The Delaware chancery court has decided two very important cases arising out notorious cases of managerial malfeasance or neglect – In re Citigroup Inc Shareholder Derivative Litigation, decided last Tuesday, and American International Group, Inc. Consolidated Derivative Litigation, decided February 10. '
The bottom line is that Chancellor Chandler dismissed a Caremark bad faith monitoring claim in Citigroup, but VC Strine let the Caremark claim proceed in AIG. Chancellor Chandler let a waste claim proceed in Citigroup based on approval of excessive compensation for Prince. Note that both cases came up on demand excuse/refusal issues, so there may be a lot more litigation to come.
I don’t need to exhaustively analyze the cases here, because they’ve been well discussed elsewhere, notably including Francis Pileggi’s discussions of Citigroup (with links to other discussions) and AIG. But I will emphasize a couple of points relating to this blog’s themes.
First, critics of Delaware indeterminacy will have a field day. Yes, one can distinguish the two Caremark claims on the ground that AIG involved claims of criminality and insider trading. But one can also ask lots of questions about how much redder the flags have to be without those elements. Also, as to the Prince compensation claim in Citigroup, there wasn’t much discussion of the Supreme Court’s Disney decision dismissing a claim for excessive compensation.
Anyway, I’ve argued that indeterminacy is more the corporation’s fault than the court’s, which brings in my next couple of points.
Second, let’s think about the Caremark claims rejected in Citigroup. Plaintiff alleged that the board (a majority of whom had also been on the Enron board) ignored problems “brewing in the real estate and credit markets” starting in 2005.
And, indeed, that’s probably true. Recall that the financial community as a whole basically bet their companies on the dubious proposition that real estate prices would keep going up, and kept the bet going amid signs that the vast Ponzi scheme that was the real estate market was starting to unravel.
However, the court rightly held that this is not the sort of deliberate failure – like a complete absence of any oversight system – that will establish Caremark liability. Basically, as long as you’re going through the motions and not ignoring distinct whiffs of smoke and bright flashes of fire you’re ok.
And as Chancellor Chandler pointed out, it has to be that way. The court simply cannot get into the habit of second-guessing business decisions, particularly when this second-guessing leads to personal liability and the extreme risk-aversion that breeds.
So the case is not wrongly decided, but it shows clearly why at least one prong of the corporate monitoring system – fiduciary duties – provides very little assurance that corporate managers are actually doing their jobs. The other prongs – shareholder voting, director oversight – similarly provide little comfort. That’s why, as I’ve discussed (most recently here, with other links) we need uncorporations, particularly in the financial sector.
Third, and perhaps most intriguingly for me, there’s the question of how these cases relate to a notable recent Delaware Supreme Court case dealing with a publicly held LLC, Wood v. Baum. As I’ve discussed, Wood indicates that the court will apply a lighter contractual standard of care in uncorporate cases, rather than adhering to the rigid corporate standard regardless of business form.
Interestingly, while VC Strine did not discuss Wood in AIG,Chancellor Chandler discussed and cited Wood several times in Citigroup. So what is going on here? Is Wood spilling over into the corporate realm or not?
Chancellor Chandler arguably was merely citing Wood for the proposition that the court will apply whatever the applicable standard is in determining excuse. Yet the Chancellor never indicated any difference in standards. That’s despite the fact that the operating agreement in Wood arguably did apply a looser standard of care -- “bad faith violation of the implied contractual covenant of good faith and fair dealing” -- than the one applicable in corporate cases under 102(b)(7). This standard suggests that to be liable you not only have to violate the contract, but you have to do so in bad faith. By contrast, the corporation statute does not allow waiver of the duty of loyalty, which can include some version of Caremark duties.
In short, Citigroup says that whether demand is excused in both corporate and uncorporate cases depends on the applicable fiduciary standard, whatever that might be. This doesn’t preclude the possibility of applying a lower contractual standard in an uncorporate than in an uncorporate case. There is no problem with all that. But I'm concerned that convergence of corporate and uncorporate standards could have the perverse effect of transmitting the corporate virus to uncorporations -- inflexible rules and costly indeterminacy.
Great post. Both Citi and AIG are some of the biggest mullets in history. The fact that noone from these firms have been banned from the securities industry or locked up is even more amazing. To learn more go to www.newyorkshockexchange.com
Posted by: Ralph | February 27, 2009 at 11:33 PM