THE UNIVERSITY OF QUEENSLAND
LEGAL RESEARCH SERIES
THE CHALLENGE OF CORPORATE LAW ENFORCEMENT IN AUSTRALIA
* BA/LLB (Hons), LLM (Queensland), TC Beirne School of Law, The University of Queensland
The introduction on 24 July 2009 of the long-awaited amendments to the Trade Practices Act 1974 (Cth) criminalising serious cartel conduct focuses attention on the important role of the criminal justice system to deal with cases of serious wrongdoing. In 1993, major reforms were made to the law relating to enforcement of the statutory duties of company officers by the introduction of the civil penalty regime found in Pt 9.4B of the Corporations Act 2001 (Cth). These reforms arose from recommendations of the Senate Standing Committee on Legal and Constitutional Affairs (the ‘Cooney Committee’) and implemented what has become known as “strategic regulation theory”. This theory provides insights on how regulatory compliance can be achieved most effectively, contending that sanctions in the enforcement pyramid should escalate as contraventions of the law become more serious and that criminal liability should apply only for continued non-compliance or for serious breaches of the law. By following this approach, the hope was that ASIC could more effectively cope with corporate misconduct. This article discusses strategic regulation theory to explore, firstly, its capacity to guide ASIC to fulfil its regulatory obligations, and, secondly, the desirability of that approach. It argues that it is not pyramidal enforcement that is inadequate, but ASIC’s perceived failure to use criminal sanctions in cases of serious corporate misconduct, and contends that this threatens to undermine its reputation as an effective regulator.
The Australian Securities and Investments Commission (ASIC), as “Australia’s corporate, markets and financial services regulator”,1 plays a key role in maintaining the integrity of the market and the wellbeing of the Australian economy. It is therefore of utmost importance that ASIC operates under an appropriate regulatory scheme and exercises its powers properly.
Traditionally Australian corporate law has been enforced by the criminal law. ASIC, like its forerunner, the National Companies and Securities Commission (NCSC), however, had problems in enforcing the directors’ duty provisions,2 because of the difficulties associated with the use of the criminal law, including the need to satisfy the criminal rules of evidence and higher standard of proof,3 with the result that these provisions were not seen as providing an effective enforcement regime.4
The system underwent a transformation when government accepted the major recommendations of the Cooney Committee5 report, which considered the vital issue of sanctions for directors and sought to construct a pyramid of enforcement mechanisms for the regulation of company officers by proposed reforms to the prevailing sanctions for contravention.6 These recommendations were that criminal liability apply only where conduct is ‘genuinely criminal in nature’,7 that is, where company directors had acted ‘fraudulently’ or ‘dishonestly’,8 and that civil penalties be provided for breaches by directors where no criminality is involved.9
Strategic regulation theory, graphically represented by the pyramidal enforcement model,10 underpinned fundamental reforms made in Australia in 1993 to the regime of sanctions for enforcement of the statutory duties of corporate officers11 when the civil penalty regime, currently contained in Pt 9.4B of the Corporations Act 2001 (Cth), was introduced.12 This was aimed at reducing the role of the criminal law so that criminal sanctions applied only to the most serious contraventions.13 The majority of cases attracted civil penalty sanctions.14 By adopting the current civil penalty approach, it was hoped that ASIC could more effectively regulate corporate misconduct.
This article will examine strategic regulation theory and pyramidal enforcement for the purposes of discussing not only the ability of strategic regulation theory to shape ASIC’s regulatory design and practice but, also the desirability of such an approach in ASIC’s quest for better regulation. In relation to the latter issue, notwithstanding that the pyramidal enforcement model provided the foundation for the introduction of the civil penalty regime and the enforcement pyramid supporting it,15 this article argues that it is not pyramidal enforcement but ASIC’s implementation of it that is the problem. Although ASIC has been committed to following strategic regulation theory and pyramidal enforcement since 1993, unless it is viewed as consistent in both its application and in taking enforcement action at appropriate levels in the pyramid, it is in danger of not being regarded as a credible regulator. This is especially the case if the perception is that, ASIC does not flex its muscles sufficiently often to use serious sanctions, that is, criminal sanctions, in cases of serious corporate wrongdoing, particularly against high profile violators.16 Criminal sanctions are not a potent deterrent to potential corporate wrongdoers,17 unless they recognize that the regulator will do more than threaten their use.
