Mankind and states are generally change-adverse. Yet when financial and other crises occur, there is a widespread response that action has to be taken. The course of conduct selected may be impulsive and not properly address the underlying problems, but passivity or inaction under such circumstances can have huge political as well as concrete costs.
A great deal has been written about the causes of the global financial crisis. Its magnitude is evidence that there are plenty of individuals, governmental regulators, and political officials to whom blame can be assigned. Fortunately, it appears that a global economic meltdown has been averted – but many of the underlying problems inflicting mankind – crime, disease, greed, immorality, intolerance and violence (taking a multitude of forms) remain.
Most people will give more thought to their sustaining minor injuries after falling down a flight of stairs, than they will about the problems of the abuse of governmental power, extreme poverty, seemingly mindless violence and other human induced problems that one can read about and ignore.
Nonetheless, a great many people will find satisfaction in learning that two former Vivendi executives will be standing trial in Paris for stock manipulation dating back 8 years, that McKinsey partner Raj Rajaratnam was arrested and charged (granted not convicted) for securities fraud, and that the regulatory and prosecutorial authorities are proceeding with their investigation of the Galleon inside trading matter, even though those who may have lost their life savings or jobs as a result are seldom made whole.
It is too ambitious to seek to solve the world’s problems. Many foundations are engaged in commendable efforts, which people would not be willing to fund their governments to accomplish. There are some things politicians can change and presently there is considerable interest in creating mechanisms that will prevent the financial crisis that occurred last year. I will focus on the commercial and regulatory situation in the U.S. since it is a topic with which I have some degree of familiarity.
Making the Fight Against Financial Crime More Proactive
As currently configured, the U.S. Securities & Exchange Commission’s focus is largely on processing and disseminating reports by private companies, which a surprisingly small number of people actually read. Desirable behavior often results from the public disclosure of information, but for this to occur appropriate action must be taken in response to information that suggests wrongdoing. It is one thing to punish unlawful conduct – it is far more important to prevent it from occurring (provided that the costs are not too high).
How should this be accomplished in the corporate and financial sectors? Some specialists have called for making the SEC and the U.S. Department of Justice (DOJ) more proactive in the enforcement of the securities laws, while at the same time increasing the scope of regulated activities such as derivatives. This could lead to increased observation of the law before illegal conduct is uncovered by government officials, journalists, and shareholders.
How does one establish a hierarchy of our objectives with respect to financial crime? Should the focus be on wrongful acts that have an impact on the greatest number of people or the largest sums of money? It is unrealistic to expect that the governments to have sufficient resources to do more than take on particularly egregious cases. Taking a tough stance on Siemens or BAE might have some deterrent impact, but for how long and to what extent have the unlawful actions of these two companies harmed most people?
In June 2009, Director of Homeland Security and Justice, Eileen R. Larence made a statement Before the Subcommittee on Commercial and Administrative Law, of the House of Representative’s Committee on the Judiciary, in which she noted that in order to maintain public faith in the operation of U.S. financial markets and prevent “corporate corruption, DOJ needed to increase its use of [Deferred and Non-Prosecution Agreements]”  DOJ has considerable discretion whether a case should be prosecuted or whether it should enter into DPAs or NPAs. Pursuant to such arrangements DOJ selects “monitors” regarded as not having either real or potential “conflicts of interests” – term that is difficult to define and one that is capable to change over time.
Monitors are assigned the responsibility to determine whether the corporations to which they are assigned have in place adequate systems of control to prevent the recurrence of such offenses as insider trading (which Milton Friedman was not convinced should be unlawful) or engaging in prohibited conduct under the Foreign Corrupt Practices or the Bank Secrecy Acts (as well as their foreign equivalents). Some monitors will hire outside contractors to develop compliance programs – of course, one size does not fit all.
According to Professor Erik Paulson:
It has become increasingly clear that the government holds all the cards in negotiations over these agreements. As long as the threat of prosecution lingers over a company, the corporation is compelled to agree to the prosecutor’s terms, vesting nearly absolute power in the government’s hands. Unable to risk a potential indictment, the corporation is thus left at the mercy of the prosecutor.
But in a criminal case, the burden of proof must be shown to be “beyond a reasonable doubt.” This suggests that the government may not hold all the cards because it often has powerful incentives to settle for a civil fine, an apology, and a promise of good conduct in the future. In most cases, prosecutors prefer DPAs or NPAs – it is preferable to losing a criminal case by well-advised and disciplined defendants. The would-be defendants also win since if the persons with ultimate responsibility to ensure that wrong doing does not occur not only generally escape punishment, they usually keep their jobs (and directors frequently continue to sit on the boards of multiple corporations). Legal persons are not really punished since their employers’ shareholders (or insurer) usually pay the applicable fine and relevant attorneys’ fees.
The Sarbanes-Oxley Act of 2004 was adopted in the aftermath of the Enron scandal. It aimed to reduce the risk of corporate malfeasance, but if recent events are any indication, its success has been limited indeed. SOX assigned significant responsibilities to corporate boards of directors and their audit committees, neither of which have always favorably distinguished themselves. Congress’ expectations were unrealistically high.
Globalization has magnified the damage caused by the corporate governance failures and ineffective regulatory or criminal deterrence system. There are many approaches that might be taken to reduce the likelihood of financial fraud in the future. Nonetheless, it is unrealistic to expect that we have the capacity to design systems that are “fraud proof.” Taking steps to increase corporate transparency is a noble objective, but it can be effective only as part of an integrated system of controls that will be difficult to establish and ensure that they are properly observed.
