Tinbergen Institute 1

LAW ENFORCEMENT UNDER IMPERFECT CORPORATE

GOVERNANCECédric ArgentonSigrid Suetens

Eric van Damme(CentER and TILEC, Tilburg University)

June 26, 2014

Tinbergen Institute 2

THE RESEARCH QUESTION

• In case a firm violates the law, who should be punished: the firm (i.e. its shareholders), the managers actually involved in the violation, or both?

•What are the effects of various possible liability regimes, given (legal and governance) constraints?

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Tinbergen Institute 3

THIS PRESENTATION

•The model•Motivation for our modeling choices•Rival modeling approaches•The results of the model•Main insights•Conclusion

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THE MODEL •Three risk neutral agents: • determines the legal regime • sets the wage contract for • chooses an action • : (Quitting) refusing the contract; • : shirking (doing Nothing); yields low output• : (Right thing) cost reduction; cost for , high output with prob. • : illegal (Collusion); cost for , yields high output for sure

• is illegal; it is detected with positive probability; • If is detected, is fined with probability , • while is then fined with probability

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THE PAYOFFSPAYOFF A PAYOFF P PREF C

Q 0 4thN 2ndR 1st

C 3rd

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MODELLING CHOICES (I)• does not regulate, but only runs a liability scheme:• does not dictate what wage contract should offer• intervenes only when is detected; does not subsidize

•Legal constraints eliminate easy solutions:•There is an upper bound on the maximum liability that can be imposed on • (There is no such upper bound on the liability of )•The probability of the fine imposed on may be smaller than the probability for :

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MODELLING CHOICES (II)• and have the same information on the action of they only observe the outcome•Contracting on detection may, or may not be allowed•Contracting on detection:• conditions the wage not only on the outcome (), but also on

whether was detected: •A wage contract is a triplet: (, )•Without contracting on detection:

•Can reimburse (), or punish ()?• It depends whether explicit incentives can be provided

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PAYOFFS UNDER CONTRACTING ON DETECTION•As compared to the earlier payoff table, only the payoffs associated with are changed•For •

•For

• (We assume that only the final conviction of is a contractible event)

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RIVAL MODELLING APPROACHES•Complete contracting approaches •Mechanism design approaches

•The starting point of these is controlling everything•We take as default a minimally interfering and take existing legal constraints seriously; our approach shows the importance of these constraints

June 26, 2014

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THE RESULTS OF THE PAPER•Without any enforcement:• The outcome is

•No contracting on detection:• Liability on only: the outcome is • Liability on only: the outcome is (if is low), otherwise• Dual liability: the outcome is (if is low), otherwise

•Contracting on detection: • Liability on only: the outcome is if λ and are sufficiently large and otherwise• Liability on only: the outcome is (if is low), otherwise• Contracting on makes the range for smaller

• Dual liability: the outcome is (if is low), otherwise• Contracting on makes the range for larger

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Pure corporate liability

Pure individual liability

Dual system

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N

N

C R

R

l̂*Rl

D non contractible

D contractible and

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N R

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( )al *Rl

**

( )bl

N R

R

(1 ) 1u p p c p D contractible and

(1 ) 1u p p c p

Case (a)

Case (b)

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THE PAPER’S ANALYSIS•We solve each game for its SPE outcome• In all cases, the SPE-outcome can be obtained by setting and at the highest possible levels•We solve all the subgames in a systematic, careful manner•There is no point in going over the details here

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Lw

w

*Lw

* cwp

u cp

R ~Q

R ~C

R ~N

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THE PAPER’S INSIGHTS (I)• If contracting on detection is not possible, then pure corporate liability can deter law violation, but this system does not reach the first-best outcome

• If (only) is punished heavily and cannot adequately control then will resort to low-powered incentive schemes, producing internal and allocative inefficiency•This insight is important, among others, for competition policy enforcement in the EU

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THE PAPER’S INSIGHTS (II)•Pure individual liability can produce the first-best outcome, but only when is sufficiently large; a condition that is not likely to hold•Under such a system, contracting on detection (CoD) may make matters worse: CoD allows to directly incentivize for taking the illegal action and this makes it more difficult to deter this action•Under pure individual liability, should not be allowed to indemnify for law violations

June 26, 2014

Tinbergen Institute 17

THE PAPER’S INSIGHTS (III)•A dual system with liability on both and performs better than a pure corporate or a pure individual system•The best performing system is a dual system in which contracting on detection is allowed: should be allowed to adjust wage when is detected, in particular in downward direction

•The lesson is about the interaction of different parts of the legal system

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THE PAPER’S INSIGHTS (IV)•When contracting on detection is allowed, then (in contrast to what Beckerian approaches suggest), not only plays a role; there is an independent effect of and it may pay to increase •The intuition is that increasing makes it easier for to incentivize not to violate the law

•The lesson is that only the fines matter, but also the quality of the enforcement

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THE PAPER’S INSIGHTS (V)•Deterrence is effected by the outside option of •For example, in the optimal system (dual with CoD), the range in which the first-best, can be implemented is increasing in hence it is easier to get the 1st best when outside options are good.•The reason is that sometimes the optimum requires to leave rents to when rents are too expensive, may not be willing to pay them; a higher reduces rents• Is it indeed easier to deter bad behavior and get the 1st best in good times?

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Tinbergen Institute 20

CONCLUSION•We constructed and analyzed a simple game theoretic model to address the question•What are the effects of different liability regimes on the

deterrence of illegal behavior by firms and on the possibilities for achieving the outcome that is best for society?

•The model includes several real life, legal imperfections•We show that a dual liability system works best and that such a system works better when CoD is allowed•The paper contains several clear messages for lawyers and policy makers

June 26, 2014