Abstract
This paper analyzes interactions between corporate governance and law enforce ment practices, focusing on cases where deterrence is weak and harmful miscon duct is profitable. We show how managerial compensation contracts, including stock-based compensation and insurance that shields managers from liability, systematically undermine enforcement efforts aimed both at the corporation and at managers. We also show that common enforcement policies such as discount ing penalties when corporations voluntarily self-report or implement compliance programs can actually lead to more social harm by increasing the profitability of misconduct. Our results suggest that to be effective policies designed to deter cor porate misconduct must account for interactions between external governance, such as laws and their enforcement, and internal governance mechanisms such as managerial compensation. The analysis offers insights into how to improve the deterrence of corporate misconduct.
1 Introduction
When corporations are created, they obtain many legal rights that enable them to own assets, sign contracts, and operate in markets. The only commitment they generally must make is to act lawfully. When a corporation breaks the law, it may face enforcement actions that result in sanctions such as monetary fines. Law enforcement might also be directed at individuals who break the law while acting on behalf of the corporation. This paper analyzes the interaction between prevailing law enforcement practices and corporate governance mechanisms such as managerial compensation structures. We show how these interactions weaken law enforcement and how some law enforcement practices can actually exacerbate corporate misconduct and harm to society. Our results have important policy implications.
In a well-known 1970 essay, Milton Friedman argued that “the social responsibility of managers is to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”1 If managers break the rules of society in their quest to “make as much money as possible,” corporations can cause enormous harm, which all too often involves deaths, physical and mental injuries, pollution, and massive financial losses. In such cases “making as much money as possible” can hardly be regarded as “socially responsible.” The recent history of numerous corporate scandals that have caused much harm suggests that laws and their enforcement have not been effective in ensuring that corporations are socially responsible, which raises research and policy issues that merit more study by economists and others. This paper examines the economic forces related to law enforcement as practiced in the corporate context as they interact with standard corporate governance mechanisms.2
Much of the research on corporate governance is concerned with making sure that the interests of the directors and managers who make key decisions on behalf of the corporation are aligned with the interests of the shareholders. The focus on internal governance in the corporate governance literature is based on the implicit assumption that external governance mechanisms including law enforcement, which control the relations between the corporation and stakeholders such as customers, employees and others, work well enough to guarantee that corporations and those acting on their behalf comply with laws. In other words, the standard approach to corporate governance presumes that maximizing shareholder wealth “would best maximize corporate value and also social welfare, as other bodies of law could regulate corporate externalities” (Lund and Pollman (2021), p. 2574). Admati (2017, 2021) point out that if laws are ineffective, financialized corporate governance can harm society.3 We show in this paper that ineffective law enforcement that fails to deter corporate misconduct is further undermined by corporate governance practices aimed at maximizing share prices, which can exacerbate social harm. Our analysis produces important new insights about how law enforcement can fail in the corporate context, and suggests potential improvement in policy.
Laws are enforced by governments and at times by people in the private sector who may have standing to take legal action. Since enforcement is generally costly, important economic trade offs can arise. Starting with Becker (1968), many economists have explored optimal deterrence, assuming a set of costs and frictions and then weighing the social costs and benefits of different enforcement policies. Actual enforcement policies, however, are the result of complex political processes within and across various institutions.4 The outcomes can involve either suboptimal over-enforcement or suboptimal under-enforcement.
