The tort foundation of duty of care and business judgment.

• Author: Rhee, Robert J.
• Position: III. Business Judgment and Economic Loss through Conclusion, with footnotes, p. 1171-1198

3. BUSINESS JUDGMENT AND ECONOMIC LOSS

   The conventional account of the failed tort analogy is also flawed because commentators have analogized the rules in corporate law to rules in tort law applicable to physical loss. The assumption is wrong, leading to a wrong analysis. Tort law distinguishes the interests at stake and the types of harms suffered, leading to different doctrinal frameworks for assessing liability. (177) For example, emotional harms and pure economic losses are treated differently than injuries to person or property. (178) Melvin Eisenberg has noted this distinction. (179) Robert Thompson has gone so far as to suggest a possible link between the doctrine of pure economic loss and the corporate liability scheme:

   Tort law provides a structure to understand the separate "wrongfulness" of fraud, but in a way that also could suggest limits on recovery. By recognizing lying as a wrong, law recognizes this conduct as an inappropriate way of treating people that gives rise to an individual right of redress, separate from the substantive decision. But as a dignitary tort different from traditional physical torts, there might be additional limits in the same way that common law courts have continued to put limits on pure economic loss cases different from physical torts. (180) Eisenberg and Thompson make an important point about the nature of the corporation's injury. They have pointed us in the right direction. The next step in constructing a corrected tort analogy is an interdoctrinal analysis of principles and theories governing pure economic loss.

   The rule of pure economic loss is simply stated: While there is a general duty of care to avoid foreseeable physical harm, (181) there is no duty to take precaution against negligently inflicted pure economic loss. (182) This rule is seen in Holmes' opinion in Robins Dry Dock & Repair Co. v. Flint. (183) The plaintiff charterer suffered lost profits when the defendant dry dock negligently damaged the propeller of the owner's boat. (184) The Court held that the dry dock had no duty to the charterer and set forth the general rule that "a tort to the person or property of one man does not make the tortfeasor liable to another merely because the injured person was under a contract with that other, unknown to the doer of the wrong." (185) The pure economic loss rule and the business judgment rule share a number of commonalities. Both are nearly universal. (186) Both have been traditionally explained in instrumental, pragmatic terms, focusing on the problem created by broad exposure to liability for defendants. (187) Both invoke the principle that the law abhors disproportionate liability or penalty. (188)

   These commonalities merit an analysis of the link between the pure economic loss rule and the business judgment rule. At the outset, I note that doctrinal analysis and comparison have one distinction. Typically, in torts cases the ex ante relation between the defendant and the plaintiff are remote, and they are connected only by the accident resulting in economic loss; in corporate cases, there is already a fiduciary relationship between a director and the corporation. (189) While this distinction limits the doctrinal utility of the comparison, the theory of pure economic loss is relevant to the question in corporate law: What is the theoretical justification for not imposing a legal duty on a director to avoid negligently inflicting economic loss on the corporation?

   Two economic analyses explain the theoretical underpinning of pure economic loss. One focuses on a microeconomic analysis of social cost. The other focuses on a political economic analysis of uncertainty and profit.

   1. Social Cost of Economic Loss

      William Bishop argued that the rule denies liability for pure economic loss because in many cases there is not a social cost. (190) In the case of a physical loss such as lost lives or damaged property, the social cost is apparent, but in economic loss cases there is often a transfer payment--that is, a private cost to one is an equal private benefit to another. (191) By imposing liability, the law may over-deter an activity that is otherwise efficiently deterred for the purpose of mitigating social cost. This theory is important and has an appealing elegance.

      A typical fact-pattern illustrating the concept is seen in 532 Madison Avenue Gourmet Foods, Inc. v. Finlandia Center, Inc. (192) A building collapse closed a Manhattan street. (193) The plaintiff delicatessen did not incur a physical loss but did suffer lost profit. (194) It sued the negligent parties who caused the building collapse, but the court held that they did not owe a duty to the plaintiff under the doctrine of pure economic loss. (195) The economic harm was not a social cost. Since there is a deli in virtually every city block in Manhattan, the plaintiff's lost profit was offset by gains of other stores. Bishop's theory works well to explain the denial of recovery.

