Corporations in the Dock

About the Authors:

Howard Darmstadter practiced business law in New York City from 1977 to 2008. He has numerous publications on commercial law and legal drafting, including the column "Legal-Ease" in Business Law Today from 1993 to 2003.

Over the last year, various federal and state prosecutors have gathered up enormous fines from the big banks. These contributors to the public fisc were led by Bank of America, which laid out $17 billion for selling defective mortgages, followed by JPMorgan Chase ($15 billion for dicey mortgage sales and foreclosures), BNP Paribas ($8.9 billion for money laundering), and Citigroup ($7 billion for misleading investors). Unfortunately, these settlements have mainly resulted in punishing the innocent, while letting the actual malefactors off easy.

Corporations and Individuals

So the question for today is: Can the banks truly have done any of these things? Or more generally, in what sense can a bank or other corporation do anything? After all, a corporation is simply an organizational form for doing business. It doesn’t have beliefs or desires, and it cannot act except through individuals. So when we say that a corporation “did” something – laundered money or lied to investors, for example – what we really mean is that individuals acting for the corporation did the laundering or lying. Saying that the corporation did something is merely a façon de parler: useful in many contexts, misleading in others.

The doctrine of respondeat superior makes business owners (including corporations) responsible for the tortious acts of their agents. For example, if an employee driving a truck on the owner’s business negligently injures a pedestrian, the owner will be liable for the employee’s negligence. It’s not that the employee is excused; both he and the owner are liable. But it’s usually the owner that gets sued, because that’s where the money is.

Early in the twentieth century, the concept of respondeat superior was ported over from tort to criminal law: a corporation could be criminally liable for the criminal acts of its employees. A corporation can’t go to jail of course, but it can pay a fine, lose a governmental license, or have certain business practices enjoined. At the dawn of the twenty-first century, in the wake of Enron and other gaudy scandals, the penalties for corporate crimes were greatly increased. (An article by Joan McPhee, a partner at Ropes & Gray, explains the evolution.)

Of course, when we say the corporation pays a fine, loses a license, or has its conduct curtailed, we should understand that we’re really talking about consequences for individuals. For the most part, it’s the corporation’s stockholders, not “the corporation,” who bear the costs. (Similarly, if someone forges your name on a check, it’s you and not your checking account that is the real loser.) But why should the stockholders suffer for the illegal act of a corporate employee? There are a number of explanations, not all equally plausible.

Bad Justifications

First, if the employee’s conduct benefited the corporation, as it might where a corporate customer is defrauded, it seems only fair that the corporation/stockholders return the ill-gotten gains. But this explains only a small part of what’s been going on recently, where no one bothers to reckon how much the corporation may have profited and little thought is given to paying over the fines to the victims of the employees’ acts. As Floyd Norris noted in the New York Times on July 17, 2014, in Citigroup’s recent $7 billion settlement of charges that it misled investors in mortgage-backed securities, “there seems to have been no effort to quantify just how much Citigroup’s improper behavior cost investors,” and “there is nothing in the settlement to benefit most of those affected.”

A second explanation is that the guilty employees usually don’t have the resources to fully compensate the victims. But this argument would never pass muster outside the corporate context: If your neighbor defrauds someone but can’t fully compensate his victim, should you have to pay the difference?

A better reason for making stockholders pay is that the possibility of punishment will encourage them to prevent illicit conduct. If the stockholders can be punished with heavy fines for the acts of corporate agents, they will, so the theory goes, elect responsible directors, who will in turn appoint responsible officers, who will in their turn institute measures to prevent criminal conduct, including more closely monitoring the corporation’s employees.

It’s no doubt true that corporate officers don’t like to explain to more senior officers or to directors why their operations incurred governmental wrath, not to mention heavy fines. But the problematic conduct usually would have occurred up and down the line: employees and officers engaged in illegal conduct, and more senior officers, directors, and stockholders were not sufficiently attentive. However, as one moves up the ladder from employees to officers to directors to stockholders, the ability to monitor and control the conduct of underlings, and the degree of culpability, rapidly erode. One has only to think of how frequently employees are able to defraud their employers to realize that there are limits to managerial control.

