By Nicholas G. Borelli
MARCH 16, 2023
Fifteen years ago today, Bear Stearns—a global investment bank—taught the world that with great risk comes a great demise as that over leveraged entity was bought out by JP Morgan Chase. Bear Stearns was emblematic of other financial institutions after it became over leveraged at a ratio of 35 to 1 as a result of betting on mortgage-backed securities. A leverage ratio such as that is enough to give even the most laid-back accountant a panic attack. When the residential mortgage market collapsed, stockholders of these financial institutions felt the pain. Stockholders and other entities turned to the Delaware Judiciary to figure out what actually happened when companies that are “too big to fail” collapse.
A Crash Course On The Great Recession
The Great Recession has been depicted in stunning detail in several novels, but the collapse of the residential mortgage market can be simply compared to another catastrophe: the Titanic. The World’s first example of “too big to fail” was a ship so grandiloquently designed and its engineers neglected to consider the worst-case scenarios. Much like the Titanic, there were not enough lifeboats to save the innocent stockholders and American Citizens attempting to achieve the American Dream that never came true.
At the epicenter of the collapse were subprime mortgages being sold to Americans in an environment of increasing home prices and low interest rates. These mortgages were then bundled into mortgage-backed securities, the riskiest were known as collateralized debt obligations (“CDOs”), which were sold to investors for an interest rate. In an effort to hedge exposure, financial institutions began to purchase credit default swaps (“CDS”), which was insurance on the CDOs if they were to fail. These CDSs were largely sold by AIG. Eventually, these financial institutions ran out of mortgages to put in these CDOs so they would “entice” investors to pick a certain number of mortgages and package them into a synthetic CDO, which could be wagered on with a CDS. Once the prices of homes began to drop and interest rates began to rise, individuals began to default on their mortgages which led to the unraveling of the mortgage-backed securities market. Many financial institutions were over exposed to mortgage-backed securities and began to fail or feel significant financial pain as a result of the increased rate of defaults.
Citigroup’s Effect on Caremark
Naturally, Caremark claims seemed to be the perfect place for stockholders to obtain relief. Caremark, notoriously one of the hardest claims in Delaware law to plead, sets oversight duties on the board of directors and management to utilize their business judgment to create and monitor a reasonable reporting system. The idea is simple, directors need to create long-term value to their stockholders; therefore, directors must create a reasonable system of internal controls to ensure criminal and fraudulent activity is reported so potential harm to the stockholders can be mitigated.
In Citigroup, the plaintiffs alleged the directors failed to monitor the risk of mortgage-backed securities and failed to act in the face of news that the residential mortgage was collapsing. In an effort to protect business judgment, the Delaware Court of Chancery held:
The Delaware Supreme Court made clear in Stone that directors of Delaware corporations have certain responsibilities to implement and monitor a system of oversight; however, this obligation does not eviscerate the core protections of the business judgment rule—protections designed to allow corporate managers and directors to pursue risky transactions without the specter of being held personally liable if those decisions turn out poorly.
The court stated that the plaintiffs did not plead how the Citigroup’s board failed to create a reasonable system of internal controls. But, the court refused to make a hindsight conclusion that would second-guess management who were forced to make a decision in a world of imperfect information and people. Further, the court stated the directors were allowed to use their business judgment to justify their company’s exposure to risk. The court refused to make hindsight judgment’s by “equat[ing] a bad outcome with bad faith.”
Goldman Sach’s Impact on Breach of Fiduciary Duty and Waste of Corporate Assets
Goldman Sachs took a bite from the same poisonous apple, over exposure to CDOs, as its competitors and began to experience a new level of financial pain incapable of comprehension by Adam Smith. Interestingly, stockholders brought claims for a breach of fiduciary duty against Goldman Sachs for creating a compensation structure that shifted the focus of the company away from generating long-term shareholder value. In addition, the stockholders of Goldman Sachs brought a claim of waste because management’s exposure to risk was not done to benefit the stockholders. With that being said, Goldman Sachs did maintain a leverage ratio of 25 to 1 in 2007, which was the worst among its competitors. The defendants, responding to those allegations, brought motions to dismiss under Delaware Court of Chancery Rules 12(b)(6) and 23.1.