There is a growing consensus that under-enforcement is common in the corporate context (see e.g. Garrett, 2014; Eisinger, 2017; Taub, 2020; Coffee Jr, 2020). Detecting law breaking by corpo rations and estimating the corresponding harm, is difficult.5 Large, complex, and well-resourced corporations can make enforcement efforts by less well-resourced governments or by private par ties costly and difficult, weakening deterrence. Diffuse responsibility within corporations makes it difficult to identify individuals who should be held accountable for corporate misconduct. In addition, law enforcement is often ineffective because of authorities’ concerns that innocent stake holders will suffer collateral harms or because of other political considerations that may protect “important” corporations.6 Finally, the limited liability of corporations, the tax subsidies that encourage the use of debt funding, and the option corporations have to seek bankruptcy protec tion and thus limit their liabilities (including from corporate misconduct) all serve to reduce the potential consequences of misconduct and the potential deterrent impact of law enforcement.7
When the profits a corporation gains from misconduct exceed the expected fines or other consequences that may result from the misconduct, the consequences may be seen as a “cost of doing business,” and “good” business models may include profitable misconduct.8 Since managers have financial incentives related to the ownership of stock and options and to performance-based bonuses, they will have incentives to engage in misconduct that increases corporate profits, unless they fear personal consequences for doing so. Profit-maximizing corporations in turn will find managers who are motivated by financial incentives and reward them in ways that ensure they act in the interest of the corporation, which can include engaging in misconduct. As we explore in this paper, managerial compensation can often be designed offset or reduce the effects of possible enforcement actions.9
To study the issues and explore the effectiveness of realistic features of law enforcement policies in deterring profitable corporate activities that create substantial social harm, we develop and analyze a model that captures key elements of corporate governance and enforcement practices. Wemaintain the standard principal-agent approach to corporate governance in which corporations set managerial compensation to align the interests of managers with those of shareholders. In our model, managers choose costly actions that vary in their impact on the corporation and on society. We examine how corporations modify their compensation structures to adjust to law enforcement policies when enforcement of the law falls short of what is necessary to deter misconduct effectively. We also consider a range of commonly-used enforcement policies aimed at either the corporation or at corporate managers and examine their effectiveness for reducing the social harm from profitable misconduct.
We show that when law enforcement is weak, contracts that ensure that the manager has incentives to maximize shareholder value can lead the corporation to engage in profitable yet harmful activities. Of course, this result is not surprising—if the manager is aligned with the shareholders, the manager will pursue harmful activities when those are profitable. What is more interesting is how managerial contracts adjust to changes in the enforcement regime. Whereas for a given incentive contract, managers will engage in less misconduct if fines are increased, the same is not always true when corporations can adjust the contract as the standard principal-agent model would predict. As we show, these adjustments can undo much—or even all—of the harm reducing effects of increasing fines. We consider various ways fines can be calibrated: to the level of ill-gotten profits, to measures of the amount of misconduct, or to the total harm caused. We then show how corporations adjust to these fines and other enforcement policies and how in some cases these adjustments can exacerbate the overall social harm.
Levying penalties directly on managers is seen by some as a better approach to law enforce ment, since large fines imposed on the corporation may lead to collateral consequences for other innocent stakeholders. Aside from the fact that it may be difficult to impose liability on individ uals in a complex organization, our analysis highlights the fact that corporations have ways to offset the deterrence effects of individual sanctions. We examine two ways the corporation can do so. First, the corporation can respond to increases in managerial liability by increasing the manager’s equity stake, which can reduce or nullify the harm-reducing effects of the sanctions. Second, the ubiquitous presence of insurance and indemnification for corporate managers allows the corporation to limit the exposure of the manager to liability, again reducing deterrence and potentially exacerbating social harm from profitable misconduct (Baker and Griffith, 2019).
Because of the difficulties in detecting and sanctioning corporate misconduct in a timely manner, authorities attempt to encourage corporations to cooperate in identifying misconduct and assisting law enforcement. Of course, some misconduct by corporate agents involves individuals taking actions that harm the corporation (e.g., embezzlement). Other actions that can be taken by employees harm society but have little or no effect on the corporation except through fines and other sanctions imposed on the corporation (e.g., an employee drives negligently while doing company business). When employees act in ways that produce no benefits but only costs to the corporation, the corporation and its shareholders have incentives to search out and punish these employees to deter this type of bad behavior. In all these cases the interests of the corporation and law enforcement are aligned. We examine cases where the corporation is conflicted with law enforcement because misconduct benefits the corporation and shareholders. This creates incentives to encourage rather than punish or reveal the misconduct.
We explore the effectiveness of two types of programs designed to encourage corporations to cooperate with authorities in exchange for discounted fines. The first type we study is a “compliance program” where the firm voluntarily implements procedures that enhance monitoring and increase the probability of detection. The other type rewards the corporation for stepping forward and self-reporting misconduct. One intended benefit of these programs is they lead to earlier detection of misconduct, which may reduce the amount of social harm.