      Bishop concedes that his theory is too simple. (196) The assessment of social cost often "depends upon innumerable particular facts of interacting markets." (197) The theory depends on empirically unverified assumptions: for example, sufficient excess capacity to meet demand overflow by competitors; no marginal cost increases associated with capacity increase; elasticity of supply and demand as to substitute inputs, goods, and services; investor risk neutrality towards variability of returns under different liability rules, and so forth. (198) If we relax these assumptions, the hypothesis of no social cost is far more complicated. (199) But in most cases the administrative costs of a detailed economic inquiry would exceed whatever social cost was lost in most cases. (200) Ultimately, Bishop's theory depends on the hypothesis that "financial losses are only poorly correlated with social cost," (201) thus justifying a blanket rule of no duty.

      Despite the limitation of Bishop's theory, the core idea--that pure economic loss from negligence is frequently not a social cost--is important in thinking about liability for economic loss from poor board decisions. In many situations involving business decisions, the private loss of the corporation and shareholders is apparent, but the social cost is not. The distributional aspect of value and wealth in many market transactions results in transfer payments for which the social cost is less apparent. More broadly, the Schumpeterian process of "creative destruction" (202) assumes that private loss of firms leads not to social cost, but in fact social gain in the form of innovation and value creation built on the ruins of lesser firms and business models. To be sure, there are cases where the social cost is readily apparent. The clearest example is Enron where the board's sustained failure over a period of time resulted in the collapse of a corporation that previously was a legitimate business. (203) Even in such cases, however, the complex interactions with other market participants make the accounting of gains and losses inordinately difficult even when the magnitude of the loss suggests that there has been a net social loss. In most cases of ordinary business loss, the intuition is that economic loss resulting from poor business decisions are loosely, if not poorly, correlated with social cost in a competitive market.

      Bishop's idea explains, in part at least, the judicial reluctance to assess liability after a poor decision resulting in economic loss. In many cases of bad business outcomes there is simply a transfer payment. Corporate law scholars and courts assume that shareholders of public companies hold a diversified portfolio. (204) A shareholder diversifies away firm-specific risk and is exposed only to market risk. In the case of a transfer payment, the individual gains and losses net out in a portfolio, suggesting that the diversified shareholder is not economically harmed from a board's "negligent" decision.

      Even if there is some social cost, as a more detailed economic analysis may show, in many instances of business loss, the administrative cost of ascertaining it would be high. Judicial review is imperfect to the task even as courts are competent to conduct such analysis. Commentators have argued that liability rules as a corrective for director error are inferior to market monitoring of agent performance. Many disputes in torts or contracts are one-shot deals that require judicial resolution to correct fault or breach. (205) On the other hand, corporations have long-term relations that create repeated opportunities for directors to internalize the cost they impose without judicial intervention. (206) Market forces can monitor director error and competence. The capital market assesses the quality of the management when it assigns the firm's cost of capital. (207) The labor market monitors executives and directors by assigning differential values to their labor. (208) The capital markets qua information markets are efficient on some level. (209) Capital markets serving as monitors are said to be superior to courts because the judicial process is costly, and because courts may have difficulties reconstructing the ex ante risks. (210)

      The argument of an imperfect judicial process is more plausible than one based on judicial incompetence, but it does not wholly explain the business judgment rule. It presents a simplistic binary choice between judicial review and market monitoring. Markets are not perfect in assessing corporate decisions and quality of management. For instance, the labor market should create proper incentives through "ex post settling up," (211) but the current problem of excessive executive compensation calls into question whether this "settling up" process is efficient, or even works when the amount of compensation diminishes an executive's long-term incentives. (212) Nor are the capital markets perfect in assessing the quality of corporate...