Monetary Liability for Breach of the Duty of Care?

Holger Spamann is Professor of Law at Harvard Law School. This post is based on a recent article by Professor Spamann.

Corporate governance eschews monetary liability for breach of the fiduciary duty of care by corporate directors and officers. In the US and many other jurisdictions, the bar to liability is explicit: the Business Judgment Rule shields directors and officers from liability for bad business decisions except in the most egregious cases. In other jurisdictions, the bar results from procedural and other hurdles to recovery. In theory, private contractual arrangements could substitute arbitration under tailored standards of liability for court-imposed liability, but in practice, they do not. In fact, the charters of large US corporations routinely reinforce the Business Judgment Rule with express waivers of directors’ monetary liability. Finally, corporations provide insurance and indemnification against any remaining risk of out-of-pocket liability.

In an article just published in the Journal of Legal Analysis, I clarify the efficiency rationale for this ubiquitous exclusion of monetary liability for breach of the duty of care. A rigorous analysis shows that the complete exclusion of liability for bad business decisions can only be justified by high litigation costs and not, as is commonly assumed, by a concern for skewed incentives, particularly incentives for risk-taking. In the standard principal-agent model of corporate governance, properly calibrated partial liability would unambiguously improve the incentives of directors and managers. While judicial or other third-party evaluations of directors’ and managers’ actions are subject to errors and manipulation, so are stock prices, accounting numbers, and other feasible inputs (“signals”) to incentive schemes. When multiple imperfect signals are available, however, it is optimal to use all of them to maximize the signal-to-noise ratio. Biases can be offset through appropriate weights and adjustments. The bottom line is that the only possible reason not to use (partial) liability is administrative costs.

The article’s starting point is the foundational problem of corporate governance: how to motivate directors and managers to run the corporation for the benefits of shareholders rather than their own. Contracts cannot specify most desirable actions ex ante. Instead, managers are incentivized to maximize shareholder value by performance pay tied to signals of desirable behavior, typically stock returns and accounting profits. Increasingly, directors receive equity awards as well. Stock prices and accounting figures, however, depend not only on the decisions of directors and managers but also and perhaps mostly a host of other factors beyond their control. Moreover, directors and managers can (legally) manipulate these signals through discretionary disclosures and accounting choices, as well as (potentially wasteful) real actions such as accelerating sales or delaying R&D. These problems are severe enough to fuel a vehement and longstanding debate about corporate governance in general and executive compensation in particular. Consequently, there is room for improving incentives by tying payoffs also to an additional, fully or partially independent signal. There is hardly a more direct signal of the appropriateness of an action than an evaluation by a court or other third party, such as an arbitrator. A regime of judicially administered liability (or rewards, for that matter) harnesses this signal and enhances its precision through litigation’s information-generating mechanisms, in particular discovery.

The key point here is that liability can be partial. Full liability would quite obviously be a bad idea, but it is not how we use other signals either. Rather, exposure to judicial findings could be scaled appropriately, just like existing incentive schemes scale down exposure to the stock price or accounting figures. To illustrate, consider a multi-billion dollar corporation whose managers and directors are incentivized by holdings of restricted stock. If the stock price drops by one billion dollars, managers and directors do not lose one billion dollars; rather, they only suffer a loss proportional to their ownership stakes. Moreover, the link to ownership is usually not mechanical, as standard compensation schemes further calibrate incentives with options and cash payments. Similar scaling and calibration could be applied to judicial findings of good or bad behavior. It is equally important to recognize that an appropriate use of judicial findings would not merely superimpose liability on existing incentive schemes but adjust the latter as well. For example, a new compensation scheme could provide that managers and directors will suffer a reduction in wealth only if the stock price drops and a court finds that the drop was due to a managerial mistake. Unless courts are completely incapable of assessing managerial actions—an unlikely proposition—, this will reduce managers’ and directors’ exposure to mere back luck. Such filtering will in itself improve incentives. In addition, it will allow scaling up pay sensitivity while keeping risk constant relative to a scheme that only uses the stock price. This will further improve incentives. In short, calibrated use of the judicial signal in combination with other inputs will improve, not reduce, incentives for risk-taking and other valuable actions by managers and directors by reducing payment for luck and punishment for bad luck.

The argument against liability thus boils down to a cost-benefit trade-off. The administrative cost of liability—litigation—is high. By contrast, its marginal benefits are likely to be low in public corporations. Courts have difficulty evaluating business decisions, making for a noisy signal. A noisy signal adds little value when fairly precise signals are already available, in particular the stock price and accounting measures, and when governance mechanisms other than incentives limit the agency problem. At the same time, recognizing the cost-benefit trade-off also points to areas where liability might be an appealing governance tool after all. In particular, the cost-benefit trade-off is more favorable when the judicial signal is more precise or when the other signal is less precise, such as for unlisted entities or worse accounting regimes. The cost-benefit trade-off also becomes more favorable as the underlying agency conflict becomes more severe. In this perspective, stringent liability for “conflicted transactions” under the technically separate duty of loyalty or similar regimes is merely one end of a spectrum analyzed in my article.

Details of the cost-benefit trade-off differ between outside directors and inside managers (who may or may not be directors as well). For the most part, my article does not distinguish them, however, because the conceptual analysis arguably applies to both. Both directors and managers are supposed to exercise their corporate power for the benefit of shareholders, but both may be swayed by personal interests such as laziness, reputation, or pet projects instead. To be sure, it is possible that loyal boards already perform the sort of third-party evaluations of managers’ actions that my article imagines courts to do. But there is pervasive concern that boards are captive to insiders, and in any event the board might have to allow judicial vetting (instead of discretionary bonuses) to commit itself to an incentive plan.

The full article is available here.

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