Research Handbook on Corporate Crime and Financial Misdealing 1783474467, 9781783474462, 9781783474479

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RESEARCH HANDBOOK ON CORPORATE CRIME AND FINANCIAL MISDEALING

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RESEARCH HANDBOOKS IN CORPORATE LAW AND GOVERNANCE Series Editor: Randall S. Thomas, John S. Beasley II Professor of Law and Business, Vanderbilt University Law School, USA Elgar Research Handbooks are original reference works designed to provide a broad overview of research in a given field while at the same time creating a forum for more challenging, critical examination of complex and often under-explored issues within that field. Chapters by international teams of contributors are specially commissioned by editors who carefully balance breadth and depth. Often widely cited, individual chapters present expert scholarly analysis and offer a vital reference point for advanced research. Taken as a whole they achieve a wide-ranging picture of the state-of-the-art. Making a major scholarly contribution to the field of corporate law and governance, the volumes in this series explore topics of current concern from a range of jurisdictions and perspectives, offering a comprehensive analysis that will inform researchers, practitioners and students alike. The Research Handbooks cover the fundamental aspects of corporate law, such as insolvency governance structures, as well as hot button areas such as executive compensation, insider trading, and directors’ duties. The Handbooks, each edited by leading scholars in their respective fields, offer far-reaching examinations of current issues in corporate law and governance that are unrivalled in their blend of critical, substantive analysis, and in their synthesis of contemporary research. Each Handbook stands alone as an invaluable source of reference for all scholars of corporate law, as well as for practicing lawyers who wish to engage with the discussion of ideas within the field. Whether used as an information resource on key topics or as a platform for advanced study, volumes in this series will become definitive scholarly reference works in the field. Titles in this series include: Research Handbook on Executive Pay Edited by Randall S. Thomas and Jennifer G. Hill Research Handbook on Insider Trading Edited by Stephen M. Bainbridge Research Handbook on Directors’ Duties Edited by Adolfo Paolini Research Handbook on Shareholder Power Edited by Jennifer G. Hill and Randall S. Thomas Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations Edited by Robert W. Hillman and Mark J. Loewenstein Research Handbook on Mergers and Acquisitions Edited by Claire A. Hill and Steven Davidoff Solomon Research Handbook on the History of Corporate and Company Law Edited by Harwell Wells Research Handbook on Corporate Crime and Financial Misdealing Edited by Jennifer Arlen

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Research Handbook on Corporate Crime and Financial Misdealing

Edited by

Jennifer Arlen Norma Z. Paige Professor of Law; Director, Program on Corporate Compliance and Enforcement; and Director, Center for Law, Economics and Organization, New York University School of Law, USA

RESEARCH HANDBOOKS IN CORPORATE LAW AND GOVERNANCE

Cheltenham, UK • Northampton, MA, USA

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© The editor and contributors severally 2018 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2017960001 This book is available electronically in the Law subject collection DOI 10.4337/9781783474479

ISBN 978 1 78347 446 2 (cased) ISBN 978 1 78347 447 9 (eBook)

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Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

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Contents vii ix

List of contributors Acknowledgments

Introduction1 Jennifer Arlen CORPORATE AND INDIVIDUAL LIABILITY FOR PART I  CORPORATE MISCONDUCT   1 Psychology and the deterrence of corporate crime Tom R. Tyler

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  2 Individual and corporate criminals Brandon L. Garrett

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  3 Criminally bad management Samuel W. Buell

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  4 Does conviction matter? The reputational and collateral effects of corporate crime Cindy R. Alexander and Jennifer Arlen

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PUBLIC ENFORCEMENT OF PUBLIC CORRUPTION AND PART II  SECURITIES FRAUD   5 Multijurisdictional enforcement games: the case of anti-bribery law Kevin E. Davis   6 Beware blowback: how attempts to strengthen FCPA deterrence could narrow the statute’s scope Matthew C. Stephenson

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  7 Corruption in state administration Tina Søreide and Susan Rose-Ackerman

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  8 Securities law and its enforcers Stephen J. Choi and A. C. Pritchard

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  9 Corporate and individual liability in SEC enforcement actions  237 Michael Klausner and Jason Hegland

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vi  Research handbook on corporate crime and financial misdealing PART III  ROLE OF PRIVATE ACTORS: COMPLIANCE, CORPORATE INVESTIGATIONS, AND WHISTLEBLOWING 10 An economic analysis of effective compliance programs Geoffrey P. Miller

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11 Behavioral ethics, behavioral compliance Donald C. Langevoort

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12 An analysis of internal governance and the role of the General Counsel in reducing corporate crime Vikramaditya Khanna

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13 When the corporation investigates itself Miriam H. Baer

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14 Bounty regimes David Freeman Engstrom

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Index

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Contributors Cindy R. Alexander, Research Fellow, Law & Economics Center, George Mason University Jennifer Arlen, Norma Z. Paige Professor of Law and Director, Program on Corporate Compliance and Enforcement, New York University School of Law Miriam H. Baer, Professor of Law, Brooklyn Law School Samuel W. Buell, Bernard M. Fishman Professor of Law, Duke University Stephen J. Choi, Murray and Kathleen Bring Professor of Law, Director, Pollack Center, and Senior Academic Fellow, Program on Corporate Compliance and Enforcement, New York University School of Law Kevin E. Davis, Beller Family Professor of Business Law and Senior Academic Fellow, Program on Corporate Compliance and Enforcement, New York University School of Law David Freeman Engstrom, Professor of Law and Bernard D. Bergreen Faculty Scholar, Stanford Law School Brandon L. Garrett, Justice Thurgood Marshall Distinguished Professor of Law and White Burkett Miller Professor of Law and Public Affairs, University of Virginia School of Law Jason Hegland, Executive Director, Stanford Securities Litigation Analytics Vikramaditya Khanna, William W. Cook Professor of Law, University of Michigan Law School Michael Klausner, Nancy and Charles Munger Professor of Business and Professor of Law, Stanford Law School, and Visiting Professor of Law, New York University School of Law Donald C. Langevoort, Thomas Aquinas Reynolds Professor of Law, Georgetown University Law Center Geoffrey P. Miller, Stuyvesant P. Comfort Professor of Law and Senior Academic Fellow, Program on Corporate Compliance and Enforcement, New York University School of Law A. C. Pritchard, Frances and George Skestos Professor of Law, University of Michigan Law School Susan Rose-Ackerman, Henry R. Luce Professor of Jurisprudence, Law School and Department of Political Science, Yale University Tina Søreide, Professor of Law and Economics, Norwegian School of Economics vii

