Why is it that every headline case of corporate losses these days gets people speculating about the loser's Caremark exposure? Case in point: JP Morgan prompted Stefan Padfield to ask "Should an inability to fully understand the risk exposure of a particular strategy or financial instrument constitute a per se violation of Caremark?" He further reports that his "current inclination is to answer that question in the affirmative."
Padfield's post prompts me to comment because, as he kindly observes, I have "noted (here), while the duty has typically been understood to cover violations of the law, there is a good argument to be made for including oversight of risk management."
As Padfield thus observes, I have argued that:
The Caremark decision asserted that a board of directors has a duty to ensure that appropriate "information and reporting systems" are in place to provide the board and top management with "timely and accurate information." Although post-Caremark opinions and commentary have focused on law compliance programs, risk management programs do not differ in kind from the types of conduct that traditionally have been at issue in Caremark-type litigation.
As Padfield also observes, however, I have also argued that:
Risk management failures do differ in degree from law violations or accounting irregularities. In particular, risk taking and risk management are inextricably intertwined. Efforts to hold directors accountable for risk management failures thus threaten to morph into holding directors liable for bad business outcomes.Caremark claims premised on risk management failures thus uniquely implicate the concerns that animate the business judgment rule's prohibition of judicial review of business decisions. As Caremarkis the most difficult theory of liability in corporate law, risk management is the most difficult variant ofCaremark claims.
In the article to which Padfield refers, I explained that:
Just because a firm has the ability to reduce risk does not mean that it should exercise that option. As the firm’s residual claimants, shareholders do not get a return on their investment until all other claims on the corporation have been satisfied. All else equal, shareholders therefore prefer high return projects. Because risk and return are directly proportional, however, implementing that preference necessarily entails choosing risky projects.
Even though conventional finance theory assumes shareholders are risk averse, rational shareholders still will have a high tolerance for risky corporate projects. First, the basic corporate law principle of limited liability substantially insulates shareholders from the downside risks of corporate activity. The limited liability principle, of course, holds that shareholders of a corporation may not be held personally liable for debts incurred or torts committed by the firm. Because shareholders thus do not put their personal assets at jeopardy, other than the amount initially invested, they effectively externalize some portion of the business’ total risk exposure to creditors.
Accordingly, as Chancellor Allen explained in Gagliardi v. Trifoods Int’l, Inc., shareholders will want managers and directors to take risk:
Shareholders can diversify the risks of their corporate investments. Thus, it is in their economic interest for the corporation to accept in rank order all positive net present value investment projects available to the corporation, starting with the highest risk adjusted rate of return first. Shareholders don’t want (or shouldn’t rationally want) directors to be risk averse. Shareholders’ investment interests, across the full range of their diversifiable equity investments, will be maximized if corporate directors and managers honestly assess risk and reward and accept for the corporation the highest risk adjusted returns available that are above the firm’s cost of capital.
As the federal Second Circuit explained in Joy v. North, this understanding of shareholder risk preferences is an important part of the rationale for the business judgment rule:
Although the rule has suffered under academic criticism, it is not without rational basis. ... [B]ecause potential profit often corresponds to the potential risk, it is very much in the interest of shareholders that the law not create incentives for overly cautious corporate decisions. ... Shareholders can reduce the volatility of risk by diversifying their holdings. In the case of the diversified shareholder, the seemingly more risky alternatives may well be the best choice since great losses in some stocks will over time be offset by even greater gains in others. ... A rule which penalizes the choice of seemingly riskier alternatives thus may not be in the interest of shareholders generally.
Just as the business judgment rule insulates risk taking from judicial review, so Caremark should insulate risk management from judicial review.
Risk management necessarily overlaps with risk taking because the former entails making choices about how to select the optimal level of risk to maximize firm value. Recall that there are only four basic ways of managing risk: avoiding it by avoiding risky activities, transferring it through insurance or hedging, mitigating it, and accepting it as unavoidable. All of these overlap with risk taking. Operational risk management, for example, frequently entails making decisions about whether to engage in risky lines of business and, more generally, determining whether specific risks can be justified on a cost-benefit analysis basis. As a result, it is becoming increasingly “difficult to draw a line between corporate governance and risk management.”
The fuzzy line between risk-taking and risk management is nicely illustrated by how corporations use derivatives. On the one hand, they can be used to hedge risk. On the other hand, they can be used as speculative investments. In many cases, they can be used as both simultaneously.
