Liability of Directors for Corporation's Losses Due to Subprime Mortgage Crisis

Corporate & Finance Alert
(Jordan S. Solomon)
November 3, 2009
As has been well documented, the subprime lending crisis, triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States, has had major adverse consequences for banks and financial markets around the globe. This crisis is one of the prime contributing factors to the recession and poor economic conditions existing today. A recent Delaware Chancery Court case addressed the potential liability of directors of a Delaware corporation for claims relating to a company suffering major losses resulting from substantial exposure to subprime mortgages. The case In re Citigroup, Inc. Shareholder Derivative Litigation (Del. Ch., Feb. 24, 2009) is significant as it reaffirms the business judgment rule and emphasizes the court’s reluctance to second guess business decisions made by a board of directors even if the company suffers large losses from such decisions.

In re Citigroup, Inc. Shareholder Derivative Litigation is a lawsuit brought by shareholders of Citigroup against current and former directors of the corporation alleging that the defendants breached their fiduciary duties by failing to properly manage the risks Citigroup faced from problems in the subprime lending market, and for failing to properly disclose Citigroup’s exposure to subprime assets. In addition, the plaintiff shareholders alleged that certain of the defendants are liable to Citigroup for corporate waste for (a) allowing Citigroup to purchase $2.7 billion in subprime loans, (b) authorizing and not suspending Citigroup’s stock repurchase program in 2007 which allegedly resulted in the company buying its own shares at artificially inflated prices, (c) approving a multimillion dollar severance package for defendant, Charles Prince, upon his retirement as Citigroup’s CEO in November 2007, and (d) allowing Citigroup to invest in structured investment vehicles that were unable to pay off maturing debt resulting in Citigroup being required to assume such debt.

Other than the claim for corporate waste for approving Mr. Prince’s severance package, the court dismissed all of the plaintiffs’ claims.

The plaintiffs’ allegations relate to Citigroup’s involvement with the subprime lending crisis. Specifically, plaintiffs alleged that beginning in 2006 the directors allowed and caused the company to engage in subprime lending, and as a result Citigroup experienced massive losses. According to the plaintiffs, Citigroup’s subprime exposure was $55 billion.

Plaintiffs claim that the defendants were liable to the company for breach of fiduciary duty for (1) failing to adequately oversee and manage Citigroup’s exposure to the problems in the subprime mortgage market, even in the face of alleged “red flags” and (2) failing to ensure that the company’s financial reporting and other disclosures were thorough and adequate. The “red flags” articulated by the plaintiffs in their complaint are statements from public documents reflecting the deteriorating conditions in financial markets and the effects that these conditions had on market participants, including Citigroup.

The plaintiffs brought this lawsuit as a shareholder derivative action which is a suit by a shareholder to enforce a corporate cause of action. Generally, under Delaware law, the board of directors makes the decision to initiate or pursue a lawsuit on behalf of the corporation. However, if a corporation refuses or fails to pursue litigation, a shareholder may take action to cause the corporation to do so. To bring a shareholder derivative lawsuit, a shareholder must either (1) make a pre-suit demand on the corporation’s directors requesting that they bring suit and showing that they wrongfully refused to do so or (2) plead facts showing that the demand upon the board would have been futile. In this case, the shareholders chose the second option. To pursue this option, the plaintiffs’ complaint must plead with peculiarity the facts showing that a demand on the board would have been futile. Further, as the shareholders here are not objecting to a business decision of the board but rather to board inaction, the plaintiffs must allege facts that create a reasonable doubt that the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. The plaintiffs alleged that the demand on the board was futile, except as to the corporate waste claim, because the defendant directors were not able to exercise disinterested business judgment in responding to a demand because their failure of oversight subjected them to substantial likelihood of personal liability. The plaintiffs’ argument was that the directors’ conscious disregard of their duties and lack of proper supervision and oversight resulted in the company being overexposed to risk in the subprime mortgage market.

Based on prior Delaware case law, to establish liability the plaintiffs must show that the directors knew that they were not discharging their fiduciary obligations, or that the directors demonstrated conscious disregard for their responsibilities by failing to act in the face of a known duty to act. A showing of bad faith is a necessary condition to director oversight liability. According to the Delaware Chancery Court judge, plaintiffs’ theory was that the defendant directors should be personally liable to the company because they failed to fully recognize the risk posed by subprime securities. The basic element of the plaintiffs’ case is an attempt to hold the defendant directors personally liable for making business decisions that in hindsight turned out poorly for the company.

The court ruled that these types of claims were to be evaluated under the business judgment rule. The business judgment rule is intended to prevent a judge or jury from second guessing director decisions if they were made as part of a rational process and the directors availed themselves of all material and reasonably available information. The court applied the business judgment ruled and concluded that the plaintiffs did not show that the defendants demonstrated bad faith in their actions and decisions.

The court stated that “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.”

Interestingly and somewhat rhetorically, the court went on to say in a footnote that if the directors were going to be held liable for losses suffered by the company for failing to accurately predict market events, then why not hold them liable for failing to profit by predicting market events that, in hindsight, directors should have seen because of certain red (or green?) flags. This observation is instructive as it shows the deference given by courts to actions taken or not taken by a corporation’s board of directors.

This case is significant as it reaffirms the business judgment rule even in the face of huge losses suffered by the corporation. The court recognized that it is understandable that investors would want to find someone to hold responsible for the substantial losses suffered by Citigroup in the subprime mortgage crisis. However, the court was quick to point out that we should not let a crisis and the desire to blame someone for our losses eviscerate Delaware corporate law doctrines governing the duties of directors of Delaware corporations. The court stated that ultimately, the discretion granted directors allows them to maximize shareholder value in the long term by taking risks without the fear that they would be held personally liable if the company sustains losses. This doctrine also means, however, that when the company suffers losses, shareholders may not be able to hold the directors personally liable. This case is important because in times of crisis it is to be expected that there will be increased scrutiny of actions by directors, particularly when the corporation has experienced significant losses. This fifty-eight page opinion makes clear that the previously established doctrines governing the liability of directors must be respected, particularly in times of crisis, to preserve the proper functioning of corporations and the ability to retain and recruit qualified directors.

Should you have any questions regarding your own situation, please contact Jordan S. Solomon of our Corporate Department.