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viii  Research handbook on corporate crime and financial misdealing Matthew C. Stephenson, Professor of Law, Harvard Law School Tom R. Tyler, Macklin Fleming Professor of Law and Professor of Psychology and Founding Director of The Justice Collaboratory, Yale Law School

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Acknowledgments I want to thank the following people for generously providing their time and expertise to provide comments on one or more of the chapters in this book. This book greatly benefited from their assistance. Miriam Baer Rachel Brewster Darryl Brown Samuel Buell Alexander Dyck Jean Ensminger Jeffrey Gordon Marcel Kahan Jonathan Karpoff Paul Lagunes Marcia Miceli Thomas Miles Daniel Richman Tina Søreide David Webber

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Introduction

Jennifer Arlen*

Corporate crimes occur all too often, causing serious harm to individuals, as well as to the economies of countries adversely impacted by crimes such as fraud and corruption. Crimes by large publicly-held firms raise special concerns because these firms have such a broad reach that they can cause tremendous harm when their employees pursue profit through criminal activities. To guard against these harms, criminal laws and regulations impose duties on corporations and those who work for them to avoid a range of harmful activities. Laws in the U.S., and in many other countries, impose criminal and civil liability on both individual wrongdoers and their corporate employers for violations of these duties. The central purpose of this liability is—and must be—to deter corporate misconduct. Deterrence should be the primary goal of corporate and individual liability for corporate misconduct for a simple reason. Any provision that sacrifices deterrence in the name of some other goal, such as retribution, leads more people to be harmed by corporate crime. Thus, pursuing retribution at the expense of effective deterrence places future victims in harm’s way. Deterrence, by contrast, both helps safeguard future victims and reduces the need for future punitive interventions. In addition, when misconduct is caused by employees of publicly-held firms, there is an additional reason to favor enforcement policies that deter misconduct over those that punish the firm: corporate liability imposed on publicly-held firms is hard to justify as a means to punish wrongdoers. Corporate liability ultimately falls on the firm’s shareholders. Yet shareholders of professionally-managed firms rarely play any role in causing misconduct; nor do they have sufficient management power to prevent misconduct (Arlen 2012; Arlen and Kahan 2017).1 Instead, public corporations’ acts and intent are really the acts and intent of employees who often have little stake in the firm. These employees often act primarily to benefit themselves (often indirectly through the compensation or job security that follows actions that confer a short-run benefit on the firm). The actions of these employees are only incompletely controlled by, and known to, those above them, even in firms with effective compliance programs. Thus, it does not seem appropriate to seek retribution against a publicly-held firm for most of the types of crimes they commit. By contrast, strong reasons exist to impose liability on corporations in order to deter corporate crime. Properly structured corporate liability can provide corporations—and in turn the managers and directors who control the firm—with incentives to intervene *  I would like to thank my research assistant, Jason Driscoll. 1   For example, under Delaware law (which governs the majority of U.S. publicly-held firms), the power to manage the firm is vested in the board of directors, not the shareholders. Delaware General Corporation Law 141(a). Shareholders can vote for the board of directors, but in most firms they cannot vote to nominate which candidates are put before them for election. They have little, if any, genuine control over the firm.

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2  Research handbook on corporate crime and financial misdealing efficiently to deter corporate crime. Corporations are vital to the effort to deter corporate crime because they control the benefit that employees derive from crime (through control over compensation and promotion policies). They also directly impact the expected cost of crime to their employees. Corporations can increase their employees’ expected cost of crime through interventions that increase the government’s ability to detect and sanction crime. These interventions include adopting an effective compliance program, investigating suspected misconduct, self-reporting detected violations, and fully cooperating to provide the evidence needed to convict responsible individuals (hereinafter “corporate policing”). Corporate policing is important because, absent corporate policing, employees engaging in misconduct often do not fear criminal punishment because they think the government is unlikely to detect the crime or identify the individuals responsible. Firms can help detect crimes and identify the wrongdoers if motivated to do so. Of course, firms will intervene to deter corporate crime only if they have an incentive to do so. The threat of criminal or civil liability for employees’ crimes can provide this incentive, if properly structured. Corporate liability must be structured to ensure that firms which have effective compliance programs, self-report and cooperate fare better than those that do not. In addition, the government must use the information produced by corporate cooperation to hold individual wrongdoers liable for the crimes they committed. After all, absent the threat of personal liability, employees will continue to commit corporate crimes. U.S. enforcement policy is evolving, adopting an increasing number of features that could help deter corporate crime. Prosecutors are encouraged to insulate firms that self-report and cooperate from formal conviction through the use of deferred and nonprosecution agreements (DPAs and NPAs). DPAs are criminal settlements that enable prosecutors to sanction firms and obtain admissions of criminal responsibility without a formal conviction. Prosecutors also adjust sanctions and mandates in response to corporate activities, including the effectiveness of the firm’s compliance program and thoroughness of the investigation. Enforcement officials can use policies governing the availability of DPAs and NPAs, as well as sanction mitigation, to incentivize firms to self-report and cooperate (Arlen 2012). In addition, enforcement authorities negotiating with managers who are not committed to deterrence can enhance deterrence by using corporate criminal settlements to require firms to undertake specific reforms or to accept a monitor (Arlen and Kahan 2017). The reforms that have transformed the U.S. system have raised a host of issues, however. These include questions about whether liability does in fact deter, whether criminal and civil liability are appropriately targeted at those responsible for the misconduct, the impact on enforcement policy and deterrence of having multiple enforcers, the potential deterrence role of whistleblowers, the most effective approach to compliance, and the complex task of conducting a corporate investigation in the modern age. The chapters in this book address these issues.

