Monday, July 29, 2019

Introducing Corporate Malfeasance Bonds

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Introducing Corporate Malfeasance Bonds


By Robert E. Wright, Nef Family Chair of Political Economy, Augustana University

Abstract

“Introducing Corporate Malfeasance Bonds” describes a corporate governance problem, the difficulties corporations face making credible commitments to behave in ethical or lawful ways, that can have severe negative consequences for long-term equity holders. It then proposes a solution, termed corporate malfeasance bonds, drawn analogically from an existing financial instrument with a long and successful history, the fidelity performance bond. The goal is to protect shareholders from the stock price volatility associated with episodes of corporate fraud and scandal by reducing corporate incentives to engage in malfeasance.

Proposal

I propose adapting fidelity performance bonds as a private ordering solution (Stringham 2015) to the endemic problem of corporate wrongdoing (Porter 2012). Under my proposal, corporations would post, or issue, “corporate malfeasance bonds” to credibly commit to not breaking their promises by pledging assets to pay whistleblowers, NGOs, regulators, third party certifiers, and victims of corporate malfeasance should obligors/issuers engage in behaviors prohibited by their bonds. Corporations will have incentives to post or issue such bonds to win back skeptical stakeholders (consumers, employees, investors, regulators) and/or to bind their own future behaviors by raising the cost of their malfeasance. Long-term investors will benefit from reduced risk of equity price declines associated with corporate scandals.
To the extent that corporations behave rationally, they engage in malfeasance when the expected total benefits of breaking laws, ethical boundaries, or promises, which are often nontrivial, exceed the expected total costs of such lapses, which are often minimal. Corporations per se cannot be imprisoned and jurists and ethicists remain divided on who exactly should be held responsible for corporate wrongdoing (Fischel and Sykes 1996; Lee 2011), rendering corporate leaders de facto immune from most criminal prosecution (Admati 2017). In addition, governments are often reluctant to impose large fines on corporations for fear of inducing their bankruptcy, hurting their presumably innocent shareholders and creditors, or even possibly fomenting financial panic or industry contagion. Moreover, many of the largest fines publicly levied upon corporations are only ever partially uncollected (Ross and Pritikin 2011). Fear of being publicly shamed may dissuade some corporate malfeasance, but obviously is not strong enough to prevent all of it (Skeel 2001; Porterfield 2018), as evidenced by the existence of a “corporate settlement treadmill” (Remus and Zimmerman 2015).
In response to their malfeasance, or suspicions of the possibility thereof, corporations create narratives that present themselves to stakeholders in the best light possible (Patelli and Pedrini 2014). Some lie, others honestly overestimate their capabilities, and yet others, like BP, engage in complex rhetorical strategies designed to convince stakeholders of the authenticity of their brand images (Matejek and Gossling 2014). Corporations also capture regulators (Dal Bo 2006) or, where that is too costly, engage in regulatory arbitrage, essentially choosing to be regulated by the least effective nations or agencies (Admati 2017: 141-44), even if that requires what Partnoy (2009) calls corporate “shapeshifting.”
Cognizant of those facts, stakeholders are often skeptical of corporate self-declarations (Waddock 2004). Third-party certification exists, in part, to add credibility to corporate claims about a variety of corporate behaviors important to various stakeholders. Certification, however, is far from a foolproof solution due to the large information asymmetries that exist between corporations, stakeholders, and certifiers (Dranove and Jin 2010). To the extent that achieving and maintaining certification is costly, corporations have incentives to attempt to dupe certifiers. Moreover, certifying bodies often have incentives to conspire with those they certify so that fees and information continue to flow. As Manasakis, Mitrokostas, and Petrakis (2013) document, the level of “certification standards depends crucially on the certifying institution” (285). Certification of certifiers has sometimes developed in response, but that approach immediately raises the specter of a reductio ad absurdum and in any event does little to alleviate the agency and asymmetric information costs at the root of the certification problem (Dranove and Jin 2010).
Long-term investors therefore face two major risks associated with corporate malfeasance, scandal-induced volatility and certification risk, the probability that a third party certification system could unexpectedly fail. To the extent that specific certified corporate behaviors are capitalized in prices, as they appear to be in many instances (Manasakis, Mitrokostas, and Petrakis 2013), a sudden change in perceptions regarding the quality of a certification regime could induce sizable equity price swings, like those experienced after the failure of Penn Central and the “questionable payments” scandals of the 1970s exposed the weaknesses of management-dominated boards (Gordon 2007), and the losses suffered after the Enron bankruptcy and corporate accounting scandals exposed the weakness of the auditing regime in place in the early Third Millennium AD (Clark and Demirag 2002). Less than a decade later, a loss of confidence in bond rating agencies had negative repercussions for both bondholders and stockholders across a range of industries (Dranove and Jin 2010). Several other crises show that even corporations not directly affiliated with a troubled certification regime are sometimes negatively affected by certification regime shocks (Bonini and Boraschi 2010; Giannetti and Yang 2016).
