Time Magazine’s “person of the year” is the “protestor.” Occupy Wall Street’s participants have generated discussion unprecedented in recent years about the role of corporations and their executives in society. The movement has influenced workers and unemployed alike around the world and has clearly shaped the political debate.
But how does a corporation really act? Doesn’t it act through its people? And do those people behave like the members of the homo economicus species acting rationally, selfishly for their greatest material advantage and without consideration about morality, ethics or other people? If so, can a corporation really have a conscience?
In her book Cultivating Conscience: How Good Laws Make Good People, Lynn Stout, a corporate and securities professor at UCLA School of Law argues that the homo economicus model does a poor job of predicting behavior within corporations. Stout takes aim at Oliver Wendell Holmes’ theory of the “bad man” (which forms the basis of homo economicus), Hobbes’ approach in Leviathan, John Stuart Mill’s theory of political economy, and those judges, law professors, regulators and policymakers who focus solely on the law and economics theory that material incentives are the only things that matter.
Citing hundreds of sociological studies that have been replicated around the world over the past fifty years, evolutionary biology, and experimental gaming theory, she concludes that people do not generally behave like the “rational maximizers” that ecomonic theory would predict. In fact other than the 1-3% of the population who are psychopaths, people are “prosocial, ” meaning that they sacrifice to follow ethical rules, or to help or avoid harming others (although interestingly in student studies, economics majors tended to be less prosocial than others).
She recommends a three-factor model for judges, regulators and legislators who want to shape human behavior:
“Unselfish prosocial behavior toward strangers, including unselfish compliance with legal and ethical rules, is triggered by social context, including especially:
(1) instructions from authority
(2) beliefs about others’ prosocial behavior; and
(3) the magnitude of the benefits to others.
Prosocial behavior declines, however, as the personal cost of acting prosocially increases.”
While she focuses on tort, contract and criminal law, her model and criticisms of the homo economicus model may be particularly helpful in the context of understanding corporate behavior. Corporations clearly influence how their people act. Professor Pamela Bucy, for example, argues that government should only be able to convict a corporation if it proves that the corporate ethos encouraged agents of the corporation to commit the criminal act. That corporate ethos results from individuals working together toward corporate goals.
Stout observes that an entire generation of business and political leaders has been taught that people only respond to material incentives, which leads to poor planning that can have devastating results by steering naturally prosocial people to toward unethical or illegal behavior. She warns against “rais[ing] the cost of conscience,” stating that “if we want people to be good, we must not tempt them to be bad.”
In her forthcoming article “Killing Conscience: The Unintended Behavioral Consequences of ‘Pay for Performance,’” she applies behavioral science to incentive based-pay. She points to the savings and loans crisis of the 80's, the recent teacher cheating scandals on standardized tests, Enron, Worldcom, the 2008 credit crisis, which stemmed in part from performance-based bonuses that tempted brokers to approve risky loans, and Bear Sterns and AIG executives who bet on risky derivatives. She disagrees with those who say that that those incentive plans were poorly designed, arguing instead that excessive reliance on even well designed ex-ante incentive plans can “snuff out” or suppress conscience and create “psycopathogenic” environments, and has done so as evidenced by “a disturbing outbreak of executive-driven corporate frauds, scandals and failures.” She further notes that the pay for performance movement has produced less than stellar improvement in the performance and profitability of most US companies.
She advocates instead for trust-based” compensation arrangements, which take into account the parties’ capacity for prosocial behavior rather than leading employees to believe that the employer rewards selfish behavior. This is especially true if that reward tempts employees to engage in fraudulent or opportunistic behavior if that is the only way to realistically achieve the performance metric.
Applying her three factor model looks like this: Does the company’s messaging tell employees that it doesn’t care about ethics? Is it rewarding other people to act in the same way? And is it signaling that there is nothing wrong with unethical behavior or that there are no victims? This theory fits in nicely with the Bucy corporate ethos paradigm described above.
Stout proposes modest, nonmaterial rewards such as greater job responsibilities, public recognition, and more reasonable cash awards based upon subjective, ex post evaluations on the employee’s performance, and cites studies indicating that most employees thrive and are more creative in environments that don’t focus on ex ante monetary incentives. She yearns for the pre 162(m) days when the tax code didn’t require corporations to tie executive pay over one million dollars to performance metrics.
Stout’s application of these behavioral science theories provide guidance that lawmakers and others may want to consider as they look at legislation to prevent or at least mitigate the next corporate scandal. She also provides food for thought for those in corporate America who want to change the dynamics and trust factors within their organizations, and by extension their employee base, shareholders and the general population.
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The last two weeks have witnessed dramatic victories against two very different lawbreaking networks. First the death of Bin Laden removed the leader of al Qaeda. Second, the conviction of Raj Rajaratnam represented a major victory for prosecutors against the so-called expert insider trading networks. Although the two lawbreaking networks have a multitude of differences – in terms of social harm, motivations, and structure – they also have important similarities.
For one thing, both terror networks and insider trading networks present an opportunity to study social networks in a rigorous manner. “Networks” are more than just loose metaphor, but instead the subject of the emerging field of network theory that borrows from and links computer science, sociology, economics and a host of other fields. “Emerging” does not mean new: some of the germinal research stretches back over four decades. For example Granovetter’s work on “weak ties” in sociology. Mark Lemley and David McGowan authored a wonderful piece on network effects and law over 10 years ago and the legal literature continues to blossom (from Aviram to Zaring). Network theory has arrived.