Federalizing U.S. Corporate Law & Governance – Ending the Race to the Bottom
Given the difficulty to get large groups of countries to adopt new rules in the area of corporate governance and the oversight of financial markets, we must focus out efforts on less ambitious tasks.
Let’s use U.S. corporate law to start. The U.S. Constitution is over 200 years old appropriate for a particular context at a particular time, both of which have largely been overtaken by time. Of course, it represents a roadmap that permits the creation of new laws and institutions and the recognition of new rights.
Today, U.S. corporations and citizens conduct business over the Internet. They buy and sell billions of dollars of goods and services from persons they have never seen or met. Their willingness to do so depends on both a belief in information they obtain, an expectation that the rules governing their interaction are largely stable, ascertainable and enforceable, and the expectation that their counterpart will abide by commonly shared principles.
This occurs despite an appreciation that credit card fraud exceeds billions of dollars annually, computer security is imperfect, identity fraud is widespread, and the existence of countless other problems that can go wrong. Still, people have the belief that their counterpart’s behavior will conform to commonly accepted norms and that one’s exposure is usually limited in the event of a dispute.
Perhaps one step that might improve the policing of U.S. corporations would be to make the operation of corporations a federal matter as opposed to one that might only fall within the jurisdiction of a particular state. Why should it be different in Pennsylvania from New York or Maryland from Virginia. Within the U.S., Delaware functions as a corporate haven. Approximately half of all publicly-traded U.S. corporations and roughly 60% of the Fortune 500 are incorporated there. What are the consequences? Corporate interests dominate the Delaware legislature’s agenda on corporate issues. Delaware legal entities are given considerable autonomy to the detriment of their equity holders.
Similarly, Delaware contract and tort law is similarly favorable to corporations. While there is some benefit in the fact that Delaware has special chancellery courts that deal entirely with corporate matters, since these courts are making its determinations based in large part on Delaware General Corporate Law (Title 8, Chapter 1 of the Delaware Code), other statutes enacted by legislatures who are particularly sensitive to corporate interests, and a common law that shares some of these features, this means that Delaware state law does little to protect consumers and individual investors.
If one looks at the last pages of the Economist, one might be surprised to discover that if one wants to buy a pre-formed company off-the-self, that in addition to jurisdictions such as the Bohamas, Belize, the British Virgin Islands, Cyprus, Gibraltar, Nevis, Seychelles, and St. Vincent , some U.S. states provide comparable vehicles such as Nevada, Utah and Wyoming LLCs. Thus, some U.S. states lacking significant regulatory enforcement can be obtained for use as single purpose entities and holding companies. Legal entities that are frequently used by organized criminal groups.
This raises the question “why not make all corporations entities governed by federally established rules?” If the U.S. had only one form of incorporation or LLC, it is likely to be more rigorously regulated by the federal government than states with small populations. The standard of care for duties of officers and directors could be expanded and made uniform, persons tasked with compliance-related responsibilities might be made liable both for acts of commission and omission; similarly the rights of minority equity holders in both limited liability companies and corporations could be strengthened throughout the country. Making them all U.S. legal entities would probably make more difficult the carrying out of economic crimes since there would be both federal and state regulators having some oversight responsibilities (as in some cases is significant with respect to securities).
The Governance, Risk and Compliance Industry
In the last 5 years a new industry has been born relating to corporate governance, risk and regulatory compliance. Many of these consulting firms are retained by corporations in the hope of establishing effective loss prevention systems – they are engaged in a range of activities: assessing potential risk areas and vulnerabilities with respect to employee theft, combating industrial espionage, conducting internal investigations, offering training in a variety of areas particularly in anticipation of regulatory inspections, and preparing compliance manuals. While others serve as “monitors pursuant to DPAs and NPAs.
A third and potential useful function would be as “agents” of regulatory officials. In many countries, the countries “outsource” the responsibility to test products to accredited laboratories and engineering firms, which ascertain whether applicable safety and other standards are being met. The “monitor” function arises only after their have been regulatory violations. Might not it make sense to use such consulting firms on a proactive basis – like have police on patrol in the hope of deterring unlawful behavior.
Given budgetary constraints, these consulting firms might operate in a manner that the word “certified public auditor” could suggest to someone unfamiliar with the way that auditing firms operate – they are hired by auditing committees that report to corporate boards of directors. In contrast, these consulting firms would be licensed and for a fee paid by the corporation to the government would be deployed by the government in the role of detecting vulnerabilities and violations of relevant regulations. In the event that these organizations detect violations they would receive a percentage of any fine ultimate imposed by the administrative or judicial body.
One benefit of this scheme would be that persons who develop expertise in the government at the conclusion of their employment would not be faced with a decision of going to work for the corporations they regulate or switch careers. They could in a sense operate as bounty hunters in the areas of environmental protection, financial fraud, and health and safety. To provide concrete examples, former prosecutors specializing in the financial fraud area would not find themselves as “white collar” criminal defense lawyers defending the very individuals who would have been their “targets” in the passed. Persons enforcing environmental regulations would no longer be seeking the least expensive way to avoid violating the law.
Corporate managers do not value individuals who inform them that they cannot proceed in a particular fashion. The incentive structure is such so that the corporation finds a way of nominally complying with the rules. By “reinventing” government in this way, we would be increasing the likelihood that the laws and regulations established are indeed observed and not circumvented.
 See generally, J. Robert Brown, Jr., Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure, 57 Cath. U.L. Rev. 45 (2007).
 Eileen R. Larence (Statement), “Preliminary Observations on DOJ’s Use and Oversight of Deferred Prosecution and Non-Prosecution Agreements GAO-09-636T, at 20, June 25, 2009).
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