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The Collusion Deterrence Effect of Corporate Leniency Programs

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The Collusion Deterrence Effect of Corporate Leniency Programs The Collusion Deterrence Effect of Corporate Leniency Programs Jeong-Yoo Kim∗ Kyung Hee University December 8, 2015 Abstract We examine the deterrence effect of the leniency program. Depending on the rela- tive importance of type I errors and type II errors, we characterize either a separating- equilibrium in which only guilty defendants apply for leniency and a pooling equilib- rium in which guilty and innocent types of defendants both apply for leniency. The leniency program has two conflicting effects on the incentive to collude. On one hand, a discount in fines reduces the expected cost of collusion and therefore increases the collusion rate. On the other hand, it discourages firms from colluding due to its in- formational efficiency. Contrary to the widespread perceptions, the model predicts that the latter effect predominates while the former effect is degenerated, so that the leniency program unambiguously reduces the overall collusion rate. Accordingly, it is socially beneficial, as long as the wrongful conviction probability of innocent firms is very low. The underlying intuition is that the antitrust authority must maintain the expected fine to the level not lower than without the leniency program to minimize type II errors, which prevents a diminution in the deterrence effect. This implies that it is never optimal to waive all penalties for any firm to self-report. Even if there are more than two co-defendants, the general intuition that the optimal leniency program allows a discount only to one defendant and the resultant collusion rate is reduced is carried over. ∗(Mailing address) Department of Economics, Kyung Hee University, 1 Hoegidong, Dongdaenumku, Seoul 130-701, Korea, (Tel & Fax) +82-2-961-0986, Email: [email protected] 1 JEL Classification Code: L41 Key Words: leniency programs, multiple defendants, deterrence Running Head: Corporate Leniency Programs 1 Introduction The leniency program has been used as a means of law enforcement against illegal antitrust behavior starting from US followed by the EU, Germany, South Korea and Japan. According to Korean Fair Trade Commission (KFTC), the corporate leniency program played a role in investigations for 17 out of 25 uncovered and fined cartels in Korea.1 According to U.S. Justice Department (2010), in the U.S. where the program was first introduced in 1978, firms have been fined more than $5 billion for antitrust crimes since 1996, with over 90 percent of the total attributed to leniency applications. Despite its efficiency argument, there are many criticisms against the leniency program. For example, some critics argue that the leniency program is unfair because it leads to inconsistent punishment for the same illegal corporate behavior and the possibility that a corporate criminal who applies to a leniency program may not receive penalty commensurate with the crime or even receive no penalty.2 Also, the leniency program may weaken the deterrent effect because the leniency program reduces the expected cost of illegal behavior. Notwithstanding these criticisms against the leniency program, it is now one of the most effective tools in cartel investigation. Recently, many authors including Aubert, Kovacic and Rey (2006), Motta and Polo (2003), Spragnolo (2003), Feess and Walzl (2004), Motchenkova (2004) and Harrington (2008) made economic analyses of the leniency program, especially focusing on the dynamic incentives of firms and the optimal design of the leniency program. However, most of the work assumes that the antitrust authority's objective is to minimize the occurrence of il- legal activities such as price fixing collusion. This assumption is problematic, because the antitrust authority must be concerned about the judicial errors, that is, the possibilities that innocent defendants are penalized (type-I error) and that guilty defendants are acquitted (type-II error) and the antitrust authority actually does care about the possibility of judicial 1See The Korea Times (2012). 2This argument is incomplete, however, because it considers only one side|the possibility that an actually guilty firm might be acquitted with the leniency program, although the opposite possibility that an actually innocent firm who is likely to be convicted might be acquitted with the leniency program clearly exists. 