Toward a public enforcement model for directors' duty of oversight.

• Author: Jones, Renee M.

ABSTRACT

This Article proposes a public enforcement model for the fiduciary duties of corporate directors. Under the dominant model of corporate governance, the principal function of the board of directors is to oversee the conduct of senior corporate officials. When directors fail to provide proper oversight, the consequences can be severe for shareholders, creditors, employees, and society at large.

Despite general agreement on the importance of director oversight, courts have yet to develop a coherent doctrine governing director liability for the breach of oversight duties. In Delaware, the dominant state for U.S. corporate law, the courts tout the importance of board oversight in dicta, yet emphasize in holdings that directors cannot be personally liable for oversight failures, absent evidence that they intentionally violated their duties.

We argue that some form of external enforcement mechanism is necessary to ensure optimal conduct from corporate leaders. Unfortunately, the disciplinary force of shareholder litigation has been vitiated by procedural rules and doctrines that make it exceedingly difficult for plaintiffs to prevail in derivative litigation. Because private shareholder litigation no longer fulfills its traditional role, the need exists for alternative mechanisms for director accountability.

We look to Australian corporate law for solutions to the problem of enforcing the duty of oversight. Australian corporate law encompasses a range of enforcement mechanisms for directors' duties. The Australian Securities and Investments Commission (ASIC) has power to sue to enforce directors' statutory duties. ASIC can seek a range of penalties for breach of duty, including pecuniary penalties and officer and director bars. ASIC has prevailed in a number of high-profile actions against directors of public companies in recent years. Despite the relative rigor of enforcement in Australia, capable directors continue to serve and its economy has thrived.

The Article explores several possibilities for incorporating public enforcement into the U.S. corporate governance system. We consider SEC enforcement of fiduciary duties and enforcement by states' attorneys general. We also consider empowering state judges to impose bars on future service, as an alternative to tort-based damages awards. Regardless of the exact model of public enforcement, the reforms advanced here would help provide for greater director accountability and thus better motivate directors to perform their duties responsibly.

TABLE OF CONTENTS I. INTRODUCTION II. THE FAILURE TO ENFORCE OVERSIGHT DUTIES IN THE UNITED STATES A. The Monitoring Model of Corporate Governance B. Enforcing the Duty to Monitor 1. The Derivative Suit 2. Oversight Duties and Good Faith C. The Economic Consequences of Oversight Failures III. ASSESSING DEFENSES OF THE LAX DIRECTOR LIABILITY REGIME A. Common Defenses of Delaware's Lax Liability Regime B. Law Compliance Literature 1. Flaws in the Norms Governance Hypothesis for Those Motivated by Normative and Social Factors 2. Flaws in the Norms Governance Hypothesis for Those Motivated by Calculated Factors 3. Multiple Motivating Factors C. Toward an Ideal Enforcement Regime IV. PUBLIC ENFORCEMENT OF DIRECTORS' DUTIES IN AUSTRALIA A. The Development of Australia's Corporate Law Regime B. The Basic Structure of Australian Corporate Law 1. Sanctions for Breach of Duty 2. Prohibition on Indemnification and Company-Provided Insurance 3. The Rationale for the Civil Penalty Regime C. Enforcing the Duty of Care in Australia 1. ASIC's Enforcement Record a. The James Hardie Group b. Other ASIC Cases 2. Assessing the Impact of ASIC Enforcement V. ENVISIONING PUBLIC ENFORCEMENT OF DIRECTORS' DUTIES IN THE UNITED STATES A. Some Advantages of Australia's Enforcement Regime 1. Pecuniary Penalties 2. Disqualification Orders B. Implementing Public Enforcement 1. Federalism Constraints 2. SEC Enforcement 3. State Enforcement a. Administrative Action b. Judicial Remedies C. Federalism's Conundrum VI. CONCLUSION I. INTRODUCTION

The precipitous collapse of many of our major financial institutions has revealed significant flaws in the U.S. corporate governance regime. Public inquiries into the failure of Bear Stearns, Lehman Brothers, and Citigroup consistently portray directors as oblivious to the scope of the risks their firms had undertaken. Directors remained blind to significant departures from approved risk management guidelines and failed to detect flaws in financial reporting practices that led to systematic underreporting of leverage and the concealment of devastating losses.

