Economic analysis has dominated interdisciplinary legal research in recent years, in part because it adds rigor to legal analysis. However, a limitation on economic analysis is that the law attempts to influence human behavior, but economists often proceed from an incomplete understanding of why
humans act as they do. As already noted, the most frequent and significant misassumption of economic analysis is that human beings are optimally rational maximizers of their expected utilities. Behavioral decision theory, which starts from more realistic assumptions as to why people act as they do, can help explain the role of law in advancing the efficiency of markets.
Consider contract law. An overarching premise of economic analysis of contracts, including those used to embody rights in corporate structures and purchases and sales of securities, is found in an aspect of the Coase Theorem which provides that the initial assignment of legal rights does not determine which use will ultimately prevail because the parties will bargain to the most efficient state of affairs.44In other words, if left to their own devices and without transaction costs, free of government interference, pro- moters of and investors in enterprises will negotiate to the most efficient possible contract.
However, research from behavioral psychology indicates that the initial assignment of legal rights matters significantly in contractual bargaining.
Evidence indicates that people are both loss averse and impacted by the endowment effect. Together, these concepts indicate that the initial distrib- ution of rights will greatly impact negotiation between two parties.45For example, if a statute provides that employees will presumptively have certain types of benefits unless they agree to forfeit them, they are much more likely to be accorded those benefits by an employer than if the statute provides that employees presumptively will nothave those benefits unless they bargain with the employer to achieve them.46Therefore, it is likely that under a corporate code that assumes shareholders will not have inspection rights or voting rights unless they take measures to have the Articles of Incorporation amended, then they are much less likely to have such rights than if the corporate code assumes that such rights exist. Economists rec- ognize that transactions costs mean that the simple Coase Theorem cannot describe reality but behavioral psychologists go further and recognize that even in the absence of material transaction costs, such a renegotiation is not likely to occur.
Besides loss aversion and the endowment effect, the related concept of the status quo bias plays a role here.Ceteris paribus, people prefer the status quo.47Part of the reason is regret aversion—that they are more likely to regret bad consequences that stem from their actions than from their inac- tions. By sticking with the status quo they reduce the risk of feeling regret in the future.48Thus, when New Jersey reduced the price of automobile insurance along with coverage but gave insureds the option to opt into a more expensive policy with broader rights and Pennsylvania did the opposite—enacted an expanded-rights presumption that gave insureds the option to opt into a cheaper regime with fewer rights to sue, in each state
most insureds chose what they perceived to be the status quo. A large majority of New Jersey residents chose cheaper insurance and less cover- age while a large majority of Pennsylvanians chose more expensive insur- ance and more coverage.49As Korobkin has demonstrated experimentally, parties tend to treat form contracts as the status quo and to accept them with little question or negotiation.50Consumers may well accept a war- ranty disclaimer or arbitration clause that is part of a form contract because it seems to be the status quo, where they would object loudly to the suggestion that such a provision be penciled into a form contract that did not contain them.51
Some argue that although the status quo bias might explain why Coasian bargaining does not occur in real life when economists theorize that it should, it does not explain why abusive terms persist. The notion is that competition should force merchants to place pro-consumer provisions in their contracts. Unfortunately, the reverse is often true. Because consumers and investors tend not to pay attention to nonprice terms and often believe that unfair collateral terms such as waivers of rights or arbitration provi- sions will never apply to them (because of the tendency people have to be unduly optimistic and to ignore low probability events), competition actu- ally forces merchants to include such terms so they will not miss out on the profits their competitors are achieving by scalping customers. The simple fact is that contract renegotiation is quite rare, indicating that contracting parties do not, when faced with a contract that is not optimal, reopen bar- gaining to work toward a better solution, indicates that the Coase theorem is unduly optimistic. If parties cannot be counted to bargain to the most efficient result, then there may well be a role for law and regulation.
