Corporate Law for Good People

Adi Libson is a lecturer at Bar-Ilan University Faculty of Law; Yuval Feldman is the Mori Lazarof professor of legal research at Bar-Ilan University Faculty of Law; and Gideon Parchomovsky is Robert G. Fuller, Jr. Professor of Law at University of Pennsylvania Law School. This post is based on their recent paper.

Our paper offers a novel analysis of the field of corporate governance by viewing it through the lens of behavioral ethics. It calls for both shifting the focus of corporate governance to a new set of loci of potential corporate wrongdoing and adding new tools to the corporate governance arsenal. In the legal domain, corporate law provides the most fertile ground for the application of behavioral ethics since it encapsulates many of the features that the behavioral ethics literature found to confound the ethical judgment of good people, such as agency, group decisions, victim remoteness, omissions of gate-keepers, vague directives and duties and subtle conflict of interests.

The behavioral ethics scholarship emphasizes the large share of wrongdoing generated by those who view themselves as “good people” whose intention is to act ethically. Their wrongdoing stems from “bounded ethicality”—various cognitive and motivational processes that lead to biased decisions that they view as either legitimate or justified. Through a combination of deliberate and non-deliberate processes, people may end up behaving unethically with limited awareness of the true ethicality of their own behavior.

One of us has recently completed a book—The Law of Good People (CUP 2018)—that attempts to introduce the area of behavioral ethics to law, focusing on how the law should deal with the ordinary unethicality of “good” people whose behavior in various legal contexts, such as contract performance or hiring an employee, is ethically bounded. The book analyzes and compares the different ways that states can regulate “situational wrongdoers” (as opposed to “intentional wrongdoers”) who will benefit themselves only to the extent that the regulatory or organizational situation allows them to feel good about their misbehavior. This suggests, for example, that regulation should identify situations in which it will be easy for the people who like to view themselves as “good people” to engage in wrongdoing, either explicitly or implicitly, rather than focusing on an ex-post approach (Feldman& Kaplan, 2020).

From a behavioral ethics standpoint there are various aspects in which the corporation is a perfect hub for situational wrongdoing. For example, in corporate settings, much of the wrongdoing does not benefit the individual herself but rather the corporation. Behavioral ethics literature has emphasized that there is a much greater likelihood for wrongdoing when it is done for the sake of others (Gino & Pierce, 2009; Wiltermuth, 2011). In corporate settings, the people who design policy are usually not the ones who execute it, and in many contexts the decision is not made by an individual but rather by dyads or groups creating a shared responsibility problem, which behavioral ethics research suggest to be more prone to wrong-doing (Weisel & Shalvi 2015). Furthermore, in corporate contexts there is often no personal relationship allowing for identification of a clear victim of unethical conduct; rather, there are multiple unidentified victims of unethical corporate policies, and many people are affected by corporate wrongdoing without them noticing (Köbis et al., 2018).

Behavioral Ethics suggests a view of corporate law that is dramatically different than that portrayed by traditional legal and economic theorists. Not only does it suggest that wrongdoing can be committed by well-intentioned people who wish to do right, but also that the self-serving biases they display call for a radically different set of legal interventions than those advocated by standard economic theory. If standard theorizing views corporate agents as self-interest maximizers, bounded ethicality perceives them as actors with varied and nuanced motivations that could benefit from subtle legal reforms of the corporate environment.

This paper’s assessment of corporate governance through the behavioral ethical lens proceeds in three stages. First, it exposes potential ethical blind-spots in which wrongdoing by ‘good people’ might be far more prevalent than previously assumed and conventional corporate governance does not address. Second, it suggests novel corporate governance interventions supported by behavioral ethics to address wrongdoing by good people. Third, it identifies existing intervention that according to behavioral ethics analysis may generate unintended adverse effects on the behavior of well-meaning corporate officers and exacerbate wrongdoing instead of mitigating it.

As we will show behavioral ethics has important implications for a wide range of topics in corporate governance. For instance, it reinforces the position that greater oversight is required on managerial decisions that promote social preferences in light of the finding in the behavioral scholarship that there is a greater tendency for wrongdoing when it benefits third parties (Gino & Pierce, 2009; Wiltermuth, 2011). This may justify requiring some form of shareholder input on such decisions (Libson, 2019).

The paper also suggests board procedures that will assist overcoming the “dishonesty shift” (Sutter, 2009) which accompanies group decision making, by assigning initial decisions to specific board members which the board will only reaffirm. Furthermore, the tendency for wrongdoing in group contexts that is created by “compensation commonality” (Gino et al., 2013) could be curtailed by adopting Eckstein and Parchomovsky’s (2018) suggestion for horizontal board duties: fiduciary duties each board member owes to the other.

The paper questions the current practice of independent directors. According to the behavioral ethics literature (Heyman & Ariely, 2004; Feldman & Halali, 2017) subtle conflict of interest that pertain independent directors, may be more powerful than stronger personal interests due to the objectivity bias. According to this strand in the literature, the fact that the conflict-of-interest is subtle makes it “invisible” to the agent. Consequently, even “good people” who are not consciously seeking to promote their personal interest will end up doing so in contexts where they can either ignore the conflict or brush it aside its importance. As such, the paper provides additional support for adopting Bebchuk & Hamdani (2016) suggestion for directors with “enhanced independence.”

In respect to the regulation of institutional investors and proxy advisory firms, the paper suggests altering the reference point of their recommendation, from the managements’ position to the activist position in light of the omission bias. The paper recommends greater reliance on ex-ante mechanisms, such as the approval by special independent committees adopted in the MFW case, rather than deterrence by ex-post litigation due to the tendency to employ “elastic justification” in cases of vagueness (Schweitzer & Hsee 2002).

The complete paper is available for download here.

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