October 28, 2008
Directors and Risk-taking
Posted by Gordon Smith

In my continuing effort to explore the connection between the financial crisis and fiduciary duty (see here and here for initial steps), I was interested to read David Rosenberg's paper, Supplying the Adverb: Corporate Risk-Taking and the Business Judgment Rule. In this paper, David explores the effect of judicial review of corporate decision making on the willingness of corporate managers to take risks, and he concludes that "courts are perfectly well-equipped to hear cases in which aggrieved shareholders claim that directors took improper risks in ways that ought to result in liability for those directors."

Note the key word in that sentence: improper.

The crux of David's argument is that the business judgment rule should not shield directors from liability for all risk taking, only appropriate risk taking. The Delaware courts routinely justify the business judgment rule on the ground that it is designed to encourage managerial risk taking, but David argues that the Delaware courts ignore their own standards if they insulate directors from liability for excessive risk taking. Obviously, the big question then becomes, what is "excessive risk taking"?

To answer that question, David turns to Stone v. Ritter, arguing that the standard of bad faith articulated there includes "knowing lack of care." David cites an excellent recent article by Claire Hill and Brett McDonnell on the subject, Stone v. Ritter and the Expanding Duty of Loyalty, 76 Fordham L. Rev. 1769 (2007). In that article, Claire and Brett imagine fiduciary duty cases as lying along a continuum of disloyalty. On the one end are classic loyalty cases, in which a director steals from the corporation. On the other end lie "classic duty of care cases[, which] also involve a director taking for herself something which should otherwise be the corporation’s: her attention and diligence." Under this version of Stone, loyalty has become an expansive concept that would permit a court to impose personal liability on directors in the following circumstances (quoting from David's paper):

Operating in an environment in which it is accepted that risky decisions often end in failure, corporate directors can still take those kinds of risks without fear that such failure will result in personal liability for them. What they plainly cannot do is choose a risky course of action knowing that the decision is a bad one or knowing they have not taken care to evaluate whether or not the risks involved will benefit the corporation.

This seems like a perfectly acceptable reading of Stone, though I suspect the number of cases in which directors would, as a factual matter, be found to have acted with a "knowing lack of care" is close to zero. This is not the sort of case in which Delaware courts seem inclined to lean toward the plaintiffs because the costs associated with a false positive -- chilling future boards from taking risks -- is much higher than the costs associated with a false negative -- failure to compensate plaintiffs in a particular case.

Returning to the issue that animates this series of posts, could we do better under a federal corporate law regime? I don't see how. David is calling for a very precise evaluation of board action, and the evaluation would not become easier just by transferring decision making power to a federal agency or court.

Corporate Governance, Corporate Law, Delaware | Bookmark

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