Enforcement Against Market-Driven Misconduct

Government plays a critical role in the design of some free markets and in the operation of many. The recent energy debacle in California resulted in part from defective governmental design of California's markets for wholesale and retail electricity. Even where markets are shaped largely by private-sector activity, government often has a critical role in influencing the incentives that guide conduct in those markets. In particular, law enforcement agencies, especially regulatory agencies, have a critical responsibility for the proper functioning of competitive markets within their jurisdiction — the responsibility to elaborate and enforce applicable laws so as to constrain market forces from driving participants into socially undesirable conduct.

As a Stanford Business School professor has put it: “The main way the government sets the rules of the market game is by writing laws and maintaining the machinery to enforce them. Laws are needed to guard against theft and fraud, to define and protect property rights, and to support contracting … Regulation sometimes is needed to supplement the courts – usually not direct regulation of firms' day-to-day activities but oversight to ensure markets are doing what they are supposed to do.” John McMillan, Reinventing the Bazaar: A Natural History of Markets 175 (2002).

If basketball referees called no fouls, how many would actually occur? If they persisted in calling none, over time fouls might even cease to be recognized as such. Like competitive pressure in basketball, market forces are very powerful. They produce what the economist Joseph Schumpeter called “creative destruction.” Creativity on the part of some may lead to economic progress, but others facing destruction will do what they think practical to prevent or delay it. Even those riding a wave of creativity may seek to ride it faster than the law permits. In highly competitive markets, the ever-present threat of loss, decline, and possible destruction creates permanent pressures to reduce costs and increase and improve output, and thereby increase (or at least maintain) revenues and profits. Unconstrained, those pressures provide a continuing temptation to achieve those goals improperly. If one firm succeeds by cheating, market forces may well drive others to cheat, too. Unless the countervailing threat of enforcement is credible, market-driven conduct — conduct thought necessary to prevail or survive in economic competition-may increasingly violate legal limits.

Internal Compliance Is Not Enough

Firms commonly have personnel and procedures to resist the pressures of market forces toward unlawful conduct. In-house counsel, regulatory affairs specialists, financial and compliance auditors, compliance training, sign-off requirements, whistleblower protections, disciplinary procedures, etc. — all are supposed to work toward that end. But their effectiveness ultimately depends on effective external law enforcement. If external enforcement is absent or weak, internal protectors of legal norms may lose internal debates with those directly responsive to market forces, and the effectiveness of internal protections against cheating may erode.

A reliable sign of enforcement failure is market-wide objectionable conduct. Where not merely one or two, but all or most firms, engage in the same kind of objectionable conduct, the most likely inference is that they all are responding to market forces in a manner unchecked by a credible threat of enforcement. Responsibility for the absence of that threat rests with the relevant enforcement officials and their political superiors in the executive and legislative branches (state or federal).

Consider a scenario in which market forces drive virtually all competitors to engage in cost-cutting or revenue-enhancing conduct that is of doubtful legality under regulatory, civil, or criminal law, or even clearly illegal. Examples of misconduct driven by cost-cutting include improper environmental or employment practices and inadequate manufacturing controls; examples of misconduct driven by revenue enhancement would be commercial bribery and advertising that is false or highly exaggerated. Suppose that the conduct is known to, or readily discoverable by, enforcement authorities, yet they do nothing because staff and budgets are fully absorbed by matters of higher priority. Suppose there is still no enforcement even after some participants in the affected market complain to the authorities. Years go by. The conduct persists and becomes entrenched. Because the market is fiercely competitive, and because virtually all competitors engage in the unlawful conduct, it becomes necessary for survival in the marketplace. Established firms and new entrants either engage in the conduct or are driven out of business.

Suddenly, the enforcement climate changes. The reasons can be many: new leadership, new resources, a readjustment of priorities in response to political or public pressure or to a particularly harmful exemplar of the objectionable conduct. Whatever the reason, the authorities publicly announce a new enforcement stance, and the market is now aware that future conduct runs the risk of an enforcement action. But what should be done with respect to past conduct (assuming that the past non-enforcement was not so extreme that the government has forfeited the right to prosecute)?

Redress of Past Conduct

A policy of seeking to impose penalties — administrative, civil, or criminal — for all past conduct within the statute of limitations would seem unjust. A law affecting competitive conduct that is persistently unenforced despite adequate notice to the authorities of pervasive violations ought not become a trap engulfing all who managed to survive in the market into the limitations period. If basketball referees call no fouls for the first three quarters, would it be fair for them at the start of the fourth quarter to rule that players who had committed more than the limit had fouled out of the game?

In my hypothetical scenario, the authorities have failed to fulfill their responsibility to maintain a credible threat to enforce applicable laws, and that failure should be considered in the assessment of an appropriate retrospective enforcement strategy. Of course, not all past market-driven misconduct should be given a pass. Particularly exaggerated cases may warrant some form of enforcement action. But in view of the past nonfeasance of enforcement officials, the enforcement policy should be that conduct typical of market participants in general warrants a warning rather than an enforcement action, or a civil (and preferably prospective) sanction rather than criminal prosecution.

