An Economic Analysis of Corporate Directors' Fiduciary Duties

Abstract:     
This paper studies how the legal liability rules for directors can be optimally designed to provide them with the incentives to fulfill their fiduciary duties and to maximize ex-ante firm value. I present a principal-agent model where the shareholders can obtain a verifiable but costly and imperfect signal on the director's fulfillment of his fiduciary duties by taking legal action against him. This allows the firm to make the director's remuneration contingent not only on performance but also upon the court's decision.The paper shows that, when damages awards are high, the widespread use of liability insurance and limited liability provisions that is observed in the US is optimal because it allows shareholders to credible commit to an optimal suing strategy. The results on the use of liability insurance are maintained when the parties can settle out of court.

Number of Pages in PDF File: 63

Keywords: corporate governance; fiduciary duties; directors' remuneration; Directors and Officers liability insurance; Limited Liability Provisions

JEL Classification: G34, K22, K41

working papers series