OVERVIEW OF THIS VOLUME This book brings together leading scholars from a variety of disciplines to explore ­mechanisms for deterring corporate crime and securities fraud through both public

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Introduction  3 enforcement and private interventions. The book is divided into three parts: Part I: Corporate and Individual Liability for Corporate Misconduct; Part II: Public Enforcement of Public Corruption and Securities Fraud; and Part III: Role of Private Actors: Compliance, Corporate Investigations, and Whistleblowing. Part I examines corporate and individual liability for corporate misconduct through four chapters that consider the causes of corporate crime, empirical analysis of public enforcement, the liability of supervisors, and the potential cost to corporations of reputational damage from corporate criminal settlement. In Chapter 1, “Psychology and the deterrence of corporate crime,” Tom Tyler reviews the effectiveness of deterrence, in and of itself, as well as relative to the influence of consensual models of regulation that rely upon legitimacy to motivate compliance. The law governing corporate criminal enforcement, and the law and economics scholarship designed to inform it, treats deterrence as the primary goal, and coercion through threatened sanctions as the most effective tool to achieve this goal. Yet, according to Tyler, the available evidence on the causes of misconduct suggests that although people do respond to threatened sanctions, the influence of coercion is often overstated relative to its actual influence upon law-related behavior. In addition, consensual approaches have been found to be more effective than is commonly supposed. Taken together these findings suggest the desirability of developing a broader approach to corporate regulation using both coercive and consensual models of regulation. Given the strength of the findings for consensual models, the persistence of coercive models as the dominant and even exclusive approach to corporate crime is striking. That dominance suggests the importance of focusing on the psychological attractions of coercion to people in positions of authority. Tyler suggests that those in authority are attracted to this approach not only because of evidence that it can be effective but also due to the psychological benefits it affords them. In Chapter 2, “Individual and corporate criminals,” Brandon Garrett examines whether corporate enforcement actions are indeed leading to the eventual prosecution of the individuals responsible for the crimes. He finds that officers and employees are only prosecuted in about one-third of the federal corporate criminal settlements involving deferred or non-prosecution agreements. Garrett’s chapter explores possible reasons for this pattern. Using the HSBC case as an example, Garrett first introduces the practical and procedural obstacles that arise in cases involving both organizations and employees. Turning to the evidence on individual prosecutions in corporate cases, Garrett then explores why prosecutors so frequently do not or cannot prosecute individuals in corporate cases, and why they so often achieve limited success when they do. Garrett concludes by describing alternative means to deter individual behavior and what significance this has for the approach to corporate prosecutions more generally. In Chapter 3, “Criminally bad management,” Samuel Buell extends the analysis of individual liability by shining the spotlight on the corporate managers who often play a vital role in either inducing crime on the one hand or deterring it on the other. After all, it is managers that produce the corporate culture that can either operate to cause crime or to deter it. Buell explores the challenges and potential promise of using criminal liability to impose sanctions on managers who were indirectly responsible for a crime but did not commit any acts to help commit it. In Chapter 4, “Does conviction matter? The reputational and collateral consequences of corporate crime,” Cindy Alexander and Jennifer Arlen evaluate the claim made by

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4  Research handbook on corporate crime and financial misdealing some critics of DPAs that the use of DPAs undermines deterrence by lowering the cost to firms of the reputational damage or stigma resulting from a criminal settlement. Criminal settlements cause firms to sustain costs from reputational damage when they release information that leads interested outsiders—e.g., customers and suppliers—to anticipate an enhanced risk of harm from future dealings with the firm. DPAs alter this cost if, but only if, they affect the information released by the criminal settlement about the firm’s expected risk of causing future harm. The authors evaluate, and reject, three potential channels through which the choice of settlement form could affect the information about future risk reaching interested outsiders: direct revelation, prosecutorial selection, and managerial selection. They then turn to the impact of DPAs on the ability of federal agencies to protect their interests by excluding or delicensing firms whose criminal settlement reveals that they present an enhanced risk of causing future harm to the agencies’ interests that is best addressed by exclusion instead of by mandated reforms. They conclude that agencies may be better able to serve their interests as interested outsiders when prosecutors employ DPAs rather than pleas because DPAs leave agencies free to use permissive exclusion and enable them to exclude when, but only when, appropriate. Part II presents five chapters focused on public enforcement of public corruption or securities fraud. Chapters 5–7 examine three different aspects of liability for corruption. Chapters 8 and 9 examine Securities and Exchange Commission enforcement of securities fraud. In Chapter 5, “Multijurisdictional enforcement games: the case of anti-bribery law,” Kevin Davis provides an economic analysis of corporate criminal enforcement for crimes, such as corruption, whose enforcement involves multiple agencies, often based in different jurisdictions. Davis shows how the interaction between the multiple enforcement agencies can be analyzed as a dynamic multi-player game in which the players include both enforcement agencies and firms. He finds that this kind of analysis can be used to formulate testable hypotheses about the outcomes of interactions between regulators and firms. Unfortunately, opportunities to evaluate these kinds of hypotheses empirically are limited because many aspects of the structure of the game are difficult to observe, and firms’ misconduct and regulators’ enforcement activities typically are only observable when they result in formal sanctions. The chapter concludes with a discussion of some of the challenges inherent in normative analysis of the outcomes of multijurisdictional law enforcement games. In Chapter 6, “Beware blowback: how attempts to strengthen FCPA deterrence could narrow the statute’s scope,” Matthew Stephenson argues that proposed reforms to the Foreign Corrupt Practices Act (FCPA) intended to deter FCPA violations more effectively—such as creating a private civil remedy, more aggressive targeting of individual defendants, and expanded use of corporate debarment—could have the opposite effect. According to Stephenson, such reforms might lead to a substantive narrowing of the FCPA, because they would lead to more litigation, much of it against more sympathetic defendants, and this in turn could lead to both judicial narrowing of ambiguous statutory terms and Congressional revisions to the statute. He concludes that the possible unintended consequence should be considered when conducting a more comprehensive evaluation of the costs and benefits of proposed FCPA reforms. In Chapter 7, “Corruption in state administration,” Tina Søreide and Susan RoseAckerman analyze the other side of the corruption equation: the supply of corrupt

