Directors’ and Officers’ Liability: Economic Analysis

Directors’ and officers’ liability marks a center point of the corporate governance debate everywhere. Legal approaches seem to have converged over recent years. Persisting differences affect the direction of multi-national companies. We argue that courts should take a functional perspective.

Liability can be described as a constraints strategy. Constraints serve to draw a line between acceptable and inacceptable behavior, the latter being subject to a monetary sanction. Using liability as a constraints strategy in limited liability corporations must distinguish between inside and outside responsibilities:  

Firstly, inside liability towards the corporation serves to protect owners against stealing and shirking by agents. Whilst possible forms of stealing can be described relatively clearly, shirking is less easily described and requires a more flexible legal test. This test is widely known as the business judgment rule. It serves to enable risk taking ex ante by shielding agents from second guessing by courts ex post.

Secondly, liability should be at hand to prevent coalitions with owners that aim at misusing the corporate veil to the detriment of parties outside the corporation. Too far reaching outside liability, however, will preclude achieving the goals of court abstention under any type of business judgment rule.

How to get the interaction between these types of liability right in practice? The real picture depends on the availability and shape of indemnification, waivers, and insurance covers as well as on the procedural setting for private enforcement.

The least resolved issues concern monitoring failures. Liability of non-executive directors or supervisory directors seems to be a double mirror of the hindsight problem. From a functional perspective it seems advisable to reconsider the thoughts that have inspired court abstention from second-guessing management decisions under the business judgment rule.

Our paper contributes to an edited volume that comprises country experience:

‘Directors & Officers Liability’ edited by Simon F. Deakin, Helmut Koziol, and Olaf Riss, forthcoming 2018.