Research Handbook on Corporate Crime and Financial Misdealing 1783474467, 9781783474462, 9781783474479

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RESEARCH HANDBOOK ON CORPORATE CRIME AND FINANCIAL MISDEALING

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RESEARCH HANDBOOKS IN CORPORATE LAW AND GOVERNANCE Series Editor: Randall S. Thomas, John S. Beasley II Professor of Law and Business, Vanderbilt University Law School, USA Elgar Research Handbooks are original reference works designed to provide a broad overview of research in a given field while at the same time creating a forum for more challenging, critical examination of complex and often under-explored issues within that field. Chapters by international teams of contributors are specially commissioned by editors who carefully balance breadth and depth. Often widely cited, individual chapters present expert scholarly analysis and offer a vital reference point for advanced research. Taken as a whole they achieve a wide-ranging picture of the state-of-the-art. Making a major scholarly contribution to the field of corporate law and governance, the volumes in this series explore topics of current concern from a range of jurisdictions and perspectives, offering a comprehensive analysis that will inform researchers, practitioners and students alike. The Research Handbooks cover the fundamental aspects of corporate law, such as insolvency governance structures, as well as hot button areas such as executive compensation, insider trading, and directors’ duties. The Handbooks, each edited by leading scholars in their respective fields, offer far-reaching examinations of current issues in corporate law and governance that are unrivalled in their blend of critical, substantive analysis, and in their synthesis of contemporary research. Each Handbook stands alone as an invaluable source of reference for all scholars of corporate law, as well as for practicing lawyers who wish to engage with the discussion of ideas within the field. Whether used as an information resource on key topics or as a platform for advanced study, volumes in this series will become definitive scholarly reference works in the field. Titles in this series include: Research Handbook on Executive Pay Edited by Randall S. Thomas and Jennifer G. Hill Research Handbook on Insider Trading Edited by Stephen M. Bainbridge Research Handbook on Directors’ Duties Edited by Adolfo Paolini Research Handbook on Shareholder Power Edited by Jennifer G. Hill and Randall S. Thomas Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations Edited by Robert W. Hillman and Mark J. Loewenstein Research Handbook on Mergers and Acquisitions Edited by Claire A. Hill and Steven Davidoff Solomon Research Handbook on the History of Corporate and Company Law Edited by Harwell Wells Research Handbook on Corporate Crime and Financial Misdealing Edited by Jennifer Arlen

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Research Handbook on Corporate Crime and Financial Misdealing

Edited by

Jennifer Arlen Norma Z. Paige Professor of Law; Director, Program on Corporate Compliance and Enforcement; and Director, Center for Law, Economics and Organization, New York University School of Law, USA

RESEARCH HANDBOOKS IN CORPORATE LAW AND GOVERNANCE

Cheltenham, UK • Northampton, MA, USA

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© The editor and contributors severally 2018 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2017960001 This book is available electronically in the Law subject collection DOI 10.4337/9781783474479

ISBN 978 1 78347 446 2 (cased) ISBN 978 1 78347 447 9 (eBook)

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Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

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Contents vii ix

List of contributors Acknowledgments

Introduction1 Jennifer Arlen CORPORATE AND INDIVIDUAL LIABILITY FOR PART I  CORPORATE MISCONDUCT   1 Psychology and the deterrence of corporate crime Tom R. Tyler

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  2 Individual and corporate criminals Brandon L. Garrett

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  3 Criminally bad management Samuel W. Buell

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  4 Does conviction matter? The reputational and collateral effects of corporate crime Cindy R. Alexander and Jennifer Arlen

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PUBLIC ENFORCEMENT OF PUBLIC CORRUPTION AND PART II  SECURITIES FRAUD   5 Multijurisdictional enforcement games: the case of anti-bribery law Kevin E. Davis   6 Beware blowback: how attempts to strengthen FCPA deterrence could narrow the statute’s scope Matthew C. Stephenson

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  7 Corruption in state administration Tina Søreide and Susan Rose-Ackerman

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  8 Securities law and its enforcers Stephen J. Choi and A. C. Pritchard

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  9 Corporate and individual liability in SEC enforcement actions  237 Michael Klausner and Jason Hegland

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vi  Research handbook on corporate crime and financial misdealing PART III  ROLE OF PRIVATE ACTORS: COMPLIANCE, CORPORATE INVESTIGATIONS, AND WHISTLEBLOWING 10 An economic analysis of effective compliance programs Geoffrey P. Miller

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11 Behavioral ethics, behavioral compliance Donald C. Langevoort

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12 An analysis of internal governance and the role of the General Counsel in reducing corporate crime Vikramaditya Khanna

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13 When the corporation investigates itself Miriam H. Baer

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14 Bounty regimes David Freeman Engstrom

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Index

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Contributors Cindy R. Alexander, Research Fellow, Law & Economics Center, George Mason University Jennifer Arlen, Norma Z. Paige Professor of Law and Director, Program on Corporate Compliance and Enforcement, New York University School of Law Miriam H. Baer, Professor of Law, Brooklyn Law School Samuel W. Buell, Bernard M. Fishman Professor of Law, Duke University Stephen J. Choi, Murray and Kathleen Bring Professor of Law, Director, Pollack Center, and Senior Academic Fellow, Program on Corporate Compliance and Enforcement, New York University School of Law Kevin E. Davis, Beller Family Professor of Business Law and Senior Academic Fellow, Program on Corporate Compliance and Enforcement, New York University School of Law David Freeman Engstrom, Professor of Law and Bernard D. Bergreen Faculty Scholar, Stanford Law School Brandon L. Garrett, Justice Thurgood Marshall Distinguished Professor of Law and White Burkett Miller Professor of Law and Public Affairs, University of Virginia School of Law Jason Hegland, Executive Director, Stanford Securities Litigation Analytics Vikramaditya Khanna, William W. Cook Professor of Law, University of Michigan Law School Michael Klausner, Nancy and Charles Munger Professor of Business and Professor of Law, Stanford Law School, and Visiting Professor of Law, New York University School of Law Donald C. Langevoort, Thomas Aquinas Reynolds Professor of Law, Georgetown University Law Center Geoffrey P. Miller, Stuyvesant P. Comfort Professor of Law and Senior Academic Fellow, Program on Corporate Compliance and Enforcement, New York University School of Law A. C. Pritchard, Frances and George Skestos Professor of Law, University of Michigan Law School Susan Rose-Ackerman, Henry R. Luce Professor of Jurisprudence, Law School and Department of Political Science, Yale University Tina Søreide, Professor of Law and Economics, Norwegian School of Economics vii

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viii  Research handbook on corporate crime and financial misdealing Matthew C. Stephenson, Professor of Law, Harvard Law School Tom R. Tyler, Macklin Fleming Professor of Law and Professor of Psychology and Founding Director of The Justice Collaboratory, Yale Law School

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Acknowledgments I want to thank the following people for generously providing their time and expertise to provide comments on one or more of the chapters in this book. This book greatly benefited from their assistance. Miriam Baer Rachel Brewster Darryl Brown Samuel Buell Alexander Dyck Jean Ensminger Jeffrey Gordon Marcel Kahan Jonathan Karpoff Paul Lagunes Marcia Miceli Thomas Miles Daniel Richman Tina Søreide David Webber

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Introduction

Jennifer Arlen*

Corporate crimes occur all too often, causing serious harm to individuals, as well as to the economies of countries adversely impacted by crimes such as fraud and corruption. Crimes by large publicly-held firms raise special concerns because these firms have such a broad reach that they can cause tremendous harm when their employees pursue profit through criminal activities. To guard against these harms, criminal laws and regulations impose duties on corporations and those who work for them to avoid a range of harmful activities. Laws in the U.S., and in many other countries, impose criminal and civil liability on both individual wrongdoers and their corporate employers for violations of these duties. The central purpose of this liability is—and must be—to deter corporate misconduct. Deterrence should be the primary goal of corporate and individual liability for corporate misconduct for a simple reason. Any provision that sacrifices deterrence in the name of some other goal, such as retribution, leads more people to be harmed by corporate crime. Thus, pursuing retribution at the expense of effective deterrence places future victims in harm’s way. Deterrence, by contrast, both helps safeguard future victims and reduces the need for future punitive interventions. In addition, when misconduct is caused by employees of publicly-held firms, there is an additional reason to favor enforcement policies that deter misconduct over those that punish the firm: corporate liability imposed on publicly-held firms is hard to justify as a means to punish wrongdoers. Corporate liability ultimately falls on the firm’s shareholders. Yet shareholders of professionally-managed firms rarely play any role in causing misconduct; nor do they have sufficient management power to prevent misconduct (Arlen 2012; Arlen and Kahan 2017).1 Instead, public corporations’ acts and intent are really the acts and intent of employees who often have little stake in the firm. These employees often act primarily to benefit themselves (often indirectly through the compensation or job security that follows actions that confer a short-run benefit on the firm). The actions of these employees are only incompletely controlled by, and known to, those above them, even in firms with effective compliance programs. Thus, it does not seem appropriate to seek retribution against a publicly-held firm for most of the types of crimes they commit. By contrast, strong reasons exist to impose liability on corporations in order to deter corporate crime. Properly structured corporate liability can provide corporations—and in turn the managers and directors who control the firm—with incentives to intervene *  I would like to thank my research assistant, Jason Driscoll. 1   For example, under Delaware law (which governs the majority of U.S. publicly-held firms), the power to manage the firm is vested in the board of directors, not the shareholders. Delaware General Corporation Law 141(a). Shareholders can vote for the board of directors, but in most firms they cannot vote to nominate which candidates are put before them for election. They have little, if any, genuine control over the firm.

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2  Research handbook on corporate crime and financial misdealing efficiently to deter corporate crime. Corporations are vital to the effort to deter corporate crime because they control the benefit that employees derive from crime (through control over compensation and promotion policies). They also directly impact the expected cost of crime to their employees. Corporations can increase their employees’ expected cost of crime through interventions that increase the government’s ability to detect and sanction crime. These interventions include adopting an effective compliance program, investigating suspected misconduct, self-reporting detected violations, and fully cooperating to provide the evidence needed to convict responsible individuals (hereinafter “corporate policing”). Corporate policing is important because, absent corporate policing, employees engaging in misconduct often do not fear criminal punishment because they think the government is unlikely to detect the crime or identify the individuals responsible. Firms can help detect crimes and identify the wrongdoers if motivated to do so. Of course, firms will intervene to deter corporate crime only if they have an incentive to do so. The threat of criminal or civil liability for employees’ crimes can provide this incentive, if properly structured. Corporate liability must be structured to ensure that firms which have effective compliance programs, self-report and cooperate fare better than those that do not. In addition, the government must use the information produced by corporate cooperation to hold individual wrongdoers liable for the crimes they committed. After all, absent the threat of personal liability, employees will continue to commit corporate crimes. U.S. enforcement policy is evolving, adopting an increasing number of features that could help deter corporate crime. Prosecutors are encouraged to insulate firms that self-report and cooperate from formal conviction through the use of deferred and nonprosecution agreements (DPAs and NPAs). DPAs are criminal settlements that enable prosecutors to sanction firms and obtain admissions of criminal responsibility without a formal conviction. Prosecutors also adjust sanctions and mandates in response to corporate activities, including the effectiveness of the firm’s compliance program and thoroughness of the investigation. Enforcement officials can use policies governing the availability of DPAs and NPAs, as well as sanction mitigation, to incentivize firms to self-report and cooperate (Arlen 2012). In addition, enforcement authorities negotiating with managers who are not committed to deterrence can enhance deterrence by using corporate criminal settlements to require firms to undertake specific reforms or to accept a monitor (Arlen and Kahan 2017). The reforms that have transformed the U.S. system have raised a host of issues, however. These include questions about whether liability does in fact deter, whether criminal and civil liability are appropriately targeted at those responsible for the misconduct, the impact on enforcement policy and deterrence of having multiple enforcers, the potential deterrence role of whistleblowers, the most effective approach to compliance, and the complex task of conducting a corporate investigation in the modern age. The chapters in this book address these issues.

OVERVIEW OF THIS VOLUME This book brings together leading scholars from a variety of disciplines to explore ­mechanisms for deterring corporate crime and securities fraud through both public

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Introduction  3 enforcement and private interventions. The book is divided into three parts: Part I: Corporate and Individual Liability for Corporate Misconduct; Part II: Public Enforcement of Public Corruption and Securities Fraud; and Part III: Role of Private Actors: Compliance, Corporate Investigations, and Whistleblowing. Part I examines corporate and individual liability for corporate misconduct through four chapters that consider the causes of corporate crime, empirical analysis of public enforcement, the liability of supervisors, and the potential cost to corporations of reputational damage from corporate criminal settlement. In Chapter 1, “Psychology and the deterrence of corporate crime,” Tom Tyler reviews the effectiveness of deterrence, in and of itself, as well as relative to the influence of consensual models of regulation that rely upon legitimacy to motivate compliance. The law governing corporate criminal enforcement, and the law and economics scholarship designed to inform it, treats deterrence as the primary goal, and coercion through threatened sanctions as the most effective tool to achieve this goal. Yet, according to Tyler, the available evidence on the causes of misconduct suggests that although people do respond to threatened sanctions, the influence of coercion is often overstated relative to its actual influence upon law-related behavior. In addition, consensual approaches have been found to be more effective than is commonly supposed. Taken together these findings suggest the desirability of developing a broader approach to corporate regulation using both coercive and consensual models of regulation. Given the strength of the findings for consensual models, the persistence of coercive models as the dominant and even exclusive approach to corporate crime is striking. That dominance suggests the importance of focusing on the psychological attractions of coercion to people in positions of authority. Tyler suggests that those in authority are attracted to this approach not only because of evidence that it can be effective but also due to the psychological benefits it affords them. In Chapter 2, “Individual and corporate criminals,” Brandon Garrett examines whether corporate enforcement actions are indeed leading to the eventual prosecution of the individuals responsible for the crimes. He finds that officers and employees are only prosecuted in about one-third of the federal corporate criminal settlements involving deferred or non-prosecution agreements. Garrett’s chapter explores possible reasons for this pattern. Using the HSBC case as an example, Garrett first introduces the practical and procedural obstacles that arise in cases involving both organizations and employees. Turning to the evidence on individual prosecutions in corporate cases, Garrett then explores why prosecutors so frequently do not or cannot prosecute individuals in corporate cases, and why they so often achieve limited success when they do. Garrett concludes by describing alternative means to deter individual behavior and what significance this has for the approach to corporate prosecutions more generally. In Chapter 3, “Criminally bad management,” Samuel Buell extends the analysis of individual liability by shining the spotlight on the corporate managers who often play a vital role in either inducing crime on the one hand or deterring it on the other. After all, it is managers that produce the corporate culture that can either operate to cause crime or to deter it. Buell explores the challenges and potential promise of using criminal liability to impose sanctions on managers who were indirectly responsible for a crime but did not commit any acts to help commit it. In Chapter 4, “Does conviction matter? The reputational and collateral consequences of corporate crime,” Cindy Alexander and Jennifer Arlen evaluate the claim made by

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4  Research handbook on corporate crime and financial misdealing some critics of DPAs that the use of DPAs undermines deterrence by lowering the cost to firms of the reputational damage or stigma resulting from a criminal settlement. Criminal settlements cause firms to sustain costs from reputational damage when they release information that leads interested outsiders—e.g., customers and suppliers—to anticipate an enhanced risk of harm from future dealings with the firm. DPAs alter this cost if, but only if, they affect the information released by the criminal settlement about the firm’s expected risk of causing future harm. The authors evaluate, and reject, three potential channels through which the choice of settlement form could affect the information about future risk reaching interested outsiders: direct revelation, prosecutorial selection, and managerial selection. They then turn to the impact of DPAs on the ability of federal agencies to protect their interests by excluding or delicensing firms whose criminal settlement reveals that they present an enhanced risk of causing future harm to the agencies’ interests that is best addressed by exclusion instead of by mandated reforms. They conclude that agencies may be better able to serve their interests as interested outsiders when prosecutors employ DPAs rather than pleas because DPAs leave agencies free to use permissive exclusion and enable them to exclude when, but only when, appropriate. Part II presents five chapters focused on public enforcement of public corruption or securities fraud. Chapters 5–7 examine three different aspects of liability for corruption. Chapters 8 and 9 examine Securities and Exchange Commission enforcement of securities fraud. In Chapter 5, “Multijurisdictional enforcement games: the case of anti-bribery law,” Kevin Davis provides an economic analysis of corporate criminal enforcement for crimes, such as corruption, whose enforcement involves multiple agencies, often based in different jurisdictions. Davis shows how the interaction between the multiple enforcement agencies can be analyzed as a dynamic multi-player game in which the players include both enforcement agencies and firms. He finds that this kind of analysis can be used to formulate testable hypotheses about the outcomes of interactions between regulators and firms. Unfortunately, opportunities to evaluate these kinds of hypotheses empirically are limited because many aspects of the structure of the game are difficult to observe, and firms’ misconduct and regulators’ enforcement activities typically are only observable when they result in formal sanctions. The chapter concludes with a discussion of some of the challenges inherent in normative analysis of the outcomes of multijurisdictional law enforcement games. In Chapter 6, “Beware blowback: how attempts to strengthen FCPA deterrence could narrow the statute’s scope,” Matthew Stephenson argues that proposed reforms to the Foreign Corrupt Practices Act (FCPA) intended to deter FCPA violations more effectively—such as creating a private civil remedy, more aggressive targeting of individual defendants, and expanded use of corporate debarment—could have the opposite effect. According to Stephenson, such reforms might lead to a substantive narrowing of the FCPA, because they would lead to more litigation, much of it against more sympathetic defendants, and this in turn could lead to both judicial narrowing of ambiguous statutory terms and Congressional revisions to the statute. He concludes that the possible unintended consequence should be considered when conducting a more comprehensive evaluation of the costs and benefits of proposed FCPA reforms. In Chapter 7, “Corruption in state administration,” Tina Søreide and Susan RoseAckerman analyze the other side of the corruption equation: the supply of corrupt

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Introduction  5 decisions by government officials. Specifically, they provide an economic analysis of corruption as a trade in decisions that should not be for sale. The size of the bribe and the consequences of corruption are functions of the bargaining powers of those involved. They suggest ways to reorganize decision-making procedures to reduce the risks of corruption but stress the difficulty of breaking up entrenched collusive environments. Furthermore, even if corruption in a public institution is well recognized, it may not be possible to identify individual offenders. The question then is whether one should sanction the entire public body. Like private entities, public institutions can be encouraged to self-police and self-report (for example, upon information from a whistleblower) if such steps will reduce the extent of some penalty. However, the criminal and administrative monetary sanctions applied to private sector entities are a poor fit for state institutions with ongoing responsibilities to the citizenry. They propose non-monetary penalties, including intensified external monitoring, reorganization of authority, disqualification of leaders, and removal of service provision responsibilities. Chapters 8 and 9 both consider aspects of public enforcement of financial misrepresentation by the Securities and Exchange Commission (SEC). In Chapter 8, “Securities law and its enforcers,” Stephen Choi and A. C. Pritchard review the existing empirical literature relating to government enforcement of the securities laws, particularly by the SEC, including comparative work, assessment of the impact of enforcement, and analysis of enforcement patterns. Choi and Pritchard also identify a particularly promising area for future research. Little work has been done to date exploring the incentives faced by attorneys who conduct investigations on behalf of the SEC and how those incentives shape enforcement decisions. This chapter offers preliminary evidence on the career paths of SEC lawyers and how those career choices might influence the enforcement actions brought by the SEC. In Chapter 9, “Corporate and individual liability in SEC enforcement actions,” Michael Klausner and Jason Hegland present an empirical analysis of SEC enforcement. Some commentators have accused the SEC of going easy on executives responsible for securities fraud and instead penalizing shareholders by imposing fines on corporations. The authors investigate that claim empirically and conclude that it is unsupported. The SEC frequently penalizes executives; it imposes monetary sanctions on corporations far less often. The chapter goes on to provide more detail on SEC practice with respect to penalizing corporations and executives in cases alleging disclosure violations by public companies. Part III contains five chapters that examine the role of private actors in deterring corporate crime. These private interventions include actions taken by corporations—such as compliance and internal investigations—as well as whistleblowing by employees and others. In Chapter 10, “An economic analysis of effective compliance programs,” Geoffrey P. Miller examines the core features of effective compliance. Tests for “effective” compliance programs take the form of lists specifying required elements in varying levels of detail. From an economic perspective, an effective compliance program can be defined more fundamentally as the set of policies and procedures that a rational, profit-maximizing firm would establish if it faced an expected sanction equal to the social cost of violations. Miller explores the idea and several of its extensions and qualifications. In Chapter 11, “Behavioral ethics, behavioral compliance,” Donald Langevoort analyzes the promise of taking a behavioral approach to compliance and ethics. Research

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6  Research handbook on corporate crime and financial misdealing in psychology and organizational behavior under the heading of “behavioral ethics” is growing rapidly, offering new insights into how people (individually and in groups) choose whether to comply with legal and ethical norms. In legal scholarship, a robust literature is emerging on the subject of organizational compliance, as public enforcers become more insistent that corporations build and maintain state-of-the-art systems. This chapter joins these two bodies of research, demonstrating the potential payoffs—and challenges—in using a behavioral frame of reference to assess compliance risks, design appropriate interventions, and communicate more effectively about both law and ethics with corporate managers and other employees. Just as compliance requires good economics skills, it requires psychological savvy as well, to help predict how incentives and compliance messages will be processed, construed and acted upon in the field. In Chapter 12, “An analysis of internal governance and the role of the General Counsel in reducing corporate crime,” Vikramaditya Khanna reviews the empirical literature on the factors related to the likelihood and detection of corporate wrongdoing, which increasingly focuses on internal governance, and examines calls to split the traditional tasks of the General Counsel (GC) between the GC and a Chief Compliance Officer (CCO) who reports directly to the Board. The reason for this is to have more independence and expertise in compliance matters than the GC’s office traditionally provides. Khanna argues that although independence is often valuable in reducing wrongdoing, in this context it is likely to come with additional costs that may make gathering information on wrongdoing more difficult. In particular, some employees may be more reluctant to provide information to a CCO than to the GC, and this may result in increased wrongdoing and weaker operating performance. These deleterious effects, however, might be somewhat ameliorated by institutional and governance design adjustments. Khanna examines what factors may drive likely outcomes and finds that further empirical inquiry would be valuable, going on to suggest some ways in which future research might engage in this inquiry. In Chapter 13, “When the corporation investigates itself,” Miriam Baer evaluates the challenges corporations face when investigating corporate crimes in the shadow of the federal government’s expectations concerning full corporate cooperation. She argues that the corporate investigation’s greatest challenges stem from familiar problems of individual and entity-level efforts to evade detection. As employees take steps to conceal their misbehavior, corporate actors must navigate a difficult relationship between government enforcers on the one hand and corporate employees on the other. Mediating these relationships would be difficult enough under any circumstance, but a vexatious deficiency of trust between corporate actors and government enforcers causes corporate actors to cling ever more intently to legal doctrines such as the corporate attorney–client privilege, while simultaneously conducting more intensive, intrusive and expensive investigations. Baer concludes by noting two developments: the Department of Justice’s latest attempt to secure cooperation from corporate defendants in identifying culpable employees (the so-called “Yates Memo”), and the increasing emphasis on workplace privacy. These two developments will place even greater pressure on the corporate investigator as she attempts to reassure the corporation’s employees and regulators that each side can in fact trust the corporation to investigate itself thoroughly yet fairly. In Chapter 14, “Bounty regimes,” David Freeman Engstrom offers a theoretical and empirical overview of whistleblower bounty schemes that pay individuals a cash “bounty”

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Introduction  7 for surfacing information about illegal conduct. Engstrom first catalogues existing bounty regimes by comparing the structure and workings of two of its most prominent exemplars: the False Claims Act and the more recent Dodd-Frank whistleblower scheme. Next, he surveys the existing scholarly literature, with particular attention to a trio of recurrent design problems. Among these are how to incentivize an optimal level of reporting, how to harmonize bounty regimes with internal corporate compliance systems, and how to weigh efficiency and democratic-control concerns when deputizing whistleblowers to do regulatory work. Finally, he turns to an aspect of the regulatory design puzzle that has yet to attract substantial attention: how the organizational structure of wrongdoing (e.g., organizational complexity, the degree to which the misconduct is centralized or compartmentalized, and the like) presents opportunities and challenges in the design of bounty regimes. He concludes that it is here that scholars are most likely to find fruitful avenues for further research. Taken together, the chapters in this volume both reveal how far we have come in our understanding of mechanisms for deterring corporate misconduct and highlight promising avenues for future research.

REFERENCES Arlen, Jennifer. 2012. Corporate Criminal Liability: Theory and Evidence. In Keith Hylton and Alon Harel (eds.), Research Handbook on Economics of Criminal Law, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, Section 1. Arlen, Jennifer and Marcel Kahan. 2017. Corporate Regulation Through Non-Prosecution, University of Chicago Law Review, 84, 323–387.

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PART I CORPORATE AND INDIVIDUAL LIABILITY FOR CORPORATE MISCONDUCT

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1.  Psychology and the deterrence of corporate crime Tom R. Tyler* 2

1. INTRODUCTION The field of economics has had an enormous and positive influence upon legal scholarship. This influence has occurred in two stages. In the first, the theoretical framework of rational choice shaped arguments about how to structure regulation and has led to the widespread adoption of deterrence models as a primary mechanism for shaping the behavior of people within work organizations (Arlen and Kraakman, 1997; Becker, 1968; Polinsky and Shavell, 2000). In the second, behavioral economics has more recently provided evidence that the assumptions of the rational choice model need to be modified to recognize that decision making exhibits systematic biases. Both of these movements share the important argument that the design of laws and legal institutions should be shaped by their presumed or observed impact upon the behavior of people. And both begin with the assumption that it is the risk and experience of sanctions that are the key to that influence. This chapter argues that policy should be based on a broader model than is often employed in economic analyses. The goal of this review is to improve our understanding of the antecedents of law-related behavior. In particular, in this chapter I argue that there is considerable empirical evidence demonstrating that consent-based models of compliance are also viable mechanisms for deterring misconduct in corporate and other work settings. What is a consent-based model? It is a model that focuses on the legitimacy of the law as a factor motivating compliance (Tyler, 2006a, 2006b). If people believe that legal authority is legitimate they consent to and voluntarily comply with legal rules and the decisions of legal authorities. Sanctions are clearly also important, but given that consent-based models are equally, or in some situations even more, effective it makes sense to move toward a strategy that pays more equal attention to both approaches, which given the current dominance of coercive models means paying greater attention to consensual approaches. More specifically research findings suggest that consensual models are not only as or more effective than are traditional coercion-based models directed at motivating compliance through a sanctioning approach, but that they are much better able to encourage voluntary cooperation with the rules, lessening the difficulties and costs associated with creating and maintaining the type of effective mechanisms of surveillance needed for sanction-based models. Finally, consent-based approaches encourage employee identification with organizations and communities, which broadly encourages employees’ engagement in their work organization (Tyler and Blader, 2005; Tyler and Jackson, 2014). This promotes productivity for companies.

*  I would like to thank Jennifer Arlen, Miriam Baer, Sam Buell, Vikramaditya Khanna, Janice Nadler and Jonathan Glater for helpful comments on a draft of this chapter.

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12  Research handbook on corporate crime and financial misdealing I further suggest that in spite of empirical evidence demonstrating the important distinct influence of consensual models, coercive models continue to dominate both law in general and the area of corporate compliance in particular. This leads to the question of why that dominance continues in spite of the evidence. This chapter addresses this issue by examining the psychological benefits of adopting an approach based upon coercion to the authorities who enact this approach to regulation.

2.  INTERNAL AND EXTERNAL REGULATION In discussing corporate crime, it is important to recognize that there are two potentially important regulatory models: coercive and consensual. The coercive model is associated with deterrence strategies; the consensual model with the legitimacy of rules and authorities. Most of the general literature on deterrence is concerned with the influence of law and legal authorities upon the behavior of individuals within organizations. People are assumed to be influenced by the penalties of the law; they are also influenced by the legitimacy of law and legal authorities. In the case of the organizations for which people work, there is also an internal regulatory system in which the organization confers rewards and punishments and has its own value-based culture. Hence, the setting of corporate crime occurs within two organizational frameworks, each with coercive and consensual elements. The internal coercive approach, in which firms structure their internal incentives and sanctions to motivate desired behavior is outlined by Arlen and Kraakman (1997). 2.1  Regulatory Goals In order to compare models of regulation it is first important to identify the goals we seek to achieve through the regulation of organizations.1 Most discussions focus on the criteria of compliance, i.e. on whether people obey rules and the directives of legal and managerial authorities. These authorities can be legal authorities, such as police officers, judges or administrative regulators who are enforcing societal laws, or corporate leaders, who are enforcing the internal rules of their organizational entities. In either case discussions of compliance focus on observed behavior. The issue is whether and why people do or do not behave in accordance with informal or formal rules. Observed compliance does not in and of itself indicate why people are complying. However, in the everyday use of that term there is often an implicit assumption that compliance is linked to cost–benefit calculations. People comply to avoid sanctions. This is the coercive model. The goal of this chapter is to separate the issue of the extent and nature of the type of behavior we want people to engage in from the motivations that people have for behaving as they do. There are several goals besides compliance with what might be desirable (Soltes, 2016). The first is the goal of deference. In contrast to compliance, deference 1   The focus of this discussion is on for-profit work organizations. The arguments being made apply more broadly to people’s relationships to any group, organization, or community. Within for-profit work organizations one issue is the internal culture of the firm. A second issue is the framework of legal authority within which the organization functions. Either of these can be coercive or consensual.

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Psychology and the deterrence of corporate crime  13 is rule-governed behavior that occurs because people have decided that they ought to accept rules and as a result do so without reference to the issue of sanctions. Deference is voluntary in that it is not linked to perceived risk of sanctioning. People consent to rules. As this distinction suggests, there is no necessary behavioral difference between compliance and deference. The difference lies in the motive for rule following. The question is not whether people are following rules, but why they are doing so.2 2.2  Goals for the Behavior of People in Organizations and Communities The distinction between the two different reasons for following rules has important implications for discussions about regulation. To the degree that rule following is voluntary then regulatory authorities either within a company or in external legal regulatory spheres do not need to expend resources toward the goal of creating viable surveillance systems, building policing forces, and developing ways to judge and punish suspected rule breakers. These resources are less needed because people are internally motivated to conform to rules. Hence, to the degree that it is possible to encourage people to consent to obeying rules, there are clear benefits to organizations and to society. In both cases, however, the focus is on rule following. For this reason, regulatory authorities are typically viewed as a cost to an organization or a community. Money spent to enforce rules is a necessary cost, but one that reduces the gains that are the goal of for-profit organizations and takes a toll on the efforts to garner resources to promote economic and social welfare that define communities. Armies, police forces and compliance officers are needed to ensure that illegal and unethical behavior does not occur and undermine company or societal viability by leading to either internal conflict or attracting the attention of external government authorities. But these security expenditures do not directly contribute to achieving the goal of enhancing profitability.3 Both companies and communities would benefit if they could allocate more of the resources they use to create credible mechanisms for deterrence to other activities. A further goal for an organization is to build the type of employee identification with the organization that promotes voluntary behaviors of a positive type, i.e. behavior that is designed to enhance company success and profitability by motivating its members to want to do the things that will lead to the well-being of the organization, i.e. to work productively and engage in desirable in-role and extra-role behavior. An ideal regulatory framework for rule enforcement would leverage employee loyalty toward behaviors beyond rule following and toward enhancing organizational viability and success (see Arlen and

2   The distinction between compliance and deference is not absolute. Corporations can create cultures that favor or disfavor deference. The motivation to defer can be enhanced by structures (Arlen, 2012). For example, a company that links employment to achieving profit-related goals is less likely to have a culture that supports discretion about whether to follow rules. 3   One way that they do contribute is by promoting the belief that those who do not follow rules will be caught and punished. Without some level of deterrence people are more likely to be free riders. Believing that the people who break rules are caught and punished is one element in viewing authorities as legitimate. An authority that allows widespread cheating or corruption is viewed as less legitimate and is less able to motivate voluntary deference among the general population of an organization or a community.

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14  Research handbook on corporate crime and financial misdealing Kraakman, 1997; Arlen, 2012). As an example, police forces enforce rules and protect communities from crime. But the type of community solidarity and social capital needed for economic and social development flows from reassurance, i.e. the belief that the police are concerned about the needs of the community and will help those in need. So, beyond controlling crime the police can be a presence that promotes community well-being. Similarly, organizational authorities, for example management, can hopefully promote identification with and commitment to the organization, thereby leading employees to work more willingly and creatively to help their company be successful (Tyler and Blader, 2000).4 Studies in both arenas suggest that exercising authority using fair procedures is a key antecedent to creating this view (Tyler, 2006a, 2006b). These distinctions can be illustrated using recent research on legal authority in communities (Tyler and Jackson, 2014). Consistent with past research, Tyler and Jackson show that risk estimates concerning the likelihood of being caught and punished have an influence on compliance. They also have an influence on voluntary deference, but that influence is weaker. But they do not shape residents’ proactive engagement in the community. Across these three forms of behavior the strength of deterrence effects diminishes as the focus moves from compliance, through deference toward positive engagement. Hence, as we move our attention toward building engagement, which promotes the well-being of the community, we increasingly need an alternative model to the coercive approach. This argument fits well with our goals in community settings, where economic and social development is a key to the future viability of the community. When the police provide reassurance and create legitimacy, rather than creating fear because they are viewed as linked to deterrence, they create a framework within which people engage themselves in the community. This does not mean that deterrence is not valuable, but it suggests the need to pursue legitimacy as a distinctly valuable goal.5 It can both help to motivate compliance and can distinctively promote deference and engagement. The same argument underlies regulation in corporate settings. Too often the compliance officer is just that and employees experience a sanction orientation backed up by many overt and covert forms of surveillance. That can include the monitoring of communications, video surveillance of the workplace, etc. While necessary for a viable command and control regime which functions through deterrence, these actions do not create identification with the company or motivate employees to work on its behalf. To gain the benefits of such motivation people need to experience rules as a product of consent and they need to regard regulatory authorities as legitimate. Compliance officers can also pursue this objective and can work to create a corporate culture that enhances the legitimacy of internal standards and values. The literature that studies policing in community settings suggests that such legitimacy can be created and maintained, and that

4   Of course this can be a double edged sword. If people are motivated to achieve success by disregarding rules this success can come at the expense of other values. In an ideal world the corporate culture emphasizes taking actions within the framework of organizational rules as well as rules of law. 5   Some scholars argue that pursuing the goal of compliance via deterrence lessens or crowds out the influence of legitimacy on behavior (see Tyler, Goff and MacCoun, 2015 for a review of this argument). This discussion will treat deterrence and legitimacy as two parallel influences on law-related behavior.

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Psychology and the deterrence of corporate crime  15 it can promote identification and actions on behalf of collective entities. This approach is also viable in corporate settings (Tyler, 2005; Tyler and Blader, 2000, 2005).

3.  HOW TO ACHIEVE THESE GOALS 3.1  Deterrence Through External Sanctions Recent empirical research suggests that the deterrence-based strategies of governance/ management can be successful. For example, recent research suggests that deterrence strategies can shape crime-related behavior (Blumstein, Cohen, and Nagin, 1978; Nagin, 1998). But the same findings also suggest that the magnitude of deterrence influences is usually small and sometimes non-existent (Bottoms and Von Hirsch, 2010; Paternoster, 2006). Further, studies suggest that the limits of deterrence effects do not reflect an inherent inability of using a risk of sanctions to shape behavior. Rather they reflect limits in resources available for surveillance and sanctioning, and situational factors which shape how effective surveillance can be. It is important to distinguish the questions of whether deterrence can work and how well it works in natural situations. Clearly it can and does work in some settings. Limits to how well it works in natural settings are linked to the realities of those situations. Studies of police presence, for example, link the level of policing to the violent crime rate (Evans and Owens, 2007; Vollaard and Hamed, 2012), with Worrall and Kovandzic suggesting “a modest inverse association between police levels and crime” (2010, p. 515). That association may be strengthened when police can be concentrated in a small area, as in hot spots policing (Weisburd and Braga, 2006). The problem is maintaining high levels of concentrated police attention on one area over time (a resource limit, not an inability of risk to shape behavior). The use of power, particularly coercive power, is found in many natural settings to require a large expenditure of resources to exert a small influence on others. This conclusion is typical of the findings of studies of compliance with the law in which deterrence is found to have, at best, a small influence on people’s behavior when we consider the proportion of the variance explained by estimates of the likelihood of being caught and punished for wrongdoing. Of course, in corporate settings firms can be encouraged to undertake this monitoring, not government. Nonetheless, whoever is responsible, the resources required to achieve the necessary threats of detection are considerable, so both firms and government would benefit from considering the possibility of other mechanisms for leveraging desirable behavior as well as threatened or enacted sanctions. When possible it would be desirable to restrict the focus of sanctions. More general reviews of deterrence research which usually focus on crime outside corporations conclude that the relationship between risk judgments and crime is “modest to negligible” (Pratt et al., 2008) and that the “perceived certainty [of punishment] plays virtually no role in explaining deviant/criminal conduct” (Paternoster, 1987, p. 191). According to Piquero, Paternoster, Pogarsky, and Laughran, a review of the literature results in “some studies finding that punishment weakens compliance, some finding that sanctions have no effect on compliance, and some finding that the effect of sanctions

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16  Research handbook on corporate crime and financial misdealing depends on moderating factors” (Piquero et al., 2011, p. 335). This argument heightens the suggestion that sanctions need to be focused, since in some populations they can crowd out other motivations for accepting and following rules, while in others those other motivations are weak or nonexistent and a deterrence threat provides a reason for compliance. Similarly, studies of more severe punishments, like imprisonment, report that more severe punishments are generally unrelated to lower rates of future criminality (Lipsey and Cullen, 2007). For example, studies on the most severe form of punishment—the death penalty—suggest that the argument that capital punishment deters crime “still lacks clear proof ” because studies have failed to produce compelling evidence that executions influence the rate of crime (Weisberg, 2005; Deterrence and the Death Penalty, 2012). Studies generally find that the linkage between severity of punishment and criminal behavior is weak. The “evidence suggests that the magnitude of deterrence is not large and is likely to be smaller than the magnitude of deterrence induced by changes in the certainty of capture” (Chalfin and McCrary, 2014, p. 26). Of course, the types of crime involved in these studies differ significantly from corporate crimes and the types of criminals are unlike those associated with “white-collar” crimes, which are economically motivated. Studies on punishment suggest that it is not only an ineffective deterrent in terms of the general deterrence impact upon society at large (others see the punishment and to avoid it do not commit the crime), but it is also minimally, if at all, effective in deterring the future criminal conduct of those being punished (as is evidenced by high rates of recidivism). Widespread punishment for minor crimes does not generally lower the rate of subsequent criminal behavior, as models of specific deterrence would predict (Harcourt, 2001; Harcourt and Ludwig, 2006). In fact, studies of juveniles suggest that incarceration actually increases the likelihood of later criminality (McCord, Widom, and Crowell, 2001). Hence, the primary impact of punishment occurs through incapacitation, with criminals unable to commit further crimes while they are in prison. Incapacitation works, but is limited in situations where a criminal is replaced by another person committing the same crime (e.g. a new corner drug dealer) and is unnecessary when it is responding to a crime risk that would disappear as a criminal naturally aged out of criminal behavior. While the previously mentioned studies refer to the effectiveness of deterrence and sanctioning generally, studies specifically focused on white-collar crime yield similar results (Huselid, 1995; Jenkins, Mitra, Gupta, and Shaw, 1998). Braithwaite and Makkai (1991) studied compliance with regulations against fraud among nursing home executives. They concluded that there were no significant deterrence effects; in other words, whether the law was followed was not related to perceptions of the likelihood of being caught and punished for breaking the law. Additional evidence comes from experiments in which participants indicate their likelihood of engaging in wrongdoing given different fact scenarios that vary the likelihood of being caught. They similarly do not find deterrence effects on people’s decisions about how to act under different conditions (Jesilow, Geis, and O’Brien, 1985, 1986). On the other hand Simpson et al. (2013) argue, based upon studies using simulated scenarios and decisions made by managers, that the “certainty and severity of informal discovery by significant others in the firm” (p. 232) shapes intentions to participate in illegal behavior. Reviewing these studies Simpson described evidence supporting the existence of deterrent effects in corporate settings as “equivocal” (Simpson, 2002). Most recently Simpson, Rorie, Alper, and Schell-Busey (2014) reviewed the literature on corporate crime

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Psychology and the deterrence of corporate crime  17 deterrence and concluded that there is some weak but inconsistent evidence, with clear methodological problems, that laws deter corporate crime; that “few significant effects” (p. 38) connect punitive sanctions to deterrent effects; and that individual data is more likely to show the effects of regulatory policy—but these are not found at the organizational level. Interestingly they found that older less rigorous studies were more likely to suggest stronger deterrence effects. Yaeger (2016) similarly suggests that “the jury remains out as to just how much deterrence the law actually brings” (p. 20) (also see Alexander and Cohen, 2011; Ugrin and Odom, 2010). Overall, studies generally find deterrence effects, but the magnitude is often small and dependent upon particular situational factors such as the possibility of detecting illegal behavior. In addition to this general effect of the law upon behavior there is the influence of deterrence from within the firm. In three studies on cooperation and employee conduct, I interviewed employees concerning their rule-breaking behaviors and their estimates of the likelihood of being caught and punished by their own management for wrongdoing, and examined the influence of employees’ judgments of risk of detection and punishment (Tyler, 2011; Tyler and Blader, 2005). The studies found minimal deterrence effects of internal sanctions on employees’ rule-following behavior (Tyler, 2011; Tyler and Blader, 2000, 2005). These findings generally point to two conclusions. First, deterrence is effective but expensive. Whenever possible it makes sense to try to focus deterrence upon particular situations or people that are high risk. Second, there are considerable advantages to combining deterrence approaches with efforts to build normative commitments to rule following, both within internal corporate cultures and in relationship to the law. These mechanisms can supplement deterrence mechanisms, and their combined impact is more effective in ensuring successful regulation. 3.2  Internal Incentives: Punishments and Rewards In addition to punishment, researchers have also considered the role of internal incentives in organizational contexts (Tyler and Blader, 2005). Based upon a workplace-based study in which employees were interviewed about the risk of punishment and possibilities of reward for different types of workplace behavior, Tyler and Blader estimated that around 10 percent of the variance in employee behavior is shaped by incentives in the work environment (Tyler and Blader, 2000; see Podsakoff et al., 2006). These results suggest that, while they are somewhat effective, incentive systems also only have a limited impact on employee behavior. In recent years, the limits of the reward and sanction-based command and control model has been emphasized in work settings. These critiques focus on systems which seek to implement regulations through sanctions and incentives (Katyal, 1997; Markell, 2000; Sutinen and Kuperan, 1999). In the legal literature on government regulation, skepticism surrounding command and control strategies has led to the flourishing of market-based models of regulation that emphasize economic incentive systems. The same research shows that changes in behavior motivated by promised incentives or threatened sanctions internal to the organization come at high material costs to the organization because they require either the provision of resources for surveillance or the widespread use of incentives. This leaves organizations vulnerable, because disruptions in

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18  Research handbook on corporate crime and financial misdealing the control of resources brought on by periods of scarcity or conflict quickly lead to the collapse of effective social order when that social order is primarily being enforced through coercion (Tyler, 2006a, 2006b). In the case of firms it applies to business downturns or crises such as scandals or episodes that undermine corporate leadership. This includes internal relationships between leaders and employees; external relationships between a company and its customers; and the balance between internal regulation and government control. When law and legal authorities and/or corporate leadership are seen as legitimate there is an alternative basis for support during difficult times. It is precisely in times of economic crisis that authorities both most need the support of those they seek to regulate and are least able to either provide incentives or effectively enforce sanctions. It is also when business leaders rely most strongly on the loyalty of customers and the confidence of government that they will manage internal crises and do not need external control. Further, when legal authorities can call upon the consent of the regulated group to encourage desired behavior, either because of an internal ethical culture or because of the legitimacy of legal authorities in a community, the authorities have more flexibility in how they deploy their resources. In particular, they are better able to use collective resources to benefit the long-term interests of the organization since they are not immediately required to ensure that ethical standards and policy objectives are being pursued. While it may be necessary to have a compliance officer, a police force or an army, viability is enhanced when those resources can be diverted into the development of the organization itself. So, to the degree that order flows from consent, linked to either a shared internal commitment to organizational values or to the law and the legitimacy of legal authorities, society is better off. The argument made here about the limits of sanctions and punishment might initially seem counterintuitive. After all, most people are familiar with many studies whose conclusion is that “deterrence” or “punishment” works. It is first important to note therefore that some of the seeming impact of deterrence is the manner in which research is conducted and presented. In particular, the use of statistical tests that examine significant departures from ‘no influence’ does not focus on how strong an influence that occurs is, only that it is significantly different from no influence. With a large sample an effect can be statistically significant but substantively unimportant. An alternative approach is to ask how much of the variance in a particular behavior a model explains. As an example, MacCoun reviewed the literature on deterrence in the case of drug use and suggested that only about 5 percent of the variance in drug use was explained by variations in the certainty and severity of punishment (MacCoun, 1993). Compare the message of a statistical significance approach with that of a percentage of variance explained model. Even when there are statistically significant effects deterrence explains at best a very small proportion of the variance in law-related behavior. In other words, a relationship between two variables can be found to be statistically significant but can nonetheless explain so little of the variance that it is of barely any consequence. 3.3  Why Do Threatened Sanctions Have Limited Effect? In addition to resource concerns, there are social costs to an organization that relies on punishment to deter non-compliance. First, if people comply with the law only in response to coercive power, they will be less likely to obey the law in the future because

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Psychology and the deterrence of corporate crime  19 acting in response to external pressures diminishes internal motivations to engage in socially desirable behavior (Tyler and Blader, 2000). This follows from the well-known distinction in social psychology between intrinsic and extrinsic motivation. Research on intrinsic versus extrinsic motivation shows that when people are motivated solely by the prospect of obtaining external rewards and punishments (i.e., extrinsic motivation), they become less likely to perform the desired behavior in the absence of these environmental reinforcements (Deci and Ryan, 1985; Ryan and Deci, 2000). On the other hand, if people are motivated by intrinsic reasons for behaving in a certain way, then their compliance becomes much more reliable and less context-dependent (Frey, 1994, 1997a, 1997b). As has been noted, the idea of crowding out or undermining intrinsic motivation (Frey, 1997b) is particularly important in work settings. Most people have norms and values that encourage them to obey rules and not be unethical or dishonest. These include moral values, social norms and feelings of responsibility and obligation to follow both organizational rules and laws. Further, the type of identification that can develop and facilitate behavior based upon a social connection has the possibility to be especially strong with a work organization, which is often a more cohesive social unit than a community of people who are frequently virtual strangers to one another. Hence, crowding out intrinsic motivations is an especially unfortunate development in work settings. Further the use of sanctions undermines value-based motivations because it sends a message to the potential targets of the sanctions telling them that the authorities view them as untrustworthy and suspect (Tyler, Jackson, and Mentovich, 2015). As a result, people become more suspicious and less trusting of the law and legal authorities. No one likes to feel that their superiors mistrust them and believe that they must be constantly watched or they might behave unethically. And in modern work organizations such surveillance can be quite pervasive. As has been noted, employees can have their computer hard drives periodically checked; their emails scrutinized; their work space scanned by video cameras and even their bathroom breaks subject to monitoring. Surveillance is a particular issue with the internal cultures of organizations. If a company communicates an atmosphere of monitoring that leads to sanctioning, it is communicating mistrust, which undermines both employees’ identification with the company and their willingness to consent to and voluntarily observe workplace rules (Tyler and Blader, 2005). Of course, this argument should not be extended too far. Companies need to make clear that they do not advocate or condone wrongdoing, and that they will punish it. This can best be communicated within the framework of a positive message about the type of people that the company believes that its employees are, and the type of behavior that it therefore expects from them. Again, the workplace is a particularly poor setting for using a strategy that is communicating mistrust. Even in high-crime neighborhoods in poor communities, most of the people in the community are not engaged in wrongdoing. Stigmatizing people in these communities is counterproductive because their cooperation is needed to identify the small group of violent criminals within their community. Similarly, stigmatizing large minority populations of Muslim Americans is counterproductive because their cooperation is needed to identify potential terror threats (Tyler, Schulhofer, and Huq, 2010). In work settings the number of individuals engaged in wrongdoing is similarly likely to be small, and their co-workers are the people most likely to be aware of their behavior. Hence,

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20  Research handbook on corporate crime and financial misdealing in all these situations it is advantageous to communicate support and trust as widely as possible. 3.4  The Importance of Resources This is not to say, as has been noted, that deterrence is irrelevant. Deterrence effects do occur and their limits are not intrinsic to any inability of risk to shape behavior, i.e. they are linked to situational limits. Research only examines the influence of the limited range of sanctions typically found within companies (Paternoster, 1987, 1989, 2006; Paternoster and Simpson, 1996), and does not explore whether the use of greater resources would lead to stronger effects.6 Conversely, we do not know how much illegal behavior would occur if employees believed that they could commit fraud or engage in other forms of illegal behavior with no risk whatsoever of being caught and punished. We generally do not know how effective deterrence could be if more or fewer resources were devoted to creating higher levels of risk. It is particularly important to note that sanctions are often ineffective because society does not put sufficient resources into surveillance and enforcement to make the risks of rule-breaking credible (Paternoster, 2006). If sufficient resources were allocated to that purpose, sanctions might more strongly influence behavior (Paternoster, 2006). The limit of such strategies is defined by resource constraints, since the resources used for surveillance only benefit a company by preventing wrongdoing, they do not contribute directly to productivity. There is an inherent trade-off between resources for surveillance and resources for other purposes. 3.5  Effective Strategies Overall there is considerable evidence that deterrence can shape behavior. This is especially true of variations in the probability of detection and punishment; and effects are typically stronger at the organizational level (Short and Toffel, 2010). However, findings equally clearly suggest that the strength of such effects is often overstated and that regulation would clearly benefit from a greater inclusion of attention to voluntary cooperation based upon consent. Research findings therefore suggest the value of a two-part strategy. The first part involves optimizing deterrence by identifying those situations within which deterrence can be effective and sustainable. This requires an ability and willingness to create and maintain a credible threat of punishment. It also works best when behavior is observable and difficult to conceal. In such settings a deterrence model is most likely to be effective. And, in any setting deterrence is a background factor of importance. If the government had no policing for legality, for example, this would encourage greater levels of rule 6   It is particularly noteworthy that students of perceptions of risk find evidence of threshold effects. It may be necessary for the likelihood of being caught to be over some level, a level often suggested to be around 30 percent, before there is any strong deterrence influence. There are very few crimes in our society (e.g. murder) that have arrest rates above this level. For example, drug use, which is a crime against which a considerable number of police resources are directed has a much lower level of risk (MacCoun, 1993).

