Do We Need the Corporate Self-Evaluative Privilege?

Abstract

This article critically examines the common justification for the corporate self-evaluative privilege (SEP) that such privilege protection is essential in order to avoid chilling corporate self-policing. We develop a formal game theoretic model to study the strategic interaction between a regulator and a firm considering a self-audit. We show that the protection accorded by the self-evaluative privilege removes the disincentive for self-auditing but does not create any positive incentive for self-auditing. In contrast, a legal regime that grants regulatory access to a firm's internal audit materials creates a positive incentive for firms to engage in self-policing and results in a higher self-auditing rate compared to an inspection regime (i.e., no regulatory access, thereby permitting inspections only). In addition, any disincentive to the firm to engage in self-policing can be minimized by limiting the admissibility of audit materials in third-party legal proceedings. Finally, mitigating possible penalties for firms engaging in good faith compliance auditing, can further encourage self-policing. Thus, as an alternative to the corporate SEP, we envision a combination of measures that maximizes the extent and probability of corporate self-policing comprising: (a) permitting regulatory access to self-audits; (b) limiting the admissibility of audit materials in third-party proceedings against the firm; and (c) providing mitigated penalties for firms engaging in good faith self-policing. These measures capture the societal benefits of increased corporate self-policing in terms of early detection and remedy of violations while minimizing the fear of collateral liability arising from one's self-evaluation efforts.