71 Pages Posted: 5 Sep 2018
Date Written: September 4, 2018
How can we ensure corporations play by the “rules of the game”—that is, laws encouraging firms to avoid socially harmful conduct? Corporate compliance programs play a central role in society’s current response. Prosecutors give firms incentives—through discounts to penaltie—to implement compliance programs guiding and monitoring employees’ behavior. However, focusing on the incentives of firms overlooks the perspective of managers, who decide how much firms invest in compliance.
We show that stock-based pay, ubiquitous for corporate executives, creates systematic incentives to short-change compliance. Compliance is a long-term investment for firms, whereas managers’ time-horizon is truncated at the date they expect to liquidate stock. Moreover, investors find it hard to value compliance programs, because firms routinely disclose little or nothing about their compliance activities. We show that stock-compensated managers prefer not to disclose compliance, because it can reveal private information about a firm’s propensity to misconduct: the greater a firm’s misconduct risk, the more valuable to it is an investment in compliance. As a result, both managers and markets are likely myopic about compliance.
How can this problem be resolved for the benefit of society and shareholders? Boards of directors are supposed to act as monitors to control managerial agency costs. We show that the increasing use of stock-based compensation for directors, justified as a means of encouraging more vigorous oversight of business decisions, also has a corrosive effect on boards’ monitoring incentives for compliance. Directors in theory face liability for compliance oversight failures, but only if so comprehensive as to amount to bad faith. We argue that this standard of liability, established in an era before ubiquitous stock-based compensation, has now become too lax.
We propose more assertive directors’ liability for compliance failures, limited in quantum to a proportionate clawback of stock-based pay. This would realign directors’ interests with those of shareholders—directors would stand to lose in parallel with shareholders should a compliance failure materialize—but limiting liability in this way would avoid pushing boards to overinvest in compliance. We outline ways in which this proposal could be implemented either by shareholder proposals or judicial innovation.
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