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‘Something distinctly not of this character’: how Knightian uncertainty is relevant to corporate governance

Published online by Cambridge University Press:  02 January 2018

Alice Belcher
Alice Belcher*
Affiliation:
University of Dundee
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Abstract

Corporate governance best practice now includes the requirement for a board to ensure that the system of internal control is effective in managing risks in the manner which it has approved. The Turnbull Guidance on this matter is ‘based on the adoption by a company's board of a risk-based approach to establishing a sound system of internal control and reviewing its effectiveness’. This involves the identification and prioritising of risks and embedding the risk management approach in the culture and processes of the business. This article explores the use of risk assessment in the law, particularly as it applies to the activities of companies. It is suggested that a concentration on, and perhaps a spurious quantification of, risk could mask the difficulty of making board-level decisions under conditions of true or Knightian uncertainty. Knight maintained that true uncertainty was something distinctly not of the character of risk. It occurs when ‘. . . there is no possibility of forming in any way groups of instances of sufficient homogeneity to make possible a quantitative determination of true probability. Business decisions, for example, deal with situations which are far too unique, generally speaking, for any sort of statistical tabulation to have any value for guidance. The concept of objectively measurable probability or chance is simply inapplicable’.

Type
Research Article
Information
Legal Studies , Volume 28 , Issue 1 , March 2008 , pp. 46 - 67
Copyright
Copyright © Society of Legal Scholars 2008

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References

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3. Ibid, p 231.

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18. The company was convicted rather than any of its workers using s 217(3) of the Water Resources Act 1991.

19. These regulations replace the Management of Health and Safety at Work Regulations 1992, SI 1992/2051 that contained the earliest explicit requirement for a risk assessment to be carried out.

20. Health and Safety at Work etc Act 1974, s 33(c).

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27. SI 1992/2051.

28. [1999] IRLR 434 at 437 (emphasis added).

29. 2004 WL 1808947.

30. [2002] IRLR 516.

31. 2006 WL 176922, [2006] All ER (D) 157 (Feb).

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33. 3 November 2005 (unreported).

34. [2005] EWHC 1342 (QB).

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36. [2006] EWCA Civ 39, [2006] 1 WLR 953 at 958.

37. Occupiers' Liability Act 1984, s 1(3)(c)

38. [2003] UKHL 47, [2004] 1 AC 46.

39. [2006] EWCA Civ 39, [2006] 1 WLR 953.

40. [2003] UKHL 47, [2004] 1 AC 46 at 87.

41. Ibid, at 65.

42. [2006] EWCA Civ 39, [2006] 1 WLR 953 at 959.

43. [2005] EWHC 2829 [2005] All ER (D) 11 (Aug).

44. 2000 WL 664535.

45. [2006] All ER (D) 104 (Mar).

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47. Ibid, at [64].

48. Ibid, at [57]; Ms and Mrs are both used in the original.

49. Ibid, at [68].

50. [2001] IRLR 336.

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57. At that time referred to as the Cadbury Code of Best Practice.

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59. Turnbull Guidance, above n 1, and revised version (Financial Reporting Council, June 2005).

60. Ibid, para 28.

61. A review of the continued appropriateness of the Turnbull Guidance was published by the Financial Reporting Council in June 2005 which confirmed that ‘The guidance should continue to cover all internal controls, and not be limited to internal controls over financial reporting’. Overall the review concluded that significant changes are not required.

62. Ibid, para 13.

63. Ibid, appendix.

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84. A popular approach is to use the Australian/New Zealand Standard AS/NZS 4360:2004 – Risk Management. This uses a five-point scale for the likelihood of the incident/problem occurring and to measure the impact on the organisation should it occur. Each potential incident/problem can then be plotted in a two-by-two matrix and risk managed according to which of the four boxes it falls into. The use of this method can make risk management appear to be a fairly qualitative, rough and ready process, but it must be remembered that behind each plotted point in the matrix is a quantitative assessment coupled with the assumption that a quantitative approach is valid. An imprecise approach to risk management does not equate to an acknowledgement of true uncertainty.

85. [2001] 1 All ER 562.

86. [2004] EWHC 1116 (QB), [2004] All ER (D) 181 (May).

87 The ‘personalistic’ theory of probability (also known as Baysian) uses the devise of an ideal person. Personalists view probability as a degree of belief of an ideal person who is consistent in their beliefs. This approach allows ideal persons to differ in their personal probabilities and be equally ‘correct’ so long as they are not inconsistent. Information is also important to Bayesians. The ideal person of personalistic theory is supposed to use observed frequencies to revise their probabilities. As more data are observed, the current probabilities generally come to relate more and more to the data observed and less to the original probabilities. See Lee, W Decision Theory and Human Behaviour (New York and London: John Wiley & sons, 1971) pp 54–55 Google Scholar.

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91. Bazerman, Loewenstein and Moore, above n 89, at 99. This claim is based on experiments done in the context of legal negotiations; see Babcock and Loewenstein, above n 90.

92. Bazerman, Loewenstein and Moore, above n 89, use these headings.

93. Knight, above n 2, pp 19–20 (emphasis added).

94. Ibid, p 232 (original emphasis).

95. Belcher, above n 4.

96. Ibid.

97. Knight, above n 2, p 231.

98 Ibid, pp 284–285. Some of his argument is framed in terms of self-trust; see also Belcher, A Trust in the Boardroom’ (2007) 16(1) Griffith Law Review 151 CrossRefGoogle Scholar.

99. Knight, above n 2, p 311.

100. Ibid, p 325.

101. Foss, K and Foss, N The knowledge-based approach and organizational economics’ in Foss, N and Mahnke, V (eds) Competence, Governance, and Entrepreneurship (Oxford: Oxford University Press, 2000), pp 62–65 Google Scholar at p 65.

102. Belcher, A and Naruisch, T The evolution of business knowledge in the context of unitary and two-tier board structures’ (2005) July, Journal of Business Law 443 Google Scholar at 443.

103 For an accessible description see Ekeland, I Mathematics and the Unexpected (Chicago and London; University of Chicago Press, 1988)Google Scholar. The labelling of risk and uncertainty has been made particularly confusing by the development of a body of economics literature which refers to decision making under uncertainty but in fact deals almost exclusively with decision making under risk; see p 9: ‘. . . under uncertainty we do not attach probabilities or likelihoods to the states of the world…If we did introduce probabilities…the analysis would be one involving risk rather than uncertainty. On this definition most of this book is not about uncertainty but about risk. Clearly I do not adhere to this distinction at all closely. To me, and many others, uncertainty is a quite general term meaning “absence of certainty” ’. This has been followed more recently by economists explicitly working in terms of Knightian uncertainty; see below.

104 W Brock and A Xepapadeas ‘Regulating nonlinear environmental systems under Knightian uncertainty’ in Arnott, R et al (eds) Economics for an Imperfect World: Essays in Honour of Joseph E Stiglitz (Cambridge MA: MIT, 2003)Google Scholar chapter 8, pp 127–144 at pp 127–128.

105. Ibid, p 142.

106. Littlechild, SC Three types of market process’ in Langlois, RN (ed) Economics as a Process (Cambridge: Cambridge University Press, 1986) pp 27–39 Google Scholar.

107. Ibid, p 29.

108. The idea that this power in the hands of directors can be an explanation of the existence of the firm, or company, can be found in Belcher, above n 2.