Boards-R-Us: reconceptualizing corporate boards.

• Author: Bainbridge, Stephen M.
• Position: III. Mapping the BSP to the Current Board A. How BSPs Address the Reasons Current Boards Fail 2. Incentives b. Liability-based Incentives through Conclusion, with footnotes, p. 1085-1119

2. Liability-based incentives

   We think the use of BSPs may also have salutary effects on the quality of corporate governance through improved judicial supervision of board activities. Courts may be more willing to hold BSPs liable than individual directors, and this could help make fiduciary duties more robust. The logic is straightforward. As noted above, directors are independent amateurs without deep pockets, but face enormous potential liability for the decisions they make. For instance, the sloppy approval of a merger could subject directors, including individual directors, to multimillion-dollar liability, not to mention the significant risk to their personal reputations. Courts seem reluctant to impose liability on directors, (146) perhaps increasingly so in recent years. (147) This could be because of institutional competency concerns, worries about hindsight bias, the potential chilling effect on risk taking, the reluctance to hold individuals (some of whom are not extremely rich) liable for potentially huge damage awards, and the potential impact of increased liability on the supply of individuals willing to provide director services. Whatever the reasons, if directors form associations to share risk, this reduces the potential negative cost on individuals, and thereby may increase the willingness of courts to impose liability.

   To see the point, consider the impact that the availability of D&O insurance has on judicial enforcement of board duties. In the absence of any insurance, courts would be significantly less likely to find individual board members liable for breaches of their fiduciary duties. In this way, third-party insurance can, at least in theory, be a mechanism for enhancing compliance with law. (148) Sharing risk (in this case through insurance contracts) reduces the costs of liability for individual directors, and therefore may make a finding of liability more likely, all else being equal. The downside of insurance--the moral hazard or shirking problem--can be reduced through monitoring (both ex ante and ex post) and some risk bearing, in the form of deductibles or the like.

   Self-insurance in the form of organizational choice is simply an extension of this idea to areas of liability beyond those currently covered by contractual insurance. Directors who are able to pool their risk through a business form we call the BSP can reduce their risk. The ability to share, and thus reduce, risk is one of the most powerful reasons for forming a business association. A single individual running a business faces all of the risk if the business fails or generates liabilities that exceed its assets. If all businesses were required by statute to be run by an individual acting as a sole proprietor, risk alone would work a serious impediment to the provision of all sorts of products and services. By forming a business association in which risk is shared among various owners, the business can take on more risk than could or would a sole proprietor. This is because some individuals will have greater risk tolerances than others, and these tolerances may not line up with other attributes that can be put to use by a firm. (149)

   The additional liability would be doing work primarily in cases in which potential damages exceed liability coverage, since this is the extensive margin where courts are most likely to feel whatever pressure they feel to take it easy on misbehaving directors. The existence of insurance for breaches of certain fiduciary duties already reduces the downside for directors, and therefore makes judicial supervision more robust than it would likely be in the absence of insurance. The additional risk reduction from operating as a business association would therefore act mostly in those cases in which the expected liability exceeds the insurance coverage. This could be either for large damage awards or for certain actions usually not covered by insurance, such as breaches of the duty of loyalty.

   The risk sharing of organizational choice may also do some work in cases in which the conduct is completely covered by insurance. There is reason to believe that the D&O insurance market does not work optimally, (150) and adding self-insurance or replacing the D&O model with self-insurance could help make corporate liability more effective. While one would expect insurance costs to discipline firms, it is not obvious this translates readily into the market for director talent, since liability is so rare, it is not often linked with necessarily bad behavior, and, in any event, the labor market for directors is thought to be so dysfunctional. (151) Directors do not bear the liability personally, except in the rarest and most extreme circumstances, and there is some evidence that directors' reputations, which we expect to provide most of the discipline, are not highly correlated with past performance. There is also some evidence that insurance prices do not obviously respond to incidents of director liability. Bringing the insurance function within the firm providing the service (either through vertical integration of the D&O function or simply through risk pooling inherent in providing services through firms) may improve the pricing of risk and the judicial treatment of defendants.

   Not only might the BSP model make courts less reluctant to impose fiduciary duties on boards, but the corporate model for boards is also likely to generate more fiduciary duty litigation. Every allegation of serious board misconduct is likely to result in multiple suits: one by the company against the BSP and one by the shareholders of the BSP against the directors of that firm. The addition of the second type of suit could work as an additional deterrent to board misconduct, malfeasance, and gross negligence. Of course, if one believes that the current amount of litigation is optimal (or even excessive) because directors face the perfect incentives to behave well, then additional liability may add costs in excess of the benefits.

3. Reputational incentives

   Another benefit of our model is that it will increase the reputational stakes of every board decision, meaning more incentive for good work, all else being equal. Reputation is already an important element of the corporate governance regime. Harnessing the reputation of directors to prevent cheating and shirking is a vital element of effective corporate governance. Lawsuits, whether settled or reduced to judgment, alleging disloyalty or insufficient care by directors can harm directors' reputations. (154) This can cost directors their position on the board in question or seats on other boards, either now or in the future. Since directorships are lucrative given the little work, and one done well usually leads to another, (155) a director's reputation could be worth several hundred thousand dollars per year or more. In addition, lawsuits may result in more general losses to directors' reputations in their other endeavors, be they in business, law, academia, politics, or other fields. Modem corporate boards often have directors who have made large investments in their reputations, and these directors can be expected to act in ways to minimize the collateral damage from misbehaving as a director. (156) For instance, the Enron board famously included the former dean of the Stanford Graduate School of Business, three CEOs of other companies, political luminaries from the United Kingdom, and the former head of the M.D. Anderson Cancer Center. (157) These are important positions that these directors worked very hard to achieve, which adds to the reputational hit for director wrongdoing.

   Some scholars believe reputation is the most important constraint on director behavior and that it alone can induce efficient board conduct. (159) Others, pointing to failures by boards filled with individuals with seemingly valuable reputations, note that the evidence suggests reputation is not doing all the work necessary to ensure good governance. (160) Of course, the existence of some corporate failures does not mean directors are engaging in suboptimal care levels or that reputation is not sufficient; the optimal level of governance failure is not obviously zero.

   But we need not resolve this debate to demonstrate the value of BSPs. Reputation and legal sanctions are complementary mechanisms for policing corporate decisionmaking, and as noted above, there is reason to believe legal sanctions are likely ineffective at inducing optimal actions by directors. The business judgment rule may be the optimal rule, but it surely lets some sloppy and self-serving transactions happen without scrutiny. Accordingly, the more work that reputational sanctions can do, the less work that law needs to do or the less we need to worry about judicial enforcement of director duties. From the current baseline of whatever work reputation is doing, greater reputational stakes can only improve governance, especially since it can relieve pressure on courts to police corporate decisions.

   In theory, the size of reputation, and therefore the work done by reputational assets in disciplining behavior, is correlated with the number of individuals whose reputations are influenced by a particular decision. This is because for associations providing services, "the reputation of the entire firm is at stake whenever a single [service] is sold." (161) If an individual makes a decision, then only the individual's reputation is at stake; if a firm of one hundred individuals makes the same decision, the reputation of the entire firm is at stake. If each of the individuals has the same amount of reputation, the stakes are one hundred times greater in the case of a firm making the decision. Of course, the full reputation of each person in a large organization may not be reduced in the event of a failure, but the net impact of reputational losses is likely increasing with the number of individuals comprising the...