2 errors.3 The leniency program appears to be quite similar to plea bargaining whereby the pros- ecutor is allowed to bargain with defendants for sentences in exchange for their promise to testify against other co-defendants. Therefore, earlier work on plea bargaining may help understand the mechanism of the leniency program through which the society can be made better off. Most of the economic analysis for plea bargaining, however, focus on the single- defendant setting. There are some exceptions such as Kobayashi (1992) and Kim (2009), which consider the situation of multiple co-defendants who are known to be connected with the same crime. However, neither of the papers addressed the dynamic effect of plea bargain- ing on crime deterrence in a multiple defendant setting. Reinganum (1993) and Miceli (1996) undertook the dynamic issue and examined how the practice of plea bargaining can influence the criminal incentive of a potential defendant, but only in a model of a single defendant. In a companion paper by Kim (2015), we considered a dynamic model of plea-bargaining of a prosecutor accusing multiple co-defendants. Thus, in the model, defendants are not ex ante known to be guilty. Guilt or innocence of defendants are endogenously determined as a result of their criminal decisions. The paper shares much intuition in common with the current paper. We will characterize all possible separating-equilibrium in which only guilty defendants apply for leniency and a pooling equilibrium in which both types of defendants (guilty and innocent) apply for leniency. In both types of equilibria, the reduced fines must be fair in the sense that the more culpable defendant receives a harsher penalty. This stands in sharp contrast to the result of Kobayashi, who demonstrated the possibility of an unfair equilibrium in which the more culpable defendant receives a less harsh penalty in a plea bargaining setting. The difference comes mainly from the equilibrium concept employed. We demonstrate that unfairness cannot happen in equilibrium as long as the spirit of Nash equilibrium is respected by implicitly requiring agents' beliefs (or predictions) to be consistent with equilibrium strategies. The clear empirical regularities in the present-day US leniency institution motivates the model in which well-reinforced beliefs support veridical matching of beliefs and objective frequency as a forcing principle leading to the equilibrium selection. In a separating equilibrium, the reduced fines must be asymmetric because it is more costly to induce a more culpable defendant to report by accepting its respective discounted 3The mission of Federal Trade Commission (FTC) is to prevent anticompetitive business practices and to accomplish this without unduly burdening legitimate business activity. (See http://www.ftc.gov/about-ftc.) This is an evidence that the antitrust authority is concerned about minimizing the occurrence of judicial errors as well, not just minimizing illegal corporate activities nor maximizing the number of convictions. 3 fine and thus only a less culpable defendant is offered a discount. In a pooling equilib- rium, both defendants are offered discounts. Intuitively, higher pooling fines increase the probability of a type-I error and decrease the probability of a type-II error. The optimal pooling equilibrium is determined by the reduction in fines that balance these two effects (i.e., equating the marginal benefit from reducing type-II error with the marginal cost of increased rates of type-I errors for each defendant). The choice between a separating equi- librium and a pooling equilibrium depends on the relative importance of type-I and type-II errors. If type-I errors are relatively important, then the discounted fines must be charac- terizable as the antitrust authority's decisions that convey the larger aggregate rewards that are offered and accepted by both types, which leads to the pooling equilibrium. In contrast, the separating equilibrium is selected whenever type-II errors are relatively important. It is worthwhile to compare our result with that of Kobayashi (1992). Kobayashi considers a complete-information game of plea bargaining with two co-defendants. His setup assumes that it is well-known that the defendants are guilty. Therefore, the prosecutor's objective is specified as maximizing the sum of the expected penalties (or, equivalently, minimizing the sum of expected discounts or aggregate rewards offered in plea-bargain discounts rela- tive to otherwise expected punishment). Kobayashi obtains the counterintuitive result that a more culpable defendant may receive a more lenient penalty, which is intuitively unfair. Such unfair outcomes may occur, for example, when a more culpable defendant (Defendant 1) believes that less culpable Defendant 2 is unlikely to accept his respective offer, while Defendant 2 believes that Defendant 1 is highly likely to accept his respective offer. In this case, Defendant 1 is more likely to reject the offer of the antitrust authority than Defendant 2. Thus, the authority is forced to make a more attractive offer to Defendant 1 to induce him to self-report by accepting its respective offer, implying that the fine offered to Defendant 1 can|in theory|be lower than the fine offered to Defendant 2 (who is less culpable) in equilibrium. This unsettling possibility of the less culpable defendant receiving a more se- vere penalty follows from Kobayashi's assumption that each defendant's belief regarding the other's acceptance decision is exogenously given. However, if the beliefs are required to sat- isfy the consistency condition so as to be consistent with defendants' equilibrium strategies, then Kobayashi's unfair plea bargains cannot occur in equilibrium. Another difference between Kobayashi's model and ours is the meaning of \more culpa- ble." In our model, we define one defendant as being more culpable if he deserves a larger penalty than the other.
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