Last week I blogged (here) that if we assume a corporate board’s duty of oversight includes monitoring risk exposure, then it should constitute a per se violation of that duty for a board to rule on a particular risky strategy without understanding the nature of the risk.  Stephen Bainbridge disagreed (here) for the following reasons:   First, such a rule would discourage appropriate risk-taking. 

As the federal Second Circuit explained in Joy v. North … "[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.” 

Second, such a rule would run counter to the business judgment rule, which precludes courts from imposing liability for bad business decisions. 

As Chancellor Chandler correctly recognized in Citigroup, "asking the Court to conclude … that the directors failed to see the extent of Citigroup’s business risk and therefore made a ‘wrong’ business decision by allowing Citigroup to be exposed to the subprime mortgage market…. [constitutes the] kind of judicial second guessing [that] the business judgment rule was designed to prevent, and even if a complaint is framed under a Caremark theory, this Court will not abandon such bedrock principles of Delaware fiduciary duty law.” 

Finally, per se rules are inappropriate in this context because what courts really should be doing is “reconciling the competing claims of authority and accountability” by “balancing competing concerns” rather than blindly applying bright-line rules.

As a general matter, I don’t disagree with any of Bainbridge’s propositions.  However, I believe they are all subject to exceptions, and a failure to demonstrate a proper understanding of relevant risk exposure may constitute such an exception.  To begin with, we want to encourage appropriate risk-taking, not recklessness.  One cannot optimize risk exposure without understanding the complexities of the particular strategy.  As Frank Partnoy discussed in terms of the recent financial crisis (here):

[O]ne of the great ironies, I think, of the financial crisis was that the senior people at the Wall Street banks apparently didn't understand or capture the magnitude of their own financial institutions' exposure to these risks, which is really stunning, if you think about it, that the people who are in charge of these banks don't know what will happen when there's a 30 percent decline in housing prices. If you think about it, if you're the director or the CEO of a bank, isn't that the one thing you should understand? What will happen to my institution if the following financial variable changes by 30 percent? That kind of worst-case scenario analysis is why you're being paid millions of dollars. That's precisely what these people should have been doing.

Secondly, if we understand the business judgment rule to be about distinguishing “honest errors” from “intentional misconduct,” then I think signing off on a particular strategy without an appropriate understanding of the risk is closer to intentional misconduct than honest error.   Post-2008 it is very difficult to take seriously any director’s claim that they didn’t realize they needed to get up to speed on risk-exposure.  Obviously, I would include reasonable reliance on an appropriate expert as satisfying this requirement, but you need more than the 2012 equivalent of Van Gorkom assuring you that house prices will go up forever.

Finally, while I agree courts frequently need the flexibility of standards that allow for the balancing of competing interests, a bright-line rule that requires directors to understand the risk-creating strategy they are reviewing as a part of their Caremark duties seems to me to appropriately give business leaders something else they crave: clear guidance.  In other words, where red flags present themselves in connection with a particularly risky investment strategy, a board would be on notice that ignoring those red flags without being able to verbalize the scope of the risk would constitute an utter failure of oversight.

PS--Over at the Glom (here), David Zaring has posted some great links on the JP Morgan loss.