Evolution ofCorporate Law & Finance

Section (c)2

Corporate law & the business cycle

Prof. Amitai AviramAviram@illinois.edu

College of LawUniversity of Illinois

Copyright © Amitai Aviram. All Rights ReservedS12D

Effect of conspicuous law enforcement on behavior of non-perpetrators

How the business cycle affects law Economic effect of the “perp walk”

Conspicuous law enforcement

Individuals’ risk perception

Individuals’ behavior

“Nothing paints a picture as well as people being led away in handcuffs” – Walter Ricciardi, SEC

When Do ProsecutorsEnforce Securities Laws?

Empirical EvidenceCyclical Enforcement: Little during boom, plenty after bust

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

95 96 97 98 99 00 01 02 03 04 05 06

S&P 500 Change, 1yr Lag SEC Enf Actions Change

When Do ProsecutorsEnforce Securities Laws?

Theory

Conspicuous enforcementis greatest when theperception gap (perceivedrisk - actual risk) is greatest

Example

• Assume risk of company insiders committing fraud is 0.002% (1:50K)– But public misperceives risk to be 1%

• AG launches anti-fraud initiative (conspicuous law enforcement)– Insiders deterred: 50% reduction in

objective risk, to 0.001%– AG “oversells” initiative; Claims 99%

reduction (to perceived risk of 0.01%)

• Private benefits to AG: Public observes that actual occurrences are closer to 0.01% than 1%; lends credibility to AG’s claims

• Narrowing the perception gap: Over-estimation of fraud reduced from 0.998% to 0.009%– ~111 times less misperception

Perceived Risk (%)

Actual Risk (%)

Perception Gap

Before 1 0.002 0.998%

After 0.01 0.001 0.009%

Example

• Perception gap reduces social welfare:– Excessive avoidance of equity investments– Excessive self-policing of companies– Excessive political pressure to regulate

• Narrowing the perception gapincreases social welfare

ExampleEffect on Social Welfare

Bias Arbitrage

Commodity Arbitrage

•Identify gap in price of gold in NY & London

• Take an action that creates private profits while also closing the price gap

Bias Arbitrage

•Identify gap between objective & perceived risk

• Take an action that creates private benefits while also closing the perception gap

Is Cyclical Enforcement a Formof Bias Arbitrage?

• I.e., does the public over-estimate fraud more following a bust?

Does the public over-estimate fraud more following a bust?

Cognitive Biases

Does the public over-estimate fraud more following a bust?

Relevant Cognitive Biases• Self-serving bias

– Stock goes up – must be my investment skills– Stock goes down – must be fraud

• Availability bias– Economic hardship removes veil that masks fraud– Economic downturn causes hardship to many firms at once

• Attribution discounting– Fraud rises as a possible cause of downturn– Causes people to discount other causes

This could have been the end, but then this paper would be called …

Counter-Cyclical

Enforcement of Corporate

Law

The Dual Message ofConspicuous Law Enforcement

• When Jane Doe hears that the SEC is investigating Acme Corp. for fraud, does she think:– “The SEC is effective in catching fraud!” (i.e., Ajax Corp.

is less susceptible to fraud)• Need to invest less in addressing risk

Or:

– “I didn’t realize there’s so much fraud going on!” (i.e., Ajax Corp. is more susceptible to fraud that I thought)

• Need to invest more in addressing risk

Reworking the Example

• Same assumptions as before, except that enforcement exacerbates perceived risk by 99% (to 1.99%)

Perceived Risk (%)

Actual Risk (%)

Perception Gap

Before 1 0.002 0.998%

After 1.99 0.001 1.989%

Perception gap

increased

Excessive avoidance

Excessive self-policing

Excessive political pressure

A vicious enforcement cycle…

Public over-estimates

risk

Incentives for conspicuous law

enforcement

Conspicuous law

enforcement

Excessive avoidance / self-policing /

political pressure

Enforcement increases perception of risk

Solution?

• Counter-cyclical enforcement– Enforce more when public under-estimates fraud

(boom) to increase risk perception

– Enforce less when public over-estimates fraud (after bust) to prevent exacerbating risk perception

• But prosecutors’ incentives favor cyclical enforcement…– Article suggests mechanisms to modify these incentives