INTRODUCTION II. BAD CORPORATE BEHAVIOR AS SECURITIES FRAUD A. Federal Enforcement: Nondisclosure of Excessive Risk as Securities Fraud B. Shareholder Securities Litigation: Nondisclosure of Excessive Risk as Securities Fraud III. EXCESSIVE RISK AS A BREACH OF FIDUCIARY DUTY A. The Duty of Care 1. Background 2. Successful (Delaware) Duty of Care Cases 3. Section 102(b)(7) B. Excessive Risk and the Duty of Care C. Excessive Risk, Compensation, and Waste IV. THE DUTY OF LOYALTY A. The Duty of Oversight B. Excessive Risk as a Breach of the Duty of Oversight C. Excessive Risk Claims in the Southern District of New York D. The Theoretical Possibility of a Duty to Monitor Risk 1. Oversight + Securities Fraud 2. Red Flags + Failure to Act V. A NEW DUTY? A. Duty to Manage Risk Is Inconsistent with Fiduciary Duty Law B. Duty to Manage Risk Would Be Inherently Unmanageable C. Duty to Manage Risk as a Disclosure Duty VI. CONCLUSION I. INTRODUCTION
To the bewilderment of many, the 2008 financial crisis resulted in few criminal prosecutions of the corporate executives whose actions, individually or collectively, caused so much harm to so many investors, employees, taxpayers, and homeowners. (1) Following the 2001 accounting scandals, the "perp walk" became a frequent occurrence, with high-profile prosecutions ending in high-stakes sentences for high-flying corporate executives such as Bernard Ebbers, (2) Martin Grass, (3) Richard Scrushy, (4) Ken Lay, (5) and Jeff Skilling. (6) These cathartic rituals were all but absent from the 2008 financial crisis, (7) a fact bemoaned by many U.S. citizens8 who suffered more widely and acutely from the actions of Countrywide Financial, Lehman Brothers, AIG, Merrill Lynch, Morgan Stanley, Goldman Sachs, Bank of America, and Citigroup than from the actions of Enron or WorldCom. (9)
At the beginning of the decade, leaders who presided over the largest firm failures, such as Enron and WorldCom, went down with their ships both in terms of their careers and their freedoms, but following the corporate failures at the end of the decade, the leaders of AIG, (10) Lehman Brothers, (11) Bear Stearns, (12) Wachovia, (13) and others would not face prosecutions, only public outcry and some reputational effects. (14) The leaders of those financial firms that survived after receiving TARP funds, though their shareholders suffered tremendous losses, have retained their positions and their wealth. (15) Though the 2001 scandals involved intentional behavior that violated state and federal laws, particularly the federal securities laws, prosecutors have made few colorable allegations of intentional violations of existing statutory law against various actors involved in the 2008 (16) financial crisis. (17) The behavior at the heart of the financial crisis involved no obviously intentional violations of criminal laws or other regulations, but did involve risky trading practices surrounding mortgage-related derivatives. (18)
Criminal law, however, rarely applies to actions that result from poor judgment, leaving risky, or negligent, acts that cause harm to the civil torts system. (19) Arguably, the overwhelming majority of actions that combined to impair the U.S. economy were not criminal. In most cases, the independent and unrelated actors who caused the financial crisis did not intend to cause harm; they made poor decisions or took "excessive" risks. (20) What has understandably angered the investing community, workers, and homeowners in the wake of the financial crisis has been the otherwise-legal risk taking climates at financial firms that encouraged traders and other employees to use firm assets to take risky investment positions--originating, holding, or purchasing residential mortgage-backed securities (RMBS); selling credit default swaps (CDS) related to RMBS; purchasing or selling collateralized debt obligations (CDOs) related to RMBS; or some combination thereof. Continuing to invest, even heavily, in these types of securities in the face of negative financial forecasts was not illegal, (21) nor was being highly leveraged. unfortunately, state and federal laws are not good at criminalizing foolishness, even foolishness involving other people's money.
