Cost-benefit analysis of the business judgment rule: a critique in light of the financial meltdown.

• Author: Aman, Todd M.

In 2008, the United States--indeed the whole world--suffered a devastating financial meltdown. We know now that a significant cause of the meltdown was that, in the face of numerous red flags, the managers of several venerable financial firms decided to take tremendous risks in the subprime mortgage market, and the directors of these firms did little or nothing to stop them. However, despite their actions, these managers and directors face little or no risk of personal liability because they are shielded by the business judgment rule and other liability-reducing mechanisms, such as director exculpation statutes. Given the magnitude of the recent financial meltdown, this article calls for a reexamination of the arguments for and against shielding corporate managers and directors from virtually all personal liability.

After providing background on the business judgment rule and director exculpation statutes, this article recasts the prominent arguments for and against the business judgment rule as cost-benefit arguments. On one hand, most pro-business judgment rule arguments focus on the benefits of shielding directors from liability risk, namely enhancing shareholder wealth. On the other hand, most critiques of the business judgment rule endeavor to show that the costs of shielding directors from liability risk are greater than generally assumed. Instead of entering this debate, this article rejects the cost-benefit framework altogether. Drawing upon arguments developed by critical legal scholars, the article claims that cost-benefit analysis is indeterminate. Because cost-benefit analysis is indeterminate, it is impossible to determine whether the costs of increasing directors' liability risk outweigh the benefits.

Cost-benefit analysis can just as readily lead to the conclusion that the benefits outweigh the costs. Therefore, due to their reliance on cost-benefit analysis, the pro-business judgment rule arguments fail to justify the rule.

1. INTRODUCTION

   In the summer of 2008, the United States suffered a spectacular financial meltdown. Since then, Americans collectively have lost trillions of dollars, (1) and millions have lost their jobs (2) and their homes. (3) Additionally, incalculable damage was inflicted on both the global economy (4) and the public's confidence in the future of and trust in the financial system. (5) The causes of this disaster are now fairly well understood. One of the most significant causes was that, in the face of numerous red flags, (6) the managers of several large and venerable financial firms decided to take on tremendous amounts of risk in the subprime mortgage market, and the directors of these firms did little or nothing to stop them. (7) However, even though they exercised such little caution in exposing their firms to such high levels of risk, the managers and directors responsible for the decisions that led to the financial meltdown will probably not suffer any personal liability. (8)

   While directors technically owe a fiduciary duty to exercise care in making business decisions, the business judgment rule and director exculpation statutes almost entirely shield directors from risk of personal liability for breaching that duty. (9) Typically, the business judgment rule and director exculpation statutes are defended with the same battery of policy arguments. (10) The following are three of the most frequently recurring policy arguments: (1) if directors' liability risk were increased, directors would be overly deterred from taking entrepreneurial risks; (11) (2) if directors' liability risk were increased, current directors and director candidates would be overly deterred from serving as directors; (12) and (3) market mechanisms, namely the market for capital and the market for corporate control, already provide sufficient incentives for directors to exercise care. (13) Fundamentally, all three of these arguments employ a cost-benefit framework. All of them purport to show that the business judgment rule and director exculpation statutes are efficient because increasing directors' risk of personal liability would impose significant costs on shareholders.

