TCS Daily

Crime? And Punishment

By Stephen Bainbridge - June 22, 2005 12:00 AM

The recent convictions of ex-Tyco executives Dennis Kozlowski and Mark Swartz and of ex-Adelphia executives John and Timothy Rigas highlight once again the growing extent to which the criminal law is being invoked to deal with problems of corporate governance.

Few serious persons would deny that fraud and theft are appropriate subjects of the criminal law. When corporate executives loot the corporation, as the Rigas were convicted of doing, they should go to jail.

Unfortunately, however, ambitious prosecutors have not limited themselves to cases of fraud or theft. Consider Martha Stewart, for example, who was sent to jail on the rather dubious charge of having misled prosecutors with respect to alleged insider trading for which she was never charged.

The Tyco case looks a lot more like the latter than the former. To be sure, Dennis Kozlowski appears to have been a prize pig, with extravagantly bad taste. But throwing million dollar parties and buying $6000 shower curtains is not criminal.

Unlike most media outlets, which simply parroted the prosecution line, while waging a little class warfare, Forbes magazine did some serious investigatory journalism in the Tyco case. What Forbes found was evidence of bad corporate governance -- directors who were often uncertain of what they were doing and so on -- but neither theft nor fraud. Unfortunately, as blawgger Larry Ribstein documents, the jurors just didn't get it.

As blawgger Tom Kirkendall points out, these convictions have a ripple effect. They make it easier for prosecutors "to bludgeon business interests into cooperating with a criminal investigation even if those business interests do not believe that they have done anything wrong."

Translating Kirkendall's point into economic terms, the criminalization of bad corporate governance has increased the expected sanctions faced by corporate executives. The probability of conviction has gone up because ambitious prosecutors can bring to bear the full panoply of coercive measures available only in criminal litigation, while the nominal sanction has gone up dramatically.

Just how much the nominal sanction has gone up is illustrated by a CNN report on Kozlowski's likely fate:

        Unlike Rigas and other recently-convicted corporate executives like former WorldCom CEO 
        Bernard Ebbers, Kozlowski is now headed for state prison. ... Because states typically 
        prosecute crimes like murder and rape, state prisons are where the most violent 
        offenders are and where the living conditions are described as brutal. Security, by necessity, 
        is extremely tight. ... "The fed system is unpleasant, but at least you're physically 
        safe there," said Gourevitch, who's now in private practice in Manhattan. "In the state 
        system, nobody would say you're physically safe."

Put bluntly, Dennis Kozlowski faces spending the rest of his life worrying about prison rape.

If we were confident that prosecutors could tell the difference between corporate criminality and mere bad corporate governance, and we were confident that prosecutors would content themselves with going after only the former, we might not care if the Kozlowskis of the world spent their days looking over their shoulders (so to speak). Yet, as the Kozlowski story illustrates, it's very hard to tell the difference between criminality and bad governance.

Indeed, as corporate law has long recognized, it can be difficult to tell the difference between good and bad corporate governance. As corporate law also has long recognized, there are serious costs associated with imposing high sanctions on executives.

Business decisions rarely involve black-and-white issues; instead, they typically involve prudential judgments among a number of plausible alternatives. Given the vagaries of business, moreover, even carefully made choices among such alternatives may turn out badly.

At this point, the well-known hindsight bias comes into play. Decisionmakers tend to assign an erroneously high probability of occurrence to a probabilistic event simply because it ended up occurring. If a jury knows that the plaintiff was injured, the jury will be biased in favor of imposing negligence liability even if, viewed ex ante, there was a very low probability that such an injury would occur and that taking precautions against such an injury was not cost effective.

Hence, there is a substantial risk that juries will be unable to distinguish between competent and negligent management because bad outcomes often will be regarded, ex post, as having been foreseeable and, therefore, preventable ex ante. If liability results from bad outcomes, without regard to the ex ante quality of the decision and/or the decisionmaking process, however, managers will be discouraged from taking risks. If it is true that lack of gumption is the single largest source of agency costs, as somebody once said, rational shareholders will disfavor liability rules discouraging risk-taking, as Judge Ralph Winter opined in Joy v. North:

        [B]ecause potential profit often corresponds to the potential risk, it is very much in the 
        interest of shareholders that the law not create incentives for overly cautious corporate 
        decisions. ... Shareholders can reduce the volatility of risk by diversifying their holdings. In 
        the case of the diversified shareholder, the seemingly more risky alternatives may well be 
        the best choice since great losses in some stocks will over time be offset by even greater 
        gains in others. ... A rule which penalizes the choice of seemingly riskier alternatives 
        thus may not be in the interest of shareholders generally.

Hence, when juries review the merits of even bad corporate governance, they run the risk of effectively penalizing "the choice of seemingly riskier alternatives."

In sum, shareholders deserve protection from theft, but not from risk taking, even when the risk in question is how much to pay an executive. Unfortunately, it's not clear that prosecutors know the difference -- or even care.


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