Parveen Gupta and Tim Leech on Board Oversight of Risk Management

Gupta and Leech argue for enhanced board attention to risk management. It's an interesting and detailed post, which I urge you to read. I am deeply skeptical, however, of their calls for greater regulatory attention to the issue. As I have written elsewhere (Stephen M. Bainbridge, Caremark and Enterprise Risk Management, 34 J. Corp. L. 967, 982-83 (2009)):

Just because a firm has the ability to reduce risk does not mean that it should. As the firm's residual claimants, shareholders do not get a return on their investment until all *983 other claims on the corporation have been satisfied.¹⁴¹ All else equal, shareholders therefore prefer high return projects.¹⁴² Because risk and return are directly proportional, however, implementing that preference necessarily entails choosing risky projects.¹⁴³

Even though conventional finance theory assumes shareholders are risk averse,¹⁴⁴ rational shareholders will still have a high tolerance for risky corporate projects. First, the basic corporate law principle of limited liability substantially insulates shareholders from the risks of corporate activity.¹⁴⁵ The limited liability principle holds that shareholders of a corporation may not be held personally liable for debts incurred or torts committed by the firm.¹⁴⁶ 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 International, Inc.,¹⁴⁷ 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.^{148 ,,,,}

Just as the business judgment rule insulates risk taking from judicial review, so [In re Caremark Int'l Inc. Derivative Litg., 698 A.2d 959 (Del. Ch. 1996)] 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.151 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.152 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.153 As a result, it is becoming increasingly “difficult to draw a line between corporate governance and risk management.”154

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.155 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.”156 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.”157

It seems to me that regulators need to be cautious in this area for precisely the same reasons former Chancellor Chandler rightfully was cautious in Citigroup.

141

Michael P. Dooley, Fundamentals of Corporation Law 33 (1995).

142

See Klein & Coffee, supra note 2, at 11-12, 45-47 (discussing creditor risk aversion and the issue or risk and control, respectively).

143

See id. at 269 (explaining that “common shareholders might be better off with the riskier investment”).

144

Id. at 196.

145

Indeed, it is this very insulation that motivates critics of corporate limited liability. See, e.g., Ronald M. Green, Shareholders as Stakeholders: Changing Metaphors of Corporate Governance, 50 Wash. & Lee L. Rev. 1409, 1414-15 (1993) (arguing that “thanks to limited liability, shareholders can fund the activities of large corporations, receive dividends and capital gains on their investments, and yet remain immune to some of the costs of misconduct or misjudgment by their corporate agents”); Henry Hansmann & Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 Yale L.J. 1879, 1882 (1991) (arguing that limited liability, inter alia, creates an “incentive ... for the shareholder to direct the corporation to spend too little on precautions to avoid accidents”).

146

See, e.g., Bus. Corp. Act Ann. § 6.22 (1984 & supp.) (stating that “[u]nless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct”).

147

Gagliardi v. Trifoods Int'l, Inc., 683 A.2d 1049 (Del. Ch. 1996).

148

Id. at 1052.

149

Joy v. North, 692 F.2d 880, 885 (2d Cir. 1982).

150

Id. at 886.

151

See Meulbroek, supra note 24, at 22 (explaining that the operational approach chosen by certain manufacturers is to stop producing a product when liability risks are too high).

152

See supra note 24 and accompanying text (providing this list).

153

Meulbroek, supra note 24, at 26.

154

Crouhy et al., supra note 14, at 87.

155

See supra text accompanying note 116.

156

In re Citigroup Inc. S'holder Derivative Litg., 964 A.2d 106, 130 (Del. Ch. 2009).

157

Id. at 126.