Law professors Bernard Black, Brian Cheffins, and Michael Klausner recently released a paper in which they claim that outside directors of corporations face minimal liability risk. As the abstract explains:
Much has been said recently about the risky legal environment in which outside directors of public companies operate, especially in the United States, but increasingly elsewhere as well. Surveys report that many prospective directors decline board posts to avoid liability risk. We report here results from a study of both law and outcomes in four common law countries (Australia, Canada, Britain, and the United States) and three civil law countries (France, Germany, and Japan). The legal terrain and the risk of "nominal liability" (a court finding of liability or a settlement) differ greatly depending on the jurisdiction. But nominal liability rarely turns into "actual liability," in which the directors pay damages or legal fees out of their own pocket. Instead, damages and legal fees are paid by the company, directors' and officers' (D & O) insurance, or both. The bottom line: outside directors of public companies face only a tiny risk of actual liability. We sketch the political and market forces that produce functional convergence in outcomes across countries, despite large differences in law, and suggest reasons to think that this outcome might reflect sensible policy.
Unfortunately for them, the timing could have been better. In recent days, we've observed several high profile cases in which outside directors have settled cases by paying out of their own pockets. Enron's outside directors agreed to pay $13 million out of their own pockets to settle shareholder litigation. WorldCom's outside directors agreed to pay $18 million out of personal funds to settle similar litigation. The WSJ($) reports that these high profile cases have scared some would be directors:
"My life savings could be in jeopardy," says Betsy Atkins, a 50-year-old venture capitalist in Miami who is a board member at tobacco concern Reynolds American Inc. and three other public companies. "It's very scary." ...
Such worries may intensify if similar settlements follow. Pending shareholder suits against other companies involved in accounting fraud, such as HealthSouth Corp., a rehabilitation and outpatient-surgery company, seek personal payments from certain former outside directors. Public pension funds, which often bring such suits, have begun offering higher contingency fees if their attorneys win personal payments from individual officials, too.
Predictably, the WSJ($)'s editorial board blames trial lawyers:
These payments are being forced despite the fact that none of the directors participated in, or knew about, the frauds at issue. In the case of Enron, reports the Journal, "a federal court in Houston previously ruled that the lead plaintiffs' attorney William Lerach and his team had no grounds on which to seek redress from directors on fraud or insider-trading claims." Mr. Lerach said he pushed for the settlement anyway because "it sends a message that directors can't just sit there in meetings and not think about what's going on under them."
Alan Hevesi -- New York's state comptroller and trustee of the retirement fund that was the lead plaintiff in the WorldCom suit -- proffered a similarly arbitrary rationale. "I felt personally that this would be unfair and not a deterrent for future failures on the part of directors if they weren't held personally liable," Mr. Hevesi told reporters. "Felt personally?" Thank you, Lord Hevesi.
Actually, we're grateful for the two attorneys because their remarks reveal that these payments are essentially punitive in nature. A court already has determined that the fraud claims against the Enron directors were baseless; what's left are claims of negligence for unknowingly signing false financial statements. It is of course in the nature of most frauds that they are unknown while they are taking place; that's why they succeed until they're revealed. The Enron directors say they were acting in good faith, but rather than risk that a jury won't believe them, they've agreed to settle without admitting guilt. ...
The big winners here aren't shareholders but are as usual the lawyers. Mr. Lerach, the king of class-action torts, stands to gain handsomely from this settlement, so don't be fooled by his public-servant pose. Mr. Hevesi is also likely to do all right, since the New York Sun has reported how much he benefits from campaign contributions from the tort lawyers that his settlements help enrich.
I'm no great fan of trial lawyers (or politicians who use public pension funds to advance their careers), but some blame must also attach to the directors in question. It's important to remember that these were settlements - not trial verdicts. The defendants could have gone to trial. If they had done so, the odds are high that they would have won. Why did then they settle? Probably risk aversion. We know from experimental psychology that people tend to be loss averse and seek to avoid instances of regret. As such, they are likely to overstate the risk of losing at trial and, accordingly, be willing to settle even when it may not be advisable from an actuarial perspective.
I explored this problem in my article The Business Judgment Rule as Abstention Doctrine, in which I explained:
Decisionmakers experience greater regret when undesirable consequences follow from action than from inaction.[1] 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 [of board decisions].
[1] See Russell Korobkin, The Status Quo Bias and Contract Default Rules, 85 Cornell L. Rev. 608, 657-59 (1998) (positing regret avoidance as an explanation of the status quo bias); Russell Korobkin, Inertia and Preference in Contract Negotiation: The Psychological Power of Default Rules and Form Terms, 51 Vand. L. Rev. 1583, 1619-20 (1998) (same).
This problem is one of many reasons why the law has traditionally used doctrines like the business judgment rule to insulate directors from liability for all but the most egregiously ill-informed decisions or self-dealing transactions. Black et al.'s finding that outside directors face minimal liability risk thus has a strong policy basis. Courts and regulators must keep this in mind when assessing efforts to impose liability on outside directors. Indeed, if the trial lawyers are successful in forcing more such settlements, it will become necessary to revisit the underlying liability rules in order to provide directors with sufficient additional insulation from liability that they will feel free to force a trial rather than settling.
