NEW YORK – Most people are familiar with the much-quoted statistic that not a single high-ranking executive at a Wall Street firm went to prison following the 2008 financial meltdown. But things were not always that way. Just a few years earlier, the CEOs of Enron, WorldCom, and a number of other public corporations went to prison for lengthy terms following an earlier stock-market bubble. Hundreds of executives were similarly jailed during the savings and loan collapse of the 1980s.1
More recently, however, senior corporate executives at opioid makers, and at major companies including Boeing, Pacific Gas and Electric, and Goldman Sachs, have escaped prosecution, despite the severe injuries their firms have inflicted on many. What explains this sudden transition from an earlier time when criminal law was used against executives? In a recently published book, Corporate Crime and Punishment: The Crisis of Underenforcement, I seek to unravel this puzzle.
Others have preceded me, offering fairly simple explanations. In his 2018 book, The Chickenshit Club: Why the Justice Department Fails to Prosecute Executives, Jesse Eisinger of ProPublica argues that prosecutors lacked the courage to take on tough cases. He could be right regarding some cases, but this is a weak general explanation. In fact, prosecutors have every incentive to bring criminal cases against high-profile executives and politicians; it is the quickest way for a prosecutor to make a reputation and advance his or her career.
In 2016, Brandon Garrett, a law professor now at Duke University, published an excellent scholarly study, Too Big to Jail: How Prosecutors Compromise with Corporations, that attributes the absence of individual criminal cases to prosecutors’ acceptance of “deferred prosecution agreements” (DPAs). Under these and other bloodless sanctions, the corporation receives a probation-like disposition and often pays a substantial fine, but (along with its executives) ultimately escapes conviction.
Garrett is quite right, but this pattern may be more a symptom of the problem than a causal explanation of it. Put differently, if he is correct that prosecutors let corporations (and their executives) off too lightly with probation-like sanctions, the implications of his assessment go beyond his criticism of DPAs and raise a deeper question: Should we have corporate criminal liability at all?
After all, once a serious corporate investigation begins, the high-ranking executives who oversee the corporation’s response to it know that they face some risk of being charged (even if they are not initially a target), because lower-ranking executives may cut a deal and testify against them (honestly or dishonestly) to save their own hides. Thus, these top executives face a choice between risking personal liability or offering to plead the corporation liable and pay a large corporate fine. Put another way, their choice is between bearing personal liability or simply passing the costs on to the corporation (and thus its shareholders). Unsurprisingly, senior executives tend to go for the second option.
But why do prosecutors accept this dubious compromise, which generates little real deterrence? Doing so may give prosecutors an immediate symbolic victory, which may enhance their agency’s prestige and even lead to higher budgetary appropriations. It also spares them immense effort and costs, allowing them to undertake other cases. And it may protect them from the risk of a loss, which increases as prosecutors try to convict higher-ranking officials who are organizationally remote from the locus of the crime (and may only have indirect and limited knowledge of the facts).
If these answers are plausible, they imply not only that DPAs (and similar dispositions) are generally undesirable, but also that corporate criminality itself may be a dubious invention that shields individuals from prosecution.
Historically, corporate criminal liability is a uniquely American invention, dating back at the federal level to the early twentieth century. In contrast, England has recognized corporate criminal liability to a much lesser degree and only in cases where senior management is directly involved in planning and supervising a crime. Civil law countries generally have not recognized corporate criminal liability at all.
What was the rationale for US lawmakers to make the corporation liable for any criminal act performed by an employee or agent who is seeking to benefit that corporate entity? Two different justifications stand out. First, if the corporation will be liable for the acts of its employees or agents, it has a stronger incentive to monitor them and prevent criminal conduct. After all, prevention is better than deterrence.
Second, often it is impossible to identify the actual agents who committed the crime (or these persons will be beyond the law’s reach, because they have fled the jurisdiction, died, or disappeared). In these cases, the corporation is the second-best cost bearer. Second-best is certainly better than nothing, and it offers a target that can be required to compensate victims.
