Corporate Governance

Opting Only In: Delaware and the Race to the Bottom (Part 4)

By J. Robert Brown

We are discussing a paper recently posted on SSRN titledOpting Only In: Contractarians, Waiver of Liability, and the Race to the Bottom and examining the development and use of waiver of liability provisions.

According to the legislative history of Section 102(b)(7), the impetus for waiver of liability was the D&O insurance crisis and the potential impact on corporate governance.

• Section 102(b)(7) and the amendments to Section 145 represent a legislative response to recent changes in the market for directors' liability insurance. Such insurance has become a relatively standard condition of employment for directors. Recent changes in that market, including the unavailability of the traditional policies (and, in many cases, the unavailability of any type of policy from the traditional insurance carriers) have threatened the quality and stability of the governance of Delaware corporations because directors have become unwilling, in many instances, to serve without the protection which such insurance provides and, in other instances, may be deterred by the unavailability of insurance from making entrepreneurial decisions. The amendments are intended to allow Delaware corporations to provide substitute protection, in various forms, to their directors and to limit director liability under certain circumstances.

The rationale was suspect, purporting to solve a problem in the D&O insurance market that either did not exist or could have been more appropriately corrected by the market. First, it presupposed that the insurance “crisis” resulted from an increased risk of liability under the duty of care, an unproven assumption at the time and one that ultimately proved incorrect. Second, there was every reason to believe that the problem would be short lived, with the market, in time, establishing a new equilibrium. In fact, by 1987, the crisis was largely over.

The purported concern over corporate governance likewise was never established. While some anecdotal “evidence” indicated a growing number of resignations, the evidence was never marshaled to show that this resulted from problems in the D&O insurance market or that adequate replacements were unavailable.  Indeed, some of the evidence suggested that directors quit not because of a threat of liability but because, in the aftermath of Van Gorkom, they had to work harder. Moreover, even if the pool had declined, companies had a ready mechanism for correcting the imbalance: increasing directors’ fees.

The adoption of waiver of liability amounted to an overbroad response to the purported concerns about “uncertainty” in the application of the duty of care. The issues arising out of Van Gorkom could have been addressed in a more narrow fashion, focusing, for example, on the basis for establishing an informed decision. The provision, however, went beyond the purported problems created by the decision, eliminating liability even in circumstances where no uncertainty existed.

In other words, the Delaware legislature adopted waiver of liability provisions to cure an insurance “crisis” that was short lived, and likely structural, in order to prevent adverse consequences for the board of directors that were unproven. And, rather than fix the perceived concerns with Van Gorkom with a narrowly tailored approach, it opted for an overbroad solution that exonerated directors for breach of the duty of care in all circumstances. In short, it was a provision designed less to solve a real governance problem and more to use the surrounding din as cover to reduce director liability.

Waiver of liability did not, therefore, restore the D&O insurance market. It did, however, restore Delaware’s pro-management position, something that had taken a beating in the aftermath of Van Gorkom. In other words, the “crisis” was little more than a cover for a substantial, pro-management change in fiduciary obligations. Indeed, in the immediate aftermath of the adoption of Section 102(b)(7), a significant number of companies reincorporated in Delaware, presumably in an effort to take advantage of the ability to waive liability for breach of the duty of care. 

Full post as published by The Race to the Bottom on February 01, 2008 (boomark / email).