And it is being put to use. A number of years ago, media reports suggested that the U.S. intelligence agencies were seeking to use network theory to crack Al Qaeda (see here for a law review article by Christopher Borgen on network theory and terrorism). The extent to which financial regulators and prosecutors have done the same with respect to insider trading is not clear, although scholars have recently suggested new potential approaches.
We may not know for a long time the extent to which network theory is influencing law enforcement. You can understand that intelligence and law enforcement would be unwilling to disclose the methods they use to catch bad guys. But the secrecy means that their methods do not enjoy the benefits – one could even say network effects – of being subject to the scrutiny of a larger community. Observers could help answer vital questions, such as “how effective are these efforts against lawbreakers?” and “could they be improved?” According to Linus’s Law: “given enough eyeballs, all bugs are shallow.” Aside from questions about efficacy, there are lingering and legitimate concerns about the implications of national security surveillance over internet communications.
But even the information we have learned about the two recent victories against anti-social networks leads to some interesting, if tentative observations. First, the ultimate value of these government operations is not in traditional deterrence alone, but in disrupting networks. In other words, successful operations against networks rely not only on crude deterrence of criminal behavior by scaring off would-be criminals. After all, it isn’t clear that a jihadist will be sobered by Bin Laden’s fate. By contrast, one thing that does disrupt networks is interfering with their capacity to send signals. Driving bad guys off the net seriously interferes with their ability to conduct business. From news reports, it doesn’t look like Bin Laden was all that successful in managing operations without an internet connection or a phone line. (Some reports suggest that the one time he did use a phone contributed to his location by U.S. intelligence.) Of course, government surveillance is thwarted not only by encryption, but by the daunting task of finding a needle in a haystack of data. Old-fashioned informants will still prove a critical tool.
Indeed media reports suggest that the government is heavily relying on informants in cracking the expert insider trading networks. From the perspective of law enforcement, this is important not only because it may lead to prosecutions, but also because it might disrupt the thing that these networks most rely on: trust.
So network theory suggests that we pay more attention to the marginalia of the Rajaratnam story. It is not the conviction alone that matters. It also argues for looking at other policy tools – such as a use of bounties in corporate crime – in another dimension, namely engendering distrust and thwarting the development of illegal networks. Of course, bounties for corporate crime and promoting snitching can create their own perverse incentives and pernicious effects. (Eleanor Brown penned an interesting essay on snitching, immigration, and terrorism that uses network theory.)
Another problem with a broader use of these tools is that they don’t always yield headline grabbing successes. No one sees the insider trading or terror attacks or law breaking that didn’t happen. The political economy of deterrence rewards prosecutors for victories in the courtroom, not necessarily for crime prevented.
Still, the events of the last week should give new life to study of network theory. There is evidence that network theory has become white hot. Consider this graph (from Google’s nifty Ngram tool) that plots the rising use of “network effect” compared to “deterrence effect” in books from1970 to mid 2007.
One can now also see a lot of those neat network graphs (see below) in news reporting.
Of course, the popularization of theory also threatens to reduce the intellectual rigor. Let’s hope the network effects of this line of inquiry are positive.
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The much anticipated day is here. Contracts as Organizations -- my paper with Brayden King -- is now available on SSRN. We have submitted the paper to law reviews, but we welcome further comments. Here is the abstract:
Empirical studies of contracts have become more common over the past decade, but the range of questions addressed by these studies is narrow, inspired primarily by economic theories that focus on the role of contracts in mitigating ex post opportunism. We contend that these economic theories do not adequately explain many commonly observed features of contracts, and we offer four organizational theories to supplement – and in some instances, perhaps, challenge – the dominant economic accounts. The purpose of this Article is threefold: first, to describe how theoretical perspectives on contracting have motivated empirical work on contracts; second, to highlight the dominant role of economic theories in framing empirical work on contracts; and third, to enrich the empirical study of contracts through application of four organizational theories: resource theory, learning theory, identity theory, and institutional theory.
Outside the economics literature, empirical studies of contracts are rare. Even management scholars and sociologists, who generated the four organizational theories just mentioned, largely ignore contracts, both in theoretical and empirical analysis. Nevertheless, we assert that these organizational theories provide new lenses through which to view contracts. While economic theories of contracting focus primarily on one purpose of contracts – mitigating ex post opportunism – the four organizational theories help us understand the multiple purposes of contracts.
Don't even try to debate the premise of this question. It's an exaggeration and it's unfair and yadda, yadda, yadda. But I have heard too many comments by economists to doubt that there is a widespread prejudice running through that profession along these lines. So let's explore some possible explanations, all of which I have heard from economists:
1. Sociologists are stupid!
2. Math: economists got there first, and sociologists are only now starting to catch up
3. Equilibrium: economists have it, and sociologists don't (that is, economists have a concept that focuses their analyses, while sociologists are scattered in their analyses)
4. Empirical Methods: economists use "hard" numbers, and sociologists use case studies, surveys, interviews, ethnographies, etc.
Though I have heard each of these "explanations" from economists, #1 is patently ridiculous. What about the other three?
UPDATE: I wrote this rather hastily in response to a comment from an economist, so I am still thinking about possible explanations. How about:
5. Economists just assume sociologists are stupid because that improves the r-squared of the economists' world view.
UPDATE2: If we did a parallel post, what should the title be? "Why do sociologists think economists are _________?"
UPDATE3: Larry Solum has some thoughts on Legal Theory Blog. The takeaway: "sociologists disagree with [economists'] fundamental assumptions and they wouldn't be considered technically sophisticated if they were economists."