SYDNEY: 16 March 2013 - A longstanding debate in corporate law is whether, and the extent to which, directors should be subject to an enforceable duty of care. More than minimal enforcement has been considered undesirable due to concerns about over-deterrence and the efficient allocation of risk. However these concerns need to be balanced against considerations of accountability.  The lack of public or private enforcement actions against and consequent lack of accountability of the directors of financial institutions for allowing their institutions to take excessive risks not only undermines the legitimacy and effectiveness of the legal framework but also raises questions about the legitimacy of corporate power. The enforcement of the duty of care needs to be revisited in the light of this.

One particular issue highlighted by the financial crisis is whether the standard of care, skill and diligence that regulators and the courts enforce is, or should be, norm setting or norm reflecting. 

The Financial Services Authority’s decision not to take enforcement action against the directors of the Royal Bank of Scotland plc. (RBS) in respect of the takeover of ABN-Amro illustrates the issue. The largest takeover in banking history, and a key cause of RBS’s collapse, proceeded on the basis of a due diligence exercise comprising two lever arch files and a CD. The FSA’s report into the collapse of RBS criticized the due diligence exercise as wholly inadequate and stated that the directors had gambled by proceeding on the basis of such due diligence. Nevertheless the FSA concluded that none of its Rules, Principles of Business or Statement of Principles for Approved Persons (APER), were contravened. Amongst the reasons it gave was that the amount of due diligence conducted was in line with market practice. Given this the standard of care required by the FSA appears to have been norm-reflecting, that is, it was set by prevailing market practices. Meanwhile as far as private enforcement is concerned, it is an open question as to whether actions against directors for breach of the duty of care, skill and diligence under s. 174 Companies Act 2006 would be successful where directors had acted irrationally but in a way that reflected market standards of behaviour, as occurred in banks prior to the financial crisis.

Much turns on how the courts and the regulator approach the concept of reasonableness. It has rightly been said that to label a decision unreasonable marks a conclusion rather than a reason. One way to give this concept content is to judge it by market norms-meaning market practices and, where relevant, rules or practices that market actors self-consciously adhere to and feel obliged to adhere to. There are good reasons why this will usually be the right way forward not least because as the Learned Hand stated in the T.J. Hooper ‘in most cases, reasonable prudence is in fact common prudence’. Nevertheless as the FSA’s approach to the takeover of ABN-Amro by RBS suggests that there are times when market practice should be judged unreasonable.

The issues then are whether and if so under what circumstances this might be permissible and who is best placed to enforce norms which are higher than the standards prevalent in the market: the courts or regulators. Parallels can be drawn with the courts’ approach in professional negligence cases. Just as in corporate law, there is concern in medical cases in particular, that the courts should not be too quick to find medics negligent due to concerns about over-deterring and the courts’ lack of institutional competence will be drawn. As a result the courts rely greatly on evidence of professional practice. It is not being advocated that the courts should show the same deference to expert evidence as is shown in medical cases, and this would be wholly inappropriate for a regulator, but it is nevertheless instructive to identify when common practice is found unreasonable in that context.

The broader questions raised by this discussion are how one regulates through broad standards/principles set ex ante - such as a duty to exercise the care of a reasonable director - which require their content to be clarified ex post in a manner that is fair to the regulated but which allows for the promotion of effective accountability through law and regulation.