning signs.

The AIG case involved claims brought by shareholders of AIG alleging that an “Inner Circle” of AIG executives and employees caused the company to engage in “widespread illegal misconduct.” Such conduct included misstating the company's financial performance to deceive investors; creating sham transactions and subsidiaries to improve the appearance of the company's balance sheet and to hide losses; engaging in tax avoidance schemes and promoting such schemes to clients; and conspiring with other companies to manipulate derivatives and insurance markets. The AIG court determined that “the pled facts support an inference that [the defendants] were conscious of the fact that they were not doing their jobs,” thereby satisfying the knowledge element required to maintain a Caremark claim. The court concluded that the AIG directors' failure to act satisfied the Caremark bad faith criterion, noting that “[t]he diversity, pervasiveness, and materiality of the alleged financial wrongdoing at AIG is [sic] extraordinary.”

The Citigroup case involved a claim alleging the defendant directors and officers had breached their fiduciary duties for failing to properly monitor and manage the company's risk exposure in the subprime mortgage market in the face of public information indicating worsening conditions in the subprime and credit markets, which ultimately subjected the company to massive losses. Identifying this public information as “red flags,” the plaintiffs claimed that the “red flags” should have put defendants on notice of the problems with the company's subprime investments.

The Citigroup court characterized the plaintiffs' theory as “a bit of a twist on the traditional Caremark claim.” Whereas a typical Caremark case involves liability for damages arising from a failure to properly monitor or oversee employee misconduct or violations of law, as in the AIG case, the Citigroup plaintiffs proposed to extend Caremark to reach directors' alleged failure to properly monitor the company's business risk. The Citigroup court explained that it saw the plaintiffs' claims instead as an attempt to hold the defendants liable for making business decisions that, in hindsight, turned out poorly for the company. The Citigroup court explained that it was “almost impossible for a court, in hindsight, to determine whether the directors of a company properly evaluated risk and thus made the 'right' business decision” due to, in part, “the tendency for people with knowledge of an outcome to exaggerate the extent to which they believe that outcome could have been predicted,” which the court described as “hindsight bias.” The Business Judgment Rule, the court asserted, avoids hindsight bias by focusing on the decision-making process rather than the merits of the decision itself.

Ultimately, the Citigroup court considered principles of both the Business Judgment Rule and Caremark, noting that, where there is a fiduciary duty exculpatory provision and no evidence of self-dealing, a common and necessary element in both analyses is bad faith. Accordingly, proof of bad faith would both establish a violation of the duty of oversight and overcome the business judgment presumption. In order to prove bad faith, a plaintiff is required “to plead particularized facts that demonstrate that the directors acted with scienter,” that is, with knowledge that their conduct was legally improper. For example, a plaintiff could allege “particularized facts that show that a director consciously disregarded an obligation to be reasonably informed about the business and its risks or consciously disregarded the duty to monitor and oversee the business.” However, the court noted, the plaintiffs faced an extremely high burden to state a claim for personal director liability for a failure to see the extent of a company's business risk, as “the burden for a plaintiff to rebut the presumption of the Business Judgment Rule by showing gross negligence is a difficult one, and the burden to show bad faith is even higher.”

The Citigroup court ultimately concluded that the plaintiffs' factual allegations were insufficient to demonstrate bad faith by the defendants, determining that: 1) the warning signs alleged by the plaintiffs were “nothing more than signs of continuing deterioration in the subprime mortgage market” and, at best, evidence that the directors made bad business decisions; 2) at no point did the plaintiffs allege how the defendants' oversight mechanisms were inadequate or how the defendants knew of these inadequacies and consciously ignored them; 3) at no point did the plaintiffs explain what the defendants did or failed to do that would give rise to a violation of their fiduciary duties; and 4) the plaintiffs' allegations that the defendants must have seen and consciously ignored the warning signs or knowingly failed to monitor the company's risk in accordance with their fiduciary duties were nothing more than “conclusory allegations.”

The Citigroup court distinguished its holding from the holding in the AIG case, explaining that failing to predict business risk is fundamentally different from failing to oversee employee fraudulent or criminal conduct (as in AIG): “oversight duties ' are not designed to subject directors ' to personal liability for failure to predict the future and to properly evaluate business risk.” The court queried:

If directors are going to be held liable for losses for failing to accurately predict market events, then why not hold them liable for failing to profit by predicting market events that, in hindsight, the director should have seen because of certain red (or green?) flags?

What remains unclear about the holding in the Citigroup case is whether the theory of oversight liability will be available in cases not involving internal fraudulent and criminal action. At times, the Citigroup court indicated disfavor with extending the analysis to situations involving other aspects of director oversight, although the court suggested that there could be a set of facts under which liability could be found.

Corporate Waste

The Citigroup case involved additional substantive claims, including that various actions by the defendants constituted corporate waste, in particular their approval of a multimillion-dollar severance package for the company's departing CEO. The Citigroup court explained that to overcome the Business Judgment Rule in the context of a claim of corporate waste, the court would analyze whether the “defendants authorized an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.” The court explained that, although directors have broad discretion to make executive compensation decisions, “there is an outer limit to the board's discretion to set executive compensation, at which point a decision of the directors on executive compensation is so disproportionately large as to be unconscionable and constitute waste.” Applying this analysis, the Citigroup court allowed the claim relating to the severance package to proceed to trial.

Impact

Fiduciary Duties of Officers

Unfortunately, under the Gantler decision, it is unclear whether every aspect of the fiduciary duties of directors have been incorporated to apply to officers, including the various analyses formulated by Delaware courts to test for violations of fiduciary duties of directors. For example, does the same Business Judgment Rule analysis apply to both officers and directors? Do officers have the same Caremark duties of oversight as directors and, if so, does the same analysis apply to a related claim for breach of the duty? Does corporate waste as a ground for liability apply to officers as well? Presumably, there will be some concepts and rules that are not directly transferable to officers due to the different roles that officers and directors serve within the corporate context. Therefore, this is likely to be an area of Delaware corporate law that will continue to increase in significance. Companies may want to review the protections available to their officers in indemnification agreements and insurance policies, for example, to ensure that the relevant documents provide the desired level of protection for claims of violations of their fiduciary duty of care. Failure to do so could expose officers to unexpected personal liability.

Oversight Liability

The AIG case establishes that, even though a claim based on the duty of oversight is extremely difficult to withstand judicial scrutiny, such claims remain viable in the face of fraudulent and criminal activity. Even though the defendants in Citigroup were found not liable for failure to monitor the business risk of the company, directors and management nonetheless may want to ensure that their oversight procedures and controls monitor not only fraudulent and criminal activity, but also activity that may result in major losses for the company, whether such activity is internal or external to the company. Moreover, directors must be vigilant. If effective oversight controls are in place and the directors reasonably monitor these controls systems and respond accordingly, it is unlikely that they will be held liable on a theory of oversight liability.

Corporate Waste

Directors may want to consider the Citigroup holding relating to corporate waste and accordingly should have a heightened sensitivity to matters of executive compensation and to awarding what may be perceived as excessive executive compensation, particularly in the context of the current economic climate. Even though the standard of proof remains very high, the Citigroup decision is likely to leave open a window of opportunity for shareholders to bring claims relating to executive compensation under the doctrine of corporate waste. Directors may want to keep themselves apprised of developments in future cases, as an increase in compensation-related claims is likely to follow.

Laurence S. Lese is a partner in Duane Morris LLP and practices in the firm's Washington, D.C., office. Richard I. Olszewski is an associate at Duane Morris in its Philadelphia office.