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Introduction  5 decisions by government officials. Specifically, they provide an economic analysis of corruption as a trade in decisions that should not be for sale. The size of the bribe and the consequences of corruption are functions of the bargaining powers of those involved. They suggest ways to reorganize decision-making procedures to reduce the risks of corruption but stress the difficulty of breaking up entrenched collusive environments. Furthermore, even if corruption in a public institution is well recognized, it may not be possible to identify individual offenders. The question then is whether one should sanction the entire public body. Like private entities, public institutions can be encouraged to self-police and self-report (for example, upon information from a whistleblower) if such steps will reduce the extent of some penalty. However, the criminal and administrative monetary sanctions applied to private sector entities are a poor fit for state institutions with ongoing responsibilities to the citizenry. They propose non-monetary penalties, including intensified external monitoring, reorganization of authority, disqualification of leaders, and removal of service provision responsibilities. Chapters 8 and 9 both consider aspects of public enforcement of financial misrepresentation by the Securities and Exchange Commission (SEC). In Chapter 8, “Securities law and its enforcers,” Stephen Choi and A. C. Pritchard review the existing empirical literature relating to government enforcement of the securities laws, particularly by the SEC, including comparative work, assessment of the impact of enforcement, and analysis of enforcement patterns. Choi and Pritchard also identify a particularly promising area for future research. Little work has been done to date exploring the incentives faced by attorneys who conduct investigations on behalf of the SEC and how those incentives shape enforcement decisions. This chapter offers preliminary evidence on the career paths of SEC lawyers and how those career choices might influence the enforcement actions brought by the SEC. In Chapter 9, “Corporate and individual liability in SEC enforcement actions,” Michael Klausner and Jason Hegland present an empirical analysis of SEC enforcement. Some commentators have accused the SEC of going easy on executives responsible for securities fraud and instead penalizing shareholders by imposing fines on corporations. The authors investigate that claim empirically and conclude that it is unsupported. The SEC frequently penalizes executives; it imposes monetary sanctions on corporations far less often. The chapter goes on to provide more detail on SEC practice with respect to penalizing corporations and executives in cases alleging disclosure violations by public companies. Part III contains five chapters that examine the role of private actors in deterring corporate crime. These private interventions include actions taken by corporations—such as compliance and internal investigations—as well as whistleblowing by employees and others. In Chapter 10, “An economic analysis of effective compliance programs,” Geoffrey P. Miller examines the core features of effective compliance. Tests for “effective” compliance programs take the form of lists specifying required elements in varying levels of detail. From an economic perspective, an effective compliance program can be defined more fundamentally as the set of policies and procedures that a rational, profit-maximizing firm would establish if it faced an expected sanction equal to the social cost of violations. Miller explores the idea and several of its extensions and qualifications. In Chapter 11, “Behavioral ethics, behavioral compliance,” Donald Langevoort analyzes the promise of taking a behavioral approach to compliance and ethics. Research

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6  Research handbook on corporate crime and financial misdealing in psychology and organizational behavior under the heading of “behavioral ethics” is growing rapidly, offering new insights into how people (individually and in groups) choose whether to comply with legal and ethical norms. In legal scholarship, a robust literature is emerging on the subject of organizational compliance, as public enforcers become more insistent that corporations build and maintain state-of-the-art systems. This chapter joins these two bodies of research, demonstrating the potential payoffs—and challenges—in using a behavioral frame of reference to assess compliance risks, design appropriate interventions, and communicate more effectively about both law and ethics with corporate managers and other employees. Just as compliance requires good economics skills, it requires psychological savvy as well, to help predict how incentives and compliance messages will be processed, construed and acted upon in the field. In Chapter 12, “An analysis of internal governance and the role of the General Counsel in reducing corporate crime,” Vikramaditya Khanna reviews the empirical literature on the factors related to the likelihood and detection of corporate wrongdoing, which increasingly focuses on internal governance, and examines calls to split the traditional tasks of the General Counsel (GC) between the GC and a Chief Compliance Officer (CCO) who reports directly to the Board. The reason for this is to have more independence and expertise in compliance matters than the GC’s office traditionally provides. Khanna argues that although independence is often valuable in reducing wrongdoing, in this context it is likely to come with additional costs that may make gathering information on wrongdoing more difficult. In particular, some employees may be more reluctant to provide information to a CCO than to the GC, and this may result in increased wrongdoing and weaker operating performance. These deleterious effects, however, might be somewhat ameliorated by institutional and governance design adjustments. Khanna examines what factors may drive likely outcomes and finds that further empirical inquiry would be valuable, going on to suggest some ways in which future research might engage in this inquiry. In Chapter 13, “When the corporation investigates itself,” Miriam Baer evaluates the challenges corporations face when investigating corporate crimes in the shadow of the federal government’s expectations concerning full corporate cooperation. She argues that the corporate investigation’s greatest challenges stem from familiar problems of individual and entity-level efforts to evade detection. As employees take steps to conceal their misbehavior, corporate actors must navigate a difficult relationship between government enforcers on the one hand and corporate employees on the other. Mediating these relationships would be difficult enough under any circumstance, but a vexatious deficiency of trust between corporate actors and government enforcers causes corporate actors to cling ever more intently to legal doctrines such as the corporate attorney–client privilege, while simultaneously conducting more intensive, intrusive and expensive investigations. Baer concludes by noting two developments: the Department of Justice’s latest attempt to secure cooperation from corporate defendants in identifying culpable employees (the so-called “Yates Memo”), and the increasing emphasis on workplace privacy. These two developments will place even greater pressure on the corporate investigator as she attempts to reassure the corporation’s employees and regulators that each side can in fact trust the corporation to investigate itself thoroughly yet fairly. In Chapter 14, “Bounty regimes,” David Freeman Engstrom offers a theoretical and empirical overview of whistleblower bounty schemes that pay individuals a cash “bounty”

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Introduction  7 for surfacing information about illegal conduct. Engstrom first catalogues existing bounty regimes by comparing the structure and workings of two of its most prominent exemplars: the False Claims Act and the more recent Dodd-Frank whistleblower scheme. Next, he surveys the existing scholarly literature, with particular attention to a trio of recurrent design problems. Among these are how to incentivize an optimal level of reporting, how to harmonize bounty regimes with internal corporate compliance systems, and how to weigh efficiency and democratic-control concerns when deputizing whistleblowers to do regulatory work. Finally, he turns to an aspect of the regulatory design puzzle that has yet to attract substantial attention: how the organizational structure of wrongdoing (e.g., organizational complexity, the degree to which the misconduct is centralized or compartmentalized, and the like) presents opportunities and challenges in the design of bounty regimes. He concludes that it is here that scholars are most likely to find fruitful avenues for further research. Taken together, the chapters in this volume both reveal how far we have come in our understanding of mechanisms for deterring corporate misconduct and highlight promising avenues for future research.