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Psychology and the deterrence of corporate crime  21 breaking. Hence, a starting point of any approach to regulation is deterrence. However, the findings also suggest that deterrence can only be a beginning point. It is important to seek to supplement deterrence mechanisms with other approaches that create and draw upon values which motivate cooperation with law and legal authorities.

4.  CONSENT-BASED REGULATION The coercive model can be contrasted to a second motivational model: consent-based deference. This model encourages people to accept rules and obey them because they believe they define the appropriate behavior to engage in. People consent when/to the extent that they believe that authority is legitimate and ought to be obeyed; that authorities can be trusted to create desirable rules which reflect shared values; that the rules reflect personal moral values defining right and wrong; and/or that the rules reflect shared norms about desirable behavior in the community (Tyler and Darley, 2000; Tyler and Huo, 2002). These factors can work together and, research shows, any of them can distinctly shape rule following. Of particular importance is legitimacy, the focus of this chapter. 4.1  Evidence on the Effectiveness of Consent-Based Approaches In the case of legal authorities, a large number of empirical studies indicate that the legitimacy of the police, the courts and the law shapes a variety of important public behaviors. These include: deference to police authority during personal encounters; everyday compliance with the law; cooperation with legal institutions; and the acceptance of police authority (for a review of this literature see Tyler, Goff, and MacCoun, 2015). This literature studies ordinary citizens, and is relevant to both street criminals and white-collar offenders. The role of values can be illustrated by considering many issues. One example is tax compliance. It is hard to argue that people pay taxes out of fear of detection for noncompliance since the likelihood of being detected is very low and penalties are both small and uncertain. Yet the rate of tax compliance in the United States is high. So, what motivates this behavior? The argument made here is that legitimacy, morality, and social norms are all motivational forces that are distinct from risk of punishment. In the United States these have all been forces that promote law-abiding behavior in this and other arenas. Of course, there are limits and when these non-instrumental factors are weak or nonexistent, as with the prohibition of alcohol consumption in an earlier era and laws against drug use today, it is more difficult to motivate rule adherence. The idea of examining explained variance has already been noted. This line of argument can be extended and leads to the suggestion that what is needed are studies that compare deterrence effects to the influence of legitimacy. Tyler and Blader (2005) do this in two studies of employees. They show that in the case of within-company social dynamics, perceived risk is relatively unimportant in shaping employee compliance with organizational rules relative to the legitimacy of the companies’ internal culture. Tyler examines this same question in a survey of 4,430 employees and finds that instrumental factors explain 1 percent of the variance in required compliance while social factors, including legitimacy, explain 19 percent of the variance (Tyler, 2011). As noted

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22  Research handbook on corporate crime and financial misdealing above, the influence of instrumental factors is statistically significant, but not as strong as the influence of social factors. Both types of influence occur, but a direct comparison of magnitude of influence suggests that values are strikingly more influential. Similarly, Trevino, Weaver, Gibson, and Toffler compare the effectiveness of rules and punishment to the internal values and culture of integrity in companies in a study of 10,000 employees in six industries (1999). Compared to compliance-based programs, values-based programs had fewer reports of unethical conduct, higher levels of ethical awareness, more employees seeking advice about ethical issues, and a higher likelihood of employees reporting violations. Key factors in values-based programs were treating employees fairly, rewarding ethical behavior, and punishing unethical behavior. Here again, a relative comparison reveals the superiority of a values-based approach. To illustrate the comparison of these models in a corporate setting, I will discuss a study I conducted in a major international corporate bank’s private banking group several years ago (see Tyler, 2011, for details about this research). In that study 612 members of the private banking group completed questionnaires regarding their workplace and their workplace behavior. For a subset of employees the answers were compared to responses from supervisors after, as promised, all identifying information was removed from the dataset. The supervisor check suggested that self-reporting was a valid measure of employee behavior (see Blader and Tyler, 2009). To reflect material gain and loss employees were asked how much they gained by rule following, multiplied by the likelihood it would be observed, and how much they lost by rule breaking, also multiplied by the likelihood it would be observed. They were also asked about their level of compensation and benefits, as well as their long-term prospects. To reflect consent, employees were asked about their judgments on the legitimacy of management; their trust in the motivations of their managers; and their views about the degree to which they and their managers shared values about appropriate goals for the organization. What are the behaviors of concern? Compliance is reported rule following. Its parallel is in-role job performance (doing what is required by your job). Deference reflects voluntary acceptance and its parallel is extra-role behavior (doing what is not required by your job). In addition, there is identification with the organization, which has been linked to all of the previously outlined behaviors and further includes general efforts to facilitate the success of your organization (Tyler and Blader, 2005). And finally, since the company studied was in the midst of a merger, the study asked if the employee embraced working to make the merger a success, a specific instance of working for the success of the (newly created) organization. These factors explained 14 percent of the variance in reported compliance with workplace policies and rules. When considered alone, incentives and coercion explained 3 percent of the variance; consent-based factors 12 percent. In the case of in-role behavior 10 percent of employee behavior was explained; coercion-based variables accounted for 3 percent and consent-based variables 8 percent. All of these influences were significant, suggesting that both factors are having an effect. However, consent factors were generally at least twice as powerful. In the case of deference, 15 percent of the variance was explained; coercion-based variables explained 3 percent and consent-based variables 15 percent of the variance. This means that while both factors are significant when considered alone, when they are

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Psychology and the deterrence of corporate crime  23 considered together consent-based variables explain all of the variance in deference. With extra-role behavior, 13 percent of the variance was explained; 4 percent by coercion-based variables and 11 percent by consent-based variables. Finally, 40 percent of the variance in identification with the organization was explained; 4 percent by coercion-based variables and 40 percent by consent-based variables. So, again, when both factors were considered together, consent-based variables explained all of the variance. This was reinforced by the variable measuring identification with the new company, with 25 percent of the variance explained in total. Coercion-based variables explained 3 percent of the variance; consent-based variables 25 percent of the variance. So with the variable central to engagement in and active promotion of the organization, consent-based variables explained all of the variance. These findings are only from one organization, and the study targeted the type of highlevel employees whose jobs are highly discretionary and rule-guided. So it is especially relevant to the issue of corporate regulation. Beyond that, the much broader study of employees already mentioned (Tyler, 2011), a study that both drew upon a nationally representative sample of employees and used a panel design, reinforced the conclusions of the study reported. Hence, there is a strong empirical base to the arguments made here. This distinction between regulatory strategies is not a new one. In 1994, Lynne Sharp Paine of Harvard addressed this dichotomy in her now famous Harvard Business Review article, “Managing for Organizational Integrity.” She contrasted command and control compliance programs with market-oriented values-based programs. A compliance approach rests on rules enforced by external force, usually the company itself, but with threats of civil and criminal punishment lurking in the background. Unfortunately, when employees are not monitored, the fear of being caught and punished diminishes, and compliance declines. The values approach, Paine argues, rests on employees governing their own behavior by voluntarily choosing such behavior in the same manner as one chooses the most appealing product in the marketplace. Paine argues that the goal is to have the employees engage with and adopt the values of the organization as their own. When this occurs, employees are more likely to comply with rules even when they are not monitored. Such employees come to be good stewards of the company’s values, helping to instill them in new employees and actively discouraging those who seek to violate them. 4.2  What Data Is Collected? The perceived dominance of deterrence is aided by the tendency to only collect data relevant to the dominant theory. In America, national surveys collect information on crime rates, arrest rates, and sentencing. These can be linked to statistics on the certainty and severity of punishment, as well as the length of sentences. However, it is not possible to compare the influence of the risk of punishment to the influence of legitimacy (Tyler, 2007). There are no national survey research studies dedicated to the periodic measurement of the legitimacy of law, the courts, or the police or administrative regulatory ­agencies. The type of comparisons presented in this discussion are typically not possible since only data on the probability and severity of punishment is available. This reinforces the approach of examining only whether such factors produce a statistically significant effect.

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24  Research handbook on corporate crime and financial misdealing

5.  THE MYSTIQUE OF INSTRUMENTALISM If corporate governance via legitimacy is a desirable and effective approach why is it so hard to build regulatory models about consensual approaches? The findings reviewed suggest that legitimacy is a highly desirable feature of social systems, with many appealing features as a possible basis for the rule of law. Why, then, is it so difficult to create and maintain a compliance system based upon legitimacy, and why do authorities use instrumental approaches based upon utilitarian models? Why is the immediate response of legal authorities to a crisis, whether it is an issue of financial misconduct or not, to focus on threats and sanctioning? My suggestion is that instrumental approaches are seductive because of their shortterm features. These approaches are appealing for both practical and psychological reasons. And, these appealing features lead authorities to discount the long-term difficulties and costs of using such models. There are attractions to deterrence approaches that reflect psychological benefits to the authorities exercising power, rather than being indices of actual effectiveness in controlling rule following. For these reasons authorities overestimate the effectiveness of the utilitarian approach to the implementation of laws and regulations. They have an excessive belief, for example, that threat deters immediate behavior and that punishment lowers recidivism. If research does not support this argument with the strength that is assumed by conventional wisdom, as is suggested by the literature reviewed above, then why would it continue to represent the conventional wisdom? A first reason already noted is the use of the statistical approach noted above. Studies are framed in ways that support an argument in favor of deterrence, when other framings would support different conclusions. In particular, a comparison of effect sizes would suggest that both coercion and consent matter, with consent being considerably stronger in its influence on behavior. Some of the conventional wisdom in favor of deterrence is likely based on the behavior that regulatory authorities see occurring in front of their very eyes every day. People faced with authorities generally comply in the moment, when the threat of those authorities is palpable (although evidence suggests that in those situations they often resist). Then, later (and, more importantly, outside the scope of plausible surveillance), when their behavior is not motivated by the immediate threat of punishment, people renege. As a consequence, those in positions of authority have the continual experience of seeing power work to influence behavior, when in fact that influence is extremely short lived and limited in scope. People in power therefore come to think that the threat and use of force is a more viable and effective strategy than it actually is. In reality, as I have detailed above, reviews of the literature consistently show that the threat and use of force is often ineffective and generally not as strong in its impact as is typically assumed. Variations in the likelihood of being caught and punished have, at best, a minor impact on criminal behavior in many natural settings. Whether people are punished is not reliably related to lower levels of future criminal conduct and more severe punishment is not linked to less criminality in the future. When this widespread lack of empirical support for force-based approaches is compared to the general belief in the effectiveness of such models, the question is why this widely held, but mistaken, belief persists? To some extent this continuation in a flawed belief reflects the self-fulfilling nature of

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Psychology and the deterrence of corporate crime  25 theories and models. Ferraro, Pfeffer, and Sutton discuss the dominant role of economic models in organizational theory and the similar lack of strong empirical support for such models in that context (Ferraro et al., 2005). They argue that whether or not a theory appears self-evident is more strongly related to whether it is consistent with cultural myths than whether it is supported by empirical evidence. This leads to the question of why people find it so compelling to think of people as utilitarian. Does utilitarianism in some way comport with our understanding of everyday experience? At least in the case of authorities, these beliefs persist because power produces compliance in the everyday personal experience of legal authorities. These beliefs have developed into a “myth of self-interest.” Studies show that people expect others to be more strongly influenced by self-interested judgments, for example about potential rewards and punishments than they actually are (Miller and Ratner, 1996, 1998). This is especially true of people in positions of authority. Once people have such a conception of their own and others’ motivational nature, it is difficult to let go of those beliefs, even when the evidence in favor of them is discredited. As Baron notes: “We tend to hold to our beliefs without sufficient regard to the evidence against them or the lack of evidence in their favor” (Baron, 2000, p. 195). Psychologists refer to this as “belief perseverance” (Anderson et al., 1980; Ross et al., 1975). Instead of openly considering evidence questioning their beliefs, research suggests that people engage in psychological strategies to blunt the impact of discordant information upon their beliefs. One approach that people use is to look primarily or exclusively for confirming information that allows them to maintain their beliefs (Kahan, 2013). For example, people shape the way they frame their study of problems in ways that support their prior views. I have noted a general tendency to frame deterrence studies as questions of whether deterrence works, in the sense that its effects can be shown to be significantly different from zero (Ziliak and McCloskey, 2008). Against this relatively low standard deterrence effects are often found and researchers can conclude that deterrence is effective. The question is whether people are drawn to this approach because it supports their suppositions, or the other way around. Because of this tendency to focus on arguments or evidence consistent with one’s prior views, a key question is what type of evidence or process can minimize these motivations and encourage people to be open to new information. Kahan has discussed this issue in the context of messages about climate change (Kahan, 2013). People have a natural tendency to interpret messages through the framework of their prior ideology and to engage in identity-protective cognitions. On the other hand, this does not mean that people are always insensitive to information that goes counter to their prior beliefs. Both the crafting of messages and general training and experience can shape openness. Kahan, for example, shows that judges are more open to discrepant messages than the general public, something that he feels may reflect their professional training and experience. The same argument suggests that there are better and worse ways to craft messages for them to have an impact (Feinberg and Willer, 2013). In the context of the environment, Feinberg and Willer found that when messages of change were framed in terms of values that conservatives support (purity), they had more influence upon attitudes. Similarly, Feygina, Jost, and Goldsmith (2010) show that the framing of environmental messages influences the ability of those messages to overcome people’s prior values. If global

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26  Research handbook on corporate crime and financial misdealing ­ arming is presented as a threat to the maintenance of the status quo, conservatives supw port measures to combat it. If they are told that global warming requires societal change, they oppose those measures. The desire to hold on to beliefs in the effectiveness of deterrence is, as noted, facilitated by the immediate effectiveness of threats of punishment in changing behavior. What is less obvious to an authority in the immediate moment are long-term problems. Consider the case of the police. A recurring problem for the police is the need to return to deal with the same situations and people repeatedly. Similarly, judges have to bring people back into their courtrooms to re-threaten them to enforce orders. Why; because as soon as they are not in the presence of an authority people renege and revert to their previous behavior. Hence, the influence of power is short lived and primarily occurs when an authority is present. As noted, even then defiance and resistance are issues, but the key issue is the lack of any long-term impact. The dynamics of power are especially pernicious in that there is at best a very modest long-term effect of coercion. Unlike an approach based upon building legitimacy and creating an internal motivation for a person to follow the directives of an authority, the use of power does not obviate the need to use power in the future. Hence, the primary issue is likely to be whether resources exist for continued presence. When there is a shortterm crackdown on some location or issue society has sufficient will to devote resources to surveillance, but such approaches are often not sustainable over time. Other issues become important and there are other claims upon resources. The need for resources for surveillance is ongoing and does not become less important over time. Hence, while there is an initial success because power can lead to immediate compliance, an approach using power creates problems for authorities over time. 5.1  Potential Motivations for Holding Instrumental Beliefs Of course the motivation to govern instrumentally is not only the result of an unwillingness to let go of an under-supported theory. Adopting utilitarian models is also psychologically attractive to the people in authority. Such models support illusions of competence, moral superiority, and enhanced security, all of which provide important psychological benefits to authorities and give them a reason to continue to embrace coercive models. 5.1.1  Illusion of competence Psychological studies suggest that people generally exaggerate their own competence and ability both relative to task difficulty and to the competence of others (Alicke and Govorun, 2005; Leary, 2007). Such illusions are psychologically satisfying and are associated with high levels of self-esteem (Taylor and Brown, 1988). As Kahneman suggests, “[m]ost of us view . . . our own attributes as more favorable than they truly are, and the goals we adopt as more achievable than they are likely to be” (Kahneman, 2011, p. 255), and “[p]sychologists have confirmed that most people genuinely believe that they are superior to most others on most desirable traits” (p. 258). Having power accentuates this tendency and leads to perceived control over outcomes “beyond the reach” of a power holder (Fast et al., 2009). Given their high levels of perceived self-competence, leaders naturally want to control decisions, and, to facilitate that goal, concentrating resources in their hands makes sense.

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Psychology and the deterrence of corporate crime  27 If someone is more competent than others, there are plausible justifications for them to be the person who decides what will happen. Utilitarian models maximize the perception of both leaders and followers that leaders are in control. Leaders create this impression when they engage in top-down management through a model in which they direct the incentives and sanctions. There never seems to be a shortage of authorities with confidence in their unique skills and insights into problems. An interesting example of this phenomenon is found in research on the accuracy of professional judgments. Researchers often find that professional legal authorities, such as police officers, have higher confidence in their judgmental abilities than do laypeople (Findley and Scott, 2006). These authorities believe that their experience gives them the capacity to make better decisions, even though research frequently fails to support this belief. For example, experts are not generally found to be better at detecting deception or making eyewitness identifications than are laypeople (Bond, 2008), but they are more confident in their abilities. Such confidence reflects high self-esteem linked to feeling like a competent expert, a feeling that is not supported by superior performance. Similarly, studies find that studies of decision making by jurors typically use decisions made by judges as a reference standard for the right answer, inferring that departures from what a judge would decide reflect the lesser ability of lay decision makers (Kalven and Zeisel, 1966). Studies, however, also suggest that judges are subject to the same types of heuristics and biases found in the decisions made by laypeople (Guthrie, Rachlinski, and Wistrich, 2007; Robbennholt, 2005), and are not necessarily more likely to ignore inadmissible evidence or deal with many of the limits in their ability to manage information or apply the law, shortcomings which are often noted in critiques of the abilities of jurors (Vidmar and Hans, 2007). An extension of this argument is that a decisive leader is better able to govern than a group. This, in turn, leads to support for the idea that “What this country needs most, more than laws and political programs, is a few courageous, tireless, devoted leaders in whom the people can put their faith.”7 Conversely, studies show that it is deliberative and participatory processes that are central to the rule of law and the creation of legitimacy (Grimes, 2006), so that the concentration of power in an individual who makes policy  ­decisions and implements them instrumentally is less likely to produce popular legitimacy. This utilitarian approach to social order may have advantages at least in the short term, which will be discussed below, but there has been and continues to be a “romance of leadership” whereby leaders’ ability to shape outcomes is exaggerated both by followers and by leaders themselves (Meindl, Ehrlich, and Dukerich, 1985). While such an exaggerated belief in competence may be beneficial to leaders’ necessary self-confidence, it undermines legitimacy insofar as it leads leaders to be dismissive of others and unwilling to work collaboratively. Exaggerated confidence leads people to take on tasks that are more complex or risky than they can actually manage (Astebro, 2003; Berner and Graber, 2008; Malmendier and Tate, 2008; Windschitl et al., 2008). As a result, leaders step confidently into situations they cannot handle well. They take on more complex tasks than they can manage, engage  

7

This is an item from the F-scale of authoritarianism.

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28  Research handbook on corporate crime and financial misdealing in riskier actions than they can control, and generally overestimate their abilities to deal with the issues that will arise in complex work settings. 5.1.2  Illusion of moral superiority A second illusion is the illusion of good character. People view others as less motivated to act upon values, or to behave in a just and moral way, than they are in fact (Messick et al., 1985). As a consequence, they view themselves as appropriate decision makers because their decisions are more likely to be linked to what is right and proper, rather than to their own self-interest. Also, because other people are viewed as acting based upon self-interest, appeals to their values are likely to be ineffective, leaving utilitarianism as the only viable basis for influencing others’ behavior (Tyler and Rankin, 2012). Consider, for example, negotiations. Negotiations require people to make inferences about other people’s actions and what those actions indicate about their character. Researchers have found that the Chinese are less likely to make dispositional attributions about others than are Americans (Morris and Peng, 1994). Why? In general, in interactions with others the Chinese are less likely to view others as acting out of poor motives, such as self-interest or a desire to win, and instead view the other parties’ actions as flowing from situational forces. Because they make situational attributions, viewing behavior as caused by forces within the situation rather than the character of the actors, they are less likely to interpret the actions of others as reflecting an untrustworthy or self-interested character, and they are more able to successfully engage in cooperative interactions. They are less likely to refuse to deal with the other party because they think they are being dishonest, untrustworthy, or immoral (Morris and Peng, 1994). Interestingly, while people in positions of authority may hold illusions of moral superiority, there are suggestions that high-power positions do not encourage people to actually be more moral. Rather, holding power can encourage displays of indifference or even harm to others (Wilkinson and Pickett, 2009). This is because high power encourages people to think of others in instrumental terms, as means to be manipulated to achieve personal goals, and less from an empathic perspective (Gruenfeld et al., 2008). The issue of morality is complex, but these findings suggest that the illusion of moral superiority among those in positions of power is particularly striking given that those individuals may in some ways wear moral blinders and actually be less ethical than people without power. 5.1.3  Psychological benefits of illusions The idea that people might benefit from holding psychological illusions was illustrated by Taylor and Brown (1988), who demonstrated that people who had exaggerated feelings about their abilities were healthier than were people who were more realistic (i.e. correct in their self-assessments). In fact, being accurate about oneself and having good feelings about oneself turn out to be a trade-off, so there are clear psychological reasons for focusing upon feeling good about oneself for enhancing personal well-being. Because of their illusions of competence and character, those in authority have lower levels of stress (Sherman et al., 2012). They are also motivated to govern instrumentally, acting proactively to control others (Keltner, Gruenfeld, and Anderson, 2003) and treating other people as objects whose value is defined by their utility in achieving instrumental goals (Gruenfeld et al., 2008). Since they believe that they are the most competent individuals in their community,

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Psychology and the deterrence of corporate crime  29 organization or society, authorities believe that they should control resources and determine how these should be deployed within the community. Because they are the most moral, they believe that it is appropriate for them to make decisions that involve the well-being of others. There are, therefore, a variety of reasons that authorities fall easily into a utilitarian approach, managing social order by the threat or use of force and deploying community resources to address the problems and concerns that they feel are of importance. 5.1.4  Illusion of control Finally, psychologists have long recognized that people want to have control over outcomes that matter to them. Because of this motivation people exaggerate their control over outcomes (Langer, 1975). When authorities (or anyone else) control resources and power they feel secure and protected because they believe that they can control the behavior of others. In other words people generally exaggerate their control over events because feeling that events are controllable is psychologically reassuring. There is further psychological reassurance in a perception of having superior force capabilities when entering an uncertain situation. As an example, the police seek to project force and dominate situations using their possession of a variety of types of weapons: guns, clubs, Tasers, mace, etc. Ironically, while being psychologically reassuring, seeking to maintain control through dominance creates a problem for authorities such as the police because it leads to anger and resistance in those who they are attempting to control. Relationships are defined by the police in terms of dominance and subordination through the use of power, and the people they are dealing with then respond within a framework of resistance and defiance (McCluskey, 2003; Kelley and Stahelski, 1970). What about work authorities? Research suggests that when employees experience dominating authorities, particularly those who act in ways they view as illegitimate or unjustified, they find ways to gain revenge (Aquino, Tripp, and Bies, 2001, 2006; Groth, Goldman, Gilliland, and Bies, 2002; Tripp, Bies, and Aquina, 2002, 2007). Such styles of authority both encourage resistance and drive behavior underground, leading to sabotage, shirking and theft. And, while the focus of much recent discussion has been on corruption in management, it should not be forgotten that issues such as theft on the job have a long history of concern, because they are massive and ongoing issues in terms of workplace loss. Beyond the desire for revenge, a large group of employees simply seek to hide their behavior, making the use of strategies to detect wrongdoing essential. 5.2  Shaping Values A second issue is the ability of authorities to create values. It could be the case that the focus on sanctions is a simple function of recognizing what the law can do. It is possible to impose sanctions. Similarly, management can impose costs or provide incentives. Can either build values? Values suffer from being viewed as “squishy” or “unmeasurable,” in contrast to sanctions, which can be quantified in terms of both threatened and delivered punishments. Authorities can feel that whatever their limits, strategies based upon command and control are based upon levers that they can control. The research-based answer is yes it is possible to develop organizational models both

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30  Research handbook on corporate crime and financial misdealing within companies and within government to create and maintain values, in particular legitimacy. Studies strongly support the argument that both moral values and legitimacy are influenced by the policies and practices of legal authorities and management. Two distinct literatures demonstrate that the actions of legal actors and of managerial authorities shape rule following. In both cases it is the procedural justice of the authorities that is central. Hence, authorities can build moral and value-based commitment to the rules by exercising their authority, using fair procedures and treating those in the organization fairly (Cohen-Charash and Spector, 2001; Colquitt et al., 2001; Tyler and Blader, 2000). These findings make two important arguments. First, that organizations can create a culture that shapes employee behavior by creating value-based motivations for rule following and ethical behavior. Second, that research indicates what such a culture should look like. It should focus upon making decisions using fair procedures and treating people justly. These arguments are consistent with the organizational culture standard in the revised Federal Sentencing Guidelines for Organizations. The guidelines state that organizations should “encourage ethical conduct and a commitment to compliance with the law” (Finder and Warnecke, 2005, p. 18). The work noted indicates that creating and maintaining such a culture requires that employees regard the rules and procedures of the organization as fundamentally fair (Tyler, 2005; Tyler and Blader, 2005). The results of such studies tell us clearly which aspects of the workplace are central to shaping values. But, consider first that what they tell us is not true. The rewards that people receive from the organization, their salary and benefits, the degree to which company policies favor them, and the risks of punishment that they face if caught violating rules do not effectively engage employee values. Further, the fairness of organizational outcomes is not a primary driver. What these results do tell us is that employees’ beliefs that their organizations are legitimate and moral and that they see managers making decisions using procedures that they believe are fair are the key factors that engage employee values. As we have argued, employees care about the fairness of their work environment. In particular, they are sensitive to the fairness of the procedures used within their work organization. The role of procedural justice is important even if we ignore values and simply look at the direct role of procedural justice in increasing rule-following behavior. When employees indicate that their workplace is or is not procedurally fair, what do they mean? Answering this question is fundamental to understanding how to design workplaces that engage employee values and encourage rule and policy adherence. Prior studies of procedural justice in work settings identify two key dimensions of employee procedural fairness judgments: fairness of decision making and fairness of interpersonal treatment. These two types of fairness can be evaluated at the organizational and work group level. This leads to four procedural factors: decision-making fairness at the organizational level; interpersonal fairness at the organizational level; decision-making fairness at the workgroup level; and interpersonal fairness at the workgroup level. Studies at the organizational level indicate that employees evaluate the procedural fairness of their overall organization, its policies and procedures, and the actions of the CEO and board. Separately, they assess the fairness of the procedures used by their workgroup supervisor and co-workers. Aspects of procedure, decision making and interpersonal treatment, independently and collectively, contribute to overall procedural justice evaluations.

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Psychology and the deterrence of corporate crime  31 At each level, employees consider two types of procedural issues: quality of decision making and quality of interpersonal treatment. The most obvious aspect of procedures is that they are mechanisms for making decisions. When thinking about those mechanisms, employees evaluate fairness along several dimensions. First, do they have opportunities for input before decisions are made? Second, are decisions made following understandable and transparent rules? Third, are decision-making bodies acting neutrally, basing their decisions upon objective information and appropriate criteria, rather than acting out of personal prejudices and biases? Fourth, are the rules applied consistently across people and over time? Quality of interpersonal treatment is found to be equally important. It involves the manner in which people are treated during the decision-making process. First, are people’s rights as employees respected; for example, do managers follow the rules specified in organizational manuals or employment contracts? Second, is their personal right to be treated politely and with dignity acknowledged, and does such treatment occur? Third, do managers consider employee input when making decisions, and are the decision makers concerned about employee needs and concerns when they make decisions? Finally, do the decision makers account for their actions by giving honest explanations about what they have decided and why they made their decisions? Research shows that each of these four aspects plays a distinct role in shaping employee judgments about whether their workplace is fair. Our argument is supported by an empirical analysis in which the influence of the four elements is considered in each of the two studies we have been examining. The results indicate that each element is independently important, with employees considering organizational-level issues of decision making and interpersonal quality of treatment and workgroup/supervisor-level judgments of the same two issues (Blader and Tyler, 2009). 5.3  Utilitarianism in an Organizational Context As has been noted, the benefit of utilitarianism is that it allows for the possibility of quick changes in the deployment of resources and resulting changes in individual behavior (Magee and Galinsky, 2008). It is easier to change the allocation of instrumental resources than it is to create values such as legitimacy. Creating values is always a long-term project. Hence, instrumental approaches are most likely to be adopted when people do not plan ahead and are managing reactively as problems develop; when people are responding to emergencies, such as terrorism or a crime wave; and when people are operating within a short-term framework. For example, police departments respond to homicides by “hot spot” policing strategies in which they flood an area with police officers (Weisburd and Braga, 2006). Crime goes down, but departments can seldom maintain the high levels of patrols needed to maintain this effect, so eventually the officers are transferred out as the threat diminishes, causing crime rates to again increase (Rosenbaum, 2006). The question of how much importance private companies will give to creating and maintaining an ethical work culture is the key to whether deterrence is the only viable model that businesses can adopt. When businesses need to achieve short-term quarterly profits or political leaders must produce rapid gains prior to an election, instrumental approaches are attractive. The problem with utilitarianism, however, is that over time it

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32  Research handbook on corporate crime and financial misdealing undermines the relationship between authorities and populations and is therefore difficult to sustain in the long run. Utilitarian control is personally satisfying to authorities and may yield short-term successes, but it fails in the long term. So, it is less desirable when there is a long term and authorities have the luxury of considering it. What are the long-term problems created by an instrumental approach? The first problem is that this approach creates an undifferentiated social reality. The key to effective interactions is to distinguish among people by identifying those who can respond to behavior based upon their values and those who must be dealt with instrumentally by making threats or promises (Kelley and Stahelski, 1970). However, when people are approached from an instrumental perspective with threats or promises they respond instrumentally by reacting in terms of costs and benefits. As a result authorities create a situation in which they deal with everyone instrumentally, irrespective of whether those people could potentially respond to them based upon values if their values were appealed to. The authorities, in other words, do not motivate anyone to obey the law because of their view that legal authorities are legitimate and ought to be obeyed, since they threaten all the members of the community with fines, arrest, or imprisonment for noncompliance. This is an inefficient strategy for creating cooperation and sub-optimal for the authorities trying to garner that cooperation (Axelrod, 1984). The pyramid of regulation is one example of the application of this approach (Ayres and Braithwaite, 1992). Ayres and Braithwaite argue that everyone should initially be approached through appeals to values. Most will respond. The few who do not can then be treated as subject to punishment. In this manner, resources can be directed toward the small group that needs surveillance and sanctioning while the majority, who respond to values, is addressed in terms of appeals to values. One important message of studies of businesses is that people often engage in unethical behavior when they are under situational pressure. They fear failure. As already noted, the tendency to take on too much risk leads to failures and puts people in situations in which they face possible or even probable failure. In such situations they may be motivated to seek short-term solutions, ignoring their values. Perhaps what is needed is an Ayres and Braithwaite model for situations. We might treat all situations as situations in which people can act on values and then refine our understanding of situational pressures to identify fear of failure situations in which values are less likely to be effective. In such settings monitoring should be stronger. In addition, surveillance is problematic because it is a self-perpetuating strategy. When managers adopt a strategy of closely monitoring employee performance they create no basis for trusting employees to work when they are not being monitored (Kruglanski, 1970; Strickland, 1958). As a consequence, managers need to continue to monitor those employees. Similarly, if the police encourage law-abidingness through the threat of punishment, they can never be sure whether people would obey the law if they were not watching. Hence, they need to continue to create a credible threat of punishment in the future. Finally, and ironically, in the long term continued surveillance turns out to be needed because a focus on instrumental factors “crowds out” the role of other motivations in shaping rule-related behavior (Frey, 1994). Even if people are initially motivated to comply with the law both because of concerns about being caught and punished, as well as for value-based reasons such as legitimacy, morality, and peer opinion, authorities’ focus

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Psychology and the deterrence of corporate crime  33 on deterrence defines the relationship between people and the law as one of risk, and it becomes instrumental. Over time this leads to a decline in the influence of value-based reasons. Eventually people primarily decide whether to comply or to fail to comply based upon their levels of fear of punishment. And, as previously noted, often this calculation leads to rule-breaking behavior. As an example, consider the well-known study that has already been noted “A Fine is a Price” by Gneezy and Rustichini (2000). A school had problems with parents picking their children up on time. They first appealed to the parents’ norm of responsibility and later introduced a fine. Parents treated the fine as the price of being late and their sense of responsibility to be on time became less central to picking up their children. In other words, introducing a fine turned what was a value-based obligation into an economic transaction. If parents paid the fine, they did not feel they had failed a social obligation by being late. Despite short-term attractions, a utilitarian strategy undermines itself in the long term. Because of the general ineffectiveness of social control, utilitarian strategies underperform relative to expectations. In particular, these approaches end up costing more than anticipated, so the availability of resources limits the degree to which they can be implemented. The massive growth in prison costs is an example (Barker, 2009). This growth in costs flows from the use of a deterrence approach combined with the resultant pressure for longer sentences. During a period of economic downturn these costs have proved unsustainable. Such failures cast doubts upon the competence of leaders. However, having framed issues instrumentally, it is difficult for authorities to go back and appeal to values. Trying to change strategy presents both psychological and political problems. First, it requires acknowledging failure, and threatens illusions of competence. Second, the position of leader requires success and acknowledging failure is often not an option. As a result, authorities often perceive little choice but to push for more severe punishments, even though research makes clear that it is certainty of punishment, not severity that matters (Blumstein, Cohen, and Nagin, 1978). Similarly, there is ongoing pressure to devote greater resources to surveillance. If they lack popular support, the police and courts have no mechanism but threat, and no recourse but massive incarceration. The authorities, furthermore, recognize that if the crime rate goes up they are likely to lose their jobs, so the tendency to double down with sanction-based approaches is extreme. Consequently, society is stuck with a costly and minimally functional system of law and law enforcement. The management literature shows that once people embark upon a course of action they cannot handle, they tend not to question their competence when their strategy begins to unravel, but rather throw more and more resources into their ongoing course of action (Brockner and Rubin, 1985). Instead of re-examining his or her sense of competence, the optimistic leader takes credit for success, but not failure, so they are unlikely to take responsibility for a losing strategy and be open to its re-examination. This is an effective psychology when the goal is persistence, but harmful when that persistence leads to a failure to recognize a failing strategy. Throwing good money after bad is not always a way to achieve long-term success and doing the same thing over and over believing that it will lead to different outcomes is often self-defeating. The overall point is that the effectiveness of coercive strategies is overstated relative

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34  Research handbook on corporate crime and financial misdealing to their research-revealed influence, and this creates problems for power holders that emerge over time after they have experienced short-term successes. The development of the coercive approach has within it the long-term seeds of its own destruction. In particular, because the effect of sanctions is typically less than anticipated, there is a temptation to increase them, anticipating that they will work more effectively at higher levels. The same is true of punishment: a dynamic emerges of ever longer sentences and higher fines. However, research is very clear that severity does not increase effectiveness. What is more effective is increasing the likelihood of detection and punishment. However, these elements, especially raising likelihood, are resource intensive. Hence, the ability of this model to work well is almost always linked to resource limits. If the authorities can, for example, expand police forces to high levels, sanctioning works better. Police can, for example, flood a crime “hot spot” with officers and lower the crime rate. But they can seldom sustain that level of visibility and presence for long periods of time. A classic example of this problem is found with efforts to control drunk driving in Scandinavia (Ross, 1982). A highly publicized crackdown lowered rates of drunk driving, primarily because people responded by overestimating the risk they faced. As time went on and people recognized that even with the heightened enforcement the actual likelihood of being caught was very low, their behavior reverted to earlier levels. Similarly, companies can seldom engage in the level of surveillance over time that is needed to effectively raise the probability of detection to levels that deter undesirable behavior. With deterrence the core problem is that by embarking on a force-based strategy, authorities undermine their rapport with the people involved, who come to mistrust and even hate the authorities, to develop oppositional consciousness, and to resist and undermine those authorities. Any hope for cooperation or collaboration is undermined by feelings of distrust and anger and by motives of concealment and misdirection. Once the ineffectiveness of a force-based strategy becomes apparent, going back is difficult. Any later efforts to appeal to people’s values or build rapport are tainted and unlikely to be successful, even when they would have been the superior strategy if pursued from the outset. Lacking alternative courses of action, and late in the game, the authorities implement the only strategy they see as possible: an even more severe forcebased approach. As a result, the opportunity for a value-based strategy is diminished and eventually destroyed. Mass incarceration is a further example. To make deterrence work there needs to be punishment. Because incarceration increases the risk of recidivism (Lipsey and Cullen, 2007), the punitive system is creating a group of long-term criminals with resulting repeat incarcerations. Moreover, there is political pressure for even more severe punishments, based upon the failure of less severe punishments to work. Of course, research makes it particularly clear that severity does not shape behavior. Severity is attractive only because in the face of the failure of deterrence in general, severity does not require the same level of increased resources that is needed to increase certainty of punishment. It appears to be a way to make deterrence, an underperforming strategy, more effective. Authorities are constantly found in a situation of declining effectiveness, but it is hard to convert a utilitarian strategy to a legitimacy strategy. Further, because value reliance has been “crowded out,” lifting surveillance often results in problems caused by non-compliance (Frey, 1994). The end of an autocratic regime is often associated with increases in crime, even if the new regime is democratic. Populations used to obeying

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Psychology and the deterrence of corporate crime  35 out of fear do not associate law-abidingness with values, and suddenly find the risk of punishment to be lower. For example, crime rates increased in South Africa during its democratic transition (Louw, 1997). And, of course a coercive strategy is currently being used to combat corruption in for-profit organizations. In 2002, Sarbanes-Oxley was passed in response to the large corporate frauds of Enron, WorldCom, and others. Sarbanes-Oxley encourages organizations to take a more command and control approach to compliance. Similarly, the government’s response to wrongdoing has emphasized the responsibility to identify and sanction wrongdoing. What is central to both is not that deterrence might be needed but that the general approach taken is framed in terms of creating credible threats of sanctioning and emphasizing mechanisms for surveillance and punishment. The centrality of sanctioning to government approaches to stopping corporate wrongdoing should not be overstated, as the Federal Sentencing Guidelines also emphasize creating an ethical culture.

6. CONCLUSION This discussion makes clear the importance of examining the limits of force-based approaches in advance of policy formation and implementation. The time to capitalize on people’s commitment to values and their prior belief that authorities are legitimate and their values moral is prior to any use of force. And, time is needed to create or strengthen values and to engage existing values through participatory and deliberative procedures, through which people come to trust their leaders and view them as legitimate. What policy implications flow from this review? Primarily the argument that we need a moral, balanced approach that builds upon the strengths of deterrence and consent-based rule following. That approach should consider the situations in which each approach will be likely to work. It should also think sequentially, trying to build and act upon values when possible, with sanctions as a back-up option to be deployed when values are inadequate. And, it is important to acknowledge and work against the seductive qualities of command and control models. These psychological characteristics, in particular the attraction of short-term benefits, often lead authorities to be inadequately sensitive to the long-term costs of building models of social control (either government regulation or within-company regulation) only or primarily using mechanisms of deterrence.

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2.  Individual and corporate criminals Brandon L. Garrett* 1

1. INTRODUCTION The former head of compliance at HSBC, the international bank, announced his resignation at a hearing before the U.S. Senate Subcommittee on Investigations, stating: As I have thought about the structural transformation of the bank’s compliance function, I recommended to the group that now is the appropriate time for me and for the bank for someone new to serve as the head of group compliance. (Hamilton and Voreacos 2012)

Perhaps he quit before he could be fired. The outgoing compliance head added: “I have agreed to work with the bank’s senior management towards an orderly transition of this important role.” Finally, he offered something on a more positive note for the committee members to consider: “I am happy, however, to be able to say that the bank has learned from its past and is already on a path to becoming a better, stronger banking institution” (Hamilton and Voreacos 2012). HSBC would soon afterwards be criminally prosecuted for money laundering and international sanctions violations: it would be perhaps the largest and most significant such case ever brought against a bank. HSBC admitted and accepted responsibility for those crimes in federal court. Yet the controversy over the case would mount, not only because of the terms of HSBC’s settlement, but because to date no HSBC employees have been federally charged with any of those crimes. Our criminal justice system should focus on holding individuals and not solely organizations accountable for corporate crimes (Arlen 1994; Garrett 2015; U.S.D.O.J. 2015). Prosecutors understandably view the criminal law as best able to hold individuals morally accountable for criminal offenses. Only individuals can be sent to jail, although corporations like HSBC can of course pay far larger monetary fines than any individual can. There are many thousands of white-collar-related prosecutions of individual offenders each year, with those prosecutions dwarfing the 200 or fewer federal prosecutions of organizations. The relationship between those corporate settlements with prosecutors and individual charging raises complex questions. Federal prosecutors have in the past decade resolved more criminal cases against publicly held firms through the use of deferred and non-prosecution agreements (hereinafter DPAs and NPAs) than through guilty pleas (Alexander and Cohen 2015, p. 581; Garrett 2014, p. 262). Prosecutors have touted the benefits of DPAs, including that they can enhance deterrence by inducing corporate self-reporting and cooperation, *  The three figures included in this chapter and several passages are adapted from an earlier article. See Brandon L. Garrett, The Corporate Criminal as Scapegoat (2015) Virginia Law Review 101.

