Volume 42 | Number 3 Summer 2007
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II. Corporate Gatekeeper Liability Theory
In the 1980s, Reinier Kraakman published two articles that expanded on the concept of “gatekeeper liability,” which he defined as liability imposed on private parties who are able to disrupt misconduct by withholding their support from wrongdoers.1 This support—which might include a specialized good, service, or form of certification that is essential for a wrongdoer to succeed—“is the ‘gate’ that the gatekeeper keeps.”2 True gatekeeper liability is designed to enlist the support of outside participants in the firm when controlling managers commit offences; the first requisite for gatekeeper liability is an outsider who can influence controlling managers to forgo offences.3 As outsiders to the firm, these professionals are less likely to risk their reputations over fraudulent or suspicious transactions. Kraakman identified outside directors, accountants, lawyers, and underwriters as potential targets for gatekeeper liability strategies: they each have access to information about firm misconduct, they already perform a private monitoring service on behalf of the capital markets, and they face incentives that differ from those of managers (that is, they are likely to have less to gain and more to lose from firm misconduct than inside managers).4 Like other liability regimes, gatekeeping imposes costs; Kraakman examines whether legal rules can induce gatekeepers to prevent misconduct at an “acceptable price.”5 After outlining possible costs of a gatekeeping model, Kraakman suggests ways to adjust these costs, such as limiting penalties that gatekeepers face for breach of duty or selecting prescribed duties for gatekeepers to undertake.6 Finally, Kraakman canvasses other enforcement strategies and concludes that gatekeepers’ response to misconduct, by withholding support, has significant advantages over other third-party enforcement duties.7
For Kraakman, legal duties should be imposed on intermediaries to act as gatekeepers in certain markets, due to defects in the ability of parties to contract or ascertain the reputation of different intermediaries.8 Stephen Choi, however, argues that Kraakman’s argument “fails to take into account the impact of different screening accuracies in the market, the incentives of intermediaries to invest in accuracy, the ex ante response of producers to the possibility of certification, and potential market defects.”9 Choi argues that “gatekeeper liability is too heavy-handed a response”10 and instead advocates for less intervention through a system of self-tailored liability, a regime where “lawmakers may allow intermediaries to choose for themselves the specific duties that they will be held accountable . . . .”11
More recently, John C. Coffee, Jr. has popularized Kraakman’s concept in the aftermath of Enron and other corporate scandals. Coffee has blamed such scandals on the failure of gatekeepers, who, he asserts, allowed management to engage in fraud.12 Coffee has defined gatekeepers as independent professionals who act as reputational intermediaries, providing verification or certification services to investors.13 Gatekeepers have less incentive to deceive; therefore, the market views gatekeepers’ assurances as more credible. Their credibility also stems from the fact that gatekeepers pledge their reputational capital.14 Theoretically, a gatekeeper would not sacrifice the reputational capital built up over many years of performing services for a single client or a modest fee. However, there are instances where reliance on gatekeepers may be misplaced, such as: where there is a sudden decline in the deterrent threat facing gatekeepers and they are thus more willing to take risks; where greater inducements are offered to gatekeepers to breach their duties; or where certain market scenarios lessen injury to a gatekeeper’s reputation.15 Included amongst Coffee’s list of gatekeepers are auditors, credit rating agencies, securities analysts, investment bankers, and securities lawyers.16 Coffee concludes that the creation of excessive liability might cause the market for gatekeeping services to fail; instead, he advocates a shift towards stricter liability standards with a ceiling on gatekeeper liability adequate to deter misconduct.17
Whereas Coffee’s proposed system is essentially regulatory, Frank Partnoy advocates a contractual system based on a percentage of the issuer’s liability.18 Under Partnoy’s proposed regime, gatekeepers would be strictly liable for any of the issuer’s securities fraud damages pursuant to a settlement or judgment.19 Although gatekeepers would not have available to them due diligence defenses, they could limit their liability by agreeing to and disclosing a percentage limitation on the scope of their liability.20 Authors such as Larry Ribstein oppose mandatory personal liability for professionals as a relatively ineffective way to encourage professional firms to perform their duties to clients and others.21 Ribstein argues that this liability is based on “an attenuated notion of responsibility and unrealistic assumptions about firm members’ ability to monitor.”22 Furthermore, he suggests, imposing personal liability on professionals may increase agency costs between professionals and their clients; affect professional firm size, structure and scope; and reduce desirable liability of the firm.23 In relation to auditors, Lawrence Cunningham prescribes a framework that uses financial statement insurance as an alternative to financial statement auditing backed by auditor liability.24 In his proposed framework, companies could opt for either model, subject to investor approval.25 Financial statement insurance policies would cover damages arising from audit failure—damages due to financial misstatements that auditors did not discover—replacing auditor and issuer liability.26
In the broader context of the regulation of gatekeepers, Richard Painter stresses the balancing act that this type of regulation entails.27 Gatekeeper regulation, he argues, is pointless if it impairs information flow to gatekeepers: “Any improvement in gatekeeper response to risk that comes from these rules has to be weighed against potential reduction in gatekeeper information and consequent impairment of gatekeeper evaluation of risk.”28 In order to optimize the regulation of gatekeepers, he suggests that experimentation with divergent rules—for example, American and European rules for auditor and lawyer intervention, rather than convergence of legal rules, will facilitate the learning process.29