As Chancellor Chandler correctly recognized in Citigroup, Caremark claims premised on risk management failures thus uniquely implicate the core concerns animating the business judgment rule in a way typical Caremark claims do not. Chancellor Chandler seemingly understood that risk management cannot be easily disentangled from risk taking, because it described plaintiffs’ claim as “asking the Court to conclude … that the directors failed to see the extent of Citigroup’s business risk and therefore made a ‘wrong’ business decision by allowing Citigroup to be exposed to the subprime mortgage market.” He declined to do so, explaining that “this kind of judicial second guessing is what the business judgment rule was designed to prevent, and even if a complaint is framed under a Caremark theory, this Court will not abandon such bedrock principles of Delaware fiduciary duty law.”
Caremark and Enterprise Risk Management (March, 18 2009). UCLA School of Law, Law-Econ Research Paper No. 09-08. Available at SSRN: http://ssrn.com/abstract=1364500
JP Morgan here suffered a loss because it took a risk. The firm was worried about its exposure to European investments, which was a perfectly reasonable concern given the on-going toxic mix of an impending recession and a seemingly unresolvable set of multiple sovereign debt crises facing the Eurozone. So it sought to hedge that risk.
JP Morgan's efforts proved unavailing. As a result, it lost money. But so what? By definition, taking risk means exposing oneself to the possibility of losing money.
Not all losses are ascribable to acts of God. To the contrary, most losses occur because people make mistakes. Primary actors commit errors of judgment and their supervisors fail adequately to provent those errors through oversight failures. In short, shit happens.
But corporate law has never imposed liability on directors just because shit happened, even when it happened because of negligence on the part of the directors. See, e.g., Joy v. North, 692 F.2d 880, 885 (2d Cir. 1982) (holding that: “While it is often stated that corporate directors and officers will be liable for negligence in carrying out their corporate duties, all seem agreed that such a statement is misleading. . . . Whatever the terminology, the fact is that liability is rarely imposed upon corporate directors or officers simply for bad judgment and this reluctance to impose liability for unsuccessful business decisions has been doctrinally labeled the business judgment rule.”); Kamin v. American Express Co., 383 N.Y.S.2d 807 (Sup.Ct.1976), aff’d, 387 N.Y.S.2d 993 (App. div.1976) (holding that the duty of care “does not mean that a director is chargeable with ordinary negligence for having made an improper decision, or having acted imprudently”); Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944) (stating that “although the concept of ‘responsibility’ is firmly fixed in the law, it is only in a most unusual and extraordinary case that directors are held liable for negligence in the absence of fraud, or improper motive, or personal interest”).
Accordingly, as Professor Bishop famously observed: “The search for cases in which directors of industrial corporations have been held liable in derivative suits for negligence uncomplicated by self-dealing is a search for a very small number of needles in a very large haystack.” Joseph W. Bishop, Jr., Sitting Ducks and Decoy Ducks: New Trends in the Indemnification of Corporate Directors and Officers, 77 Yale L.J. 1078, 1099 (1968).
In other words, it is not an "inability to understand" that gives rise to liability, even if that inability rises to the level of negligence. It is self-dealing and its ilk that more typically gives rise to liability. Hence, for example, in Parnes v. Bally Entertainment Corp., the Delaware supreme court stated that: “The presumptive validity of a business judgment is rebutted in those rare cases where the decision under attack is ‘so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.’” 722 A.2d 1243, 1246 (Del. 1999) (quoting In re J. P. Stevens & Co., Inc., 542 A.2d 770, 780-81 (Del Ch. 1988)).
Accordingly, I would argue that there is no such thing as a per se violation of Caremark. Further, I would argue that--assuming the existence of an adequate monitoring system--liability only arises where there is “a sustained or systematic failure” on the board’s part to respond to red flags that are numerous, serious, directly in front of the directors, and indicative of a corporate-wide problem. In other words, red flags that were so obvious that ignoring them "seems essentially inexplicable on any ground other than bad faith."
This interpretation of Caremark strikes me as being consistant with both Stone v Ritter and Citigroup. It also strikes me as being consistent with the rationale for the business judgment rule I developed in The Business Judgment Rule as Abstention Doctrine (July 29, 2003). UCLA, School of Law, Law and Econ. Research Paper No. 03-18. Available at SSRN: http://ssrn.com/abstract=429260, in which I explained that:
Justice Jackson famously observed of the Supreme Court: “We are not final because we are infallible, but we are infallible only because we are final.” Neither courts nor boards are infallible, but someone must be final. Otherwise we end up with a never ending process of appellate review. The question then is simply who is better suited to be vested with the mantle of infallibility that comes by virtue of being final—directors or judges?