REFERENCES Arlen, Jennifer. 2012. Corporate Criminal Liability: Theory and Evidence. In Keith Hylton and Alon Harel (eds.), Research Handbook on Economics of Criminal Law, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, Section 1. Arlen, Jennifer and Marcel Kahan. 2017. Corporate Regulation Through Non-Prosecution, University of Chicago Law Review, 84, 323–387.

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PART I CORPORATE AND INDIVIDUAL LIABILITY FOR CORPORATE MISCONDUCT

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1.  Psychology and the deterrence of corporate crime Tom R. Tyler* 2

1. INTRODUCTION The field of economics has had an enormous and positive influence upon legal scholarship. This influence has occurred in two stages. In the first, the theoretical framework of rational choice shaped arguments about how to structure regulation and has led to the widespread adoption of deterrence models as a primary mechanism for shaping the behavior of people within work organizations (Arlen and Kraakman, 1997; Becker, 1968; Polinsky and Shavell, 2000). In the second, behavioral economics has more recently provided evidence that the assumptions of the rational choice model need to be modified to recognize that decision making exhibits systematic biases. Both of these movements share the important argument that the design of laws and legal institutions should be shaped by their presumed or observed impact upon the behavior of people. And both begin with the assumption that it is the risk and experience of sanctions that are the key to that influence. This chapter argues that policy should be based on a broader model than is often employed in economic analyses. The goal of this review is to improve our understanding of the antecedents of law-related behavior. In particular, in this chapter I argue that there is considerable empirical evidence demonstrating that consent-based models of compliance are also viable mechanisms for deterring misconduct in corporate and other work settings. What is a consent-based model? It is a model that focuses on the legitimacy of the law as a factor motivating compliance (Tyler, 2006a, 2006b). If people believe that legal authority is legitimate they consent to and voluntarily comply with legal rules and the decisions of legal authorities. Sanctions are clearly also important, but given that consent-based models are equally, or in some situations even more, effective it makes sense to move toward a strategy that pays more equal attention to both approaches, which given the current dominance of coercive models means paying greater attention to consensual approaches. More specifically research findings suggest that consensual models are not only as or more effective than are traditional coercion-based models directed at motivating compliance through a sanctioning approach, but that they are much better able to encourage voluntary cooperation with the rules, lessening the difficulties and costs associated with creating and maintaining the type of effective mechanisms of surveillance needed for sanction-based models. Finally, consent-based approaches encourage employee identification with organizations and communities, which broadly encourages employees’ engagement in their work organization (Tyler and Blader, 2005; Tyler and Jackson, 2014). This promotes productivity for companies.

*  I would like to thank Jennifer Arlen, Miriam Baer, Sam Buell, Vikramaditya Khanna, Janice Nadler and Jonathan Glater for helpful comments on a draft of this chapter.

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12  Research handbook on corporate crime and financial misdealing I further suggest that in spite of empirical evidence demonstrating the important distinct influence of consensual models, coercive models continue to dominate both law in general and the area of corporate compliance in particular. This leads to the question of why that dominance continues in spite of the evidence. This chapter addresses this issue by examining the psychological benefits of adopting an approach based upon coercion to the authorities who enact this approach to regulation.

2.  INTERNAL AND EXTERNAL REGULATION In discussing corporate crime, it is important to recognize that there are two potentially important regulatory models: coercive and consensual. The coercive model is associated with deterrence strategies; the consensual model with the legitimacy of rules and authorities. Most of the general literature on deterrence is concerned with the influence of law and legal authorities upon the behavior of individuals within organizations. People are assumed to be influenced by the penalties of the law; they are also influenced by the legitimacy of law and legal authorities. In the case of the organizations for which people work, there is also an internal regulatory system in which the organization confers rewards and punishments and has its own value-based culture. Hence, the setting of corporate crime occurs within two organizational frameworks, each with coercive and consensual elements. The internal coercive approach, in which firms structure their internal incentives and sanctions to motivate desired behavior is outlined by Arlen and Kraakman (1997). 2.1  Regulatory Goals In order to compare models of regulation it is first important to identify the goals we seek to achieve through the regulation of organizations.1 Most discussions focus on the criteria of compliance, i.e. on whether people obey rules and the directives of legal and managerial authorities. These authorities can be legal authorities, such as police officers, judges or administrative regulators who are enforcing societal laws, or corporate leaders, who are enforcing the internal rules of their organizational entities. In either case discussions of compliance focus on observed behavior. The issue is whether and why people do or do not behave in accordance with informal or formal rules. Observed compliance does not in and of itself indicate why people are complying. However, in the everyday use of that term there is often an implicit assumption that compliance is linked to cost–benefit calculations. People comply to avoid sanctions. This is the coercive model. The goal of this chapter is to separate the issue of the extent and nature of the type of behavior we want people to engage in from the motivations that people have for behaving as they do. There are several goals besides compliance with what might be desirable (Soltes, 2016). The first is the goal of deference. In contrast to compliance, deference 1   The focus of this discussion is on for-profit work organizations. The arguments being made apply more broadly to people’s relationships to any group, organization, or community. Within for-profit work organizations one issue is the internal culture of the firm. A second issue is the framework of legal authority within which the organization functions. Either of these can be coercive or consensual.

