Companies Dislike Uncertainty, Now We Know Why

A combination of vague legal standards and targeted enforcement up the cost of compliance, says Alex Raskolnikov.

Two years ago, the accounting firm Grant Thornton asked business leaders in 35 countries whether they would accept higher taxes in exchange for greater guidance from authorities on how to comply with an international framework that discourages use of corporate tax havens. Three-quarters of the executives surveyed answered yes, up from 53 percent a year earlier.

The appetite for certainty makes sense to Alex Raskolnikov, the Wilbur H. Friedman Professor of Tax Law and co-chair of the Charles E. Gerber Transactional Studies Center at Columbia Law School, who studies uncertainty in legal systems and the lessons it holds for policymakers worldwide.

Companies frequently say that vagueness in laws such as the Foreign Corrupt Practices Act, or in rules like those adopted by the Internal Revenue Service, make compliance difficult. Vast enforcement discretion and a tendency of regulators to pursue the most egregious violators—what Raskolnikov terms “targeted enforcement”—add to the challenge for even compliance-minded firms.

“Our analysis suggests a strong reason for policymakers to concentrate reform efforts on making the substantive law less uncertain and its enforcement less error-prone, and highlights the value of a fairly fine-grained investigation of real-life regulatory regimes,” Raskolnikov writes with Scott Baker, a professor of law at Washington University in St. Louis, in a forthcoming issue of the Journal of Legal Studies.

To illustrate, the authors cite uncertainty in U.S. securities laws, which make it unlawful to defraud someone by means of a “material” misstatement or omission. It falls to regulators and courts to define what constitutes a material, or important, misstatement.

As Raskolnikov observes, regulators that target their enforcement are more likely to pursue a company that overstates earnings by 30 percent compared with one that misstates earnings by 10 percent, if for no other reason than it may be easier to prosecute the more egregious violation.

Combine targeted enforcement with an imprecise legal standard, and the more likely any given violation will be flagrant, raising the chance of a sanction, says Raskolnikov. The more bright-line the rule, the less potential for variation in enforcement and the better off companies will be.

Though the law is full of vague standards, most models of uncertainty overlook the interplay between uncertainty and enforcement, a dynamic that boosts costs and wreaks havoc on efforts to comply. “Once you add that insight you get the result that people could not get before,” Raskolnikov says.

Some forms of uncertainty have no bearing on compliance. A variation in resources a regulator devotes to enforcement or in the rate of inspections have nothing to do with how companies comply.

In contrast, if a regulator requires companies to obtain approval before engaging in conduct—such as asking the IRS to issue a private-letter ruling, or requesting a no-action letter from the U.S. Securities and Exchange Commission—vague legal standards benefit companies rather than harm them.

Policy payoffs

The findings can guide policymakers as they grapple with the design of rules. According to the authors, the analysis explains reluctance by the SEC to replace relatively clear Generally Accepted Accounting Principles with relatively vague International Financial Reporting Standards. The analysis also supports efforts by the U.S. Court of Appeals for the Federal Circuit to make the patent law more rule-like.

Still, uncertainty endures. The IRS has hesitated to clarify corporate tax rules and tends to resist giving guidance about enforcement, notes Raskolnikov. Companies routinely encounter uncertainty in statutes that create corporate criminal liability, as well.

Given the costs the unknown carries, “lawmakers should be interested in the effects that various types of uncertainty have on the well-being of the regulated subjects,” say the authors.

Further reading

Harmful, Harmless, and Beneficial Uncertainty in Law

Probabilistic Compliance


Posted on July 24, 2017