But there is a difficult and uncertain trade-off here. When we hold the corporation liable, on the rationale that it should be the cost bearer of last resort, we are also making it possible for senior executives to seek immunity from liability by pleading the corporation guilty (and passing the costs on to shareholders). Conversely, if we were to abolish corporate criminal liability, the corporation would have much less incentive to monitor its own employees (and might even subtly encourage those legal violations that were in its interest). Finally, the corporation is far better positioned than the state to investigate and detect misconduct by its employees.
The optimal policy, then, is to maintain corporate criminal liability, but preclude bargains by which senior executives escape responsibility and leave the corporation to take the rap. How do we chart and implement such a strategy?
THE COSTS OF DOING BUSINESS
In my book, I begin by assessing how well fines and sanctions imposed on corporations actually work. The short answer is that little evidence suggests that corporations are well deterred today. To evaluate current levels of corporate deterrence, my research assistants and I devised several event studies. In one, we constructed a sample of the 25 largest fines (both civil and criminal) imposed on public corporations that traded on US exchanges and then looked at the stock-price reaction to the fine, both on the date it was initially announced and over a slightly longer event window. We found statistically significant positive abnormal returns over both periods.
We also looked to another, more recent, data sample of large fines between 2009 and 2016. Again, we observed the same outcome: positive abnormal stock-market returns. Very briefly, here are some examples: Bank of America paid a total fine of $11.8 billion in 2012, and its stock price rose 8% on a cumulative aggregate return (CAR) basis over an eight-day event window; JPMorgan Chase paid $13 billion in 2015, and its stock held steady; Citigroup paid $7 billion in 2014, and its stock rose 7% on a CAR basis.
What does this mean? As always, interpretations of the data can be debated, but the most plausible one is that the market implicitly declared: “Good! Their problems are now over, and they can get back to business.” But if penalties are supposed to deter, one would want to see more evidence that shareholders were adversely affected. Yes, some may argue that the market had already anticipated and discounted these penalties; but that is unlikely when the penalties were record-breaking, and thus not predictable.
Equally important, at least 70% of US shareholders today consist of widely diversified and often indexed institutional investors who hold enormous portfolios and can weather the pain of their share of a few fines easily. Nor do these penalties fall heavily on corporate managers. Thus, faced with a similar choice in the future, corporate managers, who clearly do risk being ousted if they do not maximize shareholder value, may again choose illegality over disappointing profits.
So, what reforms are justified? The pattern just described involves a sharp conflict between the interests of shareholders and managers; indeed, it is the same conflict that exists in a standard self-dealing transaction in which the manager may profit at the expense of his shareholders. Thus, meaningful reform requires that the decision about how to plea bargain with prosecutors be taken away from the managers (who are conflicted even if they are not the immediate targets of the investigation, because lower-level executives may later implicate them) and given to the board of directors. The directors (and probably their audit committee as their agent) should retain independent counsel and negotiate with the prosecutors, maintaining only minimal contact with senior management.
THE BANDWIDTH PROBLEM
But this by itself will not make a major difference. The key problem is that prosecutors lack sufficient resources to investigate crime within a large, decentralized corporation. They may be able to convict some low-level corporals and sergeants, but even if these employees “flip” and a few junior lieutenants are also convicted, senior executives tend to remain very remote from the operational details. Only an extremely expensive and time-consuming investigation could uncover their indirect involvement.
The investigation of Lehman Brothers following its 2008 bankruptcy illustrates this problem. The US Attorney for the Southern District of New York assigned only minimal staff to the investigation, and ultimately found nothing. The Securities and Exchange Commission did not even interview the firm’s last chief financial officer. But, in part because Lehman was a record bankruptcy, the court appointed a bankruptcy examiner, picking Jenner & Block, an excellent Chicago law firm. Jenner & Block investigated diligently and found considerable evidence of fraud. In particular, it reported that some transactions (including a recurring accounting gimmick known as “the Repo 105 transaction”) seemed designed to hide Lehman’s limited liquidity (in probable violation of federal securities laws).
