2.2.1 Directors’ liability as a corporate governance instrument

Directors’ liability is believed to be an important corporate governance instrument that provides incentives for or imposes constraints on the behaviour of company directors. Two important views may be argued regarding directors’ liability in this respect. According to the first view, directors’ liability has a deterrent function. The threat of liability induces company directors to take due care and to avoid risky decisions that may jeopardise the company’s continuity. The second view shifts directors’ liability to the background. Risk taking is seen as a prerequisite for the survival and continuity of a company. Recognising the ‘primacy’ of risk, makes it necessary for company directors who undertake risky projects to be protected under the framework of directors’ liability legislation.1

The focus of this Chapter is on this second view, one in which the Dutch case Willemsen Beheer v. NOM plays a central role.2 In the judgment, it was assumed that the fear of personal liability may prevent company directors from undertaking risky projects that could potentially benefit the company. The Supreme Court decided that it was in a company’s best interest to have directors’ liability legislation mitigate such undesirable forms of risk aversion. This study explores the ‘defensive behaviour argument’ in more detail. To link this court decision to defensive behaviour and to understand how defensive behaviourmight result in a corporate governance problem, I intend to make an analogy with the situation in medicine by borrowing from the literature available in studies on defensive medicine and risk perception.

It has long been recognised that personal liability may cause Dutch company directors to be extra careful in their actions, since they might have to bear for any injurious conduct.3 This flies in the face of the fact that, in the Netherlands, litigation is relatively infrequent4 and the probability of out-of-pocket settlements relatively low.5 This low frequency of out-of-pocket payments may indicate that most cases are not litigated but settled within D&O policy limits and that directors are consequently insulated from the costs of legal action. As a result, these costs have little impact on the directors’ decision-making and exercise of due care. Nevertheless, empirical research indicates that the perceived probability and severity of punishment are influential in changing an individual’s mode of behaviour.6 Despite the low frequency of a company director being held personally liable and the rarity of out-of-pocket settlements, several surveys indicate that the risk apprehensions of directors do not correlate well with their actual liability risks. Some scholars have suggested that company directors respond to a perceived chance of incurring liability with defensive practices, greater precautions or avoidance of risky activities altogether.7 This position is supported by surveys indicating that the threat of directors’ liability and unfavourable legal decisions have a significant impact on a director’s willingness to accept board appointments.8 Such surveys may generally provide support for the deterrence theory by emphasising the role that an individual’s perception of legal sanction plays in the propagation of defensive practices among company directors. They do not, however, tell us anything about the manner in which and the conditions under which looming liability comes to be perceived by a company director as a serious personal threat.

Specific empirical studies on the relationship of perceived liability and risk taking are largely confined to the medical profession9 and have not been extended to cover issues relating to directors’ liability. Like a physician, a company director is considered a professional who is exposed to personal liability in exercising his or her profession and must abide by the profession’s standards of care. Liability may arise for both of these professionals if a breach of care is demonstrated and this breach results in harm. This study therefore brings new insights in the understanding of defensive director behaviour by placing the focus on a director’s liability and desire to limit it.