40

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Individual and corporate criminals  41 which enables the government to sanction those ultimately responsible—the individuals who committed the crimes (Arlen 2012a; Arlen and Kahan forthcoming). Yet concerns arise that prosecutors who enter into DPAs may be failing to take the critical next step: pursuing the individuals responsible for the crime. Data concerning DPAs bear that out (Garrett, 2015). In response to such concerns, in its Fall 2015 Yates Memo, the Department of Justice changed its organizational prosecution guidelines. The new guidelines contain an entire and prominently displayed section announcing the new “focus on individual wrongdoers” (Yates Memo, U.S.A.M, § 9-28.210). That section details how individual prosecutions will be a focus “at every step in the process,” including from the earliest stages of a corporate criminal investigation (Yates Memo, U.S.A.M, § 9-28.700). In time, if that policy is retained and followed, perhaps we will see a changing pattern of federal corporate enforcement. Prosecutors have made other changes in recent years as well, including by shifting towards the use of guilty pleas rather than DPAs, enhancing rewards for selfreporting, and changing the focus on effective compliance programs. This chapter, however, focuses on the question of the role of individual prosecutions in corporate actions, by discussing empirical evidence on whether corporate DPAs result in criminal liability being imposed on the individuals responsible for the crime. The analysis shows that in only about one-third of those federal deferred or non-prosecution agreements with organizations, including some of the highest profile corporate criminal cases of recent years, were any officers or employees prosecuted (Garrett 2014, 2015). This conclusion is based on two studies. The first study examined 255 deferred and nonprosecution agreements entered by federal prosecutors between 2001 and 2012, and found that only approximately one-third were accompanied by individual prosecutions (Garrett 2014, p. 83). Similar results were observed in cases involving public companies that were convicted and did not receive DPAs; slightly fewer (25 percent or 31 out of 125) of those convicted firms had officers or employees prosecuted (Garrett 2014, p. 84). The second and more recent study examined the path of 412 individual prosecutions accompanying 306 federal deferred and non-prosecution agreements from 2001 through 2014 (Garrett 2015). Those companies unfailingly agreed to fully cooperate with prosecutors in any investigations of individual criminal conduct. And yet the result, in almost two-thirds of the corporate cases, was that no individuals were charged. Many individuals are charged for business-related crimes, with no corporation held accountable. Conversely, where corporations received settlements, largely out of court, from prosecutors, individuals are typically not charged. What explains this pattern? This chapter proceeds as follows. Section 2 describes the HSBC case, introducing the problem of prosecuting both organizations and employees, and the practical and procedural obstacles that arise in cases involving both organizations and employees. Section 3 describes data on individual prosecutions in organization cases, both recent data collected by the author, including by describing prosecution outcomes in employee prosecutions alongside corporate deferred or non-prosecution agreements, and prior studies dating back to the 1970s. Section 3 further explores why prosecutors so frequently do not or cannot prosecute individuals in corporate cases, why they so often achieve limited success when they do, and what significance this has for the approach to corporate prosecutions more generally. In Section 4 the chapter concludes by describing alternative means to deter individual behavior and briefly describes the role of civil enforcement against

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42  Research handbook on corporate crime and financial misdealing individuals in parallel to corporate prosecutions (4.1.4). The treatment of individuals in organizational prosecutions has significance not just for understanding the goals of corporate criminal liability and of white-collar prosecutions more broadly, but also as compared with the treatment of individuals not prosecuted alongside business entities, raising still broader questions about resources and the priorities of federal prosecutions.

2.  DID HSBC BENEFIT FROM “TOO BIG TO JAIL”? HSBC, which is headquartered in the U.K., is one of the world’s largest financial institutions, with over $2.5 trillion in assets and operations in over 80 countries around the globe (Senate Report 2012, 2–3). HSBC acquired U.S. affiliates to provide a “U.S. platform to its non-U.S. clients” and to attract foreign business; yet HSBC operates in “high risk” parts of the world (Senate Report 2012, 2). In 2012, HSBC paid almost $2 billion to settle violations related to money laundering of the Bank Secrecy Act, and to international sanctions as well, in violation of the Trading with the Enemy Act and the International Emergency Economic Powers Act (“IEEPA”) (Protess and Silver-Greenberg 2012; Memorandum and Order 2013). HSBC’s compliance failures were described by regulators and prosecutors as endemic. The bank, for example, failed to conduct any anti-money laundering monitoring of “$15 billion in bulk cash transactions,” it had “poor procedures” for rating risk, and it failed “to conduct any due diligence” on affiliates, among its many “severe, widespread, and longstanding problems” (Senate Report 2012, p. 3). The U.S. Attorney for the Eastern District of New York announced the deferred prosecution reached with HSBC in 2012, stating: “Today’s historic agreement, which imposes the largest penalty in any [Bank Secrecy Act] prosecution to date, makes it clear that all corporate citizens, no matter how large, must be held accountable for their actions” (Protess and Silver-Greenberg 2012). In settling the criminal case, the bank agreed to corporate monitoring for five years, and agreed to create a new compliance program. The bank had also already made significant leadership changes, including a new CEO, Chairman, and Chief Legal Officer. Was HSBC now a reformed criminal? But what about the individual people who worked at HSBC and who had committed the crimes? We know much about the case due to the investigation by the Senate Subcommittee, chaired by Senator Carl Levin. The Subcommittee report described more than just a weak anti-money laundering program, but over $880 million in drug proceeds laundered by Mexican drug cartels through HSBC’s Mexican subsidiary, as well as approximately $660 million in transactions to sanctioned regimes, including Burma, Cuba, Iran, North Korea, and Sudan, and still more: transactions with groups linked to terrorism (Senate Report 2012, pp. 2–3). The Senate subcommittee collected over 1.4 million pages of documents, and made findings concerning severe anti-money laundering deficiencies, taking on high-risk affiliate banks, outright circumvention of sanctionsrelated controls, disregarding terrorist links, permitting suspicious bulk deposits of travelers checks, and more (Senate Report 2012, p. 10). Emails reproduced in the subcommittee report showed how a few compliance employees had raised grave concerns with their supervisors. For example, when one complained illegal transactions may have occurred with terrorist organizations, the employee was told: “I should fire you right now,” and “Are you out of your f---- mind.” The former head of

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Individual and corporate criminals  43 compliance (not the one who resigned before the Senate) had complained about a lack of staff and resources and was called “inappropriate” and then fired (Senate Report 2012, pp. 2–3). When the bank ultimately settled with prosecutors, receiving a deferred prosecution agreement that would last five years, the statement of facts accompanying the agreement described still more troubling conduct by employees and supervisors at HSBC. A “senior executive” described that anti-money laundering efforts had “gone down a hole in the past 18 months” (HSBC DPA, ¶28). The then “Head of Compliance” admitted that the Mexican subsidiary simply had “no recognizable compliance or money laundering function” (HSBC DPA, ¶30). Meanwhile, a senior compliance officer argued against “rubber-stamping unacceptable risks merely because someone on the business side writes a nice letter . . . We have seen this movie before, and it ends badly” (HSBC DPA, ¶34). Even earlier, in 2000, the then Head of Compliance argued that HSBC practices “could provide the basis for an action . . . for breach of sanctions,” but was told that “significant business opportunities” demanded that the practices continue (HSBC DPA, ¶66). No HSBC employees were prosecuted in the U.S., although specific people’s actions were detailed in the Senate Report, and again in the deferred prosecution agreement with HSBC, which included a statement of facts. The failure to charge any individuals did not go unnoticed; the HSBC case had become one of the most high-profile bank prosecutions in the U.S. At the time, Senator Charles Grassley wrote a letter to the Attorney General complaining: The Department has not prosecuted a single employee of HSBC—no executives, no directors, no AML compliance staff members, no one. By allowing these individuals to walk away without any real punishment, the Department is declaring that crime actually does pay. Functionally, HSBC has quite literally purchased a get-out-of-jail-free card for its employees for the price of $1.92 billion dollars. (Grassley 2012)

The concerns were bipartisan. Senator Jeff Merkley called it a “‘too big to jail’ approach” (Merkley 2012). Senator Elizabeth Warren stated that, in contrast to how federal prosecutors target individuals in cases not involving major corporations or financial institutions, “evidently, if you launder nearly a billion dollars for drug cartels and violate our international sanctions, your company pays a fine and you go home and sleep in your own bed at night” (Good 2013). When eventually approving the deferred prosecution agreement, federal district judge John Gleeson noted, “I am aware of the heavy public criticism of the DPA” (Memorandum and Order 2013, pp. 13–14). The judge added, “Indeed, I have received unsolicited input from members of the public urging me to reject the DPA.” As I will describe in the next section, the HSBC case was actually quite typical, although it was the subject of particularly high-profile criticism. Bank employees have simply not been prosecuted accompanying these Bank Secrecy Act deferred and non-prosecution settlements. This could be a tacit matter of policy, although no such policy has been made public. One explanation could be a view that only the bank can satisfy provisions requiring the “financial institution” to adopt adequate anti-money laundering controls. For example, 31 U.S.C. § 5318(h) requires that “each financial institution shall establish anti-money laundering programs.” Another explanation could be the difficulty in identifying the individuals responsible for a firm’s system-wide failure to employ an effective anti-money laundering system. Nevertheless, money laundering, false statements,

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44  Research handbook on corporate crime and financial misdealing concealing illegal transactions, or approval of fraudulent transactions could all support quite serious criminal charges. The then Assistant Attorney General Lanny Breuer offered this explanation for why no charges had been pursued: “As bad as HSBC’s conduct was, this is not a case where the HSBC people intended—intended—to create money laundering” (O’Toole 2012). However, amendments to the Bank Secrecy Act enacted in 1994, reacting to Ratzclaf v. U.S., 510 U.S. 135 (1994), made clear prosecutors need only show action taken “for the purpose of evading the reporting requirements,” 31 U.S.C. § 5324; 31 U.S.C. § 5322(a), and not “that the defendant knew that structuring was illegal” H.R. Rep. 103–438, at 22 (1994). We should ask, however, whether that statement is actually borne out by the emails and documents uncovered through the Senate subcommittee and federal prosecutors’ investigations. Readers can examine those reports and documents themselves. The publicly released documents portray endemic failures of compliance. Should it have been that difficult to show that supervisors knowingly tolerated violations? A prosecutor would not have to show that “HSBC people intended” to engage in money laundering, but only that they knew that criminal proceeds were being laundered (or equivalently were willfully blind to its occurrence). Perhaps prosecutors viewed the record fine and compliance reforms by the bank as an adequate deterrent. Or perhaps the demands of investigating employee intent and showing who knew what during years of complex conduct in a globe-spanning institution was just too much for the Eastern District of New York prosecutors to take on. And yet, there are real questions regarding whether it was an adequate deterrent to simply require the bank to pay a major fine and agree to make compliance changes (see Arlen 1994). The HSBC agreement contained detailed provisions regarding changes to its anti-money laundering structure, and it endeavored to hold executives accountable at higher levels. The HSBC agreement required that all senior executives have bonuses based on “the extent to which the senior executive meets compliance standards and values” (HSBC DPA 2012). HSBC has hired many thousands of compliance employees: 10 percent of its employees or 25,000 employees now work in compliance (Millman 2014). Still, several years into the agreement, the corporate monitor reports that compliance programs are still not yet adequate. Judge John Gleeson, when approving the deferred prosecution agreement, also ruled that the corporate monitor would be reporting to the court, to keep the Judge informed of progress at HSBC, and portions of those reports would be made public. As a result, we know something more about the post-deferred prosecution implementation of the agreement than is common in such cases. The results have not been heartening. The monitor stated that HSBC’s compliance was still not adequate. “It’s a work in progress,” HSBC has admitted, adding that it is “on track” to meet the goals of the corporate monitor (Ensign and Colchester 2015). Most colorful in its new compliance efforts, HSBC handed out certifications decorated with parrots to its U.S. compliance staff, that read “I am a Changed Bird” (Ensign and Colchester 2015). The monitor will recommend, apparently, that senior HSBC executives have their bonuses taken away given the inadequate compliance; the deferred prosecution agreement did provide that compensation would in the future be tied to ethics and compliance. Is HBCS a “changed bird”? Still more has come to light: new possible violations have emerged through a leak, “the biggest banking leak in history,” regarding tax evasion

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Individual and corporate criminals  45 promoted through HSBC’s Swiss subsidiary, from the same time period (2005–2007) that was also the subject of the deferred prosecution agreement (Leigh et al. 2015). HSBC explained: “We acknowledge and are accountable for past compliance and control failures” (Leigh et al. 2015). Although this was earlier conduct, if it was not sufficiently disclosed when the deferred prosecution agreement was negotiated, then there was the potential, at least, that the agreement could be reopened; prosecutors, however, have not suggested any such consequence. More recently, HSBC reported in an Annual Report that despite “progress” in compliance, the corporate monitor “expressed concerns about the pace of that progress,” including “instances of potential financial crime and systems and controls deficiencies” (Coppola 2016). In 2017, the Second Circuit Court of Appeals reversed the federal district judge’s decision to make public the HSBC monitor’s report describing those problems (United States v. HSBC Bank, U.S.A., N.A., 2017). Prosecutors adopted an approach focusing on changes at the organizational level at HSBC, together with efforts to reshape incentives for individual employees and officers. Should they have also focused their efforts on targeting individual employees and officers in criminal prosecutions? Would that have sent a stronger deterrence message to the bank or to the industry more broadly? Or was the result the best that could have been expected in a world of limited resources? And was the result in the HSBC case typical, or an outlier in the world of federal corporate prosecutions? I turn to those questions in the sections that follow.

3. DATA ON INDIVIDUAL PROSECUTIONS ACCOMPANYING FEDERAL DEFERRED AND NON-PROSECUTION AGREEMENTS In a recent book, Too Big to Jail: How Prosecutors Compromise with Corporations, I describe how of 255 deferred and non-prosecution agreements entered into by federal prosecutors between 2001 and 2012, approximately one-third were accompanied by individual prosecutions. (Garrett 2014). I also found that slightly fewer convicted public companies or their subsidiaries had their guilty pleas accompanied by charges against officers or employees (25 percent, or 31 out of 125) (Garrett 2014, p. 117). In a subsequent analysis, I explored the path of those individual prosecutions accompanying federal corporate deferred and non-prosecution agreements (Garrett 2015). I will describe those results in the section that follows. From 2001 to 2014, prosecutors entered into 306 deferred and non-prosecution agreements with companies.1 Those deferred and non-prosecution agreements were amenable to a study of accompanying individual prosecutions because they were often high-profile cases. Similarly, plea agreements with public companies could be studied, since those cases also receive more media attention. Whether individual prosecutions accompany corporate prosecutions cannot simply be ascertained by looking at federal docket sheets; the individual cases may not be jointly docketed with the corporate case, and they are

1   An online resource that I maintain with the UVA Law Library, makes available such federal deferred and non-prosecution agreements with organizations (Garrett and Ashley n.d.).

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46  Research handbook on corporate crime and financial misdealing typically not docketed together. Instead, one must know the names of individuals charged in order to pull the relevant federal docket sheets. Of course, to do this, one must know whether individuals were prosecuted and who they are. For these deferred and non-prosecution agreements, I first examined Department of Justice, U.S. Attorney’s Office, and any regulatory agency press releases announcing the corporate prosecution settlements. Those press releases (unlike the deferred and nonprosecution agreements themselves) often did note whether any individuals had been charged. However, often individual charges are filed after the entry of a DPA, either with the firm or with a parent (if a corporate group or a parent and subsidiaries settled a case together in a DPA, as sometimes occurs, it was counted as a single case). In order to locate any such cases, my research assistants and I searched news archives to locate any references to investigations or prosecutions of employees at the firms in question. Any such effort is necessarily imperfect, although as described further below, the individual prosecutions located typically occurred in the same year as the corporate prosecutions (perhaps because prosecutors were waiting to obtain full cooperation before settling with the firm), making the individual cases relatively easy to identify. Further, in many cases, some of which have already been described, prosecutors made abundantly clear that no employees had been charged or would be charged. Among those deferred and non-prosecution agreements, 34 percent or 103 companies had officers or employees prosecuted. And in those cases, there were 408 total individuals prosecuted. Most were not high-up officers of the companies, but rather middle managers of one kind or another. Of the individuals prosecuted in these cases, 13 were presidents, 26 were CEOs, 28 were CFOs, and 59 were vice-presidents. Of those 412 individuals, 266, or 65 percent, pleaded guilty while 42 were convicted at a trial. This represents a somewhat elevated trial rate of 10 percent. The highest sentence was former CEO Bernard Ebbers’ 25-year sentence in the Worldcom case (in 2005). The average sentence, including those who received probation but no jail time, was just 18 months. The average sentence among those who did receive jail time was quite a bit higher, or 40 months. Only 42 percent or 128 of the 308 individuals convicted (266 who pleaded guilty and 42 who were convicted at trial) received jail time. Of those individuals, 144 individuals were fined, with an average $382,000 fine. Figure 2.1 displays sentences among the 308 convicted individuals, in months; as noted, most received zero months of jail time). As noted, most of the convicted individuals received no jail time. Forty-two percent of these individuals received jail time (or 128 of the 305 individuals convicted, of which 266 pleaded guilty and 42 were convicted at trial). In several cases the plea agreement was sealed, and no information about the sentence could be obtained. To make rough comparisons with U.S. Sentencing Commission data, for federal fraud prosecutions, in the fiscal year 2013, 78 percent received imprisonment (U.S.S.C. 2014). For bribery prosecutions 74 percent received imprisonment; for antitrust prosecutions, 69 percent received imprisonment, and 63 percent of tax violators received imprisonment (U.S.S.C. 2014). Not only did more of these DPA-accompanying cases go to trial than is typical in federal court, these cases had far lower average sentences than are typical in federal white-collar cases. There also were large numbers of prosecution losses: 15 percent of the cases were unsuccessful, including 52 individuals with all charges dismissed pre-trial, 11 acquitted at trial, and nine with convictions reversed on appeal. Perhaps the most high-

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Individual and corporate criminals  47 350 300 250 200 150 100 50 0 2001

2002

2003

2004

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2014

Figure 2.1 Scatterplot showing individual jail time in months, 2001–2014 profile loss was the acquittal of Richard Scrushy, former CEO of HealthSouth, of fraud (he was later convicted of an unrelated bribery charge) (Frankel 2012). Moreover, 38 of these individuals were charged but are not yet convicted, because either their cases are still pending or they are fugitives and have so far escaped extradition to the United States. These data may certainly change over time. In some cases, individual prosecutions predate the entry of a deferred prosecution agreement. In the HealthSouth case, for example, a series of individuals were convicted in 2003, while the company entered its agreement in 2006. In other cases, such as the Royal Ahold case concerning accounting fraud, the company settled first, and individual charges and convictions came later. In time, there may be additional prosecutions of officers and employees in these corporate cases, and there may also be additional reversals on appeal of the subset of judgments obtained in the cases that proceeded to a trial. The average time from corporate entry of a deferred or non-prosecution agreement and the conviction of the individual was zero years (as was the median time). By far the most common situation observed (in one-third of the cases) was that individuals were convicted in the same year that the corporation also settled its case. Figure 2.2 illustrates these charging data from 2001 to 2014, focusing just on the year of the underlying corporate agreement, and whether, to date, it has been accompanied by any individual prosecutions. There is no apparent change in the steady and low rate at which individual charges accompany these prosecution settlements permitting the company to avoid a criminal conviction. The concern is that such non-prosecution agreements similarly allow individuals to avoid accountability for crimes. Federal judge Jed Rakoff has been a prominent critic of the Department of Justice’s practices in these corporate prosecutions, arguing that deterrence would be far better served by focusing resources on individual prosecutions, rather than on the corporation

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48  Research handbook on corporate crime and financial misdealing 45

Agreements with individuals sentenced to jail time

40

Agreements with individuals prosecuted

35

Total DPA/NPAs

30 25 20 15 10 5 0

2001

2002

2003

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Figure 2.2  DPA/NPAs accompanied by individual prosecutions, 2001–2014 (Rakoff 2014; Rothfeld 2014). Perhaps priorities have changed. Contrast a study by Professor Mark Cohen in the late 1980s, which found that 65 percent of non-antitrustrelated federal corporate prosecutions were accompanied by individual prosecutions; it should be noted that most of the firms in that dataset were smaller and often closely-held firms (Cohen 1991). These charging patterns may reflect a policy choice of some kind, and not just idiosyncratic practical obstacles faced in individual cases, as some prosecutors have suggested in their public statements. There is real variation, even in this relatively small universe of corporate prosecutions, between charging practices, depending on the type of crime. There were the highest numbers of corporate settlements accompanied by individual prosecutions in fraud and securities fraud cases, as Figure 2.3 shows. Eighteen out of 25 securities fraud corporate prosecution agreements were accompanied by individual prosecutions. Fifty-nine out of 109 fraud prosecutions generally (including securities fraud, mail fraud, wire fraud, etc.) were accompanied by individual prosecutions. This is consistent with the fact that the firm should not be charged unless the government can show that an employee of the firm intended to commit fraud (and did commit fraud). In contrast, Foreign Corrupt Practices Act (FCPA) cases often did not have individual prosecutions; 13 out of 75 FCPA corporate settlements were accompanied by individual prosecutions. The type of crime can be related to the particular group of prosecutors involved: only the U.S. Department of Justice (DOJ) can bring FCPA cases; perhaps they had adopted a somewhat different approach towards charging than others. Disclaiming any such policy, in 2008, the head of the unit at the DOJ that brings FCPA prosecutions commented: “It is our view that to have a credible deterrent effect, people have to go to jail” (Mohkibar 2008).

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Individual and corporate criminals  49 200

150

100

50

0

No employees prosecuted (203 cases)

Fraud (41 cases)

Securities fraud (18)

FCPA (13)

Immigration False (4) statements (5)

Pharma (7)

Other (15)

Figure 2.3  DPA/NPA crimes accompanying individual prosecutions, 2001–2014 To be sure, FCPA cases, and cases involving foreign conduct generally, can involve special practical and jurisdictional challenges. For example, FCPA corporate settlements involve both anti-bribery and accounting provision charges. Identifying the right individual to charge for an internal control violation may be more difficult than identifying which senior officer intentionally misstated the firm’s financial statements. In addition, jurisdictional challenges are not common in corporate prosecutions, where corporations typically settle matters rather than litigate such issues, but also because jurisdiction over corporations may be broader than that over individuals. For example, jurisdiction over the corporation may be premised on the company having stock listed on U.S. exchanges, or based on acts that occurred in the United States. If an individual did not engage in, for example, a bribe transaction that relied on U.S. wires or conduct in U.S. territory, jurisdiction might not be possible to prove. In contrast, jurisdiction over an individual would be more straightforward concerning an accounting violation that affected the finances of a company with stock listed in the U.S. Regarding practical challenges, cases involving foreign bribery commonly involve foreign employees of foreign companies and subsidiaries who may be difficult to successfully extradite to the U.S. That said, sometimes prosecutors have nevertheless filed charges against such individuals, which, even if the individuals remain abroad as fugitives, affects their ability to travel to countries that extradite to the U.S. Most prominently, in the largest corporate FCPA settlement to date, with Siemens, while no individuals were convicted in the U.S., eight former Siemens executives were indicted. To date, none have been extradited to the United States (FBI 2011). One individual facing FCPA charges in another case, dubbed the “Pirate of Prague,” received a ruling from the British Privy Council that he would not be extradited to face charges in the U.S., since foreign bribery was not a crime in the Bahamas (Glovin 2012). These obstacles may also arise in other

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50  Research handbook on corporate crime and financial misdealing types of international corporate cases, such as cases involving multinational banks like HSBC. The former head of a Swiss bank, sought for facilitation of tax evasion, remains a fugitive, while a UBS banker who was indicted in 2009 and captured in Italy and extradited in 2013, was acquitted at trial (The Guardian 2014; Nanavati and Thornton 2014). While extradition is not a complete explanation for reluctance to charge, practical difficulties in mounting adequate investigations of foreign conduct may explain why prosecutors may be reluctant to conduct expensive multinational investigations, if the end result may not be a successful effort to obtain jurisdiction over the individual. Cases involving financial institutions have been of special concern to commentators, lawmakers, and the public. For example, former Secretary of State Hillary Clinton has said, “Even though some institutions have paid fines and even admitted guilt, too often it seems like the people responsible get off with limited consequences (or none at all)” (Lerer 2015). Among these 306 deferred and non-prosecution agreements, 66 cases involved financial institutions, defined quite broadly to include a range of companies that focus on financial transactions, including commercial banks, investment banks, insurance companies, and brokerages (Garrett 2015). This group includes nine insurance companies, ranging from AIG to health insurance companies like HealthSouth, and it includes major Wall Street and international banks like J.P. Morgan and HSBC, but also smaller banks like Union Bank of California and United Bank for Africa, and investment banks like the Jefferies Group. Twenty-two cases were accompanied by individual prosecutions. Four of the nine cases involving insurance companies were accompanied by individual prosecutions. What financial crimes were not accompanied by individual prosecutions (Garrett 2015)? For example, one does not see any Bank Secrecy Act cases accompanied by individual prosecutions. The HSBC case was entirely typical of Bank Secrecy Act cases and IEEPA cases. None of the 14 banking or currency-reporting violations resulted in individual prosecutions of bank employees, and nor did the nine deferred and nonprosecution agreements regarding violations of the IEEPA by banks (Garrett 2015). One also wonders about cases in which employees are charged, but only quite low-level employees, and not their supervisors or higher-up officers. As noted, few of these cases involved the top leadership of the companies. Take the Pilgrim’s Pride case, in which 24 individuals were prosecuted for immigration violations at several of the company’s Texas chicken processing facilities (in addition, hundreds of non-citizens were apprehended, and many were presumably deported) (ICE 2009). At the time, the U.S. Attorney commented that “[w]ith this agreement, Pilgrim’s Pride sets itself up as an industry leader in adopting recommended immigration practices” (ICE 2009). Yet only one supervisor, a human resources employee, was prosecuted (and the charges were later dismissed), while the 23 other employees charged were prosecuted for using fraudulent documentation, and mostly received sentences of time served (ranging from about 10 to 20 months). While individuals were charged, one wonders whether any other supervisors or management were aware of the violations or should have been held responsible.

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Individual and corporate criminals  51

4. RETHINKING INDIVIDUAL AND CORPORATE PROSECUTIONS These observed patterns do not jibe with the rhetoric coming from the Department of Justice. For example, then Attorney General Eric Holder noted in a speech in 2014 that: “we have almost always reserved the right to continue our civil and criminal investigations into individual executives at the respective firms” (Holder 2014). That statement suggests that prosecutors would not formally grant immunity to individual officers or ­executives (although that is formally done in the Antitrust context, but only as regards a first company to report cartel behavior under the Antitrust Division’s Leniency Program). However, Attorney General Holder added that for “more complex transactions that involve more sophisticated traders” a prosecution “can be difficult, more complicated, to mount,” including because of “possible advice-of-counsel defenses; to the adequacy or inadequacy of written disclosures; to the difficulty to establish materiality and intent.” Attorney General Holder added, “in some instances, it is simply not possible to establish knowledge of a particular scheme on the part of a high-ranking executive who is far removed from a firm’s day-to-day operations” (Holder 2014). Defense lawyers put it differently, arguing that “[p]rosecutors do not possess the same kind of leverage over individuals that they do over companies . . . individuals are more likely to test the prosecution’s case” (Fishbein 2014). The Department of Justice substantially revised its guidelines on organizational prosecutions in Fall 2015, in Deputy Attorney General Sally Yates’ Memo placing a new focus on individual prosecutions. No longer can corporations receive cooperation credit without making efforts to identify responsible individuals. Prosecutors are to focus early on in investigations on individual accountability. While prosecutors may have said before that individual prosecutions were a priority, perhaps these data suggest they were not. If prosecutors did place a priority on individual prosecutions alongside DPAs in the past, but were simply often unable to bring cases, then those same practical obstacles may make the Yates Memo approach a more incremental change. Whether the Yates Memo has changed enforcement patterns is still hard to tell. These data pre-date the Yates Memo, and even one and a half years later, new cases being brought under the Yates Memo are still being investigated. Indeed, it may take far more time for a case to proceed to a corporate settlement post-Yates Memo precisely because individual investigations can take more time than negotiating a settlement with the firm. Moreover, other changes may impact the enforcement patterns going forward. More cases are being resolved with guilty pleas, including with financial institutions (Garrett 2016). Nor do we know what the new Administration’s priorities will be. Which better accomplishes the various goals of criminal punishment: the prosecution of individuals or corporations? Should there be a choice between the two? Prosecutors may sometimes choose to focus on resolving cases brought against the corporation, as described. Far more often in cases involving smaller firms, they may pursue individual offenders and not seek any punishment of the organization. Far too little is known about how those trade-offs are viewed in practice. Nor do we know enough about the relationship between the costs and benefits of individual versus organizational prosecutions. I have argued that prosecutors should not abandon their renewed focus on corporations.

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52  Research handbook on corporate crime and financial misdealing Corporate prosecutions can help to make the detection and punishment of individually committed crimes more effective (Arlen 1994; Arlen and Kraakman 1997). 4.1  The Goals of Corporate Prosecutions 4.1.1  Incapacitation and retribution Corporations cannot be jailed, but they can be incapacitated through fines equal to their total assets, or debarred from doing work in an industry, which can also effectively operate as a corporate “death penalty.” Use of fines to effectively terminate a company is rare. Prosecutors do not typically seek the result that a company will be debarred and unable to continue as a going concern, or fined out of existence. Perhaps they should consider imposing a corporate “death penalty” more often. Organizations are not moral agents that can be punished for the same reasons as individual persons who actually commit the blameworthy acts. Instead, the reasons given for maintaining corporate criminal liability are practical and have to do with the manner in which companies can promote criminal behavior. As a result, effective deterrence of crime within organizations may require penalties at the corporate level. However, extremely serious criminal behavior, as the sentencing guidelines reflect, may sometimes deserve the most serious penalties. If an organization ceases operations, the officers and employees can seek work elsewhere and other companies with better management can purchase its assets. Perhaps the officers and employees least responsible for the conduct will be least affected in their future prospects. There have been very few examples, though, of prosecutors seeking to dissolve a corporation, and the outcry over the demise of Arthur Andersen may explain why this has happened so rarely and why we know so little about the costs and benefits of using such an approach. 4.1.2  Organizational deterrence Deterrence of corporate crime at the corporate level raises complex questions on whether imposing fines is enough, or whether sanctions directed towards incentivizing selfreporting of violations and maintaining compliance programs to prevent future crimes must be part of the punishment regime (see Arlen 1994; Arlen and Kraakman 1997, recommending this approach). The Sentencing Guidelines, for example, reward both the self-reporting of criminal conduct, and cooperation with prosecutors, as well as compliance by adopting organizational changes. However, prosecutors informally take into consideration a range of factors, including the collateral consequences to shareholders and others, as well as cooperation, past and future use of compliance programs, and self-reporting. Apart from the corporate practices and culture, that may be affected by corporate prosecutions, individual-level criminality may be more directly affected by individual prosecutions. Of course, whether and to what degree criminal prosecutors actually deter crime is a highly contested question in the criminology literature. There may be more reason to think that, unlike street criminals, white-collar criminals may be particularly sensitive to reputation-harming sanctions (Alexander, 1999; Fisse and Braithwaite, 1983). As Professor Dan Kahan put it, your average corporate executive “probably cares a lot about what his family, his colleagues, his firm’s customers, his neighbors, and even the members of his health club think” (Kahan, 1996, p. 643). On the other

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Individual and corporate criminals  53 hand, white-collar criminals may be far more likely to think that what they are doing is not a crime at all, and is something that is a social good that benefits their company and its investors. Criminologists have described how corporate fraud can be a “team sport” due to “group-think” of sub-cultures within an organization (Ramamoorti 2008). That same group-think can make it difficult to question corporate practices or report misconduct. 4.1.3  Individual accountability through corporate settlements Not only may corporate culture encourage individual crime, but, as described, it may obscure who did what and make it more difficult to prove fault. Judge Gerald E. Lynch has noted that corporate prosecutions may be particularly justified “when the corporate form makes it difficult to establish culpability on the part of any particular individual” (Lynch, 1997, p. 51). For those reasons, I have argued that both individual and corporate prosecutions are important goals. Prosecutors may be quite right to prosecute corporations even where it is not possible to easily target the relevant individuals. However, prosecutors can also design corporate prosecution agreements in a way that promotes individual accountability. First, prosecutors can insist that corporate cooperation requires identifying culpable individuals and supplying evidence that can support prosecution efforts against those individuals (see U.S.D.O.J. 2015). In the Antitrust Division, prosecutors have detailed policies requiring that corporations do just that. Even a cooperating company cannot insulate its employees from prosecution, unless it is the first to report on a price-fixing cartel; instead prosecutors can “carve out” and prosecute employees who do not fully cooperate, and prosecutors note their focus on high-level individuals (Baer 2013; Hammond 2006). However, on occasion, other prosecutors have apparently immunized employees, explicitly, and in corporate prosecution deals that have been made public. In the AmSouth case, the prosecution agreement explicitly provided that “the United States will not prosecute any current or former AmSouth employee based upon any of the conduct described” (Amsouth DPA 2005). Few agreements contain such terms specifically immunizing employees, but, in practice, few employees are prosecuted, as noted, and occasionally, prosecutors note in press conferences that they do not intend to pursue any individual prosecutions. Yet the text of deferred and non-prosecution agreements routinely requires that the firm cooperate in any pending investigations by federal prosecutors. One would think that such cooperation would be a powerful prosecution tool. To be sure, prosecutors may have been chastened by a federal district judge’s ruling in the KPMG case dismissing individual prosecutions, based on findings that prosecutors placed pressure upon KPMG to make available culpable employees and cease paying their attorneys’ fees (Garrett 2008, 2014; United States v. Stein 2006, 2007, 2008). The DOJ organizational prosecution guidelines at the time noted, as they still do, that corporate cooperation would be an important factor in deciding whether to prosecute a company. However, those since-amended guidelines had stated that whether the company was advancing attorneys’ fees or disclosing the complete results of its internal investigations (perhaps including privileged and work product protected material) could be relevant considerations. These guidelines have since been changed (Garrett 2008, 2014). The focus on cooperation regarding individual employees has now also sharpened. Leading up to the Yates Memo, DOJ officials had begun to emphasize how “true”

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54  Research handbook on corporate crime and financial misdealing corporate cooperation can produce “evidence against” the “culpable individuals” (Miller 2014). Now the DOJ has explicitly required that: “In order for a company to receive any consideration for cooperation under this section, the company must identify all individuals involved in or responsible for the misconduct at issue, regardless of their position, status or seniority” (Yates Memo, U.S.A.M, § 9-28.700). As discussed, this is a welcome shift in DOJ priorities, but it may take time to evaluate its effect on enforcement patterns. 4.1.4  Civil enforcement against individuals Civil enforcement against individual employees cannot result in jail time, but it can result in sanctions with career-ending consequences, such as debarment from doing work in a regulated industry. In some cases, prosecutors may feel that they lack evidence to bring a criminal prosecution, but are satisfied that civil enforcement may supply some punishment. Yet these civil enforcement actions may be hotly litigated, just as criminal actions against top executives are. For example, the general counsel for Forest Labs, a pharmaceutical company that entered a plea agreement, complained that if HHS-OIG barred its CEO from federal health care program work, this would “create uncertainty throughout the industry and discourage regulatory settlements”; the agency ultimately dropped its civil enforcement action (HHS-OIG 2011). Purdue Frederick executives who had been ordered debarred by HSS-OIG for twenty years, argued that these were “career-ending” consequences, and successfully appealed and reversed the agency’s action in Friedman v. Sebelius, 686 F.3d 813, 816 (D.C. Cir 2012). 4.2  Reform Proposals I have suggested that several small-bore policy changes could improve the chances for obtaining individual accountability for corporate crimes. Some have proposed enacting new crimes for supervisory liability for certain financial and corporate crimes. Without a mens rea requirement, such crimes might have to be drafted as misdemeanor responsible corporate officer-type offenses. Such offenses, even if misdemeanors, might have some deterrent effect. That said, existing fraud and other related statutes are already incredibly broad. Perhaps the problem is more one of institutional culture and a lack of the resources to prosecute extremely complex business crime cases. A few smaller procedural changes might affect how these cases are brought, at least at the margins. The first could be to lengthen statutes of limitations for certain corporate crimes, since such investigations are complex and can depend on years of corporate cooperation. The general federal statute of limitations is five years, 18 U.S.C. § 3282(a) (2003), although offenses that “affect” a financial institution, including fraud, already have an extended ten-year statute of limitations, 18 U.S.C.A. § 3293. That said, those existing statutes of limitations are fairly lengthy, and prosecutors have not suggested or provided evidence that short statutes of limitations have hampered the ability to adequately investigate corporate crimes. A second proposal would amend the Speedy Trial Act provisions that currently permit deferred prosecution agreements, to focus specifically on organizational deferred prosecution agreements, and permit a judge to inquire into whether individuals are being adequately investigated and held accountable. Under Title 18, United States Code,

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Individual and corporate criminals  55 Section 3161(h)(2) of the Speedy Trial Act, a judge may defer the prosecution of a defendant to permit the defendant to show “good conduct” 18 U.S.C.A. § 3161(h)(2) (“Any period of delay during which prosecution is deferred by the attorney for the Government pursuant to written agreement with the defendant, with the approval of the court, for the purpose of allowing the defendant to demonstrate his good conduct”). The drafters of the 1974 Act were certainly not familiar with corporate deferred prosecutions, a far more recent phenomenon, and they had in mind several programs involving alternatives to prosecution for low-level prosecutions of individuals. Judicial review could promote more attention to the relationship between individual and corporate accountability for crimes. Federal district Judge Richard J. Leon recently rejected a deferred prosecution agreement with a company, where “no individuals . . . [were] being prosecuted for their conduct at issue here” and also where “a number of the employees who were directly involved in the transactions are being allowed to remain with the company” (U.S.A. v. Fokker 2014). In a much anticipated ruling, the D.C. Circuit reversed, and held that the district judge had exceeded his discretion under the Speedy Trial Act (United States v. Fokker 2016). In addition, the Crime Victims Rights Act, amended after the Fokker case was litigated, makes clear that in a DPA a judge must now ensure that any victims are notified and proper restitution is provided. (18 U.S.C. §§ 3771(a)(9)). Of course, even if judges provided review under an amended Speedy Trial Act, prosecutors currently also enter non-prosecution agreements with companies that are completely out of court and not subject to any judicial review (Garrett 2007). Moreover, any judicial review would be highly deferential (Arlen 2016; Garrett 2015). In the context of plea agreements, judges have occasionally intervened to express concerns with agreements with corporations in which no individuals are held accountable, but it is very rare for a judge to actually reject a plea agreement as contrary to the interests of justice (Garrett 2015). Third, the U.S. Sentencing Guidelines for organizations provide in USSG §8C2.5(g)(1)–(2) for a sentencing reduction for an organization that “fully cooperated in the investigation.” That standard is extremely flexible and it has been much criticized (Arlen 2012b). The Application Notes to USSG §8C2.5 note that “the organization may still be given credit for full cooperation” even if due to non-cooperation by individuals, there is no success in identifying the culpable individuals. That standard does not remotely resemble the standard for cooperation credit for individuals under § 5K1.1, which must be “substantial assistance” that prosecutors formally move to recognize, at sentencing, and where a judge must then evaluate whether the assistance was sufficiently substantial, under 18 U.S.C. § 3553(e). The Guidelines could demand more robust cooperation, and also with larger rewards for the firm that provides truly substantial assistance. While cases negotiated through deferred and non-prosecution agreements do not necessarily involve Guidelines calculations, revised Guidelines could still exercise an influence upon the practice. Fourth, DOJ policy could continue to emphasize, as the post-Yates Memo changes make clear, that: “Only rarely should probable individual culpability not be pursued, particularly if it relates to high-level corporate officers” (U.S.D.O.J. 2015). To help realize the goals of the Yates Memo, resources could be allocated for particularly demanding investigations of corporate employees. Those changes might have the biggest impact in the types of cases that have engendered public criticism. Fifth, the terms of organization agreements can better create individual accountability with the firm. The HSBC agreement, as noted, included terms requiring that senior

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56  Research handbook on corporate crime and financial misdealing executive bonuses be based on “the extent to which the senior executive meets compliance standards and values,” and permitting the “clawback” of bonuses for officers that fail to adhere to those standards (HSBC DPA 2012). Prosecutors can insist that compliance mean more than just hiring a compliance officer and adopting new policies, but that it be carefully audited, and that failures by employees and officers to follow the new standards result in meaningful employment consequences. Further, prosecutors can insist that not only do companies self-report, but that companies reward internal whistleblowing and reporting of violations by employees. Few prosecution agreements contain detailed terms changing the incentives of employee behavior, and far more can be done to encourage such change. The Department of Justice has increasingly spoken of the need for effective compliance to include enforcement mechanisms. In one recent speech, a DOJ official explained: The department does not look favorably on situations in which low-level employees who may have engaged in misconduct are terminated, but the more senior people who either directed or deliberately turned a blind eye to the conduct suffer no consequences. (Caldwell 2015)

Perhaps such scrutiny of the on-the-ground internal enforcement of compliance policies will improve individual accountability going forward.

5. CONCLUSION Whether prosecutors could better balance their priorities of holding institutions and individuals accountable, practices certainly vary among groups of prosecutors, perhaps not just because of the different resources of regulatory agencies that investigate different crimes or the structure of different industries or elements of different crimes, but also because of varying priorities among groups of prosecutors. There is increasingly widespread criticism, among legislators, judges, scholars, and the public, of corporate settlements that leave individuals untouched. The problem can be observed in areas facing practical obstacles to prosecution, like those involving foreign conduct by foreign individuals, but also in cases involving financial institutions, where prosecutors appear to view the underlying problem as a compliance problem and not one to be addressed through individual prosecutions. Whether this pattern can change in the future remains to be seen. More work should be done to study the relative costs and benefits of focusing on individual and corporate prosecutions, and the relationship between the two. Meanwhile, perhaps the changes in policy and priorities already announced by the Department of Justice will begin to turn towards focusing on individual wrongdoing, even when the prosecutors set their sights on the largest corporations.

REFERENCES Alexander, Cindy R. 1999. On the Nature of the Reputational Penalty for Corporate Crime: Evidence, Journal of Law & Economics, 42, 489–526. Alexander, Cindy R. and Mark A. Cohen. 2015. The Evolution of Corporate Criminal Settlements: An Empirical Perspective on Non-Prosecution, Deferred Prosecution, and Plea Agreements, American Criminal Law Review, 52, 537–593.