A better way to induce corporations to reduce malfeasance is to adapt the performance bond, whereby party A agrees to perform some activity B before some time C on penalty of $D. For example, construction companies and a variety of other entities in a position to expropriate resources from counterparties often post performance bonds (Gallagher and McCallum 2010). The obligor or surety in such cases is a third party or parties that promise to pay $D in the event of A’s default on B before C.
For centuries before the development of modern D&O insurance, corporate employees with access to company funds (and certain government officials with access to government monies) had to post a specific type of performance bond called a fidelity bond, whereby one or more sureties agreed to indemnify the employer $D if the bonded employee engaged in malfeasance. Sureties had obvious incentives to monitor the employee, but if the employee managed to expropriate corporate resources, the employer received $D in recompense (Anderson 2004). If the potential employee or officer had a poor reputation or was otherwise unworthy, he or she (quite a few NGOs by the early 19th century employed female treasurers [Bloch and Lamoreaux 2017]) should have found it costly, or even impossible, to obtain adequate fidelity bonds from a sufficient number of quality sureties to obtain a position of trust (Anon. 1936).
Corporate malfeasance bonds would fulfill a similar function by compensating stakeholders in the event a corporation breaks its promise to not engage in certain specific illegal, unethical, or untoward behaviors. A corporation that wanted stakeholders to believe, for example, that its global supply chain was free of slaves, like the statement to that effect by The Financial Times, or that it would not damage the environment in certain ways, as McDonald’s announced in 1990 (McMillan 1996), would post a bond by investing financial assets in a trust account. The corporation would receive interest, dividends, and capital gains or losses on the assets just as if they remained on its balance sheet but would have to replace the assets with others of equal value and quality before the trustee would release them to the corporation for sale or hypothecation before the end of the bond’s term. In addition, the corporation would empower the trustees to sell any or all of the assets as needed to pay valid claimants (e.g., slaves discovered in its global supply chain or those who uncovered its use of polystyrene packaging), as ascertained by some third party arbitrator(s) specified in the bond.
Some argue that corporate brands are a type of bond, an expensive investment that can decline in value if a corporation behaves in ways that offend its stakeholders (Dranove and Jin 2010; Fan 2005). Brands are indeed a type of bond (Allen 2011) but what the corporation loses, its brand value, is not received by those wronged by its untoward behavior. In addition, due to secret option backdating and other practices, stock price declines do not always chasten executives by decreasing their compensation (Fried 2008). Moreover, changes in brand equity can be difficult to measure (Simon and Sullivan 1993; Rao, Agarwal, and Dahloff 2004) but corporate malfeasance bonds represent “cash on the barrelhead,” as it were. Finally, brand value can be damaged by a wide range of corporate misbehaviors but malfeasance bond payments will be triggered only by pre-specified behaviors of particular concern to stakeholders. Brand value, in other words, might be considered a malfeasance bond of last resort.
The corporate malfeasance bonds envisioned here would be entirely voluntary; stakeholders would pass judgement on their credibility based on each bond’s size and terms, which should be designed to serve as effective commitment devices. If people wonder, for example, if they should bank at HSBC after regulators allowed it to plead guilty to laundering billions of dollars for narcoterrorists and pay only a minimal fine, HSBC could post a malfeasance bond to “put its money where its mouth is” in its effort to convince potential customers that it had reformed itself (Naheem 2015). If HSBC posts a $1 bond stating that it will not break anti-money laundering laws (AML) anymore, it will lure fewer customers (fewer non-narcoterrorist customers anyway) than if it posted a $100 billion bond. The same holds for, say, Wells Fargo committing to not opening up any more unwanted customer accounts (Verschoor 2016), Facebook promising to shore up its privacy policies, and myriad other scenarios (Markkulla Center 2018).
