Law, Norms, and the Breakdown of the Board: Promoting Accountability in Corporate Governance

AuthorRenee M. Jones
PositionAssistant Professor, Boston College Law School
Pages108-158

    Assistant Professor, Boston College Law School. Significant progress on this Article was made during a fellowship at the Edmond J. Safra Foundation Center for Ethics at Harvard University. I am grateful to Dennis Thompson, Arthur Applbaum, and seminar participants Jeffrey Abramson, Elizabeth Ashford, Thomas Cochrane, Elisabetta Galeotti, Maria Merritt, and Daniel Philpott for valuable feedback. I would also like to thank Joseph Badarraco, Mary Bilder, Lawrence Cunningham, Joan Heminway, Ray Madoff, Hillary Sale, William Simon, and Lynn Stout for helpful comments on early drafts. This Article also benefited from comments from participants in faculty colloquia at Northeastern, Boston College, and Washington and Lee law schools. Finally, thanks are due to Jason Radford, Jane Morril, Yvonne Chan, and Precious Eboigbe for excellent research assistance. Copyright 2006 by Renee M. Jones.


Page 108

I Introduction

A puzzling aspect of corporate law is the absence of an effective enforcement mechanism for the duties of loyalty and care that form its traditional foundation. A combination of substantive doctrines and procedural requirements embodied in corporate law has made it nearly impossible for shareholders to prevail when challenging the decisions and practices of corporate management. One wonders how a set of virtually unenforceable rules can be expected to influence the actions of corporate officers and directors. More broadly, our corporate governance structure raises the question of whether a system of legal rules unbuttressed by a credible threat of sanction can actually deter the conduct it seeks to control.

Many prominent scholars argue that formal legal intervention in corporate internal affairs is rarely necessary or desirable because market forces and social norms adequately constrain managerial conduct. Social norms are informal rules and standards enforced through peer-administered sanctions, such as disapproval, ostracism, or reputational injury, or through internal emotions such as guilt or shame. Some scholars argue that such internalized values, coupled with the threat of social sanctions, appropriately constrain the conduct of corporate officials.

This Article addresses the question of whether the disciplinary power of social norms can replace the threat of legal liability as an effective accountability mechanism. After analyzing the complex relationship among law, social norms, and conduct in the context of corporate governance, it concludes that social norms alone cannot adequately constrain managerial conduct. Although social norms have the potential to motivate good conduct, they are equally capable of motivating and perpetuating bad conduct.1 Psychological and social theory suggests that in order for norms to positively influence social behavior they must be supported by an external accountability mechanism. Without a reliable accountability mechanism, social norms that guide managerial conduct are likely to erode and tolerate increasing levels of unethical conduct.

This Article further argues that the existing liability regime for fiduciary duties fails as an accountability mechanism. A tradition of judicial deference has created a de facto "no liability" rule which means that directors are rarely called upon to justify their actions. The "no liability" regime results from a more complex and fundamental problem. The penalties that directors face for a breach of duty seem disproportionate in relation to the degree of wrongdoing. This draconian liability threat creates two perverse effects. First, it is a leading cause of nullification of liability rules by courtsPage 109 and legislatures. Second, the prospect of disproportionate penalties hinders the internalization of appropriate moral values by corporate leaders.

Drawing on insights from psychological literature, this Article recommends reforms to the director liability scheme that will address these problems. It argues that legal sanctions for fiduciary breaches should be modified to better reflect society's assessment of directors' degree of culpability for harms to the corporation. Drawing on the model provided by the recent WorldCom settlement, it suggests that damage awards for nonculpable breaches of the fiduciary duty of care be reduced and calibrated in a manner that reflects a negligent director's ability to pay. To be effective as a mechanism for accountability, such reform must require each negligent director personally pay a portion of the monetary penalty. If legal penalties were so calibrated, judges would be more likely to find liability in appropriate circumstances and would thus better fulfill their role as arbiters of director and executive behavior.

This Article proceeds in four parts. Part II describes the basic corporate law framework and catalogs weaknesses in existing enforcement mechanisms that have created a de facto "no liability" rule for corporate directors. Part III describes the standard defenses of the "no liability" rule, focusing mainly on law and social norms analysis. Part IV critiques the law and norms approach, especially as applied to corporate governance. It draws on insights from social psychology to demonstrate that the social norms of directors are prone to erosion in the absence of an external accountability mechanism. In light of the failure of markets and social norms to constrain corporate conduct, Part V recommends changes to the corporate liability scheme. It recommends a reduction in penalties for a negligent breach of the duty of care, accompanied by a requirement that directors contribute personally to the payment of penalties assessed for such negligent conduct.

II The "No Liability" Rule in Corporate Law

This Part describes the current corporate law regime in which directors of corporations rarely (almost never) personally pay damages or penalties for the breach of fiduciary duty or other violations of corporate or securities laws. Corporate statutes and jurisprudence wax eloquently regarding the solemn duties of directors to exercise due care and work faithfully for the exclusive benefit of the corporation. The legal doctrine provides for significant penalties for directors who fail to fulfill their duties. In reality, however, courts almost never assess damages against directors, and most costs and settlements of shareholder litigation are paid by corporations or insurance rather than the defendant directors. In this Article, I describe this reality as a "no liability" rule-an informal rule that results from the combined effect of the substantive doctrine, procedural mechanisms, and contractual protections described below.

Page 110

A The Theoretical Legal Framework

State corporate law establishes the legal obligations of corporate directors and officers to their corporations and their shareholders (in the form of fiduciary duties) and provides a remedy for the breach of such duties.2 The federal securities laws also play a significant role in the governance of large public corporations.3 However, the prescription of directors' obligations to the corporation itself has traditionally been the province of state law.

The power to direct a corporation's affairs rests in the board of directors. Delaware's general corporation law is typical in providing that "the business and affairs of every corporation . . . shall be managed by or under the direction of a board of directors . . . ."4 In most large corporations, directors delegate this broad decision-making power to executive officers who exercise the bulk of corporate power, subject to oversight by the directors.5

A director's obligations to the corporation and its shareholders are rooted in the concept of fiduciary duty. Directors are bound by fiduciary duties of loyalty and care.6 In simplest terms, the duty of care requires that directors act diligently in managing the corporation's affairs, while the duty of loyalty requires that directors place the interests of the corporation above their own. State common law jurisprudence has fleshed out the substance of these duties, which tend to be stated in general rather than specific terms.

Page 111

1. Duty of Care

As commonly articulated, the standard of care for corporate directors is that of a reasonably prudent person in like circumstances, although in Delaware the standard of care is gross negligence.7 However, the level of judicial scrutiny of board conduct differs significantly from that applied in the tort context.8 The lynchpin of this specialized standard of review is the business judgment rule, which shields most board decisions from judicial scrutiny. Under the business judgment rule, courts limit their inquiry into the adequacy of the process by which a board reached its decision, rather than the wisdom or appropriateness of the...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT