November 16, 2011
A Director's Guide to Surviving Demand Futility: Lessons From Goldman Sachs
By Stephen B. Brauerman
Vice Chancellor Glasscock’s first significant corporate law decision since his elevation from Master-in-Chancery, In re Goldman Sachs Group, Inc. Shareholders Litigation, dismissed a lawsuit challenging the Goldman Sachs Group, Inc. (“Goldman”) board of directors’ (the “Board”) approval of a compensation system that, according to plaintiffs, motivated management to engage in unreasonably risky revenue generating behavior at the expense of stockholders who disproportionately bore the risk of such activities. Though the Court dismissed the case because of plaintiffs’ procedural failure to make a pre-suit demand or adequately allege demand futility, the Court’s analysis and assessment of the plaintiffs’ allegations offers some substantive findings of import. Goldman Sachs provides guidance for independent directors who engage in business transactions with or serve on charitable boards affiliated with the corporations they steer. It may spell the end for Caremark claims based solely on a board’s failure to monitor business risk properly, given the Court’s skepticism that an enterprising plaintiff could ever prove the “bad faith indifference” necessary to sustain such a claim. In addition it suggests, Vice Chancellor Glasscock’s commitment to judicial restraint and deference to management that has characterized his predecessors and contemporaries on the Court of Chancery.
Plaintiffs, two large pension funds acting derivatively on behalf of Goldman stockholders, filed suit to challenge the Board’s approval of a compensation system that emphasized short-term profits at the expense of long term growth to maximize compensation tied directly to the firm’s revenues. While conventional wisdom holds that such “pay for performance” compensation systems align management and stockholder interests, plaintiffs alleged that stockholders disproportionately bore the risk of loss as their equity provided the assets that management used to make risky investments in exchange for a small (two percent) dividend while Goldman employees took home approximately forty percent of the firm’s revenues. Plaintiffs also criticized the Board for failing to oversee the risky strategies the firm was pursuing. This risky behavior, plaintiffs alleged, forced Goldman to seek an onerous cash infusion from Warren Buffet, accept “bail-out” money from the federal government, convert to a bank holding company, and agree to a costly settlement with the Securities and Exchange Commission as a result the “Abacus” transaction where Goldman took short positions while selling long positions to its clients – all at significant reputational and economic risk to Goldman and its stockholders.
Plaintiffs’ claims of misconduct against Goldman received little attention from the Court because Plaintiffs failed to make a pre-suit demand or adequately allege demand futility with particularity. Since Delaware law recognizes that the ability to bring a lawsuit on behalf of a Delaware corporation is fundamentally the purview of an independent board, a derivative plaintiff must, as a threshold matter, either demand that the Board file the lawsuit or allege facts with sufficient particularity that the Court can conclude that such demand is futile before bringing the action itself. Because the plaintiffs in Goldman Sachs did not make a demand on the Board, the Court examined the allegations in the complaint utilizing the standards for determining demand futility, which depend on whether the challenged action is one of omission or commission.
Under the Delaware Supreme Court’s landmark decision in Aaronson v. Lewis, if a plaintiff desires to challenge a conscious decision of a board, it must allege particularized facts that create a reasonable doubt that the directors are disinterested and independent or that the challenged transaction was otherwise the product of a valid exercise of business judgment. In contrast under Rales v. Blasband, a plaintiff who complains of board inaction must plead particularized facts that create a reasonable doubt that, at the time the complaint was filed, the board could not have properly exercised its independent and disinterested business judgment in responding to the demand. In Goldman Sachs, the Court analyzed the Board’s decision to approve the compensation system under Aaronson and its alleged failure to oversee Goldman’s business risk under Rales.
In the Complaint, Plaintiffs sought to create reasonable doubt regarding disinterestedness and independence in two ways – by alleging that the Goldman Sachs Foundation (the “Goldman Foundation”) made contributions to charitable organizations with which certain directors were affiliated and that certain directors engaged in business transactions with Goldman. At the time plaintiffs filed the lawsuit, the Board consisted of twelve directors – two management directors whom the Court presumed were interested and two directors whom the plaintiffs did not allege lacked independence. As a result, to avoid the strictures of the demand rule, plaintiffs needed to allege disabling interests against at least four of the remaining eight directors.
Of the directors allegedly disqualified because they worked with charities that received contributions from the Goldman Foundation, the allegations against five of the six directors were similar. Each director served as an uncompensated member of the charitable board and the plaintiffs failed to allege that any of them actively solicited donations from Goldman or the Goldman Foundation. The paucity of allegations concerning the materiality of the contribution – either to the charity or to the director – and how such contribution would influence each director’s decision-making process was particularly concerning to the Court. The Vice Chancellor’s reluctance to infer materiality, even in the face of six-figure gifts, suggests that directors may maintain their independence even where they hold positions with fund raising objectives in charitable organizations that receive large gifts from entities at least loosely affiliated with the corporation for which they serve as a director.
The only director for whom the receipt of charitable contributions from the Goldman Foundation gave the Court pause was Ruth Simmons. Unlike the other defendants, Simmons did not passively sit on a charitable board, but serves as the President of Brown University where her livelihood depends in part on her ability to raise funds. Nonetheless, because plaintiffs did not allege with particularity that the Goldman Foundation’s donation to the University was material or that Simmons actively solicited the donation, the Court found her independent under Aaronson. This holding is instructive because even a director whose livelihood depends on her ability to raise capital and whose principal employer received substantial capital (in excess of $200,000) from an entity affiliated with the corporation on which she serves, did not automatically face disqualification. Plaintiffs apparently will have to allege particularized facts that demonstrate the materiality of the funds received by the charity (i.e. a threshold based on the percentage of the funds received from the corporation or its affiliate of the total funds received by the charity) and that the donation might impact her decision-making process on the Board.
Two important lessons seem to emerge from Goldman Sachs. First, the Court emphasized that under Aaronson and contrary to the more generalized standard necessary to state a claim, a plaintiff seeking to plead demand futility must state its allegations with particularity. As a practical matter, this may require substantial pre-filing investigation, not only of the corporation and its directors, but also of the charities on which they serve in order to allege the materiality of the donation with any specificity. Second, the decision implies that a more direct connection between the charitable giving and corporate service may help lower the materiality threshold. As the Court observed, the Goldman Sachs Foundation was independent of Goldman and managed by a board that consisted of at least of a majority of directors who never were or no longer were affiliated with Goldman. Though plaintiffs alleged that the Board controlled the Goldman Foundation, the Court disregarded the conclusory allegation, requiring instead specific factual allegations demonstrating such domination. Presumably a donation to the charity directly from the corporation would lower the materiality threshold and enhance the potential to create a disabling interest. The plaintiffs in Goldman Sachs did not make sufficiently particularized allegations for the Court to reach such a conclusion in this case.
Plaintiffs also tried to plead demand futility based on three directors’ business dealings with Goldman. Specifically, plaintiffs claimed that Goldman’s alleged investment of at least $670 million in funds managed by a Goldman director, its investment of at least $600 million in a fund advised by a Goldman director, and its provision of billions of euros in financing to a company in which a third Goldman director served as President and Chief Executive Officer, rendered these directors interested and lacking independence under Aaronson. Although these types of allegations (i.e. a significant financial relationship between the allegedly independent director and the corporation), are traditionally viewed as disabling, Vice Chancellor Glasscock found the allegations in the complaint wanting.
With respect to the director whose company borrowed significant amounts of money from Goldman, the Court observed that Goldman is an investment bank and simply borrowing money in a series of market transactions does not disqualify a director under Aaronson. The Court noted that in the absence of allegations that the financing terms were below market, that the director’s company could not obtain financing from other sources, or that the Goldman loans constituted a substantial portion of the company’s funding, Goldman was more dependent on the director (for future fees generated by underwriting his company’s debt offerings) than the director was dependent on Goldman (for future financing). Again, the Court looked for particularized allegations from which it could conclude a lack of independence and found none because plaintiffs limited their allegations to the existence of a financing relationship and did not focus on the materiality, terms, or impact of such relationship on the director.
Similarly the Court refused to infer that a fund manager relied on the management of such funds for his livelihood in the absence of specific factual allegations to that effect. The absence of specific allegations with regard to the timing of the investment appeared to concern the Court as it was not clear from plaintiffs’ allegations when the investment occurred. The paucity of allegations concerning the investment-advisor-director also troubled the Court, which observed that plaintiffs did not allege that the director derived a substantial benefit from serving as an advisor, that he solicited funds from Goldman, that the fund received money from Goldman because of his involvement, or that his future employment with the fund was dependent on Goldman’s investment. Taking a formalistic approach, the Court acknowledged that specific factual allegations concerning these business relationships could demonstrate interestedness, but declined to reach such conclusion on the record before it.
