03 Oct 2007Working Paper Summaries

The Causes and Consequences of Industry Self-Policing

by Jodi L. Short and Michael W. Toffel

The corporate confession is a paradox, as described in this paper aimed at managers, policymakers, and citizens. Why would a firm that identifies regulatory compliance violations within its own operations turn itself in to regulators, rather than quietly fix the problem? Economic intuition suggests that firms will self-disclose violations only when the cost of doing so is less than the expected cost of hiding violations. However, while the cost of doing so can be increased regulatory scrutiny, there is often almost no expected cost of hiding violations. To explore the complex behavior of corporate self-disclosure, Short and Toffel conducted a large-scale analysis in the context of the U.S. Environmental Protection Agency's Audit Policy. They investigated what factors lead organizations to self-disclose violations that went undiscovered by regulators, and asked whether these self-disclosing organizations were obtaining any unofficial regulatory benefits above and beyond formal penalty mitigation. They also evaluated whether self-policing promotes the regulatory objective of improving compliance records. Key concepts include:

Government regulatory scrutiny is a leading factor that drives firms in a public-private partnership where firms self-police their own regulatory compliance and self-disclose violations.
Self-policing and self-disclosing provide mutual benefits for regulators and firms, although ongoing investment in government enforcement remains a critical success factor.

Author Abstract

Several innovative regulatory programs are encouraging firms to police their own regulatory compliance and voluntarily disclose, or "confess," the violations they find. Despite the "win-win" rhetoric surrounding these government voluntary programs, corporate confessions presents something of a behavioral paradox. Tasked with monitoring the legality of its own operations, why would firms that identify violations turn themselves in to regulators rather than quietly fix the problem? And why would regulators entrust regulated entities to monitor their own compliance and enforce the law against themselves? This paper addresses these questions by investigating the factors that lead organizations to self-disclose violations, the effects of self-policing on regulatory compliance, and the effects of self-disclosing on the behavior of regulators. We investigate these research questions in the context of the US Environmental Protection Agency's Audit Policy.