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Individual and corporate criminals  57 Amsouth Deferred Prosecution Agreement, 7 (October 13, 2005). Arlen, Jennifer. 1994. The Potentially Perverse Effects of Corporate Criminal Liability, Journal of Legal Studies, 23, 833–867. Arlen, Jennifer. 2012a. Corporate Criminal Liability: Theory and Evidence. In Keith Hylton and Alon Harel (eds.), Research Handbook on the Economics of Criminal Law, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, 144–203. Arlen, Jennifer. 2012b. The Failure of the Organizational Sentencing Guidelines, Miami Law Review, 66, 231–362. Arlen, Jennifer. 2016. Prosecuting Beyond the Rule of Law: Corporate Mandates Imposed Through Pretrial Diversion Agreements, J. Legal Analysis, 8, 191–234. Arlen, Jennifer and Marcel Kahan. forthcoming. Corporate Regulation Through Non-Prosecution, University of Chicago Law Review. Arlen, Jennifer and Reinier Kraakman. 1997. Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes, New York University Law Review, 72, 687–779. Baer, Bill. April 12, 2013. Statement of Assistant Attorney General Bill Baer on Changes to Antitrust Division’s Carve-Out Practice Regarding Corporate Plea Agreements, Department of Justice, Office of Public Affairs. Caldwell, Leslie. March 16, 2015. U.S. Department of Justice, Assistant Attorney General Caldwell Remarks at the ACAMS Anti-Money Laundering & Financial Crime Conference. Cohen, Mark A. 1991. Corporate Crime and Punishment: An Update on Sentencing Practice in the Federal Courts, Boston University Law Review, 71, 268–398. Coppola, Frances. 2016. HSBC’s Catalogue of Lawsuits, Forbes, February 28, https://www.forbes.com/sites/ francescoppola/2016/02/28/hsbcs-catalog-of-lawsuits/#329ab39057fc Ensign, Rachel Louise and Max Colchester. 2015. HSBC Struggles in Battle Against Money Laundering. Wall Street Journal, January 12. FBI Press Release. December 13, 2011. Eight Former Senior Executives and Agents of Siemens Charged in Alleged $100 Million Foreign Bribe Scheme. Fishbein, Matthew. 2014. Why Individuals Aren’t Prosecuted for Conduct Companies Admit, New York Law Journal, September 14. Fisse, Brent and John Braithwaite. 1983. The Impact of Publicity on Corporate Offenders, Albany: State University of New York Press. Frankel, Alison. 2012. Sarbanes-Oxley’s Lost Promise: Why CEOs Haven’t Been Prosecuted, Reuters, July 27. Garrett, Brandon L. 2007. Structural Reform Prosecution, Virginia Law. Review, 93, 853–957. Garrett, Brandon L. 2008. Corporate Confessions, Cardozo Law Review, 30, 917–947. Garrett, Brandon L. 2014. Too Big to Jail: How Prosecutors Compromise with Corporations, Cambridge, MA: Harvard University Press. Garrett, Brandon L. 2015. The Corporate Criminal as Scapegoat, Virginia Law Review, 102, 1789–1849. Garrett, Brandon L. 2016. The Rise of Bank Prosecutions, Yale Law Journal Forum, 126, 33–56. Garrett, Brandon L. and Jon Ashley. n.d. Corporate Prosecution Registry, University of Virginia School of Law, at http://lib.law.virginia.edu/Garrett/corporate-prosecution-registry/index.html (last visited November 26, 2017). Glovin, David. 2012. Kozeny Won’t be Sent to U.S., U.K. Privy Council Rules, Bloomberg, March 28. Good, Chris. 2013. Elizabeth Warren Wants HSBC Bankers Jailed for Money Laundering, ABC News, May 7. Grassley, Sen. Charles. December 13, 2012. Press Release, Justice Department’s Failure to Prosecute Criminal Behavior in HSBC Scandal is Inexcusable, at https://www.grassley.senate.gov/news/news-releases/ grassley-justice-department%E2%80%99s-failure-prosecute-criminal-behavior-hsbc-scandal The Guardian. 2014. Swiss Banker Raoul Weil Acquitted in Tax Evasion Trial in Florida, The Guardian, November 3. Hamilton, Jesse and David Voreacos. 2012. HSBC Executive Resigns at Senate Money-Laundering Hearing, Bloomberg, July 23. Hammond, Scott D. March 29, 2006. Measuring the Value of Second-in Cooperation in Corporate Plea Negotiations, American Bar Association Section of Antitrust Law Spring Meeting. HHS-OIG Letter, Press Release, HHS-OIG Drops Potential Action against Forest CEO, August 5, 2011. Holder, Eric. September 17, 2014. Attorney General Holder Remarks on Financial Fraud Prosecutions at NYU School of Law, New York City, NY, U.S. Department of Justice, at http://www.justice.gov/opa/speech/ attorney-general-holder-remarks-financial-fraud-prosecutions-nyu-school-law HSBC Deferred Prosecution Agreement (December 11, 2012), Statement of Facts. ICE News Release. December 30, 2009. Justice Department and ICE Reach $4.5 Million Agreement with Pilgrim’s Pride, at http://www.ice.gov/news/releases/0912/091230beaumont.htm Kahan, Dan M. 1996. What Do Alternative Sanctions Mean?, University of Chicago Law Review, 63, 591–653. Leigh, David, James Ball, Juliette Garside, and David Pegg. 2015. HSBC Files Show How Swiss Bank Helped Clients Dodge Taxes and Hide Millions, The Guardian, February 8.

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58  Research handbook on corporate crime and financial misdealing Lerer, Lisa. 2015. Hillary Clinton to Propose Increasing Capital Gains Taxes as Part of 2016 Campaign Plans, Associated Press, July 20. Lynch, Gerard E. 1997. The Role of Criminal Law in Policing Corporate Misconduct, Journal of Law & Contemporary Problems, 60, 23–65. Memorandum and Order, U.S. v. HSBC, 12-CR-763 (E.D.N.Y., July 1, 2013), at https://www.justice.gov/sites/ default/files/usao-edny/legacy/2015/04/06/HSBC%20Memorandum%20and%20Order%207.1.13.pdf Merkley, Sen. Jeff, December 13, 2012. Press Release, Senator Jeff Merkley, Merkley Blasts “Too Big to Jail” Policy for Lawbreaking Banks. Miller, Marshall L., September 17, 2014. U.S.D.O.J., Remarks by Principal Deputy Assistant Attorney General for the Criminal Division Marshall L. Miller at the Global Investigation Review Program. Millman, Gregory J. 2014. HSBC Costs Illustrate New Cost of Banking, Wall Street Journal, November 4. Mohkibar, Russell. 2008. Mendelsohn Says Criminal Bribery Prosecutions Doubled in 2007, 22 Corporate Crime Reporter, 36(1). Nanavati, Jay R. and Justin A. Thornton. 2014. DOJ and IRS Use “Carrot’n Stick” to Enforce Global Tax Laws, Criminal Justice, 7. O’Toole, James. 2012. HSBC: Too Big to Jail, CNN Money, December 12, at http://money.cnn.com/2012/12/12/ news/companies/hsbc-money-laundering/index.html Protess, Ben and Jessica Silver-Greenberg. 2012. HSBC to Pay 1.92 Billion to Settle Charges of Money Laundering, The New York Times DealBook, December 10. Rakoff, Jed S. 2014. The Financial Crisis: Why Have No High-Level Executives Been Prosecuted?, The New York Review of Books, January 9. Ramamoorti, Sridhar. 2008. The Psychology and Sociology of Fraud, Issues in Accounting Education, 23, 529–533. Rothfeld, Michael. 2014. Firms Are Penalized, But Workers Aren’t, Wall Street Journal, January 16. Slater, Steve. 2013. Banker Bonus Clawbacks Yet to Bite at HSBC, Reuters, March 4. United States v. Fokker Servs., B.V., 818 F.3d 733, 742 (D.C. Cir. 2016). USA v. Fokker Services B.V., Docket No. 1:14-cr-00121 (D.D.C. Jun 04, 2014). United States v HSBC Bank, U.S.A., N.A., 863 F.3d 125, 142 (2d Cir. 2017). United States v. Stein, 435 F. Supp. 2d 330, 338–339 (S.D.N.Y. 2006). United States v. Stein, 495 F.Supp.2d 390, 420–24 (S.D.N.Y. July 16, 2007). United States v. Stein, 541 F.3d 130 (2d Cir. 2008). U.S. Attorneys’ Manual (U.S.A.M.), § 9-28.000, Principles of Federal Prosecution of Business Organizations (revised in November, 2015), at http://www.justice.gov/usam/usam-9-28000-principles-federal-prosecution-bus​ iness-organizations U.S. Department of Justice (U.S.D.O.J), U.S. Attorneys’ Manual § 9-28.000. 2015 (Yates Memo). U.S. Department of Justice (U.S.D.O.J), Principles of Federal Prosecution of Business Organizations, U.S.A.M. § 9-28.200, at http://www.justice.gov/opa/documents/corp-charging-guidelines.pdf U.S. Senate, Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs. 2012. U.S. Vulnerabilities to Money Laundering, Drugs, and Terrorism Financing: HSBC Case History (Senate Report). U.S. Sentencing Commission (U.S.S.C.). 2014. 2013 Sourcebook, Offenders Receiving Sentencing Options in Each Primary Offense Category, Fiscal Year 2013, Table 12, at http://www.ussc.gov/sites/default/files/pdf/ research-and-publications/annual-reports-and-sourcebooks/2013/Table12.pdf

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3.  Criminally bad management Samuel W. Buell* 1

1. INTRODUCTION Few would disagree that malfeasance committed within large corporations can inflict outsized harms on the public; that it occurs within complex, diverse, and often opaque institutional contexts; and, therefore, that it calls for particularized and determined regulatory responses. Most who have thought about this problem would concede that the role of corporate managers is a central point of intervention for law: a locus to which wrongdoing often can be traced and where deterrent messages can achieve leverage given that managers wield disproportionate power within firms. American corporate law, regimes of securities regulation, and many other systems of regulation designed with the corporation in mind proceed from these premises. This point about directing incentives towards corporate managers is only more important, while also trickier to get right, when managers do not personally commit the relevant delicts—a scenario that has been repeating in very large firms, particularly those that are publicly traded and operated under complex and layered governance and compensation regimes. Furthermore, when corporate malfeasance implicates arguments about criminal punishment—either because the wrongdoing is plainly criminal according to existing legal definitions, or because reformers might call for using the special potency of criminal ­sanctions—the role of managers can present a particular problem. Especially in the repeating systemic breakdowns of recent years, corporate managers often bear serious responsibility for what happened but were not involved in crime, either as direct perpetrators or as fully complicit accomplices or conspirators. Conventional legal doctrines, for good reasons, do not authorize personal criminal sanctions. Some special doctrines of supervisory criminal liability exist but they are controversial and, to date, have been narrowly tailored. The law, of course, has other tools available for influencing management behavior, both directly and indirectly. Only one of those tools, however, can claim the label “criminal” and can mobilize a criminal justice process with all that entails, including the core idea of punishment. That tool is corporate criminal liability. It is criminal. It is a form of punishment. And it is directed, in important part, towards managers of firms. Or so this chapter will suggest. The argument that follows is not intended as a knock-down case in favor of corporate criminal liability. The literature on that question is beyond voluminous and I am guilty

*  For exceptionally helpful comments, many thanks to Jennifer Arlen, Mark Osiel, J. J. Prescott, and Dan Richman. Thanks also for help from the participants in an April 2015 conference of the NYU Center on Corporate Compliance and Enforcement and a faculty workshop at the University of Iowa College of Law.

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60  Research handbook on corporate crime and financial misdealing of having contributed to the overweight (Buell 2006, 2016; DiMento et al. 2000). Suffice it to say that no conclusive argument has been recorded for or against corporate criminal liability and none is likely to be discovered in the short term. The objective here is to identify one underappreciated benefit of corporate criminal liability, and to make a modest normative claim from there. Crucial to any understanding of corporate criminal liability is recognizing that, as currently practiced in the United States, the doctrine and its enforcement have developed organically—largely through the collective and incremental practices of enforcement authorities and the bar—to fill a gap between criminal law and corporate regulation. Understanding the nature of this gap, and the reasons for it, is essential to giving corporate criminal liability its due, something it has not always received in recent commentary. The doctrine’s tenacity and its growth in practice can be understood as a natural response to the problem of how to influence, and even punish, corporate managers in relation to corporate crime. The modest normative extension of this point will be to say that corporate criminal liability might be a second-best measure for dealing with management responsibility for corporate crime, given that individual criminal liability comes up short. This claim does not come close to settling the debate over corporate criminal liability in the United States. It is riddled with empirical uncertainties, as are competing claims. Arguments holding that forms of civil liability could fill the gap just as well, at least if one could redesign regulatory systems from scratch, remain plausible. But the current legal landscape should be taken as evidence for something about the function of corporate criminal liability. It also must be accepted as the context in which the law will manage the next fiasco of corporate malfeasance that arises today or tomorrow. Corporate criminal liability is a useful existing tool for responding to the problem of what might be called criminally bad management. To show this, section 2 will describe the problem, mostly by way of examples; section 3 will describe the demand for criminal liability and punishment in the corporate context; section 4 will explain the limitations of individual criminal liability in satisfying that demand; and section 5 will show how corporate criminal liability fills the gap.

2.  THE NATURE OF THE PROBLEM 2.1  Management Failure and Corporate Crime In a great many of the recent cases of corporate malfeasance that have worried both the American public and those who work in legal institutions, the facts could not speak more clearly to the responsibility of management for damaging acts of misconduct committed by mid- and lower-level employees. Managers of the companies embroiled in these scandals struck the wrong balance, to say the least, between quarterly earnings and compliance—between corporate offense and defense—with disastrous and, in hindsight, predictable results. Yet in nearly all of these cases it is equally clear that senior managers committed no serious crimes themselves—at least in the sense of having violated the terms of American criminal prohibitions, even if they might have done things the public would understandably want to call “criminal.”

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Criminally bad management  61 There is a clear relationship between corporate management, indeed bad corporate management, and corporate crime. It is a relationship that arises from the nature of the large, complex institution, especially the for-profit firm. It is not one, however, that lies within the boundaries of conventional concepts of criminal liability. Economic analysis of corporate regulation has usually understood this relationship as having to do with management not preventing corporate crime—as a failure of internal or private policing (Arlen and Kraakman 1997; Kornhauser 1982; Sykes 1984). This is what is encompassed by the common and now banal terminology of “compliance” (Baer 2009; Miller 2014). This understanding is incomplete. In many scandals of corporate malfeasance, especially the ones that worry the public the most, the failure of management is not just a failure to prevent crime. It also includes complicity—and therefore desert of blame—in the production, or fostering, or tolerance of a corporate environment that was, to borrow a term in vogue with street crime, criminogenic (Laufer 1994). Managers did not just fail to constrain the natural impulse in the corporate context to violate the law for profit. They helped it along. This perspective brings into the analysis of corporate wrongdoing the notoriously elusive concept of “corporate culture” (Bucy 1990). Culture eludes theorizing because it is complex, diverse, and deeply contingent on fact. There can be no dispute, however, that culture is real and that corporate managers bear responsibility for it. 2.2  Contemporary Examples The relationship of managers to corporate crime can be seen more clearly through examples. Consider four recent ones. 2.2.1 BP On April 20, 2010, BP’s Deepwater Horizon rig exploded in the Gulf of Mexico, killing 11 people and releasing millions of barrels of crude oil into one of the world’s most economically important ecosystems.1 If professional criminals—terrorists perhaps—had done this awful deed, the story about how the disaster was caused and who should be held responsible would have been straightforward. But because a corporation did it, explanation and accountability were complex, at the levels of both actions and mental state. (The less precise term “culpability” might be better than mental state since, for purposes of institutional responsibility, the question is how to describe the collective decision making of all the relevant actors within the corporation, and corporations of course do not have states of mind.) The best explanation for the BP affair combines immediate events with more gradual developments. The rig exploded when the men in charge of temporarily capping the well failed to call ashore for help though all signs pointed to an impending and disastrous failure. The events were not brought under control much earlier because BP did not do

 1  See United States v. BP Exploration and Production, Inc., Crim. No. 2:12-cr-00292 (E.D. La. Nov. 14, 2012) (criminal information, plea agreement, and sentencing order); United States v. Kaluza, Crim. No. 12-265 (E.D. La. Nov. 14, 2012) (superseding indictment).

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62  Research handbook on corporate crime and financial misdealing enough as an organization, in the Gulf or elsewhere, to prioritize accident prevention while pursuing an aggressive corporate strategy to find larger and deeper offshore oil deposits. Robert Kaluza and Donald Vidrine are not at the center of the public’s understanding of the BP case, even though they were the two BP employees federal prosecutors said were responsible for failing to alert others to the escalating problem at the well. Kaluza and Vidrine were charged with manslaughter. A third BP employee, David Rainey, was indicted for obstruction of justice for concealing information after the accident about how much oil was flowing out of the well site on the floor of the Gulf. Few people closely followed the prosecutions of these men, which became tied up in pre-trial wrangling in federal court. That wrangling produced a victory for Kaluza and Vidrine, who persuaded the Fifth Circuit to affirm the trial court’s dismissal of the maritime manslaughter charges on the ground that the federal statute does not apply to persons whose job on a vessel does not relate to navigating the craft.2 (This ruling was poor statutory interpretation deployed in a bad cause. But that is another topic.) In the end, Vidrine pled guilty to violating the Clean Water Act (CWA), Kaluza was acquitted of the same charge after a trial, and another jury acquitted Rainey of the obstruction charges. More was at stake in this case. Observers of the BP affair rationally placed responsibility on the corporations—primarily BP—that owned the rig, drilled the well, profited from the enterprise, hired and trained the workers, made the critical decisions and policies about equipment and safety, and so on. Yet the trouble with blaming BP’s managers is that, as in many cases of corporate crime, it is difficult to pinpoint who within the massive, bureaucratic global organization that is BP both knew enough and was in charge enough to be the correct target for blame for the Gulf spill. This is more than a lawyer’s problem, a mere difficulty of proof. It is a problem of responsibility and blame. The higher you go in BP, the more responsible the managers seem to be. (Remember how the world felt about former CEO Tony Hayward in the spring of 2010 when BP’s well was dumping oil and he said he wanted his “life back”?) But responsibility does not easily translate into liability. The higher you go in BP, the less the managers knew and were involved day to day in the specific problem of the Deep Horizon rig. As one ascends the corporate ladder, the case for responsibility becomes more and more “you did a bad job of setting responsible priorities and preventing crime” and less and less “you took the following act or decision that triggered that terrible explosion and spill.” Yet criminal liability usually requires just such an act. 2.2.2 GM The case of the scandalous deaths of drivers of General Motors cars involves an even deeper thicket of causation and responsibility within a massive corporate organization (Valukas 2014). Years of engineering designs and redesigns, accident reports and reconstructions, litigation teams, and endless meetings, documentation efforts, and corporate reporting chains reduce to a stunningly simple problem. The spring mechanism in the starter GM installed in some car models—the place where the key goes in—was not strong   United States v. Kaluza, 780 F.3d 647 (5th Cir. 2015).

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Criminally bad management  63 enough. When drivers knocked a leg into a key chain that had heavy doodads on it, the starter could rotate out of the run position, causing the engine to turn off and preventing the air bag from deploying, with disastrous consequences for those in the car. To date, it appears that 124 people likely died when a leg jostled a key chain in the wrong way at the wrong time.3 It is bad enough that GM would design and use a faulty starter switch when making a properly functioning one would have been so easy. It is much worse that GM’s managers failed to identify this simple problem and fix it in the face of nearly nine years of lawsuits and mounting evidence that GM’s cars were spontaneously shutting down on the road. All the while, they were managing a gigantic firm, one in the business of making America’s most lethal consumer product, whose employees joked about how meetings predictably ended with the “GM nod” (meaning “someone should do something about that”) or the “GM salute” (in which one crosses arms pointing to the persons to one’s left and to one’s right as the responsible parties). There is one traditional villain in the GM story. An engineer responsible for the switch corrected the design—no doubt after realizing the problem, though he incredibly claims to have forgotten the whole thing. Yet he did not document the change or the reason it was needed, as required by company policy. The engineer’s concealment suppressed what would have been a red flag, thus keeping GM lawyers and investigators off the trail of the bad starter switch and greatly prolonging the problem. But many others at GM were responsible for the fatally flawed switch and GM’s failure to discover and act on the cause of all the deadly accidents. Those responsible included numerous lawyers at the company who tracked the relevant lawsuits as well as senior managers at GM who presided over an organization in which such a major problem could develop over such a long time without anyone thinking to raise the alarm with top executives. Even the General Counsel was not told. Assume for the sake of argument—there is certainly one to be made—that what was done at GM that killed those drivers deserves, generally speaking, to be treated as a crime. Who is the criminal at GM? One could perhaps imagine that, with more facts, there might be a legal theory on which to prosecute the engineer who concealed the change in switch design. But that would hardly seem like an appropriate end to the matter at GM—just as prosecuting the rig engineers alone at BP would not have been an adequate response to the Gulf spill. One can go up the management chain at GM, just as one could at BP, but the problem at GM, even more than at BP, is one of “you should have been a better corporate manager, your communication channels were lousy.” When it comes to the approach to safety that resulted in deaths, the culpability of GM senior managers, even more than for BP’s top executives, is for sins of omission rather than commission.

  Chris Isidore, Death Toll for GM Ignition Switch: 124, CNN Money, Dec. 10, 2015.

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64  Research handbook on corporate crime and financial misdealing 2.2.3  JP Morgan Then there is the case of the group of traders at JP Morgan that included Bruno Iksil, who became known as the “London Whale.”4 Those traders managed a profitable book of derivative securities that earned the bank as much as $1 billion annually. Like all successful traders in the highly competitive investment banking industry, they were well compensated with bonuses tied to the profits they generated for the bank. When the market for their products turned rather suddenly against them in 2012, the traders knew they had a large quantity of securities on their books that should be marked down—in an amount that later resulted in nearly a billion dollar loss on JP Morgan’s publicly reported financial statements. Instead of reporting the truth about the plummeting value of their books internally within the bank, and thus ultimately to shareholders and the public, the key players in this trading group lied—no doubt justifying their actions with the tried and true belief of the fraud perpetrator that the market would turn around and no one would need to be the wiser. Investors in JP Morgan were victims of fraud because, to the tune of nearly $1 billion, the bank gave them false information about the value of its portfolio. Senior managers at JP Morgan approved that information and its release. They also approved the compensation system that can fairly be said to have caused the traders in London to take big risks and then lie when their risks went bad. Managers also were responsible for reporting and compliance systems within the bank that did not include a means of preventing the traders from controlling how the bank valued the London derivatives book in its overall financials. But, as far as public evidence shows, the top managers at JP Morgan did not know that the numbers from the usually legitimately profitable group in London had turned massively false. Iksil earned a non-prosecution agreement and stood ready to testify against his boss Javier Martin-Artajo. Martin-Artajo’s London group primarily traded credit default swaps in a “synthetic credit portfolio.” Prosecutors in the Southern District of New York must have believed that a jury would see Iksil, whale-sized trading book or not, as a junior minion who did the bidding of an overbearingly aggressive manager. Martin-Artajo, whom the government alleges brushed away a compliance employee at the bank with, “I’m a trader, I do not mark the books to U.S. GAAP, my job is to manage risk,” went to Spain. There he will likely remain, having somehow persuaded a Spanish court to deny American prosecutors’ request that he be extradited to New York to be tried on charges of securities fraud.5 No one above Martin-Artajo at JP Morgan has been charged in this large, familiar, and predictable instance of accounting fraud in the marking of derivatives books by bonus-incentivized traders. Do not expect such charges. Managers offering steep bonuses for profitable books and then inadequately monitoring those books is not, at least in the absence of proof of knowledge of serious red flags, criminal. The bank itself settled civilly with the SEC, not the Justice Department. This was one of the SEC’s recent enforcement deals in which

 4   United States v. Martin-Artajo, Crim. No. 13 Crim. 707 (S.D.N.Y. Sept. 16, 2013) (indictment); In re JPMorgan Chase & Co., United States Secs. & Exchange Comm’n Exchange Act Release No. 70458 (Sept. 19, 2013).  5   Spain: Court Rejects Extradition of JP Morgan Trader, New York Times, Apr. 23, 2015.

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Criminally bad management  65 admissions of wrongdoing are required as a price of settlement. The facts admitted by JP Morgan in the SEC settlement consist of a scolding of New York management and the firm’s Audit Committee for failing to implement adequate controls on the bank’s trading books and having sclerosis in the reporting channels that led up to senior management. (Note that it was in 2012—years after the worst problems of the investment banking industry came to light—that these management and control deficits enabled the fiasco of the London Whale.6) 2.2.4 Walmart As a last example, consider Walmart. The retailing behemoth is reported to be in the process of negotiating a resolution with the U.S. Department of Justice over violations of the Foreign Corrupt Practices Act, which prohibits bribing foreign officials for business purposes. The core of the scandal involves revelations that Walmart operatives in Mexico paid numerous bribes to speed the approval process for constructing new stores in that country, which at the time was Walmart’s fastest area of growth in the world (Barstow 2012). The bribery was a result of Walmart’s relentlessly expansionist business model and its lack of effective controls on the employees driving that expansion in foreign countries. Walmart’s legal troubles have been made worse by a culture of denial and insularity at its corporate headquarters that caused Walmart to minimize and fail to pursue information about bribery in Mexico appropriately when the problem first surfaced through an internal whistleblower. Perhaps that pathology of denial related to Walmart’s famously successful obsession with cost cutting. A prestigious national law firm initially recommended to corporate managers that they commission an expensive outside investigation of the company’s Mexico operations. Walmart’s management rejected this advice, choosing wishful thinking (and an internal investigation by the division allegedly responsible for the problem) over steep legal bills. The cost of Walmart’s FCPA sanctions is likely to be much higher because of this decision. More will be learned about the facts of the Walmart case when it is inevitably settled in expensive enforcement actions.7 Based on currently available information, however, it has not been established that any senior Walmart manager in the United States knew of the bribery while it was going on. There is serious senior management responsibility for what happened at Walmart—both in terms of the incentives and controls in Mexico and in terms of the company’s initial response to allegations of criminality. But that responsibility is unlikely to lead to individual criminal liability, for bribery or perhaps even obstruction of justice.

 6   If space permitted and the point about management responsibility for corporate crime needed further illustration, the major scandal in 2016 in which the bank Wells Fargo fired 5,300 employees for creating millions of fraudulent customer accounts would fit here just as well.  7   The case has been somewhat opaque since the release of an initial, extremely detailed media report (Barstow 2012). See Aruna Viswanatha and Devlin Barrett, Wal-Mart Bribery Probe Finds Few Signs of Major Misconduct in Mexico, Wall Street Journal, Oct. 19, 2015.

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3.  THE ROLE OF CRIMINAL LAW Before considering the law’s alternatives when it comes to criminal sanctions, one should ask whether criminal sanctions are even necessary. Perhaps private arrangements, encouraged by legal regulation, could better control the relationship between corporate management and corporate crime. American law also has large and vibrant institutions of civil sanctioning, both private and public, and those institutions are as theoretically open to normative analysis and reform as institutions of criminal sanctioning. 3.1  Private Sanctioning Many non-legal incentives influence the corporate agent in decisions about whether to engage in behaviors that violate the law. Chief among these are the hiring, compensation, and promotion programs of a particular firm, which can vary widely and are subject to relatively little legal control (Arlen and Kraakman 1997; Efendi et al. 2007). (At least not substantively; disclosure regimes are extensive.) Another group of important influences are temporal. When an actor knows herself to be in a last period of employment, or that her firm may be in a final period of solvency, her incentives can change dramatically (Arlen and Carney 1992). Reputational incentives can also be important, and may push in the other direction, if a corporate actor expects to have a prolonged career in her profession or industry. Perhaps these non-legal forces can be manipulated through legal policy, as many observers have discussed with respect to the banking industry in the wake of the 2008 crisis. Just as one can debate how to structure the financial and career incentives of managers to counteract the potentially damaging agency costs of “short termism,” one could discuss how to arrange those incentives to reward efforts to prevent corporate crime. Available tools, which could be encouraged as a matter of good corporate governance or mandated by legal regimes, include restricted stock (or bonuses) that would vest (or be paid) only after a specified tenure of “clean” (crime-free) management; provisions for clawing back compensation in the event of corporate crime; and even abandonment of equity compensation altogether. Indeed, some legal regimes are moving in this direction.8 The details of such programs are devilish, as they are in general on the question of the optimal structure of compensation for executives of large public firms, a question that has hardly produced consensus in an extensive recent literature (Bhagat et al. 2014). Unanticipated and perverse consequences are always a problem in such design projects. Indeed, consider all that has happened with option compensation itself. Among other problems, this type of program would import into the arena of compensation design many of the same difficulties that confront the design and enforcement of regimes of corporate criminal liability themselves. The challenge is more than getting to a compensation system that eliminates or dampens the agency cost problem in corporate

 8  See Hamid Mehran and Joseph Tracy, Deferred Cash Compensation: Enhancing Stability in the Financial Services Industry, Fed. Res. Bank of N.Y. Econ. Policy Rev., Aug. 2016; Bank of England, News Release, Prudential Regulation Authority and Financial Conduct Authority Announce New Rules on Remuneration, June 23, 2015.

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Criminally bad management  67 crime; it is also defining what instances of corporate crime are in fact the product of agency costs and thus the ones that ought to implicate management’s compensation. That is, shifting the point of intervention from liability to compensation does not avoid the challenge of determining when the instrument should apply. Moreover, compensation penalties could perversely enhance managerial incentives not to report or to cover up corporate crime (Arlen 1994). There is also a problem of theory. This problem is implicated in the general problem of corporate criminal liability but it arises more directly and problematically in the design of management compensation. The problem of crime by corporations is not just a problem of agency costs between owners and managers (and employees) of large firms. It is also, maybe even principally, a problem of externalities (Schwarcz 2015). The non-investing public has at least as big a stake in the regulation of corporate crime as the investing public, especially when it comes to the big cases—the ones involving reverberating harms caused by banks, oil companies, automobile manufacturers, and other large industrial firms. But, the lessons of 2008 and other systemic crises notwithstanding, the noninvesting public does not have as big a stake in the design of executive compensation as do firms’ investors. Put differently, managerial short termism with respect to the financial performance of the firm is not the same problem as managerial short termism with respect to the social costs of corporate crime. A deeper literature, both positive and normative, on the relationship between management compensation and corporate crime would certainly be welcome. There is much work to do before it will be known whether compensation is a more promising instrument for deterring corporate crime, and specifically for addressing the relationship between firm managers and crimes committed by the firm’s employees, than the status quo arrangements of American law. 3.2  Civil Sanctioning Two observations would seem to make civil sanctioning an attractive response to the type of corporate malfeasance that concerns this chapter. First, American law places well-known heightened constraints on criminal sanctioning, in both its rules of substantive criminal liability and its regime of criminal procedure. Enforcers thus can levy civil sanctions on corporate managers more easily than criminal ones. Second, corporations cannot be imprisoned. Civil sanctioning regimes thus could sanction corporations just as well as criminal prosecution (Khanna 1996). Oddly, though perhaps not illogically, these two observations add up to the claim that when it comes to corporate crime the difficulties of criminal sanctions should be avoided altogether because such sanctions are both exceptional and not really that special at all. In the theoretical argument over corporate criminal liability, comparative arguments about civil and criminal sanctioning for corporations have been at the heart of the contest (Fischel and Sykes 1996; Khanna 1996). To repeat, this chapter does not seek to settle that enduring debate. Indeed, it is not likely an argument that can be won with the tools of theory. Its final resolution depends on empirical questions that could not be answered except through grandiose counterfactual experimentation. On paper, one can design all manner of civil sanctioning regimes, applicable to both individual corporate managers and firms, that might achieve the optimal deterrence of

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68  Research handbook on corporate crime and financial misdealing corporate crime. One can even imagine a world in which Congress enacted a theoretically optimal set of regimes, perhaps abetted by new administrative enforcement structures. One cannot know without trying, however, whether such a regime would perform better than the current mix of civil and criminal liability, or any other mix that does include some form of corporate criminal liability. Much of this uncertainty is because the effects of criminal sanctions include components that are difficult to specify in theoretical models or measure in empirical analysis. Most would agree as a matter of positive fact that criminal sanctioning includes a stigmatic (or expressive or normative or reputational) effect that civil sanctioning cannot fully replicate. That effect has a lot to do with social meaning (Buell 2006; Kahan 1997). Therefore, it is highly contingent on particular social and legal arrangements. Theory can suggest a lot, including even arrangements in which criminal sanctioning no longer has such special effects and civil sanctioning has more communicative potency. At that point, “criminal” and “civil” would no longer mean what they now do and the discussion is left on dry ground that does not seem a useful place from which to think about problems like BP, GM, JP Morgan, and Walmart. The argument over civil versus criminal sanctioning can be somewhat advanced with what is known about present legal institutions. As for individual corporate managers, at least two forces that appear difficult to dislodge constrain the influence of civil sanctions. First is the basic structure of American corporate law, which not only allows but welcomes indemnification, advancement, and compensation of managers for sanctions, attorneys’ fees, and other expected costs of liability for conduct on the job (Baker and Griffith 2010; Buell 2007). Not only does law bless these arrangements, the market for corporate talent makes them the norm.9 On top of this, corporate law has ensconced the business judgment rule, a special substantive doctrine of deference that, where it applies, places a legal buffer around the decisions of corporate managers.10 It is believed that the economy is better off when the most talented managers can be persuaded to take legally risky jobs, and to take risks while doing those jobs, without excessive fear of personal ruin. Legal analysis in this area can be criticized for sometimes speaking out of both sides of the mouth: “Hit those managers hard in their own pockets, that will deter all this corporate malfeasance. But don’t scare away the talent lest we squelch innovation and job creation.”11 A second force limiting civil sanctioning of individual managers is asset insufficiency. In the language of economic analysis, the corporate manager will often turn out to be insolvent in relation to the optimal sanction. According to the Beckerian model, the less likely is detection of crime—by consensus a special problem in the corporate context—the higher the sanction must be set in the cases that are prosecuted (Becker 1968).

 9   There are limits to indemnification for monetary sanctions imposed for criminal or bad faith conduct, and imprisonment of course cannot be indemnified against. But advancement of expenses in defending against such charges is allowable and routine, and claw-back of advanced expenses following liability has been sporadic at best. 10  See In re Walt Disney Co. Derivative Litig., 906 A.2d 27 (Del. 2006). 11   This sort of ambivalence about the capitalist project pervades the project of managing corporate wrongdoing and is the organizing theme of this author’s book-length treatment of corporate crime (Buell 2016).

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Criminally bad management  69 The problem is worse than that: ex post the corporate crisis, managers might have pockets too shallow for a big enough fine. (Think of Enron’s Ken Lay or Worldcom’s Bernard Ebbers, who levered everything they had on their equity holdings in their own companies.) It is that the wealth that managers have accumulated might largely have come from the troubled corporate venture itself, whether or not that wealth represents proceeds of actual crimes. They may have substantial funds in their own pockets, but those funds can consist of recent compensation rather than a wealth stake accumulated while working for years by the sweat of the brow. Civil sanctions would have to make it so the game of potentially lucrative misconduct is not worth the candle for senior managers. But if the firm doles out the candles to the players just for sitting down at the table, there is little reason not to play—even if the player perceives a high risk that both the game and the candle will be lost. While shareholders, at least in theory, do not want managers to engage in legal misconduct, shareholders do want managers to engage in some level of risk-taking. American markets and law not only allow but encourage open, welcoming tables and robust incentives for corporate players to play the game, including the riskiest versions of the game in which aggressive players can go all in, that is, bet the firm. Moving from the individual to the firm, the two most important observations about current sanctioning institutions have to do with criminal liability, not civil. First, criminal liability imposes, and therefore threatens, a reputational consequence on firms that civil liability cannot replicate under current conditions. Reputational sanctions are hard to measure fully and their sources are multiple and complex (Arlen and Alexander 2017; Karpoff et al. 2008; Karpoff and Lott 1993). It is not fully clear how the criminal legal process interacts with other factors such as publicity and the nature of a firm’s industry to produce the reputational sanction. But that sanction is real, it can be an existential threat to at least some types of firms, and whatever reputational effects civil lawsuits or enforcement actions might have are not as strong. Second, present institutional arrangements mean that criminal sanctioning communicates more strongly and differently than civil sanctioning, and can have greater material consequences to firms—which, of course, feeds back to the reputational effects of corporate criminal liability. Procedurally, criminal cases must meet a much higher burden of proof and must achieve jury unanimity. Substantively, criminal statutes usually (though not always) require that the government’s proof meet a higher fault standard (mens rea or scienter) than civil statutes. Of course, the Justice Department and corporations rarely go to trial in these cases. And at least some in the corporate sector would argue that prosecutors do not always adhere to the Department’s policy of declining to charge or threaten a criminal case unless it is strong enough to produce a guilty verdict.12 If this is true, prosecutors may risk losing some of corporate criminal sanctioning’s special communicative force. For now, that does not appear to have happened. Two other institutional features of the criminal process set corporate criminal liability apart from civil (Khanna 1996). The ability to charge corporations for criminal violations creates the power to investigate those violations, which brings in an array of investigative   U.S. Dep’t of Justice, U.S. Attorneys’ Manual § 9-27.220.

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70  Research handbook on corporate crime and financial misdealing tools, most importantly the grand jury, that are not available to civil enforcement agencies. Under present federal law, criminal convictions of corporations raise the specter of debarment and delicensing rules that are spread (in disorganized fashion, alas) through the federal regulatory regimes that govern many industries. For many firms, this increases the existential threat of corporate criminal liability and supplies prosecutors with additional sanctioning leverage not present in civil enforcement. To continue further down this line would risk rehearsing the full theory debate over corporate criminal liability, the bracketing of which has been sincerely promised. Enough has been said to justify what follows: a closer look at precisely how, given the limitations of present legal institutions, criminal law might best address the problem of criminally bad management.

4.  THE ROLE OF INDIVIDUAL CRIMINAL LIABILITY When it comes to the most costly, systemic lapses in large firms, an effective program for deterring corporate crime should cause senior personnel to fear personal consequences for failures of management responsibility. This is a hard task for criminal law. The corpus of Anglo-American criminal law includes crimes and expansive theories of liability—such as conspiracy and accomplice liability, and their more elaborate modern follow-ons such as RICO (racketeering)—that deal with problems of group wrongdoing. But these doctrines reject, at their philosophical cores, the idea of punishing individuals for failing to prevent the wrongs of others. As scholars of corporate criminal liability have observed, ancient rules for punishing individuals purely vicariously, such as medieval law’s “frankpledge,” have been discarded in the common law’s dustbin (Alschuler 2009). 4.1  The Role of Management in Corporate Crime The most common observations about the limitations of criminal prosecutions with respect to senior corporate managers are that cases are hard to win and there have not been enough of them to make a difference (Partnoy 2011). Criminal enforcement’s deficits are said to include, among others, thorny problems of detection and evidence discovery in the policing of white-collar crimes, high hurdles for proof in criminal proceedings, and reliable features of individual psychology in the business context that work against law’s deterrent message (Buell 2014). But consider again the relationships between the senior managers of BP, GM, JP Morgan, and Walmart and the wrongs described earlier in this chapter: the deaths and oil slicks, the car crashes, the accounting fraud, and the bribery. Individual criminal sanctions suffer from a more fundamental limitation in deterring corporate crime. Oftentimes, such sanctions are not directed to the source from which individual wrongdoing springs. Even successfully punishing individual violators does not deter the management behaviors that must be discouraged in order to prevent corporate crime over the long haul. And punishing managers faces higher barriers than the practical difficulties of criminal enforcement. It runs into the basic architecture of criminal law.

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Criminally bad management  71 4.2  The Problem of Mens Rea Take a few of the categories of criminal violation most commonly charged in investigations of major corporate crime: fraud, bribery, lying in communications to the government (and thus often to the public), and polluting public lands, waters, and airways. The federal criminal code infamously deals with these forms of wrongdoing through dozens, if not hundreds, of statutes and regulations, many of them nauseatingly complex (Beale 1994). But most statutes that can lead to serious prison time share common forms of threshold that have to do with individual mental state, and sometimes also with the scale of the harm. Imposing criminal liability for fraud requires proof that the defendant had the specific intent to defraud, meaning that she set about her conduct knowing and desiring that it would deceive another person in a way that could lead that person to part with property or another important interest (Buell 2011). In cases of fraud by affirmative misrepresentation, this requirement generally includes that the defendant knew she was uttering falsehood. (Some federal cases have suggested recklessness as to falsity might be sufficient for criminal liability, though this is controversial.) In cases of fraud by omission or ­nondisclosure, this requirement generally means that the defendant thought about her obligation to make disclosure and decided to disregard that duty in order to deceive the victim. Criminal liability for bribery, including under the Foreign Corrupt Practices Act, depends not just on proof of a quid pro quo (a contract-like understanding) between the briber and bribed official (or at least an attempt by the briber to create one), but also on the defendant having acted with a “corrupt” state of mind, meaning the purpose of inducing the official to violate legal obligations.13 Laws that police honesty in dealings with the government usually authorize criminal sanctions only upon proof that an individual knew of the falsity of, for example, a regulatory filing.14 A good example are the so-called Sarbanes-Oxley certification requirements, statutes sometimes said to be a strong tool against corporate managers because they require senior officials to personally certify the accuracy of financial statements on pain of criminal punishment.15 Criminal violations of these statutes require proof that the signer knew that the financial statements were false; reliance on accountants, lawyers, and other delegates of responsibility is as much a defense under these laws as it has always been in cases of financial reporting fraud. Tax prosecutions include a general mistake-of-law defense, under Supreme Court rulings that the requirement that the defendant act “willfully” in the criminal tax statutes means he must have acted with knowledge of illegality.16 Securities regulations include a provision that provides a kind of mistake-of-law defense for violating the SEC’s filing requirements if the defendant can prove he lacked knowledge of the relevant rule.17 Money laundering liability requires proof that the defendant knew the funds he helped     15   16   17   13 14

18 U.S.C. §§ 201, 666; United States v. Bonito, 57 F.3d 167 (2d Cir. 1995). 18 U.S.C. § 1001; United States v. Hsia, 176 F.3d 517 (D.C. Cir. 1999). 18 U.S.C. § 1350. Cheek v. United States, 498 U.S. 192 (1991). 15 U.S.C. § 78ff(a).

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72  Research handbook on corporate crime and financial misdealing bank or otherwise transact derived from criminal activity.18 Felony liability for violating the Clean Water Act requires proof of actual knowledge that a discharge is unauthorized or exceeds a permit.19 Felony liability for misbranding pharmaceuticals (that is, illegally marketing them for off-label use) requires proof of intent to defraud.20 All of these mens rea requirements are subject, of course, to the general constitutional mandate of proof beyond a reasonable doubt.21 For crimes based on knowledge rather than forms of specific intent (to defraud, to obstruct justice, and the like), the doctrine of willful blindness might appear to ease the path to conviction. But the federal courts have been at pains to prevent this doctrine from  being treated as anything less than a genuine, and justifiable, substitute for knowledge.22 Willful blindness is not recklessness. A defendant’s awareness of some risk of falsity or some risk that banked funds are derived from crime, for example, will not suffice. A defendant must both know of a substantial risk that the operative fact exists and take affirmative steps to avoid acquiring additional knowledge. Red flags thus are not sufficient to establish willful blindness. Chronic inattention, as opposed to affirmative suppression of information, also will not suffice. Courts seek a basis for concluding that the defendant all but knew, such as a directive to others not to inform the defendant or an otherwise inexplicable failure to act in response to information.23 The mens rea demands of substantive criminal law mean two things for the large cases of corporate crime that concern this chapter. First, provable, and thus punishable, criminal violators will tend to occupy lower rungs on the corporate ladder. There will be the occasional case like Enron or Worldcom in which a conspiracy to commit accounting fraud, for example, extends fully into the inner management suite. But in most cases individuals close enough to the execution of the product or transaction to know enough for criminal liability will not be the senior managers (and certainly not the board members) who bear responsibility for designing and implementing systems for the prevention of crime. Second, senior managers will know—whether they admit to liking it or not—that they enjoy insulation from punishment for the vast majority of criminal violations that might occur within their firms, even as they may benefit from the enhanced corporate income or reduced costs such crimes produce. Indeed, the effect of criminal law is at least partially perverse: the demands of proof of mens rea for individual criminal liability provide an incentive for managers to shield themselves from what is going on, possibly reducing corporate efforts to prevent crime. A compulsion to golf is bad corporate management but   18 U.S.C. §§ 1956, 1957.   33 U.S.C. § 1319(c)(2). 20   21 U.S.C. § 333(a)(2). 21   In re Winship, 397 U.S. 358 (1970). 22   Global-Tech Appliances, Inc. v. SEB S.A., 563 U.S. 754 (2011); United States v. Salinas, 763 F.3d 869 (7th Cir 2014). 23   Although it didn’t matter because the proof of actual knowledge was overwhelming, the Second Circuit may have pushed the envelope a bit in approving the use of a willful blindness argument in the prosecution of Worldcom’s Bernard Ebbers, on the ground, the court said, that there was evidence that Ebbers threw reports in the trash without reading them. United States v. Ebbers, 458 F.3d 110 (2d Cir. 2006). 18 19

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Criminally bad management  73 good criminal defense. (The point about a perverse incentive not to monitor, of course, has also been made with respect to corporate criminal liability (Arlen 1994).) American criminal law is far from naïve about the problem of individuals who shield themselves from liability for the crimes of underlings. Long experience with organized crime, international narcotics trafficking, terrorism, and other problems has produced flexible and powerful statutes and doctrine such as conspiracy law, RICO, and broad anti-terrorism laws. But BP’s Tony Hayward is not Tony Soprano. The non-fictional likes of Soprano have been convicted under conspiracy laws and their analogues without proof of direct involvement in substantive offenses because their businesses are thoroughly, completely criminal. Proof of “association,” “involvement,” and the like is itself proof, at least in part, of criminality. This proof dynamic is unavailable in cases of corporate crime. Senior managers of even the most broken corporations spend most of their time on legitimate activities that have been licensed, indeed warmly welcomed, by state and federal governments. No defendant would attempt, at a criminal trial, to disprove the existence of British Petroleum as one might dispute the existence of La Cosa Nostra. Calls to “use RICO against the big banks” and like firms are tiresome given that RICO, while a powerful device for dealing with problems like joinder and statute of limitations, in no way displaces the requirement that underlying criminal violations be proved.24 Labeling Lehman Brothers a “RICO enterprise” would not have been a way of bootstrapping individual criminal violations by mid- and lower-level employees into crimes by management personnel. 4.3  The Problem of Actus Reus Generally speaking, American law rejects criminal liability for omissions. Failure to rescue, failure to aid, and (most aptly here) failure to prevent another from committing a crime (or even failing to help the police catch a violator) do not give rise to criminal liability. Whatever morality mandates, our legal obligations to each other do not generally require us to do these things (LaFave 2010). The matter of duties to render aid is, of course, subject to lively normative debate. But positive law sides with familiar arguments against such criminal liability, ranging from American commitments to individual liberty and choice, to worries about incentives that might cause people to do more harm than good, to deep problems of line-drawing in specifying conditions under which law might obligate affirmative action (Dressler 2012). Exceptions to this principle are constructed around duty, which is certainly a familiar concept in the legal regulation of corporate managers. But “duty” is of course an empty concept standing alone: One has a legal duty to do what law imposes a duty to do. In criminal law, the duties that courts and legislators have found to give rise to an obligation to act, at pain of criminal liability for omissions, are those that inhere in special relationships such as parent–child, spouse–spouse, doctor–patient, or teacher–student. The duty question most often arises with so-called result crimes, in which the issue is the duty of the omitting person (such as the parent) to have acted to prevent a harmful result (such as death) that befell the victim (such as the child). A sadly repeating fact pattern is   18 U.S.C. §§ 1961 to 1963.

