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DC Circuit Upholds Dismissal of Derivative Suit Against Fannie Mae Executives
Pirelli Armstrong Tire Corp. Retiree Medical Benefits Trust v. Franklin D. Raines
No. 07-7108, U.S. Court of Appeals for the D.C. Circuit, 07/31/2008
Companies Mentioned: Federal National Mortgage Association, Pirelli Armstrong Tire Corporation Retiree Medical Benefits Trust, Wayne County Employees' Retirement System
Holding
The U.S. Court of Appeals for the DC Circuit affirmed the dismissal of a shareholder lawsuit against directors of Fannie Mae over accounting irregularities and the $31 million in severance packages for the company's former Chief Executive Officer ("CEO"), Franklin D. Raines, and Chief Finance Officer ("CFO"), J. Timothy Howard. The DC Circuit held that the shareholders, led by the Wayne County Employees' Retirement System in Michigan and Pirelli Armstrong Tire Corp. Retiree Medical Benefits Trust, can sue on behalf of the corporation only after first making a demand on the board of directors to pursue the compensation claims itself. The DC Circuit rejected the shareholders' argument that they could not make such prior demand because a majority of the 13 directors could not render a disinterested and independent decision. Allegations of missed "red flags'' and claims that Raines controlled a majority of the board were not supported by the evidence and dif not create a reasonable doubt about the board's independence to consider a demand. On the basis of the foregoing, the DC Circuit affirmed the judgment of dismissal by the US District Court for the District of Columbia.
Detailed Summary
Fannie Mae is a federally chartered corporation authorized by Congress in 1934 and created in 1938. Initially established as a public entity, Fannie Mae was privatized in 1968. Fannie Mae thus has shareholders, directors, and officers like other non-governmental corporations. Opinion, p. 3.
Fannie Mae’s mission is to increase affordable housing for moderate- and low-income families. It purchases mortgages originated by other lenders and helps lenders convert their home loans into mortgage-backed securities. The goal is to provide stability and liquidity to the mortgage market. This allows mortgage lenders to provide more loans, thereby increasing the rate of homeownership in America. Id.
In this case, certain Fannie Mae shareholders, the appellants in this appeal, filed a derivative suit on behalf of Fannie Mae against the company’s directors. The complaint accused the directors for failing to prevent accounting irregularities. The complaint also challenged the directors’ decision to approve severance arrangements for two Fannie Mae officers, appellee Raines and Howard. Id., p. 2.
The parties agreed that Delaware law provides the substantive standards for evaluating plaintiffs’ complaint. Shareholders ordinarily must make a demand on the company’s board of directors in order to bring a derivative suit. Although these shareholders did not make such a demand, the law does not require demand when it would be futile. Appellants argued that demand was excused in this case because a majority of the directors could not render a disinterested and independent decision whether to pursue those claims. But consistent with the long-standing principle that directors and not shareholders manage a corporation, the Delaware precedents on demand futility make clear that the bar is high, the standards are stringent, and the situations where demand will be excused are rare. Id., p. 3.
After applying Delaware precedents, the district court found that appellants’ complaint failed to meet the test for demand futility and dismissed the case. Thus, appellants brought this appeal to seek a reversal of the district court’s dismissal of their complaint.
On the accounting-related claims, appellants claimed that the directors ignored a $200 million audit difference originating in 1998. Id., p. 16, citing Second Am. Comp. at ¶¶ 28-30. That year, Fannie Mae incurred $440 million of expenses on its mortgage holdings. Id. at ¶ 28. Instead of adjusting its income by $440 million, Fannie Mae adjusted its income by $240 million and deferred the remaining expenses to subsequent years. Id. at ¶ 29. Deferring the expenses and engaging in other manipulative accounting practices enabled Fannie Mae to meet its performance target and thus increased the company executives’ incentive-based compensation. Id. at ¶¶ 31-32.
