Liability and Your Board of Directors

Decisions made by public companies' boards of directors face greater scrutiny—and increased possibility of being challenged in a courtroom

By James L. Sanders

As the economy continues to falter due to the ongoing recession, officers and directors of public companies face the increasing possibility that their decisions will be challenged by investors, regulators, and even criminal prosecutors. This increased scrutiny makes it more important than ever that directors understand their obligations and potential liabilities.

Public criticism of executive compensation packages has grown as the recession has continued. On a near-daily basis, headlines highlight stories of bigname companies assailed on all sides by resentful shareholders and their legal representatives. In addition to private litigation, the government is increasing its activity on this front. The recent publicity and threatened government action concerning the AIG bonuses is just one example of this increased scrutiny. Another aspect is the recent announcement by Chairman Mary Schapiro that the Securities and Exchange Commission (SEC) is preparing a measure that will press corporate boards to explain in more detail how the board oversees risk. With these new initiatives come new potential litigation hazards for directors.

Compensation: The Doctrine of Corporate Waste

While the scope of the potential liability on compensation issues is not fully clear, a recent Delaware decision establishes that in certain instances, directors can be liable for excessive compensation decisions under a theory that by making the payments, they are wasting corporate assets.

In a case involving Citigroup, the Delaware Chancery Court dealt with allegations that the directors of Citigroup had violated their fiduciary duties to the corporation by approving a multimillion-dollar payment and benefit package upon the retirement of Citigroup's CEO. The plaintiffs alleged that this payment constituted a waste of corporate assets because the value of the compensation package far outweighed the value of any future benefits that the former CEO would provide to Citigroup.

In declining to dismiss this claim at the pleading stage, the Court held that while the directors of a corporation have broad discretion and authority with respect to executive compensation decisions, that authority is not unlimited. The board's discretion is bound by an outer limit "at which point a decision of the directors on executive compensation is so disproportionately large as to be unconscionable and constitute corporate waste," wrote Chancellor William B. Chandler in the decision. Without reaching the ultimate issue of whether the compensation in this case was excessive, the Court held that the allegations that the former CEO had received $68 million and other valuable consideration in exchange for a non-compete agreement, a non-disparagement agreement, a non-solicitation agreement, and a release of claims at least raised a reasonable doubt about whether the severance package was so onesided that it was beyond the "outer limit" described by the Delaware Supreme Court. In reaching this decision, the Court noted that on the face of the pleadings the record was unclear as to the real value, if any, of the promises given by the former CEO in the non-compete and related documents. On this basis, the Court allowed this portion of the plaintiffs' claim to go forward.

The importance of the Citigroup decision to directors is clear: plaintiffs and the courts are willing to look beyond executive compensation decisions in order to evaluate whether the corporation is getting a benefit from the compensation, or whether the compensation approved by the board is "so disproportionately large as to be unconscionable and constitute corporate waste." It remains to be seen what position the SEC will take in its compensation measure. In the interim, directors should bear the Citigroup ruling in mind when making compensation decisions.

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