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74  Research handbook on corporate crime and financial misdealing the obtuse or abusive parent prosecuted for failing to obtain medical help for a child who was gravely ill or injured and ultimately died.25 Drafters of criminal laws have the option of sweeping within those duty relationships that give rise to a general theory of omission liability the relationship between a corporation’s managers and its owners. (I assume the relevant duty would not run between managers and the public at large, for that would be a capacious duty without analogue in existing law.) The argument perhaps would hold that a corporate manager can be criminally liable for omitting to prevent the crime of a corporate employee because she has a duty to prevent harm to the corporation, and crime (or this crime) harms the corporation. This sort of move would strain the basic structure of American criminal law, not to mention corporate law. It is difficult to think of any analogue to this form of duty in the relationships that criminal law has recognized as giving rise to omission liability. These relationships generally are close, one-to-one, and such that the bearer of the duty is positioned highly proximate to the harm. Given the role occupied by the duty bearer and her capacity to respond and intervene (the parent being the paradigm case), the instrumental and deontological cases for punishing the failure to act are persuasive. Criminal law’s restrictions on the categories and scopes of these duties ensure that the omission cases that are prosecuted tend to be normatively compelling. For example, criminal law might impose liability on a school nurse who kept a drugoverdosing student “resting” in the infirmary instead of calling for an ambulance if the student then had a seizure and died for lack of speedy hospitalization. However, criminal law would not likely impose liability on the nurse who sat in his office while a deadly virus spread undetected in the cafeteria because he had failed to distribute hand sanitizer throughout the building. Some of the difference between these two cases has to do with the degree and form of the actor’s recklessness or negligence. But a lot has to do with how the duties are conceived—conceptions that implicitly include considerations of the causal relationship between the bearer of the duty and the harmful result. In the sort of corporate cases relevant here, the senior manager is much more like the second nurse than the first. A requirement that the corporate manager act based on a duty extending to all corporate affairs would also dismantle barriers between corporate and criminal law. This is a familiar worry from the long legal contest over the use of an “honest services” theory under the federal mail and wire fraud statutes to prosecute corporate officials for breaches of loyalty to corporate owners. That struggle concluded with the Supreme Court rejecting the idea of criminal fraud based solely on a duty breach, requiring prosecutors to prove that such a miscreant corporate official also received a bribe or a kickback.26 It would be an even greater threat to regimes of corporate regulation to bootstrap a general duty of managers to prevent corporate crime—a Caremark duty, that is—into a form of criminal liability.27 One might complain that the phenomenon of criminally bad management is not really  E.g., State v. Norman, 808 P.2d 1159 (Wash. Ct. App. 1991).  See Skilling v. United States, 561 U.S. 358 (2010); see also ibid. at 415 (Scalia, J., concurring). 27   In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ct. Chancery 1996); see also Assaf Hamdani and Reinier Kraakman, Rewarding Outside Directors, 105 Mich. L. Rev. 1677 (2007). 25 26

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Criminally bad management  75 a matter of omissions to act at all. If one adjusts the time frame in these cases, one can make the manager’s failure to intervene and prevent crime a form of affirmative participation (Kelman 1981). When managers of GM pushed aggressive cost cutting through the company, their acts provided incentives for employees deeper within the firm to take steps that caused the ignition switch failures. When the managers of BP implemented a strategy of going for riskier offshore deposits, they caused the Deep Horizon well to blow up. When JP Morgan’s managers set their compensation and monitoring programs for their derivatives traders, they caused the traders to deliberately mismark the books. When Walmart’s global managers pushed fast into Mexico, they caused managers there to use bribery to get stores built. Moving the time frame in this way, though, only runs the problem into the other pillar of criminal law, that is, mens rea. Put another way, concurrence of the elements is a requirement in analysis of criminal liability. The further back one moves in time to locate the actus reus, the weaker the argument is for the relationship between any mens rea at that point in time and later events for which one might argue responsibility should be imposed. And moving the time frame requires playing another game of stretching in criminal law, one much like stretching time frames: the game of levels of abstraction. This is a recurring problem in cases of negligence or recklessness. The relevant criminal event now has to be some well accident, some auto engineering failure, some financial misreporting, or some bribery—not the actual violations in the case. The existing contours of criminal law either cannot accommodate individual liability for criminally bad management, or they can do so only with strained and questionable arguments. One turns, then, to the question of how individual criminal liability might be reshaped to address criminally bad management. 4.4  Strict Liability and Paths for Reform Law could reject, or at least migrate away from, the basic architecture just described. It could impose punishment for forms of management misconduct, or undesirable behavior, not previously subject to serious criminal liability. These days, any such expansionist move raises hackles because of the American criminal justice system’s bad reputation for over-criminalization in substantive law and over-incarceration in the enforcement of law. But the option nonetheless should be examined. One direction for reform would be to dispense with mens rea requirements and impose liability solely on a manager’s relationship of supervision or responsibility toward the part of a corporation’s operations in which wrongdoing occurs. There are, of course, already lots of strict liability offenses in federal white-collar criminal law. Industry groups and over-criminalization critics have long lamented this (Walsh and Joslyn 2010). Some federal statutes do impose liability for particular non-actions (omissions). It can be a crime, for example, to fail to file one’s taxes28 or to fail to maintain adequate systems of accounting controls.29 With these offenses, there is no need to wade into murky questions of general duties. If there is something the law really wants corporate managers to

  26 U.S.C. § 7203.   15 U.S.C. §§ 78m, 78ff.

28 29

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76  Research handbook on corporate crime and financial misdealing do, a statute can simply say what that is and that criminal penalties may be imposed for failing to do it. This is what the “responsible corporate officer” doctrine does. It is a form of liability imposed by a limited number of federal statutes (Henning 2014; Sepinwall 2014). These rules are often described as something like “strict liability for CEOs.” But they are more than that. They are strict liability for omissions to act. And it is the omission part (the lack of affirmative actus reus), not the strict liability part (the lack of mens rea) that really make the responsible corporate officer doctrine American criminal law’s closest thing to a crime of criminally bad management. John Park of the famous United States v. Park30 was President of Philadelphia-based Acme Markets, Inc., a company the Food and Drug Administration (FDA) caught with rat droppings in its Baltimore warehouse. Park was held criminally liable because he failed to do enough about sanitation in his company’s facilities when that matter was within his responsibilities as head of the company. Indeed, while his liability was technically strict under the statute, Park himself had some mens rea: the FDA had warned the company in writing about the problem in its warehouses and Park saw the FDA’s letter. The responsible corporate officer doctrine probably gets more attention in law schools and legal commentary than it deserves. There is no such general “doctrine” in federal law. It can arise only by statute. Instances of which I am aware of Congress imposing this form of liability are in relation to the Food, Drug, and Cosmetic Act (FDCA), for responsible managers failing to prevent the misbranding or adulteration of statutorily covered products,31 and the Clean Water and Clean Air Acts, for responsible managers failing to prevent covered discharges without, or in violation of, permits.32 Both of these statutes impose misdemeanor liability only. The closest thing to these offenses in securities law is the “books and records” provision of the Securities Exchange Act of 1934, which can be violated by the mere failure to maintain adequate systems of accounting controls.33 The securities prohibition, however broad, does not impose strict criminal liability: a criminal case requires proof that the defendant “willfully” violated the record-keeping requirements.34 Regulatory crimes such as these, which the Supreme Court has sometimes referred to as “public welfare offenses,”35 are not often implicated in the big corporate scandals involving fraud, bribery, safety, and pollution. If this style of criminal offense were expanded into the realm of serious felony punishment, two constitutional challenges would be likely. First, a statute would have to describe the “it” that the corporate manager could be punished for omitting to do, with sufficient specificity to defeat constitutional notice objections. “Manage well at pain of imprisonment” might not be a constitutionally acceptable rule. Second, if the Supreme Court had occasion to review the question of what scope of strict liability Congress intended to impose on corporate managers for failure to act, it might not hold to the expansiveness of the Park decision.   421 U.S. 658 (1975).   21 U.S.C. § 331 (as interpreted in United States v. Dotterweich, 320 U.S. 277 (1943)). 32   33 U.S.C. § 1319(c)(6). 33   15 U.S.C. § 78m. 34   15 U.S.C. § 78ff. 35  E.g., United States v. Balint, 258 U.S. 250 (1922). 30 31

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Criminally bad management  77 Admitedly, the only case in which the Court has rejected criminal omission liability on due process grounds is the famous and dated case of Lambert v. California,36 in which Los Angeles attempted to criminalize the act of being in the city by convicted felons who had failed to register with city hall. The problem in Lambert was the combination of omission liability with unfair surprise about the content of law. If Congress wanted to make it a crime for the CEO or CFO of a public corporation to fail to prevent securities fraud by the company’s employees, maybe it could do so. But probably only within reason, and maybe not beyond misdemeanor liability. In any event, the ultimate issue is normative. Should American law impose criminal omission liability on corporate managers for failure to prevent fraud, bribery, environmental offenses, and the like? Over-deterrence would be the obvious and fairly massive worry. If we really wanted to deter managers from allowing or failing to prevent corporate crime, we could take the China approach: the death penalty for tainted milk. (Assuming that the defendants in that example did not taint the milk themselves, directly or indir­ ectly.) Deterrence arguments, carried to the extreme, can be used to justify punishing even wholly innocent persons. Responsible corporate officer liability under the FDCA and CWA does not seem to have shut down pharma or the sewage treatment industry, nor has it destroyed the market for executives in those sectors. Would imposing such liability for fraud in the banking industry, for example, decimate entrepreneurship in finance and scare competent managers away from such jobs? It is clear what the Chamber of Commerce would say. But it is hard to know. The more compelling objection to this kind of legislative program is a prior one. It likely would lead to punishment of those who do not deserve it. As is the habit in the American criminal justice system, especially the federal one, prosecutors could be relied on to charge only managers whose nonfeasance was truly appalling.37 But that is not guaranteed to be the outcome. A corporate manager, one might fairly contend, simply does not deserve imprisonment sanctions for failing to prevent a fraud of which she was not aware. (If she was aware, then she is likely liable for conspiring or aiding and abetting.) This is not a controversial assertion. It will not become one until the American social and economic order experiences changes that have nothing to do with criminal law—that is, a fundamental re-conception of the role of the for-profit corporation in society and the moral obligations that those who control it have to the rest of us.38 To be sure, the sort of criminally bad management under discussion here can fall   355 U.S. 225 (1957).   For example, in a notable recent prosecution the government deployed the responsible corporate officer doctrine to obtain three-month prison sentences for managers of an egg business that shipped products with salmonella, making purchasers sick. The government’s proof included abundant, though legally unnecessary, evidence of the defendants’ negligence. United States v. DeCoster, 828 F.3d 626 (8th Cir. 2016). Indeed, one appellate judge concurred in affirming the prison sentences, he said, only because of the presence of the negligence evidence. 38   Morally, corporate responsibility does not approximate military command responsibility. In the context of warfare, law and norms justify holding the supervisor responsible for the crimes of subordinates because the supervisor must train, and order, subordinates to surrender their moral agency, including the agency not to kill other humans. Even in that context, the imposition of 36 37

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78  Research handbook on corporate crime and financial misdealing between full-blown, conventional group criminal liability and strict liability for failure to prevent crime. A responsible manager might have known enough to be seriously at fault in what happened but not enough to have been an accomplice or conspirator in the specific criminal violation. So what might be accomplished through new crimes of recklessness or negligence? Consider, for example, what England has recently done. Parliament has enacted a criminal offense, punishable by up to seven years in prison, of what might be called (though English law does not call it this) reckless bankruptcy of a bank.39 The elements of this crime are the following: (1) that the defendant was a senior manager of a financial institution (these are defined terms); (2) that the defendant participated in a decision or failed to take steps to prevent a decision; (3) which decision caused the failure of the financial institution; (4) the defendant was aware at the time of the decision that implementing the decision risked the failure of the institution; and (5) the defendant’s “conduct in relation to the taking of the decision [fell] far below what could reasonably be expected of a person in [the defendant’s] position.” This criminal statute has no close analogue in American white-collar criminal law, though some have argued in the wake of the banking crisis that prosecutors in the United States should have pursued criminal prosecutions of bank managers for recklessness, or at least that Congress should have legislated to authorize such prosecutions (Eisinger 2014; Partnoy 2011; Taibbi 2014). There are ironies here. American criminal law has clung to some harsh ideas like felony murder and capital punishment that English criminal law has jettisoned. And some may recall that after the wave of criminal and civil corporate enforcement in the United States following the collapse of Enron in the early 2000s, a common cry of alarm in New York and Washington was that capital was fleeing offshore to the safer regulatory haven of London. Perhaps London now looks legally scarier for corporate managers. Recklessness is, of course, a less controversial basis for criminal liability in the United States than negligence. Recklessly caused deaths are routinely treated as serious criminal homicides (“involuntary manslaughter”) and recklessness can be found in statutes defining other serious offenses, such as forms of assault and arson.40 In the corporate context, keep two points about recklessness in mind. First, recklessness in criminal law is not gross or especially serious negligence. Being really careless is not being reckless. Recklessness is a knowledge state, specifically awareness of risk.41 The reckless individual must consciously advert to the question of risk and decide to press forward. That is the form of thinking that makes recklessness sufficiently blameworthy to warrant criminal punishment, at least when bad things happen after people choose to run risks. Second, risk in the criminal law is not a vague concept floating in the air. Recklessness offenses require that the actor has consciously disregarded a sufficiently large and serious risk of a particular sort. In other words, the mental state of recklessness is one element of the offense but the result or factual circumstance as to which the actor must be reckless is criminal liability on commanders without requiring some degree of subjective mens rea is controversial (Martinez 2007). 39   United Kingdom Financial Services Act 2013 § 36. 40  E.g., N.Y. Penal Law §§ 120.01, 150.05. 41   American Law Institute, Model Penal Code § 2.02(2)(c).

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Criminally bad management  79 another and equally important element.42 The manslaughter defendant disregards the risk that his conduct (drunk driving, for example) will cause the death of another person. The reckless sexual assaulter disregards the risk that the person with whom he has intercourse has not consented. There can be no such thing, therefore, as a crime of “reckless corporate management.” Such an offense would leave the question of reckless as to what? England’s new banking statute does not go this far, but maybe it comes close. While the statute specifies that the defendant must have been aware of a risk that her decision, or the decision she failed to prevent, presented a risk of the financial institution failing, “failure” of a firm encompasses a large array of scenarios. The statute further defines failure as insolvency but does not say anything about what causes qualify and, of course, does not even attempt to specify what level of probability constitutes risking the firm for purposes of this law. The English statute therefore comes down to the part of the offense that involves negligence (or perhaps gross negligence), not recklessness: the requirement that the defendant’s “conduct in relation to the taking of the decision [fell] far below what could reasonably be expected of a person in [the defendant’s] position.” But then the law is in the perilous and perhaps undesirable realm of drawing lines, if they even can be drawn, between the lack of due care in management that warrants imprisonment and the carelessness that should draw at most a lawsuit for breach of fiduciary duty. And, of course, there is the serious, though not consensus, argument that a person’s negligence never provides sufficient justification for criminal sanctions (Alexander and Ferzan 2009). There is an even more essential point about criminal liability for recklessness in this context. Managers of corporations are supposed to press forward in the face of risk of failure. Indeed, the mere act of taking the management reins of a business necessarily requires one to consider and accept the risk of insolvency. Consider this rhetorical question, which might seem trenchant (especially for the GM case): “American law imposes felony liability on reckless automobile drivers who kill, so why would it be any real departure to impose felony liability on senior managers who manage (drive) corporations in a way that kills people?” The analogy fails because assessment of risk is completely different in the two cases. Except perhaps in a case of serious exigency, there is no social value in risky driving. There is social value in risky corporate managing, where the question is whether and how risks are weighed, not whether they should be taken in the first place. Or think about it this way. As Ken Simons has explained, risk analysis in the criminal law of recklessness and negligence includes a mostly hidden dimension of specificity versus generality or, if you like, known identity of the victim or harm (Simons 2012). To take a hypothetical, Sally, the manager of a massive tunnel construction project, orders that an expensive section be lowered into place immediately, before it breaks at great cost, even though Joe the worker appears trapped beneath it and likely will be crushed. Sally might be guilty not only of reckless homicide but of murder. However, if manager Betty authorizes starting the same tunnel construction project in the first place, knowing that there is a high probability that at least one worker will be killed during the project, she

 Ibid.

42

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80  Research handbook on corporate crime and financial misdealing is not likely guilty of any crime at all. The risk-taking manager of a large bank is usually Betty and rarely Sally. Reform is not out of the question. But it would be a heavy lift. The point here has been to run to ground the severe limitations of American criminal law, as both a positive and normative matter, as a tool for imposing individual liability on corporate managers for running firms in ways that enable and fail to discourage criminal violations by employees. Take the individual prosecution of Donald Blankenship, the CEO and Chairman of Massey Energy, a now notoriously transgressing coal company.43 The government alleged that Blankenship “closely managed” (indeed, obsessively micromanaged) the company, that he knew of hundreds of safety violations, that he “had the ability to prevent most of the violations,” and that, in a ruthless quest to extract coal profits, he “fostered and participated in an understanding that perpetuated [a] practice of routine safety violations” at a West Virginia mine which eventually experienced a fatal explosion that killed nearly 30 miners. If the government had proved even half of the facts alleged, it would have established a level of personal culpability of Blankenship for disastrous corporate management that far outstrips a case like BP, GM, JP Morgan’s London Whale, or Walmart. Nevertheless, the government secured a conviction of Blankenship only for one misdemeanor count charging a mine safety violation. On the other charges, which included securities fraud, the government was unable to prove beyond a reasonable doubt, among other propositions, that Blankenship knew it was a lie for the company to say that it “does not condone” mine safety violations and strives “to be in compliance with all regulations at all times,” or that Blankenship conspired with others at the company to willfully violate mine safety laws and to obstruct the Mine Safety and Health Administration from enforcing federal law. Blankenship was a micromanager but things still became cloudy at his trial. Even the most culpable of corporate managers can be hard to convict for what happens on their watches. The fit between basic concepts of individual criminal responsibility, which have remained stable for a long time, and the structure of the large corporate institution, which has changed a great deal over time, is awkward at best.

5.  THE ROLE OF CORPORATE CRIMINAL LIABILITY There is a gap when the law comes to management responsibility for corporate crime. Increasing public frustration with corporate crime has produced a demand for law to fill that gap. Politically responsive institutions, chiefly prosecutors’ offices, have looked for ways to use existing legal tools to meet that demand. The story of corporate criminal liability’s evolution and growth in the American legal system over the last two or three decades can be understood as driven, in important part, by this dynamic between public demand and enforcement institutions. Corporate criminal liability has been serving as a substitute to individual criminal liability. It functions to deter corporate managers from engaging in practices that enable

43   United States v. Blankenship, Crim. No. 5:14-cr-00244 (S.D. W. Va. Nov. 13, 2014) (indictment).

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Criminally bad management  81 and tolerate employees’ criminal violations. Whether this legal tool is optimal or not is unclear and remains hotly debated. Meanwhile, both corporate managers and federal prosecutors act as if they understand corporate criminal liability as filling the gap. 5.1  Managers and Corporate Criminal Liability If one spends time with the corporate defense bar and corporate management—even if one regularly reads the Wall Street Journal and the business pages—one cannot help but appreciate how the prospect of corporate criminal liability is the first, last, and greatest concern of legal risk for corporate managers and their counsel. In most or all major industries, managing the firm to avoid this form of legal sanction is an overriding practical imperative. When managers think about corporate criminal liability, they do not of course think about the prospect of landing in prison themselves. But they do think about personal consequences. To steer one’s company into the roiling waters of indictment and likely conviction is, in many important economic sectors, to have failed almost per se as an executive—with all the consequences that might bring in reduced compensation, shrunken reputation, weaker career prospects, and lost self-esteem. A massive federal investigation followed by admission of widespread misconduct and an onerous settlement can be harmful to an executive résumé. Many of corporate criminal liability’s costs, to firms and thus indirectly to those in charge, can be measured in lost market capitalization, loss of revenue from clients or customers, and lost income opportunities from temporary or permanent cancellation of licenses and contracts in whole lines of business. Those grave material costs can run as far as liquidation of the firm, the doomsday scenario contemplated in sectors such as professional services, pharmaceutical manufacturing, and (at least until recently) banking. Personal costs in this scenario can extend beyond those to the firm, at least as a temporal matter. The manager who runs the corporate ship aground on a criminal prosecution may have a hard time, at least in the market for public company executives, getting that signal event off of her résumé. And the psychological consequences could be lasting and profound. The committed executive of the large firm has to have the success, much less the survival, of the firm deeply woven into her personal identity. The corporate management profession would not expend such enormous energy—both in individual cases and in general discussion about regulatory policy—lamenting corporate criminal liability, and fighting its imposition, if this form of sanction did not, from the perspective of managers, have a sharp, even deadly, bite. Managers are highly motivated to avoid corporate criminal liability. Thus corporate criminal liability has a deterrent effect on managers, even when managers face no prospect of individual criminal liability. The skeptic might respond with two thoughts. First, those who manage America’s largest corporations might prefer the risk of an occasional, episodic run-in with the Department of Justice when something goes wrong to comprehensive, aggressive programs of preventative regulation imposed throughout industries. Incessant talk about corporate criminal liability is a way of keeping the discussion about regulating corporate malfeasance in that arena and leaving the impression that corporate criminal liability is a costly, and therefore effective, control on industry. Second, managers might talk up the potency of corporate criminal liability to play into prosecutors’ fears that corporate

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82  Research handbook on corporate crime and financial misdealing criminal liability can be too strong, imposing bad collateral consequences that include the destruction of jobs and other economic value. This kind of talk conditions prosecutors to be more amenable to forms of settlement that forgo indictments and trials, and maybe more open to declining prosecution altogether. If one has closely followed the discussions in this field over the last two decades, it seems implausible that corporate managers secretly like corporate criminal liability and enjoy dealing with the Justice Department. Of course industrial interests exaggerate the problems they face. It used to be said that no major bank could sustain a criminal conviction without having to close its doors; now several of them have pled guilty to antitrust and other violations with only short-term harm to their stock prices.44 But the expenses firms incur in managing even potential prosecutions speak to their treatment of corporate criminal liability as a deadly serious matter. Siemens Corporation, for example, spent over $1 billion on professional services (primarily law and forensic accounting) to curry favor with the Justice Department and a court when it ultimately resolved its criminal bribery case.45 Walmart has by now spent well over $500 million in legal fees in a similar effort, with resolution of its case still to come.46 There is a reason why the defense practice in the field of government investigations and white-collar crime has become such a lucrative mainstay for America’s largest corporate law firms: these are treated as “bet the company” cases; management does not dare slash these legal expenses in the manner that has threatened large law firms’ practices in areas such as corporate finance, products liability litigation, intellectual property, and commercial real estate (Weisselberg and Li 2011). 5.2  The Department of Justice and Corporate Criminal Liability If the manager of the large firm does genuinely fear corporate criminal liability, the question is precisely what corporate criminal liability deters managers from doing (or encourages them to do). That question brings in the prosecutors. The Justice Department also understands corporate criminal liability as a tool for influencing individual manager behavior. The now familiar story of the evolution over the last several decades of what Jennifer Arlen calls the de facto regime of corporate criminal liability does not need repetition, especially for the experienced reader in this field (Arlen 2012). The U.S. Attorneys’ Manual, the Holder, Thompson et al. memos, the deferred prosecution agreement, the non-prosecution agreement, the corporate compliance program, the corporate monitor, the U.S. Sentencing Guidelines for corporations,

44  See Plea Agreement, United States v. Credit Suisse AG, No. 1:14-CR-188 (E.D. Va. May 19, 2014); Statement of Facts, United States v. Credit Suisse AG, No. 1:14-CR-188 (E.D. Va. May 19, 2014); Statement of Facts, United States v. BNP Paribas, S.A. (S.D.N.Y. July 9, 2014); Andrew Grossman, John Letzing, and Devlin Barrett, Credit Suisse Pleads Guilty in Criminal Tax Case: Agrees to Pay $2.6 Billion to Settle Probe by U.S. Justice Department, Wall Street Journal, May 19, 2014; Jessica Silver-Greenberg and Ben Protess, BNP Paribas Pinned Hopes on Legal Memo, in Vain, New York Times, June 3, 2014. 45   United States v. Siemens Aktiengesellchaft, Crim. No. 1:08-cr-00367 (D.D.C. Dec. 12, 2008) (Department’s Sentencing Memorandum). 46   Wal-Mart Says Bribe Probe Cost $439 Million in Two Years, Bloomberg, March 26, 2014.

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Criminally bad management  83 and the other institutions of contemporary federal enforcement and corporate criminal defense—these are American corporate criminal liability (Arlen 2012; Garrett 2014). The essence of de facto corporate criminal liability is this: what the Justice Department wants above all to see when it confronts a case of corporate crime—whether as a reason not to prosecute or as a reason to settle on favorable terms—is effective management practices designed to prevent, and certainly not to foster, crime by a firm’s employees. As documented most clearly in Brandon Garrett’s work, prosecutors are more concerned—at least in the mine-run of cases involving FCPA violations, pharma marketing practices, bank money laundering, environmental offenses, and the like—with the organizational dynamics that generate corporate crime than they are with the individuals who execute the criminal acts (Garrett 2014). Federal prosecutors just might be right. At the least, they have a theory for what they are doing and are not wantonly throwing around all that discretion they enjoy. (This is an at least partial answer to Judge Jed Rakoff’s puzzling over the Department’s emphasis on corporate over individual liability (Rakoff 2014).) The low-level sales manager in the foreign office who pays the bribe is fungible. Prosecuting the likes of her, one might argue, is like prosecuting all the bookies in Brooklyn or Newark and expecting that to make a dent in organized crime. Using corporate criminal liability to effect change in management practices, and perhaps even industry practices, has a better prospect of actually reducing corporate crime, and the widespread harms it can impose on the public, over the longer term. Corporate criminal liability, because of the leverage it affords the government over managers both in terrorem and in the negotiation of settlements (and even in the occasional criminal sentencing of a firm), gives prosecutors (and occasionally judges) a tool to effect firm and industry-wide change. Whether or not the Justice Department is succeeding in delivering on the promise of its theory is a real question, one that is hard to answer empirically. But at least there is a theory. One can see this theory in action at both the front and back ends of cases of corporate criminal liability. Indictment and settlement discussions are dominated by arguing over how much an instance of corporate crime can be attributed to bad management. How high up was the wrongdoing? How pervasive? What kind of compliance program did the firm have? Is the company a recidivist? The terms of settlements are then dominated by measures designed to change management practices to make future violations less likely.47 Maybe corporate criminal liability American style has developed—as the voluminous literature has canvassed—by accident, or path dependence, or political economy, or rent seeking by the bar, or another dynamic unconnected to optimal regulatory design. But maybe also Justice Department personnel have figured out, as they have confronted the scale of firms, the economy, and public harms, that the problem of corporate crime is a problem of management. And that individual criminal liability—as lawyers who practice criminal law know better than anyone—is not well suited to addressing the source of the problem. So they have turned to corporate criminal liability as the best available alternative among the legal tools that federal law gives them. Even when the Justice Department wants to focus on individual responsibility for

47   U.S. Dep’t of Justice, U.S. Attorneys’ Manual § 9-28.000; United States Secs. & Exchange Comm’n Exchange Act Release No. 44969 (Oct. 23, 2001) (“Seaboard Report”).

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84  Research handbook on corporate crime and financial misdealing corporate crime, it cannot help but stress corporate criminal liability. In an obvious reaction to public complaints during the Obama Administration that not enough senior corporate officials were in prison, a Deputy Attorney General issued a memorandum to prosecutors in late 2015 that leaned hard, rhetorically at least, on the importance of aggressive prosecution of individuals.48 The memo itself, which described six purportedly new initiatives, only restated the basic theory of the Justice Department’s longstanding program in corporate crime: use corporate criminal liability as the means to force firms (i.e., firms’ management) to police and investigate themselves and produce evidence of criminal wrongdoing. The Justice Department seems to play into the hands of its critics. Declaring a “bold” but not really new effort to prosecute more individual cases confirms the misapprehension that more corporate managers would be in prison if only prosecutors had tried harder. Such a declaration leaves unnoticed the fundamental barrier: criminal law, the foundations of which are controlled, even still in this age of over-criminalization and discretion, more by Americans and their legislators than by prosecutors. 5.3  Optimizing a Second-Best Instrument Understanding corporate criminal liability as a tool for deterring criminally bad management is not only a path to a more complete positive account of corporate criminal liability’s place in American law. The perspective also provides guidance for normative analysis. If an attractive theory of corporate criminal liability is that it can be used to influence senior people to manage firms so as to prevent, and certainly not enable, criminal violations by employees, then its practice should seek to optimize that influence. Future analysis and research should pursue the work of scholars, some of them economists, who have long evaluated the Justice Department’s prosecution work on this score (Arlen and Kraakman 1997). Firms should be rewarded with no prosecution, or lenient settlement, when corporate crimes are committed notwithstanding best efforts. (Prosecutors must beware hindsight bias.) Firms should be punished more harshly when corporate crimes result from bad management. Self-reporting and cooperation in prosecution must continue to earn some reward, lest the Justice Department’s enforcement program virtually shut down. But malfeasance that is genuinely institutional must be met with punitive sanctions no matter how well managers respond when the firm gets caught. The difficulties with such enforcement programs lie, of course, in their details, which require separate treatment from this discussion. Much of the evaluation of the relationship between corporate crime and the corporate institution, including firm management, turns on soft and holistic considerations of institutional culture, which are highly situational and fit poorly with traditional forms of legal doctrine. The much-lamented prosecutorial discretion in this field may be unavoidable. But that discretion can still be rigorously analyzed and critiqued, and perhaps even controlled with law. Meanwhile, there is some promise that the Justice Department has been at least a little

48   U.S. Dep’t of Justice, Memorandum of Deputy Attorney General Sally Quillian Yates to Assistant Attorneys General and United States Attorneys, Sept. 9, 2015.

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Criminally bad management  85 responsive to normative analysis. Towards the end of the last administration, leaders of the Criminal Division committed in principle to greater clarity, transparency, and rigor in the process of evaluating firms’ compliance efforts and the relationship of those efforts to decisions whether to prosecute, not prosecute, require a conviction or guilty plea, extend favorable settlement terms, and the like.49

6. CONCLUSION Corporate crime is an institutional problem. Changing institutions requires changing the behavior of the people who control them. With large corporations, those people are the senior managers. There are many legal and non-legal instruments for influencing senior corporate managers, as the vastness of the field of corporate law attests. Most of the time, however, the only such tool that involves criminal law is corporate criminal liability. This is because individual criminal liability, in its basic structure, does not fit the problem of bad management that produces corporate crime. Law could be reformed to create such fit only with radical changes that lie beyond likely current American consensus. Meanwhile, corporate criminal liability as practiced in the federal system is an available—if not ­optimal, and certainly not yet optimized—tool for dealing with criminally bad management.

REFERENCES Alexander, Larry and Kimberly Kessler Ferzan. 2009. Crime and Culpability: A Theory of Criminal Law, Cambridge: Cambridge University Press. Alschuler, Albert. 2009. Two Ways to Think About the Punishment of Corporations, American Criminal Law Review, 46, 1359–1392. Arlen, Jennifer. 1994. The Potentially Perverse Effects of Corporate Criminal Liability, Journal of Legal Studies, 23, 833–867. Arlen, Jennifer. 2012. Corporate Criminal Liability: Theory and Evidence. In K. Hylton and A. Harel (eds.), Research Handbook on the Economics of Criminal Law, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Arlen, Jennifer and Cindy Alexander. 2017. Does Conviction Matter? The Reputational and Collateral Consequences of Corporate Crime. In Jennifer Arlen (ed.), Research Handbook on Corporate Crime and Financial Misdealing, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Arlen, Jennifer and William Carney. 1992. Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, University of Illinois Law Review, 691–740. Arlen, Jennifer and Marcel Kahan. 2017. Corporate Governance Regulation Through Nonprosecution, University of Chicago Law Review, 84, 323–387. Arlen, Jennifer and Reinier Kraakman. 1997. Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes, New York University Law Review, 72, 687–779. Baer, Miriam. 2009. Governing Corporate Compliance, Boston College Law Review, 50, 949–1019. Baker, Tom and Sean Griffith. 2010. Ensuring Corporate Misconduct, Chicago: University of Chicago Press. Barstow, David. 2012. Vast Mexico Bribery Case Hushed-Up by Wal-Mart after Top-Level Struggle, New York Times, April 21. Beale, Sara. 1994. Too Many and Yet Too Few: New Principles to Define the Proper Limits of Federal Criminal Jurisdiction, Hastings Law Journal, 46, 979–1018.

49   U.S. Dep’t of Justice, Remarks of Assistant Attorney General Leslie R. Caldwell, N.Y.U. School of Law Program on Corporate Compliance and Enforcement, Apr. 17, 2015; Compliance Counsel to Help DOJ Decide Whom to Prosecute, Wall St. J. Risk & Compliance J., July 30, 2015.

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86  Research handbook on corporate crime and financial misdealing Becker, Gary. 1968. Crime and Punishment: An Economic Approach, Journal of Political Economy, 76, 169–217. Bhagat, Sanjai, Brian Bolton, and Roberta Romano. 2014. Getting Incentives Right: Is Deferred Bank Executive Compensation Sufficient?, Yale Journal on Regulation, 31, 523–564. Bucy, Pamela. 1990. Corporate Ethos: A Standard for Imposing Corporate Criminal Liability, Minnesota Law Review, 75, 1095–1184. Buell, Samuel. 2006. The Blaming Function of Entity Criminal Liability, Indiana Law Journal, 81, 473–537. Buell, Samuel. 2007. Criminal Procedure within the Firm, Stanford Law Review, 59, 1613–1670. Buell, Samuel. 2011. What is Securities Fraud?, Duke Law Journal, 61, 511–581. Buell, Samuel. 2013. Liability and Admissions of Wrongdoing in Public Enforcement of Law, University of Cincinnati Law Review, 82, 505–522. Buell, Samuel. 2014. Is the White Collar Offender Privileged?, Duke Law Journal, 63, 823–889. Buell, Samuel. 2016. Capital Offenses: Business Crime and Punishment in America’s Corporate Age, New York: W. W. Norton & Co. DiMento, Joseph, Gilbert Geis, and Julia Gelfand. 2000. Corporate Criminal Liability: A Bibliography, Western State University Law Review, 28, 1–64. Dressler, Joshua. 2012. Understanding Criminal Law, New York: LexisNexis. Efendi, Jan, Anup Srivastava and Edward P. Swanson. 2007. Why Do Corporate Managers Misstate Financial Statements? The Role of Option Compensation and Other Factors, Journal of Financial Economics, 85, 667–708. Eisinger, Jesse. 2014. Why Only One Top Banker Went to Jail for the Financial Crisis, New York Times Magazine. Fischel, Daniel and Alan Sykes. 1996. Corporate Crime, Journal of Legal Studies, 25, 319–349. Garrett, Brandon. 2014. Too Big to Jail, Cambridge, MA: The Belknap Press of Harvard University Press. Hamdani, Assaf and Reinier Kraakman. 2007. Rewarding Outside Directors, Michigan Law Review, 105, 1677–1711. Henning, Peter. 2014. A New Crime for Corporate Misconduct?, Mississippi Law Journal, 84, 43–90. Kahan, Dan. 1997. Social Influence, Social Meaning, and Deterrence, Virginia Law Review, 83, 349–395. Karpoff, Jonathan, Scott Lee, and Gerald Martin. 2008. The Cost to Firms of Cooking the Books, Journal of Financial and Quantitative Analysis, 43, 581–612. Karpoff, Jonathan and John Lott. 1993. The Reputational Penalty Firms Bear from Committing Criminal Fraud, Journal of Law and Economics, 36, 757–802. Kelman, Mark. 1981. Interpretive Construction in the Substantive Criminal Law, Stanford Law Review, 33, 591–673. Khanna, V. S. 1996. Corporate Criminal Liability: What Purpose Does It Serve?, Harvard Law Review, 109, 1477–1534. Kornhauser, Lewis. 1982. An Economic Analysis of the Choice Between Enterprise and Personal Liability for Accidents, California Law Review, 70, 1345–1392. LaFave, Wayne. 2010. Criminal Law, St. Paul: West. Laufer, William. 1994. Corporate Bodies and Guilty Minds, Emory Law Journal, 43, 647–730. Martinez, Jenny. 2007. Understanding Mens Rea in Command Responsibility, Journal of International Criminal Justice, 5, 638–664. Miller, Geoffrey. 2014. The Law of Governance, Risk Management, and Compliance, New York: Walters Kluwer. Partnoy, Frank. 2011. Should Some Bankers be Prosecuted?, New York Review of Books, November 10. Rakoff, Jed. 2014. The Financial Crisis: Why Have No High-Level Executives Been Prosecuted?, New York Review of Books, January 9. Schwarcz, Steven. 2015. Misalignment: Corporate Risk-Taking and Public Duty, Social Sciences Research Network (working paper), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2644375 Sepinwall, Amy. 2014. Responsible Shares and Shared Responsibility: In Defense of Responsible Corporate Officer Liability, Columbia Business Law Review, 2014, 371–419. Simons, Ken. 2012. Statistical Knowledge Deconstructed, Boston University Law Review, 92, 1–87. Sykes, Alan. 1984. The Economics of Vicarious Liability, Yale Law Journal, 93, 1231–1280. Taibbi, Matt. 2014. The Divide, New York: Spiegel & Grau. Valukas, Anton. 2014. Report to Board of Directors of General Motors Company Regarding Ignition Switch Recalls, New York: Jenner & Block. Walsh, Brian and Tiffany Joslyn. 2010. Without Intent: How Congress Is Eroding the Criminal Intent Requirement in Federal Law, Washington, DC: The Heritage Foundation. Weisselberg, Charles and Su Li. 2011. Big Law’s Sixth Amendment: The Rise of Corporate White-Collar Practices in Large U.S. Law Firms, Arizona Law Review, 53, 1221–1300.

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4.  Does conviction matter? The reputational and collateral effects of corporate crime Cindy R. Alexander* and Jennifer Arlen**

1. INTRODUCTION In the United States, prosecutors can convict a corporation for any illegal acts committed by any of its employees in the scope of employment, provided that they intended in part to benefit the firm.1 Yet notwithstanding their broad authority to convict corporations, U.S. prosecutors regularly resolve corporate criminal cases through the use of deferred

  *  Cindy Alexander thanks James Cooper and the staff of the Law & Economics Center for their support for the portions of the DPA study relating to this chapter, and colleagues at the SEC, and former colleagues at the DOJ and CEA, for helpful discussions. The SEC disclaims responsibility for any private publication or statement by any of its employees. This chapter expresses the views of the authors and does not necessarily reflect the views of the Commission or the authors’ colleagues upon the staff of the Commission. **  We would like to thank the following for their helpful comments and discussions: Danny Alter, Miriam Baer, George Canellos, Mark Cohen, Greg Demske, Mark Goodman, Marcel Kahan, Jonathan Karpoff, Daniel Klerman, Jeffrey Knox, Alex Lee, Michael Loucks, Geoffrey Miller, Jonathan Olin, David Reiffen, Daniel Richman, and participants at the American Law and Economics Association annual meeting, the NYU Program on Corporate Compliance and Enforcement Conference on Corporate Crime and Financial Misdealing, and the faculty workshops hosted by Duke University School of Law; ETH/ESCB Europe; Georgetown Law Center; Antonin Scalia School of Law, George Mason University; Harvard Law School; UCLA School of Law; and the University of Sydney School of Law. We also would like to thank Jason Driscoll, Cristina Vasile and Jerry Goldsmith for excellent research assistance. This chapter was prepared for a conference on Corporate Crime and Financial Misdealing, at the New York University School of Law.  1  See New York Cent. and Hudson River R.R. Co. v. United States, 212 U.S. 481, 493 (1909). The corporation can be convicted even if the crime violated corporate policy and the firm had an effective compliance program. E.g., United States v. Basic Constr. Co., 711 F.2d 570, 573 (4th Cir. 1983); United States v. Twentieth Century Fox Film Corp., 882 F.2d 656 (2d Cir. 1989); United States v. Potter, 463 F.3d 9 (1st Cir. 2006); United States v. Ionia Mgmt. S.A., 555 F.3d 303 (2d Cir. 2009); accord U.S. Attorney’s Manual, Section 9-28.800 (the existence of a corporate compliance program, even one that specifically prohibited the very conduct in question, does not absolve the corporation from criminal liability under the doctrine of respondeat superior).   By contrast, most other countries narrow corporate liability in one of three ways. Some, for example France, only hold corporations criminally liable if the crime was committed by an employee in the “directing mind” of the firm. Others, for example Italy and Chile, do not hold a corporation criminally liable if it had an effective compliance program. A final group of countries (including 12 OECD countries), does not impose criminal liability on firms at all, though some of those, such as Germany, impose administrative or civil sanctions with many of the core features of corporate criminal liability, including the threat of exclusion and delicensing (OECD 2016).

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88  Research handbook on corporate crime and financial misdealing prosecution agreements (DPAs), which enable prosecutors to impose criminal sanctions without convicting the firm.2 Enforcement policies that enable prosecutors to use DPAs as an alternative to plea agreements can enhance the general and specific deterrence of corporate crime. Yet some scholars claim that DPAs weaken deterrence3 on the grounds that DPAs lack the stigmatizing effect of a corporate conviction (Uhlmann 2013, at p. 1335; Garrett 2014; see Garrett 2007); thus their use lowers the cost to firms of reputational damage arising from a criminal settlement.4 This chapter evaluates the claim that corporate criminal settlements implemented through a DPA impose lower costs from reputational damage or stigma on firms than criminal settlements through a guilty plea, holding all else constant (e.g., the firm, charges, statement of facts, sanctions, voluntary reforms, and mandates).5 Corporations sustain costs from reputational damage when “interested outsiders”—e.g., customers, suppliers and other counterparties—conclude, based on information released by the criminal ­settlement, that they face an enhanced risk of harm from future dealings with the firm and thus should take their business elsewhere absent concessions or reforms that are costly for the firm to provide.6 To evaluate whether a change in the form of settlement could lead to a change in the cost of reputational damage to the firm, we consider how the choice between a DPA and a guilty plea might change the information about the firm’s likelihood of committing a future offense that outsiders receive. For this purpose, we introduce a framework for evaluating differences in the qualitative information that is released under different forms of settlement, focusing on those differences that appear likely to influence outsiders’ reactions and thus the expected cost of reputational damage to the firm from the settlement. Corporate criminal settlement agreements provide extensive qualitative information that interested outsiders can use when evaluating the risk of harm to them from a future offense by the firm. This information includes: the nature of the crime (e.g., whether it harmed other similarly situated interested outsiders), the corporation’s responsible relationship to the crime (including the effectiveness of the firm’s compliance program), the nexus between the source of the misconduct and the corporate activities affecting the interested outsiders, the firm’s  2   Under a DPA, the prosecutor files criminal charges but agrees not to seek conviction so long as the firm satisfies the terms of the agreement. Under an NPA, the prosecutor agrees not to charge the firm so long as it satisfies the agreement. See, e.g., Greenblum (2005), Garrett (2007), Arlen (2012a), Alexander and Cohen (2015).  3   According to Uhlmann, prosecutors “achieve less in terms of punishment and deterrence when we enter deferred prosecution and non-prosecution agreements” (2013, at p. 1336).  4   Critics’ claim that lowering the reputational sanction undermines deterrence assumes that higher total sanctions necessarily deter more crime. Higher total sanctions can indeed promote general deterrence, although there are circumstances under which the opposite effect can occur. Specifically, when corporations are strictly liable for crimes committed in the scope of employment, then higher sanctions can deter firms from detecting, fully investigating, and self-reporting crime, thereby potentially reducing the expected sanction imposed on individuals contemplating misconduct (Arlen and Kraakman 1997; Arlen 2012a, pp. 183–184).  5   Throughout this chapter we focus on corporations characterized by a separation of ownership and day-to-day control.  6   We refer to those outsiders whose reactions affect the cost to the firm of the settlement as interested outsiders.

