Why aren't corporate executives held more accountable for a company's failures? Executive contracts have to be written with sticks as well as carrots, according to a new article by Boyd Law school graduate Elias P. George, '11.
The article, "Using Game Theory and Contractarianism to Reform Corporate Governance: Why Shareholders Should Seek Disincentive Schemes in Executive Compensation Plans," was published in the May 2012 installment of the Golden Gate University Law Review.
The article focuses on why relying heavily on incentives without providing sufficient deterrents has not been a successful approach to preventing corporate directors and officers from harming their companies.
George said that his economics background is what steered him toward writing this paper. "Seeing the collapse in the market, I was curious to find out what Congress, the courts, or the private sector could implement to make corporate managers more accountable [to shareholders]," George said.
He added that his economics background emphasizes the neoclassical school of thought - that the private sector is best able to align incentives to create a more efficient market.
"The problem is that the current judicial scheme has misaligned this structure, tilting the scale in favor of corporate managers and effectively incentivizing them to steal money and opportunities from the companies they lead," he said.
In discussing possible solutions to this problem, George said: "What's interesting is that so often we focus closely on properly structuring incentives between corporate managers and shareholders, but we don't often think about disincentives."
By disincentives, George means that the public and private sectors have not established effective mechanisms for punishing managers who steal money or opportunities from shareholders.
Seeing this problem, George's research looked at how the private contract market could address this problem.
"What I'm asking is this: What can we do to force corporate managers to have some skin in the game? What I propose is creating a disincentive scheme by punishing managers and titling the scale back in favor of shareholders. This can be done by including a provision in executive compensation contracts that requires managers to pay, as damages, the amount of money stolen divided by the probability of them being caught."
This solution effectively requires executives to pay damages proportionate to the severity of their illicit activities.
George said that he got this idea while working as an investment advisor from 2006-09, but he wasn't able to properly articulate his idea until he took business law courses while at the Boyd School of Law.
He said that the judicial system limits what corporate managers must pay if they steal money; the law requires that they only pay back any ill-gotten gains (i.e., disgorgement).
"The courts have effectively capped shareholder recovery; and that's really powerful because if we as shareholders demand more accountability and stronger markets, we can't allow managers to abuse their role as fiduciaries without proportionate consequences," he said.
"The specific provision works this way: If you steal $100, and it's discovered that the probability you were going to get caught equaled 100 percent, you'd pay $100 as damages. But if you steal $100, establish an offshore bank account, file false tax returns, create sham entities, and take additional steps to conceal your illicit activity, this is evidence I can use to show that you've significantly reduced your probability of being caught."
George went on to say, "So if I can prove that, through your efforts, you have effectively reduced your chances of being caught to 50 percent, you pay me twice what you stole. In other words, with this specific provision corporate managers police themselves."
The article has already gained some attention. Within two months of its publication it made the Top 10 downloaded list for the Social Science Research Network's Game Theory & Bargaining Theory list for all newly announced papers.
Currently, George is working as an associate at Gordon Silver in Las Vegas. His practice focuses on intellectual property and litigation. He said the best advice that he could give to law students and recent graduates is to continue researching, writing, and becoming a student of your craft.
