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Employee Indemnification

By Harvard Law School Program on Corporate Governance

(Editor’s Note: This post comes from Wallace P. Mullin of George Washington University and Christopher M. Snyder of Dartmouth College.)

In Should Firms be Allowed to Indemnify Their Employees for Sanctions? which was recently published by the Journal of Law, Economics, and Organization, we analyze the widespread practice of employee indemnification using a three player model, where there is a principal and agent, as well as a governmental player that sets and enforces sanctions. In our model, the government authority can always deter crime with a sufficiently high combination of fines on the firm and employee. The challenge is to deter crime at minimum social cost. We show that deterrence can typically be obtained at minimum social cost by sanctioning the firm alone. This maintains deterrence without exposing the agent to risk from sanctions or inducing the exit of productive, law-abiding firms.

Sanctioning the agent is valuable in limited circumstances. If deterrence is especially difficult, it may be optimal to hit the agent with a sanction large enough to bankrupt him. Although the de jure sanctions cannot vary with actual guilt?imperfect enforcement prevents this?bankrupting the agent allows the de facto agent sanction to vary with his wealth. The agent needs to be paid a premium to induce him to commit a crime, and so the agent of the criminal firm ends up having more wealth to be seized than the agent of a law-abiding firm. Indemnification need not be explicitly banned for this strategy to work: the agent’s sanction can be set so high that the firm would not choose to indemnify the agent even if allowed by law.

Indeed, if sanctions are set appropriately, the government’s policy toward indemnification becomes moot. Either the agent should not be sanctioned at all, in which case there is nothing for the firm to indemnify, or the agent should be sanctioned so harshly that the firm chooses not to indemnify the agent even if it could. The government’s policy toward indemnification is not moot in an extension of the corporate-crime model in which the agent’s cooperation can help convict a criminal firm. The authority can offer to reduce the employee’s fine in return for his cooperation; an offer the firm can unravel by pledging to indemnify him fully.

The broad lesson to be drawn from the analysis is that authorities should be wary of sanctioning employees let alone banning their indemnification. Typically, firm sanctions deter crime more efficiently than unindemnifiable employee sanctions. Readers can find a link that provides free access to the full paper at Professor Snyder’s homepage here.

Full post as published by The Harvard Law School Corporate Governance Blog on March 03, 2009 (boomark / email).