For each of these programs, we show that although they generally reduce the duration of misconduct, they can also make matters overall worse. By offering discounts for cooperation, effective penalties are lowered, which makes misconduct more profitable. This fact means that the corporation will pursue the harmful activity with greater intensity up to the point of detection or profit-maximized self-reporting. This greater intensity can ultimately create more harm even though the misconduct will likely be detected earlier. Since programs offering discounts in fines can be counterproductive, a better approach may involve making compliance programs specific and mandatory without giving fine reductions. Other steps taken to increase the likelihood of detection (for example by encouraging and providing protection for whistleblowers) are less likely to be counterproductive. Finally, increasing the level of fines will generally be a more effective and reliable way to reduce harm.
Our paper speaks to controversies related to corporate purpose and its interaction with corpo rate law. Whereas the standard approach to corporate governance essentially equates corporate purpose with the creation of “shareholder value,” the CEOs of 181 US corporations committed their firms to benefit of all stakeholders, including customers, employees, suppliers and communi ties as well as shareholders. Claims that corporations should have a broader purpose are related to the growth of Environmental, Social, and Governance (ESG) metrics, which purportedly en able investors to monitor corporations’ impact across a range of socially relevant issues. The very existence of these concerns about purpose and how corporations affect other stakeholders seems to reflect a widespread recognition that governments are failing to set and enforce proper rules to ensure that corporations act in society’s interests. This recognition seems to have led to attempts to make investors and others more responsible for ensuring that corporations account for how they affect stakeholders and social welfare.
Whether pressuring corporations to meet broader corporate objectives will improve overall welfare has been the subject of much debate.10 For our purposes, however, we note that no matter how corporate law and key decision makers within corporations define and operationalize corporate purpose, corporations must comply with all laws. Once realistic law enforcement frictions are then incorporated into the analysis, we show that what might be considered “good” corporate governance practices, ones that succeed in aligning the interests of shareholders and managers, might produce bad outcomes for society.
In addition to relating to research on corporate governance and corporate misconduct discussed above, our paper also relates to the optimal deterrence literature, which examines how to structure legal sanctions optimally to deter wrongdoing. Particularly relevant to our analysis are discussions of the choice of whether to impose liability on the manager or the corporation, the choice between strict versus duty-based liability regimes, and the choice between public and private enforcement of the law.11 We must emphasize that our analysis does not involve positing a set of frictions and then identifying the optimal enforcement policies for deterrence in the presence of those frictions. Instead, we start by assuming that enforcement policies are weak, an assumption that is strongly supported by the evidence, and we examine how internal governance decisions respond to changes in enforcement policies in weak enforcement environments. Our findings reveal some important considerations for improving enforcement and deterrence, but we are not deriving specific policies that we claim are optimal.
Our paper is also related to the literature on the interaction of managerial compensation and corporate tax avoidance. Chen and Chu (2005) investigate (profitable) tax evasion in a principal-agent model.12 Crocker and Slemrod (2005) similarly analyze contracts when profitable tax evasion is possible, and analyze how those contracts change with changes to the enforcement regime. Crocker and Slemrod show that fines on the manager are generally more effective for deterrence than fines on the corporation. Similar to our results, they show that adjustments to managerial compensation can partially offset and undermine the effect of enforcement efforts.
The remainder of the paper is organized as follows. In the next subsection we provide some institutional background on corporate law enforcement along with some illustrative examples showing how enforcement can be weak and lead to inadequate deterrence. In Section 2 we develop our formal model. Section 3 shows various ways that internal governance mechanisms can reduce or even nullify the deterrent effects of fines. It also shows how basing fines on harm caused by misconduct rather than profits that are gained can lead to more harm. Section 4 considers the role that compliance programs and self-reporting might play in deterring corporate misconduct and shows that cooperation motivated by discounts in fines can actually increase harm and reduce welfare. Section 5 offers policy recommendations and concluding remarks.
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