Historically, civil liability for extremely poor judgment, whether negligent or grossly negligent, has filled gaps that criminal law leaves behind. Actions without evil intent should arguably not be punished by the criminal law, but many of these same actions should give rise to civil liability to compensate the injured and deter future bad conduct. Without any type of criminal retribution for wrongdoers, shareholders of the foolhardy financial firms could theoretically bring civil lawsuits against the officers and directors of their firms for poor decision making. These corporate actors made bad decisions that not only affected the economy as a whole, but also lost substantial sums of money belonging to the corporation and thus its shareholders, to whom those actors owe fiduciary duties. Therefore, one could argue that, in the months leading up to the financial crisis, many boards of directors breached their duties to those shareholders to manage their firms responsibly. This argument stems from, and is bolstered by, the astounding losses of many firms, particularly financial firms. Specifically the numerous actions of firm employees taking on "excessive" risk at the outset proved devastatingly unwise, even stupid. (22) The concept of a new duty to manage risk provides a glimmer of hope that those at fault--corporate boards and officers--may be forced to compensate the firms for the "house money" that they lost at the Wall Street casino. Going forward, the argument continues, the existence of such a duty may have a deterrent effect on future boards, which may demand stricter internal systems for monitoring firm risk.
However, the existing corporate law scheme for challenging poor judgment does not leave much room for a cause of action based on mismanaging risk, even financial risk within financial firms. This corporate law reality is not a quirk of history, but the product of design; corporate law specifically anticipates and rejects claims based on poor judgment. (23) Though personal injury law embraces the theory of liability for simple negligence, corporate law in most states emphatically does not, preferring to rely on the market for capital and the market for labor to discipline poor or even mediocre management. (24) In other words, shareholders can sell shares of companies that are poorly managed, and companies can fire poorly performing managers; imposing liability through a shareholder suit is the least efficient way to discipline management. State law derivative actions do allow for directors and officers to be liable for grossly negligent decisions, conflicts of interest, and actions taken in bad faith. (25) Because of various doctrinal protections to preserve the judgment of directors and officers, however, most notably the business judgment rule, (26) absent a claim of a conflict of interest or obvious bad faith, shareholders rarely prevail in claims that directors breached fiduciary duties to the corporation. (27)
These impediments within corporate fiduciary duty law notwithstanding, several lawsuits have attempted to prevail on fiduciary duty claims, with predictably little success. Not to be stymied, some scholars have argued for courts to recognize this new duty (or a new component of an existing duty). (28) To do so, courts are urged to analyze board decisions either under a framework of how reasonable managers make decisions that impact overall firm risk (duty of care) or a framework of how reasonable managers monitor internal systems designed to manage firm risk (duty of loyalty). (29) In addition, in these and similar lawsuits, litigants have alleged breaches of the fiduciary duties relating to board decisions approving incentive compensation plans that encouraged excessive risk taking or approving large compensation packages for those who engaged in excessive risk taking. (30) Relatedly, some litigants have made other attempts to create a cause of action under federal securities law for failing to disclose excessive risk taking. (31)
This Article argues that not only does a duty to manage financial risk not exist within the prevailing corporate law framework of fiduciary duties, but also that recognizing a separate duty to manage financial risk (32) would be imprudent. (33) Breaches of this duty would be identifiable only in hindsight, and such a duty would require courts to resolve questions best left to individual firms and their shareholders. For example, courts would have to determine what amount of risk taking is excessive for a given firm at the point of time the decision was made, and whether lack of risk taking would still be actionable as a failure to manage risk. Theoretically, the duty to manage financial risk would also encompass failures to take risks, making risk-averse firms also susceptible to breach of duty claims. Furthermore, a duty to manage risk would seem to encompass not only financial risks, but also other sorts of risks, such as business risk, litigation risk, political risk, environmental risk, tort risk, and disaster risk.
This Article does not seek to rehash the arguments about the causes of the 2008 financial crisis. Though many may disagree over which factors were primary or contributing, most commentators agree that the economy was harmed by "excessive borrowing, risky investments and lack of transparency" at systemically important financial institutions, "collapsing mortgage lending standards," the holding of over-the-counter derivatives by financial institutions, and conflicts of credit rating agencies.34 This Article reviews the litigation that emanated from the financial crisis in which shareholders of financial institutions attempted to gain legal redress from those actions...
The duty to manage risk.
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COPYRIGHT GALE, Cengage Learning. All rights reserved.
COPYRIGHT GALE, Cengage Learning. All rights reserved.