Most importantly, efforts should be made to prevent persistent non-enforcement and the consequent descent into widespread objectionable conduct. Those who have an interest in the proper functioning of a market — sellers and buyers in that market, trade associations of sellers or buyers, consumer groups, participants in upstream or downstream markets and their associations — also have an interest in effective law enforcement in that market. If an interested party sees the beginnings of misconduct that, if allowed to continue, might become market-wide, that party should seriously consider blowing the whistle to whoever will listen — the company or companies involved, trade associations, enforcement authorities, politicians, the press, consumer groups, others.

The easy course of doing nothing may lead to conditions in which many firms are sucked into objectionable conduct. They may engage in that conduct against their institutional wills, but nevertheless in the end may pay a heavy price and inflict serious injury on themselves and their constituencies, the market, and all who depend on it.

Conclusion

Obtaining enforcement may not be easy. Enforcement officials may believe they need additional legal authority or resources, investigative assistance from interested private parties, or a persuasive showing that the objectionable conduct is seriously harmful. It may be necessary to lobby their political superiors and legislators and to prod them to action. In some circumstances, however, these commonly daunting tasks may be less costly than going along with objectionable conduct. In recent years, in a number of industries, the costs of going along have come home to multiple firms in the form of criminal prosecutions, civil and administrative enforcement actions, class actions, large settlements, and sometimes bankruptcy or destruction of the company.

When objectionable conduct, particularly criminal conduct, begins in a firm, those asked to participate in it may face a moral crisis. Depending on the culture of the firm, they may be able to refuse or even to stop the conduct; if not, their options may be to go along or quit. It may take a kind of heroism to break sharply with expected forms of deference in order to do the right thing, but doing it may save them from grief in the end.

The same may be true of a company when objectionable conduct, particularly criminal conduct, begins in its market, and market forces start to press the company to replicate the misconduct of its competitors. Despite the difficulty, it may be time to press enforcement authorities to fulfill their responsibility. For government has a duty not only to promote commerce by providing essential background conditions such as political stability, a reliable legal system, sensible monetary and fiscal policies, and certain kinds of infrastructure (eg, public education, roads, fire departments). It has a duty to keep the marketplace honest by steady deterrence of market-driven misconduct.

Government plays a critical role in the design of some free markets and in the operation of many. The recent energy debacle in California resulted in part from defective governmental design of California's markets for wholesale and retail electricity. Even where markets are shaped largely by private-sector activity, government often has a critical role in influencing the incentives that guide conduct in those markets. In particular, law enforcement agencies, especially regulatory agencies, have a critical responsibility for the proper functioning of competitive markets within their jurisdiction — the responsibility to elaborate and enforce applicable laws so as to constrain market forces from driving participants into socially undesirable conduct.

As a Stanford Business School professor has put it: “The main way the government sets the rules of the market game is by writing laws and maintaining the machinery to enforce them. Laws are needed to guard against theft and fraud, to define and protect property rights, and to support contracting … Regulation sometimes is needed to supplement the courts – usually not direct regulation of firms' day-to-day activities but oversight to ensure markets are doing what they are supposed to do.” John McMillan, Reinventing the Bazaar: A Natural History of Markets 175 (2002).

If basketball referees called no fouls, how many would actually occur? If they persisted in calling none, over time fouls might even cease to be recognized as such. Like competitive pressure in basketball, market forces are very powerful. They produce what the economist Joseph Schumpeter called “creative destruction.” Creativity on the part of some may lead to economic progress, but others facing destruction will do what they think practical to prevent or delay it. Even those riding a wave of creativity may seek to ride it faster than the law permits. In highly competitive markets, the ever-present threat of loss, decline, and possible destruction creates permanent pressures to reduce costs and increase and improve output, and thereby increase (or at least maintain) revenues and profits. Unconstrained, those pressures provide a continuing temptation to achieve those goals improperly. If one firm succeeds by cheating, market forces may well drive others to cheat, too. Unless the countervailing threat of enforcement is credible, market-driven conduct — conduct thought necessary to prevail or survive in economic competition-may increasingly violate legal limits.

Internal Compliance Is Not Enough

Firms commonly have personnel and procedures to resist the pressures of market forces toward unlawful conduct. In-house counsel, regulatory affairs specialists, financial and compliance auditors, compliance training, sign-off requirements, whistleblower protections, disciplinary procedures, etc. — all are supposed to work toward that end. But their effectiveness ultimately depends on effective external law enforcement. If external enforcement is absent or weak, internal protectors of legal norms may lose internal debates with those directly responsive to market forces, and the effectiveness of internal protections against cheating may erode.