Strategic regulation theory and the pyramidal enforcement model
Strategic regulation theory is an economic theory of regulation, which recognizes that it is not possible for any regulatory agency to detect and enforce every contravention of the law it administers and which provides a macro perspective on the role of enforcement sanctions in achieving regulatory compliance.18 It advocates that regulatory compliance can be secured most effectively by persuasion, rather than legal enforcement, since legal proceedings are expensive, whereas cooperation between the regulator and the regulated is cheap.19
The core strategic concept of a pyramid of enforcement was developed by Braithwaite who argued, in To Punish or Persuade,20 that compliance is most likely when a regulatory agency displays an explicit enforcement pyramid. The pyramid model requires the regulator to be armed with a wide range of sanctions that escalate in severity from education and persuasion at the base, through various other stages to criminal sanctions and incapacitation at the apex of the pyramid for continued non-compliance or serious breaches of the law.21 The regulator should move from one level to the next, beginning at the lowest level in most cases.
Significantly, Ayres and Braithwaite, who coined the phrase ‘responsive regulation’ in 199222 and elaborated on the pyramidal enforcement model, argue that regulatory agencies are often best able to secure compliance when they are “benign big guns”.23 Regulators will be able to speak softly when it is known that they carry big sticks. The tougher and more various the sanctions, the greater the success regulators are likely to achieve by proceeding softly. The more those sanctions can be kept in the background, the more regulation can be transacted through moral suasion, the more effective regulation will be.24
Ayres and Braithwaite believe that the regulatory agencies most effective in achieving their objectives are those that strike some sort of balance between the ‘deterrence’ and ‘compliance’ models of regulation.25
The fundamental question has thus become: “When to punish; when to persuade?”26
The Game Theorist’s Answer
Pyramidal enforcement proceeds from the “game theory” of regulation, which posits that regulatory compliance is a dynamic game of negotiation and interaction between the regulator and the persons regulated.27 It presumes that those regulated are rational, single actors who decide whether to comply with regulation by an assessment of the costs and benefits resulting from compliance at a particular time.28 Accordingly, effective regulation requires more than just issuing commands in the expectation that there will be penalties for those who fail to comply.
Employing the approach of game theory regulation developed by Scholz,29 Ayres and Braithwaite30 explain the crucial role of mutual cooperation and the contingent role of deterrent punishment in cases of defection from that mutual cooperation:
Scholz models regulation as a prisoner’s dilemma game wherein the motivation of the firm is to minimize regulatory costs and the motivation of the regulator is to maximize compliance outcomes. He shows that a TFT [tit-for-tat] enforcement strategy will most likely establish mutually beneficial cooperation, under assumptions he believes will be met in many regulatory contexts. TFT means that the regulator refrains from a deterrent response as long as the firm is cooperating; but when the firm yields to the temptation to exploit the cooperative posture of the regulator and cheats on compliance, then the regulator shifts from a cooperative to a deterrent response. Confronted with the matrix of payoffs typical in the enforcement dilemma, the optimal strategy is for both the firm and the regulator to cooperate until the other defects from cooperation. Then the rational player should retaliate (the state to deterrence regulation; the firm to a law evasion strategy). If and only if the retaliation secures a return to cooperation by the other player, then the retaliator should be forgiving, restoring the benefits of mutual cooperation in place of the lower payoffs of mutual defection.31
TFT Regulation and Motivational Diversity in Business
The TFT policy prescription expounded by Scholz for regulators to try cooperation first is not premised on the assumption that business people are cooperative in nature. Rather, it proceeds on the basis that the payoffs in the regulation game make cooperation a rational choice until the other players defect from cooperation and that the motivational account of the firm is of a unitary actor concerned only with maximizing profit.32
In Responsive Regulation, however, relying on the data collected from empirical work undertaken by Braithwaite on corporate offending,33 Ayres and Braithwaite contend that a strong case for TFT enforcement - “regulation that is contingently provokable and forgiving” - can be made from the wide range of motivational accounts of business conduct disclosed by these studies.34 The studies reveal motivations, such as reputation, social responsibility and making money, as well as demonstrating that business actors often have plural or mixed motivations, and, in some cases, unvirtuous, economically irrational or undesirable motivations. The robust nature of TFT regulation is thus highlighted justifying it as a general strategy.35 Further, since sound public policy must speak to the diverse motivations of the regulated public, it is argued that TFT regulation which is consistent with these motivations may work well in not merely constraining non-compliance of purely economic actors, but also in fostering the inculcation of trust and civic virtue.36
Braithwaite’s research with Fisse in The Impact of Publicity on Corporate Offenders, demonstrates that both corporations and individual executives are concerned about reputational interests and not just money.37 The ramifications of this initial empirical questioning of the pure economic rationality model of business conduct do not appear very dramatic. If business actors are deterred not only by economic but also reputational losses, then adverse publicity sanctions should be available to deal with regulatory offenders, which are precisely the policy solutions put forward by Fisse and Braithwaite.38 Thus, TFT can operate properly with adverse publicity providing a punishment payoff.39
