Rewarding outside directors.

AuthorHamdani, Assaf

While they often rely on the threat of penalties to produce deterrence, legal systems rarely use the promise of rewards. In this Article, we consider the use of rewards to motivate director vigilance. Measures to enhance director liability are commonly perceived to be too costly. We, however, demonstrate that properly designed reward regimes could match the behavioral incentives offered by negligence-based liability regimes but with significantly lower costs. We further argue that the market itself cannot implement such a regime in the form of equity compensation for directors. We conclude by providing preliminary sketches of two alternative reward regimes. While this Article focuses on outside directors, the implications of our analysis extend to other gatekeepers as well.

TABLE OF CONTENTS INTRODUCTION I. EQUITY COMPENSATION AS A REWARD MECHANISM II. THE LIMITS OF DIRECTORIAL LIABILITY A. The (Very Limited) Scope of Negligence-Based Liability B. The Costs of Negligence-Based Liability III. THE BENEFITS OF DIRECTORIAL REWARDS A. How a Reverse Negligence Regime Works B. Error Rates C. Recruitment D. Decision-making E. Risk Shifting IV. OBSTACLES TO A REWARD REGIME A. Moral Hazard B. Funding C. Computing Reward Amounts D. Board Divisiveness E. Political Skepticism V. TOWARDS WORKABLE REFORM A. The Resignation Rule B. A Board-Administered Regime: Rewarding Leadership C. Extensions CONCLUSION I. INTRODUCTION

The proper role of legal sanctions in motivating directorial oversight is one of the most difficult issues in corporate governance. On one hand, the law has long been reluctant to hold directors effectively liable for negligently supervising managers. Indeed, U.S. corporate law goes far to insulate directors from such liability because, it is said, directors would otherwise hesitate to serve or would become overly risk averse. On the other hand, the law has also been reluctant to give directors a free pass for all misconduct short of intentional wrongdoing--presumably because lawmakers fear that doing so would leave dangerously little incentive for boards to monitor management. As might be expected, moreover, the tension between distrusting boards and fearing liability has stimulated awkward doctrine and a considerable literature about the costs and benefits of liability in the complex setting of the boardroom. (1) This Article adds to that literature obliquely. We do not attempt to assess the optimal level of liability in the boardroom. Instead, we look beyond the traditional debate over the desirable scope of liability to explore a logical alternative: namely, the possibility of employing rewards to motivate directors.

The law conventionally relies on sanctions rather than rewards to motivate behavior. Among the many plausible reasons for this asymmetry are the lower intrinsic costs of penalties, greater ease of administration, law's characteristic task of enforcing minimal--rather than exceptional--behavioral norms, and a deep-rooted public sentiment that compliance with the law is a duty rather than a compensable service. (2) As legal mandates shade into the fine-tuned regulation of markets and complex organizations, however, the difference between the law's objectives and those of a private employer or principal begin to shrink. One class of examples includes so-called "gatekeepers"--parties such as accountants, lawyers, underwriters and outside directors, who, although not primary wrongdoers, may be able to prevent misconduct at little cost by virtue of their institutional positions. (3)

Two factors make penalizing gatekeepers--including outside directors--especially costly. The first is that liability may make gatekeepers overly risk averse, particularly since they act on behalf of third parties and therefore do not bear the full costs of taking precautionary measures or making conservative decisions. (4) The second is that if, for institutional reasons, the market fails to respond flexibly to gatekeeper liability, this liability may not only make gatekeepers excessively risk averse and their services more costly but also lead to an exodus of talented professionals. (5) Thus, to the extent that the law attempts to enlist gatekeepers as "cops on the beat," lawmakers face challenges similar to those faced by principals of highly skilled agents. The law's objective is no longer to enforce minimal standards of behavior. It is, instead, to secure the cooperation of sophisticated actors whose knowledge of local circumstances typically far exceeds that of enforcement officials. It follows that the advantages of penalties over rewards are less clear-cut for gatekeepers than for primary wrongdoers.