Plaintiffs also brought a Caremark claim questioning the Board’s oversight of Goldman’s risky business practices. The Court analyzed the allegations of this claim under Rales’ standard for demand futility and found them insufficient to demonstrate demand futility because, the Court held, the Board could exercise its independent and disinterested business judgment in responding to a demand.
In reaching this conclusion the Court also considered whether a board’s Caremark duties include a duty to monitor business risk as opposed to the well-settled duty to monitor corporation’s compliance with applicable law. Quoting Caremark, the Court observed that directors may have a duty to be reasonably informed about a corporation’s compliance with law and its business performance. The Court reluctantly acknowledged the theoretical existence of such claim, but declined to reach the ultimate conclusion about whether Caremark imposes a duty to monitor business risk, because the facts plead in the complaint did not give rise to a Caremark claim. The Court noted, however, that “it would be, appropriately, a difficult cause of action on which to prevail” that would require proof of either a board’s conscious failure to implement any reasonable monitoring system or a conscious disregard of red flags raised by such a system because the appropriate amount of risk borne by the corporation falls squarely within the business judgment of the board. That the Board made decisions to hedge exposure during the deterioration of a housing market that left Goldman vulnerable to large risks, including reputational risks, did not demonstrate that directors consciously disregarded their oversight obligations, even if Caremark recognized a duty to monitor business risk.
Goldman Sachs provides useful guidance for directors who wish to serve on charitable boards that receive donations from the corporations they serve or enter into business relationships with the corporation. Such activities likely will not automatically to render a director interested. Before questioning a director’s independence in the context of a demand futility analysis, the Court of Chancery will require specific, particularized allegations demonstrating interestedness; consistent with the Court’s fundamental deference to the business judgment of directors of Delaware corporations. Even if directors make reasonably informed decisions that expose corporations to significant risk, the Court will not substitute its business judgment for the board’s absent specific allegations of disinterestedness or lack of independence.
Reprinted with permission from the November 16, 2011 issue of Delaware Business Court Insider. (c) 2011 ALM Media Properties, LLC. Further duplication without permission is prohibited.
Vice Chancellor Glasscock’s first significant corporate law decision since his elevation from Master-in-Chancery, In re Goldman Sachs Group, Inc. Shareholders Litigation, dismissed a lawsuit challenging the Goldman Sachs Group, Inc. (“Goldman”) board of directors’ (the “Board”) approval of a compensation system that, according to plaintiffs, motivated management to engage in unreasonably risky revenue generating behavior at the expense of stockholders who disproportionately bore the risk of such activities. Though the Court dismissed the case because of plaintiffs’ procedural failure to make a pre-suit demand or adequately allege demand futility, the Court’s analysis and assessment of the plaintiffs’ allegations offers some substantive findings of import. Goldman Sachs provides guidance for independent directors who engage in business transactions with or serve on charitable boards affiliated with the corporations they steer. It may spell the end for Caremark claims based solely on a board’s failure to monitor business risk properly, given the Court’s skepticism that an enterprising plaintiff could ever prove the “bad faith indifference” necessary to sustain such a claim. In addition it suggests, Vice Chancellor Glasscock’s commitment to judicial restraint and deference to management that has characterized his predecessors and contemporaries on the Court of Chancery.
FACTUAL AND PROCEDURAL HISTORY
Plaintiffs, two large pension funds acting derivatively on behalf of Goldman stockholders, filed suit to challenge the Board’s approval of a compensation system that emphasized short-term profits at the expense of long term growth to maximize compensation tied directly to the firm’s revenues. While conventional wisdom holds that such “pay for performance” compensation systems align management and stockholder interests, plaintiffs alleged that stockholders disproportionately bore the risk of loss as their equity provided the assets that management used to make risky investments in exchange for a small (two percent) dividend while Goldman employees took home approximately forty percent of the firm’s revenues. Plaintiffs also criticized the Board for failing to oversee the risky strategies the firm was pursuing. This risky behavior, plaintiffs alleged, forced Goldman to seek an onerous cash infusion from Warren Buffet, accept “bail-out” money from the federal government, convert to a bank holding company, and agree to a costly settlement with the Securities and Exchange Commission as a result the “Abacus” transaction where Goldman took short positions while selling long positions to its clients – all at significant reputational and economic risk to Goldman and its stockholders.
