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Article Excerpt
I. INTRODUCTION
According to a recent issue of Business Week, many hotshots of American industry are fleeing publicly traded corporations for "the money, freedom and glamour of private equity." (1) Among the reasons cited for their departure is the Sarbanes-Oxley Act of 2002, (2) which not only dramatically escalated penalties for white-collar crimes, but also diluted the mens tea (or "guilty mind") requirement for criminal regulatory offenses. More and more activities, especially of publicly traded corporations, fall within the potential scope of the criminal law; and whether they actually do is left ever more unpredictably to the discretion of prosecutors and juries.
When Outback's long-time and much-praised CFO, Bob Merritt, resigned two years ago, he criticized the multiplying regulations that have made his professional life such a misery:
[O]ver the last two years I've found myself spending more time and resources on regulatory matters than supporting the management of the company and improving the businesses we operate. Because I'm a business-development oriented person, and administration is not my strength, I believe there are other people out there who can do a much better job at managing in this environment than I. (3)
Merritt's suggestion, seconded by others in the journalistic and academic community, is that entrepreneurial-minded executives are being replaced by "bean counters"--that is, those who delight in the minutia of regulatory compliance. To be sure, this is part of the story, but the truth may be more complicated.
Ours is a story about adverse selection. Economists have deployed the idea of "adverse selection" in contexts as varied as health and car insurance, (4) financial market imperfections, (5) and employment decisions by firms; (6) but it has seldom been used in the study of the criminal law. In broad strokes, adverse selection refers to the fact that in any given group of people, with various risk profiles and moral dispositions, there is the risk that some will choose to exit the group; and further, that those remaining in the group will be, in some way, the less wholesome of the bunch. To prevent the better sorts from leaving, there must first be some mechanism to identify them, and then to accord them preferential treatment. Mens rea played such a sorting function with respect to the enforcement of the criminal law. (7) Because the law operated, at least traditionally, only against those who had formed a specific mental intent to do harm, or mens rea, persons inclined to be law-abiding could signal their efforts to obey the law by investing in precautions. Those charged with enforcing the criminal law could then distinguish such individuals from those who acted reckless of the law's demands.
Although the common law's embrace of amens rea requirement in the criminal law reflected an advance--on both moral and efficiency grounds--over ancient law, recent legal developments suggest an unfortunate return to what are, in effect, strict liability crimes. Some modern criminal laws have explicitly abandoned any mens tea requirement, creating de jure strict liability; more commonly and insidiously, criminal laws applicable to many regulated industries are so ambiguously drafted, and entail such severe penalties, that the effect of the law is what we call de facto strict liability. In this article, we argue that these two trends--soaring penalties for corporate crimes and dilution of amens rea requirement--could have the paradoxical consequence of creating more corporate crime and not, as the standard story goes, less. And the reason is that a form of adverse selection is now operating in which the best (most law-abiding) entrepreneurs are fleeing the scene, leaving the less wholesome sorts behind.
With the Sarbanes-Oxley Act of 2002, Congress stepped closer towards life imprisonment as the maximum sentence for white-collar crimes. (And really, why stop at life imprisonment: why not hang a white-collar criminal now and again? (8)) Sarbanes-Oxley did not simply increase penalties, however; it also continued the already mentioned trend in American law, diluting the mens tea requirement for various criminal offenses. For example, one of the most notorious provisions in Sarbanes-Oxley, (9) section 302, requires chief executives and chief financial officers to certify that all financial filings contain no "untrue statement[s]" and "fairly present in all material respects the [company's] financial condition." (10) According to one observer, "[t]he personal responsibility imposed on the signing officers in section 302 makes this among the most draconian sections of the Sarbanes-Oxley Act." (11) Other scholars have argued that section 302 is more about atmospherics than meaningful change in the pre-existing law on disclosure. (12) Even to the extent that this is true, the atmosphere is important--try to breathe without it--and the atmosphere is becoming increasingly noxious for corporate executives who excite the interest of federal prosecutors: The penalty for violating section 302 is five million dollars and twenty years in prison.
Our model begins with a crucial fact, ignored or slighted in much of the recent law and economics literature on criminal law: Most people are neither risk-averse nor risk lovers; we are both. In certain aspects of life, we are risk averse (hence we buy insurance), but in other aspects of life, we are risk lovers (we play the lottery). (13) Indeed, what we will call "the ideal entrepreneur" has a conflicted attitude towards risk: In business matters, she is risk-neutral: She will forego projects with certain four percent gains for riskier projects with expected returns in excess of four percent. Yet with respect to compliance with the criminal law, the ideal entrepreneur is risk-averse: She will pay the certain costs of compliance rather than risk being found guilty of a crime, even when a purely rational (or risk-neutral) individual would engage in the criminal behavior because the low probability of detection renders the expected penalty less than the cost of compliance.