The law currently employs liability to motivate some--but not all--gatekeepers. For example, auditors, who have an explicit monitoring methodology, are often held liable for negligence, (6) while directors, whose responsibilities are far less clear-cut, are seldom held liable for negligent oversight. (7) As we discuss below, one reason that directors escape liability is that directorial negligence is peculiarly difficult to identify with confidence (i.e., the legal error rate is likely to be high). Another contributing factor is that a dense latticework of contractual risk-shifting devices--such as insurance, indemnification, and exculpatory charter provisions--insulates directors from what little liability the law does impose. (8) Given these barriers to directorial liability, this Article asks whether rewards might be a more workable substitute. Put differently, assuming that legal intervention is required to improve directorial oversight, (9) we consider whether rewards can outperform liability in incentivizing directors.

Much of our analysis is a comparison of two possible legal regimes: a negligence regime in which outside directors face personal liability for failure to reasonably monitor top management, and a "reverse negligence" regime in which directors are rewarded for satisfactorily discharging their monitoring obligations. Both regimes stand in sharp contrast to the status quo, in which, despite widespread belief to the contrary, directors actually face very little pressure from liability (or rewards). (10) We compare these regimes in order to isolate their common problems and, more importantly, to locate the points at which their costs and benefits diverge. The liability regime we discuss is the familiar proposal to hold directors personally liable for negligent monitoring. By contrast, the reward regime we outline is a decidedly unfamiliar proposal to reward directors who demonstrate that they did not discharge their monitoring obligations negligently. We argue here that this reward regime answers several of the most troubling drawbacks of its liability counterpart. Given the novelty of our reverse negligence regime, we do not expect it to find immediate acceptance. We do believe, however, that it can yield important insight into the legal gatekeeper strategy and also suggest less ambitious reforms that hold promise for improving directorial monitoring of senior managers.

One more qualification. The hypothetical reward regime that we consider is almost--but not quite--the mirror image of a negligence regime. A negligence regime imposes liability contingent upon the occurrence of a triggering event (i.e., harm), followed by an ex post determination that the harm resulted from the failure of an actor to perform her legal duty (i.e., behave reasonably). The mirror image of such a regime would make a reward contingent on the absence of harm over a period of time, and an ex post determination that this absence was "caused" by an actor's faithful performance of her legal duties. For reasons that we develop below, however, establishing that harm failed to occur because directors monitored adequately (or merely establishing that directors did monitor adequately over a lengthy period) is an impossible task. Therefore, instead of framing the absence of harm as a triggering event for possible awards, we look to the occurrence of harm just as a negligence regime does. Under our regime of reverse negligence, directors are rewarded if, after the occurrence of harm (or one of its correlates), they are found to have monitored reasonably, even if they failed to prevent harm. In other words, we would not require directors to prevent harm to become eligible for rewards, because we expect heightened monitoring itself to act as a deterrent against managerial misconduct, even when it falls short of preventing harm in particular cases.

The resemblance of rewards to compensation raises a threshold issue that we must address at the outset. A large body of literature on directorial compensation parallels the literature on directorial liability (although the two rarely intersect). (11) A principal theme of the compensation literature is that directors ought to be paid in equity--options or restricted stock--like senior managers, and for much the same reason: to align their financial interests with those of shareholders. Put more strongly, many commentators view equity compensation as the principal answer to the board's incentive problems, (12) and some might argue that firms can automatically induce effective monitoring by implementing the right sort of high-powered equity compensation in the boardroom. We disagree for reasons that we elaborate in Part I. (13)

Our discussion is organized as follows: Part I demonstrates the limitations of equity compensation as a means of inducing directorial monitoring, however salubrious its effects might otherwise be. Part II then expands on the limitations and costs of negligence-based liability as a device for motivating directorial monitoring. Part III introduces the reverse negligence regime and uses it to offer our core analytical comparison of rewards and liability as incentive devices for outside directors. Part IV considers the potential costs of reward regimes and...

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