“Operation Codebreaker” and the Culture of Compliance

Michael W. Peregrine is a partner at McDermott Will & Emery LLP. This post is based on his McDermott Will & Emery memorandum.

The latest revelations in baseball’s sign-stealing scandal confirm more explicitly than ever its relevance to corporate governance across industry sectors, particularly the board’s critical obligation to preserve a culture of compliance within the organization.

Moreover, the new revelations serve to refocus attention on compliance and ethics at a time when organizational interest and budgetary support for these functions may be waning. The documented conduct of the Houston Astros provides a unique, if unlikely, connection between America’s pastime and corporate ethics, to which an exceptionally broad audience may relate. This is an opportunity for board compliance committees to strengthen leadership and organizational awareness of ethical expectations.

The Fiduciary Duty

Fiduciary obligations relating to the oversight of an organizational culture of compliance have long been embodied in corporate law, enforcement guidelines, governance principles and other standards. They are grounded in part by the seminal Delaware Chancery decision in in re Caremark Derivative Action and its progeny. [1] Another foundational piece is the description in the Federal Sentencing Guidelines of the elements of an “Effective Compliance Program.” This description requires boards to (i) be knowledgeable about the content and operation of the compliance and ethics program and (ii) exercise reasonable oversight with respect to the implementation and effectiveness of that program (i.e., to promote an organizational culture that encourages ethical conduct and a commitment to compliance with the law). [2]

In addition, leading statements of governance principles uniformly express the obligation of the board to both (iii) establish a “tone at the top” in support of the company’s commitment to integrity and legal compliance and (iv) exercise oversight of the company’s compliance program, remaining informed about any significant compliance and corporate responsibility issues that may arise. [3]

Similar expectations of board oversight can be found in regulatory guidelines and manuals, such as the Department of Justice Criminal Division’s guidance on evaluating corporate compliance programs. [4] Pursuant to this guidance, prosecutors are expected to evaluate whether there exists a high-level commitment by company leadership to implement a culture of compliance from the top. Specific focus is placed on whether senior leaders, through their words and actions, have encouraged or discouraged compliance, including the type of misconduct involved in a particular investigation.

The importance of board oversight in fostering a culture of compliance is underscored by the widely discussed and analyzed 2019 Delaware decisions of Marchand v. Barnhill and in re Clovis Oncology Derivative Litigation. [5]

The Astros sign-stealing scandal implicates this oversight duty in a very basic way; a comprehensive top-to-bottom effort by employees to engage in competitively driven activity they knew, or should have known, was in clear violation of established rules.

The Background

The basic elements of the sign-stealing scandal are fairly well known. In sum, after an extensive investigation, Major League Baseball (“MLB”) concluded that during the 2017 season, and for a portion of the 2018 season, the Houston Astros applied various methods to decode and transmit (some through the use of technology, often through less sophisticated means) [6] to Astros batters the sign sequences of opposing teams. [7] The Boston Red Sox have also been implicated by the investigation for a similar scheme.

The investigative report (“MLB Report”) concluded that the sign-stealing scandal was primarily player-driven. [8] Yet MLB Commissioner Rob Manfred chose to hold senior Astros executive leadership responsible, due to their “failure to adequately manage the employees under their supervision, to establish a culture in which adherence to the rules is ingrained in the fabric of the organization [emphasis added], and to stop bad behavior as soon as it occurred.” [9] Both executives were suspended from MLB for one year; they were subsequently terminated by the team.

The New Developments

On their own, the results of the investigation (the “MLB Investigation”) provide a uniquely useful corporate-compliance based teaching moment, especially for self-regulating organizations, and corporate boards which, might hold senior executives responsible for ensuring that employees understand and adhere to key rules and regulations.

But it is a series of subsequent developments that convert an interesting teaching moment into a powerful, broadly relevant message about the need for boards to focus closely on their role as overseers of their organizations’ culture of compliance.