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Psychology and the deterrence of corporate crime  13 is rule-governed behavior that occurs because people have decided that they ought to accept rules and as a result do so without reference to the issue of sanctions. Deference is voluntary in that it is not linked to perceived risk of sanctioning. People consent to rules. As this distinction suggests, there is no necessary behavioral difference between compliance and deference. The difference lies in the motive for rule following. The question is not whether people are following rules, but why they are doing so.2 2.2  Goals for the Behavior of People in Organizations and Communities The distinction between the two different reasons for following rules has important implications for discussions about regulation. To the degree that rule following is voluntary then regulatory authorities either within a company or in external legal regulatory spheres do not need to expend resources toward the goal of creating viable surveillance systems, building policing forces, and developing ways to judge and punish suspected rule breakers. These resources are less needed because people are internally motivated to conform to rules. Hence, to the degree that it is possible to encourage people to consent to obeying rules, there are clear benefits to organizations and to society. In both cases, however, the focus is on rule following. For this reason, regulatory authorities are typically viewed as a cost to an organization or a community. Money spent to enforce rules is a necessary cost, but one that reduces the gains that are the goal of for-profit organizations and takes a toll on the efforts to garner resources to promote economic and social welfare that define communities. Armies, police forces and compliance officers are needed to ensure that illegal and unethical behavior does not occur and undermine company or societal viability by leading to either internal conflict or attracting the attention of external government authorities. But these security expenditures do not directly contribute to achieving the goal of enhancing profitability.3 Both companies and communities would benefit if they could allocate more of the resources they use to create credible mechanisms for deterrence to other activities. A further goal for an organization is to build the type of employee identification with the organization that promotes voluntary behaviors of a positive type, i.e. behavior that is designed to enhance company success and profitability by motivating its members to want to do the things that will lead to the well-being of the organization, i.e. to work productively and engage in desirable in-role and extra-role behavior. An ideal regulatory framework for rule enforcement would leverage employee loyalty toward behaviors beyond rule following and toward enhancing organizational viability and success (see Arlen and

2   The distinction between compliance and deference is not absolute. Corporations can create cultures that favor or disfavor deference. The motivation to defer can be enhanced by structures (Arlen, 2012). For example, a company that links employment to achieving profit-related goals is less likely to have a culture that supports discretion about whether to follow rules. 3   One way that they do contribute is by promoting the belief that those who do not follow rules will be caught and punished. Without some level of deterrence people are more likely to be free riders. Believing that the people who break rules are caught and punished is one element in viewing authorities as legitimate. An authority that allows widespread cheating or corruption is viewed as less legitimate and is less able to motivate voluntary deference among the general population of an organization or a community.

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14  Research handbook on corporate crime and financial misdealing Kraakman, 1997; Arlen, 2012). As an example, police forces enforce rules and protect communities from crime. But the type of community solidarity and social capital needed for economic and social development flows from reassurance, i.e. the belief that the police are concerned about the needs of the community and will help those in need. So, beyond controlling crime the police can be a presence that promotes community well-being. Similarly, organizational authorities, for example management, can hopefully promote identification with and commitment to the organization, thereby leading employees to work more willingly and creatively to help their company be successful (Tyler and Blader, 2000).4 Studies in both arenas suggest that exercising authority using fair procedures is a key antecedent to creating this view (Tyler, 2006a, 2006b). These distinctions can be illustrated using recent research on legal authority in communities (Tyler and Jackson, 2014). Consistent with past research, Tyler and Jackson show that risk estimates concerning the likelihood of being caught and punished have an influence on compliance. They also have an influence on voluntary deference, but that influence is weaker. But they do not shape residents’ proactive engagement in the community. Across these three forms of behavior the strength of deterrence effects diminishes as the focus moves from compliance, through deference toward positive engagement. Hence, as we move our attention toward building engagement, which promotes the well-being of the community, we increasingly need an alternative model to the coercive approach. This argument fits well with our goals in community settings, where economic and social development is a key to the future viability of the community. When the police provide reassurance and create legitimacy, rather than creating fear because they are viewed as linked to deterrence, they create a framework within which people engage themselves in the community. This does not mean that deterrence is not valuable, but it suggests the need to pursue legitimacy as a distinctly valuable goal.5 It can both help to motivate compliance and can distinctively promote deference and engagement. The same argument underlies regulation in corporate settings. Too often the compliance officer is just that and employees experience a sanction orientation backed up by many overt and covert forms of surveillance. That can include the monitoring of communications, video surveillance of the workplace, etc. While necessary for a viable command and control regime which functions through deterrence, these actions do not create identification with the company or motivate employees to work on its behalf. To gain the benefits of such motivation people need to experience rules as a product of consent and they need to regard regulatory authorities as legitimate. Compliance officers can also pursue this objective and can work to create a corporate culture that enhances the legitimacy of internal standards and values. The literature that studies policing in community settings suggests that such legitimacy can be created and maintained, and that

4   Of course this can be a double edged sword. If people are motivated to achieve success by disregarding rules this success can come at the expense of other values. In an ideal world the corporate culture emphasizes taking actions within the framework of organizational rules as well as rules of law. 5   Some scholars argue that pursuing the goal of compliance via deterrence lessens or crowds out the influence of legitimacy on behavior (see Tyler, Goff and MacCoun, 2015 for a review of this argument). This discussion will treat deterrence and legitimacy as two parallel influences on law-related behavior.

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Psychology and the deterrence of corporate crime  15 it can promote identification and actions on behalf of collective entities. This approach is also viable in corporate settings (Tyler, 2005; Tyler and Blader, 2000, 2005).

3.  HOW TO ACHIEVE THESE GOALS 3.1  Deterrence Through External Sanctions Recent empirical research suggests that the deterrence-based strategies of governance/ management can be successful. For example, recent research suggests that deterrence strategies can shape crime-related behavior (Blumstein, Cohen, and Nagin, 1978; Nagin, 1998). But the same findings also suggest that the magnitude of deterrence influences is usually small and sometimes non-existent (Bottoms and Von Hirsch, 2010; Paternoster, 2006). Further, studies suggest that the limits of deterrence effects do not reflect an inherent inability of using a risk of sanctions to shape behavior. Rather they reflect limits in resources available for surveillance and sanctioning, and situational factors which shape how effective surveillance can be. It is important to distinguish the questions of whether deterrence can work and how well it works in natural situations. Clearly it can and does work in some settings. Limits to how well it works in natural settings are linked to the realities of those situations. Studies of police presence, for example, link the level of policing to the violent crime rate (Evans and Owens, 2007; Vollaard and Hamed, 2012), with Worrall and Kovandzic suggesting “a modest inverse association between police levels and crime” (2010, p. 515). That association may be strengthened when police can be concentrated in a small area, as in hot spots policing (Weisburd and Braga, 2006). The problem is maintaining high levels of concentrated police attention on one area over time (a resource limit, not an inability of risk to shape behavior). The use of power, particularly coercive power, is found in many natural settings to require a large expenditure of resources to exert a small influence on others. This conclusion is typical of the findings of studies of compliance with the law in which deterrence is found to have, at best, a small influence on people’s behavior when we consider the proportion of the variance explained by estimates of the likelihood of being caught and punished for wrongdoing. Of course, in corporate settings firms can be encouraged to undertake this monitoring, not government. Nonetheless, whoever is responsible, the resources required to achieve the necessary threats of detection are considerable, so both firms and government would benefit from considering the possibility of other mechanisms for leveraging desirable behavior as well as threatened or enacted sanctions. When possible it would be desirable to restrict the focus of sanctions. More general reviews of deterrence research which usually focus on crime outside corporations conclude that the relationship between risk judgments and crime is “modest to negligible” (Pratt et al., 2008) and that the “perceived certainty [of punishment] plays virtually no role in explaining deviant/criminal conduct” (Paternoster, 1987, p. 191). According to Piquero, Paternoster, Pogarsky, and Laughran, a review of the literature results in “some studies finding that punishment weakens compliance, some finding that sanctions have no effect on compliance, and some finding that the effect of sanctions