Under Delaware law, directors are insulated from liability when they rely in good faith on the opinions of outside experts who are acting within their expertise. Opinion, p, 17, citing DEL. CODE ANN. tit. 8 § 141(e); Brehm v. Eisner, 746 A.2d 244, 261-62 (Del. 2000). According to the DC Circuit, the complaint shows that the Audit Committee relied on its tax and accounting firm’s (KPMG LLP) opinions with respect to the audit difference, which turned this allegedly red flag into a green flag. Id.
Appellants further alleged that the Assets and Liabilities Policy Committee – another standing committee of the Board of Directors – should have known that management was using improper “hedge accounting” practices. According to appellants, Fannie Mae’s executives improperly applied “hedge accounting” principles to its financial instruments, thereby spreading the company’s losses on derivatives over a number of years rather than booking them immediately. The DC Circuit however found that this allegation did not create a substantial likelihood of personal liability under the standards of Delaware law for director oversight claims. The DC Circuit reasoned that the complaint merely alleged that the directors should have known about the accounting violations even though KPMG assessed the implementation of this accounting policy. Id.,p. 18, citing Second Am. Comp. at ¶¶ 256-57, 399.
With respect therefore to the accounting-related claims, the DC Circuit found the complaint failed to establish a substantial likelihood of personal liability for the outside directors. Therefore, under Delaware law, the accounting-related allegations did not create a reasonable doubt about the disinterestedness of the Board to consider a demand with respect to those claims. Id., p. 19.
On the severance-related claims, appellants alleged that the directors’ decisions to allow Raines and Howard “to resign or retire with more than $31 million in severance benefits” and to absolve the executives of their “legal obligation to disgorge compensation that they had procured via accounting manipulations and insider trading” create a “reasonable doubt” that they were the product of a valid business judgment by the directors .Id. p. 20, citing Plaintiffs’ Br. at 29; Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984).
The business judgment rule establishes a “presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” Id., p. 20, citing Aronson, 473 A.2d at 812.
But the DC Circuit rejected appellants’ argument, stating that appellants failed to allege particularized facts that demonstrated that the process was similarly flawed or that the directors acted without adequate information or deliberation. The complaint itself acknowledged that the termination decision was made in a series of board meetings held over several days. Id., p. 21, citing Second Am. Comp. at ¶ 414. Thus, on the severance-related claims, the complaint failed to create a reasonable doubt about the Board’s disinterestedness to consider a demand because it failed to create a reasonable doubt whether the Board exercised a “valid business judgment.” Id. , p. 23.
Finally, appellants argued that nearly all of the 10 outside directors lacked the necessary “independence” to evaluate the demand because (1) the Raines-controlled Fannie Mae Foundation made charitable donations to non-profit organizations affiliated with individual Board members, (2) the directors had other conflicting business and personal relationships with each other, and (3) Raines otherwise controlled and dominated the directors. Id., p. 24, referring to Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993) ; Aronson, 473 A.2d at 814. “
The DC Circuit again rejected this argument, stating that the basic hurdle for appellants stemmed from the fact that the kinds of relationships alleged in the complaint exist at many companies. The DC Circuit explained that directors tend to be experienced and accomplished business persons; those individuals also tend to be comparatively wealthy and have a wide range of professional and charitable affiliations and relationships. Id., pp. 23-24. It is usually considered in the interests of corporations and their shareholders to attract experienced and accomplished business leaders as directors. So as not to preclude service by such persons, Delaware law creates a very high bar for using the kinds of relationships alleged here as a basis for finding a lack of independence and thereby excusing demand in a derivative suit. Id.
The commonplace business, professional, and personal relationships alleged in this case were not remotely sufficient under Delaware law to disqualify the challenged directors from evaluating demand in an independent manner. In sum, under the standards set forth by Delaware law, the complaint’s allegations did not create a reasonable doubt about the Board’s independence to consider a demand.
On the basis of the foregoing, the DC Circuit affirmed the district court’s judgment dismissing the complaint.
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