Directors getting the jitters

An article in today’s W$J is about the market for corporate directors in the aftermath of Enron and WorldCom, discussed here and here. The problem is that the directors in those cases were held liable for what non-fraudulent and even (as they thought at the time) conscientious behavior. 

In hindsight we know that their inattention was arguably problematic. But what signal does this send to future directors who don’t have the benefit of hindsight?  While the shareholders would hope that the liability would simply make the directors more careful (that is, avoid Type II error), good and careful directors may be overcareful, or simply avoid serving (Type I error).

We can address these problems by either paying directors to tale the risk, or protecting them with insurance. 

The problem regarding insurance is that this liability might be the kind of shock to the market that the insurers have a hard time pricing – like what happened after Van Gorkom.  See Romano, Corporate Governance in the Aftermath of the Insurance Crisis, 39 Emory L.J. 1155 (1990).  So insurance may be very costly or unavailable for some companies, particularly the riskier ones.  There may be an adverse selection problem – only the least valuable, most risk-preferring directors will be willing to take the liability risk of serving. The companies that most need monitoring by good outside directors therefore will have the hardest time attracting them. As a result, the riskiest companies -- i.e., the most innovative ones – will have the hardest time entering the capital markets.

We might try paying directors more to compensate them for the liability risk that insurance doesn’t cover.  The problem with increased compensation is that undiversified directors are going to want more to cover their risk than the diversified shareholders are willing to pay.

Maybe these dire effects won’t happen, or maybe they’re worth the benefit of more monitoring, either by directors or by their insurers.  But these are tradeoffs that should be made in the market for state law, which can experiment with different levels of liability, and not laid down as an edict at the federal level, which is what’s happening in these WorldCom and Enron federal securities lawsuits and in Sarbanes-Oxley.

Finally, maybe the public simply won’t accept the sort of misconduct that went on in these companies without some major changes and accountability.  But as I keep saying, there’s an alternative to the corporation. . .

PS: Professor Bainbridge also comments on director liability, noting the WSJ article I discuss and the Enron and WorldCom settlements, and some of the policy considerations against director liability. He links with his writing on the business judgment rule. It bears emphasis that the WorldCom and Enron settlements were under federal securities regulation – one (WorldCom) involving fairly strict liability for signing disclosure documents, the other (Enron) involving some stock trading by directors. Expanding federal securities liability, and not the sort of state liability that is implicated in the business judgment rule, is the real threat to directors I focus on in the above post.