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Does conviction matter?  89 actions and voluntary reforms once the crime was detected, and the effectiveness of any reforms and undertakings mandated by the agreement. To evaluate whether an outsider might react differently to a DPA than to a guilty plea agreement, we consider whether settlement through a guilty plea reveals information that the firm presents an enhanced risk of causing a future harm that would not be revealed if the firm settled through a DPA. To assess this, we review the decisions of the prosecutor and firm that lead to the settlement and, thus, may affect its form and content. We then identify and reject three distinct hypotheses about the channel through which the choice of settlement form (plea versus DPA) could affect the information revealed to interested outsiders about the risk of harm from future dealings with the firm. The first, the direct revelation hypothesis, posits that information about future risk revealed by plea agreements is either more reliable or more salient than the information produced by a DPA. We find no intrinsic differences in the content of the two forms of settlement to support a conclusion that pleas provide different information about the future risk of harm from dealing with the firm. Nor do differences in the conditions supporting the adoption of pleas appear to render the information in pleas more salient or reliable than the information in DPAs. Both pleas and DPAs can contain the same information about the crime, the firm, and the settlement. The charges, facts and sanctions in both forms of agreement are negotiated and not verified by a judge or a jury. Finally, the salience of the settlement to interested outsiders appears to be tied primarily to the magnitude of the sanction, the harm caused, and the salience of the corporation itself and not to the form of the settlement. Under the second, the prosecutor selection hypothesis, the prosecutor’s decision to pursue conviction, instead of a DPA, provides a signal to interested outsiders that the prosecutor observed information that the firm presents an enhanced risk of harming them through future misconduct. This hypothesis could hold if, for example, prosecutors are more likely to enter into pleas when there is a high risk of a repeat offense. We find no support for this hypothesis. Our review of the considerations that drive prosecutors’ choices of settlement form reveals that the choice depends on considerations that have no apparent relation to the risk of future misconduct. Specifically, the choice depends primarily on three considerations: whether conviction could trigger exclusion or delicensing of the firm, whether the firm self-reported misconduct, and whether the firm provided full material cooperation to government investigators. These focal considerations determining whether the prosecutor seeks a plea do not appear to systematically indicate that the firm presents a higher risk of future harm; thus, interested outsiders should be unlikely to rely on prosecutors’ choices to insist on a plea as a signal of the risk of future harm. Indeed, in contrast with the prosecutorial selection hypothesis, both forms of ­settlement—plea agreements and not just DPAs—contain information about a host of corporate reforms—both voluntary and those mandated by prosecutors—that are designed to deter future misconduct. These include compliance program improvements and monitorships (Arlen 2012a; Alexander and Cohen 2015; Arlen and Kahan 2017; see also Alexander 1999; Khanna and Dickinson 2007; Garrett 2007). The mandates, which can be imposed through a guilty plea or a DPA, are relevant for two reasons. First, certain mandates (such as monitors) may provide a superior signal of the firm’s future risk of misconduct when the settlement is announced to the extent that prosecutors employ them when they believe the firm presents an enhanced risk of future misconduct.

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90  Research handbook on corporate crime and financial misdealing Second, mandated reforms that outsiders expect to be effective should diminish outsiders’ expected risk from dealing with the firm in the future. As a result, a convicted firm subject to intrusive mandates could present a lower expected risk of future harm than a similar firm without detected misconduct. The third hypothesis, managerial selection, posits that pleas may signal that the firm is likely to offend in the future if interested outsiders believe that management is systematically more willing and able to accept a corporate guilty plea when members of the management team both have hidden information regarding their own complicity in the misconduct and can obtain insulation from the risk of individual liability by allowing the firm to plead guilty. This hypothesis is unlikely to hold given two institutional features of corporate criminal negotiations. First, when senior managers are potentially implicated, firms tend to delegate criminal settlements to a committee of disinterested directors, who would breach their fiduciary duties, and face potential personal liability, if they accepted a corporate guilty plea in order to provide personal benefits to management. Second, federal prosecutors are directed to pursue individual convictions and must report decisions concerning implicated individuals to supervisors.7 Moreover, even if this hypothesis did hold, it would not support critics’ claim that the use of pleas enhances deterrence through their impact on reputational damage costs. To the contrary, here pleas produce a higher cost of reputational damage only because of an assumed prosecutorial willingness to undermine deterrence (by protecting wrongdoers) in order to obtain a corporate guilty plea. Thus, interested outsiders with discretion to respond to criminal settlements should not interpret the prosecutor’s choice to settle through a plea, rather than a DPA, as a signal that the firm is more likely to engage in future misconduct. Nor should the outsider interpret any observed preference of management for a plea as such a signal. While interested outsiders may react to news of a criminal settlement by taking their business elsewhere—thereby imposing costs from reputational damage on the firm— this does not appear to be any more likely to occur if the settlement is a plea than if it is a DPA, other things being equal. Instead, the self-interested response of the interested outsider is to consider other information, contained in the settlement document, regarding the firm’s future risk of misconduct. An example is the effectiveness of any mandates that are imposed by the agreement and expressly designed to affect the chance of future misconduct by the offending firm. Our analysis is not complete, however, without considering the reactions of those federal agencies which interact with firms as interested outsiders. Agencies of the federal government often operate as direct and indirect counterparties to corporations. They may have incentives not to deal with firms likely to harm their interests in the future. This presents the question of whether prosecutors’ use of DPAs negatively impacts federal agencies’ ability to exclude, debar or delicense firms when it is in their best interest to do so. Federal agencies with discretion over how to respond to a firm with detected misconduct are unlikely to alter their decisions based on the choice of settlement form. Like other interested outsiders, they will focus on whether the criminal settlement reveals

 7   Sally Quillian Yates, Memorandum, Individual Accountability for Corporate Wrongdoing (September 9, 2015) (hereinafter the Yates Memo) https://www.justice.gov/archives/dag/file/769036/ download.

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Does conviction matter?  91 information that the firm presents a future risk of harm. If so, they may decide to reduce the risk of future harm by excluding or delicensing the firm. Federal agencies have other options to exclusion, however. Alternatively, they may decide to enter into a settlement with the firm that imposes mandates designed to reduce the risk of future harm.8 In either event, the choice depends on the facts about the firm, the crime, and available mandates and not on the choice of settlement form. Federal agencies often are constrained by laws that determine when the agency may or must exclude a firm from dealing with the agency or particular markets, however. As a result, the choice of settlement form can impact an agency’s exclusion decision. Conviction may trigger permissive or mandatory exclusion. DPAs, in and of themselves do not. As a result, the expected risk of exclusion should be lower with a DPA than with a guilty plea. To evaluate the implications for deterrence, we evaluate whether DPAs undermine agencies’ ability to exclude firms when it would serve their interests, and conclude they do not for two reasons. First, when a firm is charged with an offense against the agency’s interests, the agency generally has authority to exclude a firm, should it wish to do so, even if the firm entered into a DPA if it finds that the firm violated the law. In turn, an agency presented with a convicted firm is generally required to assess whether the firm presents an excessive risk of future misconduct, not addressable by mandated reforms, before it decides whether to exclude. Second, the few federal agencies that are legally required to exclude firms convicted of specific felonies should be better off when prosecutors regularly use DPAs. Agencies can better achieve their goals when they have discretion to exclude a firm if, but only if, the agency determines that the firm presents a genuine risk of causing future harm to the agency’s interests that cannot be more efficiently addressed by other solutions, such as mandates—discretion which the agency retains after a DPA but not after a plea. In summary, we conclude the potential for settlements to impose costs from reputational damage does not provide a deterrence-based justification for a policy favoring conviction over DPAs.9 The rest of this chapter proceeds as follows. Section 2 discusses the costs that may be directly imposed on firms by conviction and DPAs, and concludes there are no systematic differences between the two. Section 3 identifies the types of information released by a criminal settlement that may affect the cost to a corporation from reputational damage. Section 4 assesses the qualitative information released by guilty pleas and DPAs to determine whether pleas are likely to reveal more information indicating that the firm presents a heightened risk of future misconduct. Section 5 examines the responses of federal agencies acting as interested outsiders to evaluate whether, given the laws that constrain

 8   Agencies also can be expected to, and do, employ a less costly response than exclusion or delicensing when possible. That is, agencies regularly eschew exclusion in favor of reform mandates designed to reduce the future risk of misconduct. The choice of DPAs versus pleas should not affect that preference, as we explain.  9   Of course, federal enforcement policy could be reformed to target convictions at firms with enhanced risk of future misconduct, thereby providing a signal to interested outsiders. But there are other ways to provide this signal and such a policy would sacrifice other goals, such as inducing self-reporting and cooperation (Arlen 2012a; Arlen and Kraakman 1997). A policy favoring conviction in most cases would be inconsistent with this effort.

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92  Research handbook on corporate crime and financial misdealing them, agencies are undermined in their ability to exclude corporations when they would prefer to do so by prosecutors’ use of DPAs. Section 6 concludes.

2. FORMAL SANCTIONS, REFORMS AND MANDATES: PLEA V. DPA Critics of existing enforcement policy argue that DPAs undermine deterrence by lowering the overall cost of the criminal sanction to the corporation (Uhlmann 2013; Garrett 2014). In this section, we consider the formal sanctions, reforms, and mandates that are revealed by the corporate criminal settlement agreement.10 We examine whether prosecutors’ ability to impose these sanctions and mandates is more constrained when they settle through DPAs than pleas. Costs that are imposed on companies directly through the criminal settlement arise from the exercise of discretion by prosecutors, and the ultimate bargain reached with the management of the firm (negotiated with the firm), in drafting three parts of the agreement. First, the criminal settlement can detail and require the firm to admit to the criminal misconduct. Second, it can impose criminal fines and other monetary sanctions. Finally, the agreement can require the firm to undertake costly reforms, including specific changes to the firm’s compliance program and a requirement that the firm accept a monitor. We find no differences between DPAs and pleas in these areas. Thus, the validity of the claim that DPAs necessarily impose lower costs on companies than pleas rests on whether the choice of settlement form alters the other, indirect costs to the company (see Section 3). 2.1  Admission of Wrongdoing Corporate convictions generally result from negotiated plea agreements. Thus, corporate convictions occur without a trial or any other finding of guilt by an independent factfinder. In a plea agreement, the prosecutor and the firm document the alleged misconduct and the firm admits to the wrongdoing. Discussion of corporate misconduct in criminal settlements contains three features: formal charges; a detailed statement of the facts of the crime; and a corporate admission of responsibility for criminal conduct. Usually the content of each is the product of a negotiation between the firm and the prosecutor, and is contained in a negotiated resolution. DPAs have a similar structure. Prosecutors entering into DPAs file formal charges against the firm that are recounted in the DPA.11 The agreement includes a statement of the admitted facts of the crime that is negotiated between the prosecutor and the firm—a statement that could be used as evidence against the firm if the agreement is breached. 10   Firms adopt reforms voluntarily prior to the criminal settlement, and also as mandated by the settlement. Prior to and during settlement negotiations firms regularly undertake reforms. Prosecutors may discuss those reforms during the criminal settlement. In addition, the prosecutor and firm may agree to include some of the reforms that were proposed voluntarily as mandates. We accordingly discuss in this section reforms that firms announce at the time of settlement independently of their inclusion as formal mandates in the agreement. 11   NPAs are similar to DPAs except that formal charges are not filed with a court.

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Does conviction matter?  93 As with a plea agreement, firms entering into DPAs generally expressly admit that they engaged in specific acts that violated the law.12 Thus, DPAs and plea agreements both typically include statements of facts that are negotiated in the shadow of the prosecutor’s threat of trial and that contain the firm’s admission of criminal wrongdoing. With both plea agreements and DPAs, the information on charges filed and the contents of the agreement are publicly disclosed. Both agreements are filed in court. In addition, both types of agreements generally are available through the press releases issued by federal prosecutors, and often are discussed (and available) through law firm client memos, blogs, and press coverage. 2.2  Monetary Sanctions Prosecutors entering into corporate criminal settlements can impose monetary sanctions that include fines and criminal restitution. The use of a DPA rather than a plea agreement does not change this. Prosecutors entering into DPAs can impose the full range of, and same magnitude of, monetary sanctions, including monetary sanctions that are delineated as “criminal fines.” As with guilty pleas, prosecutors’ ultimate authority to impose fines is governed by the statutory provisions that set forth the sanctions that may be imposed on a firm for the charges filed. Beyond this, DOJ policy encourages prosecutors to seek sanctions consistent with the Organizational Sentencing Guidelines, where applicable, but prosecutors have discretion to recommend sentences that deviate from the Guidelines’ fine range in appropriate circumstances—for example to reward self-reporting. Thus, the use of a DPA does not appear to limit the prosecutors’ authority to impose monetary sanctions.13 Indeed, monetary sanctions in federal corporate criminal settlements are not generally lower under DPAs than pleas. In their study of criminal settlements involving public companies, Alexander and Cohen (2015) found that, between 2007 and 2011 the median monetary sanctions under DPAs were almost three times larger ($28.9 million) than under pleas ($10.6 million). They also found a greater frequency of DPAs involving parent corporations, as well as differences in the types of cases typically resolved through guilty pleas and settlements. For example, antitrust and environmental cases generally are resolved through guilty pleas whereas Foreign Corrupt Practices Act (FCPA) and Antifraud and Money Laundering charges against financial institutions tend to be settled 12   This is not a requirement of policy to our knowledge, yet we have found very few DPAs in which the firm did not admit to a violation of a criminal statute (and, thus, criminal wrongdoing). The point for our purposes is that prosecutors can and usually do structure DPAs to ensure that the firm admits to the misconduct. 13   The possibility remains that differences in the influence of the judge could lead to differences in settlement outcomes between DPAs and pleas. With pleas, prosecutors negotiate the sanction that is set forth in the plea, but the judge has the final authority to determine the sentence. Judges have authority to alter recommended sanctions in either direction. U.S. v. Booker, 543 U.S. 245 (2005). By contrast, with DPAs prosecutors both negotiate and determine the sanction, subject to the constraint imposed by the firm’s ability to seek review by the DOJ (Main Justice) should the prosecutor abuse her discretion. DPAs are filed in court, but this judicial oversight authority does not appear to include authority to alter any lawful monetary sanctions imposed. U.S. v. Fokker Services, B.V., 818 F.3d 733 (D.C. Cir. 2016).

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94  Research handbook on corporate crime and financial misdealing through DPAs. All of this is consistent with the view that prosecutors have no less ability to impose monetary sanctions through DPAs than through guilty pleas. 2.3  Corporate Reforms and Mandates In addition to the admission of wrongdoing and the monetary sanction, criminal settlement agreements provide information about both reforms that the firm has announced at the time of settlement, and reforms and undertakings that the firm is required to continue or implement in the future.14 We refer to them as reforms and mandates. Following the detection of misconduct, firms regularly implement voluntary reforms to both ensure and convince outsiders that there is a low risk of future misconduct. For example, firms regularly reform their compliance programs and terminate employees implicated in the misconduct (Alexander 1999; Alexander and Cohen 2011, 2015). Voluntary reforms are typically announced at settlement even when implemented earlier. Corporate criminal settlements regularly mandate that certain reforms continue for the duration of the agreement (Arlen and Kahan 2017). In addition, criminal settlement agreements often require firms to implement reforms or undertakings beyond what has already taken place, such as additional compliance program reforms and hiring a monitor (see Greenblum 2005; Garrett 2007; Alexander and Cohen 2015; Arlen and Kahan 2017). Mandated reforms result from bargaining between the prosecutor and the firm. Mandated reforms can impose new duties on the firm (Arlen and Kahan 2017). These can include changes to the firm’s compliance program, changes to management or board oversight of compliance or particular business practices, the addition of independent directors, and a requirement that the firm hire a monitor acceptable to the prosecutor (Garrett 2007, 2014; Alexander and Cohen 2015; Arlen and Kahan 2017; see Khanna and Dickinson 2007).15 Both pleas and DPAs set forth the details of the mandates that are imposed.

14   These are sometimes known as non-monetary sanctions. For example, see Khanna and Dickinson (2007), Alexander and Cohen (2015). Arlen and Kahan (2017) explain that mandates are not non-monetary sanctions as such because mandates do not primarily serve to sanction past misconduct, but instead create and impose a new legal duty that is enforced by the threat of future sanctions. Indeed, when mandates are effective at deterring future violations (and are expected to be so) they reduce the cost of settlement to the firm if their actual and perceived impact on the firm’s risk of future violations reduces the firm’s expected costs (from both reputational damage and future liability) by more than the cost to implement the reforms (see infra Section 3.3). 15   A literature has emerged to provide empirical evidence and supporting theory regarding prosecutors’ use of criminal settlement agreements to impose new duties (i.e., mandates) on corporations. E.g., Garrett (2007); Alexander and Cohen (2011); Arlen (2012a); Garrett (2014), Alexander and Cohen (2015), and Arlen and Kahan (2017); see also Khanna and Dickinson (2007, analyzing monitors). Explanations of the economic role of voluntary reforms and/or mandates can be found in Alexander (1999, observing that voluntary reforms can serve as a form of reputational repair), Alexander and Cohen (1999, proposing a link between the governance structure of the firm and the occurrence of corporate crime), Khanna and Dickinson (2007, viewing monitors as a nonmonetary sanction potentially justified by asset insufficiency), Alexander and Cohen (1999, 2015; voluntary and mandated reforms can reduce agency costs), and Arlen and Kahan (2017, voluntary and mandated reforms can be justified only when agency costs plague corporate “policing,” e.g., compliance, self-reporting, investigations, and cooperation).

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Does conviction matter?  95 These mandates are intended to, and may, improve the firm’s ability to deter misconduct in the future. But they also can impose significant direct costs on the firm—costs properly attributed to the criminal settlement (Alexander 1999; Alexander and Cohen 2015; Arlen and Kahan 2017). For example, mandated compliance programs can be substantially more expensive than those firms would voluntarily adopt. Monitors also can impose substantial direct costs on firms in their efforts to improve the firm’s performance of its legal duties (Khanna and Dickinson 2007; Arlen and Kahan 2017; see Garrett 2007). As with other costs imposed by prosecutors through criminal resolutions, prosecutors’ ability to impose mandates is not weakened by the choice to enter into a DPA instead of a plea. Prosecutors can impose the same range of reforms through either agreement.16 In fact, prosecutors not only can, but usually do, impose mandates when entering into DPAs (Arlen and Kahan 2017). Prosecutors have in practice obtained more governance reforms and mandates through DPAs than through plea agreements, on average (Alexander and Cohen 2015).17 The frequent announcement of voluntary and mandated reforms at the time of both DPA and plea settlements is apparent in trends from public company data after the 2003 Thompson memo, as shown in Table 4.1.18 Further, the use of a DPA does not appear to limit the ability of the prosecutor to impose other constraints, such as restricting the ability of a firm to enter into certain lines of business. Firms also have terminated managers responsible for the wrongdoing—including senior managers—in

16   There are some procedural differences. The USAM contains provisions governing monitors imposed through DPAs and NPAs that are designed to enhance oversight by Main Justice and limit opportunities for cronyism (USAM, §§ 163, 166). In addition, mandates imposed through pleas are subject to judicial review, whereas the D.C. Circuit concluded that those imposed through DPAs are not (unless they are unconstitutional) (U.S. v. Fokker Services, B.V., No. 15-3016, D.C. Circuit (April 5, 2016)). The attention accorded to one judge’s decision to modify a monitor imposed by a plea to give him oversight over the monitor suggests that it is unusual for a judge to alter the terms of such a mandate. See Andrew Levine et al., Judicial Scrutiny of Corporate Monitors: Additional Uncertainty for FCPA Settlements?, Compliance and Enforcement (June 22, 2017),  discussing United  States v. Teva Pharmaceutical Industries Ltd., Deferred Prosecution Agreement, No. Cr. 20968 FAM (S.D. Fla. Dec. 22, 2016) https://wp.nyu.edu/compliance_enforcement/2017/06/22/ judicial-scrutiny-of-corporate-monitors-additional-uncertainty-for-fcpa-settlements/. 17   Prosecutors have included more than twice the number of governance reform mandates in DPAs than in plea agreements, post-2003, on average. The number of governance reform mandates per agreement in 2007–2011 was 3.4 for DPAs and 1.3 for plea agreements for public company settlements in that period, with both numbers higher than in 2003–2006. See Alexander and Cohen, 2015 at p. 590. Differences in mandates also may result from differences in case type (e.g., antitrust versus FCPA), practice area (environmental division versus Fraud section), and offender type, which are correlated with the use of DPAs and pleas. 18   The empirical evidence in Table 4.1 is from a sample of settlement agreements collected for the Alexander and Cohen (2015) study that compared the use of pleas and DPAs to settle criminal investigations of public companies before and after the 2003 Thompson memo. The signatory of each settlement agreement was the DOJ (or USAO) and a public company or its controlled subsidiary. Evidence of reforms and mandates were obtained from settlement documents and press statements from the settlement period. Other researchers have obtained different results by using a different sample selection method, delineating the reforms differently, or by limiting attention only to reforms that are mandated or discussed in the settlement agreement (e.g., Garrett 2014; Arlen and Kahan 2017).

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96  Research handbook on corporate crime and financial misdealing Table 4.1 Selected governance reforms and mandates in DPA and plea agreements with public corporations, 2003–2011 DPA (65)

Plea Agreement (Conviction) All (167)

USAM (77)

All* (321)

Compliance and audit program revisions

95% (62)

33% (54)

52% (40)

57% (183)

Hotline or ombudsman

49% (32)

12% (20)

22% (17)

28% (91)

Training

77% (50)

28% (47)

48% (37)

46% (149)

Business unit shut down or divested

14% (9)

1% (1)

1% (1)

6% (19)

Other business changes

26% (17)

16% (13)

1% (1)

2% (5)

Debarred or suspended

– (0)

3% (0)

6% (5)

2% (5)

Note:  * The total (All) is the sum of DPA and All Plea Agreements from a sample of 321 agreements with available signed settlement documents, 2003–2011. USAM Plea Agreements exclude antitrust and environmental convictions. The source is hand collected data from 486 settlement agreements between the U.S. Department of Justice (including USAOs) and public companies, 1997–2011, by the staff of the Law and Economics Center GMU with support from the Searle Civil Justice Institute. NPAs are excluded. See Alexander and Cohen (2015) for detail on the sample, sample selection procedure, and variable definitions.

the course of entering into both types of agreements (Alexander and Cohen 2015, discussing DPAs and plea agreements; see Arlen and Kahan 2017, discussing DPAs; see also Alexander 1999, discussing plea agreements). 2.4 Summary Thus, the decision to resolve a corporate criminal investigation through a DPA instead of a plea agreement does not limit the ability of the prosecutor to impose costs directly on the corporations through the settlement. Prosecutors are able to obtain admissions of wrongdoing, impose monetary sanctions, and obtain reforms and mandates through a DPA as well as through a plea. Prosecutors thus have access to all of the forms of sanction that are available to them when negotiating plea agreements when they settle through a DPA. Differences in the overall costs of the settlement nevertheless could arise from differences in the reactions of interested outsiders to the two forms of settlement. Criminal ­settlements can directly or indirectly release information bearing on the expected future costs to interested outsiders of dealing with the firm in the future. This could cause

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Does conviction matter?  97 interested outsiders to respond in ways that impose costs on the firm. This cost from reputational damage is a cost of a criminal settlement, as we discuss in the next section. Critics of DPAs claim that DPAs produce lower costs of reputational damage, thereby weakening the general deterrent effect of the settlement (e.g., Uhlmann 2013; Garrett 2014). The rest of this chapter considers in depth whether there is a basis for the view that settlement through a DPA affects the cost to the company from reputational damage relative to what would occur if the company settled the same charges, with the same sanctions and reforms, through a plea agreement. Section 3 explains how criminal settlements can affect the cost to the firm from reputational damage by influencing the reactions of interested outsiders. Section 4 explores whether the decision to settle through a DPA instead of a plea affects this cost through its effects on the information released or signaled to interested outsiders about their expected costs of dealing with the firm in the future. In Section 5, we consider the role of the government agency as an interested outsider, focusing on agencies whose discretion is constrained by laws on exclusion and delicensing. We assess whether DPAs undermine federal agencies’ abilities to employ exclusion and debarment to protect their interests.

3. COST OF REPUTATIONAL DAMAGE: OUTSIDERS’ REACTIONS TO THE SETTLEMENT In this section, we consider how the qualitative information that is contained in and released by a criminal settlement agreement can affect the cost from reputational damage or stigma to the company from the settlement.19 Firms sustain costs from reputational damage or stigma when they enter into a criminal settlement that leads outsiders who would otherwise deal with the firm in the future to be less willing to do so (hereinafter interested outsiders). In this section, we identify the types of information released by a criminal settlement that may affect interested outsiders’ reactions to the settlement, using a framework that we develop for this purpose. We conclude that criminal settlement agreements contain and lead to the dissemination of qualitative information about the offense, the offender’s relation to it, and reforms or mandates that can influence outsiders’ reactions to the criminal misconduct, and, thus, the cost of reputational damage to the firm.20 Even when the firm’s misconduct is already public knowledge, a criminal settlement can alter—and potentially increase (or decrease)—the cost to the firm from reputational damage relating to the offense.

19   As explained in Section 2, the prosecutor and firm release information relating to the s­ ettlement in various formats over a period of time that leads up to and includes the formal date of the settlement. For simplicity, we refer to the information that would not be released but for the settlement in this section as the information that is released “by” the settlement. 20   The Appendix to this chapter illustrates these points using a formal model that indicates ways in which the release of information through a settlement agreement can influence outsider reactions and thus the cost of reputational damage to the firm.

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98  Research handbook on corporate crime and financial misdealing 3.1 How Interested Outsiders’ Expectations Determine the Cost of Reputational Damage The expected cost to a firm of reputational damage following a criminal settlement depends on the degree to which the settlement causes the release of information that leads interested outsiders to expect a heightened risk of harm to them through future misconduct if they deal with the firm. Thus, unlike the formal legal sanction, the cost from reputational damage is not directly imposed by prosecutors. It is imposed by the “market” or, more specifically, by the reactions of outsiders who could have been expected to deal with the firm in the future and whose self-interested reactions to a negative signal can impose costs on the firm.21 We refer to these outsiders as “interested outsiders.” They may include prospective customers and clients, suppliers, and government agency payees.22 It is the voluntary nature of their dealings with the firm that empowers interested outsiders to react to the criminal settlement, and to do so in a manner that can be costly for the firm (see, e.g., Darby and Karni 1973).23 Several basic factors must be present for the information revealed by the settlement to cause interested outsiders to react in a way that imposes costs on the firm from reputational damage. First, the settlement information must lead the outsiders to update their views about their future risk of harm from doing business with the firm.24 The information revealed by the criminal settlement might indicate that a future offense is more likely to occur or would be more harmful to the outsider than previously anticipated. The outsider might also face higher costs of precautions to avoid such harm. The point is that the information provided through the settlement must lead the outsider to anticipate a greater cost, or lower gain (greater risk of loss) from dealing with the firm in the future than previously expected.25

21   For a formal model, see the Appendix to this chapter. A central insight of the economics literature on alternatives to legal rules as a source of discipline on firms is that outsiders can impose a future cost on the firm through their future reactions to the firm’s failure to provide services of anticipated (high) quality. For early examples, see Darby and Karni (1973), Darby (1975), Dybvig and Spatt (1980, 1985); Klein and Leffler (1981), Shapiro (1983); see also Tirole (1988 at p. 123 provides a survey). 22   See infra Section 5 (discussing government agencies as interested outsiders). The position of the interested outsider in relation to the offender is similar to the that of the related party in Alexander (1999) and trading partner in Iacobucci (2014), in which the cost of reputational loss to the firm arises because “observers have changed their views about the benefits of dealing with the offender that has revealed by its wrong its type as one that is unattractive to trading partners with trading conceived broadly” (Iacobucci 2014, at p. 190). The outsider reaction to the DPA settlement depends in part on its publicness; for a model of the impact of private settlements, see Mungan (2017). 23   A related literature examines the link between formal sanctions and the cost to the defendant of a formal conviction. For example, Daughety and Reinganum (2015) assume a greater outsider reaction to conviction than to plea, and explore the effects on the plea outcome. In considering informally the choice between plea and DPA, we allow the outsider’s reaction to vary with the information revealed by the settlement. 24   Harm takes the form of ex post regret about choice of counterparty in this setting, evaluated from the individual outsider’s perspective. 25   See infra note 30.

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Does conviction matter?  99

Interested outsiders can refuse to deal with firm or adjust terms Information in agreement signals that firm has heightened risk of causing future harm to interested outsiders

Yes

Firm can costlessly eliminate increased expected risk

Yes

No

No

Yes

No Firm bears cost from reputational damage following criminal settlement

Firm does not bear cost from reputational damage as a result of criminal settlement

Figure 4.1  Interested outsiders’ decisions that affect the cost of reputational damage Second, the interested outsider must be willing and able to respond to the increased risk of loss from future dealings with the firm by taking his business elsewhere. This could involve avoiding dealing with the firm entirely or in part, such as by diverting some or all transaction volume to one of the firm’s competitors.26 Third, the anticipated outsider reaction must be costly to the firm. The future business that outsiders take elsewhere must be of value; the firm cannot be indifferent to its loss. The firm may attempt to avoid this cost by making concessions or undertaking reforms to prevent the loss of outsider business. The cost of such concessions or undertakings is a cost from reputational damage where it arises from the prospect of lost future business beyond what the firm would otherwise face. Thus, the aggregate cost from reputational damage is a combination of the cost of lost business and the cost of reforms and concessions to avoid such loss (e.g. a better price, reforms that eliminate the risk, or investment to enhance quality) (see Figure 4.1). 3.2  Impact of a Criminal Settlement on the Cost of Reputational Damage Firms committing crimes that harm outsiders, such as fraud, may incur costs from reputational damage whether or not the government ever brings criminal charges. Indeed, the early scholarly analyses of reputational damage costs examined how firms could be deterred from committing fraud by the expectation that some customers would discover

26   To deter misconduct, it is sufficient for the firm to anticipate an outsider response (regardless of whether the response actually occurs). In considering alternative outsider responses and their effect on the cost of reputational damage in this chapter, we take the perspective of the firm and limit attention in this chapter to those responses that a firm would plausibly anticipate at some future settlement.

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100  Research handbook on corporate crime and financial misdealing the fraud on their own and react by refusing to deal with the firm in the future and possibly spreading the information to other customers, who might respond similarly (Darby and Karni 1973). Nevertheless, several considerations can limit the deterrent effect of this response. The first is the quality of information reaching outsiders about the existence of and causes of any harms suffered as a result of corporate misconduct. Parties dealing with the firm sometimes cannot reliably determine that they were injured, whether their injury was attributable to corporate misconduct, such as fraud (Darby and Karni 1973), and whether the conditions that led to the fraud are likely to persist. Second, individual discoveries of corporate misconduct may not be broadly disseminated to all current and future interested outsiders who might beneficially respond to this information. Corporate criminal settlements can affect the expected reputational damage costs to firms of corporate misconduct by improving both the quality and accessibility of the information that reaches interested outsiders.27 Criminal settlements can provide more precise information to outsiders about the nature and extent of the harm from the misconduct. They can also potentially improve the quality of outsiders’ information about the offending firm’s relation to the offense. Further, criminal settlements can affect the cost of reputational damage by disseminating information about the misconduct more widely, both in the U.S. and abroad.28 In addition, criminal settlements can affect interested outsiders’ expectations by releasing information about reforms undertaken by the firm post-crime. For example, they can include provisions that enhance the transparency of voluntary reforms undertaken by the firm to avoid future misconduct. They may relatedly mandate reforms designed to influence the outsider response by altering the firm’s future risk of misconduct.29 The next sub-sections explore when and how the information released by criminal settlements about the offense, the offender, and future undertakings may affect outsiders’ expectations in a way that causes the firm to incur costs from reputational damage. 3.3  Offense Type and the Interested Outsider In evaluating news of the settlement, interested outsiders have access to the government’s press release announcing the criminal resolution, the content of the criminal settlement itself, and the press coverage and related news reports discussing the settlement. These sources provide interested outsiders with information about the crime—the facts of the offense, the charges filed, and the sanctions imposed. This information about the offense may, but need not, lead them to be unwilling or less willing to deal with the firm going forward. Interested outsiders voluntarily divert transactions away from a firm with admitted wrongdoing when it is in their self-interest to do so.30 News that the firm admitted to a   See infra the Appendix.   This increased access can occur both through the public press release announcing the settlement and through press coverage of the criminal settlement. 29   See infra Section 3.4.2. 30   Indeed, interested outsiders arguably change their plans for dealing with the firm in the future only when the news of the conviction reduces their expectations about the net benefits of future purchase from, or relationships with, the firm. A criminal settlement can alter interested 27 28

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Does conviction matter?  101 crime that harmed some interested outsiders can cause other similarly situated outsiders not to want to deal with it in the future.31 The canonical case is conviction for actions that injure a corporation’s customers.32 The rational self-interested reaction of potential future customers to news of such a conviction would be to limit their future dealings with the firm in order to limit their risks of being harmed by a future offense. Specifically, they may take their business elsewhere, reduce their willingness to pay, or insist on additional oversight or guarantees, depending on their access to alternative sources of supply and thus their private costs of doing so.33 This assumes the news of the offense signals a heightened risk of harm from future misconduct. It also assumes the customer can avoid the harm by taking her business elsewhere. If this last assumption is violated, however, interested outsiders would have no reason, based on news of the misconduct itself, to alter their future dealings with the firm because going elsewhere would not change their future risk of harm. Consequently, they would have no reason to be less willing to deal with the firm in the future, notwithstanding the criminal settlement.34 To illustrate, consider three different types of crimes: fraud; environmental crimes that harm those in the vicinity of the firm’s operations; and illegal price-fixing agreements by all the firms in an industry. 3.3.1 Fraud A firm convicted of defrauding a subset of customers may face costs of reputational damage because fraud typically implicates all three factors discussed above. First, potential customers contemplating future dealings with the firm may view news that the firm defrauded similarly situated customers as a signal that they face a greater risk of being defrauded by this firm than they previously believed. Second, those customers may

outsiders’ expected benefit of dealing with the firm by causing them to expect a higher risk of harm from future misconduct by the firm.   Of course, in retail markets, consumers sometimes react to misconduct that does not expressly harm them. For example, some consumers may experience disutility from corporate misconduct involving violations of child labor laws if, upon learning of the violation, they would feel responsible for illegal or inhumane conditions in the factories producing the goods they purchase. As a result, they may be less willing to purchase goods from a firm convicted of such practices if they anticipate such misconduct could happen in the future. In addition, it is possible that some people may have social-regarding preferences that cause them to eschew all dealings with all convicted corporations in the belief that the firm has violated the social compact, even when they otherwise would obtain a material benefit from dealing with the firm. Yet many people behave as though they focus primarily on their own interests, and tend to make decisions based on the expected value of their purchases and business relationships to themselves. 31   In addition, the criminal settlement may reveal facts about the firm’s internal governance and/or reforms undertaken by the firm that affect the outsider response. See also supra note 30 (discussing other types of future expected costs). 32   Direct dealings are also absent from money laundering, as noted in Iacobucci (2014 at p. 192) and Alexander (1999; money laundering as a third-party offense). 33   A firm may harm counter-parties indirectly by committing the type of malum in se offense in the production of the goods that could cause those purchasing from the firm to experience disutility from purchasing a good (thus decreasing the demand for the good) whose production resulted in illegal and immoral acts (such as extreme labor violations). 34   See supra note 30.

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102  Research handbook on corporate crime and financial misdealing rationally respond by taking that business elsewhere or requiring concessions from the firm to compensate for the higher risk of harm from future frauds. 3.3.2  Environmental crime In contrast, a firm that enters into a criminal settlement for an environmental crime that harms people living in the vicinity of the firm’s operations is unlikely to incur costs from reputational damage. News of the settlement may signal that the firm is more at risk of causing environmental harm in the future. Yet the harm from this type of environmental offense does not fall on people who purchase from or sell to the firm. Those interested outsiders, in contemplating future dealings with the firm, are unlikely to conclude based on news of the crime that a decision to deal with the firm would expose them to an increased risk of future harm.35 As a result, they would likely continue to deal with the firm as before. The offending corporation should not incur costs from reputational damage from this type of offense (Jones and Rubin 2001; see also Karpoff and Lott 1993; Lott 1996; Alexander 1999; Karpoff, Lott, and Wehrly 2005; but see Cohen 1992).36 3.3.3  Antitrust (collusive price-fixing and bid-rigging) News that a group of firms entered into a criminal settlement for colluding to fix prices or rig bids may signal to interested outsiders that they face an increased risk of future harm from dealing with the offending firm. Nevertheless, the firms involved may not incur substantial costs from reputational damage because their customers may be unable to avoid future dealings with the offending firms to the extent that all firms in the industry—all suppliers of a good or service—are involved in the offense. Thus, the second factor is not fully implicated because customers who cannot turn to substitute unimplicated suppliers may prefer to stick with the convicted supplier rather than incur the costs of switching to another product or withdrawing from the market altogether. For this reason, the cost from reputational damage to the offending firms often will not be high for offenses involving collusive behavior, such as price-fixing. This underscores the importance of ascertaining interested outsiders’ ability to reduce expected harm by avoiding dealing with the offender when assessing the expected cost to the firm from reputational damage. For offenses that

35   We recognize that monetary sanctions can cause a firm to face financial distress that can create moral hazard problems that introduce a risk of a future offense. It appears unlikely that differences in the form of settlement would create any differences in the effects of the monetary sanction on the cost that firms face through this channel, however. 36   The essential point is that it is difficult for victims of environmental crimes to avoid the harm by choosing (individually) not to deal with the offending firm, even with advance knowledge of the misconduct. An environmental conviction could produce a reputational penalty if, as Mark Cohen suggests, news that a firm knowingly discharged waste or falsified evidence of environmental wrongdoing adversely affects customers’ perceptions about the quality of the firm’s products (Cohen 1992). This effect appears unlikely when the perceived link between the firm’s misconduct and the value to consumers of the firm’s products is tenuous.   In addition, some infamous environmental crimes could produce a cost of reputational damage to the extent that customers conclude that the firm’s conduct was reprehensible and thus the firm no longer deserves their business. The empirical evidence suggesting no reputational damage for environmental harms (Jones and Rubin 2001; Alexander 1999; Karpoff, Lott and Wehrly 2005) indicates that firms tend not to sustain material losses from this kind of customer response.

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Does conviction matter?  103 implicate all firms in an industry, the cost from reputational damage is likely to be lower than if the offense involves only one of the firms. 3.4  Aggravation and Mitigation of the Outsider Response Criminal settlement documents generally contain information about the corporation’s relation to the offense that may affect interested outsiders’ assessment of their expected future harm from dealing with the firm. Outsiders assessing the probability of being harmed by future misconduct may take into account the prosecutor’s determination of whether the firm’s compliance program was effective,37 as well as the discussion (or lack of discussion) of specific deficiencies in the compliance program. In addition, they may consider information in the criminal settlement about whether the crime was either committed by individuals who remain at the firm, or committed or condoned by senior managers. Interested outsiders also may consider whether criminal misconduct was wide-spread (implicating many employees or many divisions across the firm), occurred over a long period of time, or was incentivized by the firm’s compensation or promotion policies.38 In addition, outsiders may treat as red flags evidence that the firm detected misconduct but failed to address initial concerns that were brought to management’s attention, as well as evidence that the firm conducted an inadequate or obstructive investigation, that, for example, resulted in the prosecutor requiring the firm to have a monitor. Some observers may interpret evidence that the crime involved only one, low-level employee, or that the firm promptly detected and put a halt to the crime, as indicating a low risk of a repeat offense. We use the term “aggravating factors” to refer to conditions that would amplify the outsider reaction to the offense if present, and thus increase the cost to the firm from reputational damage. Offender characteristics that an outsider would associate with a relatively low risk of harm from a future offense are here termed “mitigating factors.”39 Information released by the criminal settlement about aggravating and mitigating factors may affect interested outsiders’ expectations, and thus the cost from reputational damage, if it is new information (not already known by the outsiders) and credibly signals 37   Interested outsiders’ reactions to statements in the criminal settlement document that the firm’s compliance program was or was not effective may be influenced by their views on the prosecutor’s ability to identify an effective compliance program, as well as by statements about specific deficiencies and the scope and duration of the misconduct. 38   Corporate crime can be a direct or indirect result of management’s exercise of influence in the firm. Misconduct arising from misalignment between the incentives of management and the incentives of outside shareholders is an agency cost of the firm (Macey 1991; Arlen and Carney 1992; Arlen 1994; Arlen and Kraakman 1997; Alexander and Cohen 1992, 1999; Burns and Kedia 2006; Bergstresser and Philippon 2006; and Efendi, Srivastava, and Swanson 2007). Misalignment may occur through promotion or job-security incentives and through compensation packages. News of a conviction can signal that the firm’s compensation and promotion system provides incentives to pursue risky strategies that provide short-term benefits, including intentional crime (Arlen and Kraakman 1997), and that its internal governance and compliance does not fully deter wrongdoing (see Beasley 1996; Agrawal and Chadha 2005). 39   We use the terms aggravating and mitigating factors to refer to considerations that can differ from those deemed aggravating and mitigating factors by the U.S. Sentencing Guidelines Governing Organizations.

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104  Research handbook on corporate crime and financial misdealing a difference in the risks relating to a further offense from the outsiders’ perspective. This is relative to the reaction that would occur in the absence of such offender-specific information. In summary, settlement agreements often indicate how many separate departments, divisions or subsidiaries of the firm were involved in misconduct, how many different offenses were committed, and the duration of the offenses. Information released at the time of settlement may further reveal that management ordered or condoned the crime, or that the firm had (and has) a compensation system that appears to have incentivized the misconduct. Offense-date-specific information may alternatively suggest that a future offense by the same firm is unlikely to occur. Such a crime might be said to originate from the actions of “a single rogue employee.”40 This information may inform the outsider reaction to the settlement. 3.4.1  Information on the relation of offender to offense In the United States a corporation can be convicted for the misconduct of an individual employee, including a low-level employee, which is committed in the scope of his employment and with at least some intent to benefit the company. In deciding how to respond to news that a firm was sanctioned for misconduct, outsiders assessing their risk of harm from a future violation may seek to determine whether the misconduct provides a signal of a broader, ongoing risk of misconduct by the firm. For example, they may seek information on whether the crime took place in a part of the corporation with which the outsider expects to deal in the future. They also may seek information on the quality of the firm’s internal governance and on whether the risk of future harm is likely to be eliminated by terminating individuals involved in the instant offense. First, some observers may find it useful to consider the detailed statements of facts about the crime set forth in the criminal settlement document for information about a variety of factors about the crime that bear on the likelihood of future misconduct. For example, criminal settlement agreements often reveal facts bearing on whether the crime was an isolated event or part of a pattern of events.41 These include information about how many separate offices were involved, how many different offices were involved, and the duration of the offenses. Information released at the time of settlement may further reveal that management ordered or condoned the crime, or that the firm had (and has) a compensation system that appears to have incentivized the misconduct. In addition, public attention to the roles of specific individuals in the misconduct may affect ­interested outsiders’ beliefs about the expected harm from dealing with the firm, depending in part

40   On crime as an agency problem of the firm that arises from individual employees’ pursuit of private benefits see Macey (1991), Arlen (1994), and Arlen and Carney (1992). For theory and evidence on crime as a principal-agent problem of the modern corporation, in which management faces a trade-off between private benefits and costs of actions to prevent criminal acts by lowerlevel employees, see Alexander and Cohen (1992, 1999). 41   In addition to the internal conditions of the firm, external conditions can directly and indirectly affect the occurrence of crime. We focus on internal conditions as these are most likely to become known through information disclosed by the criminal settlement, and thus are the most promising potential source of a differential impact of pleas and DPAs.

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Does conviction matter?  105 on the seniority of the people involved and whether the settlement or related news coverage indicates that those individuals have remained with the firm.42 In addition, criminal settlements can reveal information about features of the corporation’s internal operations potentially relevant to interested outsiders’ assessment of the risk of future harm from either the type of offense that occurred or other offenses. As previously noted, criminal settlement documents often reveal information about the overall effectiveness of the firm’s compliance program (Alexander 1999; see also Laufer 1999), including specific deficiencies (Arlen and Kahan 2017). The criminal settlement also may contain information about the firm’s culture (Tyler and Blader 2005; Simpson et al. 2014), the tone at the top and the incentives of its top management and employees (Arlen and Kraakman 1997; Alexander and Cohen 2011; Langevoort, Chapter 11 in this volume), along with its ownership and board governance (Alexander and Cohen 1999; Arlen and Kahan 2017). It also may reveal whether the firm instituted compensation and promotion policies that create pressure to violate (or comply with) the law (see Arlen and Kraakman 1997). Outsiders’ expectations also can be affected by information about the firm’s response to news of the misconduct. Firms can deter crime through a credible policy favoring in-depth investigation, self-reporting, and cooperation that provides evidence about the individuals responsible for the crime as these activities should increase employees’ expected costs of crime (Arlen and Kraakman 1997). Internal governance that promotes such “policing” activities may thus reduce agency costs, thereby reducing misconduct in general. Finally, when the firm does not appear to be plagued by misconduct in all its operations, interested outsiders may consider the specific location of the crime in the firm in assessing their own expected cost of dealing with the firm. Criminal settlements regularly identify specific divisions, subsidiaries, or offices as being responsible for the misconduct. This may lead interested outsiders to regard the risk of a future offense to be lower if the central nexus of their dealings with the firm lies elsewhere.43 Such an outsider might, for example, react differently to information indicating that the crime was entirely attributable to the firm’s Nigerian operations if the outsiders’ future dealings are likely to be distant from the Nigerian operations of the company than to information that misconduct occurred in the division with which the outsider is likely to deal in the future. Similarly, an interested outsider who purchases jet engines from a firm might respond differently to a corporate criminal settlement for fraud harming customers if the criminal settlement reveals the fraud involved the jet engine division than if it involved a separate health care division. Interested outsiders who treat these considerations as material to their assessment of the future risk of harm when dealing with a firm sanctioned for committing a particular

42   The content of the settlement agreement can influence the extent to which public attention and blame attach to a specific individual or entity within the company. This can lead to differences in the reactions of interested outsiders. See Section 4.1 for discussion of the potential for differential media attention to result from criminal settlement through a plea instead of a DPA. 43   Indeed, most large organizations are complex multi-faceted institutions composed of numerous offices or divisions that may be quite independent of each other. It does not automatically follow from news that an “organization” committed a crime that the areas of the firm of interest to a given outsider present an enhanced risk of future misconduct.

