Thursday, March 14, 2013

Should managers be liable in court?

It is fair to say people are quite upset that managers are not criminally prosecuted for crimes their businesses do. As the latest case with HSBC shows, where the bank laundered massively money related to circumventing political embargoes and drugs trafficking, was convicted several times and faced only fines that were lower than the profit gained, it seems impossible to adequately punish corporate crime. While lawyers may have some justification for this, let us look at the economics of it.

Andreas Engert and Susanne Goldlücke claims it is difficult to find a case for managers being liable for their mistakes. This comes from the nature of their compensation contract and the reliability of court decisions. When managers take poor decisions, their compensation suffers from it. Thus, one has to be careful not to add too much risk for the manager when the courts add to the ill effects of poor decisions, especially as courts are not perfect either. Part of the argument has to do with the classical principal-agent problem: the performance signal is imperfect, and even if the manager was very careful, luck may be against him, his compensation already suffers, and courts should not pile it on. The nature of the compensation contracts thus matters a lot. With a linear contract, it is never good for the courts to punish the manager. If it non-linear (convex), then it depends on how precisely the courts can work.

Now this all applies to poor decisions, there is not necessarily a crime involved. But as a business is fined for a crime, the compensation of the manager is typically impacted. Is this then sufficient? I am not sure this paper helps completely in this regard. Indeed, crimes are punished with incarceration. The loss of freedom adds another dimension to the punishment which is difficult to reflect in a fine to a business and how this translates in loss of compensation. Someone should look into that.

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