Plaintiffs’ claims of misconduct against Goldman received little attention from the Court because Plaintiffs failed to make a pre-suit demand or adequately allege demand futility with particularity. Since Delaware law recognizes that the ability to bring a lawsuit on behalf of a Delaware corporation is fundamentally the purview of an independent board, a derivative plaintiff must, as a threshold matter, either demand that the Board file the lawsuit or allege facts with sufficient particularity that the Court can conclude that such demand is futile before bringing the action itself. Because the plaintiffs in Goldman Sachs did not make a demand on the Board, the Court examined the allegations in the complaint utilizing the standards for determining demand futility, which depend on whether the challenged action is one of omission or commission.
Under the Delaware Supreme Court’s landmark decision in Aaronson v. Lewis, if a plaintiff desires to challenge a conscious decision of a board, it must allege particularized facts that create a reasonable doubt that the directors are disinterested and independent or that the challenged transaction was otherwise the product of a valid exercise of business judgment. In contrast under Rales v. Blasband, a plaintiff who complains of board inaction must plead particularized facts that create a reasonable doubt that, at the time the complaint was filed, the board could not have properly exercised its independent and disinterested business judgment in responding to the demand. In Goldman Sachs, the Court analyzed the Board’s decision to approve the compensation system under Aaronson and its alleged failure to oversee Goldman’s business risk under Rales.
ENGAGING IN CHARITABLE SERVICE
In the Complaint, Plaintiffs sought to create reasonable doubt regarding disinterestedness and independence in two ways – by alleging that the Goldman Sachs Foundation (the “Goldman Foundation”) made contributions to charitable organizations with which certain directors were affiliated and that certain directors engaged in business transactions with Goldman. At the time plaintiffs filed the lawsuit, the Board consisted of twelve directors – two management directors whom the Court presumed were interested and two directors whom the plaintiffs did not allege lacked independence. As a result, to avoid the strictures of the demand rule, plaintiffs needed to allege disabling interests against at least four of the remaining eight directors.
Of the directors allegedly disqualified because they worked with charities that received contributions from the Goldman Foundation, the allegations against five of the six directors were similar. Each director served as an uncompensated member of the charitable board and the plaintiffs failed to allege that any of them actively solicited donations from Goldman or the Goldman Foundation. The paucity of allegations concerning the materiality of the contribution – either to the charity or to the director – and how such contribution would influence each director’s decision-making process was particularly concerning to the Court. The Vice Chancellor’s reluctance to infer materiality, even in the face of six-figure gifts, suggests that directors may maintain their independence even where they hold positions with fund raising objectives in charitable organizations that receive large gifts from entities at least loosely affiliated with the corporation for which they serve as a director.
The only director for whom the receipt of charitable contributions from the Goldman Foundation gave the Court pause was Ruth Simmons. Unlike the other defendants, Simmons did not passively sit on a charitable board, but serves as the President of Brown University where her livelihood depends in part on her ability to raise funds. Nonetheless, because plaintiffs did not allege with particularity that the Goldman Foundation’s donation to the University was material or that Simmons actively solicited the donation, the Court found her independent under Aaronson. This holding is instructive because even a director whose livelihood depends on her ability to raise capital and whose principal employer received substantial capital (in excess of $200,000) from an entity affiliated with the corporation on which she serves, did not automatically face disqualification. Plaintiffs apparently will have to allege particularized facts that demonstrate the materiality of the funds received by the charity (i.e. a threshold based on the percentage of the funds received from the corporation or its affiliate of the total funds received by the charity) and that the donation might impact her decision-making process on the Board.
Two important lessons seem to emerge from Goldman Sachs. First, the Court emphasized that under Aaronson and contrary to the more generalized standard necessary to state a claim, a plaintiff seeking to plead demand futility must state its allegations with particularity. As a practical matter, this may require substantial pre-filing investigation, not only of the corporation and its directors, but also of the charities on which they serve in order to allege the materiality of the donation with any specificity. Second, the decision implies that a more direct connection between the charitable giving and corporate service may help lower the materiality threshold. As the Court observed, the Goldman Sachs Foundation was independent of Goldman and managed by a board that consisted of at least of a majority of directors who never were or no longer were affiliated with Goldman. Though plaintiffs alleged that the Board controlled the Goldman Foundation, the Court disregarded the conclusory allegation, requiring instead specific factual allegations demonstrating such domination. Presumably a donation to the charity directly from the corporation would lower the materiality threshold and enhance the potential to create a disabling interest. The plaintiffs in Goldman Sachs did not make sufficiently particularized allegations for the Court to reach such a conclusion in this case.
