Those who’ve been around for a while may recall that diehard libertarian Alan Greenspan was forced to admit after the crisis that he had found a flaw in his ideology, and that self interest of financial institutions didn’t lead them to protect their shareholders.
Now despite that world-shaking incident, neoclassical economics remains the dominant economic ideology, which means that policy-makers are still subjected to corporate friendly blather about how companies can be relied upon to mind for themselves because the reputational cost of Doing Bad Things is large, and if that isn’t enough, litigation and the existing (ever weakening) regime of fines for bad behavior is more than adequate.
Again, as anyone who watched the crisis and its aftermath knows, all the big banks suffered was cost of doing business fines.
And this problem is widespread, as a new paper by Roy Shapira, Associate Professor at IDC Herzliya Radzyner Law School and Luigi Zingales, Professor at University of Chicago’s Business School suggests.
The authors make a case study of DuPont’s failure to remedy the emissions of a harmful chemical, C8. used in making Teflon, that eventually led to a $670 million settlement earlier this year. Du Pont is the sort of blue-chippy company that cares about corporate governance enough to make sure it gets good marks on those scorecards. On top of that, DuPont is a top player in environmental and toxic substances research. They conclude it was nevertheless perfectly rational for DuPont to keep polluting.
This conclusion won’t come as a surprise to anyone who has taken note of rampant corporate short-termism and the rise of the “IBG-YBG” mentality, that job churn is so high that any bad stuff being done now won’t rise to the level of being a real problem until after the people with their fingerprints on it have moved on.
But that view is, in corporate finance terms, tantamount to having a discount rate that is artificially high, which results in assigning incorrectly low costs to long term risks.
The interesting part of the Shapira/Zingales paper is that they argue that for Du Pont to keep polluting was a rational decision, using reasonable discounting assumptions. From their summary of their paper at Harvard Law School’s Corporate Governance and Financial Regulation blog:
The key decision point for DuPont came in 1984, when alarming information about the potential consequences of C8 emissions caused the company to call a top-executives meeting. By 1984 DuPont was aware that C8 is toxic, associated with birth defects, does not break down in the environment, and accumulates in human blood over time. Essentially, by 1984 C8 could already be considered a perennial red flag. DuPont’s executives acknowledged that the legal and medical departments would recommend stopping the usage of C8 altogether in light of the new alarming information. Yet, the business side overruled these recommendations and opted to continue C8 emissions (in fact they doubled them). Importantly, DuPont’s decision-makers also opted against investing in abatement options that were on the table, such as building an incineration device that would greatly reduce C8 emissions.
Was this a myopic managerial decision? An agency problem? The internal documents allow us to conduct a cost-benefit analysis, showing that even a shareholder-value-maximizing manager would have chosen to pollute. Our calculation shows that even if DuPont managers could have forecasted all future legal liabilities, they would have preferred to pollute as long as they thought that the probability of getting caught was less than 19%. Given the extreme set of unlikely events that led to the payment of heavy legal fines, and given the fact that other C8 users (like 3M) have escaped such heavy legal liability, we conclude that at that time polluting without abating was a reasonable bet by DuPont’s decision makers. Thus, it was value-maximizing for DuPont to pollute, in spite of the fact that—as we show—the costs C8 pollution imposed on society greatly exceeded DuPont’s own estimates of abatement costs.
The authors stress that potential legal costs weren’t a sufficient deterrent due to the time lag, particularly since companies like DuPont are in a position to create delays via clever PR that creates doubt about the dangers, court strategies, and influencing regulators. They also point out (emphasis original):
Regulation was not enough either. The Toxic Substances Control Act grandfathered in existing chemicals, making it difficult for regulators to obtain information about possible health risks. Even when regulators receive alarming information, large chemical companies can pull levers to soften regulatory enforcement, such as revolving door offers.
Given the large power imbalance when companies misbehave, Shapira’s and Zingales’ remedies are insufficient. They incorrectly frame the problem as in informational, as opposed to about incentives.
They call for bounties for whistleblowers plus a large tax on gag settlements in environmental cases. But it is hardly a secret, save maybe in academia, that whistleblowers ruin their careers and often their marriages, and pay a big psychological price, when the financial payoff is far from certain. Economists of the caliber of Shapira and Zingales should know that people are risk averse, and for good reason: there’s no reason to think you have more than one life. Why throw it away on a fight, even a righteous fight, which parties with much deeper pockets and staying power than you have who will do everything they can to pound you into the ground?
Similarly, the idea of a tax on gag settlements is just silly. The incremental cost of the tax will be too small to change behavior. Shapira’s and Zingales’ objective is to more disclosure, which would help regulators and parties considering litigation, when the companies will just pay the tax.
The obvious solution is to make executives accountable, by at a minimum forcing the payment of any large fines to come out of deferred comp and to require executives above a certain level to have a significant portion of their compensation be deferred. Only by hitting the executives where it hurts, in their wallets, and to enough of a degree to affect their standard of living, do you start to have a chance of changing behavior.