Monitoring: The Behavioral Economics of Corporate Compliance with Law

Tuesday, January 1st, 2002 at 12:00 am by Donald C. Langevoort
Donald C. Langevoort, Monitoring: The Behavioral Economics of Corporate Compliance with Law, 2002 Colum. Bus. L. Rev. 71

One of the many places where business organizations confront the difficulty of monitoring their employees is with respect to legal compliance. A firm wants its employees to be sensitive to legal requirements in order to minimize the threat of legal sanctions and reputational harm that it faces when a violation occurs. As the recent Enron debacle amply demonstrates, however, employees have a different set of compliance incentives. Recent years have brought an abundance of scholarly and practical literature on the challenge of organizational compliance. Firms are under increasing pressure to engage in aggressive monitoring of their employees, which in turn raises questions about the net consequences of these efforts. Some critics claim that greater attention to social institutions such as norms and trust would actually produce better incentive compatibility and higher rates of compliance than high-pressure supervision. To this end, scores of articles advocate a more ethics or integrity-based effort at building compliance cultures within firms. But this remains a contested field and aggressive monitoring is still the baseline for most compliance initiatives.

The focus of this paper is to determine what social and cognitive psychology research-the stuff of contemporary behavioral law and economics -has to say about the task of compliance and the contest between hard and soft monitoring strategies. The psychological work touching on this subject is tentative, often contestable, and always highly context-dependent, making it difficult to articulate strong, confident predictions. My aim, however, is slightly less ambitious. Most of the legal discourse on supervision and compliance today makes behavioral predictions while ignoring this body of research entirely. I am content to think about what conclusions might follow if it turns out that these psychological predictions are robust within firms. In other words what are the risks associated with ignoring these predictions?

The potential pay-off from this effort is two-fold. As we shall see, there is a growing consensus that the law must do something other than simply relying on its conventional strategy of strict vicarious corporate liability in order to induce good monitoring. Firms must be sanctioned for having poor systems or be given some sort of bonus for having good ones. But that necessarily means that a fact-finder has to make a reasonableness determination with respect to any given system, which in turn implies some cost-benefit analysis. My main claim here-the subject of Part I-is that these evaluations are prone to unexpected error in two somewhat off-setting directions. First, evaluators are likely to overestimate the extent to which a firm can rely on line supervisor monitoring to detect possible illegality. While such supervision will catch some misconduct, a host of forces thwart its effectiveness overall. Here, the bias is toward tolerating sub-optimal monitoring. Secondly, there is also a likelihood of underestimating the costs associated with the most obvious cure for line supervisor bias: third-party compliance audits. This likely error biases the legal response towards insisting on too much auditing, forcing unnecessarily costly compliance initiatives.

I cannot quantify the net impact of these kinds of errors, which limits the precise policy lessons we can draw from the analysis. But if these unexpected or immeasurable costs of monitoring turn out to be high enough, it might mean that any affirmative regulatory insistence on high-powered monitoring will be inefficient. The problem is less severe if these costs turn out to be less, but it still does not go away. My point for now is simply that judges are likely to do a poor job of estimating the costs associated with specific compliance initiatives in a given firm, creating at least the risk that the legal regime will be an inefficient one. These errors may also create disincentives for firms to experiment with so-called integrity-based systems, which as I show in Part II have some promise even if they can be expected to fail rather dramatically on occasion. Part III offers some tentative policy conclusions. I want to be careful at the outset to make clear all I am doing is pointing out a risk of inefficiency in the process of evaluating compliance, with a bias in the direction of forcing excessive monitoring. This does not automatically translate into a reason for the law to become less aggressive. It may be that the social costs of the particular illegality in question are sufficiently large or immeasurable (as in health and safety regulation) that this bias is a risk worth tolerating. My sense is that my analysis has the greatest normative bite in settings where (1) the harms in question are economic and (2) large externalities do not result from the conduct. In other words, we should most worry about this problem where the costs of over-precaution are most readily passed on to the class of persons who are the beneficiaries of the regulation. Here, at least, my sense is that the risk of inefficiency via insistence on too much monitoring is sufficiently strong that the law presumptively ought to take a fairly moderate position with respect to firm-level obligations. Some carrots and sticks are desirable with respect to compliance: vicarious liability is necessary, but not sufficient, for optimal organizational compliance. However, I would normally set the bar at medium height. Two steps seem wise along these lines. One is limiting our insistence on compliance to that which is already a best practice within the relevant industry (as opposed to trying to force steps to significantly improve on these standards, de novo). The other is shifting the emphasis to individual supervisory liability when supervisors actually ignore the red flags waving in their faces.

While these cautionary lessons are important, they are not the only pay-off from this exploration. Lawyers are frequently given the task of designing and overseeing corporate compliance systems. They are the compliance engineers in many firms. I would predict that they, too, are prone to these same errors regarding the efficacy of line supervisor monitoring and the costs associated with third-party compliance auditing as judges. Ex ante, then, an awareness of the difficulties of monitoring should make them better designers and overseers even if nothing in the law were to change.

Finally, I have a more general academic goal. The notion of good-quality monitoring is pervasive in the literature on the principal-agent problem and related contractual settings. More specifically, reputation is given preeminent place as a control mechanism in economic relationships, and reputational incentives require something akin to monitoring-accurate observation of opportunistic behavior-in order to succeed. While conventional law and economics scholars have long recognized that limitations on observability (e.g. imperfect information) can diminish the power of reputational incentives, there has been surprisingly little inquiry into the particular mechanisms that might interfere with observational accuracy in this setting. My sense is that many of the psychological insights about monitoring in the compliance context can be extended to a broad range of agency cost issues. I thus hope at least to prompt greater interest in this angle as part of the behavioral law and economics research agenda.

Author Information

Professor of Law, Georgetown University Law Center