ENGAGING IN BUSINESS RELATIONSHIPS WITH THE CORPORATION
Plaintiffs also tried to plead demand futility based on three directors’ business dealings with Goldman. Specifically, plaintiffs claimed that Goldman’s alleged investment of at least $670 million in funds managed by a Goldman director, its investment of at least $600 million in a fund advised by a Goldman director, and its provision of billions of euros in financing to a company in which a third Goldman director served as President and Chief Executive Officer, rendered these directors interested and lacking independence under Aaronson. Although these types of allegations (i.e. a significant financial relationship between the allegedly independent director and the corporation), are traditionally viewed as disabling, Vice Chancellor Glasscock found the allegations in the complaint wanting.
With respect to the director whose company borrowed significant amounts of money from Goldman, the Court observed that Goldman is an investment bank and simply borrowing money in a series of market transactions does not disqualify a director under Aaronson. The Court noted that in the absence of allegations that the financing terms were below market, that the director’s company could not obtain financing from other sources, or that the Goldman loans constituted a substantial portion of the company’s funding, Goldman was more dependent on the director (for future fees generated by underwriting his company’s debt offerings) than the director was dependent on Goldman (for future financing). Again, the Court looked for particularized allegations from which it could conclude a lack of independence and found none because plaintiffs limited their allegations to the existence of a financing relationship and did not focus on the materiality, terms, or impact of such relationship on the director.
Similarly the Court refused to infer that a fund manager relied on the management of such funds for his livelihood in the absence of specific factual allegations to that effect. The absence of specific allegations with regard to the timing of the investment appeared to concern the Court as it was not clear from plaintiffs’ allegations when the investment occurred. The paucity of allegations concerning the investment-advisor-director also troubled the Court, which observed that plaintiffs did not allege that the director derived a substantial benefit from serving as an advisor, that he solicited funds from Goldman, that the fund received money from Goldman because of his involvement, or that his future employment with the fund was dependent on Goldman’s investment. Taking a formalistic approach, the Court acknowledged that specific factual allegations concerning these business relationships could demonstrate interestedness, but declined to reach such conclusion on the record before it.
RESPONSIBILITY FOR MANAGING BUSINESS RISK
Plaintiffs also brought a Caremark claim questioning the Board’s oversight of Goldman’s risky business practices. The Court analyzed the allegations of this claim under Rales’ standard for demand futility and found them insufficient to demonstrate demand futility because, the Court held, the Board could exercise its independent and disinterested business judgment in responding to a demand.
In reaching this conclusion the Court also considered whether a board’s Caremark duties include a duty to monitor business risk as opposed to the well-settled duty to monitor corporation’s compliance with applicable law. Quoting Caremark, the Court observed that directors may have a duty to be reasonably informed about a corporation’s compliance with law and its business performance. The Court reluctantly acknowledged the theoretical existence of such claim, but declined to reach the ultimate conclusion about whether Caremark imposes a duty to monitor business risk, because the facts plead in the complaint did not give rise to a Caremark claim. The Court noted, however, that “it would be, appropriately, a difficult cause of action on which to prevail” that would require proof of either a board’s conscious failure to implement any reasonable monitoring system or a conscious disregard of red flags raised by such a system because the appropriate amount of risk borne by the corporation falls squarely within the business judgment of the board. That the Board made decisions to hedge exposure during the deterioration of a housing market that left Goldman vulnerable to large risks, including reputational risks, did not demonstrate that directors consciously disregarded their oversight obligations, even if Caremark recognized a duty to monitor business risk.
CONCLUSION
Goldman Sachs provides useful guidance for directors who wish to serve on charitable boards that receive donations from the corporations they serve or enter into business relationships with the corporation. Such activities likely will not automatically to render a director interested. Before questioning a director’s independence in the context of a demand futility analysis, the Court of Chancery will require specific, particularized allegations demonstrating interestedness; consistent with the Court’s fundamental deference to the business judgment of directors of Delaware corporations. Even if directors make reasonably informed decisions that expose corporations to significant risk, the Court will not substitute its business judgment for the board’s absent specific allegations of disinterestedness or lack of independence.
Reprinted with permission from the November 16, 2011 issue of Delaware Business Court Insider. (c) 2011 ALM Media Properties, LLC. Further duplication without permission is prohibited.