Corporate Governance

Delaware Courts and Exonerating the Board from Supervising Risk: In re Citigroup Derivative Litigation (The Facts)

By J. Robert Brown

We are discussing In re Citigroup Derivative Litigation.

In late 2007, Citigroup began to announce large losses relating to subprime related assets, particularly those associated with structured investment vehicles.  Without repeating the details, the court conceded that the losses were "staggering." 

Among other things, plaintiffs alleged a failure to adequately oversee and manage Citigroup's exposure to the problems in the subprime mortgage market, even in the face of alleged 'red flags.' They also alleged that directors engaged in waste by permitting certain large purchases of subprime loans, by not not suspending the financial institution's repurchase program, and by approving the benefit package awarded to Prince, the CEO of Citigroup, upon his retirement in November 2007.

As usual, the case wound its way to the demand excusal issue.  Under Aronson, plaintiffs made no real effort to show that the directors were not independent. 

Instead, under the second prong, shareholders alleged that the directors "faced a substantial threat of personal liability because their conscious disregard of their duties and lack of proper supervision and oversight caused the Company to be overexposed to risk in the subprime mortgage market."  Conscious disregard, of course, is the standard for alleging a violation of the good faith requirement, something made necessary by the ubiquitous presence of waiver of liability provisions.  These provisions require shareholders to plead something beyond a breach of the duty of care.

The case turned on the board's role (or lack of role) in the excessive risk taking by Citigroup.  This was not a case where the plaintiffs had to establish a role for the board in the assessment of risk.  The board in fact had a system in place.  The board had established the Audit and Risk Management Committee. The ARM Committee had as a duty the obligation to assist the board:

• in fulfilling its oversight responsibility relating to policy standards and guidelines for risk assessment and risk management. The ARM Committee was also charged with, among other things, (1) discussing with management and independent auditors the annual audited financial statements, (2) reviewing with management an evaluation of Citigroup's internal control structure, and (3) discussing with management Citigroup's major credit, market, liquidity, and operational risk exposures and the steps taken by management to monitor and control such exposures, including Citigroup's risk assessment and risk management policies. According to plaintiffs' own allegations, the ARM Committee met eleven times in 2006 and twelve times in 2007.

The case was really about this committee and why it didn't catch the problem.  One answer might have been that the directors acted with extraordinary care and genuinely believed that management had the matter under control.  Another possibility was that the system for risk management was not meaningful and the directors either did not know about the risks or, if they did, did nothing in response, despite deteriorating financial conditions in the banking sector.  Given the staggering losses, plaintiffs wanted an opportunity to determine which was the case. 

We will continue this in the next post.  As usual, we have posted primary materials on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on March 13, 2009 (boomark / email).