6. Enforcement
6.1 Concerns Identified by the Law Commission
32. The Law Commission identifies enforcement action designed to promote compliance with the rules necessary for the orderly operation and good governance of markets as a public good. It notes that "The public enforcement function can be performed either by creating an incentive for a debtor to act in a particular way, or by applying sanctions for irresponsible commercial behaviour or dishonest conduct. This public function is independent of the recovery of money for the benefit of creditors" (para 140).
33. The Law Commission states that "The most constant criticism leveled against State involvement in the insolvency process by members of the commercial country (sic) with whom we consulted informally, was the perceived lack of enforcement action by regulatory authorities to act as a deterrent to irresponsible or undesirable commercial behaviour" (para 139).
6.2 Relationship between Penalties, Enforcement and Economic Efficiency
34. The modern economics literature on the optimal level of enforcement is summarized in Becker (1968), Garoupa (1997) and Polinsky and Shavell (1998a and 1998b). To consider the optimal level of enforcement in respect of insolvency proceedings, we begin by defining damage, penalties, enforcement and deterrence:
- Damage or harm is measured as the loss in economic efficiency resulting from a specified action in a defined market;
- Penalties are costs imposed on those whose crimes are detected and prosecuted;
- Enforcement is the probability that an individual who has committed a crime will be detected and prosecuted; and
- Deterrence is the use of penalties and enforcement to influence behaviour so as to maximise social welfare.
35. If a party is certain to be found guilty each time that they breach the Companies Act, then the proper magnitude of the penalty is the harm that the party has caused. If penalties equal the harm caused, then parties will have socially correct incentives to avoid actions that may breach the Companies Act and to consider the frequency with which they undertake activities that may risk breaching the Commerce Act thus reducing the likelihood that their firm will become insolvent.
36. Penalties provide incentives for compliance with the law. The stronger the incentives for compliance, the fewer resources will need to be allocated to monitoring compliance with the law. Penalties should be set at a level that will ensure that potential perpetrators of an offence will take into account the damage to the market that they may cause when they consider taking actions that may be illegal. Penalties set in this way will result in individuals internalising the potential damage of possible illegal acts.
37. If there is some positive probability that any given breach of the Companies Act will go undetected, then for any individual who is risk-neutral, penalties set at the level of the harm will not provide the efficient level of avoidance by firms. To correct for this problem, the penalty should be set so that it is equal to the harm multiplied by the reciprocal of the probability of detection. Thus, where h = harm and p = the probability of detection, the penalty should be
This implies that the higher the probability of detection, the closer to the value of the harm that the party has caused will be the efficient penalty.
38. Where individuals are risk-averse, the combination of enforcement and penalties need not be set at levels that provide an expected penalty equivalent to the level of harm: a smaller expected penalty may provide the optimal level of deterrence.
39. Where damage can vary as a result of factors that are beyond the control of the perpetrator (for example, macroeconomic shocks may influence the likelihood that any action will result in insolvency) a distinction between actual and potential damage may be drawn. Actual damage must always be no greater than potential damage. Potential damage is the relevant quantity for penalties, because even if actual damage is relatively small, the behaviour that induced this damage may have carried with it the potential for much greater damage. It is the greater damage that the penalty system seeks to see potential perpetrators impound into their decision-making. Where there are no factors bearing on the damage to the market that are outside the control of the perpetrator, then the expected penalty should be based on the actual level of the damage to the market.
40. When the level of detection or investment in enforcement can be varied, high sanctions may be optimal, for this allows a relatively low level of investment in enforcement to be employed, saving on enforcement costs. For risk-neutral individuals, the optimal fine is theoretically speaking the limit of their personal wealth. If individuals have no personal wealth (are bankrupt) then long prison sentences may allow savings in enforcement costs, though here the costs of incarceration have to be weighed against the benefits from deterrence that are obtained.
41. The probability of detection of a breach of the Companies Act or the Securities Act is high because all creditors who face losses have an incentive to make available information that might identify illegal acts, and both the liquidation and reorganization have, as costless by-products, the production of information about the past actions of officers of the company that are relevant to its attaining an insolvent position.
