Bell Curve The Law Talking Guy Raised by Republicans U.S. West
Well, he's kind of had it in for me ever since I accidentally ran over his dog. Actually, replace "accidentally" with "repeatedly," and replace "dog" with "son."

Tuesday, October 14, 2008

Comments on the Modern Corporation

Capitalism is a system built around private property. Market forces in this system include the risk/reward system. The limited liability corporation, however, is a state-created institution of the mid-late nineteenth century. It is intended to increase rewards and reduce personal risks. Prior to the period of general incorporation laws, chartered corporations that sheltered investors from the consequences of their actions were rare and only created by special legislative acts. Lloyd's of London, dating to an earlier era, for example, is a private mutual association without such limited liability. The limited liability feature is a primary source of moral hazard in modern capitalism, because the owners and managers of a modern corporate enterprise bear no personal responsibility for the actions of the institution beyond the amount of their investment (if any). Banks may require the owners of small corporations and sole proprietorships to put their personal assets on the line for loans, but not so with larger institutions.

It is fair to say that much of corporate regulation over the past century and a half has been a history of the problem of corporate structure creating some unhealthy incentives. The first major expansion of regulation was the antitrust regulation. The need to combat monopolies and trusts is now so widely accepted that even some libertarians think it is "natural." In the 1930s, another set of failures led to the creation of the SEC. A major problem that led to the SEC was stock price manipulation and forms of insider trading, and when the market finally crashd it was dizzying, with a total loss of confidence of investors in the marketplace. The SEC was intended to provide real information to investors in order to permit investors to make informed choices without having to invest additional time and money in acquiring information. This expanded the pool of available investors. What developed, however, in the SEC and in counterparts around the world, was largely a system of self-reporting that relied on third party auditors.

This system is now falling apart before our eyes. I expect the only sensible response will be a dramatic change in the SEC from occasional enforcement of self-reporting violations to aggressive inspection and auditing. The basic problem, as I see it, is that nobody wanted the costly enforcement role in the system. That costly enforcement role would cut the enforcers out of the massive profit potential of corporate capialism.

In the wake of the Enron scandal, Sarbanes-Oxley tried to turn attorneys into the whistleblowers. Unfortunately, that solution is unworkable because it is wholly incompatible with the lawyerly profession. Auditor as whistleblower also failed, because - among other things - big auditing firms simply got too invested in their relationships. I have read most of the deposition testimony from a major corporate scandal (all confidential, so I will not say which - like Enron but not Enron) which shows just how intent the corporation was in manipulating the accountants, and how a handful of well-placed partners at a major accounting firm could use their connections with the client to advance within the auditing firm (gaining praise, reputation, and wealth) in exchange for protecting the client's secrets. That's not what an auditor is supposed to do, of course.

But accountants didn't want that role of enforcer either. I have gotten the sense from work I've done in accounting defense that the accounting profession developed over time a set of deniability rules that made their work less useful for spotting harm. Gradually, it seems to me that accounting profession developed the habit of saying "the numbers add up right, but I can't take responsibility for where the numbers come from." This is a natural evolution of the profession which did not want the enforcement function. The result today is that nobody has that enforcement function in the corporate system.


Dr. Strangelove said...

I would love to hear you expand more upon the first paragraph. I have been mystified by the "corporation" concept for a while. Especially the corporation-as-person idea. If the whole point of a corporation is to shield individuals, why do we treat *it* as an individual? (Or do we?)

LTG remarks: "That costly enforcement role would cut the enforcers out of the massive profit potential of corporate capitalism."

It occurs to me that in most countries around the world--and throughout history--people have coveted such costly enforcement roles... Because they could extract bribes and kickbacks from those they were meant to regulate. In a way, that is what happened to the auditing firms, although we call it being "invested in a relationship" rather than scratching each other's backs.

What you identify here is something I have not heard before, that seems important: the regulators need incentives--personal incentives--to do their jobs. Love of country isn't going to cut it forever when there's so much money just out of reach. "Agency capture" happens a lot, as has been noted here and in many places.

Which leads me to newfound respect for product liability laws and attorneys. The huge damage awards actually give attorneys personal incentive to combat bad behavior. Sure, it can be misused--and certainly has been. Litigation needs reform, yes. But the basic approach--making the bad guys pay you lots of money if you are right about them--seems like something an economist could approve.

Raised By Republicans said...

'Gradually, it seems to me that accounting profession developed the habit of saying "the numbers add up right, but I can't take responsibility for where the numbers come from."'

This is exactly what I have heard from my CPA relatives and friends. Furthermore, one friend of mine who was a controller for a small company complained that S-O required him to sign his name to the books making him personally liable for any problems. But he said it was like pulling teeth (and sometimes impossible) to get legally required information from his superiors and even division directors in the company (who don't out rank my friend but don't answer to him either). He felt very exposed because he didn't like the way the information was being cooked. So he left and now works as a staff accountant (a less prestigious job title) at a much larger company.

Raised By Republicans said...

I too am interested in reading how the different corporate structures relate to issues of moral hazard.

But I don't see how this could lead to a blanket condemnation of private property motives or capitalism in general.

The Law Talking Guy said...

1. I don't see that connection either, RBR. Limited liability corporations are a fundamental feature of modern capitalism, but there doesn't seem to be anything in market theory that would require their existence, certainly not in current forms.

The problem is, as you have pointed out, who "signs" for the corporation's public statements being accurate? Inside accountants say "we just do the math, we didn't find the numbers." Outside auditors say, "we can't audit what they don't give us." Executives say, "I relied on advice of counsel." Also, they are covered by D&O insurance for everything but knowing fraud. Lawyers say "privilege." Nobody has to put their home and savings on the line, least of all the executives who get big golden parachutes no matter how badly the corporation fails.

I think this needs to change. The best possible enforcement system is easy to construct: give the person with all the power within the corporate management structure (the CEO) the legal (and moral) responsibility to verify that the corporation is being honest with the public and its creditors. That person would have the incentive and the power to do right.

The problem with the adversarial system of litigation, Dr.S., is that it is phenomenally inefficient. A regulator costs, let's say, $100K for a year in salary. He or she can do dozens of different actions in a year. By contrast, a single securities case will last 2-3 years at least and cost several hundred thousand dollars.

Also, it feels random. Enforcement under this system is rather like police speedtraps. The penalty for being caught can be awful (not just the big fine, but jacking up insurance rates etc.) but the persons caught feel like they are victims of random enforcement, not fairly caught.

Dr. Strangelove said...

A lot of corporations work very hard to avoid lawsuits. Not to avoid breaking the law, mind you--but to avoid lawsuits. While enforcement may be random, the fear is pervasive. Just like, as you say, speeding tickets. Not the best answer. But more palatable than regulation to many.

(I mean, if you wanted to stop speeding, just require all manufacturers put a governor in the car that prevents it from going over 75 mph, the highest legal speed you'll find on pretty much any highway in the US except maybe Montana or something.)

The Law Talking Guy said...

I would question how hard corporations work to avoid lawsuits. A lot of (usually cheap) things are done to avoid tort suits, but I am not so sure in the securities area.