The Business Judgment Rule and the Diversified Investor
Encouraging Risk in Financial Institutions
Aaron Brumbaugh
Posted Monday, July 17, 2017

The realm of corporate law has applied modern financial portfolio theory to support the insulation of corporate decision makers from liability in order to encourage risk taking, primarily using the Business Judgment Rule. This is done in the name of the diversified investor, who desires corporate decision makers take more risks than they would without a guarantee of protection. Encouraging more profitable risk taking, even at the risk of firm specific losses, is supposedly beneficial to diversified investors because they care about the return of their entire portfolio, normally reflecting the whole market, but corporate decision makers want to minimize potential liability resulting from their firm’s losses.

However, the Great Recession has taught valuable lessons about the nature of risk in the finance and banking sector. Despite the unique danger of contagion, when one firm’s demise impacts the market as a whole (“too big to fail”), the theory of diversification is being misappropriated to encourage risktaking in the financial sector, often applied to the very firms and behavior that contributed to the crisis. Thus, the Business Judgment Rule is applied in the name of the diversified investor, yet when used to encourage risk taking in firms whose failures would actually have market wide impact, creates market volatility especially dangerous to a diversified investor. This article takes a detailed look at the concrete mechanics of diversification and risk taking and how these concepts coexist with the protection of the Business Judgment Rule and if that relationship is truly desirable.