Costs of Oversight: Outtasight!

I occasionally peruse the lawblog on the Wall Street Journal. A post from today covers the topic of the costs imposed by investigations of potential corporate misbehavior. In this case, the focus is backdating options granted to senior executives. The blog reports that one firm accused of this practice, Mercury Interactive, estimated costs of $70 million to deal with the scandal. That is a lot of money.

The blog also reports that boards are sparing no expense when it comes to doing investigations of this nature. This is good for lawyers and accountants. It is probably not so good for shareholders.

Personal liability for board members can, in theory, induce appropriately prudent behavior, which benefits all interested constituencies. However, the threat of significant personal liability may also induce behavior that is decidedly self-interested, lacking the greater benefit for investors.

One can think about this problem in this way: if a store manager is held personally responsible for all thefts from the store, the manager is either going to want a very large compensation package, or else she will want to be able to spend company money to stop the losses. If we opt for the latter - spending company money -- you can be she will spend more on a security system than that system will save in lost merchandise, as long as it comes out of the company's pocket. This overspending is a function of the strong liability rule, which is disconnected from any impact of the costs to prevent the theft.

A more appropriate system will focus on some form of carrot-based structure for incentives, which will induce thoughtful and prudent behavior to stop the outside thefts in a cost-effective way. We would not spend more on the security system than we believe it will save the firm. Some losses would be tolerable.

That incentive system makes sense if the thefts are coming from outside, but perhaps not so much if the thefts come from the clerks, who are the manager's best friends. Here, a threat of personal accountability may well induce the manager to overcome the natural tendency to look the other way when your close associates are doing wrong.

Board members may well need some kind of inducements to make them focus on executive compensation issues in advance. Market forces, including those operative on reputation, may allow for better functioning boards when details about executive compensation are freely available to the public. On a prospective basis, that may well be the best way to deal with these issues.

Shareholders should be vigilant, however, when investigations over past misbehavior gets funded by the corporate dime. The risks to the company, as well as the risks to personal reputations, are so high that the amount of the expenditures are unlikely to be constrained by considerations of the good of the shareholders. And we all know about the many situations (Enron being one of them) where wrongdoing is found, but the money to repair the harm just isn't there. Moving on may well be the most prudent decision. Like the store manager, sometimes you just have to let some of those losses go.

EAM

The WSJ Law blog can be found here:
http://blogs.wsj.com/law/?mod=hps_us_inside_today