Directors’ and Officers’ Liability: Economic Analysis

This paper will be published as a chapter of the forthcoming volume ‘Directors & Officers Liability’ edited by Simon F. Deakin, Helmut Koziol, and Olaf Riss. It explores D&O liability from a law and economics perspective with a view to identify trade-offs of different legal settings. The paper is organised along the general structure of the edited volume.

Limited shareholder liability marks the starting point for understanding the rationale of outside D&O liability towards creditors where the delegation of decision making is misused by owners. In turn, inside liability towards the corporation protects owners against misbehavior of their agents. Outside and inside liability inter-act in that they both serve to reduce the overall costs of firms with delegated management.

Inside liability is shaped by the duty of loyalty which protects the corporation against stealing and the duty of care that prevents shirking by agents. The differences between these types of duties are a result of the limited possibilities to specify rules of behavior ex ante one the one hand and the need for open standards regarding risk taking which concretize only ex post on the other hand. The danger of hindsight by courts can be reduced by procedural tests that serve as abstention rules to preclude second guessing. Internal monitoring can prevent misbehavior but failures of internal monitors seem to be a double mirror of the hindsight problem that inspired abstention from reviewing management decisions.

Outside D&O liabilities to third parties can be seen as a strategy to prevent opportunistic behavior of owners especially in regard to financial disclosure and insolvency. The overall incentive structure depends on the availability of ex ante indemnification, ex post waivers, and insurance covers.