Still, it took 130 Jenner & Block attorneys more than 14 months to reach this conclusion. For its very persuasive final report, the firm was paid $53.5 million by the bankruptcy court. Neither the SEC nor the US Attorney could pay such a price, nor could they allocate even 10% of the same manpower that Jenner & Block used. In his reporting, Eisinger was able to identify only one Assistant US Attorney who was regularly assigned to focus on the Lehman investigation (and even she did not work on it full-time). The implication is that while prosecutorial cowardice or political protection may explain the failure to prosecute some executives (as Eisinger concludes), the greater challenge is the sheer logistical mismatch. Whereas the US Attorney cannot assign 130 attorneys or spend $53.5 million to investigate a single case, a defense counsel can do that and more if the defendant is willing to pay.
Thus, what typically happens nowadays is that the prosecution will require, as a condition of a DPA, that the defendant corporation hire an independent outside law firm to conduct a detailed study of the events surrounding the alleged criminal behavior and any involvement of managerial personnel. Such a report may take a year or more and cost anywhere from $5 million to $100 million (and sometimes even more). In fact, these independent investigations are currently the hottest growth area in “big law” legal practice. Firms can throw dozens of associates into a global investigation, hire accountants and other experts, produce a 2,000-page report, and bill a king’s ransom. But almost never do these reports implicate senior management.
This shortfall may reflect the fact that senior management was not involved (which is certainly true in many cases), but it also may mean that the law firm did not really try to pursue every clue that pointed upward to the executive suite. The lawyers conducting these investigations are extremely professional, and I am not suggesting that they are covering up “smoking guns.” But smoking guns are rare, whereas ambiguous clues that are not pursued are common. Attorneys who have an extraordinarily profitable practice do not want to acquire a reputation for being hostile to, or suspicious of, the defendant corporation’s management; that might cost them future work for other corporations. In this field, excessive zeal is not a virtue.
AIM AT THE EXECUTIVE, NOT THE ENTITY
The bottom line here is that much of the investigatory work traditionally conducted by prosecutors has been delegated to private counsel hired by defendants. The reports that follow under this system are necessarily subject to a serious conflict of interest. What is the solution? One fairly obvious answer would be to condition a DPA on an independent study conducted by a law firm chosen by the prosecutor. Lawyers are good at discerning what their client really wants and then delivering that product. There are legal problems with this answer that are too complex and convoluted to discuss here, but one conclusion seems inescapable: if DPAs are awarded based on a flawed process (as they appear to be today), their utility is highly questionable.
Given all these problems, it has become increasingly clear that effective enforcement needs to focus more on convicting individual executives than on going after the corporate entity. This does not mean that we should abolish corporate criminal liability; rather, its key role should be to encourage corporations to prevent crime by monitoring their employees and turning in responsible officers.
But how does one do this if a corporation is prepared to pay billion-dollar cash fines rather than expose its executives to prosecution? The fact that even record-breaking fines appear not to have deterred corporations may mean that we still have not threatened them adequately. If fines of $10 billion and higher do not work, how much higher dare society go?
The deeper problem here is that severe penalties cause negative externalities. A $10 billion fine might deter most companies, but it would result in major layoffs and adversely impact both shareholders and stakeholders. Over time, these groups – including unions, local communities, bondholders, and shareholders – would likely develop a powerful coalition to oppose severe cash penalties.
