Schwarcz, Steven L.

English

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Corporate Risk-Taking and the Decline of Personal Blame

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Tags: Corporate liability, Liability standards, Moral hazard, Risk, Risk-taking, Securities enforcement, Shadowbanking, Systemic riskMore from: Steven SchwarczEditor's Note: Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School ofLaw.Federal agencies and prosecutors are being criticized for seeking so few indictments against individuals in the wake of the2008 financial crisis and its resulting banking failures. This article analyzes why—contrary to a longstanding historicaltrend—personal  liability  may be on the decline,  and whether  agencies and prosecutors  should  be doing more.  Theanalysis confronts fundamental policy questions concerning changing corporate and social norms. The public and themedia perceive the crisis’s  harm as a “wrong” caused by excessive risk-taking. But that  view can be too simplistic,ignoring the reality that firms must take greater risks to try to innovate and create value in the increasingly competitive andcomplex global economy. This article examines how law should control that risk-taking and internalize its costs withoutimpeding  broader  economic  progress,  focusing  on  two  key  elements  of  that  inquiry:  the  extent  to  which  corporaterisk-taking should be regarded as excessive, and the extent to which personal liability should be used to control thatexcessive risk-taking.There is confusion and ambiguity over what corporate risk-taking is excessive. Corporate governance law already covers,and subjects managers to personal liability for engaging in, certain types of excessive risk-taking. But it does not cover thetype of increasingly common risk-taking that led to the financial crisis—risk-taking that could have systemic consequencesto the financial system. Until that crisis, a firm’s managers were viewed as agents for—and thus corporate risk-taking wasassessed by its potential impact on—the firm’s investors, focusing on the balance between risk-seeking shareholders andmore risk-averse creditors. Excessive risk-taking was therefore implicitly viewed as risk-taking that violated that balance;in practice, that was relatively easy to assess because, absent actual or contingent insolvency, managers owed their dutysolely to the shareholders.Systemic risk, however, is complicating that assessment. A systemically important firm’s failure can harm not only itsinvestors but also, by triggering a systemic collapse, the public at large. As a result, firms engage in transactions that areexpected to be profitable even though their failure could increase systemic risk, since much of the harm from a resultingsystemic collapse would be externalized. The article argues that corporate governance law should require managers totake that externalized harm into account, in order to protect the public. That could be done by viewing a firm’s managersas agents for—thereby assessing corporate risk-taking by its potential impact on—all of the affected parties, the public aswell as the firm’s investors. Given that reformulation of corporate governance law, the article examines how managerscould assess the impact of risk-taking on the public and also how they could attempt to balance that impact with theimpact on investors.Just  as  corporate  governance  law  already  subjects  managers  to  personal  liability  for  engaging  in  certain  types  ofexcessive risk-taking, the article argues that managers should be subject to liability for engaging in excessive systemicrisk-taking. In traditional corporate governance, shareholder derivative suits are the primary means to impose liability onmanagers. Shareholders would have no interest, however, in imposing liability on managers of their firm for externalizingsystemic harm. Therefore, the government, by default,  should have the right to impose that liability.  The article alsoexamines whether managers being exposed to that liability  should be protected by the business judgment rule (andconcludes they should).Posted by Steven L. Schwarcz, Duke University, on Thursday, February 12, 2015Corporate Risk-Taking and the Decline of Personal Blame http://corpgov.law.harvard.edu/2015/02/12/corporate-risk-taking-and-the...1 of 2 12/11/2015 1:57 PMFinally,  the article analyzes less direct  ways to impose personal  liability  to deter  excessive systemic risk-taking. Forexample, by protecting a firm’s shareholders from the firm’s liabilities (except to the extent of invested capital), corporatelimited liability fosters moral hazard, leading to excessive corporate risk-taking. In the past, corporate limited liability wasjustified because (by addressing shareholder risk aversion) it encourages equity-capital investment, and its potential forharm was thought to be limited to the firm’s investors. The externalized systemic harm associated with the rise of shadowbanking shifts that balance radically, however. Because shadow-banking firms are often managed directly by their primaryshareholders, who are entitled to a significant share of their firm’s profits but are protected under limited liability fromlosing more than their invested capital if the risk turns out poorly, those shareholder-managers have strong incentives totake high risks that could generate outsized profits.  Moreover,  the failure of  a shadow-banking firm is likely to havesystemic  consequences:  shadow  banks  not  only  engage  in  financial  intermediation  on  which  the  real  economy  isdependent  but  also  are  highly  interconnected  with  traditional  banks.  To  help  reduce  these  systemically  risk-takingincentives, the article proposes narrowing the limited liability protection of shareholder-managers who have the power tocontrol their shadow-banking firms.The full article is available for download here.Corporate Risk-Taking and the Decline of Personal Blame http://corpgov.law.harvard.edu/2015/02/12/corporate-risk-taking-and-the...2 of 2 12/11/2015 1:57 PM

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Corporate Risk-Taking and the Decline of Personal Blame

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