Importantly, research has found that the effectiveness or threat of a sanction is affected by the size, power and culture of the organization.40 Negative publicity, for instance, seems to be the most effective sanction as far as large corporations are concerned.41 This point is well illustrated by what transpired in the James Hardie controversy. When the James Hardie Group restructured in 2001, the liability-ridden subsidiaries42 were cut adrift from the parent company and the group43 and a special purpose fund, known as the Medical Research and Compensation Foundation (MRCF) was established to manage the payment of asbestos related claims against the subsidiaries.44 Later, when it became apparent that the MRCF would not have sufficient funds to pay all likely future claimants, James Hardie was adamant that it had taken all proper steps in establishing the Foundation and that further substantial funds beyond the initial funding of around $293 million would not be made available to the Foundation. Without the adverse publicity and public outcry surrounding its corporate reconstruction and clear under-funding of the Foundation, which led, in February 2004, to the New South Wales government setting up a Special Commission of Inquiry, and the negative findings of that Inquiry,45 along with the involvement of the Australian Trade Union movement in the matter, it is doubtful that the James Hardie Group would have taken the necessary steps to ensure that asbestos victims would be adequately compensated. This only occurred on 7 February 2007,46 when the shareholders of the parent Dutch company, JHINV,47 voted to accept, a plan whereby the group would provide $4 billion over the next 40 years to fund claims against the former subsidiaries.48 The enormous amount of adverse press, no doubt, also, put political pressure on ASIC to take enforcement action against James Hardie and a number of its former directors and officers.49
Ayres and Braithwaite, point out, however, that other data suggest that there is a need to examine carefully the limitations of the rational choice model of business conduct.50 Research has found that:
Corporate actors are not just value maximizers - of profits or of reputation. They are also often concerned to do what is right, to be faithful to their identity as a law abiding citizen, and to sustain a self-concept of social responsibility.51
Yet, research also, found that the rhetoric about putting social responsibility before profits was often not matched by responsible action52
Ayres and Braithwaite explain that it was such findings which led Braithwaite to argue, in To Punish or Persuade,53 that a sound regulatory enforcement policy could not be developed without an appreciation that sometimes business actors were powerfully motivated by making money and sometimes they were powerfully motivated by a sense of social responsibility.54 Braithwaite thus rejected a regulatory strategy based solely on persuasion and one based solely on punishment. He concluded that:
business actors exploit a strategy of persuasion and self-regulation when they are motivated by economic rationality. But a strategy based mostly on punishment will undermine the good will of actors when they are motivated by a sense of responsibility…When actors see themselves as pursuing a higher calling, to treat them as driven by what they see as baser motivation insults them, demotivates them.55
Ayres and Braithwaite go on to explain that the danger of a punitive approach which projects negative expectations of the regulated actor is that it undermines self-regulation,56 a fact which they emphasize is not unique to business regulatory encounters.57 They also emphasize that it is not confined to individual behaviour, with Bardach and Kagan’s work identifying that one of the difficulties of a largely punitive approach is that it engenders an organized business subculture of resistance to regulation where that subculture allows for the sharing of knowledge about methods of legal resistance and counterattack.58
However, rejecting “punitive regulation is naïve; to be totally committed to it is to lead a charge of the Light Brigade. The trick of successful regulation is to establish a synergy between punishment and persuasion”.59 As Ayres and Braithwaite argue:
Strategic punishment underwrites regulatory persuasion as something that ought to be attended to. Persuasion legitimates punishment as reasonable, fair, and even something that might elicit remorse or repentance.60
Further, they explain how wading in with punishment as a strategy of first choice is counterproductive in a number of ways.61 In the first place, punishment is expensive, persuasion is cheap. If persuasion is attempted first and is successful, increased resources are available to expand regulatory coverage. Second, punitive enforcement results in a game of regulatory cat-and-mouse where firms seek to defy the spirit of the law by exploiting loopholes, and the state continues to make more and more specific rules to close the loopholes. The result can be:
rule making by accretion that gives no coherence to the rules as a package; and
a barren legalism concentrating on specific, simple visible violations to the neglect of underlying systemic problems.62
Third, reliance must be placed on persuasion rather than punishment in industries where technological and environmental factors change so fast that regulations cannot keep abreast of those changes.63
Ayres and Braithwaite go on to explain that, in view of these problems of punitive enforcement and since large numbers of corporate actors in a variety of contexts seek to fit the model of the ‘responsible’ citizen,64 persuasion is preferable to punishment as the strategy of first choice.65 To adopt punishment as a strategy of first choice is unworkable, unaffordable and counterproductive, as it undermines the goodwill and motivation of those committed to compliance.66