Shareholders alone, however, do not have the same political veto power to block high penalties, which suggests that deterrence should target shareholders, rather than the entity itself. For decades, I have argued that when truly severe penalties are needed, they should be imposed not in cash but in the corporation’s stock, thereby focusing the burden on shareholders (and not stakeholders). If we want to pressure the corporation so that it will cooperate and turn over responsible executives, the better strategy is to threaten an equity fine – a penalty set equal to perhaps 10-25% of the corporation’s shares (depending on the severity of the crime). These shares would be issued from authorized but unissued stock, and would be transferred to a state-run victim compensation fund. The net result would be to minimize externalities by diluting the existing shareholders, while sparing bondholders and employees any adverse impact. Nor is the corporation itself rendered less solvent or creditworthy; its balance sheet would be unaffected, except that the number of shares outstanding would increase. To be sure, shareholders would suffer; but they also profited from the crime.
PENALTIES WITH PRECISION
Two other advantages also follow from imposing an equity fine. First, as noted earlier, cash fines do not seem to deter corporate crime effectively. Even when the cash fine exceeds $10 billion or more, there is rarely a negative stock-market reaction. Second, when high cash penalties are threatened, defendant corporations can (and do) threaten to declare bankruptcy. Several of the major opioid producers and distributors recently did precisely this, as the likelihood grew that they would be held liable for billions of dollars in civil damages.1
Sentencing judges are likely to pull their punches when they fear that a harsh penalty might trigger a bankruptcy filing. But an equity fine would offer deterrence and could not be evaded through bankruptcy. If a company with a market capitalization of $100 billion were subjected to an equity fine equal to 20% of its outstanding shares, this would imply a $20 billion issuance of shares (well above any cash penalty), and the stock-market decline would presumably be in the range of 20%. But there would be no necessary impact on employees or bondholders, and the sentencing judge would not have to worry about causing bankruptcy.
In fact, such a penalty may only rarely need to be imposed. The US criminal justice system essentially operates through plea bargaining. If the board of the corporate defendant wanted to avoid such a penalty, it could offer to turn over all evidence of involvement by senior executives (and also waive the attorney-client privilege), in effect sacrificing these executives to save their shareholders, which would be entirely consistent with the board’s fiduciary duties.
Moreover, even if the board lacked evidence of wrongdoing, it could commission a tough former prosecutor to conduct an investigation that it knew would satisfy the prosecutors with whom it was dealing. If this investigation turned up sufficient evidence to justify indicting senior executives, that, too, could justify a reduced penalty for the corporation (for example, a more modest equity fine of only 2%). At last, prosecutors would have a threat that could be used to elicit complete cooperation by the corporate defendant.
But isn’t this approach unfair to individual senior executives? No – defendants would still have their day in court, with their legal expenses reimbursed by the corporation under standard indemnification agreements. All that they would lose is their ability to cause the corporation to pay a high fine in exchange for the prosecution’s agreement to end the investigation. Under President Barack Obama, such trades were forbidden by the Yates Memorandum (which required the corporation to disclose all inculpating information in its possession). But this document seems to have served mainly as an aspirational statement during the Obama years, and had no impact at all under the Trump administration.
That said, the equity fine proposal does have one glaring problem: It would require legislation (probably at the federal level), which the business community would oppose and lobby against ferociously. Only at the right time (such as shortly after Lehman’s failure or in the wake of the Enron and WorldCom scandals) would meaningful reform legislation be politically feasible. But another such occasion is sure to arrive sooner or later.
Thus, we have the outline of an integrated strategy. The corporation would be given a strong incentive to turn in responsible senior executives (to avoid the equity fine), and these executives could similarly plea bargain and turn in the corporation in exchange for leniency for themselves. Structured properly, this would resemble the classic “prisoner’s dilemma” in which both sides know that only the first to confess will receive any real concession.
DETERRING WILLFUL BLINDNESS (AND NEGLIGENT NEAR-SIGHTEDNESS)
Still, one assumption in the foregoing analysis may often be unrealistic. Those in the “C Suite” at corporate headquarters seldom know that much about operating details in the field. The modern giant corporation is radically decentralized, with operating details and decisions left to divisional heads. The CEO and CFO typically will not know if divisions (and particularly subsidiaries abroad) are paying bribes, fixing prices, polluting the environment, or selling dangerous and unsafe products. As a result, they can profess pious shock when they later learn the details. The bottom line, then, is that efforts to implicate senior executives in the crime often may fail because they do not in fact have knowledge of the details of the crime.