The court reviewed the challenges to the compensation structure using Aronson, which is a two pronged test. Under the first prong, the court held that plaintiffs failed to prove with particularity that the board acted in its own self-interest when approving the compensation structure. Turning to the second prong of Aronson, the court rejected the allegations that basing employment compensation on a proportion of the revenue earned was done in bad faith because there was no proof that the defendant’s acted against the interests of the stockholders. The court also rejected claims that the board was not adequately informed because they did not use certain metrics to justify compensation because the pleadings proved the board was adequately informed by using other metrics.
Turning to the waste claim, plaintiffs alleged that the high levels of compensation for employees was so unreasonable that the board’s decision to provide this level of compensation was not an exercise of its business judgment. Plaintiffs pleadings were based on three different arguments: (1) Goldman Sachs’ payment per employee was higher than its peers, (2) the compensation should be compared to its peers, and (3) that the earnings and compensation were the direct result of risky trading. The court found no particularized allegations that an individual, rather an average of Goldman Sachs’ employees, received excessive compensation despite some of the employees not carrying out “God’s work[.]” Also, the court held that even if other hedge funds would have been adequately comparable to Goldman Sachs, the differences in compensation was not so excessive to constitute waste.
Challenging Settlements As A Result Of The Countrywide Acquisition
Countrywide Financial Corporation (“Countrywide”) was once one of the nation’s leading underwriters of mortgages, but it began running into major liquidity issues by 2007. In need of hero, The Bank of America Corporation (“Bank of America”) agreed to surgically inject the $2 billion into Countrywide in exchange for a 16% stake. The following year Bank of America purchased all of the stock in Countrywide for $4 billion. Within days, plaintiffs filed a consolidated class action lawsuit against the board of Countrywide for breach of fiduciary duties by accepting the merger agreement with Bank of America. By 2008, the stockholders had reached a proposed settlement which allowed the merger to go through and stipulated that any potential members of the class lost the ability to bring certain claims on behalf of Countrywide.
Prior to the settlement of the lawsuit in Delaware, another group of plaintiffs (the “California Plaintiffs”) had brought suit in the United States District Court for the Central District of California. When the settlement of the Delaware suit occurred, the California Plaintiffs lost standing to challenge the merger. The California Plaintiffs and another stockholder, SRM Global Fund Limited Partnership (“SRM”), objected to the proposed settlement.
The Delaware Court of Chancery then considered the objectors claims in light of the Polk Factors:
The considerations applicable to [determine the reasonableness of a settlement] include: (1) the probable validity of the claims, (2) the apparent difficulties in enforcing the claims through the courts, (3) the collectibility [sic] of any judgment recovered, (4) the delay, expense and trouble of litigation, (5) the amount of the compromise as compared with the amount and collectibility [sic] of a judgment, and (6) the views of the parties involved, pro and con.
The court recognized that the allegations brought by the California Plaintiffs are difficult to win because of the ability for directors to exercise their business judgment. In light of that standard, the court stated that the California Plaintiffs had not provided any evidence that Bank of America’s payment to Countrywide’s stockholders was unfair. Also, the California Plaintiffs did not prove that the board’s decision to sell the entire company, rather than auction off some of the assets, objectionable. The court found that the California Plaintiffs’ claims did not overcome the presumption of the business judgment rule because there was not enough evidence to prove the directors conduct was so egregious to rebut the presumption.
