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Companies may find it more profitable to misbehave and suffer penalties rather than follow the rules.

In November 2018, a wildfire tore across Butte County in Northern California. The inferno engulfed homes, leveled the town of Paradise, and killed 85 people. Investigators discovered that aging and poorly maintained transmission lines operated by Pacific Gas & Electric had sparked the fire, the most destructive in California history.

A person facing more than 80 counts of involuntary manslaughter could be sentenced to as many as 90 years in prison. But the law treats corporations differently, since they cannot go to prison and financial penalties may fall on innocent people. When PG&E pleaded guilty to causing the deaths, it agreed to pay the maximum penalty—a total of $3.4 million, less than $42,000 for each life lost. No company executives or employees were charged in connection with the fire.

This is one of several examples in a that explores how the rules governing corporate misconduct can fall short of their objectives and even encourage worse behavior.

Written by Stanford Graduate School of Business finance professors Anat Admati and Paul Pfleiderer and Nathan Atkinson, Ph.D., an assistant professor of law at the University of Wisconsin, Madison, the paper examines how companies may find it more profitable to misbehave and suffer penalties rather than follow the rules. Using economic modeling and drawing from real-world examples, the authors argue that when law enforcement is weak, focusing on maximizing shareholder value can be harmful.

"It's all about incentives," Admati says. Yet shaping those incentives to deter corporate malfeasance is a tricky endeavor. "Reasonable-sounding changes in policies can actually lead to bad results," Atkinson says.

The failure of fines

In traditional business theory, maximizing shareholder value is a cornerstone of good corporate governance. Yet as the authors point out, this priority may conflict with broader social good and may lead to people being harmed. "Economists often assume any economic activity that passes the market test is beneficial for society and don't seriously consider the possibility that corporations can find it profitable to cause harm," Admati says.

To explore how enforcement policies may not deter corporate misconduct, the researchers created a model to explore how profit-maximizing corporations would adjust internal incentives in response to fines and sanctions for breaking the law. Not surprisingly, they found that when fines are set at a low level, they are treated as another cost of doing business.

"There are many reasons why the fines are set too low," Atkinson says. If a company is a point of national pride—think Boeing in the U.S. or Volkswagen in Germany—governments may be loath to punish them too heavily. Policymakers also may worry that steeper penalties will force corporations to lay off workers or go out of business. And corporations spend significant amounts to lobby lawmakers and fund candidates in hopes of weakening regulations.

Why not simply raise the fines?

"We definitely favor having large enough fines that serve as serious deterrents," Atkinson says. But in their model, the researchers show that bigger fines aren't strong enough incentives. Sometimes, companies use managerial incentives like stock-based compensation to reduce or completely undo the effects of the increased fines. "They can ramp up the incentives for managers in ways that offset higher fines so that shareholder value is maximized," Pfleiderer says.

Companies also use insurance policies to shield their executives and directors from the negative financial consequences of their actions. After the 2018 fire, PG&E settled a civil suit brought against its executives and board members for $117 million, which was entirely covered by the company's insurers. Bankruptcy can also be used to limit the consequences of misconduct. As its legal troubles grew, PG&E declared Chapter 11 bankruptcy, limiting its liabilities and preserving shareholder value. Under this process, many fire victims did not receive enough money to rebuild their homes.

What penalties work?

Could detecting corporate misconduct early—perhaps by giving corporations lower fines if they report bad behavior—be a solution?

"On one level, this strategy sounds reasonable," Admati says. "Yet our results give reasons to be highly skeptical."

The researchers found that when governments try to incentivize early disclosure by promising lower fines, they can make it more profitable for corporate managers to misbehave, increasing the harm done.

"We show that in some situations, voluntary programs based on discounted fines do not improve things at all," Pfleiderer says. "And in a subset of those, they actually make things worse."

Although an incentive program with discounted fines might shorten the overall time a corporation misbehaves, lowering the fine makes misconduct more profitable and increases the intensity of misconduct before its detection. Crucially, since these programs are voluntary, profit-maximizing corporations will report misbehavior only if doing so benefits shareholders.

As an example of where incentives to self-report can backfire, Pfleiderer mentions tax fraud.

"Imagine a world where one could write a letter to the IRS and say, 'I cheated on my taxes. I didn't pay all the money that I was supposed to, but I am a good person and produced things of value to society.'" If the IRS let you off with a fine smaller than what you owed in taxes, it is clear that tax fraud would increase even if more cases were detected.

The researchers did not set out to identify the optimal way to deter corporate misconduct, but their analysis suggests areas for improvement. Moving forward, they suggest more research into ways to encourage a corporation's employees to report misconduct, such as increased protections for whistleblowers. Research could also examine possible limits on corporations' use of debt and bankruptcy to reduce their liability for misconduct.

Since individual decision makers often drive misconduct, the authors stress the importance of identifying managers who should be held accountable and establishing meaningful consequences (such as prison time) for breaking the law.

Above all, Admati, Pfleiderer, and Atkinson want economists and lawmakers to take a closer look at how the financial incentives of corporations and their managers can conflict with their responsibilities to society. Admati says that when profit maximization is the overriding goal, we can't rely on corporations and their shareholders to refrain from causing significant harm.

"Corporations have an enormous impact on our lives," she says. "Society needs to govern corporations through well-designed and effectively enforced rules."