Professor Regan on the Goldman Sachs Decision

— Prof. Paul L. Regan, Widener University School of Law, Wilmington, Delaware

Newly installed Vice Chancellor Sam Glasscock has issued an opinion dismissing a shareholder derivative action that the shareholders of Goldman Sachs attempted to bring on behalf of the company against its directors and officers arising from the company’s compensation plan during the recent mortgage crisis and its aftermath. In In re The Goldman Sachs Group, Inc. Shareholder Litig., C.A. No. 5215-VCG (Del. Ch. Oct. 12, 2011), the shareholders of Goldman Sachs alleged that the company’s directors breached their fiduciary duties by establishing a compensation structure that assertedly encouraged highly “risky trading practices and over-leveraging of the company’s assets.” The plaintiffs also alleged a Caremark claim, asserting the Goldman directors failed to fulfill their oversight responsibilities with regard to the firm’s compensation plan which in turn, according to the plaintiffs, led to unethical and illegal business practices as well as overly-risky business decisions.

The defendants successfully moved to dismiss the complaint under Court of Chancery Rule 23.1 for failure of the plaintiffs to allege with particularity that pre-suit demand was excused. With regard to the decision of the Goldman board to approve the firm’s compensation structure, Vice Chancellor Glasscock applied a straightforward Aronson analysis and concluded that the complaint failed to allege (1) that the board was interested or lacked independence when it approved the compensation scheme or (2) that the board did not otherwise validly exercise its business judgment in this regard. On the Caremark claim, the Court applied the Rales test and ruled that the complaint failed to allege with particularity that the Goldman directors faced a substantial likelihood of personal liability on their asserted failure to fulfill their oversight responsibilities. Thus demand was not excused because the plaintiffs did not allege facts creating a reasonable doubt that the Goldman directors would be deemed personally interested in responding to a demand that such an oversight claim be brought.

As noted the Court’s application of the Aronson test was fairly straightforward. Of note here is the Court’s Caremark analysis. The plaintiffs asserted that the Goldman directors failed to fulfill their fiduciary duty of oversight both with regard to monitoring compliance with applicable law and the company’s business performance and risk. The Court’s rejection of the complaint’s legal compliance/oversight claim conventionally followed Caremark and Stone v. Ritter. On the issue of monitoring business risk (as opposed to legal compliance), Vice Chancellor Glasscock noted that “this Court has not definitively stated whether a board’s Caremark duties include a duty to monitor business risk.” Goldman Sachs, slip op. at 60. Ultimately however, the Court declined to reach this interesting legal issue, ruling that the complaint failed to allege that the Goldman directors “acted in bad faith or consciously disregarded their oversight responsibilities in regards to Goldman’s business risk.” Id. at 64. As in the Citigroup case decided in 2009 by then Chancellor William Chandler, Vice Chancellor Glasscock signaled very little patience for the plaintiffs’ attempt to recast a claim attacking a business judgment over employee compensation into a oversight claim concerning business risk. Emphasizing the traditional judicial inquiry into the process but not the substance of board decision-making, the Court in Goldman Sachs emphasized: “If an actionable duty to monitor business risk exists, it cannot encompass any substantive evaluation by a court of a board’s determination of the appropriate amount of risk.” Id. at 62.

Following the Court of Chancery’s decisions in Goldman Sachs and of course Citigroup, it remains unsettled whether Caremark’s early reference to the possibility of an oversight claim arising from a board’s monitoring of business risk is viable. Outside of Delaware, the Model Business Corporation Act suggests such a possibility, at least with regard to “major risks” facing a publicly owned company. See MODEL BUSINESS CORPORATION ACT, Section 8.01(c)(2) (“In the case of a public corporation, the board’s oversight responsibilities include attention to … major risks to which the corporation is or may be exposed”.) The early returns from Delaware case law suggest a different emphasis in policy on the question of director accountability for business risk — i.e., protecting the board’s managerial authority under our director-centric model of corporate governance; encouraging entrepreneurial risk taking; encouraging qualified directors to serve; avoiding the unfairness of hindsight bias for decisions that turn out badly; and avoiding second guessing of business decisions by ill-equipped members of the judiciary. Thus far at least, the Delaware Court of Chancery has concluded that a conventional business judgment rule analysis should apply to such “oversight” business risk claims. Diversified stockholders who are unhappy with what they regard as unreasonable levels of business risk can always exit by selling their shares or otherwise seek to replace the directors in a contested election.

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