New media reporting from The Wall Street Journal, The Athletic and MLB Network provide illuminating detail on the origins and extent of the sign-stealing scheme (alternatively referred to by Astros personnel as “the System,” “Operation Codebreaker” or “the Dark Arts”). [10] These reports create the impression of pervasive organizational disregard for basic tenets of corporate ethics and responsibility, e.g.:

  • The basics of “Operation Codebreaker” were designed by an intern, then embraced and expanded upon by coaches, players and front office personnel.
  • The intern was ultimately promoted within the front office.
  • The various suggestive names used to refer to the scheme failed to trigger any internal concern as to its underlying credibility.
  • There was a general lack of familiarity within the organization of MLB’s rules prohibiting the use of technology to decode the signs of opposing teams.
  • There was a presumption that players, coaches and senior management was aware of how “Operation Codebreaker” was to be applied in games.
  • Performance levels of many Astros players increased significantly while “Operation Codebreaker” was in use.
  • Astros personnel went to great lengths in games to conceal “Operation Codebreaker.”.
  • Despite broad organizational awareness of “Operation Codebreaker,” it is not clear that any employee at any level forcefully spoke out against its use.

Perhaps the most notable example of culture failure was the conduct of on-field leadership. The team’s bench coach and one of its most senior players were described by the MLB Investigation as active participants in use of “Operation Codebreaker.” Furthermore, the Astro’s manager was aware of the scheme, even expressed personal distaste for its use, but took no action to end it. Poignantly, Astros players reportedly said that had the manager asked them to stop pursuing “Operation Codebreaker,” they would have done so. [11]

Additional Compliance Program Pressures

The board’s evaluation of the Astros’ compliance culture failures may profitably be considered in the context of emerging concerns about stagnant or decreasing levels of corporate commitment to compliance programs, and regulatory and enforcement pressures on compliance officers in particular industries.

  • Compliance Program Data. According to a new survey, corporate investment in compliance is lessening at major companies across the globe, [12] despite increasing enforcement activity and more complex regulation. This is consistent with prior concerns that compliance programs may be viewed as lower budgetary and operational priorities by management. [13]
  • NYCBA Report. Related concerns with compliance program effectiveness are noted in the recent report from The New York City Bar Association, “Chief Compliance Officer Liability in the Financial Sector.” This detailed report identifies the unnecessary risks that financial firm compliance officers face and which serve to undermine compliance program, and compliance officer, effectiveness and related regulatory and enforcement goals. [14]

The Relevance

The coming of spring training and its promise of the regular season are viewed by millions as an icon of optimism: the gray of winter giving way to the sunshine of spring. The Astros’ sign-stealing scandal represents a violent intrusion into this pattern of domesticity and tradition, and has thus attracted the unfavorable attention of the American public. And it could get worse, with MLB’s focus now turning to allegedly similar practices by the Red Sox. Scandals like these in the sports world draw popular attention to the importance of ethics in a way perhaps no other corporate scandal could.

Board and executive leadership may wish to leverage the notoriety of the Astros’ scandal for both internal review and necessary corrective action. Could a similar situation arise within our own company? Is there something unique to baseball that caused highly competent and highly compensated professionals to fail to react to actions that, with 20/20 hindsight, appear so obviously wrong? Are our employees aware of the key laws and regulations which bind our company? What would they do if faced with similar circumstances? Are our leaders focused on “the tone at the top” and driving messages of ethics throughout the company?

This review could also logically lead to a re-evaluation of the strength of the corporate compliance program and the extent to which the code of ethics is accepted throughout the organization. Issues such as funding for compliance and ethics staffing, compliance education and monitoring, compensation for compliance officers, the company’s approach to corrective action and its alignment of compensation incentives with ethical goals are all fair game for board consideration.

Such a review process would not only be responsive to the broad compliance issues raised in Astros’ scandal, but also reflect recognition “the smartest guys in the room” can be present in any form of organization. It would also serve as a good faith effort to satisfy the board’s culture of compliance oversight responsibilities at a time when organizational compliance efforts may be lagging or stagnant. And, given recent interpretations of the Caremark standard by the Delaware courts, it may also serve to reduce the board’s liability profile.