But even when this is true, senior executives will still know whether or not they are running a law-compliant organization. They should know this because law compliance requires both an appropriate organizational culture and substantial investment in internal controls and monitoring. In most cases, the greater likelihood is not that the CEO is in on the crime, but that the CEO remained negligently (or even willfully) blind to what was happening. Some lawmakers (including Senator Elizabeth Warren of Massachusetts) would like the law to hold senior officials vicariously liable for misconduct by their underlings, but the legal profession generally agrees that vicarious criminal liability is fundamentally unjust.
Given that position, what kind of reform can sensibly address this problem? The best answer may involve the creation of an intermediate sanction for these cases through the use of corporate probation. A convicted corporation in the federal system can be both fined and placed on probation. Most think of probation as merely involving monitoring controls (possibly under the supervision of a court-appointed observer). But much more can be done. Under the federal probation statute, conditions that are preventive or incapacitating can be imposed.
What would this mean in the case of an organization? A strong case can be made that excessive incentive compensation is criminogenic. For example, by late 2007, many investment bankers realized that the securitization market for subprime mortgages was collapsing, but still continued to close deals that would fail shortly thereafter. Their motivation, of course, was to secure extreme bonuses – in some cases $20 million if two more deals closed by the end of that year. The point here is only that high bonuses (usually a multiple of the employee’s base salary) can cause the corporation’s employees to bend or break the law.1
Now assume that such a corporation is convicted. A sentence of probation specially designed for this corporation might not entail only a monitor, but could limit all forms of incentive compensation – including stock options and bonuses – for the period of probation (which is limited to five years). This limitation might be total (zero incentive compensation) or partial (incentive compensation not exceeding, say, 50% of base salary in any year). In any case, this would create both a preventive restraint and a penalty that would fall on precisely those executives who were negligently tolerant of a corporate culture that was not law-compliant.
This kind of intermediate sanction – economically painful but carrying no stigma or loss of liberty – seems appropriate for those who have tolerated weak compliance. Equally important, such a probation condition might have a real deterrent effect. Employees would fear that legal violations could cost them their incentive compensation. The corporate culture might come to disapprove of legal risk-taking. In this scenario, employees might dissuade one another from legal violations or even report to senior management fellow employees who were taking legal risks that could cost them money. Social pressure is a powerful force, and it should be mobilized to turn those cutting legal corners into pariahs within their own organizations.
NO MORE SOFTBALL
Within the last decade, we have moved from a legal system that combined carrots and sticks to combat corporate misconduct to a legal system that increasingly relies only on carrots. Deregulation, the reflexive use of DPAs, and the “tone at the top” set by President Donald Trump were all part of this slippage. The best corrective is not simply to increase penalties, but rather to design penalties and enforcement that modify executive behavior by changing their incentives.
A first step should be to create a prisoner’s dilemma-like mechanism whereby both the corporation and its executives are pressured to implicate the other because they know that only the first to confess will be rewarded. Here, the equity fine could play a critical role. A second step would be to give the US Department of Justice the same authority as is now given to the SEC to award whistleblowers a bounty from the penalty imposed on the defendant. Today, between 10% and 30% of any substantial penalty received by the SEC must go to the whistleblower who first provided the “original information” that led to the penalty. Fewer executives would sleep comfortably at night if they knew that fellow employees could become rich by turning them in.
These may seem like harsh measures, but criminal justice is a game of hardball. Today, most prosecutors are still playing softball with corporate defendants.
John C. Coffee, Jr.: Professor of Law and Director of the Center on Corporate Governance at the Columbia Law School, is the author, most recently, of Corporate Crime and Punishment: The Crisis of Underenforcement (Berrett-Koehler Publishers, 2020).