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16  Research handbook on corporate crime and financial misdealing depends on moderating factors” (Piquero et al., 2011, p. 335). This argument heightens the suggestion that sanctions need to be focused, since in some populations they can crowd out other motivations for accepting and following rules, while in others those other motivations are weak or nonexistent and a deterrence threat provides a reason for compliance. Similarly, studies of more severe punishments, like imprisonment, report that more severe punishments are generally unrelated to lower rates of future criminality (Lipsey and Cullen, 2007). For example, studies on the most severe form of punishment—the death penalty—suggest that the argument that capital punishment deters crime “still lacks clear proof ” because studies have failed to produce compelling evidence that executions influence the rate of crime (Weisberg, 2005; Deterrence and the Death Penalty, 2012). Studies generally find that the linkage between severity of punishment and criminal behavior is weak. The “evidence suggests that the magnitude of deterrence is not large and is likely to be smaller than the magnitude of deterrence induced by changes in the certainty of capture” (Chalfin and McCrary, 2014, p. 26). Of course, the types of crime involved in these studies differ significantly from corporate crimes and the types of criminals are unlike those associated with “white-collar” crimes, which are economically motivated. Studies on punishment suggest that it is not only an ineffective deterrent in terms of the general deterrence impact upon society at large (others see the punishment and to avoid it do not commit the crime), but it is also minimally, if at all, effective in deterring the future criminal conduct of those being punished (as is evidenced by high rates of recidivism). Widespread punishment for minor crimes does not generally lower the rate of subsequent criminal behavior, as models of specific deterrence would predict (Harcourt, 2001; Harcourt and Ludwig, 2006). In fact, studies of juveniles suggest that incarceration actually increases the likelihood of later criminality (McCord, Widom, and Crowell, 2001). Hence, the primary impact of punishment occurs through incapacitation, with criminals unable to commit further crimes while they are in prison. Incapacitation works, but is limited in situations where a criminal is replaced by another person committing the same crime (e.g. a new corner drug dealer) and is unnecessary when it is responding to a crime risk that would disappear as a criminal naturally aged out of criminal behavior. While the previously mentioned studies refer to the effectiveness of deterrence and sanctioning generally, studies specifically focused on white-collar crime yield similar results (Huselid, 1995; Jenkins, Mitra, Gupta, and Shaw, 1998). Braithwaite and Makkai (1991) studied compliance with regulations against fraud among nursing home executives. They concluded that there were no significant deterrence effects; in other words, whether the law was followed was not related to perceptions of the likelihood of being caught and punished for breaking the law. Additional evidence comes from experiments in which participants indicate their likelihood of engaging in wrongdoing given different fact scenarios that vary the likelihood of being caught. They similarly do not find deterrence effects on people’s decisions about how to act under different conditions (Jesilow, Geis, and O’Brien, 1985, 1986). On the other hand Simpson et al. (2013) argue, based upon studies using simulated scenarios and decisions made by managers, that the “certainty and severity of informal discovery by significant others in the firm” (p. 232) shapes intentions to participate in illegal behavior. Reviewing these studies Simpson described evidence supporting the existence of deterrent effects in corporate settings as “equivocal” (Simpson, 2002). Most recently Simpson, Rorie, Alper, and Schell-Busey (2014) reviewed the literature on corporate crime

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Psychology and the deterrence of corporate crime  17 deterrence and concluded that there is some weak but inconsistent evidence, with clear methodological problems, that laws deter corporate crime; that “few significant effects” (p. 38) connect punitive sanctions to deterrent effects; and that individual data is more likely to show the effects of regulatory policy—but these are not found at the organizational level. Interestingly they found that older less rigorous studies were more likely to suggest stronger deterrence effects. Yaeger (2016) similarly suggests that “the jury remains out as to just how much deterrence the law actually brings” (p. 20) (also see Alexander and Cohen, 2011; Ugrin and Odom, 2010). Overall, studies generally find deterrence effects, but the magnitude is often small and dependent upon particular situational factors such as the possibility of detecting illegal behavior. In addition to this general effect of the law upon behavior there is the influence of deterrence from within the firm. In three studies on cooperation and employee conduct, I interviewed employees concerning their rule-breaking behaviors and their estimates of the likelihood of being caught and punished by their own management for wrongdoing, and examined the influence of employees’ judgments of risk of detection and punishment (Tyler, 2011; Tyler and Blader, 2005). The studies found minimal deterrence effects of internal sanctions on employees’ rule-following behavior (Tyler, 2011; Tyler and Blader, 2000, 2005). These findings generally point to two conclusions. First, deterrence is effective but expensive. Whenever possible it makes sense to try to focus deterrence upon particular situations or people that are high risk. Second, there are considerable advantages to combining deterrence approaches with efforts to build normative commitments to rule following, both within internal corporate cultures and in relationship to the law. These mechanisms can supplement deterrence mechanisms, and their combined impact is more effective in ensuring successful regulation. 3.2  Internal Incentives: Punishments and Rewards In addition to punishment, researchers have also considered the role of internal incentives in organizational contexts (Tyler and Blader, 2005). Based upon a workplace-based study in which employees were interviewed about the risk of punishment and possibilities of reward for different types of workplace behavior, Tyler and Blader estimated that around 10 percent of the variance in employee behavior is shaped by incentives in the work environment (Tyler and Blader, 2000; see Podsakoff et al., 2006). These results suggest that, while they are somewhat effective, incentive systems also only have a limited impact on employee behavior. In recent years, the limits of the reward and sanction-based command and control model has been emphasized in work settings. These critiques focus on systems which seek to implement regulations through sanctions and incentives (Katyal, 1997; Markell, 2000; Sutinen and Kuperan, 1999). In the legal literature on government regulation, skepticism surrounding command and control strategies has led to the flourishing of market-based models of regulation that emphasize economic incentive systems. The same research shows that changes in behavior motivated by promised incentives or threatened sanctions internal to the organization come at high material costs to the organization because they require either the provision of resources for surveillance or the widespread use of incentives. This leaves organizations vulnerable, because disruptions in