   Given the magnitude of the recent financial meltdown, however, a reconsideration of the desirability of shielding directors from nearly all liability risk is in order. The business judgment rule has already been criticized on a number of grounds. For the most part, the existing critiques employ the same cost-benefit framework used by the pro-business judgment rule arguments. Whereas the pro-business judgment rule arguments focus on the costs of increasing directors' liability risk, most of the existing critiques focus on the benefits, endeavoring to show that the benefits of increasing directors' liability risk would be much greater than previously thought. (14) While such critiques can serve as counterweights to the pro-business judgment rule arguments, they do not definitively show that the pro-business judgment rule arguments fail to justify the rule. To do so, a critique of the business judgment rule based upon cost-benefit analysis would have to actually demonstrate that the business judgment rule's costs exceed its benefits, which would require "catalog[ing] all of the costs and benefits associated with directors' liability for lack of care," (15) quantifying them, and adding them up. Otherwise, such a critique "cannot by itself lead to any strong normative conclusion one way or the other." (16) However, putting aside for the moment that it might not be possible to perform such a calculation in a determinate and objective manner, (17) performing the calculation would pose an empirical problem of Herculean proportions. In contrast, a few critiques of the business judgment rule reject the cost-benefit framework altogether. Some of these critiques challenge the basic assumptions or value judgments underlying the arguments for the business judgment rule, (18) while others find logical contradictions or untenable distinctions within them. (19) Either way, these critiques are more effective in rebutting the pro-business judgment rule arguments because they avoid the herculean task of determining whether the business judgment rule's costs actually outweigh its benefits.

   However, none of the existing critiques of the business judgment rule make the claim that cost-benefit analysis is indeterminate, and therefore the pro-business judgment rule arguments fail to justify the rule due to their reliance on the cost-benefit framework. The claim that cost-benefit analysis is indeterminate is part of a collection of arguments developed by critical legal studies ("CLS") scholars to critique the "law and economics" movement. (20) Essentially, the argument is that cost-benefit analysis yields multiple correct answers (21) to questions like, "Do the costs of a given legal rule outweigh its benefits?" One analyst performing a cost-benefit calculation could conclude that costs outweigh benefits, while another analyst performing the same calculation could conclude that benefits outweigh costs, and both analysts could be equally correct. (22) This line of critique has been applied to several areas of law, such as contract, tort, property, (23) and administrative law, (24) but it apparently has not been applied to corporate law. (25) I argue that, when this critique is applied to the three common policy arguments for the business judgment rule identified above, it shows that they fail to demonstrate that the business judgment rule is efficient.

   In Part II of this article, I explain how the business judgment rule and director exculpation statutes operate to shield directors from personal liability for breaches of the fiduciary duty of care. In Part III, I set out the three policy arguments commonly made on behalf of the business judgment rule. I argue that, at bottom, all three arguments are cost-benefit arguments. In Part IV, I describe prominent existing critiques of the business judgment rule and discuss their limitations. In Part V, I describe the CLS critique of law and economics, particularly the argument that cost-benefit analysis is indeterminate. In Part VI, I apply the argument that cost-benefit analysis is indeterminate to the three common policy arguments for the business judgment rule. I conclude that, due to the indeterminacy of cost-benefit analysis, it is impossible to determine whether the costs of increasing directors' liability risk outweigh the benefits. Instead, cost-benefit analysis can just as readily lead to the conclusion that the benefits outweigh the costs. Therefore, the three common policy arguments for the business judgment rule fail to show that the rule is optimal from the standpoint of economic efficiency. Finally, in Part VII, I suggest some ways to extend this style of critique to other corporate law rules.

2. THE BUSINESS JUDGMENT RULE AND DIRECTOR EXCULPATION STATUTES

   A central problem of corporate law is that, because directors do not own the corporations that they manage, "they may have insufficient incentive to perform their duties carefully." (26) In response to this problem, the law imposes on directors a fiduciary duty of care, which is meant to deter them "from making uninformed or careless decisions." (27) The duty of care is usually framed as a requirement that directors use the same degree of care in managing the corporation as a "reasonably prudent person" would use under the circumstances. (28) Put this way, the duty of care sounds like the negligence standard in tort. It seems to require that directors' conduct satisfy an objective, "reasonable man" standard, (29) just like the conduct of doctors, lawyers, and other professionals. (30) However, unlike other professionals, (31) directors are almost entirely shielded from risk of personal liability by (A) the business judgment rule, and (B) exculpation statutes. As a result, directors' conduct is evaluated under a far more lenient...