Professor Bainbridge mourns the increasing criminalization of corporate governance:

Business decisions rarely involve black-and-white issues; instead, they typically involve prudential judgments among a number of plausible alternatives. Given the vagaries of business, moreover, even carefully made choices among such alternatives may turn out badly.

At this point, the well-known hindsight bias comes into play. Decisionmakers tend to assign an erroneously high probability of occurrence to a probabilistic event simply because it ended up occurring. If a jury knows that the plaintiff was injured, the jury will be biased in favor of imposing negligence liability even if, viewed ex ante, there was a very low probability that such an injury would occur and that taking precautions against such an injury was not cost effective.

Hence, there is a substantial risk that juries will be unable to distinguish between competent and negligent management because bad outcomes often will be regarded, ex post, as having been foreseeable and, therefore, preventable ex ante. If liability results from bad outcomes, without regard to the ex ante quality of the decision and/or the decisionmaking process, however, managers will be discouraged from taking risks. If it is true that lack of gumption is the single largest source of agency costs, as somebody once said, rational shareholders will disfavor liability rules discouraging risk-taking, as Judge Ralph Winter opined in Joy v. North [692 F.2d 880, 886 (1982)]:

[B]ecause potential profit often corresponds to the potential risk, it is very much in the interest of shareholders that the law not create incentives for overly cautious corporate decisions. ... Shareholders can reduce the volatility of risk by diversifying their holdings. In the case of the diversified shareholder, the seemingly more risky alternatives may well be the best choice since great losses in some stocks will over time be offset by even greater gains in others. ... A rule which penalizes the choice of seemingly riskier alternatives thus may not be in the interest of shareholders generally.

Hence, when juries review the merits of even bad corporate governance, they run the risk of effectively penalizing "the choice of seemingly riskier alternatives."

posted by James DeLong @ 7:35 AM | Accounting

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