Summary

The Houston Astros’ “Operation Codebreaker” represents an extraordinary example of how a sophisticated business organization led by accomplished executives can fail, in a spectacular manner, to maintain a framework of ethics and commitment to applicable rules. As one of the most notorious scandals in MLB history, it has attracted widespread public opinion. Boards across industry sectors may wish to use this scandal as a means of re-examining the effectiveness of their own obligations to exercise oversight of the organization’s commitment to compliance and ethics.

Endnotes

1In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 967 (Del. Ch. 1996).(go back)

2Federal Sentencing Guidelines, Chapter Eight, Section 8B2.1”Effective Compliance and Ethics Program”, https://www.ussc.gov/guidelines/2015-guidelines-manual/2015-chapter-8.(go back)

3See, e.g., The Business Roundtable Principles of Corporate Governance 2016, https://s3.amazonaws.com/ brt.org/Principles-of-Corporate-Governance-2016.pdf.(go back)

The Commonsense Principles of Corporate Governance 2.0, https://millstein.law.columbia.edu/sites/default/files/content/images/Commonsense%20Principles/CommonsensePrinciples2.0.pdf.

4U.S. Department of Justice, Criminal Division Guidance on Evaluating Corporate Compliance Programs (April 30, 2019), https://www.justice.gov/criminal-fraud/page/file/937501/download.(go back)

5In re Caremark Int’l Inc. Deriv. LMarchand v. Barnhill, 212 A.3d 805 (Del. 2019)., 212 A.3d 805 (Del. 2019); In re Clovis Oncology, Inc. Derivative Litig., C.A. No. 2017-0222-JRS (Del. Ch. Oct. 1, 2019).(go back)

6This refers to the infamous “tub thumping” practice in the dugout to alert batters.(go back)

7Jared Diamond, The Wall Street Journal, “Dark Arts” and “Codebreaker”: The Origins of the Houston Astros Cheating Scheme (February 7, 2020); https://www.wsj.com/articles/houston-astros-cheating-scheme-dark-arts-codebreaker-11581112994.(go back)

8https://img.mlbstatic.com/mlb-images/image/upload/mlb/cglrhmlrwwbkacty27l7.pdf.(go back)

9Id. The MLB Report acknowledges that the Astros General Manager (i) was unaware of the banging scheme; and (ii) “neither devised nor actively directed” certain efforts to decide signs.(go back)

10See, e.g., Jared Diamond, The Wall Street Journal, “The Astros Front Office Created Codebreaker. The Players Took it from There” (February 12, 2020), https://www.wsj.com/articles/the-astros-front-office-created-codebreaker-the-players-took-it-from-there-11581508800; Jared Diamond, The Wall Street Journal, ”The Astros Offer No Apologies for Winning Now Tarnished 2017 World Series” (February 14, 2020); https://www.wsj.com/articles/astros-offer-no-apologies-for-winningnow-tarnished-2017-world-series-11581625542; John Lott, The Athletic Daily; “Dave Hudgens knew why the Astros were banging trash cans. He let it go on. Now he says he’s sorry” (February 13, 2020); https://theathletic.com/1603582/2020/02/12/dave-hudgens-knew-why-the-astros-were-banging-trash-cans-he-let-it-go-on-now-he-says-hes-sorry/?source=dailyemail. MLB Network, MLB Network’s Exclusive Interview with A.J. Hinch, YouTube (Feb. 7, 2020), https://www.youtube.com/watch?v=uU3sK2kImKs.(go back)

11F.n. 8. Supra.(go back)

12Jack Queen, Compliance Chiefs Feeling the Squeeze Ad Budgets Stagnate, Law360 (Feb. 5, 2020, 5:26 PM, http://www.law360.com/articles/1240424.(go back)

13See.e.g., Michael W. Peregrine, “Has Compliance Had its Fifteen Years of Fame?” NYU Law School Compliance and Enforcement blog (October 10, 2016); https://wp.nyu.edu/compliance_enforcement/2016/10/19/has-compliance-had-its-fifteen-years-of-fame/.(go back)

14The Bar Association of New York City, “Chief Compliance Officer Liability in the Financial Sector (February 4, 2020); https://www.nycbar.org/member-and-career-services/committees/reports-listing/reports/detail/chief-compliance-officer-liability-in-the-financial-sector.(go back)

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