As indicated in the previous chapter, trust is an important part of a busi- ness environment, and law can foster trust. People do not wish to do busi- ness in a crooked marketplace. This is true in part because of rational fears of being exploited by dishonest companies and individuals. In addition, it is true because people inherently value fairness. “Humans are guided by an innate sense of fairness that drives their actions, attitudes and behaviors.”52 Although it is not always rational for people to act fairly toward others in a one-shot ultimatum game context, they often do. They do because fair- ness matters, as research in behavioral decision theory indicates. In the experimental ultimatum game, A may be given US$100 with the power to offer any division between himself and B. But if B rejects the division, neither party receives anything. Rationally, economists say, A should offer US$1 to B and propose to keep US$99 for himself. B should accept this because US$1 is better than nothing. However, typically offerors propose much fairer divisions of the US$100 (often 50/50) and offerees who are offered a very small share often reject it. They would rather receive nothing
in order to punish the offeror for acting inequitably than to receive an amount they perceive as unfair. Many offerees are willing to suffer an eco- nomic loss in order to promote perceived fairness.53
Contract rules that promote fairness can not only benefit society by rec- ognizing that efficiency is not the only value that policy should be con- cerned with; they can also promote efficiency by creating the type of economic atmosphere in which people wish to do business. To promote fairness, contract law allows incapacitated people to disaffirm their con- tracts.54Not only does this policy deter and punish inequitable conduct and prevent the government’s enforcement mechanism from being used for an inappropriate purpose,55it also advances efficiency because incapacitated people are unlikely to allocate their resources in an optimal manner. To promote fairness, contract law prohibits fraud. As Farnsworth points out, intentional misrepresentation is the type of act that invites courts to make moral judgments.56Fortunately, this rule also promotes efficiency, for fraud undermines the efficient allocation of resources.
The importance of law in this regard is difficult to overstate, for an unreg- ulated system of private contracting can lead to rampant opportunism. For several reasons, many having to do with the tenets of behavioral decision theory, a lawless market is suboptimal. First, people are usually unable to tell when they are being lied to. Many studies show that few people can guess at a better than chance level as to when people are lying to them.57 Worse yet, because of overconfidence, people think they are adept at lie detecting, leaving them particularly vulnerable. The consensus effect exac- erbates an already bad situation by increasing an honest person’s vulnera- bility when they are dealing with someone they perceive to be “like them”
(hence the popularity of affinity frauds). And even if people learn that the person they are contracting with is untrustworthy, insensitivity to source means that they may well fail to take adequate steps to protect themselves.
Those who do not fall prey to fraud may be overly cautious and frightened of any investment, for fear of being defrauded, even when the other party is honest. Contract rules that refuse to enforce unfair and inefficient con- tracts and that punish fraudsters advance fairness and efficiency concerns.
In both contract law and tort law, it is often argued that governmental regulation and law-imposed liability are unnecessary because reputational constraints will suffice to discipline contract breakers and tortfeasors.
Contracting parties will not commit fraud because it will ruin their reputa- tion in the marketplace. Sellers will not market defective products because word will spread and no one else will buy from them.
Because a rational person has concern for his or her long-term reputa- tion, some economists have presumed that government regulation of fraud is unneeded in securities and other markets. Repeat players must act
properly or else they will be punished. As just one example, Judge Easterbrook, a leading law and economics scholar as well as a federal judge, has opined that even in the face of a financial scandal with a busted audit, judges should presume that the auditors were not reckless because their long-term reputational interest makes it “irrational” for them to do any- thing other than make their clients toe the line.58Chapter 2 has demon- strated how reputational sanctions cannot produce an efficient level of honesty, and behavioralism only enhances the economic problem.
Unfortunately, the past few years have made it surpassingly clear that too many actors in our capital markets, perhaps because of time delay traps or other problems with intertemporal decisionmaking, are more than willing to sacrifice long-term reputational capital for short-term financial gain.
Corporations such as Enron, WorldCom, Global Crossing, HealthSouth, and Tyco had wonderful reputations in the late 1990s. Enron was widely known as the world’s most innovative company. WorldCom was a marvel of the hot new telecommunications sector. Yet all these companies, and many others, ruined their own reputations by financial skullduggery. Enron moved debt offits books and engaged in transactions designed to produce the temporary appearance of income, ultimately costing its investors US$70 billion. WorldCom inflated earnings by US$11 billion. Global Crossing collapsed under US$12.4 billion in debt that it had hidden. Quest restated US$2.5 billion in revenue in 2000 and 2001. Indeed, 10 percent of NYSE-listed companies had to restate their financials between 1997 and June 2002, and writeoffs of US$148 billion erased virtually all of the profits reported by NASDAQ companies between 1995 and 2000. While recogniz- ing that empirical studies show that there are long-term benefits to build- ing a reputation for providing reliable and timely disclosures, Professor Dechow and colleagues noted after a recent empirical study that “the sample offirms investigated in this study chose to risk (and ultimately lose) those benefits for the prospect of short-term gain.”59
Of course, the actions of corporations are really the actions of individ- uals. What about their reputational capital? Enron officers sacrificed their long-term reputation in order to loot the firm of hundreds of millions of dollars in bonuses and stock options that they pretended to earn by enter- ing the firm into deals that ultimately lost billions and by fraudulently inflating the stock price through all manner of devious accounting maneu- vers. Enron’s outside directors damaged their own long-term reputations by negligently and perhaps recklessly failing to detect the officers’ shenanigans and by foolishly waiving the firm’s conflict-of-interest policy. Enron’s law firm also suffered serious reputational injury when its attorneys forgot that their ultimate loyalty was to the corporate entity and the shareholders rather than to the individual officers whom they aided and abetted in many
of their more spurious transactions. Stock analysts chose short-term lucre over long-term reputation by publicly hyping (while privately condemning) stocks of companies like WorldCom as their share price tanked, in order to cultivate investment banking business for their employers.
