Another perspective on Citigroup and AIG

The Delaware chancery court has decided two very important cases arising out of notorious cases of managerial malfeasance or neglect – In re Citigroup Inc Shareholder Derivative Litigation, decided February 24, and American International Group, Inc. Consolidated Derivative Litigation, decided February 10.

As discussed in a Wachtell, Lipton, Rosen & Katz client memorandum posted here last week, and by Francis Pileggi here, the Citigroup decision reaffirms business judgment protection in Delaware by emphasizing the “extremely high burden” plaintiffs face in suing directors for breach of Caremark oversight duties. In this case, Chancellor Chandler held that merely claiming that directors made a bad business decision by failure to monitor business risk was not enough to excuse demand in a derivative suit.

However, in the AIG decision, Vice Chancellor Strine refused to dismiss a Caremark claim in the face of allegations of criminality and insider trading. This case was also analyzed by Francis Pileggi here.

Rather than rehashing the excellent analyses of these cases discussed in the posts linked above, I will focus on the broader implications of these opinions for corporate fiduciary jurisprudence in the post-meltdown era. I will emphasize three issues: the indeterminacy of corporate fiduciary law, the weakness of this law and other corporate monitoring devices in addressing the recent breakdown in corporate governance; and how these cases relate to Delaware jurisprudence on unincorporated business entities.

Indeterminacy
These cases seem to support the claim by William Carney and George Shepherd in The Mystery of Delaware Law’s Continuing Success (William Carney & George Shepherd, 2009 U. ILL. L. REV. 1) that Delaware law is infected by costly indeterminacy. After these cases, where, exactly, does a duty of loyalty claim for breach of Caremark duties stand?

The courts in these cases distinguished a claim that directors ignored the inadequate controls of patent business risks (Citigroup) from one that the directors ignored inadequate controls of insider wrongdoing (AIG). While these distinctions seem clear, and the cases seem rightly decided on their facts, the distinctions fray at the edges. Deliberately and knowingly ignoring either kind of risk can give rise to a claim. The defendants in Citigroup, even if careless, did not sink to that standard, while the AIG defendants did. So how does insider wrongdoing affect the determination? Must the flags be redder to trigger liability where there is no insider wrongdoing, but the risk could bring the company down? If so, how much redder? Is there a sliding scale for the degree of insider wrongdoing the defendants allegedly ignored. In AIG, the complaint supported an assertion that the insiders led, in Vice Chancellor Strine’s words, a “criminal organization.” Would the result be different if the alleged wrongdoing had been somewhat less pervasive? But does not the pervasiveness tie to the defendants’ knowledge, which leads back to square one?

In fairness, though, this does not necessarily support a criticism of Delaware law. As Chancellor Chandler wrote (with Anthony A. Rickey) in responding to Carney & Shepherd’s criticism in Manufacturing Mystery: A Response to Professors Carney and Shepherd’s “The Mystery of Delaware Law’s Continuing Success (2009 U. Ill. L. Rev. 95), Delaware is at least no more indeterminate than other jurisdictions.

Indeed, I argued in my own response to Carney & Shepherd, The Uncorporation and Corporate Indeterminacy, (2009 U. ILL. L. REV. 131), that indeterminacy is inherent in corporate law rather than specifically in Delaware jurisprudence. The solution is to turn to “uncorporate” law, which leads directly to my next two points.

The efficacy of corporate fiduciary duties
Let us now focus on 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, plaintiff likely could support that claim. The Citigroup management basically bet the company’s future on the vast Ponzi scheme of the real estate market amid growing signs that the scheme was unraveling.

Chancellor Chandler, however, rightly held that this is not the sort of deliberate failure that will establish a duty of loyalty claim for breach of Caremark duties. As the Chancellor reasoned, courts should not second-guess business decisions, particularly when this second-guessing leads to personal liability.

So the case is not wrongly decided. However, 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. Basically, as long as the board goes through the motions and does not ignore distinct whiffs of smoke and bright flashes of fire it should be able to withstand a duty of loyalty claim under Caremark.

The other prongs of the corporate monitoring system – shareholder voting, director oversight –provide equally little comfort. That is why I have argued, in Uncorporating the Large Firm, that we need “uncorporations” – private equity, hedge funds and other unincorporated firms. That is particularly true in the financial sector in the wake of the meltdown, as I discussed most recently in Ideoblog in More on the uncorporation and investment banking (February 25, 2009).

Duties in corporations and uncorporations
This brings me to the most intriguing issue in these cases – that is, how they relate to Delaware duties in “uncorporate” cases. As I discussed here, the Delaware Supreme Court recently decided Wood v. Baum, a case involving demand excuse in a publicly traded limited liability company. In Wood, Justice Jacobs applied the standard in the firm’s operating agreement in determining whether to excuse demand – specifically, that whether the complaint alleged a “bad faith violation of the implied contractual covenant of good faith and fair dealing.” Under this standard, the defendants not only have to violate the contract interpreted in light of the implied good faith covenant, but they have to do so in bad faith, meaning knowingly. Note that there are two elements here – bad faith, and the contractual standard. This suggests that if the contract explicitly waives Caremark duties, the managers can stare a failure to have internal controls right in the face and still not be liable.

Although Vice Chancellor Strine did not cite Wood in the AIG case, Chancellor Chandler discussed and cited Wood several times in Citigroup. Does this case indicate that Wood is spilling over into the corporate realm? That seems unlikely, since the Delaware corporate and LLC statutes clearly differ. Delaware G.C.L. §102(b)(7) clearly holds unenforceable duty of loyalty waivers, while the statute applied in Wood, §18-1101(e) of the Delaware Limited Liability Company Act, permits the contract to eliminate fiduciary duties. Thus, it is more reasonable to interpret Citigroup as holding that, under Wood, the applicable standard of loyalty or care, whatever that may be, determines demand excuse. In an LLC, the applicable standard may be a purely contractual one. In Citigroup, the statute sets a higher floor.

Chancellor Chandler, in citing Wood, did not, however, make this distinction clear. This presents the risk that future Delaware cases might go down the road of converging the corporate mandatory standard and the uncorporate contractual standard. That would be unfortunate. As I argued in the articles linked above, the uncorporate approach of letting firms contract for fiduciary duties has significant advantages for some firms. Uncorporations can trade off fiduciary duties for the more effective discipline that has enabled hedge funds, private equity and other uncorporations to avoid the severe governance problems of incorporated financial firms. Uncorporations also can avoid the costly indeterminacy that, as discussed above, inheres in corporate fiduciary duties. At the same time, corporations, which lack uncorporate-type discipline, continue to need at least the baseline monitoring duty Vice Chancellor Strine applied in AIG.

Parties to firms now can choose whether they want to go down the corporate or the uncorporate path. It would be unfortunate if Delaware courts eliminated that choice by converging the two regimes.