This past Friday, the D.C. Circuit Court of Appeals "ruled that the tobacco industry engaged in a half-century-long campaign to deceive Americans about the health hazards of smoking." This reminded me of Ford's cost-benefit analysis of safety improvements versus a total of 360 preventable burn deaths and serious burn injuries. It also made me think of McDonald's insistence that its coffee be served at 180-190 degrees (making it not only hot, but "scalding – capable of almost instantaneous destruction of skin, flesh and muscle") despite the fact that McDonald's had received "more than 700 claims by people burned by its coffee between 1982 and 1992", some involving third-degree burns. (Some have suggested McDonald's did this to avoid having to give out so many free refills.) So it should probably not come as any surprise to hear this Deutsche Bank whistleblower's claim:
[W]e have a moral hazard problem. . . . the system of incentives encourages people to take risks. I have seen honest, high-integrity people lose themselves in this cowboy culture, because more risk-taking generally means better pay. Bizarrely, this risk comes with virtually no liability, and this system of O.P.M. (Other People's Money) insures that the firm absorbs any losses from bad trades.
As these losses have grown, taxpayers are being forced to absorb these losses. As an example, my firm recently received nearly $12 billion from American International Group (which has effectively been nationalized with $180 billion in taxpayer funds). Essentially, every American household sent my firm a check for $105. The reason for this payment: my firm bought credit default swaps from A.I.G. In plain-speak, we bought unregulated "insurance" from A.I.G. to cover losses from bad trades. What did taxpayers get in return? Nothing. Taxpayers simply paid an I.O.U. triggered by our gambling losses.
And people wonder why I tend to favor vigorous regulation of these "soulless" entities.
{ 7 comments… read them below or add one }
I do not see what the tobacco, hot coffee, and pinto cases have to do with the AIG situation or how those cases would support a need to regulate corporations. In each of those cases except the AIG case, the corporations have had to pay for the harm they caused in addition to large punitive awards (at least in some of the cases). Those companies were exposed to the full risks that they chose to undertake (and more). I don't understand why AIG, its shareholders, and those who did business with AIG should not face the consequences of the actions they chose to take. It's not as if the federal government set up a fund to pay coffee burn victims to prevent McDonald's from going under. It's the bailout that caused the moral hazard, not the lack of regulation.
That many on Main Street cannot see or understand the mechanics of a wrong on Wall Street enables the O.P.M. syndrome. That Main Street cannot see the mechanics of a wrong on Wall Street is partly due to the lack of intelligent and efficient regulation. Government can regulate Wall Street to save itself and many of Main Street's dollars. But, the government is not interested in doing so because Main Street does not understand what happens behind the curtain on the side of the Capital stage running from Washington to Wall Street.
It seems people do not elect politicians b/c of what's going on in Wall Street, instead they focus on their more immediate economic situation. Why would a politician do anything not related to getting elected? In case of the bailout, Congress had to do something to tend to clean up the mess that its neglected monster made else be accountable in the next election.
Main Street does not understand much about how Wall Street uses capital even though Wall Street gets much of its capital ultimately from Main Street. Main Street ignorantly thinks the money on Wall Street is O.P.M. – or at least not Main Street's. Despite that Main Street entrusts Wall Street with its money to increase the timely availability of capital to those who need it – and earn a return in the process – it seems Wall Street has been careless, if not reckless, in carrying out its end of the arrangement. IMO, this has much to do with why we are where we at.
Main Street is unsure exactly what is going on, who should be accountable, and what should happen to promote a better capitalism that increases wealth for Main Street and Wall Street. A meaningful, revamped 21st century compliance regime that is efficient and transparent is a great place to start.
The argument that there is no need for additional regulation arising out of the tobacco, Pinto and coffee cases because those companies were held accountable for their wrongs is, I believe, only correct if (1) all companies that commit such wrongs are caught, or (2) the cost imposed on those that are caught is such as to make the risk of getting caught an effective deterrent even assuming some probability of escaping detection. I think both of those propositions are highly questionable. (And this is putting aside the question of whether the burn victims would agree there is no problem because the companies paid something.)
Whether there is some moral hazard problem inherent in our current system of corporate governance that underlies all these cases, including the AIG case, is a very interesting question. There certainly seems to be a consensus that there is an inherent agency problem, but that is not necessarily the same thing. An agency problem exists when, for example, the managers of capital are not the owners of capital and have an incentive to use the capital to benefit themselves rather than the owners. A moral hazard problem exists when an individual is able to reap the reward of an activity without having to incur any of the cost. One could imagine a situation where someone had a conflict of interest but still incurred the costs of an activity. However, I think one only needs to spend some time at a site like The Race to the Bottom to see that there are some very strong arguments that in the case of corporations the agency problem overlaps with a moral hazard problem. Corporate insiders have incentives to benefit themselves at the expense of the "owners" (and the community at large) and they are often immunized from the negative consequences of these actions.
