June 01, 2006

Posted by Larry Ribstein

Some say that, for all its potential flaws, we need corporate criminal liability because it’s the only sanction that will keep the Lays and Skillings of the world honest. In other words, it’s a necessary deterrent. Given the serious problems with corporate liability, we’d want to be sure about this. But it’s really a dubious proposition.

In the first place, consider the other deterrence mechanisms we have at our disposal – crushing civil liability, loss of a prestigious job and livelihood, the destruction of a hard-earned reputation. Petty crooks and drug dealers don’t worry a lot about these things, but corporate executives do.

In fact, we have to ask, why would somebody like Jeff Skilling risk spending the rest of his life in jail just to lie to the shareholders, particularly if it’s not even clear he gained personally from these lies? Well, of course, he had no idea he was taking this risk – this ex post facto problem with making up corporate criminal liability as we go along is a big part of the problem.

But let’s focus on the Lays and Skillings of the future, now that they know what can happen to them. As I discussed in my initial SOX article, published as Market v. Regulatory Responses to Corporate Fraud, 28 J. Corp. L. 1, 19-22 (2002), people may be overconfident in their judgment and ability to control future events. In fact, Don Langevoort argues that it’s the most self-confident, those with the most self-esteem, that tend to make it to the top of high-flying firms like Enron. These are just the sort of people who could persuade themselves that everything was ok even in the face of evidence that would persuade more reasonable people to the contrary.

Moreover, once these people realize that things are going downhill, a different heuristic steps in. Now they see they’ve already lied and gotten themselves in big trouble. Even if they’re not going to jail, they stand to lose their jobs and reputations. At the same time, they still believe that lying is the morally right thing to do. After all, the shareholders are being misled by the market’s fleeting judgments, while the insiders are sure their business plan is really still sound. Now they will be willing to participate in a cover-up even if it has only a small tendency to succeed in the long run.

This is why even criminal liability is not an effective deterrent. Only the strongest measures have any chance of penetrating the reality shields the worst offenders have erected around themselves, and these sanctions can only make things worse by increasing incentives to cover up.

Suppose that we can find some way to ratchet up the criminal liability and kick it in at precisely the right point to achieve some significant marginal deterrence. Should we do it? Well, we still have all the problems I’ve discussed in prior posts, plus the cost of over-deterring innocent managers. These are the sort of reasonable people who are fully immersed in the real world. They will want to stay very far away from conduct that has even the slightest chance of landing them in jail. Why should they take even the slightest chance just to get a few extra bucks for the shareholders?

Moreover, it’s not just the careful people we’re deterring. The risk-prone executives discussed above aren’t necessarily criminals. They’re the sort of people who do the really stupid-seeming things that end up being spectacular business successes, like competing with the US Postal Service (Fedex) or with Ma Bell (WorldCom).

Some of these people might end up as crooks under the wrong conditions, but some will just be the founders of great, world-changing companies. As things stand, they’re going to hesitate before doing it in companies that are subject to the criminal penalties of the US securities laws.

Conglomerate Forum: Enron, Enron

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Comments (1)

1. Posted by ac on June 1, 2006 @ 10:44 | Permalink

What are some examples of deterred behavior that we want to encourage? In my mind, misstating revenues is not the same kind of risky behvior as pursuing an improbable business plan. It is the difference between steroids and a suicide squeeze.

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