We conceive of the competition for corporate control as waged by three human "types"--the ideal entrepreneurs, the swashbucklers and the bean counters. From society's perspective, the optimal environment is one that allows the ideal entrepreneur to thrive. Unlike bean counters, she is willing to take entrepreneurial risks that benefit society. Unlike the swashbucklers, she is hard-wired to comply with the criminal law even at substantial cost. But as the criminal law becomes increasingly draconian, and its application unpredictable--that is, as it becomes one of strict liability--our model demonstrates that she will flee for other environments. Who, then, will be "left behind" as CEOs and CFOs? (14)
First of all, there will be the bean counters. These are entrepreneurs altogether without "animal spirits": they are risk-averse with respect to both business and law decisions. Such men and women will avoid any possibility of legal trouble by parking capital in low-risk enterprises and then spending eighty hours per week crossing every t, and dotting every i. Also thriving, however, are the swashbucklers--that is, people who are risk-neutral and possibly even risk-loving with respect to business matters and legal compliance. Such persons are not particularly deterred by the increase in penalties. Crunching the numbers, they may discount punitive statutory penalties due to a perceived low rate of detection and conviction. As every increase in criminal penalties more thoroughly drives away the ideal entrepreneurs, adverse selection operates, and the swashbucklers more completely dominate the field. The ultimate irony is that the indeterminate widening of the scope of white-collar criminal law, and the penalties that attach for its violation, may drive away the very people most susceptible to being deterred by the criminal law. Those "left behind" are truly the "unrighteous"--those who are not, and, absent absurdly draconian penalties, cannot be deterred.
Our plan is as follows: Part II presents a psychological profile of the ideal entrepreneur, focusing on her attitude towards risk in both entrepreneurial and legal compliance issues. She is what we will call a "global rational calculator" in the sense that she has made a one-time decision, good for all time, to obey the criminal law, thus removing compliance issues from the ordinary mix of variables that are subject to cost-benefit analysis. Part III introduces the idea of adverse selection. Traditionally, amens rea requirement functioned as a crucial sorting mechanism, staving off the problem of adverse selection; it allowed enforcers of the criminal law to distinguish between those determined to comply with the criminal law (such as the ideal entrepreneur) and those indifferent to the law's strictures (such as the swashbucklers). Part IV provides a brief historical tour of American criminal law, emphasizing the movement away from a mens rea requirement and toward strict liability crimes. In Part V, we offer a simple mathematical model to predict how the ideal entrepreneurs and swashbucklers will fare, in their competition for corporate control, as we move from amens rea word to one governed by strict liability crimes.
II. RISK AND THE IDEAL ENTREPRENEUR
Our typical reader attends, or has attended law school, which marks her as relatively risk-averse in financial matters. She, like both of us, prefers a steady, if unspectacular, income to the uncertainty, both upside and downside, of a life as an entrepreneur. The best corporate executives are not like us. They have more tolerance for risk. In this part, we first explore how an entrepreneur's "animal spirits," or instinctive risk-neutrality, is beneficial, both to herself and society. Second, we explore how the person we call the ideal entrepreneur compartmentalizes her risk-neutrality. With respect to business decisions, she coolly compares the expected value of various activities, but with respect to legal compliance, she does not engage in such hard-headed (or stone-hearted) calculations. Instead, she will be risk-averse, preferring to incur the costs of legal compliance even when they are more costly than the expected sanction.
A. "Animal Spirits" and Entrepreneurial Attitudes Towards Risk
In most of our individual decisions we are, due to our diminishing marginal utility of consumption, risk-averse. (15) Yet a thriving market economy depends on the existence of a core of entrepreneurs and corporate managers whose utility function and psychic composition are such that they are risk-neutral in financial matters. (16) That, in a nutshell, is our argument in this section. John Maynard Keynes famously used the phrase "animal spirits" to describe why some people, in the face of so many obstacles and reasons for pessimism, nonetheless act:
[I]f the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;--though fears of loss may have a basis no more reasonable than hopes of profit had before.... .... ... [I]t is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance. (17)
In a sense, Keynes is simply making the point that entrepreneurs have more spirit--that is, a more acute taste for adventure and greater tolerance for adversity and uncertainty--than the typical law professor or economist. (18) But insofar as Keynes suggests that this spirit is opposed to our "rational selves," we think he may mischaracterize the matter. Actually, entrepreneurs with "animal spirits" may be more rational than the rest of us, at least in the sense that they more coolly and mathematically prefer those enterprises with higher expected values. It is not, as Keynes writes, that their "spontaneous optimism" allows them to dispel from their minds "the thought of ultimate loss." (19) To the contrary, that possibility is considered in all its brutal reality, but when offset by the possibility, even slim possibility, of large success, the entrepreneur makes the purely rational, or risk-averse, judgment.
