Taking Compliance Seriously

67 Pages Posted: 5 Sep 2018 Last revised: 13 Jan 2020

See all articles by John Armour

John Armour

University of Oxford - Faculty of Law; University of Oxford - Said Business School; European Corporate Governance Institute (ECGI)

Jeffrey N. Gordon

Columbia Law School; European Corporate Governance Institute (ECGI)

Geeyoung Min

Michigan State University College of Law

Date Written: September 4, 2018

Abstract

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 penalties—to implement compliance programs that guide and monitor 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 to 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 such disclosure can reveal private information about a firm’s propensity to misconduct. 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 egregious as to amount to bad faith. We argue that this standard of liability, established in an era before ubiquitous stock-based compensation for both managers and directors, 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 add power to the alignment of directors’ interests with those of shareholders— directors would stand to lose more than just a decrease in the value of their stock in the event of a compliance failure—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.

Suggested Citation

Armour, John and Gordon, Jeffrey N. and Min, Geeyoung, Taking Compliance Seriously (September 4, 2018). 37 Yale Journal on Regulation 1 (2020) , Columbia Law and Economics Working Paper No. 588, Available at SSRN: https://ssrn.com/abstract=3244167 or http://dx.doi.org/10.2139/ssrn.3244167

John Armour (Contact Author)

University of Oxford - Faculty of Law ( email )

St Cross Building
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Oxford, OX1 3UL
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+44 1865 281616 (Phone)

HOME PAGE: http://www.law.ox.ac.uk/people/john-armour

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain

HOME PAGE: http://www.sbs.ox.ac.uk/about-us/people/john-armour

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Jeffrey N. Gordon

Columbia Law School ( email )

435 West 116th Street
Ctr. for Law and Economic Studies
New York, NY 10027
United States
212-854-2316 (Phone)
212-854-7946 (Fax)

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Geeyoung Min

Michigan State University College of Law ( email )

MI 48105
United States

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