Counter-Cyclical Enforcement of Corporate Law

Abstract:     
Corporate and securities laws are seen to mitigate corporate fraud by 'manipulating the incentives of agents': presenting corporate agents with a probability of being caught and punished if they commit fraud. This article suggests that the same laws also affect corporate fraud in a significant but unappreciated manner, by 'manipulating the perceptions of the principals': affecting the principals' efforts in monitoring the agents by making them perceive the risk of fraud as more or less likely.

Due to several cognitive biases discussed in this article, principals misperceive the risk of fraud by their agents in a cyclical manner: they under-estimate the likelihood of fraud during booms and over-estimate it following busts. As a result, they insufficiently police the agents during booms and excessively do so during busts.

Conspicuous law enforcement triggers cognitive biases that could be thoughtfully used to counter the public's cyclical bias. But political pressures that prosecutors face, as well as their failure to consider law enforcement's effect on principals' perceptions, result in enforcement that is itself cyclical and may exacerbate the biased perception of the risk of fraud.

Monetary policy is analogous in requiring counter-cyclical government intervention, and central banks have successfully stepped up to the task despite facing similar pressure not to intervene counter-cyclically. This article concludes by examining whether institutional safeguards that free central banks to operate counter-cyclically can be adapted to the context of corporate fraud.

Keywords: optimal deterrence, optimal enforcement, cognitive bias, behavioral law & economics, corporate fraud, monetary policy, central bank

JEL Classifications: D72, D73, D74, E58, K14, K22, K42

Working Paper Series