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106  Research handbook on corporate crime and financial misdealing offense may respond differently to two firms sanctioned for the same offense (of the same magnitude), depending on the information provided in the criminal settlement document about these aggravating and mitigating factors. 3.4.2  Mitigation through offender reforms and mandates Interested outsiders’ expected costs depend on the risk of harm from the firm in the future, and not at the time of the offense. Criminal settlements can both reveal and cause a difference between the risk of misconduct at the time of the crime and the risk to outsiders when dealing with the firm in the future. Criminal investigations and corporate criminal settlement negotiations can take many years to conclude. During this time, the risks of future misconduct may change as a result of voluntary reforms (Alexander 1999) as well as mandates imposed by prosecutors and regulators (Alexander and Cohen 2015; Arlen and Kahan 2017). Settlement documents often contain detailed information about reforms and mandates that an outsider might interpret as signaling a higher or lower chance of a repeat offense, depending on their expected effectiveness.44 It is reasonable to consider reforms and mandates among the mitigating factors that an outsider might consider in reaction to the offense.45 Of particular importance, many, if not most criminal settlements include prosecutormandated changes to the firm’s compliance program (Garrett 2007; Alexander and Cohen 2011; Arlen 2012a; Alexander and Cohen 2015; Arlen and Kahan 2017).46 Prosecutors often mandate that the firm maintain specific voluntarily-adopted compliance program reforms. In addition, they regularly impose new duties on the firm designed to deter future misconduct (Arlen and Kahan 2017). These mandates include requirements that the firm implement specific changes to its compliance program, adopt new management committees, and enhance oversight over particular types of contracts. The firm also may agree to comply with agreements with regulators that subject the firm to enhanced oversight and internal reforms (e.g., Corporate Integrity Agreements) (Alexander and Cohen 2015; Arlen and Kahan 2017). Settlement agreements may also impose mandates that provide for enhanced independent oversight over the firm’s efforts to comply with the law. Some mandates enhance

44   Criminal settlements often separately present information about both the effectiveness of the firm’s compliance program leading up to the crime and reforms initiated between the crime and ­settlement. These reforms can cause the firm’s risk of future misconduct to change in between when the crime occurred and the settlement. In addition, firms with detected misconduct may undergo a change of control in between the time the crime was detected and the criminal settlement. This also may alter the expected risk of future misconduct (Arlen and Kahan 2017). 45   The offender characteristics that we discuss in this section reflect our appraisal of candidate factors that an outsider might plausibly consider in evaluating the prospect of a future offense, conditional on settlement. The list may be over-inclusive and is offered to inform our analysis in the next section of the different channels through which a difference in form of settlement might lead to a difference in the cost of reputational damage to the firm. The question of what offender characteristics are in practice the best predictors of a firm being charged with a future offense is accordingly beyond the scope of this chapter and left for consideration elsewhere. 46   The practice of announcing reforms and mandates around settlement pre-dates the Sentencing Guidelines (Alexander 1999).

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Does conviction matter?  107 oversight by internal parties, such as independent directors and specialized management committees. Other mandates provide for enhanced external oversight of the firm’s efforts to comply with the law. These include provisions in many settlement agreements that compel the firm to incur the costs of appointing and maintaining an external monitor or facing scrutiny from a regulator beyond what would occur otherwise (Khanna and Dickinson 2007; Alexander and Cohen 2015; Arlen and Kahan 2017). Elsewhere we refer to mandates that may enhance management’s prevention effort or policing activities as “internal governance reforms” (Alexander and Cohen 2015) and “meta-policing mandates” (Arlen and Kahan 2017), respectively. Effective reforms can fundamentally change the cost to the firm of any reputational damage or stigma that it might sustain under either conviction or a DPA. While reforms can be costly to the firm (properly viewed as a cost of reputational damage), when sufficiently effective they can reduce outsiders’ negative reaction and thus the (net) cost of the criminal settlement. As a result, in principle, a firm sanctioned for a serious crime could experience little cost from reputational damage if it were able to prevent a negative signal from being triggered by the settlement by implementing low-cost reforms that interested outsiders expect to be effective. 3.5 Summary As we have seen, corporate criminal settlement does not automatically cause the firm to incur costs from reputational damage relating to the offense. Instead, the cost of this form of stigma depends on the type of crime and whether it can plausibly trigger such costs. Crimes such as procurement fraud, health care fraud, and other crimes involving harm to outsiders who are engaged in voluntary dealings with the offending firm are among the most plausible candidates. Environmental crimes are not. In addition to these basic considerations, the costs of reputational damage from the ­settlement may vary according to the presence of aggravating and mitigating factors that may influence each interested outsider’s assessment of their risk of future harm from the firm. These include the nexus between the crime and interested outsiders, as shown in Table 4.2. They also include information about the firm’s internal governance, including information about any reforms or mandates that may be undertaken contemporaneously with, or imposed by, the criminal settlement.

4. REPUTATIONAL CONSEQUENCES OF CONVICTION VERSUS DPA As we have seen, the form of settlement could affect the cost to the firm from reputational damage through its effect, if any, on the information that is released to interested outsiders about their future costs of dealing with the firm (“risk of future harm”). In this section, we evaluate whether any part of the process of resolving a criminal investigation through a plea instead of a DPA, in and of itself, signals that the firm has a higher risk of future misconduct, independent of the information about the crime, the firm’s governance, sanctions, and reforms that is contained in and released by either type of settlement agreement. We focus on the choice between a DPA and a guilty plea because corporate

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108  Research handbook on corporate crime and financial misdealing Table 4.2  Candidate indicators of the risk of future harm to interested outsiders Information about the Crime

Information about the Firm

Nature of the Crime

Causes of the Crime

Broader Governance

Compensation policy   induced crime? Managers’  involvement Quality of training Effectiveness of   compliance program Managers detect and  intervene? Wrongdoers  terminated?

Quality of employee  training Resources for compliance  program Quality/seniority of   compliance officer Evidence of director  oversight Quality post-crime  reforms Mandated reforms Mandated oversight

Nexus to Outsider

Geographical Did crime harm  interested outsiders  or subject-area distance between Magnitude of harm wrongdoers Number of charges and locus of Duration of crime outsiders’ dealings with firm Number of  different offices implicated Seniority of  wrongdoers

convictions are typically obtained through plea rather than going to trial.47 For this purpose, we extend the framework that we introduced in Section 3 and evaluate how the choice of settlement form could affect the cost to the firm arising out of reputational damage from the settlement. Interested outsiders would be less willing to deal with the firm going forward if the use of a plea, instead of a DPA, in and of itself, either signals the presence of new (hidden) information about the risk of future harm or enhances the weight placed on existing information about that risk.48 There is otherwise no reason to react differently based on the form of the settlement alone. We introduce three hypotheses about the channel through which the DPA–plea choice could affect the information that interested outsiders receive about their risk of future harm from the firm. Under the direct revelation hypothesis, the use of a plea is assumed to provide more reliable or salient information about the corporation’s misconduct.49 The prosecutorial selection hypothesis posits that prosecutors require resolution 47   See, e.g., Chapter Eight, Organizational Sentencing Components, Interactive Sourcebook of Federal Sentencing Statistics, U.S. Sentencing Commission (July 2016), at Table 53 (reporting that almost 97.7% of the 132 organizations sentenced in FY 2016 under the Guidelines pled guilty and thus avoided a trial). Similar figures are found in earlier years. 48   Before considering these three channels it is important to note that a variety of cases can be excluded from consideration right from the outset. In particular, we would not expect the information about the form of settlement to matter if the firm is convicted of the types of crime that do not plausibly signal that interested outsiders face an increased risk of harm in dealing with the firm. For example, many environmental crimes that harm third parties and regulatory violations that do not harm counterparties are unlikely to produce material reputational damage costs regardless of the form of settlement. We exclude such cases from the discussion below. 49   Although we consider three channels, only one, direct revelation, could support a policy favoring conviction of almost all firms with detected misconduct, as apparently favored by some

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Does conviction matter?  109 through a plea, instead of a DPA, when they have information—not fully revealed in the ­agreement—that the firm presents an enhanced risk of future harm. Finally, under the managerial selection hypothesis, pleas are assumed to provide a negative signal that managers accepted a plea agreement in order to avoid being held individually culpable and face individual sanctions for the misconduct. We compare the information that outsiders receive under each of these hypotheses, based on both an institutional analysis of how criminal settlements are negotiated and released and an analysis of the specific considerations likely to be most important to a rational prosecutors’ office, assuming prosecutors are seeking to resolve the case, with appropriate sanctions, without incurring unnecessary costs.50 We find no reason to conclude that pleas convey more or stronger information that the firm presents a heightened risk of harm from future misconduct than DPAs, holding constant the charges, identity of the firm, facts of the crime, voluntary reforms, and mandates imposed. We accordingly conclude that the use of a plea instead of a DPA is not likely to provide hidden information to interested outsiders about the expected cost of dealing with the firm through any of these channels, and thus should not affect the cost to the firm from reputational damage following a criminal settlement. 4.1  Direct Revelation: Weight Accorded to Information Released at Settlement? As explained in Section 2, the criminal settlement agreements and associated press releases for pleas and DPAs can contain the same information about charges, misconduct, and the other candidate factors that may indicate to interested outsiders that they face an unexpectedly high future cost51 of dealing with the firm, as discussed in Section 3. In this sub-section we consider whether interested outsiders nevertheless might place greater weight on such information if it is released through a plea than a DPA.52 We consider two possible reasons for this—reliability and salience. 4.1.1  Reliability of settlement documents and press releases First, we consider the possibility that the interested outsider might regard guilty pleas as providing more reliable information about the statements of the firm’s misconduct than DPAs.53

scholars (see Uhlmann 2013). The other two channels require that prosecutors reserve pleas for firms with an enhanced risk of future misconduct. 50   We expect prosecutors to be particularly focused on the impact of pleas on the costs of the criminal settlement given that, as explained in Section 2 supra, the choice between plea and DPA does not have a direct effect on the content of the settlement agreement. 51   Throughout this article, “cost” refers to opportunity cost and is not limited to costs that are out of pocket or readily quantified, unless otherwise indicated. 52   We focus on reliability and salience because prosecutors can disclose the same information about charges, misconduct, sanctions, corporate compliance, voluntary reforms, and mandates in pleas and DPAs (see supra Section 2, explaining that the information that can be included in the agreement is independent of the choice of settlement form). 53   Recall from Section 2 that both types of criminal settlement can and do contain the same disclosure of facts about the nature of the crime and potential aggravating and mitigating factors, including post-crime reforms. Both tend to provide (1) a detailed discussion of the facts of the crime including the number of offenses, their duration, locations, and involvement of senior

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110  Research handbook on corporate crime and financial misdealing Statements in DPAs about charges, the facts of the crime, the firm’s internal governance, and other matters are the product of negotiations between prosecutors and the corporation and are not subject to independent review. Accordingly, a conviction could produce more reliable information if prosecutors seeking to convict took the extra step of establishing the facts of the crime beyond a reasonable doubt through evidence submitted by both parties to an independent decision maker. Yet this not the case. Corporate convictions are almost always obtained through guilty pleas negotiated by the parties in the shadow of the cost and risk to both sides of going to trial. In addition, although judges must approve both DPAs and plea agreements, judges do not make independent findings about the facts of the case in either context. Thus, both criminal pleas and DPAs involve statements of facts, charges, and sanctions that are negotiated by the prosecutor and the corporation.54 In neither situation are the facts of the crime proven or validated by an external arbiter such as a judge or jury. Pleas also could provide more reliable evidence of guilt if the DOJ instructed or encouraged prosecutors to use DPAs in weaker cases. Yet this does not appear to be the case. The legal standard for determining whether it is appropriate for a prosecutor to proceed against the firm through a plea or a DPA is the same: prosecutors are not supposed to seek either a conviction or a DPA unless the prosecutor believes she could establish the crime beyond a reasonable doubt.55 Indeed, rather than reserving DPAs for weak cases, the U.S. Attorneys’ Manual directs prosecutors to employ a DPA even when the firm could easily be convicted if circumstances—such as mitigating considerations like the firm’s compliance program, corporate self-reporting, full cooperation, and collateral consequences—warrant it. The DOJ’s willingness to adjust the form of settlement independently of guilt is evidenced by recent declinations announced by the Fraud Section, which insulated firms from criminal sanction, notwithstanding their violation of the FCPA, because the firm self-reported and fully cooperated to provide prosecutors with evidence about the misconduct and those responsible for it.56

management; (2) the charges filed; (3) the firm’s admission of wrongdoing; (4) a discussion of the firm’s compliance program at the time of the offense and its response to the crime (including firm-initiated reforms); and (5) the sanctions imposed, including details of any mandates imposed. In both cases, the details of the resolution not only are disclosed in the agreement, but also are presented in prosecutor-issued press releases and press conferences. 54   But see supra notes 13 and 16 (discussing judicial authority over sanctions in plea agreements). 55   The legal standard for determining whether the firm engaged in misconduct under the two types of agreements is the same: respondeat superior. 56   The Fraud Section of the DOJ publicly announced declinations involving the following companies with detected bribery, based, in part, on the fact that the companies voluntarily disclosed, investigated, and cooperated: Nortek Inc. (June 3, 2016), Akamai Technologies Inc. (June 6, 2016), Johnson Controls (June 21, 2016), HMT LLC (Sept. 29, 2016), NCH Corp. (Sept. 29, 2016), Linde North America, Linde Gas North America LLC (June 16, 2017), and CDM Smith Inc. (June 21, 2017) https://www.justice.gov/criminal-fraud/pilot-program/declinations   Finally, interested outsiders might assume that the use of a guilty plea, instead of a DPA, signals that the prosecutor or firm has hidden information bearing on the firm’s future risk of harm. We address this possibility below in Section 4.2, focusing on the information available to the prosecutor and its role in guiding the prosecutor’s choices.

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Does conviction matter?  111 4.1.2  Salience of the criminal settlement Information contained in the settlement agreement bearing on the firm’s risk of future misconduct57 could produce a greater reaction from interested outsiders when the settlement is a plea instead of a DPA if pleas are more salient than DPAs. This could occur if outsiders have easier access to the information provided through pleas than through DPAs. Yet prosecutors can, and do, make both corporate DPAs and pleas available to the public. Prosecutors’ offices tend to issue press releases online when entering into both forms of settlement which include a link to the actual document. This information is in turn conveyed to interested outsiders through a wide range of channels, including law firm client memos, blogs, internal company reports, and the media. Information in pleas also could be more salient if pleas received more media coverage. A firm might then expect a higher cost of reputational damage from the greater release of adverse information about the firm contained in a settlement agreement if it pleads guilty, instead of settling through a DPA. Yet this does not appear to be the case. Media coverage of criminal settlements appears to depend primarily on the public profile of the offending firm and offense. Criminal settlements involving national and multinational corporations for offenses of concern to the public receive substantial media attention even when they were resolved through DPAs—as evidenced by the media coverage of the DPAs involving JP Morgan Chase, HSBC, General Motors, and Toyota. In contrast, less (or no) coverage accompanied the release of news about guilty pleas for the economic crimes of such smaller companies as Four Seasons Property Services Inc. and Medex Ambulance Inc. This is the opposite of what would occur if the form of settlement were a reliable predictor of media coverage. For these reasons, differences in media coverage do not appear to provide a reason to expect a greater reaction by interested outsiders to a plea than a DPA, other things being equal.58 In addition, media coverage tends to treat both DPAs and pleas as criminal settlements, specifically discussing that the firm is being penalized for criminal misconduct or felony charges.59 In each case, the coverage tends to also identify the specific type of misconduct (e.g., money laundering) and the size of the penalty. While sophisticated outsiders may recognize that in some cases the “criminal” charges were resolved through a DPA instead of a plea, sophisticated outsiders can be expected to seek more information about future risk from the criminal settlement if they have material dealings with the firm—information that is not affected by the choice of settlement form. Thus, there appears to be no basis for concluding that the information conveyed through pleas is more salient. Corporate criminal settlements occur throughout any given year. Media coverage of them varies from one day to the next, and one case to the next,

57   Throughout this section, we use the phrase the risk of future misconduct to refer to the product of the chance of misconduct by the firm and the harm to interested outsiders from that misconduct. See supra Sections 3.1 and 3.2. 58   The similarity in media attention between cases settled as DPAs and pleas is most apparent in the cases that appear to be of particular concern to critics of DPAs: those involving large firms. 59   This can be seen in the New York Times coverage of the $1.7 billion penalty imposed on J.P. Morgan for misconduct relating to its dealings with Bernie Madoff. Ben Protess and Jessica Silver-Greenberg, JPMorgan Is Penalized $2 Billion Over Madoff, https://dealbook.nytimes. com/2014/01/07/jpmorgan-settles-with-federal-authorities-in-madoff-case/.

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112  Research handbook on corporate crime and financial misdealing for many reasons— other than the form of the settlement. Even recognizing that salience and its determinants is ultimately an empirical question, we have found in this instance no evidence to suggest that resolution through a DPA, in and of itself, mutes press attention to the settlement. Overall, the form of settlement does not, in and of itself, appear to affect the salience or reliability to interested outsiders of the information released by a criminal settlement agreement. While other features of these settlements, such as magnitude of the penalties, may lead interested outsiders to place more weight on the information in one settlement agreement than another, the form of settlement does not appear to be one of those reasons. 4.2 Prosecutorial Selection: Does Conviction Reveal Hidden Information about the Crime or Internal Governance Bearing on the Risk of Future Wrongdoing? Here we consider whether interested outsiders could reasonably view resolution through a guilty plea as signaling that the prosecutor has information that the firm has an enhanced risk of causing future harm (prosecutorial selection hypothesis). Pleas are likely to produce higher costs of reputational damage through this information channel only if the considerations that drive prosecutors to insist on a guilty plea are the same as the set of factors that bear on the future risk of harm to interested outsiders, as identified in Section 3. Contrary to this hypothesis, we conclude in this sub-section that the choice of plea does not signal the risk of future harm from the firm because the considerations determining prosecutors’ choice of settlement form are not the same as those that affect the interested outsider’s expected risk of future harm from the firm. This is based on our evaluation of the federal enforcement policy and the considerations that would be most salient to a rational prosecutor’s choice of settlement form, assuming prosecutors seek to resolve the case, with appropriate sanctions, without incurring excessive direct or indirect costs. We first identify the conditions that must be met for the prosecutor selection hypothesis to hold. We next identify the range of considerations that could influence prosecutors’ decisions to seek a guilty plea. We then identify the subset of considerations that outsiders would expect to have the greatest influence on the prosecutor’s choice of settlement form, assuming that prosecutors’ offices aim to resolve corporate cases, with appropriate ­sanctions, without incurring excessive direct or indirect costs (hereinafter “focal factors”).60 Focusing on these focal factors, we next observe that prosecutors can regularly have private information, beyond what is disclosed by the criminal settlement, about each of these factors—information that may be signaled by the prosecutors’ choice of settlement form. We conclude that this signal should not affect the reactions of interested outsiders because the factors that determine the form of settlement do not reliably determine the firm’s risk of future misconduct. Finally, we consider how prosecutors’ announced use of mandated reforms to deter

60   See supra note 50. We focus on the prosecutors’ decision under the assumption that the bargain managers can reach in return for settling rather than going to trial depends on whether the prosecutor is inclined to insist on a guilty plea.

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Does conviction matter?  113 future misconduct may affect interested outsiders’ reactions in ways that are ­inconsistent with the prosecutor selection hypothesis. This can occur in either of two plausible circumstances. First, if interested outsiders expect prosecutors to impose mandates when the firm presents a heightened risk of harm, but do not expect them to be effective, then interested outsiders should draw their inference about the firm’s future risk of harm from the prosecutors’ decision whether to impose a mandate—and not the choice of settlement  form. Alternatively, interested outsiders who observe mandates that they expect to be effective at reducing future risk may conclude that the settling firm presents a low risk of harm, regardless of any negative information about the firm prior to the settlement. 4.2.1  Prosecutorial selection: necessary conditions The prosecutor selection hypothesis applies only if interested outsiders treat a prosecutor’s decision to settle through a plea instead of a DPA as evidence that the firm has an enhanced risk of harming them through a future offense. Such an inference is plausible only if the following conditions are met. First, interested outsiders must know (or be able to infer) the set of factors that consistently lead a case to settle through a guilty plea instead of a DPA (hereinafter “focal factors”). Second, prosecutors’ assessment of these focal factors must depend in part on information that is not fully disclosed in the criminal settlement document.61 In addition, interested outsiders must be able to infer when the prosecutor’s choice is not fully explained by her public statements about the considerations favoring a plea.62 Third, the considerations that lead prosecutors to seek a guilty plea must reliably indicate that the firm has a relatively higher risk of causing future harm to interested outsiders (see Section 3 supra). The situation where a plea may signal hidden information about such risk is illustrated in Figure 4.2. When these considerations are met, interested outsiders can infer from the prosecutors’ insistence on settling through a guilty plea that the available information, as of the time of the criminal settlement, led the prosecutor to anticipate an enhanced risk of future misconduct by the firm. This could lead them to be less willing to deal with a firm that pled guilty than one that entered into a DPA with otherwise identical terms. 4.2.2  Candidate factors potentially affecting prosecutors’ choices Prosecutors’ decisions to convict are potentially affected by two types of considerations. The first are those that are set forth in the United States Attorneys’ Manual, Principles 61   If, by contrast, all information affecting the prosecutor’s choice was fully disclosed in a settlement document, outsiders would not alter their expectations about the firm’s future risk of harm based on the prosecutor’s choice of settlement form because the prosecutor’s choice would not reveal any information not fully disclosed by the settlement itself. 62   Interested outsiders cannot obtain a reliable signal of prosecutors’ hidden information when all publicly disclosed information favors a single choice: the choice the prosecutor made. This circumstance could arise if: (1) the prosecutor had additional hidden information that reveals the firm is even riskier than disclosed; (2) the prosecutor had no hidden information; (3) the prosecutor had hidden information favoring the other choice unrelated to the risk of future harm; or (4) the prosecutor had hidden information favoring the other choice that was unrelated to the risk of future harm. Absent a divergence between the information revealed and the choice made, it is difficult for interested outsiders to infer the type of hidden information observed by prosecutors.

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114  Research handbook on corporate crime and financial misdealing

Indicators of high risk of crime

Federal policy & prosecutors’ objectives

Factors that favor a plea

Inference of high risk

Prosecutor observes hidden information

Guilty plea

DPA

Figure 4.2 Prosecutor selection hypothesis: situation where the prosecutor’s choice is a ipsum signal of theLorem expected risk of future harm of Federal Prosecution of Business Organizations (the “Principles”).63 The second are considerations relating to the effect of a plea on the ability of the prosecutors’ office to achieve an assumed central aim: which is to resolve corporate criminal cases imposing appropriate sanctions and mandates without imposing excessive costs, as explained below (hereinafter the efficiency objective).64 Most corporate criminal settlements are governed by the Principles of Federal

63   U.S. Attorneys’ Manual, 9-28.000: https://www.justice.gov/usam/usam-9-28000-principlesfederal-pro​secution-business-organizations.   Federal prosecutors negotiating corporate criminal settlements are governed by ten factors set forth in the Principles of Federal Prosecution of Business Organizations contained in the U.S. Attorneys’ Manual. Certain divisions in the Department of Justice, such as Antitrust, Environmental, and Tax have their own policies governing the application of the USAM principles to corporate prosecutions. For example, the Antitrust Division has a policy of reserving corporate leniency (e.g., DPAs and NPAs) for the first member of a cartel to self-report (https://www.justice. gov/atr/page/file/926521). Our analysis excludes from consideration those areas where the enforcement action would not tend to cause the firm to sustain a cost of reputational damage, regardless of the form of settlement, such as antitrust, environmental, and tax offenses (see supra Section 3). We consider the application of the USAM factors in those areas where the criminal settlement can be expected to trigger costly reputational damage, and where the form of settlement could thus potentially affect that cost, such as fraud. 64   See supra note 50. Prosecutors may face incentives to structure current settlements to send signals to firms that prosecutors hope can benefit them in future cases, especially in offices that regularly enter into corporate settlements. In particular, they may consider the incentives they provide to corporations to self-report and fully cooperate by a systematic practice of using different settlement forms for firms that self-report or cooperate and those that do not. See, e.g., U.S. Attorneys’ Manual 9-47.120, FCPA Corporate Enforcement Policy (2017) (hereinafter FCPA Enforcement Policy) https://www.justice.gov/usam/usam-9-47000-foreign-corrupt-practices-act-1977#9-47.120.

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Does conviction matter?  115 Prosecution of Business Organizations contained in the U.S. Attorneys’ Manual (USAM). The Principles provide a public statement of factors that prosecutors should consider when deciding whether to convict or enter into a DPA, and thus reveal to interested outsiders many of the considerations that influence prosecutors’ choices. Prosecutors will often have hidden information relating to some of these considerations. The Principles sets forth ten factors that prosecutors generally should consider when deciding whether to convict (9-28.300). These ten factors are: (1) The nature and seriousness of the offense, including the harm to the public; (2) the pervasiveness of the wrong­ doing within the firm, and management complicity in perpetrating or condoning the crime; (3) the corporation’s history of similar misconduct; (4) the quality of the compliance program at the time of the misconduct; (5) the firm’s timely and voluntary disclosure of wrongdoing; (6) the firm’s remedial actions, including compliance program reform, actions against individuals, and restitution; (7) corporate cooperation; (8) whether agencies’ regulations provide that conviction for the offense triggers mandatory or permissive debarment or delicensing, and thereby impose disproportionate harm on shareholders, employees, customers, pensioners or others who were not personally culpable; (9) the adequacy of other remedies, such as civil or regulatory enforcement actions; and (10) the adequacy of individual prosecutions. Prosecutors tend to make public statements in the criminal settlement agreements and accompanying disclosures about their conclusions with respect to the USAM factors.65 Yet those statements often do not reveal all the material information observed by prosecutors about the USAM factors and other factors influencing their choice. For example, prosecutors may mention collateral sanctions (such as exclusion) but often do not disclose the full range and magnitude of those collateral sanctions both in the U.S. and abroad that could be triggered by conviction immediately or in the future. In addition, prosecutors tend to make summary statements that the firm did or did not fully cooperate, without going into detail about the genuineness and fullness of the cooperation.66 Hidden information on

65   Prosecutors reveal their conclusions regarding the USAM factors both in the course of discussing the choice of resolution and also when presenting criminal fine calculations under the U.S. Sentencing Guidelines Governing Organizations. 66   Criminal settlement agreements generally state if a conviction would trigger exclusion by a federal agency. Yet the magnitude of the impact on the firm of exclusion generally is not disclosed. Agreements also do not tend to discuss the firm’s statements regarding the potential threat to it of debarment or delicensing by foreign government authorities, now or in the future.   Similarly, statements that misconduct was widespread tend to exclude discussion of detected but uncharged misconduct. They also regularly include conclusory statements about whether the firm had “an effective compliance program,” without revealing the underlying factual bases for, and the degree of the prosecutor’s conviction in, that conclusion.   In addition, prosecutors’ decisions often are influenced by two other types of hidden information. First, in situations where the ten USAM factors do not all favor the same choice, the decision to convict will depend on an additional consideration: the identity of the subset of factor(s) that this prosecutor considers most important in deciding which form of criminal settlement to seek. The prosecutor’s personal weighting of the various factors matters because the USAM gives prosecutors discretion to determine which USAM factors to accord the most weight when deciding whether to convict. As a result, a prosecutor can employ a DPA even when all but one of the USAM factors favor conviction if the factor is one the prosecutor considers to be outcome-determinative (e.g., self-reporting or collateral consequences).

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116  Research handbook on corporate crime and financial misdealing USAM factors favoring a guilty plea thus may be signaled by a prosecutor’s choice to seek a guilty plea in a case where some USAM factors favor a plea whereas others do not.67 Although prosecutors’ decisions can be affected by hidden information bearing on the USAM factors, interested outsiders should only regard the choice of a plea as a signal of hidden information about the risk of future harm if they expect the considerations that influence the choice of settlement form to be reliable indicators of that risk. To assess this, we begin with the USAM. Some of the USAM factors—specifically USAM factors (1)–(6)—do bear on the risk of future misconduct. But, as will be explained in detail below (see infra 4.2.4), other factors that influence prosecutor choice have nothing to do with the prospect of future misconduct. Accordingly, in order to assess the prosecutorial selection hypothesis, we must first identify the subset of USAM factors that influence the decision whether to encourage a guilty plea instead of a DPA from a firm that is inclined to settle, and then determine whether any of those factors have bearing on the risk of future harm. 4.2.3  Identifying prosecutors’ focal criteria Prosecutors have discretion to decide how to weigh the various USAM factors. This includes authority to focus on a subset of factors. They also are explicitly authorized by the USAM to take into account considerations beyond the ten expressly listed factors.68 The objectives of federal prosecutors, when entering into a corporate criminal settle67   In some situations, the settlement document may fully reveal that all ten USAM factors favor a particular choice, for example to require a conviction. In this instance, the decision to convict does not reveal anything new about the prosecutor’s private weighing of USAM factors. When all publicly available factors favor a particular choice, the prosecutor who selected that choice could have had (i) no additional hidden information, (ii) additional hidden information favoring the choice (that could be related or unrelated to the risk of harm), (iii) additional hidden information weighing against the choice that was unrelated to the risk of future harm, or (iv) additional hidden information weighing against the choice that was related to the risk of harm but which did not alter the outcome because the prosecutor placed little weight on that factor. As a result, when all the USAM factors point in the same direction, differences in the conditions leading to the selection of a plea versus a DPA should not lead to differences in the cost of reputational damage between the two forms of settlement.   Thus, the actual decision to use a plea should not affect the reputational damage cost imposed on a firm for a crime that would not trigger collateral penalties, involving many charges for misconduct by senior managers occurring over a long period of time, that was detected but not self-reported, and where the firm obstructed the prosecutors’ investigation instead of cooperating. Interested outsiders might be less willing to deal with such a firm, but their decision would be based on the negative facts disclosed in the criminal settlement and not on the prosecutors’ ultimate decision to convict in this instance. Nor can interested outsiders infer anything relevant to reputational damage costs from the fact that the prosecutor selected a settlement form consistent with the USAM factors and not contrary to them. When all USAM factors point in the same direction, a prosecutor would go the other way only if he chose to disclose information that is contrary to his choice and keep hidden the information that supports his choice. This is unlikely unless the prosecutor’s decision was predicated on factors (such as strategic factors) not listed in the USAM. These are not likely to indicate the firm’s risk of future misconduct. 68   U.S. Attorneys’ Manual, Principles of Federal Prosecution of Business Organizations, § 9-28.300 (comment b); see U.S. Attorneys’ Manual, Principles of Federal Prosecution of Business Organizations, § 9-28.900 (“Prosecutors have substantial latitude in determining when, whom, how, and even whether to prosecute for violations of federal criminal law. In exercising that discretion, prosecutors should consider the following statements of principles that summarize the consid-

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Does conviction matter?  117 ment include specific deterrence, general deterrence, and punishment. Prosecutors achieve these objectives by setting the terms of the settlement agreement—the charges, statements of fact, monetary sanctions and mandates. They can employ any of their preferred provisions in either a plea or a DPA (see supra Section 2). The efficiency of criminal settlement in achieving these objectives depends in part on the ability of prosecutors to efficiently detect misconduct and obtain the needed evidence to demonstrate that it occurred (Arlen and Kraakman 1997). It also depends on prosecutors’ ability to achieve an efficient settlement (e.g. in terms of litigation costs or the need for additional negotiations with outside agencies). In light of these considerations, prosecutors, given discretion, can be expected to focus on the considerations that enable them (and in turn the DOJ) to efficiently resolve corpor­ate criminal cases.69 That is, holding constant the charges, the monetary sanctions, statements of fact, and mandates contained in the criminal settlement agreement, a prosecutor considering the choice between a plea and a DPA can be expected to consider the direct and indirect costs to the prosecutors’ office, the DOJ, and the public of selecting one ­settlement form over another. As a result, a prosecutor can be expected to consider whether insistence on a guilty plea instead of a DPA would lead the firm to reject settlement or, alternatively, require the prosecutor to incur the added cost and delay of negotiating side deals with multiple agencies in order to enable the firm to plead guilty without the risk of collateral sanctions, such as debarment, and, in the extreme case, fear of financial ruin. Prosecutors may also consider the degree to which offering (or signaling a willingness to offer) a DPA could facilitate this particular settlement—and potentially future corporate criminal cases—by providing an incentive for the firm to self-report detected wrongdoing and/or to fully cooperate to enable the government to readily obtain evidence about the misconduct and those responsible that prosecutors often could not easily obtain otherwise (see Arlen and Kraakman 1997).70  Finally, prosecutors may consider whether a plea would inefficiently impose costs on the innocent third parties, such as customers. Thus, prosecutors seeking to achieve an efficient resolution can be expected to focus on three considerations: the potential threat to the firm and its customers of exclusion or delicensing, whether a firm that detected misconduct reported it or not, and the degree

erations they should weigh and the practices they should follow in discharging their prosecutorial responsibilities”). 69   The prosecutor might perceive the benefit and cost as accruing to the prosecutors’ office and/ or to the Department of Justice. The conclusions of this part apply independently of the prosecutor’s views on how the benefits and costs of the individual case resolution are distributed across the offices of the DOJ or between those offices, on the one hand, and outside parties, on the other. 70   The use of enforcement policy to incentivize self-reporting and cooperation promotes efficient settlement in two ways. First, prosecutors who individually expect to be repeat players in these types of cases would have an incentive to structure enforcement to signal to future firms that they will be better off if they self-report and fully cooperate. Second, prosecutors acting as loyal agents for the DOJ would have an incentive to take actions likely to lead future firms to self-report or cooperate with prosecutors in other offices immediately and in the future (see generally Arlen and Kraakman 1997). Consistent with this, the DOJ’s FCPA Enforcement Policy places particular emphasis on whether a firm self-reported. This can affect the type of resolution, magnitude of the fine and whether a monitor is imposed. See FCPA Enforcement Policy, supra note 64.

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118  Research handbook on corporate crime and financial misdealing to which the firm conducted a full investigation and cooperated with authorities, or, alternatively resisted the government’s efforts to obtain information. Interested outsiders would reasonably expect such a prosecutor to presumptively avoid a guilty plea for charges that would leave the firm vulnerable to mandatory or permissive exclusion or delicensing for several reasons. First, prosecutors interested in resolving the matter quickly should favor a DPA because corporations have strong incentives to resist settlement through a plea if it would trigger debarment or exclusion. Prosecutors thus may prefer DPAs under these circumstances as DPAs enable them to resolve the case more efficiently, without reducing either the sanctions prosecutors can impose or federal agencies’ ability to exclude a firm through their own processes if they so choose (see infra Section 5). Second, prosecutors acting as loyal agents of the DOJ should favor DPAs in these cases because the DOJ as a matter of policy has indicated a preference for settlement without conviction when conviction could trigger exclusion or delicensing that would harm innocent third parties, such as customers.71 Finally, prosecutors may prefer to avoid pleas that would trigger exclusion or delicensing that would harm innocent customers. As a result of these considerations, the outsider would not expect a prosecutor to insist on a plea in a case likely to trigger exclusion or delicensing unless there is known to be an offsetting policy goal (such as to sanction a firm that impeded an investigation).72 In most other cases, prosecutors may be able to achieve their enforcement objectives by incorporating the appropriate provisions on monetary sanctions and mandates into a DPA. Overall, prosecutors presented with a firm that would be threatened by collateral consequences appear to have strong incentives to use a DPA.73 Prosecutors also can be expected to employ DPAs with firms that self-reported, fully 71   In discussing collateral consequences (USAM 9-28.1100), the USAM lists a range of collateral consequences (including harm to employees, investors, pensioners, and customers), but singles out as a collateral consequence of settlement—such as debarment and exclusion—harm to innocent third parties, such as customers, as a consideration favoring “a non-prosecution or deferred prosecution agreement with conditions designed, among other things, to promote compliance with applicable law and to prevent recidivism . . . [because o]btaining a conviction may produce a result that seriously harms innocent third parties who played no role in the criminal conduct.” The DOJ notes that a DPA in this situation can “help restore the integrity of a company’s operations, . . . preserve the financial viability of a corporation that has engaged in criminal conduct, . . . [preserve] the government’s ability to prosecute a recalcitrant corporation that materially breaches the agreement, [and potentially provide] prompt restitution for victims.” 72   Even in this situation, the benefit of using the plea to achieve the offsetting policy goal would need to exceed the added costs to the prosecutor (of the adjustments needed to employ a plea without triggering federal exclusion or delicensing) that include the costs of time and attention that is required to negotiate with the relevant federal, state and foreigner government authorities to obtain a waiver of exclusion or delicensing, if possible, or alter the charges to avoid the collateral sanctions (as discussed in Section 5). 73   Indeed, the General Accountability Office (GAO) in 2009 examined DPAs and observed that collateral penalties are a central consideration in determining whether a firm gets a DPA (see U.S. General Accountability Office (2009), identifying collateral consequences as a central consideration in the decision to impose DPAs). Alexander and Cohen provide evidence that is consistent with this observation. To the extent that plea agreements with parent corporations expose more business units of the firm to U.S. collateral sanctions than do plea agreements with their subsidiaries (which may be foreign), we would expect prosecutors to be relatively more inclined to use DPAs to resolve cases with parent corporations. Alexander and Cohen find that the majority of DPAs and NPAs

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Does conviction matter?  119 cooperated and remediated, as well as with firms that failed to self-detect but later provided genuine full cooperation and remediated. The DOJ highlighted the separate and distinctive importance of self-reporting and cooperation when it revised the Principles in 2015 specifically to treat self-reporting and full cooperation as independent factors. It further highlighted its focus on self-reporting and full cooperation in the FCPA Pilot Program adopted by the Fraud Section in April, 2016,74 that is now incorporated into the USAM provisions governing FCPA cases. These provisions effectively create a presumption against convicting firms that self-report, fully cooperate, and remediate. Such a presumption incentivizes firms to self-report and cooperate. Self-reporting and cooperation saves the DOJ resources that it could otherwise devote to detection and investigation. Efforts to encourage these activities would be undermined were prosecutors to regularly require firms that self-report and cooperate to plead guilty (Arlen and Kraakman 1997; Arlen 2012a). In turn, the DOJ has encouraged the use of guilty pleas against firms that resist full cooperation, especially if they impede the government’s investigation. To obtain pleas in such cases, prosecutors have been willing to negotiate with multiple agencies to obtain waivers of exclusion and debarment, apparently concluding that the message to future corporate defendants warrants the added cost of these negotiations.75 Thus, an interested outsider can be expected to conclude that the three most important factors in determining whether a prosecutor prefers a DPA are whether a plea would trigger exclusion or delicensing, whether the firm self-reported, and whether the firm fully cooperated, on the one hand, or resisted the government’s efforts to investigate the crime, on the other. In cases where the use of a DPA or a plea appears to be consistent with these considerations, we expect interested outsiders to conclude that prosecutors focused on these considerations, including any hidden information about the fullness of the self-reporting or cooperation and the extent of the threat of exclusion or delicensing. Of course, there are cases where the choice of settlement form does not appear to be explained by the three considerations discussed above. Yet even here a reasonable interested outsider would be unlikely to assume that the choice of settlement form was based on the firm’s risk of future misconduct and related harms. First, the decision may reflect

(52% and 76% respectively) involve a parent company, while only 41% of plea agreements involve parent companies (Alexander and Cohen 2015, p. 580). 74   FCPA Enforcement Policy, supra note 64. 75   For example, in announcing the first two guilty pleas against financial institutions, DOJ officials explicitly cited the firm’s failure to cooperate as a reason for the plea. The press release announcing the conviction of BNP Paribas quoted the Deputy Attorney General: “BNP ignored US sanctions laws and concealed its tracks. And when contacted by law enforcement it chose not to fully cooperate . . . This failure to cooperate had a real effect – it significantly impacted the government’s ability to bring charges against responsible individuals, sanctioned entities and satellite banks. This failure together with BNP’s prolonged misconduct mandated the criminal plea and the nearly $9 billion penalty that we are announcing today” (https://www.justice.gov/opa/pr/ bnp-paribas-agrees-plead-guilty-and-pay-89-billion-illegally-processing-financial).   Credit Suisse was also required to plead guilty for conspiracy and aiding and abetting U.S. ­taxpayers in tax evasion. The misconduct included failing to provide accurate information to federal authorities. In the plea, the firm got no credit for self-reporting or cooperating (https:// www.justice.gov/iso/opa/resources/6862014519191516948022.pdf).

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120  Research handbook on corporate crime and financial misdealing either the prosecutor’s idiosyncratic views on the importance of guilty pleas, on the one hand,76 or her willingness to offer a DPA in exchange for some other concession, on the other. It could also depend on undisclosed considerations that do not bear on the firm’s future risk of harm: for example, a prosecutor might prefer a plea for a crime that caused death or seriously bodily injury if she could convict the firm without harming innocent customers. Finally, the choice might depend on considerations that are fully disclosed in the agreement. Given how many considerations could plausibly lead a prosecutor to make a decision contrary to expectations, the likelihood of interested outsiders deriving a reliable signal from the choice to use a plea appears to be low. 4.2.4 Do the focal considerations signal hidden information about the risk of future harm Having assessed the three considerations likely to determine a prosecutor’s choice of ­settlement form, we now consider whether an interested outsider would likely interpret a prosecutor’s selection of a plea based on these criteria to be a reliable signal of heightened risk of future harm. Prosecutors’ choices can convey undisclosed information about these three factors even though prosecutors often include explicit statements about the USAM factors and reasons they selected a particular settlement form in the agreement or press release. These public statements do not reveal all the information that may have affected the choice because the statements are often summary conclusions and incomplete. For example, prosecutors tend to disclose that a firm “self-reported” or “cooperated” without disclosing all the information known to the prosecutor bearing on the timing, completeness, and managerial support for these undertakings—considerations that may well affect the choice of settlement form. Nor do statements about collateral consequences disclose all information relied on by the prosecutors on the expected cost to the firm of any delicensing or exclusion that could be triggered by a plea to the charges the prosecutor considers appropriate.77 Yet any information about the three focal considerations signaled by the prosecutor’s choice of settlement form should not affect a firm’s cost of reputational damage because there is no reason to believe that these three factors, individually or jointly, are reliable indicators of the risk of future harm from the firm. Consider first the potential threat of corporate delicensing or exclusion. Although administrative agencies tend to have discretion not to exclude or delicense a convicted firm even when a conviction could trigger these collateral sanctions, firms would reasonably resist pleas that could trigger exclusion or debarment because the decision whether to accept a plea is typically made before the agency has indicated whether it would exclude or delicense the firm if convicted. Accordingly, firms, and thus prosecutors, can be expected to predicate their bargaining position on whether, under the law, conviction on a particular set of charges could trigger exclusion or delicensing even if the agency probably would not exclude the firm if convicted because it has a low risk of future harm 76   See GAO Report (U.S. General Accountability Office 2009), finding that many U.S. Attorneys’ Offices never entered into DPAs whereas a subset used them regularly. 77   For example, prosecutors tend not to disclose in the settlement agreement either their personal views on the appropriateness of using DPAs or their assessment of senior management’s culpability or the chance of a future offense.

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Does conviction matter?  121 (see infra Section 5). Thus, in considering collateral consequences, prosecutors will focus on considerations relating to the consequences of exclusion even when the probability of exclusion is low. Examples include: whether and, if so, the extent to which, the firm sells goods or services under the authority of a federal, state, or local agency with exclusion authority; the number of potential agencies implicated; whether conviction would trigger mandatory or permissive exclusion; and the agencies’ policies and practices governing exemptions from exclusion, including the agencies’ willingness to waive exclusion ex ante, before the criminal settlement is finalized. Prosecutors may also predicate their choices on corporate self-reporting. Although a credible commitment to self-report can deter misconduct (Arlen and Kraakman 1997), a specific instance of self-reporting may not signal that a firm has a low risk of future misconduct. A self-reporting firm might self-report, notwithstanding an internal policy against doing so, because it concluded that detection was imminent. Alternatively, a firm that is committed to legal compliance nevertheless may decide not to self-report detected misconduct because, under existing enforcement policy, a corporation’s expected criminal liability may be higher if it self-reports than if it does not (Arlen and Kraakman 1997; Arlen 2012b).78 Because self-reporting enables the government to sanction the firm for misconduct that might have escaped detection, firms have a good reason not to selfreport if the expected improvement in settlement terms they obtain from self-reporting is not substantially greater than the improvements associated with full cooperation and remediation alone (Arlen and Kraakman 1997; see Arlen 1994).79 A firm might conclude it would not obtain a sufficient benefit from self-reporting if it does not otherwise expect the crime to be detected, and further expects that, upon detection, the prosecutor would enter into a DPA in return for full cooperation (even if it does not self-report). In addition, large firms that self-report obtain a relatively small percentage reduction in their fine under the Organizational Sentencing Guidelines, relative to what they can get by cooperating alone (Arlen 2012b).80 Finally, firms operating overseas may be deterred from self-reporting to the U.S. authorities if self-reporting could trigger enforcement actions overseas in a country that does not provide any leniency for self-reporting. Consequently, a firm may fail to self-report for the simple reason that doing so would increase its excepted costs, even though it is committed to deterring misconduct and thus has a low probability of future misconduct. Thus, under existing policy, signals sent by prosecutorial decisions predicated on corporate self-reporting do not systematically bear on the interested outsider’s risk of future harm from the firm. 78   An optimal enforcement policy would ensure that firms have a strong incentive to self-report and fully cooperate. In this case, a firm that self-reports is likely to do so in the future, creating expectations of a heightened risk of detection that deters employees from future crime (Arlen 1994; Arlen and Kraakman 1997). Existing enforcement policy does not reliably ensure that firms are better off if they self-report and cooperate (Arlen 2017). 79   Moreover, the firm will only self-report and cooperate if the benefit of the additional reduction in expected sanctions for self-reporting, relative to the expected sanctions for full cooperation, exceed the cost to it of reporting a crime that might have gone undetected (Arlen 2012b). 80   Indeed, the disincentive to self-report is particularly great for large firms operating in many countries. Large firms can rely on no more than a 50 percent reduction in their fine relative to the fine if they cooperated but failed to self-report under both the Organizational Sentencing Guidelines (Arlen 2012b, at p. 348) and the FCPA Enforcement Policy, supra note 64.