The real challenge is the argument that while there may be serious problems with corporations, any attempt to solve that problem with further regulation will only make things worse. In other words, one could agree that the elevation of growth and profit over seemingly all other considerations–together with various less glowing aspects of human nature–will lead to a never-ending procession of corporate scandals, but that the overall benefit of such a system outweighs the costs of increased regulation. I just think that in this current climate (pun intended), that is becoming a harder and harder argument to make.
Finally, even if one agrees that there are problems with our current system, there remains that little issue of precisely what forms of corrective action are best-suited for the task.
Don't let anyone ever tell you that corporate law is dull.
What you might be hinting at there is that corporations have gotten too big to be effectively regulated. I rather suspect that somehere in the maze of existing regulations there were/are rules that would have prevented some of this if applied. The question is, given the size and power of the big boys, are there any other forms of regulation that would be better than what we have (had before Bush)? There was a time when big outfits e.g. Standard Oil were broken up and others were restrained by fear of similar action. I don't think anyone is afraid of regulatory agencies any more because they own them. This mostly stems from the deregulation of banks and insurance companies starting in the Reagan era. Can it be reversed?
I am having trouble understanding what kind of regulation you are advocating. Is the regulation that you are advocating targeted (1) at the activities of the corporation towards third parties or (2) at the internal affairs of the corporation? The weaknesses you cite regarding the ability of damage awards to deter wrongdoers and compensate victims are not unique to the corporate form. If Ronald McDonald were a sole proprietor, he would have the same incentive to sell scalding hot coffee as a corporation if he believed that the increased profits from selling hot coffee were sufficient to overcome the potential risk. I don’t think the soullessness of the corporation affects whether regulation is needed in that regard.
I agree that the corporate management can have an incentive to benefit itself rather than the shareholders of the corporation, but I don’t necessarily believe that government regulation is the answer. The shareholders can protect themselves by electing competent directors, amending the corporation’s articles and bylaws to provide greater shareholder protection, or simply selling their shares. If the elected directors of a corporation approved compensation plans that did not align management’s interests with those of the shareholders and as a result management made decisions that harmed the shareholders, it is entirely appropriate for the shareholders of the corporation to lose their entire investment.
To the extent that corporate law has immunized directors from liability, I think the law should allow shareholders, through the articles and bylaws, to define what the directors may be held liable for.
The short answer to your question about what kind of regulation I am advocating for is "both". From my perspective, we have essentially gutted much of both the federal and state, as well as internal and external, regulation of corporations in the name of the free market. We are paying for that now and hopefully will beef up our oversight of these powerful entities on all fronts. As I have already mentioned, I fully recognize that all these points are controversial. One could argue that we already have too much regulation; that whatever costs the current financial (and environmental) crisis has wrought, they are outweighed by the overall benefits we have gained; and that our attempts now to solve the problems we see as underlying the current financial crisis via further regulation of the corporation will only cause more problems. I also recognize, perhaps more importantly, that this global debate about "free" markets versus regulation is in a very meaningful sense empty. The real issues involve the particular points of particular regulation. But I also believe that the overall orientation matters. One could be dramatic and say there is a battle raging for the hearts and minds of our citizens, and so generalized discussions of free versus regulated markets do matter. More to the point, in the context of this blog post I am consciously speaking in general terms. There are, and will be, other blog posts and venues where I am more specific.
I do not agree that, generally speaking, a rational sole proprietor will be as cavalier about causing injury as a group of managers employed by a corporation. I don't believe an unincorporated sole proprietor has as many means to externalize risk and I think this does flow, at least in part, from the "soulless" nature of the corporation with its inherent diffusion of responsibility and arguable encouragement of the abdication of personal values in pursuit of shareholder wealth maximization. And even if the two are identical in that respect, the general difference in terms of magnitude of impact matters. It is interesting to note that one of the leading theorists in the field, Prof. Ribstein, strongly advocates a return to what he calls the "Uncorporation" as part of the solution to our current problems.
Finally, the actual ability of individual shareholders to effectively protect themselves from managerial misconduct is in great dispute. Under our current system there are a lot of legal, procedural and behavioral obstacles to effective shareholder oversight. That is why so many of the current reform proposals involve increasing shareholder voice in management. Again, whether this is actually the best way to go is also the subject of much debate.
I've been subjected to exhortations to invest in something since I was old enough to spell the word; it seems generally to be thought of as a good thing if more and more ordinary folks do so. The fact is ordinary working slobs cannot become sufficiently expert to know when they are being fleeced. The only ones who theoretically can are those who have so much invested that they can be professionals, i.e. have no other occupation than studying their financial interests, and the Madoff debacle suggests even those relatively few can be grossly deceived.
That said, it still seems to me that if we could manage to do all the regulating already prescribed in some federal statute or regulation, we could eliminate the worst of these cases. The problem is not lack of regulations; it's lack of enforcement.
Going all the way to the top, I agree with P.O.L. that Ford Pintos, McD's coffee (by the way I'd say they're back to scalding hot with it.) and big tobacco are irrelevant. Two of these – McD's & Big Tobacco are proof of nothing but the principle of deep pockets as a deciding factor. The third is an example of regulation by jury, which deep pockets aside works rather well a good bit of the time.