In the face of such gatekeeping failures, one response is to take refuge in mutual funds. However, even sophisticated investors were victimized nearly as much as lay investors by the frauds of these various actors. In addition, mutual funds have victimized unsophisticated investors in a wide variety of ways. Former SEC head Arthur Levitt has termed some of these abuses
“the most egregious violation of the public trust of any of the events of recent years.”60 There is substantial evidence that market timing abuses were systemic, and that industry professionals knew about the abuses and did nothing. Jack Bogle, founder of Vanguard Group, notes that “increas- ingly everything in the fund industry is favoring the manager at the expense of the shareholder.”61
Nor can the reputational concern of auditors adequately protect investors. While Judge Easterbrook assumes that auditors would not risk their long-term reputations by acting recklessly, behavioral research pro- vides a plethora of potential explanations for why reckless and fraudulent auditing is hardly an infrequent occurrence. In addition to the rational reasons discussed in Chapter 2, several explanations for auditor failings arise from 30 years’ worth of behavioral research in accounting.62Among those are the following:
● Confirmation bias: Numerous studies indicate that auditors are prone to the confirmation bias and tend to perceive evidence and empha- size results that confirm their initial hypothesis, which is often estab- lished by the client’s documents or their work from the previous year’s audit.
● Cognitive dissonance: Once an auditor has taken a public position by certifying the accuracy of a client’s financial statements, it becomes very difficult to process information that undermines the conclusion that the client is in sound financial shape and that its financial state- ments accurately reflect its financial condition.
● Memory limitations: As noted earlier, people are more likely to remember facts that support their beliefs than facts that undermine them. Memory of documents is extremely important to the audit process, and problems can arise from this tendency to remember selectively, especially because studies show that auditors are over- confident regarding the accuracy of their memories.
● Undue optimism and overconfidence: 83 percent of auditors, in one study, believed that they possessed above average skills. Such
overconfidence about their abilities and undue optimism about how things will turn out for themselves and their clients can cause audi- tors to cut corners and thereby create problems.
● Insensitivity to source: Studies indicate that auditors are better than most people at discounting information that comes from question- able sources, however even they tend to overweight client-provided explanations in situations where the client obviously has a strong interest at stake.
● False consensus effect: Because of the false consensus effect, honest auditors, like other people, have difficulty believing that the people they deal with are dishonest. This tendency can cause major prob- lems for an honest auditor with a crooked client.
● Anchoring and adjustment: Innumerable studies show that people’s judgments become easily anchored by irrelevant numbers. This tendency can cause obvious problems for auditors who are often anchored by the numbers provided by the client that they then must audit.
● Self-serving bias: As noted earlier, auditors and everyone else tend to gather, process, and recall information in ways that advance their own interests, even when they try to be fair. This bias is extremely robust and studies show that auditors suffer from it. For example, studies show that if there is any question as to the appropriate outcome auditors tend strongly to favor the client in order to keep the client happy and the stream of revenue coming in. Even if there is a strong conflict between the client and the auditor as to an appropri- ate treatment for a transaction, the auditor tends to defer to the client unless the client is in financial trouble and thereby presents a significant litigation risk for the client.
● Tangible vs. abstract: Not only does the time delay trap prevent people from assessing future consequences rationally, auditors also suffer from the fact that if they stand up to their client they may cause current, tangible harm to people whom they know and like, includ- ing their clients’ employees and their colleagues. The potential victims of reckless auditing, on the other hand, are nameless and faceless and may, after all, never materialize.
Put all these factors together and it is not terribly surprising that audi- tors act recklessly from time to time. As Professor Loewenstein has noted,
“if one wanted to create a business setting that would virtually guarantee unethical behavior, it would be difficult to improve on the existing case of independent auditing.”63It is Pollyanna-ish to believe that the reputational constraint is sufficient in light of these behavioral tendencies.
Similar analyses could be done of each of the other gatekeepers who dropped their respective balls during the Enron scandal. It should be clear that it is easy to rest too much reliance on securities actors’ rational incen- tive to preserve their long-term reputations as a substitute for government regulation. “[T]here are limits to reputation.”64Reputation added to legal constraints were insufficient to prevent major frauds in the 1990s. Take away the legal constraints, and things would have been much worse.