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Friday, March 18, 2005

Outside Director Liability

Steve Bainbridge points us to this essay on outside director liability from the Stanford Lawyer. One section asks, "Will the Settlements Deter Capable People From Serving on Boards?" It says:

Despite the importance of outside directors and the considerable amount of time now required of them, directors' fees are not very high by the standards of people who generally take these positions—about $140,000 for the largest companies and a lot less for smaller ones. Perceived liability risk would not have to increase much to induce attractive boardroom recruits, such as chief executives of major public companies, to decline directorships.

Outside directors already overestimate the likelihood of out-of-pocket liability, and frequently cite the fear of liability as a reason not to serve. According to surveys we have conducted, even prior to the WorldCom and Enron settlements outside directors believed on average that out-of-pocket liability occurs in about 5 percent of shareholder suits. The actual number is far lower—only a few instances out of several thousand cases—but it is the perception of liability risk that affects directors' willingness to serve.

The WorldCom and Enron settlements will increase liability fears among outside directors. This would be a natural consequence of any high-visibility out-of-pocket payment. The perception of liability risk in the wake of WorldCom and Enron, however, is compounded by the political overtones associated with the lead plaintiffs' being public entities. Even if politics played no role in these cases, one can reasonably be concerned that political considerations unrelated to corporate governance will cause lead plaintiffs in the future to insist on personal payments by outside directors. Especially in light of the praise for the Enron and WorldCom settlements, others making litigation decisions on behalf of public entities may think "If Alan Hevesi made the outside directors pay in WorldCom, I'll look pretty bad if I don't do so as well."

click here for the whole article.

This a great example of the law of unintended consequences. I was recently reading (for the third time) a copy of Thomas Sowell's book Applied Economics: Thinking Past Stage One. In it, he recounts a story of his grad school days when one of his professors asked him what would happen in a given scenario. After his answer, the professor then asked, "then what would happen?" After more thought, Sowell gave his answer. Then, the professor asked, "And THEN what would happen?" It reminded me that actors in a system will always adjust their actions.

I was recently talking to a friend who serves on several boards. He mentioned that he's dropping off most of the boars he serves on because of this very issue.

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