Turning to the SRM objection, the court needed to consider whether the preclusive effect of a non-opt out class action settlement would violate the Fourteenth Amendment Due Process clause. The court detailed the careful process of approving a class action settlement under Delaware Court of Chancery Rule 23 to ensure the due process rights of the class members. The court held that the unique necessity of SRM to prove reliance in its common law fraud claim was an individual question that would not be answered by the adjudication of the equitable claims brought in the Countrywideaction. Having said this, the court refused to certify the class under Rule 23(b) because precluding SRM’s claims predominate over the equitable claims.
While all of these cases were brought under different legal theories, there is one underlying issue with all of these companies: risk management. Inherent in risk management is the idea of business judgment. Corporate involvement in the Great Recession was a hot button topic in the Court of Public Opinion, a jurisdiction where hindsight determinations are allowed, but Delaware is different. The Delaware Court of Chancery excellently balanced the interests of stockholders against the business judgment rule to determine the correct application of Delaware law and these cases are still relied on today.
 Robin Sidel et al., J.P. Morgan Buys Bear in Fire Sale, As Fed Widens Credit to Avert Crisis, Wall St. J. (Mar. 17, 2008), https://www.wsj.com/articles/SB120569598608739825?mod=Searchresults_pos8&page=1.
 William F. Cohan, How We Got the Crash Wrong, The Atlantic (Jun. 15, 2012), https://www.theatlantic.com/magazine/archive/2012/06/how-we-got-the-crash-wrong/308984/.
 In re Bear Stearns Companies, Inc. S’holder Litig., C.A. No. 3643-VCP, 2008 WL 959992, at *2 (Del. Ch. Apr. 9, 2008) (stating that Bear Stearns’s stock was trading at $57 per share on March 14, 2008, and JP Morgan acquired Bear Stearns for $2 per share two days later).
 Ryan Barnes, The Fuel That Fed the Subprime Meltdown, Investopedia (June 24, 2022), https://www.investopedia.com/articles/07/subprime-overview.asp (stating that some subprime mortgages came with adjustable rates that began at affordable rate but would explode into unaffordable premiums once the teaser rate expired).
 Michael Lewis, The Big Short: Inside The Doomsday Machine 72–84 (2011) (stating that the creation of a CDO involves gathering a massive amount to subprime mortgages to convince the rating agencies that this new security was diversified and not as risky as the underlying loans may seem).
 Andrew Ross Sorkin, Too Big To Fail: The Inside Story of How Wall Street And Washington Fought To Save The Financial System – And Themselves 160–61 (2010).
 Lewis, supra note, 1 at 75–78. These synthetic CDOs included subprime mortgages from already existing CDOs. Id.
 What Was the Financial Crisis of 2007–2008? Causes, Outcomes & Lessons Learned, TheStreet (Oct. 8, 2022), https://www.thestreet.com/dictionary/f/financial-crisis-2007-2008.
 In re Caremark Int’l. Inc. Derivative Litig., 698 A.2d 959, 967 (Del. Ch. 1996).
 Id. at 967 (describing Caremark claims as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”); Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362, 370 (Del. 2006) (stating that directors will be liable under Caremark when the plaintiff proves with sufficient particularity that: “(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.”); In re McDonald’s Corp. S’holder Deriv. Litig., C.A. No. 2021-0324-JTL, 2023 WL 387292, at *9–14 (Del. Ch. Jan. 26, 2023) (extending a stockholder’s ability to bring Caremark claims against executives).
 Caremark, 698 A.2d at 967–70.
 In re Citigroup Inc. S’holder Deriv. Litig., 964 A.2d 106, 114–15 (Del. Ch. 2009).
 Citigroup, 964 A.2d at 125.
 Id. at 123–26.
 Id. at 125–26.
 Id. at 120–31; Stone, 911 A.2d at 373.
 In re Goldman Sachs Group, Inc. S’holder Litig., No. 5215-VCG, 2011 WL 4826104, at *3–5 (Del. Ch. Oct. 12, 2011). Plaintiffs also brought Caremark claims, but those claims need not be repeated because Citigroup came to a similar conclusion. Id. at *18–23; Citigroup, 964 A.2d at 120–31.