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18  Research handbook on corporate crime and financial misdealing the control of resources brought on by periods of scarcity or conflict quickly lead to the collapse of effective social order when that social order is primarily being enforced through coercion (Tyler, 2006a, 2006b). In the case of firms it applies to business downturns or crises such as scandals or episodes that undermine corporate leadership. This includes internal relationships between leaders and employees; external relationships between a company and its customers; and the balance between internal regulation and government control. When law and legal authorities and/or corporate leadership are seen as legitimate there is an alternative basis for support during difficult times. It is precisely in times of economic crisis that authorities both most need the support of those they seek to regulate and are least able to either provide incentives or effectively enforce sanctions. It is also when business leaders rely most strongly on the loyalty of customers and the confidence of government that they will manage internal crises and do not need external control. Further, when legal authorities can call upon the consent of the regulated group to encourage desired behavior, either because of an internal ethical culture or because of the legitimacy of legal authorities in a community, the authorities have more flexibility in how they deploy their resources. In particular, they are better able to use collective resources to benefit the long-term interests of the organization since they are not immediately required to ensure that ethical standards and policy objectives are being pursued. While it may be necessary to have a compliance officer, a police force or an army, viability is enhanced when those resources can be diverted into the development of the organization itself. So, to the degree that order flows from consent, linked to either a shared internal commitment to organizational values or to the law and the legitimacy of legal authorities, society is better off. The argument made here about the limits of sanctions and punishment might initially seem counterintuitive. After all, most people are familiar with many studies whose conclusion is that “deterrence” or “punishment” works. It is first important to note therefore that some of the seeming impact of deterrence is the manner in which research is conducted and presented. In particular, the use of statistical tests that examine significant departures from ‘no influence’ does not focus on how strong an influence that occurs is, only that it is significantly different from no influence. With a large sample an effect can be statistically significant but substantively unimportant. An alternative approach is to ask how much of the variance in a particular behavior a model explains. As an example, MacCoun reviewed the literature on deterrence in the case of drug use and suggested that only about 5 percent of the variance in drug use was explained by variations in the certainty and severity of punishment (MacCoun, 1993). Compare the message of a statistical significance approach with that of a percentage of variance explained model. Even when there are statistically significant effects deterrence explains at best a very small proportion of the variance in law-related behavior. In other words, a relationship between two variables can be found to be statistically significant but can nonetheless explain so little of the variance that it is of barely any consequence. 3.3  Why Do Threatened Sanctions Have Limited Effect? In addition to resource concerns, there are social costs to an organization that relies on punishment to deter non-compliance. First, if people comply with the law only in response to coercive power, they will be less likely to obey the law in the future because

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Psychology and the deterrence of corporate crime  19 acting in response to external pressures diminishes internal motivations to engage in socially desirable behavior (Tyler and Blader, 2000). This follows from the well-known distinction in social psychology between intrinsic and extrinsic motivation. Research on intrinsic versus extrinsic motivation shows that when people are motivated solely by the prospect of obtaining external rewards and punishments (i.e., extrinsic motivation), they become less likely to perform the desired behavior in the absence of these environmental reinforcements (Deci and Ryan, 1985; Ryan and Deci, 2000). On the other hand, if people are motivated by intrinsic reasons for behaving in a certain way, then their compliance becomes much more reliable and less context-dependent (Frey, 1994, 1997a, 1997b). As has been noted, the idea of crowding out or undermining intrinsic motivation (Frey, 1997b) is particularly important in work settings. Most people have norms and values that encourage them to obey rules and not be unethical or dishonest. These include moral values, social norms and feelings of responsibility and obligation to follow both organizational rules and laws. Further, the type of identification that can develop and facilitate behavior based upon a social connection has the possibility to be especially strong with a work organization, which is often a more cohesive social unit than a community of people who are frequently virtual strangers to one another. Hence, crowding out intrinsic motivations is an especially unfortunate development in work settings. Further the use of sanctions undermines value-based motivations because it sends a message to the potential targets of the sanctions telling them that the authorities view them as untrustworthy and suspect (Tyler, Jackson, and Mentovich, 2015). As a result, people become more suspicious and less trusting of the law and legal authorities. No one likes to feel that their superiors mistrust them and believe that they must be constantly watched or they might behave unethically. And in modern work organizations such surveillance can be quite pervasive. As has been noted, employees can have their computer hard drives periodically checked; their emails scrutinized; their work space scanned by video cameras and even their bathroom breaks subject to monitoring. Surveillance is a particular issue with the internal cultures of organizations. If a company communicates an atmosphere of monitoring that leads to sanctioning, it is communicating mistrust, which undermines both employees’ identification with the company and their willingness to consent to and voluntarily observe workplace rules (Tyler and Blader, 2005). Of course, this argument should not be extended too far. Companies need to make clear that they do not advocate or condone wrongdoing, and that they will punish it. This can best be communicated within the framework of a positive message about the type of people that the company believes that its employees are, and the type of behavior that it therefore expects from them. Again, the workplace is a particularly poor setting for using a strategy that is communicating mistrust. Even in high-crime neighborhoods in poor communities, most of the people in the community are not engaged in wrongdoing. Stigmatizing people in these communities is counterproductive because their cooperation is needed to identify the small group of violent criminals within their community. Similarly, stigmatizing large minority populations of Muslim Americans is counterproductive because their cooperation is needed to identify potential terror threats (Tyler, Schulhofer, and Huq, 2010). In work settings the number of individuals engaged in wrongdoing is similarly likely to be small, and their co-workers are the people most likely to be aware of their behavio