Many law enforcement agencies reduce punishments for corporations that report their own offenses. My research shows that these self-reporting schemes may help deter crime within a certain range of leniency. But the level of leniency has a U-shaped relationship with the level of deterrence: As the severity of punishment decreases, the probability that a crime will occur first decreases and then increases.

Direct and Indirect Punishments of Executives

The United States, the United Kingdom and other countries have strengthened corporate self-reporting programs to help them detect non-antitrust offenses such as securities fraud and foreign bribery as well as antitrust violations. My research studies how these non-antitrust self-reporting programs affect deterrence.

In self-reporting programs, the level of leniency is determined by prosecutors or explicit guidelines, but the relationship between the level of leniency and deterrence is not yet fully understood. On the one hand, corporate punishments are necessary to induce firms to prevent their executives and other employees from committing corporate crimes. On the other hand, punishment should be reduced in order to induce firms to detect and self-report such crimes.[1]

By rewarding corporations with reduced punishment, corporate self-reporting programs give them an incentive to detect and self-disclose the wrongdoing of executives and employees. If firms detect and self-report, individual wrongdoers may be prosecuted and receive direct punishment, such as fines and imprisonment. Reducing corporate sanctions may thus increase the expected direct punishment of individual wrongdoers by increasing the probability of crime detection. Yet how much should corporate sanctions be reduced? Without guidance, prosecutors may abuse their discretion, or authorities may establish inappropriate guidelines for corporate sanctions. My research shows that the following two points in particular should be considered in determining the level of corporate leniency.

First, since the probability of prosecuting an individual for a corporate crime is low, the degree to which corporate leniency can increase the expected direct punishment of individual wrongdoers is limited. In practice, the difficulties of establishing proof in individual prosecutions are greater than those in corporate prosecutions.[2] In particular, prosecuting executives may be difficult because they may not be engaged in the most obviously culpable day-to-day conduct even if they have created inappropriate policies or strategies. If a corporate crime is revealed, the probability of prosecuting an individual, particularly a senior executive, is far below 100 percent. Corporate self-reporting schemes are therefore limited in the extent to which they can increase the expected direct punishment of individual wrongdoers, even if stipulated sanctions, including fines and jail time, are high.

Second, even if individual wrongdoers avoid prosecution, they may suffer indirect punishment as a result of a decrease in their wealth, such as stocks and bonuses, when their company is punished. Managers and employees often receive compensation tied to the value of their firm. For example, in the United States, the chief executive officers of public companies have significant stocks and options.[3] If a firm is punished, its value will decrease, and the compensation of its managers and employees may decrease as well. If corporate crimes are detected, companies may need to disgorge profits, pay fines, and suffer reputational loss, all of which reduce their stock prices and thus reduce the wealth of managers and employees.

The U-shaped Relationship Between the Level of Reduced Sanctions and the Level of Deterrence of Corporate Crime

Based on these observations, my research presents a simple model of corporate self-policing and self-reporting that illuminates the relationship between the level of corporate leniency and the level of deterrence of individual wrongdoers, particularly senior executives. Senior executives often play a leading role in large-scale corporate crime,[4] and their compensation is more strongly tied to the value of their firm than the compensation of lower-level employees. Therefore, understanding the effects of reducing corporate sanctions on the direct and indirect punishments of senior executives should be a matter of policy interest.

The model consists of two players, a firm’s manager and a firm’s board, and three time periods. The manager has a certain proportion of the firm’s shares and maximizes her expected payoff, and the board maximizes the firm’s value. In the first period, the manager privately decides whether to commit a corporate crime. In the second period, the board decides whether to conduct an internal investigation to detect the crime. If the board detects the crime and reports it to an enforcement agency, the firm receives a reduced sanction under a corporate self-reporting program, and there is a certain probability the manager will be prosecuted. In the third period, if the board has failed to investigate during the second period, the enforcement agency may investigate the firm. If the agency detects the crime, the firm receives a typical punishment, and there is a certain probability that the manager will be prosecuted.

With this setup, my research shows that there may be a range of reduced sanctions for corporate self-reporting in which both the corporation’s incentive to self-report and deterrence of the manager increase. In this range, the level of corporate sanctions has a U-shaped relationship with deterrence: As the level of corporate sanctions decreases, receding from the upper limit of the range, the probability that the crime will occur first decreases and then increases.

The reason can be summarized as follows. In committing the crime, the manager is exposed to two expected punishments: indirect and direct. If the corporation is punished, the manager is punished indirectly through a decrease in the value of her shares of stock in the company. If the manager is prosecuted and is convicted or pleads guilty, she can be punished directly, too. When the enforcement agency needs to increase deterrence, it can use the corporate self-reporting program to strengthen the firm’s incentive to detect the manager’s crime by reducing the corporate sanction. If there is a certain threat of crime detection by the enforcement agency and the degree of leniency is reasonable, the firm will have the incentive to detect and report the crime. If the probability of crime detection increases, the indirect and direct punishments are more likely to be imposed on the manager. Although the size of the direct punishment of the manager (i.e., the size of the individual penalty) is fixed, the size of the indirect punishment of the manager is reduced because of the reduction of the corporate sanction.

If the corporate sanction is insufficiently reduced, the probability of crime detection remains almost unchanged, and the total of the expected indirect and direct punishments of the manager remains almost unchanged as well. However, if the corporate sanction is sufficiently but not excessively reduced, the probability that the crime will be detected and reported is increased, and the total expected punishment of the manager is increased as well, despite the decrease in the indirect punishment of the manager. If the corporate sanction is excessively reduced, since this means that the size of the indirect punishment of the manager is also excessively reduced, the total expected punishment of the manager remains almost unchanged or decreases despite the increase in the probability of crime detection. Because of this mechanism, the corporate self-reporting program can enhance deterrence within a certain range of reduced sanctions for corporate self-reporting. But the level of corporate leniency has a U-shaped relationship with the level of deterrence in that range.

ENDNOTES

[1] Jennifer, & Kraakman, Reinier. 1997. Controlling Corporate Misconduct: an Analysis of Corporate Liability Regimes. New York University Law Review, 72(4), 687–779.

[2] Garrett, Brandon L. 2015. The Corporate Criminal as Scapegoat. Virginia Law Review, 101(7), 1789–1854.

[3] Larcker, David F., & Tayan, David F. 2019. CEO Compensation. Stanford Graduate School of Business, Corporate Governance Research Initiative, Data Spotlight.

[4] Steinzor, Rena I. 2014. Why Not Jail? Industrial Catastrophes, Corporate Malfeasance, and Government Inaction. Cambridge University Press.

This post comes to us from Masaki Iwasaki, a Terence M. Considine Fellow in Law and Economics and S.J.D. candidate at Harvard Law School and an associate at the Tokyo-based law firm of Nishimura & Asahi. It is based on his recent paper, “A Model of Corporate Self-Policing and Self-Reporting,” available here.