 Goldman, 2011 WL 4826104, at *3–5. Plaintiffs alleged that Goldman Sachs’ short-term success came from over leveraging and exposure to CDOs. Id. at *4. In addition, plaintiffs claimed that management benefited from this growth at a substantially higher level than the 2% dividend received by stockholders. Id.
 Goldman Sachs, 2011 WL 4826104, at *4.
 Id. at *5–7; Ct. Ch. R. 12(b)(6); Ct. Ch. R. 23.1 (stating that the plaintiffs need to prove particular facts that they can bring a lawsuit on behalf of the corporation because filing a demand on the board would have been futile).
 Goldman Sachs, 2011 WL 4826104, at *7–12.
 Id. (analyzing plaintiffs’ claims that the board members had an interest in approving the compensation structure because some of the directors had “significant financial relationships” with Goldman Sachs, others were interest when Goldman Sachs had made charitable donations to charities that some directors were affiliated with, and a few directors were interest from other financial interactions with Goldman Sachs); Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984).
 In re J.P. Morgan Chase & Co. S’holder Litig., 906 A.2d 808, 824 (Del. Ch. 2005) (stating that plaintiffs must plead “particularized facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision.”) (quoting In re Walt Disney Co. Deriv. Litig., 825 A.2d 275, 286 (Del. Ch. 2003); Aronson, 473A.2d at 812–814.
 Goldman Sachs, 2011 WL 4826104, at *14 (“The decision as to how much compensation . . . is a core function of a board of directors exercising its business judgment. The Plaintiffs’ pleadings fall short of creating a reasonable doubt that the [defendants] have failed to exercise that judgment here.”).
 Id. at 15–16 (“At most, the Plaintiffs’ allegations suggest that there were other metrics not considered by the board that might have produced better results. The business judgment rule, however, only requires the board to reasonably inform itself; it does not require perfection or the consideration of every conceivable alternative.”).
 Id. at *16; Citigroup, 964 A.2d at 136 (stating that “the plaintiff must overcome the general presumption of good faith by showing that the board’s decision was so egregious or irrational that it could not have been based on a valid assessment of the corporation’s best interests.”).
 Goldman Sachs, 2011 WL 4826104, at *16.
 Id. at *16–18.
 Id. at *17.
 In re Countrywide Corp. S’holder Litig., C.A. No. 3464-VCN, 2009 WL 846019, at *1 (Del. Ch. Mar. 31, 2009).
 Id. at *2.
 Countrywide, 2009 WL 846019, at *3–4.
 Id. at *4.
 Id. at *4–6. The California Plaintiffs have objected the to the merger on two grounds. Countrywide, 2009 WL 846019, at *7. First, the directors of Countrywide breached their fiduciary duties by not valuing the shares of Countrywide prior to the merger. Id. at *7–10. Second, granting the proposed merger would leave the former stockholders of Countrywide with insufficient value because any successful derivative claim would be reduced by their proportional value of ownership in Bank of America, which is 2% of the outstanding shares. Id. SRM objected to granting the settlement because SRM’s common law claims predominated over the equitable claims being sought in Delaware. Id. at *10–13.
 Countrywide, 2009 WL 846019, at *6; Polk v. Good, 507 A.2d 531, 536 (Del. 1986).
 Polk, 507 A.2d at 536.
 Countrywide, 2009 WL 846019, at *8–9.
 Id. at *9.
 Countrywide, 2009 WL 846019, at *10 (stating that Fourteenth Amendment issues arise with non-opt out class settlements because the granting of a settlement precludes the claims of other potential class members who have not had their day in court); U.S. Const. amend. XIV, § 1.
 Countrywide, 2009 WL 846019, at *10 (citing Ct. Ch. R. 23).
 Id. at *10–13.
 Id. at *10–15.