Harmful, Harmless, and Beneficial Uncertainty in Law

Law is full of vague standards, legally relevant facts are frequently unclear, sanctions and damages are often uncertain, and the likelihood of detection is rarely known precisely. In our forthcoming paper, we ask how these sources of uncertainty, common in any legal system, affect the utility of risk-neutral actors such as business firms. We conclude that the answer depends on the source of uncertainty and the specifics of the enforcement environment.

Our most consequential finding is that an increase in legal or factual uncertainty harms firms when enforcement is targeted, meaning that greater deviations from what the law demands lead to a greater probability of enforcement. For example, if securities regulators are more likely to commence an enforcement action against a firm that overstated its earnings by 30 percent than another firm with a 10 percent overstatement—even if the regulators conclude that both overstatements are “material” and violate the law—the regulators target their enforcement. Regulators constrained by limited resources may target enforcement because more egregious violations are easier to prove in court, because they produce greater recoveries if sanctions are graduated, because they offend the enforcers’ sense of justice, or for some other reason. Although we are not the first ones to suggest that targeted enforcement is common, we are unaware of any prior formal model of targeted enforcement.

Targeted enforcement of uncertain legal commands creates an asymmetry in payoffs after the uncertainty is resolved. If the regulator (or some other law enforcer) concludes that a firm complied with the law, the firm is not sanctioned. Notably, it makes no difference whether the firm barely cleared the compliance threshold or took an unassailable position. If, however, the firm is found to violate the law, it matters whether the violation is slight or egregious. Greater legal uncertainty (in the mean-preserving spread sense) makes any given violation more likely to be egregious. This increases the chance of a sanction when enforcement is targeted.

Given this asymmetry, a firm might respond to an increase in uncertainty by slightly increasing or decreasing its compliance effort. But because the original position was optimal, the benefit from this slight change is second order. In contrast, the increased chance of sanctions has the first-order effect of reducing the firm’s payoff. Overall, the firm is worse off.

Given this result, we should not be surprised that when a global accounting firm surveyed 2,580 businesses from 35 jurisdictions to see if they would be willing to pay higher taxes in exchange for a greater clarity about what constitutes acceptable tax planning, three quarters of the respondents answered in the affirmative. Our conclusion also helps explain the reluctance by the Securities and Exchange Commission to replace more rule-based Generally Accepted Accounting Principles with more standard-based International Financial Reporting Standards, as well as the SEC’s preference for a more rule-like approach to the regulation of financial instruments rather than a more standards-oriented strategy preferred by the Commodity Futures Trading Commission. Likewise, our result offers some support for the efforts of the U.S. Court of Appeals for the Federal Circuit to make the patent law more certain—an effort that has been repeatedly stymied by the U.S. Supreme Court.

Even if targeted enforcement is absent, we show that legal or factual uncertainty harms business firms if sanctions are graduated based on the egregiousness of the underlying conduct. Although graduated sanctions exist in tax and environmental law, regulators are generally reluctant to adopt them. This reluctance benefits business firms.

In contrast with these results, we show that risk-neutral firms are indifferent to changes in uncertainty that depend on factors unrelated to the firm’s effort to comply with the law. The likelihood of detection, for example, may vary (more or less broadly) with resources available to the securities regulators, IRS auditors, or environmental inspectors at any given time. A judge may impose harsher or milder sanctions within a given range (which may be broad or narrow) depending on the factors unrelated to the case at hand. These types of detection and sanction uncertainty neither harm nor benefit risk-neutral firms.

Taken together, our findings suggest that whether one considers significant legal and detection uncertainty in the corporate tax area, or considerable (and increasing) legal and sanction uncertainty of corporate criminal liability, making the law more certain would benefit the firms while reducing the detection or sanction uncertainty would not.

Finally, we show that firms benefit from legal uncertainty when they must obtain a pre-approval of their action from a cautious regulator. A regulator may be cautious to avoid regretting its permissive interpretation later on, to acquire more information about the relevant behavior, to avoid making a close call, or to make a later judicial reversal less likely. Whatever the reason, the regulator’s caution in preapproving the firm’s interpretation of an uncertain legal command creates a payoff structure that is the inverse of the one in the targeted enforcement scenario. Thus, whether a firm requests a no-action letter from the SEC, or a private letter ruling from the IRS, or a zoning variance from a local zoning board, greater legal uncertainty benefits the firm.

Our analysis highlights the value of a fairly fine-grained investigation of real-life regulatory regimes. The cost of uncertainty in a legal system depends on the type of uncertainty, the structure of sanctions, and the specifics of enforcement. The literature has largely ignored these distinctions. Economic models of law-related uncertainty often represent it using a single variable. While appropriate for some purposes, we show that this simplification obscures the difference between harmful, harmless, and beneficial uncertainty in law.

This post comes to us from Professor Scott Baker at Washington University in St. Louis School of Law and Professor Alex Raskolnikov at Columbia Law School. It is based on their recent paper, “Harmful, Harmless, and Beneficial Uncertainty in Law,” available here.