Since the 2008 financial collapse, Congress and financial regulators have adopted major reforms designed to prevent the recurrence of such calamities. Similarly, in 2002, Congress, the SEC and self-regulatory organizations adopted reforms aimed at preventing future financial frauds. Despite these major federal reform initiatives, a basic corporate governance problem remains unresolved. The 2001-2002 corporate governance scandals and the 2008 financial crisis have laid bare a basic reality. Directors are not providing the kind of corporate oversight that forms a fundamental tenet of the monitoring model of corporate governance.

The director's role as corporate monitor serves as an article of faith among most corporate theorists. Prestigious institutions, from the American Law Institute to the Business Roundtable, embrace the monitoring model. The monitoring model forms the basis of the Sarbanes-Oxley reforms that sought to strengthen the hand of independent directors vis-a-vis corporate management. Likewise, state judges, who act as principal enforcers of fiduciary duties, consistently emphasize the importance of board oversight. In judicial opinions and outside commentary, judges urge directors to pay attention, stay informed, and act as vigilant monitors of the conduct of corporate managers.

Despite broad acceptance of the monitoring model, courts have yet to develop a coherent doctrine governing director liability for the breach of oversight duties. In Delaware, the dominant state for U.S. corporate law, courts curiously tout the importance of board oversight in dicta, yet emphasize in holdings that directors cannot be personally liable for oversight failures, absent evidence that they intentionally violated their duties. (1) While setting a high bar for liability, courts have offered little guidance about the kinds of facts that would satisfy this arduous standard.

Many commentators defend this laissez-faire approach to enforcing directors' duties. (2) They argue that the law should stand aside to let private forces such as the market and social norms promote responsible conduct among corporate officials. These commentators maintain that a rigorous liability regime would harm shareholder interests by discouraging risk taking and deterring qualified directors from serving. (3) The risk of unfair hindsight bias, litigation costs, and shareholders' asserted ability to limit their risk exposure through portfolio diversification serve as further rationales for shielding directors from liability. (4)

Another reason courts refrain from enforcing the duty of oversight is that the penalties seem harsh when compared to an outside director's degree of responsibility for the alleged harm. (5) To avoid reaching what is perceived as an unjust result, courts have too often spared directors from any consequence for their failure to perform their core function. (6) This unwillingness to enforce the duty to monitor leaves directors with little guidance on the content of their duties, contributing to the kind of board passivity associated with recent corporate collapses.

When directors fail to provide proper oversight, the consequences can be severe for corporations, investors, employees, and society at large. Although markets and social factors can influence director behavior, some form of external discipline is necessary to ensure optimal conduct. The shareholder lawsuit was created to serve this function. (7) Unfortunately, the disciplinary force of shareholder litigation has been vitiated by procedural rules and doctrines that make it exceedingly difficult for plaintiffs to prevail in derivative litigation. Because private shareholder litigation no longer fulfills its traditional role, the need exists for alternative mechanisms for director accountability.

We look to Australian corporate law for possible solutions to the problem of enforcing the duty of oversight. (8) U.S. and Australian corporate law both emerge from the "Anglo-American" common law tradition. Thus, the United States and Australia share the same basic corporate governance structure. Like the United States, Australia has a highly developed economy with sophisticated trading markets, characterized by dispersed share ownership. (9) In recent decades however, Australia has revamped its corporate law system, confronting the difficulties that federalism posed to maintaining uniform national standards and bolstering mechanisms for enforcing the obligations of corporate officers and directors. (10) Thus, despite a shared legal tradition, enforcement practices in Australia now diverge significantly from U.S. custom. (11)

The Australian example matters in part because its financial regulatory system has drawn the attention of commentators in the United States and throughout the world. Its "twin peaks" approach to financial regulation has been held up as a model for global financial reform initiatives. (12) Under twin peaks, responsibility for financial regulation is divided according to regulatory objectives, with a systemic risk regulator and a business conduct regulator. (13) The twin peaks approach figured prominently in former Treasury Secretary Henry Paulson's "Blueprint" for financial reform and in the Group of 30's similar set of recommendations. (14) Although the Blueprint and the G-30 report...