Corporate & Securities Law

Turning Bad Faith into Full Employment for Lawyers

By Stephen Bainbridge

Edward M. McNally and Patricia A. Winston have posted an article seeking to give content to the emergent Delaware concept of “bad faith” director conduct. It’s worth reading. Setting aside the merits of their definitional efforts, however. I was struck by their conclusion:

Ryan suggests that directors must be cautious when confronting unusual corporate actions or any corporate action not in the normal course of its business. Directors should seek the advice of counsel when undertaking any unusual corporate action. Counsel will advise directors of the applicable law, legal obligations and the effects of action or inaction. Such advice will allow directors to defend any allegation of intentional wrongdoing by waiving attorney client privilege and revealing the steps taken in good faith reliance on that advice. This course of action will make it difficult for plaintiffs to establish a claim that the directors failed to act or consciously disregarded their responsibilities.

In other words, Ryan v. Lyondell is “The Lawyer (and sometimes Investment Banker, Auditor, Compensation Consultant, Risk Management Guru, or Whatever Other Expert is Relevant) Full Employment Act of 2008.” If this holds up, Ryan will continue the legacy of Smith v Van Gorkom as a source of excess investment in process. If their advice is followed, even more board decisions will be subjected to exhaustive review, with detailed presentations by experts. Why? The answer lies in the incentive structures of the relevant players. Who pays the bill if the director is found liable for breaching the duty of care? The director.  Who pays the bill for hiring lawyers and investment bankers to advise the board? The corporation and, ultimately, the shareholders. Suppose you were faced with potentially catastrophic losses, for which somebody offered to sell you an insurance policy. Better still, you don???t have to pay the premiums, someone else will do so. Buying the policy therefore doesn???t cost you anything. Would not you buy it?

It???s also important to consider the incentives of the lawyers who advise corporations. Deciding how much time and effort to spend on making decisions is itself a business decision. Because that decision is driven by liability concerns, however, legal advice is usually critical to the making of the decision. Why might lawyers have an incentive to encourage boards to over-invest in the decisionmaking process? The cynical answer is that a more complicated decisionmaking process, which is driven by liability concerns, is likely to result in higher fees. A less cynical explanation is that the law is full of sports, mutants, and mistakes. Clients often lack the information or willingness to recognize that their situation was one of the exceptions that proves the rule. Instead, clients tend to blame the lawyer for an adverse outcome even if the lawyer did nothing wrong. Because the lawyers will be blamed even if losing the case was an act of god equivalent to a 100-year flood, lawyers are often conservative in giving advice. (The term conservative here is not used in its political sense, but rather in the sense of being cautious.) In economic terms, lawyers are risk averse. In a risky situation, the best thing for the lawyer to do is to point the client towards strategies whose outcome is certain.

In sum, the incentives of both sellers and buyers of legal advice are congruent. Lawyers have strong incentives to encourage clients to expend a lot of time, energy, and money on the decisionmaking process (and to write articles recommending such expenditures, for that matter), while corporate boards of directors have strong incentives to take that advice.

Full post as published by BusinessAssociationsBlog.com on October 23, 2008 (boomark / email).