Corporate directors operate within a pervasive web of accountability mechanisms. A very important set of constraints are provided by a competition in a number of markets. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by directors and managers. Granted, only the most naïve would assume that these markets perfectly constrain director decisionmaking. It would be equally naïve, however, to ignore the lack of comparable market constraints on judicial decisionmaking. Market forces work an imperfect Darwinian selection on corporate decisionmakers, but no such forces constrain erring judges. As such, rational shareholders will prefer the risk of director error to that of judicial error. Hence, shareholders will want judges to abstain from reviewing board decisions.
The shareholders’ preference for abstention, however, extends only to board decisions motivated by a desire to maximize shareholder wealth. Where the directors’ decision was motivated by considerations other than shareholder wealth, as where the directors engaged in self-dealing or sought to defraud the shareholders, however, the question is no longer one of honest error but of intentional misconduct. Despite the limitations of judicial review, rational shareholders would prefer judicial intervention with respect to board decisions so tainted. [As Delaware Chief Justice Veasey observes, “investors do not want self-dealing directors or those bent on entrenchment in office. . . . Trust of directors is the key because of the self-governing nature of corporate law. Yet the law is strong enough to rein in directors who flirt with abuse of that trust.” E. Norman Veasey, An Economic Rationale for Judicial Decisionmaking in Corporate Law, 53 Bus. Law. 681, 694 (1998).]
The affirmative case for disregarding honest errors thus simply does not apply to intentional misconduct. To the contrary, given the potential for self-dealing in an organization characterized by a separation of ownership and control, the risk of legal liability may be a necessary deterrent against such misconduct.
Note the resulting link between this justification of the business judgment rule—i.e., the likelihood of judicial error—and the preceding justification—i.e., encouraging optimal risk taking. In theory, if judicial decisionmaking could flawlessly sort out sound decisions with unfortunate outcomes from poor decisions, and directors were confident that there was no risk of hindsight-based liability, the case for the business judgment rule would be substantially weaker. As long as there is some non-zero probability of erroneous second-guessing by judges, however, the threat of liability will skew director decisionmaking away from optimal risk-taking. That this result will occur even if the risk of judicial error is quite small is suggested by the work of behavioral economists on loss aversion and regret avoidance.
Behavioral economists have demonstrated that people evaluate the utility of a decision by measuring the change effected by the decision relative to a neutral reference point. Changes framed in a way that makes things worse (losses) loom larger in the decisionmaking process than changes framed as making things better (gains) even if the expected value of the two decisions is the same. Hence, a loss averse person (as are most people) will be more perturbed by the prospect of losing $100 than pleased by that of gaining $100. A bias against risk taking is a natural result of loss aversion, because the decisionmaker will give the disadvantages of a change greater weight than its potential advantages. Hence, the so-called status quo bias.
Closely related to the loss aversion phenomenon, and a possible explanation for it, is the psychological concept of regret avoidance. Decisionmakers experience greater regret when undesirable consequences follow from action than from inaction. Hence, decisionmakers tend towards inertia. Because the effect of these cognitive biases is considerably greater than traditional rational choice theory predicts, even a small risk of liability can be expected to have a large deterrent effect on managers who are already risk averse by virtue of their non-diversifiable investment in firm specific human capital. Accordingly, shareholders will prefer judicial abstention to judicial review.
And I believe that to be the case even when it requires judges to abstain from reviewing cases of a failure fuly to understand the risks being taken. Unless that failure is so inexplicable that no other explanation that bad faith or disloyalty makes sense.
Finally, I should note that that same article includes a discussion suggesting that per se rules are undesirable in this context:
... once we recognize that reconciling the competing claims of authority and accountability is the central problem for business judgment rule jurisprudence—indeed, for all of corporate governance—the misnomer inherent in the law’s nomenclature becomes apparent. It has become conventional to distinguish between standards and rules. Rules say, “Drive 55 mph,” while standards say, “drive reasonably.” Within that dichotomy, the business judgment rule clearly is misnamed—it is a standard, not a rule. The question is not whether the directors violated some bright-line precept, but whether their conduct satisfied some standard for judicial abstention. The greater flexibility inherent in standards frequently comes into play in business judgment rule jurisprudence, as courts fine tune the doctrine’s application to the facts at bar. Much of that fine tuning can be explained as an unconscious attempt to strike an appropriate balance between authority and accountability under specific factual circumstances. The principal law reform implication of this analysis thus may be that courts ought to be more explicit both about the fact that they are balancing competing concerns and why they believe the balance struck in a particular case is the appropriate one.
, Brian Tamanaha argues that "law schools are failing abjectly. Recent front-page stories have detailed widespread dubious practices, including false reporting of LSAT and GPA scores, misleading placement reports, and the fundamental failure to prepare graduates to enter the profession."
Recent Comments