Misalignment: Corporate Risk-Taking and Public Duty

ABSTRACT This Article argues for a "public governance duty" to help manage excessive risk-taking by systemically important firms. Although governments worldwide, including the United States, have issued an array of regulations to attempt to curb that risk-taking by aligning managerial and investor interests, those regulations implicitly assume that investors would oppose excessively risky business ventures. That leaves a critical misalignment: because much of the harm from a systemically important firm's failure would be externalized onto the public, including ordinary citizens impacted by an economic collapse, such a firm can engage in risk-taking ventures with positive expected value to its investors but negative expected value to the public. The Article analyzes why corporate governance law should, and shows how it feasibly could, take the public interest into account. INTRODUCTION I. THE REGULATORY MISALIGNMENT A. Compensation B. Contingent Capital C. Too Big to Fail D. Volcker Rule E. Firm-Specific Financial Requirements II. Redesigning Regulation A. Additional Regulation Is Needed B. Regulating Substance C. Regulating Governance III. Towards Regulatory Alignment: A Public Governance Duty A. Analyzing a Public Governance Duty Under Corporate Governance Legal Theory 1. The Stakeholder Model of Governance 2. The Contractarian Model of Governance 3. The Shareholder-Primacy Model B. Implementing a Public Governance Duty 1. Legally Imposing the Duty 2. Assessing Costs and Benefits 3. Balancing Costs and Benefits 4. Enforcing a Public Governance Duty 5. Business Judgment Rule as a Defense 6. Protecting Managers Under D&O Liability Insurance CONCLUSION APPENDIX: MODEL REGULATORY LANGUAGE FOR A PUBLIC GOVERNANCE DUTY Public Governance Duty Act SECTION 1. TITLE SECTION 2. DEFINITIONS SECTION 3. PUBLIC GOVERNANCE DUTY SECTION 4. LIABILITY AND ENFORCEMENT SECTION 5. DEFENSES AND INSURANCE SECTION 6. WHISTLEBLOWING RIGHTS AND OBLIGATIONS INTRODUCTION Should corporate governance law take into account risk-taking that could systemically harm the public? Corporate risk-taking is certainly economically necessary and often desirable. (1) Successful risk-taking increases profitability, thereby enhancing welfare by generating jobs and purchasing power. (2) But corporate risk-taking can sometimes cause harm. There is widespread agreement that excessive corporate risk-taking was one of the primary causes of the systemic economic collapse that became the 2008-2009 global financial crisis (the "financial crisis"). (3) There is also a consensus that existing regulatory measures to curb that risk-taking and prevent another crisis are inadequate. (4) Many of the regulatory responses to the financial crisis, both in the United States and abroad, seek to mitigate excessive risk-taking by systemically important financial firms. (5) Various of those responses are designed to control that risk-taking by aligning managerial and investor interests to reduce agency costs and make managers less likely to engage their firms in risky business ventures that could jeopardize investors. These responses implicitly assume that the investors themselves would oppose excessively risky business ventures. That assumption, however, is flawed, and therefore financial regulation based on the assumption's validity is unreliable. The assumption is flawed because what constitutes "excessive" risk-taking depends on the observer. Risk-taking is excessive from a given observer's standpoint if it has a negative expected value to that observer (i.e., the expected costs to that observer exceed the expected benefits). …