Delaware Gets Tough on National Issues
Scholars often detect a strengthening of Delaware corporate law amid national crises that can ignite interest in having the federal government increasingly preempt state corporation law. Two recent cases may support that conjecture, allowing some surprising claims to withstand motions to dismiss:
(1) a claim against AIG’s directors asserting that they presided, with sustained and systemic neglect to control, over what was essentially a “criminal enterprise”; and
(2) a claim against Citigroup’s directors asserting that they committed waste in approving a lavish payout to a departing CEO who presided over the destruction of billions of dollars of wealth at the corporation.
The opinions coincide with rising public outage over executive compensation and strict federal laws capping executive compensation for scores of public companies, mostly banks, but also automobile companies and finance affiliates. They coincide with ongoing frustration over the government’s injection of more than $120 billion into AIG while it continues to report staggering losses reportedly exceeding $50 billion this quarter alone.
Calls will continue for federal legislation that limits corporate executive compensation, taking away Delaware corporation law’s role on the subject; calls may heat up for broader federal preemption of a wide range of state law, certainly in banking and insurance, and just possibly corporation law as well, at least for institutions of systemic significance.
Whether Delaware is really responding to those threats or simply taking the cases on the merits, the two opinions are of considerable interest, even though written merely by the trial court and merely addressing motions to dismiss.
In the AIG case, the court denied defendants’ motion to dismiss shareholder derivative claims asserting that the directors violated both their duty of care, stating claims that could even overcome the formidable business judgment rule, and their duty of loyalty, including by failing to act in good faith.
The complaint’s allegations support claims of a “sustained and systematic failure” to maintain proper internal controls over what the complaint credibly alleged involved “fraudulent and criminal” conduct at an enterprise that could be characterized as a “criminal organization.”
In the Citigroup case, the court granted defendants’ motion to dismiss such shareholder claims when they merely asserted that directors failed to detect “red flags” involving the sub-prime mortgage market. These allegations do not support claims of a sustained or systematic failure to maintain internal controls or bad faith but instead concern business decisions to which the business judgment rule applies.
In addition, Citigroup has adopted the charter provision authorized by Delaware law [Section 102(b)(7)] that relieves directors from personal liability for money damages for breach of fiduciary duty, other than actions that violate the duty of loyalty or are not taken in good faith. While the complaint made assertions of lack of good faith, these were merely conclusory and distinguishable from AIG.
On the other hand, the Citigroup court denied defendants’ motion to dismiss claims of waste, which is an extremely rare and difficult claim to sustain, even at the pleadings stage. It requires pleading particularized facts creating an inference that directors approved 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 hurdle is even higher concerning compensation decisions.
Even so, there is “an outer limit” to board discretion over compensation. Waste can be shown if “executive compensation is so disproportionately large as to be unconscionable and constitute waste.” Further, the Delaware Supreme Court has said that waste constitutes bad faith, so a showing of waste would expose directors to personal liability for money damages notwithstanding the 102(b)(7) charter provision. The Citigroup court wrote as follows:
According to plaintiffs’ allegations, the November 4, 2007 letter agreement provides that Prince will receive $68 million upon his departure from Citigroup, including bonus, salary, and accumulated stockholdings. [It] provides that Prince will receive from Citigroup an office, an administrative assistant, and a car and driver for the lesser of five years or until he commences full time employment with another employer. Plaintiffs allege that this compensation package constituted waste and met the “so one sided” standard because, in part, the Company paid the multi-million dollar compensation package to a departing CEO whose failures as CEO were allegedly responsible, in part, for billions of dollars of losses at Citigroup. . . . [Accordingly] there is a reasonable doubt as to whether the letter agreement meets the admittedly stringent “so one sided” standard or whether the letter agreement awarded compensation that is beyond the “outer limit” . . .