The Agent’s Problem

by Asaf Eckstein & Gideon Parchomovsky

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Abstract

The agency problem, the idea that corporate directors and officers are motivated to prioritize their self-interest over the interest of their corporation, has had a long-lasting impact on corporate-law theory and practice. In recent years, however, as federal agencies have stepped up enforcement efforts against corporations, a new problem has surfaced: what we call the “reverse agency problem.” The surge in criminal investigations against corporations, combined with the rising popularity of settlement mechanisms, including pretrial diversion agreements and corporate plea agreements, has led corporations to sacrifice directors and officers in order to reach settlements with law enforcement authorities as expeditiously as possible. This phenomenon is the mirror image of the agency problem—the agent’s problem.

Although such settlements are in the best interests of companies and shareholders, they can have devastating effects on individual directors and officers. When they agree to settle a criminal prosecution, suspect companies collectively attribute wrongdoing to a large group of directors and managers without distinguishing between the guilty and the innocent. As a result, directors and officers implicated in settlements often suffer severe reputational losses, regardless of their culpability. Furthermore, the wrongdoing attributed to directors and officers in settlements exposes them to derivative lawsuits for breaches of their fiduciary duties. Unfortunately, extant law does not provide directors and officers with a means to prove their innocence or clear their names. In fact, it does not even give them a voice in the negotiations leading to the drafting of settlements. Thus, it dooms many directors and officers who have done no wrong to live with the mark of Cain and endure the economic consequences thereof.

Four legal reforms could remedy the plight of nonculpable individual officers and directors. The first seeks to amplify the voices of individual corporate officers in settlement negotiations by giving them the right to a hearing prior to the completion of a settlement. The second gives directors and officers implicated in settlements the right to bring an action for a declaration of innocence that would clear their names and preempt derivative actions against them. The third solution recognizes a horizontal fiduciary duty between directors and officers, thereby allowing innocent directors and officers the right to sue their guilty colleagues for breaching such duty. The fourth, which should only become available in rare cases, is to let directors and officers sue the corporation for which they worked for the harms they suffered as a consequence of the corporation’s actions and admissions.

The Agent’s Problem

by Asaf Eckstein & Gideon Parchomovsky

Click here for a PDF file of this article

Abstract

The agency problem, the idea that corporate directors and officers are motivated to prioritize their self-interest over the interest of their corporation, has had a long-lasting impact on corporate-law theory and practice. In recent years, however, as federal agencies have stepped up enforcement efforts against corporations, a new problem has surfaced: what we call the “reverse agency problem.” The surge in criminal investigations against corporations, combined with the rising popularity of settlement mechanisms, including pretrial diversion agreements and corporate plea agreements, has led corporations to sacrifice directors and officers in order to reach settlements with law enforcement authorities as expeditiously as possible. This phenomenon is the mirror image of the agency problem—the agent’s problem.

Although such settlements are in the best interests of companies and shareholders, they can have devastating effects on individual directors and officers. When they agree to settle a criminal prosecution, suspect companies collectively attribute wrongdoing to a large group of directors and managers without distinguishing between the guilty and the innocent. As a result, directors and officers implicated in settlements often suffer severe reputational losses, regardless of their culpability. Furthermore, the wrongdoing attributed to directors and officers in settlements exposes them to derivative lawsuits for breaches of their fiduciary duties. Unfortunately, extant law does not provide directors and officers with a means to prove their innocence or clear their names. In fact, it does not even give them a voice in the negotiations leading to the drafting of settlements. Thus, it dooms many directors and officers who have done no wrong to live with the mark of Cain and endure the economic consequences thereof.

Four legal reforms could remedy the plight of nonculpable individual officers and directors. The first seeks to amplify the voices of individual corporate officers in settlement negotiations by giving them the right to a hearing prior to the completion of a settlement. The second gives directors and officers implicated in settlements the right to bring an action for a declaration of innocence that would clear their names and preempt derivative actions against them. The third solution recognizes a horizontal fiduciary duty between directors and officers, thereby allowing innocent directors and officers the right to sue their guilty colleagues for breaching such duty. The fourth, which should only become available in rare cases, is to let directors and officers sue the corporation for which they worked for the harms they suffered as a consequence of the corporation’s actions and admissions.