Corporate Criminal Liability and Firm Value

Corporate criminal liability is one of the most hotly contested areas of corporate governance. Enterprise-level liability can incentivize firms to detect and punish wrongdoers, a task they may be better equipped to perform than the government. On the other hand, some commentators argue that criminal liability should be imposed on individual lawbreaking executives rather than at the firm level. However, these debates elide a more fundamental question: how do we know that corporate criminal law matters at all? The formal doctrine of entity-level criminal law may bear little resemblance to the real-world prosecution of firms. Moreover, jurisdictions usually evolve concepts such as corporate criminal law slowly over time, rendering causal empirical claims tenuous.

In a new paper, forthcoming in the Journal of Law, Economics, and Organization, I argue that corporate criminal doctrine has an economically significant effect on firm value. This effect is influenced by the identity of the firm’s controlling shareholder and the level of monitoring to which the controller is subject. I exploit a landmark 2010 Indian Supreme Court decision establishing that corporate mens rea—i.e., a criminally culpable state of mind—exists if a person or group of people controlling that firm are shown to have criminal intent themselves. I hypothesize that this decision increased the prospect of corporate criminal liability for firms controlled by individuals and families. These companies had a clearly identifiable set of human controllers whose criminal intent could be ascribed to the firm after the Supreme Court’s decision.

I find that these firms experienced negative and statistically as well as economically significant abnormal stock returns around the Supreme Court’s decision. Firms controlled by individuals and families suffered a 0.72–0.86 lower cumulative abnormal return in the five days after Iridium was announced. The increase in possible corporate criminal liability through the development of mens rea doctrine destroyed value at affected companies. Corporate criminal law doctrine can thus affect firm value even in judicial systems with imperfect criminal law enforcement. India’s legal system is mired in corruption and delays, so the effect of corporate mens rea doctrine on firm value is noteworthy.

Further confirming the value-destroying implications of individual and family control in the wake of the Supreme Court’s decision, I find that the negative stock returns are concentrated in companies that are both controlled by individuals or families and also belong to Indian business groups. Business group companies controlled by individuals and families experienced a negative cumulative abnormal return of more than a percentage point in the five days after Iridium. Many Indian companies belong to business groups, whose constituent firms in different industries are linked through cross-ownership by common controllers. These common controllers are often founding families, whose influence on corporate governance at group companies extends beyond ownership and whose reputation is even more intermingled with their controlled companies than majority owners at non-group firms. The results being stronger for these companies, where individual controllers are more synonymous with the company, reinforces the link between controller identity and firm value in evaluating the effects of imputed corporate mens rea.

Having established that the identity of the controller, and the extent to which she is entrenched, influence criminal liability’s impact on firm value, I turn to the possible moderating influence of two types of actors who could theoretically monitor the controller. First, I examine the role of foreign institutional investors. Foreign institutional investors play an important monitoring role in portfolio companies in emerging economies, adhering to global best-practices in corporate governance and being relatively independent of management at portfolio companies. Therefore, firms with higher foreign institutional ownership may be less adversely affected by the expansion of criminal liability, because these equityholders were already monitoring management to prevent misconduct.

Consistent with this notion, I find that greater foreign institutional ownership is associated with lower value destruction caused by the Supreme Court decision at companies controlled by individuals or families. This corrective effect of foreign institutional ownership is greatest for companies that are both controlled by individuals or families and also members of business groups, consistent with foreign institutional investors playing a monitoring role where the controller’s ability to promote her self-interest is greatest.

Consumers can also theoretically monitor lawbreaking by controllers, because they often demand that corporations behave in prosocial ways. However, unlike foreign institutional investors, the nature of consumer monitoring is more reactive. Research on consumers prosociality shows that they punish firms for highly visible incidents of antisocial behavior after such misconduct has been publicly revealed, by choosing not to purchase goods and services from offending companies. Unlike foreign institutional investors, consumers do not have ownership stakes or governance expertise to monitor controllers or reduce their likelihood of misconduct in advance of prosecution. Instead of being ex-ante monitors, consumers are more likely to increase firms’ ex-post costs from being criminally liable.

The results for consumer interaction are the mirror image of those for foreign institutional ownership: firms controlled by individuals or families suffer a larger loss in value if they are in consumer-facing industries, and this decline is even larger if they also belong to a business group. This is consistent with consumers not being adequate ex-ante monitors of controller misconduct that harms them and other stakeholders, but is consistent with the ex-post costs of criminal liability being greater for firms with more consumer interaction, because consumers are likely to punish corporate lawbreaking after it is publicized.

I find that the post-decision value destruction at firms with human controllers is smaller for firms that are in corruption-prone industries, which are less vulnerable to enforcement actions because they are more likely to be politically connected. In subsample analysis, I also find suggestive evidence that the negative abnormal returns for individual-controlled companies were stronger for companies headquartered in states with tighter kinship networks, defined as the share of households belonging to joint families exceeding the median for all Indian states and territories. Markets may assess controller misconduct as more problematic for firms where controlling families are more likely to function as a cohesive and tightly-knit group whose mental state can be imputed to the firm.

Turning to longer-term effects of the decision, I find that firms controlled by individuals or families increased their spending on lawyers in the years immediately after the decision, by about ten percent relative to other companies. Pretrend analysis shows that these companies only increased their legal spending immediately after the decision. Although considerable data limitations preclude more direct evidence of the Supreme Court’s ruling having a long-term impact, this finding is consistent with the decision increasing criminal exposure for firms with individual or family controllers.

The empirical analysis has implications for our understanding of corporate criminal liability. It suggests that doctrinal changes in corporate criminal law have concrete effects on firm value, even in systems with imperfect criminal enforcement, judicial delay, and biased enforcement. The results also suggest that foreign institutional investors can play a monitoring role in reducing the ex-ante probability of controller misconduct, while consumers increase the ex-post punishment costs associated with corporate criminal liability. Finally, the concentration of the stock price reaction in firms controlled by individuals and families rather than other controllers shows that the identity of the controlling shareholder matters when evaluating the effect of corporate criminal law doctrine.