Even if one were to accept the dubious notion that stockholders can control corporate misconduct, that still doesn’t explain a case like Bank of America, where most of the illegal conduct was committed by Countrywide Mortgage and Merrill Lynch personnel before those companies were acquired by BofA. It’s standard corporate law that a surviving company is liable for the acts and obligations of an acquired company, but that makes little sense in the criminal context. Certainly, Bank of America’s stockholders could have done nothing to prevent illegal acts at Countrywide or Merrill before BofA acquired them. So why does the least culpable group, the stockholders, take nearly all the hit?

A Mutuality of Interest

One reason is that the process is controlled by prosecutors and corporate officers, and it is in their mutual interest that things work this way. One manifestation of this mutuality is that while corporate crimes must be committed by the corporate personnel, the guilty individuals usually suffer no punishment more grievous than losing their jobs. (Their legal costs are almost invariably paid by the corporation: that is, by the stockholders.)

For a prosecutor, pursuing corporate employees for criminal activities raises all sorts of problems. For one thing, it requires amassing detailed evidence as to the employees’ activities. Moreover, juries are much more likely to punish an abstract entity like a corporation than a flesh-and-blood employee, so indicting individuals can prove embarrassing. (In the 2001 Tap Pharmaceuticals case, for example, the company settled for $875 million and an onerous corporate integrity agreement, after which a jury acquitted the 13 corporate employees whose supposed crimes were the basis for the charges against the company.) And massive fines, of a size that no employee could pay, are profitable for the government and produce headlines that can make a prosecutor’s career (the Rudy Giuliani effect).

On the corporate side, no one wants to go to jail, least of all well-paid corporate directors and officers. Far better to take the question of individual guilt off the table and lumber the stockholders with the fine. (Directors and officers are usually stockholders too, but they bear only a miniscule percentage of the economic damage.) Most important, a criminal conviction – even an indictment – can be a death knell for a company. (The accounting firm Arthur Andersen collapsed after being indicted. Its subsequent conviction was posthumously overturned by a unanimous U.S. Supreme Court.) The prosecutor’s offer is not one a company can lightly refuse; better to settle for a sum that, while impressively large, does not threaten the company’s existence.

The result is that corporate criminal prosecutions have turned the Justice Department into a kind of protection racket. Since no individuals are charged (though the government is reportedly going to charge Countrywide Mortgage’s former CEO) and the corporation cannot risk an indictment, let alone a conviction, prosecutors do not have to put any facts before an independent judge and jury. Instead, the prosecutors and the corporation simply agree on a dollar settlement that will be large enough to burnish the prosecutor’s resume while permitting the corporation to survive. Nobody goes to jail.

Strict Criminal Liability?

Viewed this way, corporate criminal prosecutions resemble certain types of civil actions. In most states there is “strict liability” for death or injury caused by defective products. That is, the victim needn’t prove negligence in the design of the product, only that it was defective. Even though no one at the manufacturer was derelict in their duty, the corporation is still required to compensate the victim. The usual explanation for such a rule is that where someone is injured by a faulty product, it’s the corporation that was best placed to avoid the injury by preventing the product defect.

Whatever you may think of strict product liability, the similarities with corporate criminal prosecutions are dwarfed by the differences. Most obviously, a plaintiff in a product liability case has to prove that the product was defective, that the defect caused the injury, and the amount that will adequately compensate for the injury. In a corporate criminal prosecution, in contrast, prosecutors will not have to prove that a crime was committed or the amount of the damages because the corporation cannot risk going to court.

It’s understandable that prosecutors will want to raise money for the government and to make their careers, and that corporations will want to avoid oblivion. But what makes this situation possible is public anger over particular corporate scandals such as Enron and, more generally, over the recent recession. But anger is a poor guide to action. Anger over September 11 can lead us to blame Muslims generally, with results both silly – stopping a mosque near the World Trade Center site – and tragic – invading Iraq. In each case there is what we might call a metaphysical confusion, which leads us to punish innocent individuals who are connected in our minds with an abstract entity: Islam or the corporation. The result in the corporate context is a corporate version of lynch law where, without any determination by an independent fact-finder, innocent stockholders are hung, drawn, and quartered.

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