The securities fraud suit brought by the SEC against Citigroup found its way into the news recently when the trial judge refused to approve the proposed settlement negotiated by the parties. Briefs have been ordered on a number of issues and there could be some shift in the final terms. Ultimately, as was the case with the proposed settlement with Bank of America, a settlement will be approved.
Of greater interest, however, is the contrast between federal and state law in the context of Citigroup's travails in the subprime market. The first effort to legally challenge the company's behavior was in state court. Shareholders filed a derivative suit in Delaware alleging that the board should have played a more active role in overseeing the excessive risk taking by the Bank in the subprime market.
In what has to stand out as an extraordinarily out of touch opinion, the Delaware Chancery Court dismissed the claim, essentially holding that boards had no responsibility to supervise corporate risk taking. The court likened the claim to an attempt to impose on the board an obligation to review all risks taken by the company, inserting directors into the day to day management of the company. As the court put it:
To the extent the Court allows shareholder plaintiffs to succeed on a theory that a director is liable for a failure to monitor business risk, the Court risks undermining the well settled policy of Delaware law by inviting Courts to perform a hindsight evaluation of the reasonableness or prudence of directors' business decisions. Risk has been defined as the chance that a return on an investment will be different that expected. The essence of the business judgment of managers and directors is deciding how the company will evaluate the trade-off between risk and return. Businesses--and particularly financial institutions--make returns by taking on risk; a company or investor that is willing to take on more risk can earn a higher return. Thus, in almost any business transaction, the parties go into the deal with the knowledge that, even if they have evaluated the situation correctly, the return could be different than they expected.
For the Chancery Court, the fact that Citigroup was taking a risk that ultimately came close to bankrupting the entire company made no difference. In that opinion, all risk was the same.
In contrast, the SEC found greater fault with the actions of Citigroup. The SEC brought, as it must, a disclosure claim. The complaint asserted that the Bank misstated its exposure to the subprime market. As the complaint alleged:
Citigroup represented that it had reduced its investment bank's sub-prime exposure from $24 billion at the end of 2006 to $13 billion or slightly less than that amount. In fact, however, in addition to the approximately $13 billion in disclosed sub-prime exposure, the investment bank's sub-prime exposure included more than $39 billion of "super senior" tranches of-sub-prime collateralized debt obligations and related-instruments called "liquidity puts" and thus exceeded $50 billion.
In addition to bringing an action against the Bank, the SEC brought an administrative proceeding against two officers. The directors have so far escaped blame, although the trial judge asked for additional briefing on the identity of "senior management" involved and on why the SEC had chosen to pursue only the two officers. Moreover, private suits against Citigroup under the securities laws have continued.
What does this juxtaposition of the different treatment in Delaware and federal court tell us? Allegations based on similar behavior are dismissed in Delaware with the court treating the claims with derision. In the federal system, the claims are treated with much greater seriousness and have a much greater possibility of some resolution on the merits (albeit in the form of a settlement or dispositive motion rather than an actual trial).
As Congress increasingly federalizes corporate governance (Dodd-Frank being the most recent example), Delware continues to play a diminished role in the governance process. Similarly, as the courts refuse to impose meaningful duties on the board of directors and go so far as to exempt directors for oversight of "bet the ranch" risk taking, litigation in the state (and the reasoning of its courts) becomes increasingly less important, supplanted by federal litigation.
Material on the SEC's case against Citigroup, including the judge's order requiring additional briefing, can be found on the DU Corporate Governance web site.