The Effectiveness Of Fines In Preserving Competition Finance Essay - Free Essay Example

Competition is a public good and society does not expect the victims of anticompetitive conduct to protect themselves. Authorities remain on the forefront in enforcing rules and regulations prohibiting actions that restrain or are likely to restrain competition (Baker 2006). The Financial Service Authority (FSA) requires firms and their management to have systems and controls in place to ensure they submit accurate and timely data and/or information.   The FSA uses this information to: detect and investigate suspected market abuse, insider trading and market manipulation; identify market wide risks and have a comprehensive understanding of the activities of each firm. In September 2010, FSA fined the London-based firm Goldman Sachs International (GSI) a total of  £17.5 million for breaching trust. The fine relates to GSIs failure to ensure that it had in place adequate systems and controls to enable it to comply with its UK regulatory reporting obligations. Th e FSA investigation found that GSI defective systems and controls compromise the level and quality of its communications with the FSA. GSI co-operation with FSA and agreeing to settle at an early stage qualified it for a 30% discount. Without the discount the fine would have been  £25 million. (FSA Press Release GSI Case) Also in April 2010, the FSA fined three firms a total of  £4.2m for failing to provide accurate and timely transaction reports to the FSA. The three firms were Credit Suisse ( £1.75m fine), Getco Europe Limited ( £1.4m) and Instinet Europe Limited ( £1.05m).   Credit Suisse is a bank, Getco is a market maker trading on electronic markets, and Instinet is an agency broker. The firms cooperated fully with the FSA in the course of the investigations and agreed to settle at an early stage thereby each firm qualified for a 30% discount. Without the discounts the total fines would have amounted to a  £6m (FSA Press Release Case 2). The cases focu s on sharing of valuable transactions information. Emphasis is not only on transparency but also quality and timeliness of the information. These define crucial features of market structure that influence competition and potentially anti-competitive actions in markets. According to the efficient market hypothesis, it is assumed that in efficient markets, price reflects all available information. Holding firms accountable for enhancement of transparency is desirable for industry competition as it suppresses actions that restrain or are likely to restrain competition. The actions include collusion, parallel pricing, predatory pricing, limit pricing, harmful mergers, abuse of dominant position, and arrangements intended to monopolize. Besanko et al (2010) observe that when transactions are public, deviations from competition rules are easier to detect than when they are covert. It is also important to note that industry competition is not only price competition, but also involves qu ality competition. Product quality affects consumer decisions and firms strategies. If consumers are uninformed, this may result in the adverse selection and lemons problems in the market. Other key highlights from the cases are (a) the problem of incomplete contract- though GSI knew that one of its UK traders was under United States Securities and Exchange Commission (SEC) investigation for allegedly defrauding investors, FSA was not aware. And as a result of asymmetric information, that staff approved by FSA in November 2008 to trade. (b) the importance of international cooperation in enforcement of completion rules, had the SEC and FSA been sharing vital information on matters of mutual interest FSA would have not approved the said trader; and (c) the need of an effective compliance monitoring system firms even established ones like GSI cannot be relied on to comply. Fines, unlike damages which are meant to penalize the violations, are meant for deterrence purposes. Wils ( 2005) argues that the imposition of fines can contribute in three ways to the prevention of competition rules violations: through deterrent effects, through moral effects, and by raising the cost of violations. But the vital question is, are these fines large enough for deterrence purposes? Are they proportionate to the crimes? Considering the GSI fine, as Prately commented, it was a trifling sum by the banks standards; nobody at Goldman Sachs went hungry as a result of the  £17.5m fine. However, the public revelation of such defective corporate controls hurts more. Langus and Motta (2007) present empirical evidence that news of such penalties decreases the firms market value due to noise on stock market prices as stock markets react to the news (firms share prices are often very responsive even to minor events). The key issue in these fines is setting fines that are large enough to discourage prospective violators. How large is optimal is a question that needs further resea rch and debate. However, it is important that optimal fines be the minimum fines necessary to discourage violations. In addition Mottaa (2007) emphasizes that possible economic costs associated with large fines such as leading the firm to close or downsize its operations; leading a firm to dispose off its assets; reducing the financial asset available to the firm, which in turn may decrease its ability to borrow from financial markets and a possibility to pursue profitable investments should be considered in setting up fines. Wils (2005) points out that fines which exceed the firms ability to pay would lead to bankruptcy. A successful strategy that deters violations is one which penalizes the violators and effectively discourages the prospective violations (the firm must perceive that its expected net gain from violations is lower than its expected cost). Wils (2005) argues that because of overconfidence bias, prospective offenders are likely to overestimate the gain and underest imate the probability of detection and punishment. Therefore, a necessary condition for deterrence to work is that the expected fine, discounted for the probability of detection and punishment, should exceed the gain which the offender expected to obtain from the violation. Connor (2002) observes that though fines have a deterrent effect on violations, they are not sufficient to effectively preserve competition. Other additional ways need to be incorporated including: Introduction of criminal penalties for the executives found guilty of violations (Motta 2007). This provides a very strong deterrent as the risk averse managers would find it very risky to engage in anticompetitive actions. This will also address the principal-agency problem. The managers (agents) may engage in violations which may not be the objectives of the firm owners. But since it is the shareholders (principals) that eventually pay the fine, the managers may not care. It also explains why the (i) senior staff at GSI did not pass information about the staff in the centre of the case on to the UK authorities despite knowing that the said staff had been accused of serious breaches of U.S. laws; (ii) Despite repeated reminders from the FSA during the course of 2007 and 2008, none of the 3 firms in the second case carried out regular reviews of its data to prevent the breaches. Promotion of the private actions for damages: add damages recognized to consumers to the fines firms have to pay, thereby increasing deterrence for instance, the USA case involving vitamins conspirators, who to date have made direct payments amounting to more than $1 billion to victimized buyers (Baker 2006). Additional ways include the use of leniency programs to increase the probability that violators will be uncovered (Leniency programs may lead to prosecutions of violators that may otherwise have remained secret and possibly in operation). Also introduction of administrative fines and director disqualificatio n for managers to align personal incentives with firms decisions. And promoting (forcing where necessary) the diffusion of competition compliance programmes and the code of conduct in firms. The main criticism of the fines in the literature is that they force firms into bankruptcy and that they are eventually paid by the consumer through higher prices for further research. These need further research before conclusion is done about them. In conclusion, fines are important and necessary in deterrence of violations of competition rules, even though, they alone are not sufficient in promotion of competition in the industry concerned. Successful preservation of competition calls for inclusion of other ways in addition to fines. The setting up of fines also should take into consideration of the magnitude of the offence, economic implications and nature of firm. I agree with Baker (2006) that the possibility to impose high fines is limited by inability to pay, by the social and econ omic costs of high fines, and by requirements of proportional justice. To avoid a deterioration of the market structure as a result of the imposition of fines, where high fines are imposed and where there is a significant difference in the ability to pay of the various offenders, the amount of the fines imposed on the different firms should be differentiated so as to reflect their respective ability to pay. (1,486 words)