Holding the sum at risk constant, potential customers will find the commitments of HSBC and other corporate malfeasors more credible the more respected the trustees and arbitrators named in their bonds are (Kaplinksy and Levin 2008). The Bank of New York-Mellon, State Street, and other leading custodial banks would doubtless be unobjectionable to most, but the local barkeep is probably only a good place to safekeep a couple of sawbucks riding on the outcome of some sporting event (Klees 2012).
Of course few situations are as cut-and-dried as the outcome of a sporting event, so the arbitration clause will be a crucial consideration for stakeholders when evaluating malfeasance bonds. A credible arbitration clause might randomize the selection of arbitrator over a large group so that no collusion could occur, or be expected. The terms of malfeasance should be defined as clearly as possible (e.g., slave as defined by the UN’s 1956 supplementary convention; money laundering as defined by the Financial Action Task Force) and precisely quantified when possible. Potential claimants need to be carefully specified as well and their remuneration from the corporate malfeasance bond’s assets should make economic sense. Victims should be rewarded, of course, but so too should whistleblowers, NGOs, certifiers, and perhaps even regulators, who discover, report, and bring to arbitration instances of malfeasance. Some thought should be given to minimizing spurious or “shot in the dark” claims by cranks and speculators, but existing statutory and case law related to qui tam litigation (whereby informants receive legal fees plus part of the fines and damages imposed on parties that try to defraud governments but do not recover their legal fees if their case fails) may be sufficient to minimize such behavior (West 2001; Broderick 2007).
If corporate default on bond obligations is costly and compensation for those wronged relatively unimportant or diffuse, then the trustee arrangement can be dispensed with and marketable malfeasance bonds can be issued to investors. That type of malfeasance bond would oblige the issuing corporation to pay some extra fixed dollar amount with the next coupon payment(s) if an arbitrator rules that it had committed some specific corporate atrocity, like laundering money or exceeding a promised level of greenhouse gas emissions. The difference between yields on the malfeasance bonds and the issuer’s regular debt would create information about market perceptions of the likelihood of malfeasance. (For more on prediction markets, see Wolfers and Zitzewitz [2004] and Berg and Rietz [2014].) If everyone believed that HSBC would never break AML again, for example, the yield on its malfeasance bonds should be identical to the yield on its regular debt (holding term, liquidity, and so forth constant) in the secondary market. The yield on malfeasance bonds would decrease, however, as doubts about the issuing corporation’s continued commitment to keep its promise rises because the probability of a windfall payment would increase and hence the malfeasance bonds’ market price would rise.
Regulators, securities holders, and D&O insurers would do well to watch for sudden increases in the yield spread as an indicator of potential problems (Baker and Griffith 2007). Moreover, if executive cash bonuses were tied inversely to the size of the spreads (and executives were banned from owning the bonds), the incentives of corporate leaders and stakeholders interested in the performance of corporate promises (e.g., not allowing dangerous chemical plants, oil rigs, or pipelines to leak or explode) would be more closely aligned because executives would suffer automatic financial penalties as malfeasance became more likely and spreads widened.
Corporations should readily issue malfeasance bonds consonant with the brand narratives that they want stakeholders to believe because the expected costs of credibly committing to their narratives (like no sexual harassment will be committed by members of the C-suite) will be low if they have the proper screening and monitoring procedures in place to prevent malfeasance. To the extent that they are rational, corporations will not lose millions or billions on their bonds because they will keep their promises, especially if breaking the terms of their corporate malfeasance bonds is tied directly to executive compensation. The bonds will credibly signal their intent by putting some “skin in the game,” as the saying goes (Cremers, Driessen, Maenhout, and Weinbaum 2009). People who would otherwise have been victimized by corporate malfeasance will gain, as will long-term investors because the corporations they invest in will suffer from fewer scandals and attendant losses of stakeholder custom (Romani, Grappi, and Bagozzi 2013) and shareholder equity (Marciukaityte, Szewczyk, Uzun, and Varma 2006).
Nothing can prevent all wrongdoing, but our society can certainly do a better job of discouraging corporate malfeasance by encouraging corporations, and their leaders, to keep their promises or suffer significant, automatic negative consequences. While new financial instruments can certainly cause great harm, they can also do great good when the incentives they create are carefully considered, as exemplified recently by the development of forest resilience bonds (Knight and Gartner 2018). Corporate malfeasance bonds will protect long-term equity holders and many others by reducing the incentives of corporations, and the people who run them, to engage in illegal or unethical practices.

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