Breaching the Accountability Firewall: Market Norms and the Reasonable Director

• Publication year: 2014

SEATTLE UNIVERSITY LAW REVIEWVolume 37, No. 3, SPRING 2014

Breaching the Accountability Firewall: Market Norms and the Reasonable Director

Joan Loughrey(fn*)

I. INTRODUCTION

The Parliamentary Commission on Banking Standards recently de-scribed the lack of public or private enforcement action against bank directors in the United Kingdom in the wake of the financial crisis as "an accountability firewall."(fn1) Given that the primary fault of bank boards has been excessive risk taking and incompetence,(fn2) one might have expected that these directors would have faced actions for failing to discharge their duty of care. The fact that the directors did not face such actions highlights the difficulty of holding directors accountable for negligent conduct.

Not all would agree that this is problematic.(fn3) The debate over the extent to which the directors' duty of care should be enforced is longstanding, and different jurisdictions adopt widely divergent approaches. In the United States, corporate law rarely holds directors of public companies accountable because of the business judgment rule and Statutes permit corporations to exempt directors from monetary damages for breaching the duty.(fn4) In Australia, in contrast, there have been a number of very high profile decisions in which the director's statutory duty of care(fn5) has been enforced through action taken by the Australian Securities and Investment Commission.(fn6) Australia also has a common law and eq-uitable duty of care, which is enforced privately.(fn7) The United Kingdom, meanwhile, lies somewhere between the two. Under section 174 of the Companies Act of 2006, directors must exercise the care, skill, and dili-gence of a reasonably diligent person in the director's position.(fn8) There is no business judgment rule, and the duty is subject to private enforcement only. Directors of financial institutions also have a regulatory duty to exercise "due skill, care and diligence in managing the business of the firm for which [they are] responsible," which was originally enforceable by the Financial Services Authority (FSA) and now by the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA).(fn9)

While Professor Coffee has suggested that enforcement intensity may matter more in promoting the impact of a law than its substantive content,(fn10) the substantive content and how it is interpreted can affect the viability of enforcement. The financial crisis highlights the issue of whether directors' conduct should be measured against a standard of care that is norm-setting or norm-reflecting, and if the latter, which norms these should be. The FSA's decision not to take enforcement action against the directors of the Royal Bank of Scotland (RBS) with respect to the takeover of ABN Amro illustrates this point. The largest takeover in banking history, and a key cause of RBS's collapse, proceeded on the basis of a due diligence exercise comprising of two lever arch files and a CD.(fn11) The FSA's report on the collapse of RBS (the RBS Report) criti-cized the due diligence exercise as wholly inadequate, but also concluded that there had been no contravention of any regulatory rules or principles partly because the exercise had been in line with market practice.(fn12) In other words, the directors were exonerated because the FSA judged their conduct by a standard that reflected market norms.

This Article examines and evaluates the role of market norms in de-termining whether directors have acted reasonably and the appropriate-ness of setting a standard of reasonableness that reflects market norms. It argues that although there are situations in which a standard that reflects market norms may not be appropriate for determining the reasonableness of a director's conduct, it is the best standard more often than not. While this Article focuses on the U.K. director's duty of care, the question of whether compliance with market norms should be exculpatory arises every time legal or regulatory enforcement depends upon establishing that a market actor has acted unreasonably. For example, the Financial Services and Markets Act of 2000 holds bank directors accountable for contraventions of regulatory requirements in their areas of responsibility unless they can demonstrate that they took all such steps as a person in their position could "reasonably be expected to take" to prevent this.(fn13)

As the financial crisis and subsequent LIBOR scandal demon-strated, market norms can be irrational, short-termist, inefficient, and even criminogenic. If, as a result, directors should be held to higher standards, it again raises a question of broader significance: namely, how one regulates through broad ex ante standards-the precise requirements of which can only be clarified ex post-in a manner that is fair to the regulated but allows for the promotion of effective accountability.

Part II of this Article addresses arguments for and against enforcing a requirement that directors act with reasonable care and argues that enforcement is important to promote accountability. Part III reviews the role market norms play in the standard of care set by the courts. Next, given that weakness in private enforcement in the United Kingdom has led to calls for public enforcement of directors' duties,(fn14) Part IV consid-ers the approach of the U.K. financial service regulators to enforcing a regulatory duty of care. Part V argues that in both private and public en-forcement, the standard of care should usually be norm-reflecting but then considers under what circumstances it might be permissible to en-force norms ex post that are higher than those employed by the market. Finally, Part VI concludes by highlighting other issues raised by this Article.

This Article uses a modified version of Eisenberg's threefold classi-fication to define what is meant by market norms.(fn15) The first type com-prises behavioral patterns, which entail no sense of obligation and are not self-consciously adhered to.(fn16) The second, like the first type, entails no sense of obligation but are self-consciously adhered to, such as the prac-tice of beginning and ending classes at a particular time:(fn17) these practices could be changed without criticism. These two categories indicate types of behavior that are considered permissible, though not required,(fn18) and together will be referred to as "market practices." The third type consists of "obligational market norms"-non-legal rules or practices that actors both self-consciously adhere to and feel obliged to adhere to unless there are good reasons not to.(fn19) These may be formal obligational norms such as those contained in codes of practice, industry standards, and instruments such as the U.K. Corporate Governance Code. Although nonlegal, these will be referred to as "soft law" norms. There may also be "informal obligational norms" that reflect what market actors feel they ought to do. Finally, the term "market norms" refers to both market prac-tices and obligational norms.

II. THE IMPORTANCE OF ENFORCEMENT

There are several arguments against more rigorous enforcement of the director's duty of care. Easterbrook and Fischel argue that private enforcement is unnecessary because the market adequately constrains directors' conduct. Careless directors will see a drop in their corpora-tion's share price and will be dismissed or lose their jobs through a hos-tile takeover.(fn20) The concept of market discipline, however, has been much criticized in the wake of the financial crisis.(fn21) Even in normal times, it is unclear that the market can accurately price for careless behavior.(fn22)

There is also an argument that minimal enforcement is supported by the terms of a "hypothetical bargain" between directors and shareholders.(fn23) The hypothetical bargain theory asks what parties, as rational bar-gainers, would have bargained for in a given situation had they turned their minds to the issue or if the costs of bargaining for the term were sufficiently low.(fn24) In bargaining for the content of the duty of care, shareholders, as rational bargainers, would take into account that strong enforcement could lead to over-deterrence and so would agree to a less onerous duty and limited enforcement.(fn25) The hypothetical bargain analysis has been criticised for its indeterminacy(fn26) and for assuming that shareholders would contract for minimal performance with minimal ac-countability. This is by no means self-evident. The rational bargainer might take into account that reducing directors' incentives to take care could increase the probability that unreasonable risks will be taken, which could turn out to be more costly than imposing such incentives.

It is not possible to judge whether fears that enforcement would over-deter risk taking and discourage people from taking up directorial roles (unless they were inefficiently compensated for the risk(fn27)) are well founded.(fn28) There is some evidence of a deterrent effect.(fn29) Thus, empirical research indicated that criminal sanctions might have some chilling effect on directors' decision making, but it did not demonstrate that this constituted over-deterrence or that civil enforcement would have similar effects.(fn30) In the United States, insurance premiums rose after the decision in Smith v. Van Gorkom, and the protection provided by insurance policies was reduced. As a result, some...