Rethinking Corporate Prosecutions

John C. Coffee, Jr. is Adolf A. Berle Professor of Law and Director of the Center on Corporate Governance at Columbia University Law School. This post is based on his recent book, Corporate Crime and Punishment: The Crisis of Underenforcement.

Today, a familiar pattern plays out over and over in corporate prosecutions. A U.S. Attorney’s Office begins an investigation and quickly finds its scope will overwhelm their logistical capacity. For example, it may be a Foreign Corrupt Practices case that spans six countries and three continents, has thousands of documents, millions of emails, and at least 50 persons (speaking eight languages) who need to be questioned at length. The U.S. Attorney can assign three AUSAs to this case and hopefully find some FBI agents and maybe an SEC staffer or two to work on it. That is a mismatch.

As a result, almost inevitably in the case of larger corporations with decentralized structures, the U.S. Attorney will agree to the defendant hiring an independent law firm to conduct a detailed investigation and prepare a lengthy and costly report (which can cost up to a $100 million). The implicit deal is that the prosecutors will approve a deferred prosecution agreement that spares the company a criminal conviction (and thus the risk of collateral civil liability in follow-on actions). As a result, much of the investigatory work traditionally conducted by prosecutors has now been outsourced—delegated to private counsel hired by the defendants. Critics have claimed that this de facto system reflects political cowardice or agency capture of the enforcers. They may be sometimes correct, but the bigger problem is logistics. In the Lehman investigation, where the company was bankrupt and could not pay for an expensive investigation, neither the SEC nor the U.S. Attorney did much of anything. The final Lehman CFO was not even interviewed. Eventually, the bankruptcy court retained Jenner & Block to serve as an examiner, and it diligently prepared a thorough report, which took 130 of its attorneys, 14 months, and resulted in a $53.5 million fee to that firm. Even if one suspects that that fee was slightly padded (as bankruptcy examiner fees tend to be), that is several orders of magnitude above what a federal agency can afford.

Worse yet, the investigations conducted for the corporation by their retained counsel rarely identify corporate officials above a fairly junior level. This is not to claim that counsel are covering up “smoking guns.” The counsel involved are highly professional, but they need not pursue every ambiguous clue that leads up towards the executive suite (particularly not after the Trump Justice Department recently relaxed the rules). Put simply, independent investigations are the hottest growth area in “big law” practice, and successful counsel do not want to acquire a reputation for being suspicious of their client. In this field, excessive zeal is not a virtue.

So what should be done? One possibility is to have the prosecution pick the law firm (or at least approve its choice). But once the government “controls” the investigation, the Fifth Amendment becomes applicable and the corporation can no longer command it employees to “talk or walk.” Another possibility that I spell out in my recent book, Corporate Crime and Punishment: The Crisis of Underenforcement (2020), is to deliberately structure a “Prisoner’s Dilemma” so that both the corporation and its employees are strongly incentivized to turn the other in. In no event, however, should the mere preparation of an internal investigation entitle the corporation to a deferred prosecution agreement.

What threat could cause corporations to agree to turn in senior executives? Clearly, current penalties are not sufficient. In some event studies that we conducted for my book, the stock prices of corporations sentenced to record fines actually went up on the day of sentencing (even though these record fines could not have been easily predicted). This does not prove that corporations cannot be deterred, but only that cash fines on huge public corporations can be easily digested. Yet, heavy penalties can cause externalities that fall on the least culpable: low-level employees who might be laid off, creditors whose debt securities will decline in value, and local communities who depend upon the local industry to provide its tax revenues. We need therefore to focus the necessary penalty on the shareholders—who alone can take action to reform their firm and who are probably for the most part well diversified.

How can one do this? My proposal is the “equity fine”: a fine levied not in cash but in common shares. This fine would transfer some percentage of the corporation’s authorized, but unissued, stock to a victim compensation fund. Forcing the company to issue 10% to 20% of its stock is certainly severe enough to deter shareholders through dilution, but it has no real impact on low-level employees, creditors, or other stakeholders. Nor does it render the corporation less solvent or threaten bankruptcy (as cash fines do). Of course, it would require legislation that would be bitterly resisted by the business community. Over the years, much thought has been given to the issue of corporate criminal liability, but almost none to the issue of what is the optimal corporate criminal sanction.

Defense counsel will respond that, in calling for such a reform, I am assuming that senior executives are guilty, when they may be only ignorant (and at most negligent). That is indeed possible, and often likely, but this is probably the larger problem, as it implies that the corporation has inadequate internal controls. This too can be corrected—at sentencing. One measure that I propose is the use of corporate probation to impose incapacitative and preventive restraints. For example, if Lehman had not gone bankrupt and had instead been convicted of securities fraud, it should have been not only fined, but also placed under probationary restraints that would have sharply curtailed its ability to pay incentive compensation or award stock options for the period of its probation. Put bluntly, incentive compensation can be criminogenic by creating perverse incentives for employees to risk defying the law.

Equally important, such a restriction would have dramatic deterrent impact on the corporation’s employees, who are not deterred much (if at all) by a large monetary fine on their corporation, which is borne instead by shareholders. If threatened with the loss of incentive compensation, fellow employees not directly involved in the crime might resist, dissuade, and ultimately report up the ladder (or even “blow the whistle” on) misbehaving fellow employees. Today, the incentives for employees not directly involved in the crime are to remain quiet bystanders—saying nothing and doing nothing.

These proposals can be debated at length, but the system we have today is simply not working.

The book is available for purchase here.

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One Comment

  1. Dave Bell
    Posted Wednesday, January 6, 2021 at 3:32 pm | Permalink

    It is an interesting concept and worthy of some consideration. I think you’ll need to think further through the second and third order consequences. For example, the employees are not prisoners — they can leave for other employment. The corporation will need to offer them competitive compensation to retain talent or lose them to competitors. If there is no incentive compensation, that means higher salaries (to make up for the probability weighted difference), that will have meaningful consequences for results, and may lead to the departure of top talent (those most likely to outperform will look for the greater upside elsewhere). Similarly, what would the transfer of ownership look like, how would it impact voting? Wouldn’t the shares largely go back to the stockholders in a round trip (having been deprived of honest services and reporting)? Would the shares somehow go to competitors that lost business? Would the treasure vote them in the meantime?

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