Accordingly, by a very different approach from the economic rationality calculus in the work of Scholz,67 Ayres and Braithwaite point out that TFT is the best strategy:
TFT is the best strategy for Scholz because, in maximizing the difference between the punishment payoff and the cooperation payoff, it makes cooperation the most economically rational response. TFT is the best strategy in To Punish or Persuade because it holds the best hope of nurturing the non-economic motivations of firms to be responsible and law abiding... By cooperating with firms until they cheat, regulators avert the counter productivity of undermining the good faith of socially responsible actors. By getting tough with cheaters, actors are made to suffer when they are motivated by money alone; they are given reason to favour their socially responsible, law-abiding selves over their venal selves. In short, they are given reason to reform, more so because when they do reform they find the regulator forgiving. When they put reforms in place, they find that the forgiving regulator treats them as if their socially responsible self was always their ‘real’ self. For Scholz, forgiveness for firms planning to cooperate in the future is part of maximizing the difference between the cooperation and punishment payoffs. In To Punish or Persuade, forgiveness is advocated for its importance in building a commitment to comply in the future.68
By fostering expectations of responsibility and cooperation, “the regulator can coax and caress fidelity to the spirit of the law even in contexts where the law is riddled with gaps or loopholes,” so that in this way TFT also resolves the loophole-opening contradiction of punitive regulation.69
Ayres and Braithwaite therefore conclude, importantly, that analyses of what makes compliance rational and what builds business cultures of social responsibility converge on the point that “compliance is optimized by regulation that is contingently ferocious and forgiving”.70
‘Single-round regulatory encounters’
Ayres and Braithwaite, however, identify that TFT regulation is unlikely to work with the determinedly profit maximizing actor in a regulatory context where the regulator and the actor are in “a single-round regulatory encounter”.71 While acknowledging that Handler may be right to recognize that “continuity of relation is probably the norm in the modern state”,72 Ayres and Braithwaite also recognize that there are areas where regulatory encounters are not continuous but are one-off episodes.73 Indeed, this article argues that many of the serious corporate contraventions are one-off episodes that need to be dealt with separately by prosecuting only the most serious cases and, in less serious cases, either seeking court-ordered remedies and civil penalties or reaching a settlement where the defendant agrees to provide a remedy or otherwise be subject to a sanction. Interestingly, this accords with the ideas of Baldwin and Black in Really Responsive Regulation,74 who argue that there are cases where it may not be appropriate to adopt a stepwise progression up the enforcement pyramid. They believe that “where potentially catastrophic risks are being controlled it may not be feasible to enforce by escalating up the layers of the pyramid and the appropriate reaction may be immediate resort to the higher levels”.75
Punishment and Motivational Diversity
The central aspect of TFT regulation which is clearly evident from the foregoing is that it does not assume a particular motivational set on the part of the actors whose cooperation is sought. Under a well-designed pyramid of enforcement, the same motivational neutrality is reflected by the criminal sanctions to which the enforcement process can be escalated if necessary.76 For corporations and individuals this means the regulator having recourse to a wide range of sanctions, so that non-financial burdens, such as community service orders and adverse publicity sanctions,77 can be imposed as well as fines or civil penalties.
Ayres and Braithwaite make the point, that punishment should not be regarded in one-dimensional or static terms, as simply a deterrent measure, but as something which can be structured so as to encourage cooperation.78 They advance the idea of ‘super-punishment’,79 as a means of motivating a recalcitrant party to become cooperative:
First, super-punishments increase the height of the regulatory pyramid. Furthermore, the threat of the super ‘stick and stick’ punishment preserves scarce regulatory resources by channeling violators to ‘stick and carrot’ punishments (where violators cooperate in implementing self-sanctions). Also, by increasing the credibility of regulatory responsiveness it more effectively channels industry behaviour to more cooperative paths to regulatory compliance. With effective super-punishments, agencies can more credibly deter noncompliance because they can more convincingly say ‘if you violate it is going to be cheap for us to hurt you (because you are going to help us hurt you).’ The notion of escalating super-punishments even further broadens the notion that pyramids can engender cooperation – because super-punishment theory shows that, even within the most punitive portions of the enforcement pyramid, eliciting firm cooperation can enhance the channeling effects of responsive regulation.80
Pyramids of enforcement and their design
The strategy of pyramidal enforcement postulates a hierarchy of regulatory responses. As we have seen, this pyramid has at its base the use of less punitive, less costly and less intrusive compliance measures, such as persuasion; as one rises to the apex, these methods become increasingly punitive, costly and intrusive. Under this model, the regulator ascends the pyramid through more severe and complex mechanisms, such as warning letters to civil penalties, leading to more costly and stigmatising actions, such as the use of criminal sanctions and to licence suspension and ultimately to licence revocation and imprisonment.81 There are various examples of enforcement pyramids found in the literature on corporate enforcement. Figure 1 below is one example set out in Responsive Regulation.