1. Evolution of Corporate Law & Finance Section (c)2 Corporate law & the business cycle Prof. Amitai Aviram Aviram@illinois.edu College of Law University of Illinois Copyright © Amitai Aviram. All Rights Reserved S12D

2. Effect of conspicuous law enforcement on behavior of non-perpetrators How the business cycle affects law Economic effect of the perp walk Conspicuous law enforcement Individuals risk perception Individuals behavior Nothing paints a picture as well as people being led away in handcuffs – Walter Ricciardi, SEC

3. When Do Prosecutors Enforce Securities Laws? Empirical Evidence Cyclical Enforcement: Little during boom, plenty after bust

4. When Do Prosecutors Enforce Securities Laws? Theory Conspicuous enforcement is greatest when the perception gap (perceived risk - actual risk) is greatest

5. Example Assume risk of company insiders committing fraud is 0.002% (1:50K) –But public misperceives risk to be 1% AG launches anti-fraud initiative (conspicuous law enforcement) –Insiders deterred: 50% reduction in objective risk, to 0.001% –AG oversells initiative; Claims 99% reduction (to perceived risk of 0.01%) Private benefits to AG: Public observes that actual occurrences are closer to 0.01% than 1%; lends credibility to AGs claims

6. Narrowing the perception gap: Over-estimation of fraud reduced from 0.998% to 0.009% –~111 times less misperception Perceived Risk (%) Actual Risk (%) Perception Gap Before10.0020.998% After0.010.0010.009% Example

7. Perception gap reduces social welfare: –Excessive avoidance of equity investments –Excessive self-policing of companies –Excessive political pressure to regulate Narrowing the perception gap increases social welfare Example Effect on Social Welfare

8. Bias Arbitrage Commodity Arbitrage Identify gap in price of gold in NY & London Take an action that creates private profits while also closing the price gap Bias Arbitrage Identify gap between objective & perceived risk Take an action that creates private benefits while also closing the perception gap

9. Is Cyclical Enforcement a Form of Bias Arbitrage? I.e., does the public over-estimate fraud more following a bust?

10. Does the public over-estimate fraud more following a bust? Cognitive Biases

11. Does the public over-estimate fraud more following a bust? Relevant Cognitive Biases Self-serving bias –Stock goes up – must be my investment skills –Stock goes down – must be fraud Availability bias –Economic hardship removes veil that masks fraud –Economic downturn causes hardship to many firms at once Attribution discounting –Fraud rises as a possible cause of downturn –Causes people to discount other causes

12. This could have been the end, but then this paper would be called … Counter- Cyclical Enforcement of Corporate Law

13. The Dual Message of Conspicuous Law Enforcement When Jane Doe hears that the SEC is investigating Acme Corp. for fraud, does she think: –The SEC is effective in catching fraud! (i.e., Ajax Corp. is less susceptible to fraud) Need to invest less in addressing risk Or: –I didnt realize theres so much fraud going on! (i.e., Ajax Corp. is more susceptible to fraud that I thought) Need to invest more in addressing risk

14. Reworking the Example Same assumptions as before, except that enforcement exacerbates perceived risk by 99% (to 1.99%) Perceived Risk (%) Actual Risk (%) Perception Gap Before10.0020.998% After1.990.0011.989% Perception gap increased Excessive avoidance Excessive self-policing Excessive political pressure

15. A vicious enforcement cycle… Public over- estimates risk Incentives for conspicuous law enforcement Conspicuous law enforcement Excessive avoidance / self-policing / political pressure Enforcement increases perception of risk

16. Solution? Counter-cyclical enforcement –Enforce more when public under-estimates fraud (boom) to increase risk perception –Enforce less when public over-estimates fraud (after bust) to prevent exacerbating risk perception But prosecutors incentives favor cyclical enforcement… –Article suggests mechanisms to modify these incentives