Overview and Contributions:

In “Profitable Misconduct, Corporate Governance, and Law Enforcement,” Anat R. Admati, Nathan Atkinson, and Paul Pfleiderer show how misconduct, managerial compensation, and enforcement policy are closely — and at times perniciously — related. Corporate misconduct can cause extensive harm, including death, physical and mental injury, and environmental destruction. Profit-maximizing corporations can also harm democracy and the rule of law by impacting both the language and the enforcement of the law. This paper focuses on a situation in which, as is often the case, law enforcement efforts to address corporate misconduct are ineffective. There are many reasons for this situation, including difficulties in monitoring opaque corporations and detecting misconduct, as well as the many ways corporations can limit their liabilities.

The authors show that when managerial compensation aims to motivate maximizing profits for shareholders, managers will generally engage in profitable misconduct and, importantly, that corporations can reduce or nullify the deterrence effects of fines and penalties that target either the corporation or managers directly might have, thus further weakening already insufficient enforcement. They also show that common enforcement policies, such as those that offer discounted fines when corporations self-report misconduct or implement compliance programs, can backfire and exacerbate harm by making misconduct more profitable. Understanding corporations' strategic responses to law enforcement is essential for designing more effective policies to deter misconduct.
 

Corporate Governance, Misconduct, and Law:

The authors begin by discussing why the policing of corporate misconduct is so difficult. One problem arises because corporations are collections of individuals, which renders responsibility diffuse and complicates the identification of perpetrators. Detecting misconduct often depends on highly visible, chance events such as plane crashes, whistle-blowing, or media investigations. When the profits gained from misconduct exceed the expected fines and other financial consequences, executives may view misconduct as a “cost of doing business.” Other problems are due to the difficulties encountered in estimating the extent of the harm and the limitations on the penalties that can be imposed. Even when misconduct is detected, fines often fall short of the corporation’s private gains from that misconduct. In notable cases, corporations can limit the consequences by declaring bankruptcy. It is also very rare for directors and executives to face meaningful criminal liability.

Governments have often been unsuccessful in prosecuting misconduct because of the high legal bar required to show personal intent to commit crimes and the reticence of prosecutors to pursue challenging cases due to career concerns and limited resources, especially relative to the resources corporations can access. As we saw in the financial crisis, authorities often worry about targeting “important” corporations and imposing significant fines and sanctions.
 

Argument and Implications:

The authors’ mathematical model captures some of the complexities involved in the interactions among corporations, managers, and governments. One of the values of a model is that it can show how well-intentioned and seemingly reasonable policies can be counterproductive once one accounts for various ways profit-maximizing actors will respond. The authors consider, for example, some policies that have been designed to increase the probability that misconduct will be detected in a timely way. These policies encourage corporations to implement “compliance” programs or to self-report misconduct by promising that any fines they must pay will be heavily discounted. Using their model to analyze the effectiveness of this approach, the authors find that these policies can make matters much worse. This is because the discounted fines can increase the profitability of misconduct while it is undetected or not self-reported. This can lead to firms engaging more aggressively in misconduct, knowing that this can be self-reported later, and the corporation will be subject to reduced fines. If corporations strategically take all this into account, the total harm may actually increase. The authors are not contending that these policies will always increase harm, but they are pointing out that these policies are quite likely to be inferior to others that don’t allow strategic responses that can make things worse.

One reason that the fines imposed directly on corporations are often inadequate to deter misconduct is that authorities are reluctant to levy sufficiently large fines because they fear this will lead to “collateral damage” suffered by innocent stakeholders like employees and customers. These concerns are allayed if, instead of corporate-level fines, large fines are imposed on managers. The authors’ model shows that it can be very expensive for shareholders to offset the potential deterrence effects of managerial fines if the only way shareholders can do this is by increasing the manager’s stock-based compensation to make misconduct more rewarding relative to the level of fines. Because it is so expensive for the corporation and shareholders to respond in this way, relying more on managerial fines might be a good policy. Unfortunately, shareholders have much less expensive ways to offset fines on managers — they can indemnify the manager or provide insurance that pays for fines. Essentially, they can simply offset the fines with cash, which is much cheaper. As the authors point out, this suggests that, to strengthen enforcement and deterrence, limitations on corporations' ability to indemnify and insure managers are likely a good way forward.
 

One of the main lessons of the authors’ analysis is that internal governance practices set by the corporation and its shareholders can profoundly influence the effectiveness of external governance designed to limit the harm created when corporations and their managers engage in profitable misconduct. Further study of these interactions and their implications for effective enforcement policies is clearly warranted.

*Research-in-Brief prepared by Adam Fefer.