For super short posts, my Twitter handle is @robertewright
This is still the spot to go for more in-depth analyses and social innovations, like this:
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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