A reliable sign of enforcement failure is market-wide objectionable conduct. Where not merely one or two, but all or most firms, engage in the same kind of objectionable conduct, the most likely inference is that they all are responding to market forces in a manner unchecked by a credible threat of enforcement. Responsibility for the absence of that threat rests with the relevant enforcement officials and their political superiors in the executive and legislative branches (state or federal).

Consider a scenario in which market forces drive virtually all competitors to engage in cost-cutting or revenue-enhancing conduct that is of doubtful legality under regulatory, civil, or criminal law, or even clearly illegal. Examples of misconduct driven by cost-cutting include improper environmental or employment practices and inadequate manufacturing controls; examples of misconduct driven by revenue enhancement would be commercial bribery and advertising that is false or highly exaggerated. Suppose that the conduct is known to, or readily discoverable by, enforcement authorities, yet they do nothing because staff and budgets are fully absorbed by matters of higher priority. Suppose there is still no enforcement even after some participants in the affected market complain to the authorities. Years go by. The conduct persists and becomes entrenched. Because the market is fiercely competitive, and because virtually all competitors engage in the unlawful conduct, it becomes necessary for survival in the marketplace. Established firms and new entrants either engage in the conduct or are driven out of business.

Suddenly, the enforcement climate changes. The reasons can be many: new leadership, new resources, a readjustment of priorities in response to political or public pressure or to a particularly harmful exemplar of the objectionable conduct. Whatever the reason, the authorities publicly announce a new enforcement stance, and the market is now aware that future conduct runs the risk of an enforcement action. But what should be done with respect to past conduct (assuming that the past non-enforcement was not so extreme that the government has forfeited the right to prosecute)?

Redress of Past Conduct

A policy of seeking to impose penalties — administrative, civil, or criminal — for all past conduct within the statute of limitations would seem unjust. A law affecting competitive conduct that is persistently unenforced despite adequate notice to the authorities of pervasive violations ought not become a trap engulfing all who managed to survive in the market into the limitations period. If basketball referees call no fouls for the first three quarters, would it be fair for them at the start of the fourth quarter to rule that players who had committed more than the limit had fouled out of the game?

In my hypothetical scenario, the authorities have failed to fulfill their responsibility to maintain a credible threat to enforce applicable laws, and that failure should be considered in the assessment of an appropriate retrospective enforcement strategy. Of course, not all past market-driven misconduct should be given a pass. Particularly exaggerated cases may warrant some form of enforcement action. But in view of the past nonfeasance of enforcement officials, the enforcement policy should be that conduct typical of market participants in general warrants a warning rather than an enforcement action, or a civil (and preferably prospective) sanction rather than criminal prosecution.

Most importantly, efforts should be made to prevent persistent non-enforcement and the consequent descent into widespread objectionable conduct. Those who have an interest in the proper functioning of a market — sellers and buyers in that market, trade associations of sellers or buyers, consumer groups, participants in upstream or downstream markets and their associations — also have an interest in effective law enforcement in that market. If an interested party sees the beginnings of misconduct that, if allowed to continue, might become market-wide, that party should seriously consider blowing the whistle to whoever will listen — the company or companies involved, trade associations, enforcement authorities, politicians, the press, consumer groups, others.

The easy course of doing nothing may lead to conditions in which many firms are sucked into objectionable conduct. They may engage in that conduct against their institutional wills, but nevertheless in the end may pay a heavy price and inflict serious injury on themselves and their constituencies, the market, and all who depend on it.

Conclusion

Obtaining enforcement may not be easy. Enforcement officials may believe they need additional legal authority or resources, investigative assistance from interested private parties, or a persuasive showing that the objectionable conduct is seriously harmful. It may be necessary to lobby their political superiors and legislators and to prod them to action. In some circumstances, however, these commonly daunting tasks may be less costly than going along with objectionable conduct. In recent years, in a number of industries, the costs of going along have come home to multiple firms in the form of criminal prosecutions, civil and administrative enforcement actions, class actions, large settlements, and sometimes bankruptcy or destruction of the company.

When objectionable conduct, particularly criminal conduct, begins in a firm, those asked to participate in it may face a moral crisis. Depending on the culture of the firm, they may be able to refuse or even to stop the conduct; if not, their options may be to go along or quit. It may take a kind of heroism to break sharply with expected forms of deference in order to do the right thing, but doing it may save them from grief in the end.

The same may be true of a company when objectionable conduct, particularly criminal conduct, begins in its market, and market forces start to press the company to replicate the misconduct of its competitors. Despite the difficulty, it may be time to press enforcement authorities to fulfill their responsibility. For government has a duty not only to promote commerce by providing essential background conditions such as political stability, a reliable legal system, sensible monetary and fiscal policies, and certain kinds of infrastructure (eg, public education, roads, fire departments). It has a duty to keep the marketplace honest by steady deterrence of market-driven misconduct.