This paper clarifies why corporate governance arrangements in public firms generally do not make use of judicial evaluations of boards’ and managers’ business decisions. In principle, information generated in litigation, particularly discovery, could usefully supplement public information (particulary stock prices) in the provision of performance incentives. In particular, the optimally adjusted combination of standard performance pay and litigation could impose less risk on boards and managers than standard performance pay alone. Caps, indemnification, or insurance could achieve the requisite tailoring of litigation payments; ruinous liability risk and ensuing risk aversion would not be an issue. Similarly, court biases can be offset by contractual adjustments. The appendix shows this in a formal model summarizing well-known results.
Consequently, the reason not to use litigation incentives is not absolute but a simple cost-benefit trade-off. Litigation is expensive, while the benefits from additional information are limited. Stock prices already provide fairly good information, courts have difficulties evaluating business decisions and thus provide only noisy information, and the agency conflict in standard business decisions is limited. A different result may obtain, however, when other governance mechanisms are weaker, particulary when stock prices or other reliable public signals are not available; when courts can measure the decision against an accepted benchmark; or as the agency conflict becomes more severe.
C.V.Starr Professor of Economics