Even if we lack the venture capitalist's "animal spirits," which may largely amount to her risk-neutrality, as members of society we benefit greatly from the existence of such men and women, both as investors and as consumers.
As risk-averse investors, we should seek out companies managed by executives who do not share our risk profile. Suppose, for example, that the opportunity arises to invest in Project A, which will yield $1 million profit with certainty, or Project B, which will yield $0 with probability 1/2 or $3 million with probability 1/2. If presented with these options as individuals, most of us would presumably pick Project A, despite its lower expected return. (20) Yet as investors who hold a diversified portfolio we should expect corporate managers to opt for Project B, due to its considerably higher expected payout. (21)
As consumers, furthermore, we are better off when there are some individuals in society with enough tolerance for risk that they stake their fortunes on positive payout ventures with a high variance of outcomes. James Glassman notes in this context the story of Ruth Fertel, a divorced mother who quit a job as a lab technician in 1965, mortgaged her house, and invested her life savings in a steakhouse. Forty years later, Fertel's original investment of $22,000 has become a company (Ruth's Chris Steak House) that has gross annual revenues of over $250 million. (22)
The idea that entrepreneurship is critical for the development and growth of any economy was popularized long ago by Joseph Schumpeter. (23) He argued that entrepreneurs spark economic growth by introducing new products, developing novel methods of production, and discovering previously untapped sources of raw materials. (24) Various studies have supported Schumpeter's thesis, which perhaps explains, at least in part, the differential growth rates among countries. (25) We owe many of the notable innovations of the past century to small firms headed by innovative and risk-taking entrepreneurs. (26)
In sum, much of what distinguishes those men and women who serve society by innovating (and thereby creating wealth) from the rest of us, who are content humbly to perform assigned tasks, is a propensity for taking calculated and rational risks. (27) Entrepreneurs are willing to gamble, often quite reasonably, that a particular market can be conquered or that a new product will take off or that their facility will dramatically lower costs. The gamble may well be a "reasonable" one, given the finite downside risk and the momentous upside potential.
B. Legal Compliance Risk
Although some individuals may be risk averse, and others may be risk-preferring, (28) nothing in theory precludes an individual from being both. (29) The reader is probably familiar with someone who is conservative in professional decisions, but adventurous in personal endeavors. Such an individual may be cautious when investing in stocks or bonds, and then hop off a cliff, tied to a bungee cord of course, on weekends. Conversely, an individual might be quite adventurous in financial matters, and extremely conservative in personal matters. (30)
Now we come to a vital point in our argument: The ideal entrepreneur is risk-neutral when deciding whether to open a new restaurant or factory. Yet when considering whether to comply with a law that criminalizes a failure to prevent e-coli contamination or certain chemical pollution, she will not be risk neutral, but risk-averse.
Entrepreneurs, we should recall, are hired to manage companies because of their talent at taking calculated risks that yield the highest possible rates of return. Corporate executives should thus be risk-neutral when choosing among business opportunities: Instead of investing in the sure thing with a small return, the best managers will fund projects with a higher variance of outcomes, at least when there is a higher expected return than the safer projects. They are, again, risk-neutral. Some of the standard law and economics literature on white-collar crime assumes that the corporate managers' risk neutrality will bleed over into decisions about compliance with the criminal law. (31)
In fact, however, we demand that the very same corporate managers who are risk-neutral with respect to business matters be risk-averse when confronted with the criminal law. Professor (formerly Chancellor) William Allen has written that "corporate directors will not direct management to calculate the costs and benefits of compliance with criminal law. Nor will their lawyers advise them that they may safely do so. The pedagogic message of criminal sanctions is 'take all necessary steps to avoid the proscribed act.'" (32) It is important to see that civil sanctions do not impose similar duties on citizens to "take all necessary steps" regardless of cost to comply with the law. In its classical understanding, the civil law regulates activities that entail both costs and benefits to society, and therefore the law should not entail penalties (and opprobrium) so punitive as to...
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