6.3 Enforcement Decisions of a Public Enforcement Agency
42. A key feature of the crimes referred to here is that the alleged perpetrator is known: the object of investigation is the evidence to support a criminal conviction and the preventative value of obtaining a conviction in that case. The key question then is, does the Insolvency and Trustee Service have the incentives to make the correct decisions about the resources employed in enforcement vs the resources employed in insolvency management? This means considering both the precedent value of enforcement (since enforcement now will result in less criminal activity in the future) and the balance between expenditure on enforcement and expenditure on insolvency management.
43. While it is possible to argue that it should be for Parliament to assess the appropriate level of enforcement by allocating a specific appropriation for this purpose, the alternative view (and the one on which we would place most weight) is that the decision is best made by an agency that is close to the market and has the opportunity to consider the best use of resources available to support enforcement and a range of other aspects of the Insolvency and Trustee Service. This assumes that in aggregate the agency is funded at an appropriate level: if it is not (as many people in the commercial community appear to believe) then the allocation may be optimal given the available resources but enforcement will be below the optimal level. There may in addition be scope for improving the focus that the Service places on these issues through the performance objectives of the senior staff in the Service and the annual budget round, and through greater transparency in reporting on expenditure on enforcement and the priorities driving that expenditure.
44. At any point in time a public enforcement agency with a limited budget (unrelated to the number of convictions or the fines obtained) will face a large number of cases in which they could bring prosecutions to the court. The cost that the agency bears is the resource cost of investigation and litigation and the potential negative publicity should they lose. The latter is particularly important in the case of public enforcement, since the use of the power of the state to bring charges against people who are subsequently found innocent generates very negative publicity. Against these costs the enforcement agency will weigh the probability of obtaining a conviction and the value of any conviction obtained as a precedent and in making credible the threat of punishment for those who might consider similar breaches of the law in the future. Notice in particular that the combination of their budget constraint, and the potential negative publicity flowing from charges brought that are not upheld by the court, means that the public enforcement agency will choose to litigate only those cases with the highest benefit to cost ratio, primarily those with high probabilities of obtaining a conviction and high precedent/deterrence value. This is because each case that they lose may bring considerably scrutiny on whether the resources invested in prosecuting the case were invested wisely.
45. Consequently, the agency may choose not to litigate cases where the probability of conviction is low and the precedent value is low, even though that case may be widely discussed by the public and media. Alternatively, the agency may choose to litigate cases where the precedent value and/or the probability of a conviction are high, even though these cases may appear trivial to the public and the media. In both cases there is likely to be public criticism of the enforcement agency, but this does not mean that the actions of the enforcement agency are inefficient (Posner 1992: 603).
46. Finally, we note that the Law Commission does not provide any explicit consideration of private enforcement as a complement or supplement to public enforcement. Given the important role for private enforcement in other areas of commercial law such as the Commerce Act, it would be helpful if the Law Commission could indicate precisely where private enforcement is ineffective in respect of breaches of insolvency law.
6.4 Summary on Enforcement
47. To summarise the views expressed in this section:
- The economics literature on enforcement suggests that increasing the penalties is an alternative to increasing expenditure on enforcement but the Law Commission provides no indication that it has considered this alternative approach to the enforcement problems that it has identified.
- Efficient enforcement action by a public agency with a budget constraint will fall short of prosecuting every case on which a conviction is possible. Adverse publicity associated with state agency prosecution of parties subsequently found to be innocent and the budget constraint will lead them to focus on litigating cases with a high probability of conviction and/or with high precedent/deterrence value.
- Enforcement decisions by a public agency may be efficient even though they do not conform to the expectations of the media, parties who have suffered harm, or other parties not fully informed about the facts of the case and the budget constraints faced by the agency.
- Convictions of bankrupts for breaches of insolvency law in New Zealand are very high by international standards. With the responsibility for director disqualification now assigned to the Insolvency and Trustee Service, prosecution of these cases is now underway again.
- The issues identified by the Law Commission do not provide compelling evidence that enforcement is currently below the optimal level, and do not justify any change in the current enforcement regime.
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