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122  Research handbook on corporate crime and financial misdealing Finally, prosecutors’ hidden information about corporate cooperation—and ­ on-cooperation—also does not reliably signal the firm’s future risk of harm. While it n is likely that some firms fail to cooperate because management is not committed to legal compliance, more generally it appears that firms decide whether to cooperate or not for reasons that are independent of their risk of causing future harm to interested outsiders. Anecdotal evidence suggests that U.S. firms with U.S. counsel generally cooperate— independent of future risk—in order to obtain a DPA and other benefits. The anecdotal evidence is that the firms that fail to cooperate fully and in a timely way often are foreign firms which are either unaccustomed to cooperating with government investigators, or are constrained by laws in their country of origin against providing the access to employees, emails, and internal data required by U.S. prosecutors (see Garrett 2011, finding that foreign firms are more likely to be convicted).81 Accordingly, we conclude that the criteria relied on by prosecutors when determining whether to insist on a guilty plea do not indicate a heightened risk of future harm. That is, interested outsiders who observe that a case was settled through a plea may infer hidden information about the risk of debarment or exclusion, or the value of the firm’s self-reporting and cooperation, but will not derive a signal about hidden information that reliably indicates that the firm presents a higher risk of future harm to interested outsiders, as illustrated in Figure 4.3.82 4.2.5  Dynamic considerations: impact of reforms Finally, corporate reforms undertaken during, or mandated by, the settlement process may affect interested outsiders’ beliefs about the risk of future harm from the firm. Both DPAs and guilty pleas are accompanied by the release of information about voluntary and mandated reforms that are ostensibly undertaken to reduce the risk of future misconduct (see supra sub-sections 2.3 and 3.4.2). Criminal settlements regularly disclose voluntary reforms, such as changes to the firm’s compliance program and changes in management. Prosecutors also regularly (and in the case of DPAs, usually) use criminal settlements to mandate reforms beyond those undertaken voluntarily (see Alexander 1999; Arlen and Kahan 2017; Alexander and Cohen 2015). These mandates include detailed and prescriptive reforms of the firm’s compliance program, additional internal oversight requirements for certain contracts, and limitations on certain types of contracts or lines of business that present a heightened risk of misconduct. In addition, 81   For example, the management of the firm might not provide U.S. prosecutors with the full results of their own investigation if they are unaccustomed to the U.S. approach to corporate investigations, or are governed by foreign laws (or subject to instructions from foreign enforcers) that limit their ability to fully cooperate. 82   Of course, not all cases are driven by these factors. Yet even in these cases the prosecutorial selection hypothesis generally will not hold. So many considerations can affect the choice of settlement form—including prosecutors’ personal preferences—that interested outsiders are unlikely to be able to reliably infer which factors determined a choice not explained by the three focal factors. Moreover, even if they can, many considerations likely to impact prosecutors’ choice, such as the magnitude of the publicly disclosed harm or the difficulty of obtaining evidence—either are fully disclosed in the settlement document or do not indicate a higher risk of future harm. See also supra note 67 (explaining why the prosecutors’ choice does not signal private information when all candidate factors favor the choice the prosecutor made).

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Does conviction matter?  123

Indicators of high risk of crime

Few collateral consequences

Inference of low collateral cons

equences

Federal policy & prosecutors’ objectives

Factors that favor a plea

Prosecutor observes hidden information

Inference of few collateral consequences

Guilty plea

DPA

Figure 4.3  Prosecutors’ choices based on factors other than risk of future harm

the settlement agreement may compel the firm to incur the costs of appointing and maintaining an external monitor (Khanna and Dickinson 2007; Alexander and Cohen 2015; Arlen and Kahan 2017).83 These mandates undermine the prosecutorial selection hypothesis in either of two situations, depending on interested outsiders’ beliefs about why they are imposed and their likely effect. Consider first interested outsiders who believe that prosecutors impose certain types of mandates, such as monitors, when they have information indicating that the firm presents a higher risk of future misconduct. In this situation, a prosecutor’s choice of mandate should provide a stronger signal about the prosecutor’s undisclosed information about the firm’s future risk of harm than her choice of whether to settle through a DPA or a plea. Interested outsiders can be expected to predicate their responses to the criminal settlement on the decision whether to impose a significant mandate, such as a monitor, rather than on the choice of settlement form, especially since the latter tends to be determined by factors uncorrelated with the risk of harm, as we have seen. Alternatively, interested outsiders may believe that certain types of mandates—for

83   While modern criminal settlement agreements now regularly include an explicit discussion of voluntary and mandated reforms, the practice of announcing governance reforms at the news of corporate crime is not new. In her study of reputational damage costs following criminal and civil settlements for corporate fraud prior to 1999, Alexander found that 40 percent of the companies announced new training, audit, and monitoring programs, as well as other reputation-rebuilding actions (Alexander 1999, at p. 514, Table 4). More recent studies have documented the presence of similar undertakings as mandates in DPAs (Arlen and Kahan 2017).

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124  Research handbook on corporate crime and financial misdealing example external monitors—are effective at deterring misconduct. Criminal settlement agreements that contain credible statements about apparently effective reforms may lead interested outsiders to conclude that the conditions that led to the past offense will not be present going forward. In this case, outsiders may not expect an enhanced risk of harm from a firm that entered into a guilty plea—even if the outsiders received a strong signal that the firm had an enhanced risk of future harm at the time of the crime—if the plea agreement imposed a set of mandates that outsiders expect to be effective at deterring misconduct. Indeed, if voluntary and mandated reforms produce firms with effective internal governance, interested outsiders might well expect less risk of harm from such firms than from the average firm. For these reasons, under plausible assumptions about how interested outsiders respond to reforms, the prosecutor’s preference for encouraging reforms or imposing reform mandates would not cause her use of a plea to be a reliable signal of the risk of future harm to the interested outsider. This is regardless of whether the reforms and mandates are themselves effective in preventing future misconduct. 4.3  Management Selection: Does Conviction Reveal Agency Problems in the Firm? The management of the firm negotiates the settlement with the prosecutor in coordination with the firm’s other agents, such as lawyers and the board of directors. Interested outsiders thus may derive a signal about management’s hidden information from the chosen form of settlement. We therefore consider whether use of a guilty plea instead of a DPA could reasonably be interpreted by interested outsiders as a signal that management has information that the firm has an enhanced risk of harm from a future offense (Managerial Selection Hypothesis).84 First, management may have hidden information about either the misconduct or the firm that has bearing on the expected payoff to the firm of entering into a guilty plea versus going to trial. For example, even when there is no risk of exclusion by federal agencies, management may prefer a DPA based on insider knowledge of the cost to the firm of potential collateral sanctions imposed by state or foreign government agencies.85 They also may have hidden information about the firm’s ability to withstand either a protracted settlement negotiation or the costs and risk of going to trial. Each of these types of information can be expected to influence management’s willingness to accept or resist a guilty plea. Yet these factors do not appear to be related to the risk of harm from a future offense, and thus decisions based on these

84   Managers can influence the outcome in two ways: directly through their stance during the negotiation and indirectly through decisions they make regarding compliance, investigation, selfreporting, and remediation. We focus on the former because managers’ pre-negotiation actions are only relevant if those actions tend to affect the prosecutors’ decisions to pursue a conviction or a DPA in ways that indicate a heightened risk of future wrongdoing. Were this the case, we would expect the Prosecutor Selection Hypothesis to apply. 85   They also may have information about the likelihood that the firm would expand into new jurisdictions in the future in which a past conviction could preclude the firm from engaging in profitable lines of business.

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Does conviction matter?  125 considerations should not affect the interested outsiders’ expected risk of future harm from dealing with the firm. Second, interested outsiders might view the decision to accept a guilty plea as providing a negative signal about the management of the firm. This could occur if interested outsiders expect management to cause the firm to enter into a plea instead of a DPA in return for private gain in the form of insulation from individual prosecution.86 Settlements that sacrifice shareholder interests for such private gain could signal the presence of weak internal governance and agency problems within the firm that an outsider may associate with a heightened the risk of future misconduct by the firm.87 Separately, such settlements could signal weak internal governance within the DOJ as such settlements would allow the culprits to escape punishment in order to enable prosecutors to obtain a corporate guilty plea. If these settlements occurred regularly, then pleas could lead firms to bear higher costs from reputational damage by signaling that managers were complicit but avoided sanction by having the firm plead guilty, and now remain at the firm, potentially willing and able to violate the law with sanctions imposed on organizations but not on individuals.88 Although it is possible that managers occasionally protect themselves at the firm’s expense, we conclude, based on examining cases of corporate misconduct and the standard bargaining process that produces a corporate criminal settlement, that interested outsiders, aware of this process, are unlikely to view a guilty plea as a reliable signal that the firm is managed by individuals who are complicit in, able to avoid, but still willing to commit, misconduct, for two reasons. First, many criminal settlements are for offenses that do not implicate senior management. Bribery of foreign officials, for example, rarely involves managers in the executive suite. Members of senior management who are not implicated in the offense have no reason to accept a corporate guilty plea for private gain. In these instances, a plea does not produce a plausible signal that management has a high risk of committing misconduct. Second, when management is implicated in the crime, they generally should be unable to obtain a settlement that protects themselves at the expense of the firm. In this situation, boards of directors generally delegate oversight of the investigation and the settlement negotiations to a committee of independent directors. This committee has little reason to accept a guilty plea to protect senior management, particularly in light of the potential

86   In 2015, the Department of Justice formally adopted a policy designed to discourage this practice. See the Yates Memo, supra note 7. It is difficult to determine the extent to which these types of settlement have occurred. First, individual convictions often follow corporate criminal ­settlements, instead of being resolved contemporaneously. Second, in cases where the wrongdoer lives overseas, the individual may be prosecuted by a foreign justification. Nevertheless, if one examines DPAs entered into before the Yates Memo one does find some agreements with provisions stating that no individual convictions will follow. 87   See, e.g., Macey (1991), Arlen and Carney (1992), Alexander and Cohen (1992, 1996). 88   As with prosecutorial selection, the Managerial Selection Hypothesis holds only if three conditions must be met: first, the manager’s decision whether to accept a plea must depend on hidden information; second, interested outsiders can predict the factors that would lead management to accept a conviction instead of a DPA; and third, the factors likely to lead to a guilty plea also indicate a heightened risk of future wrongdoing.

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126  Research handbook on corporate crime and financial misdealing threat of personal liability should they so act in bad faith.89 In addition, under DOJ policy, prosecutors generally should neither offer nor accept a guilty plea in return for insulating individuals. Indeed, a memo issued by Deputy Attorney General Eric Holder in 1999 specifically mentioned the importance of individual prosecutions. A subsequent memo, issued by then Deputy Attorney General Sally Yates in 2015 clearly stated that prosecutors should seek individual prosecutions whenever possible, and required them to justify any corporate conviction that is not accompanied by charges against the individuals responsible for the crime. Prosecutors thus should be resistant to any effort by senior management to sacrifice the interests of the firm to protect themselves and subject the firm to the resulting costs. As a result, when a firm accepts a guilty plea, it is unlikely to lead interested outsiders to conclude that the firm has a high risk of future harm because its senior management was complicit in the crime and had sufficient influence to use the corporate settlement to escape punishment. Finally, from a policy perspective, even if implicated managers were able to cause the firm to plead guilty in order to protect themselves, this would not justify a policy favoring guilty pleas as a means of adding a cost from reputational damage to the sanction. Managerial Selection enhances the cost of reputational damage only if guilty pleas reliably signal that the settlement is being used to insulate culpable management from prosecution. This source of reputational damage costs would hardly be an argument favoring pleas because deterrence is undermined by corporate convictions that insulate the individuals responsible for the crime from prosecution (Arlen 1994; Arlen and Kraakman 1997). Thus, to the extent that pleas impose enhanced costs of reputational damage through this channel, the public interest would be better served by strengthening, rather than weakening, the tendency to use DPAs rather than plea agreements. 4.4 Summary: What Can Outsiders Learn from Conviction about their Risk of Future Harm? Outsiders can obtain information about a firm’s risk of causing them future harm from the contents of the settlement agreement and the related public statements of the prosecutor and the firm that accompany its release. We conclude in this section that outsiders are not likely to gain information about the firm’s risk of future misconduct from the choice of settlement form—from the use of a plea instead of a DPA. Accordingly, the decision 89   Corporations not only often delegate oversight of criminal investigations and settlements to a committee of independent directors, but also regularly authorize the independent committee to hire its own counsel. The committee’s express objective is to act in the best interests of the firm. The committee should resist a guilty plea unless the total cost to the firm of the settlement offered involving a plea is less than the total cost to the firm of the settlement offered through a DPA. Boards that allow a corporate conviction in order to protect individual managers could be subject to personal liability imposed through a shareholder derivative suit (see Stone v. Ritter, 911 A.2d 352 (Del. 2006)) (directors can be liable if they intentionally fail to act in the best interests of the firm). Finally, in situations where a plea could trigger substantial collateral sanctions, the senior managers and directors who are not implicated in the crime have a private incentive to resist any effort to have the firm accept a plea in order to insulate the wrongdoers because, under the assumption that the plea would limit the business prospects of the firm, it also would limit the business prospects of the firm’s management as such.

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Does conviction matter?  127 to resolve a case through a plea instead of a DPA is not likely to influence the cost of reputational damage to an offending firm, all other things being equal. We reach this conclusion after identifying and considering three possible ways in which the form of settlement conviction might affect interested outsiders’ beliefs about dealing with a firm in the future: direct revelation, prosecutorial selection, and management selection.90 We do not find support for any of these hypotheses. Rather than looking to the form of settlement, we expect interested outsiders to focus on the probative information available at the time they learn the form of settlement: the information released by the agreement about the offense, the offender’s relation to the offense, the sanctions, reforms, and any mandates imposed.91 Thus, there is nothing intrinsically more stigmatizing about a corporate conviction given existing federal enforcement policy, if stigma is measured in terms of the reputational damage cost to the firm. This conclusion begs the question of why firms appear to care about whether they are convicted. Firms do not necessarily always care, especially if the plea involves only misdemeanor charges. When they do care, it appears that the primary factor that motivates firms to resist a plea is if conviction could trigger collateral penalties in the United States or in other countries that could reduce the firm’s expected profits. Firms’ preferences for DPAs may thus derive from concerns about collateral consequences that could be imposed immediately or in the future. For example, a firm may face a risk of being blocked from pursuing future business in a new jurisdiction that refuses to license or do business with firms that have prior convictions. As a result, such a firm might avoid conviction as a means of preserving such future business opportunities, all else being equal, even in the absence of any U.S. collateral sanctions. This concern is distinct from a concern that a conviction would trigger costs from reputational damage through the channels evaluated in this section. Of course, some forms of collateral penalties—such as those imposed by many independent federal agencies—are a form of reputational damage cost. They are the process through which federal agencies may protect themselves, or the markets under their jurisdiction, from doing business with firms that present an excessive risk of harm. Accordingly, in order to further assess whether conviction triggers—and is needed to trigger—greater reputational damage costs, we next consider whether agencies that employ collateral penalties to guard against future harm predicate their decision to impose collateral sanctions on the simple fact of whether the firm was convicted or subject to a DPA.

90   Note that the prosecutorial selection and managerial selection channels apply only in settings where the interested outsider faces some initial uncertainty about whether a case will settle through a plea agreement or a DPA. Thus, these channels would not operate under a regime in which prosecutors are directed to always settle through a plea, instead of a DPA, and are expected always to do so. A policy of always requiring a plea or always requiring a DPA would thus eliminate any cost from reputational damage produced by either prosecutorial or managerial selection. 91   That is, the value to the outsider of the information about the form of the settlement is an incremental value that might be high if outsiders knew only the form of settlement, but is in reality low because the prosecutor and firm release so much other information to the public when they make the settlement announcement.

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5. EXCLUSION OR DELICENSING: GOVERNMENT AGENCIES AS INTERESTED OUTSIDERS In this section, we evaluate whether DPAs undermine the ability of government agencies acting as interested outsiders to react in their own interests to information revealed by the criminal settlement about the risk of future harm from dealing with a firm. In federal criminal enforcement actions, the interested outsider may be a government authority, such as federal agency.92 Government agencies act as interested outsiders when they directly or indirectly purchase goods or services from a corporation, such as weapons and health care. Government agencies also act as interested outsiders when they are vested with the responsibility for protecting customers in particular markets (such as health care) by regulating firms’ access to those markets. Government agencies acting as interested outsiders have an incentive to respond to criminal settlements that reveal information that the firm presents an enhanced risk of imposing costs either on the agency as a purchaser or on the customers the agency was established to protect. In responding, agencies generally have the authority to exclude the firm from being able to deal with the agency or participants in the markets it regulates. Consideration of the cost of reputational damage to corporations for crime is thus not complete without consideration of the reaction of the government as an interested outsider to the settlement (see Alexander 1999). In this section we evaluate whether DPAs undermine agencies’ abilities to respond, to efficiently protect their interests, to information released by a criminal settlement about a firm’s future risk of harming the agency or customers in markets for which it acts as a gatekeeper. We assume that, in their interested outsider capacity, agencies’ objectives are to reduce dealings with the firm if, but only if, two conditions are met. First, the criminal settlement reveals information indicating that the firm presents an enhanced risk of harming the agency as a purchaser or the customers it safeguards (see supra Section 3). Second, responses such as exclusion or delicensing are more efficient responses to this risk than alternative responses available to the agency, such as imposition of mandates. Agencies’ reactions to settlements that indicate an increased risk from dealing with the firm require separate consideration because the options available to agencies when responding to a risk revealed by a criminal settlement differ from those discussed in Section 3. First, agencies often do not have full discretion over the decision whether to exclude a corporation revealed to present a high risk. Instead, many agencies’ decisions are governed by laws that identify the specific circumstances where the agency is entitled to exclude or delicense a firm; some laws mandate exclusion in certain instances (see infra 5.2). Second, agencies may be able to more efficiently respond to information that the firm presents a high risk by employing measures other than exclusion that preserve the relationship but reduce the firm’s future risk of misconduct. Specifically, many agencies have authority to require the firm to implement measures—such as corporate integrity agreements, enhanced reporting requirements, and outsider monitors—intended to deter

92   In addition, other government authorities, such as state governments, foreign governments, and non-governmental organizations (e.g., The World Bank) can act as interested outsiders who may respond to news of a criminal settlement by exclusion or delicensing (e.g., Auriol and Søreide 2017; Hjelmeng and Søreide 2014).

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Does conviction matter?  129 future misconduct. These reforms impose costs on the firm and can thus constitute a cost of reputational damage, but the cost of reforms generally will be less than the cost of exclusion. Finally, agencies acting as gatekeepers for particular markets may more efficiently protect customers in those markets by releasing information about the firm, allowing customers to decide whether the benefit of dealing with the firm is worth the extra risk. This brings us to the question of whether prosecutors’ use of DPAs systematically reduces agencies’ ability to use exclusion, debarment or delicensing to protect their interests in situations where the criminal settlement reveals that the firm presents an enhanced risk of causing future misconduct that cannot be better addressed through other interventions, such as mandates. Our analysis of this issue proceeds in two stages. We first determine when an agency would exclude a firm with detected misconduct if it had discretion to decide, case-by-base, whether exclusion serves the agency’s interests. We assume that agencies would want to exclude only if the two conditions discussed above are met.93 We conclude that agencies with discretion would not exclude all, or even most, firms that enter into criminal ­settlement and find that agencies with full discretion would not predicate their exclusion decisions on whether the prosecutor settled through a guilty plea or a DPA. We next examine how the choice of settlement form affects the exclusion decision of agencies constrained by laws that govern when they may and must exclude. We focus on whether a prosecutor’s decision to settle through a DPA undermines agencies’ ability to exclude or delicense when they would prefer to do so. This possibility arises because pleas often trigger an agency’s ability to exclude whereas DPAs do not. We conclude that DPAs do not undermine, and indeed may enhance, agencies’ abilities to make their preferred exclusion decisions under these laws. First, although standard laws governing exclusion treat conviction, and not DPAs, as a trigger that can justify exclusion, resolution through a DPA does not undermine an agencies’ ability to exclude when it serves their interests to do so. Laws governing agencies’ authority to exclude convicted firms typically grant the agency authority to exclude firms that the agency itself has found to have violated laws within its jurisdiction. Thus, agencies can respond to criminal settlements that reveal that the firm harmed the agencies’ interests by proceeding directly to find that the firm has committed misconduct—a finding that permits the agency to exclude the firm, should it wish to do so. Second, in some circumstances, agencies may be better able to serve their objectives when prosecutors settle through DPAs. Some agencies are required to exclude firms convicted of certain offenses, even when exclusion does not serve the agency’s interests. In this context, under a plea-only policy, the interests of the agency and the prosecutor may conflict. Settlements requiring a firm to plead guilty to such charges would undermine the agency’s ability to avoid exclusion in this instance.

93   First, the criminal settlement or the agency’s own investigation must provide evidence that the firm presents a risk of future harm from the perspective of the agency. Second, the agency can more efficiently protect its interests through exclusion or delicensing than by relying on interventions such as required reforms to reduce the risk of future misconduct.

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130  Research handbook on corporate crime and financial misdealing 5.1  How Agencies Would Approach Exclusion if Granted Full Discretion If granted full discretion over whether to exclude or delicense a firm, an agency promoting its interests would not necessarily exclude every firm that enters into a criminal settlement for misconduct within its jurisidiction. Instead, the agency would determine whether exclusion is warranted based on its assessment of the firm’s risk of imposing costs on the agency (or the customers it is authorized to protect) in the future, taking into account information revealed by the criminal settlement. The agency can be expected to consider the factors discussed in Section 3, including information about the charges filed, scope and duration of the misconduct, harm caused, sanctions imposed, identity of the victims, and any voluntary reforms or mandates set forth in the settlement agreement or imposed by other sources. In evaluating these factors, it also may consider its private information about the offender and offense from its own investigation of the misconduct. As a result, the agency might not exclude an offender if it determines that dealing with the  firm is not associated with an enhanced risk of harm, even after a high-profile conviction. An agency also may decide that exclusion is not in its best interests if it determines that it can more efficiently limit the risks, and adverse effects, of a future offense by not incurring the cost of excluding the entire firm. First, an agency with discretion might exclude only part of the firm, such as a specific division, office, or individuals. Alternatively, it may intervene to reduce the future risk of misconduct by encouraging voluntary reforms or using its own settlement agreement to impose mandates designed to deter future misconduct. Examples of mandates include corporate integrity agreements and monitors that the agency concludes are effective in reducing the risk of future misconduct.94 The costs of the reforms and mandates imposed by agencies as interested outsiders would be part of the cost of reputational damage to the firm at settlement. Finally, agencies authorized to bar firms from dealing with customers in particular markets may conclude that it is more efficient to instead employ sanctions, reforms, and enhanced oversight, along with disclosure to customers to reduce the risk of future harm. Agency disclosures of misconduct to customers can enable them to make their own decisions about whether the expected cost of dealing with the firm exceeds the benefit. The bottom line is that, in the absence of legal constraints, agencies would not always (or even often) exclude or delicense firms with criminal settlements that sell goods or services which provide a material benefit to the agency or customers. Instead, exclusion would be based on the risk of harm to the agency’s interests, signaled by the information about the factors identified in Section 3, revealed by the criminal settlement and, if relevant, the agency’s own investigation. Thus, the agency would focus on the underlying facts and not on whether the prosecutor entered into a plea or a DPA. Moreover, agencies 94   Firms may agree to costly mandates as an alternative to exclusion in part because, when agencies do intervene with exclusion, the cost to the firm may exceed the value of the business directly lost as a result of debarment from dealing with the agency. In particular, disclosure of an agency’s decision to debar the firm based on its independent assessment of future risks can convey information to other interested outsiders beyond what is revealed in the criminal settlement and thus further reduce their willingness to deal with the firm.

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Does conviction matter?  131 would tend not to exclude a firm, even when the facts indicate the firm could present an increased risk to the agency’s interests, to the extent they can employ alternative solutions that impose lower costs on the agency or customers, such as interventions that directly reduce the firm’s risk of future misconduct. In any event, agencies would not need prosecutors to resolve cases through a plea instead of a DPA in order to use exclusion or delicensing to promote their interests. 5.2  Laws Constraining Agencies’ Authority to Exclude In actual practice, federal agencies generally do not have unfettered discretion to decide when and whether to exclude or otherwise restrict dealings with a firm. Instead, statutes and regulations constrain the exercise of discretion over exclusion by determining when an agency can—or even must—exclude a firm found to have committed certain types of misconduct. Statutory provisions governing exclusion vary from agency to agency. Nevertheless, they usually share some common features. First, provisions governing exclusion tend only to allow agencies to exclude firms that commit specific offenses. The list tends to include offenses that directly harm either the agency—such as submitting a false claim—or participants in the market the agency is authorized to protect. Some statutes allow agencies to exclude firms sanctioned for specific offenses against other parties, such as fraud, whose commission could signal a risk of future harm to the agency itself. Second, in most situations, even if a firm is convicted, agencies usually retain discretion over whether to exclude the firm. Many laws governing exclusion provide that all (or most) convictions implicating the agencies’ interests trigger permissive (and not mandatory) exclusion. Statutes providing for permissive exclusion tend to provide that the agency should exclude only when the firm both presents a risk of future harm and the risk is not better addressed through mandates, such as corporate integrity agreements and monitors.95 In situations where an agency (or those it serves) was a victim of the misconduct, the agency generally is given discretion to exclude should the agency prevail in its own enforcement action against the firm, even if no criminal charges are filed. Finally, although some agencies are subject to provisions that mandate exclusion of firms convicted of particular offenses, many, if not most, agencies retain discretion to waive exclusion. Agencies are often encouraged to waive when they conclude that the firm does not present a significant risk of future harm (see Velikonja 2015). Agencies with authority to waive can do so after the firm is convicted or they can agree in advance of the plea that they will exempt the firm from exclusion. Some agencies are subject to mandatory exclusion provisions that limit their ability to waive exclusion, however. Conviction of particular offenses could thus trigger mandatory

95   For example, the provisions governing debarment by federal contracting officers provide that debarment and suspension should “be imposed only in the public interest for the Government’s protection and not for purposes of punishment” (48 CFR Ch. 1 9.402 Policy). The list of factors to be considered in determining whether to exclude closely resemble the factors set forth in Section 3. Other agencies also consider the risk of future harm in evaluating both permissive exclusion and waiver of mandatory exclusion, and regularly waive mandatory exclusion (Velikonja 2015).

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132  Research handbook on corporate crime and financial misdealing exclusion, whether or not the agency wants to exclude, unless the prosecutor adjusts the charges filed or the identity of the corporate defendant to avoid that outcome.96 5.2.1  An example: Health and Human Services To illustrate, it is useful to consider the rules governing when the Department of Health and Human Services (HHS) can and must exclude a corporation that deals directly with the agency or patients following a criminal settlement. The governing statute provides that the agency only has authority to exclude if the firm is found to have committed a particular set of offenses. These include misconduct aimed directly at the agency (such as filing a false claim with the agency) and offenses that are within the agency’s direct enforcement authority. The types of misconduct potentially triggering exclusion include submitting claims for excessive charges or unnecessary services, engaging in fraud, kickbacks or other prohibited activities, knowingly making or causing to be made certain types of false statements, and a range of other offenses that bear on the entities’ suitability as either a government counterparty or a provider of services to patients. In addition, some other forms of fraud (such as false claims against other agencies) may trigger permissive exclusion, but only under certain circumstances, discussed below (Social Security Act 42 USC § 1320a-7(a) (3) & (4)). A firm detected engaging in misconduct of the type described above can be excluded if the firm was convicted of the offense or the agency determined on its own that the firm committed the offense (provided the offense is one that the agency has the authority to enforce).97 Thus, while DPAs do not trigger HHS’s exclusionary authority, the agency generally can exclude a firm that settled through a DPA by proceeding on its own to establish that the firm committed the offense (see Social Security Act 42 USC § 1320a-7(a) (3) & (4)). There is one situation where the choice between a plea and a DPA affects HHS’s ability to permissively exclude: where the firm is charged with fraud, embezzlement, or financial misconduct and related offenses with respect to a program (other than a health care program) that is operated or financed by a federal, state, or local government agency other than HHS.98 HHS cannot exclude following a DPA because the agency does not have jurisdiction over these offenses, but it could exclude following a plea. In order to exclude, the agency would need to determine that the plea signals that the firm has a future risk of harming health care programs, as explained below. Determinations that trigger HHS’s authority to permissively exclude often, and indeed usually, do not lead to corporate exclusions. Instead, in line with the analysis in Section 5.1, HHS determines whether to exclude by assessing if the firm presents a future risk of harm to federal health care programs. The risk assessment includes many of the factors discussed in Section 3. Of particular importance, mandated reforms can obviate the justification for exclusion. According to recent HHS guidance, exclusion “often” is not

  See infra text accompanying note 106.   The only offenses where the agency can permissively exclude if the prosecutor convicts but not otherwise are frauds against other agencies. 98   The statute permits permissive exclusion if the firm was convicted “(B) of a criminal offense relating to fraud, theft, embezzlement, breach of fiduciary responsibility, or other financial misconduct with respect to any act or omission in a program (other than a health care program) operated by or financed in whole or in part by any Federal, State, or local government agency” (Social Security Act, Section 1128B(f), 42 U.S.C. 1320a-7). 96 97

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Does conviction matter?  133 necessary if the wrongdoer agrees to “appropriate integrity obligations”—i.e., mandated reforms—or if a monitor would suffice to protect the agency’s interests.99 Thus, firms that agree to corporate integrity agreements or monitors can expect to avoid permissive exclusion even if they plead guilty. There is one situation where the choice of settlement form has a material effect on HHS’s authority to exclude. The Social Security Act provides that felony conviction of a firm for either health care fraud or crimes relating to controlled substances triggers mandatory exclusion, whereas HHS’s own determination that the firm committed these offenses triggers permissive exclusion (Social Security Act 42 USC § 1320a-7(a)(3) & (4)). The statute also substantially restricts the agency’s ability to waive mandatory exclusion. The agency can only exempt a firm from exclusion if the agency determines both that the entity is the sole source of an “essential service in a community” and that exclusion would impose a hardship on the beneficiaries.100 In addition, the agency must determine that the exclusion would not be in the public interest (42 CFR 1001.1801). Even when a waiver is granted, it is limited to the program (and the service) for which the waiver was granted. Thus, under these provisions, a convicted firm could end up excluded from selling most of its products to Medicaid bene­ ficiaries, even if it is granted a waiver with respect to some of them. As a result, conviction can force the agency to exclude a firm that it would otherwise not exclude. By contrast, when such cases are resolved through DPAs, the agency can proceed against the firm itself and then determine whether to pursue permissive exclusion or use alternatives such as mandates. Accordingly, analysis of the rules governing the agency’s exclusion decisions reveals that these rules can sometimes compel agencies to make the exclusion decisions that they would prefer not to make if given full discretion. The question to be considered is whether, in light of the standard constraints placed on agencies’ authority over exclusion, agencies are better able to serve their interests by excluding those firms when, but only when, they present an enhanced risk of misconduct and the risk is most efficiently addressed by exclusion. 5.3  Do Guilty Pleas or DPAs Better Facilitate Efficient Exclusion In this section we evaluate whether agencies are better able to use exclusion to promote their interests as interested outsiders when prosecutors resolve many, if not most, cases through DPAs, instead of being required to resolve almost all cases through a guilty plea. To address this question we limit ourselves to the subset of offenders and offenses that potentially implicate exclusion. For all other crimes, the use of DPAs has no effect on agencies’ decisions on whether to exclude. We first consider the effect of the choice for the set of crimes that trigger permissive exclusion. We then consider mandatory exclusion, beginning with agencies with full waiver authority, and then moving to those with constrained authority to waive mandatory exclusion.  99  See Criteria for Implementing Section 1128(b)(7) Exclusion Authority, Office of the Inspector General, Health and Human Services (April 18, 2016), https://oig.hhs.gov/exclusions/ files/1128b7exclusion-criteria.pdf. 100   In restricting waiver to providers who are the “sole source,” and thus limiting waiver to the sole providers of goods or services, these waiver provisions appear to mandate exclusion in a broader range of situations than would trigger exclusion if the agency had full discretion and followed the analysis outlined in Section 5.1 supra.

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134  Research handbook on corporate crime and financial misdealing 5.3.1  Pleas that trigger permissive exclusion As previously explained in Section 5.2, regulations governing exclusion grant agencies authority to decide whether to exclude a firm only if the firm committed one of a particular set of offenses. The core set of offenses that trigger exclusion are those that directly implicate the agency’s interests as an interested outsider; these offenses also are the ones the agency has jurisdiction to enforce (see supra Section 5.1). In the case that these core offenses trigger permissive exclusion, the agency’s authority to exclude is not undermined, or even altered, by the use of a DPA instead of a plea. Statutes granting permissive exclusionary authority when a firm is convicted of such offenses also generally allow the agency to seek permissive exclusion even absent a conviction, following a determination by the agency that the firm committed the offense. Thus, for these core offenses, resolution through a guilty plea does not open a door leading to potential exclusion that the agency could not open on its own following resolution of the case through a DPA. Of course, it might at first appear that agencies can better employ exclusion to protect themselves from high-risk firms when prosecutors employ pleas because the plea relieves the agency of the burden of pursuing its own action to find that the agency committed misconduct. Yet this is not the case. The guilty plea saves the agency from having to make the initial determination that the firm engaged in the misconduct in question. Yet, the agency still must employ a formal process to determine whether exclusion is appropriate. The determination of whether exclusion is appropriate generally depends on a factual assessment of whether the firm presents an increased risk of future harm best addressed by exclusion, in light of considerations such as the nature and scope of the misconduct, the effectiveness of the firm’s compliance program at the time of the crime, whether the firm self-reported and fully investigated the misconduct, whether the firm has sanctioned individuals responsible for the misconduct, and whether the firm has undertaken voluntary reforms of its internal governance (see, for example, provisions governing debarment of government contracts, 48 CFR Ch. 1 9.406-1). Thus, whether a case settles through a plea or a DPA, crimes that trigger permissive exclusion should result in the agency predicating exclusion on factors bearing on the firm’s risk of harming the agency’s interests in the future, and not on the choice of settlement form. Moreover, whether the case is resolved through a plea or a DPA, the agency can be expected not to exclude if it can employ alternative measures to reduce the firm’s future risk of misconduct that impose lower expected costs on the agency or those it serves than are imposed by exclusion. Consequently, even when a firm has pleaded guilty, agencies tend not to exclude if the agency concludes that the firm’s risk of future misconduct can be adequately addressed by mandated internal governance reforms or monitors (see supra Section 5.2). The agency’s interest in considering alternatives to exclusion or delicensing are particularly great when exclusion would deny the agency or the public access to valued goods and services, as may occur with high-profile firms.101 The observation that agencies tend to prefer mandates to exclusion in these cases has particular relevance for the concern

101   Agencies considering exclusion that would preclude firms from dealing directly with certain customers (e.g., patients) will also evaluate whether, following disclosure of the misconduct (and any mandated reforms), it would better serve the agency’s interests to allow the firm to deal with any customers who continue to want to do so.

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Does conviction matter?  135 of critics of DPA that DPAs weaken the cost of reputational damage. Firms entering into DPAs usually adopt reforms and enter into agreements expressly requiring reforms (Alexander and Cohen 2015; Arlen and Kraakman 1997). Similarly, an agency acting as an interested outsider may address concerns about future harm through mandated reforms rather than exclusion even if the firm were required to plead guilty to charges triggering permissive exclusion. Of course, a prosecutor’s decision to employ a DPA instead of a guilty plea will preclude permissive exclusion by some agencies in a particular set of cases. Some agencies, for example HHS, can exclude a firm that defrauded a different government agency (other than HHS) if, but only if, the firm was convicted (see supra Section 5.2). Resolution of such cases through a DPA precludes exclusion by such agencies (though the victim agency may be able to exclude). Yet this only undermines agencies’ ability to serve their interests as interested outsiders if they would be likely to exclude in such cases. We expect that this occurs infrequently. First, an agency is unlikely to consider exclusion unless the misconduct against the other agency also signals that the agency in question faces a risk of future harm. This will depend on considerations that may include the effectiveness of the firm’s compliance program, whether the agency deals with the unit of the firm responsible for the offense, and the agency’s assessment of senior management (see supra Section  3). Second, the agency is unlikely to exclude if any risk of future misconduct has been addressed by either voluntary reforms or mandates imposed by the criminal settlement agreement.102 Thus, while the choice to use a DPA could affect a few cases, it appears likely that most cases resolved through DPAs would not lead to exclusion by a federal agency even if the firm were convicted. Consequently, when the firm faces criminal charges that can trigger permissive exclusion, the choice of settlement form generally should not affect the agency’s decision to exclude the firm. In either case, the agency generally will have authority to exclude. In either case, the agency will predicate the exclusion decision not on the choice of settlement form, but instead on an assessment of the firm’s future risk of committing misconduct (see Section 3). Finally, following either resolution, the agency generally will resist exclusion, even if it perceives a heightened risk of harm, in favor of imposing (or encouraging the imposition of) reforms designed to deter future misconduct.103

102   In addition, in principle, an agency that concluded that the firm presents a significant risk to itself, may be able to signal to the prosecutor that the public’s interests would be best served by a guilty plea—although we are not aware of situations where agencies have sought to debar a publicly-held firm based on harms to other agencies. 103   This is evident from our earlier examination of the Social Security Act. The Act empowers the Secretary to seek permissive exclusion even if the firm was not convicted of a crime if the Secretary determines that the firm engaged in fraud, false claims, bribery, kickbacks or other offenses relating to health care. The Secretary has authority to make its own determination about whether key civil or criminal laws relating to health care were violated, and to impose permissive exclusion should it determine they were. Indeed, the Secretary’s authority to seek exclusion extends beyond violations that impose substantive harms, to the firm’s decisions to violate various duties to provide timely and accurate information, and similar types of misconduct, arguably going to the firm’s probity.

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136  Research handbook on corporate crime and financial misdealing 5.3.2  Pleas that trigger fully waivable mandatory exclusion The conclusion is similar in situations where the firm is charged with misconduct that would trigger mandatory, but fully waivable, exclusion if the firm enters into a guilty plea. The reason is that most statutes providing for mandatory exclusion for particular offenses also grant the agency permissive authority to exclude, even absent a conviction, based on its own determination that the firm engaged in the misconduct (see discussion in Section 5.2). In addition, the central consideration bearing on whether the agency should or should not permissively exclude—the firm’s risk of a future offense—is also the central consideration bearing on whether an agency should exempt a firm from exclusion that was (or would be) automatically triggered by a guilty plea (see, e.g., Velikonja 2015, discussing exclusion waivers). Of course, the choice between a DPA and a plea does affect the cost to the agency (transactions costs) of deciding whether to exclude a firm. A plea triggers exclusion unless the firm can establish that exclusion is unwarranted. By contrast, following a DPA, the agency would need to establish that exclusion is warranted. The choice of settlement form thus could affect the agency’s decision whether to exclude when the transaction costs of an action by the agency to exclude or waive are greater than the net benefit of the decision. This can occur when the evidence does not strongly indicate that the firm presents a high or low risk of future misconduct. Yet cases where the net benefit of exclusion is small are also those where the agency has the least to gain from exclusion. The net expected benefit of exclusion is lower the weaker the evidence is that the firm presents a risk of future harm to the agency’s interests. In these borderline cases, the agency would likely prefer to use mandated reforms, instead of outright exclusion.104 Thus, even though pleas lower the cost of excluding a firm, agencies may not respond by increasing the use of exclusion since mandated reforms are likely to be viewed as preferable in those cases where the settlement form could matter. Accordingly, we conclude that the choice of settlement form is unlikely to have a material effect on the decision to exclude by agencies that would have discretion over whether to exclude the firm should it be convicted. 5.3.3  Pleas that could trigger mandatory exclusion that is not generally waivable We now consider the subset of cases where a plea would trigger mandatory exclusion that the agency does not retain sufficient discretion to waive. The most obvious examples are felony convictions for health care fraud and false claims brought against pharmaceutical firms. In this situation, the agency would have discretion to exclude the firm if the prosecutor enters into a DPA, but could be required to exclude if the firm pleads guilty to felony charges (see supra Section 5.2, explaining when waiver is possible). DPAs enable the agency to exclude when, and only when, the agency determines exclusion serves its objectives.

104   To the extent that the transactions costs of exclusion decisions differ following pleas and DPAs, it is far from clear that the difference should favor pleas. While it is true that a plea shifts the burden of establishing waiver to the firm (potentially lowering the agency’s costs), the overall transaction costs associated with pleas that trigger exclusion could be higher if the firm were to delay settlement until it obtained waivers from all agencies that could debar it as a result of the conviction. The transactions costs of obtaining the needed waiver can be particularly high if the firm could be debarred by multiple federal and state agencies if convicted, necessitating the need to obtain ex ante commitments not to exclude from each one.

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Does conviction matter?  137 The use of pleas increases the rate of exclusion in such cases because felony pleas mandate exclusion whereas exclusion is discretionary following a DPA. Therefore, the use of a plea increases the cost of the offense to the firm, relative to the use of a DPA, in this setting. This conclusion does not weigh in favor of requiring pleas, however. First, pleas are preferable only if the agency’s interest is most efficiently served by excluding the convicted firm in such cases. There are good reasons to believe that this condition is not met. Agencies’ interests are not served by excluding a firm unless the misconduct signals that the firm presents a future risk of harm to the agency. Yet, as explained in Section 3, even when a firm has committed misconduct against an interested outsider, the firm may not present a high risk of harming a similarly situated interested outsider in the future for a variety of reasons. For example, an agency would be unlikely to anticipate a high risk of future harm from a firm convicted for fraud by a single (since terminated) individual that was promptly detected by the compliance program and reported to the agency (see supra Section 3). Agencies’ interests are served by retaining discretion not to exclude in many situations—a discretion available following a DPA. In addition, even if the firm would otherwise have an enhanced risk of future harm, agencies may prefer to address this risk by using mandated reforms and monitors instead of exclusion, when mandates impose lower costs on the agency or those it serves. Accordingly, to the extent that agencies generally prefer not to exclude, agencies’ abilities to achieve an efficient outcome with respect to exclusion are better served through the use of DPAs that leave the agency empowered to exclude if (but only if) it so chooses, than through a plea which would likely require the agency to exclude a firm that it might not want to. Pleas, by contrast, impose costs because they may require an agency to exclude when its objectives are better served by not excluding. Additionally, the adoption of a rule requiring guilty pleas even when a felony conviction would trigger mandatory exclusion could distort the settlement process to the extent that prosecutors prefer not to trigger exclusion. In such situations, a prosecutor may be able105 to alter either the charges filed or the identity of the firm charged to reduce the scope of the mandatory exclusion or eliminate its effect altogether. For example, in the health care context, the prosecutor could avoid triggering mandatory exclusion by charging the firm with a misdemeanor instead of a felony. Alternatively, a prosecutor could narrow the scope of the exclusion by entering into a plea agreement with a subsidiary, rather than the parent corporation. This would limit the scope of the mandated exclusion to the subset of the firm’s activities that are located in the subsidiary.106 This points to a 105   This prosecutor may have an incentive to alter the charges to settle the case, if the firm makes a credible threat to go to trial rather than accept a guilty plea that would trigger mandatory exclusion (see Section 4.2.3 supra). Alternatively, the prosecutor might alter the charges to avoid mandatory exclusion at the request of the agency or to avoid harming innocent customers, in keeping with policy concerns expressed in the USAM. 106   For an example of this approach, see also the guilty plea entered into against the Pfizer Corporation. According to the press release “Pfizer” pleaded guilty but the guilty plea in fact was with a Pfizer subsidiary, whereas the Pfizer, the parent company, entered into a pretrial diversion agreement (https://www.justice.gov/opa/pr/justice-department-announces-largest-healthcare-fraud-settlement-its-history). For discussion, along with empirical evidence on the different frequencies with which parents and subsidiaries enter into DPAs and plea agreements as signatories see Alexander and Cohen (2015).

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138  Research handbook on corporate crime and financial misdealing potentially perverse effect of requiring plea agreements in an effort to trigger mandatory exclusion in those cases where the exclusion as such is not in the public interest. Namely, the prosecutor may face an incentive to adjust the settlement to limit the risk of exclusion. In this situation, there are two effects. First, these adjustments insulate the firm in question from exclusion, notwithstanding the use of a guilty plea. Second, as a result of these adjustments, the prosecutor also has to alter the information contained in the criminal settlement to support the charges filed against the firms that were charged. The possibility arises that the net effect could lead to guilty pleas that lead interested outsiders to impose lower cost of reputational damage to the extent that information released by the guilty plea indicates that the parent corporation was less responsible, or committed a less serious offense, than the information would have been revealed had the firm entered into a DPA with the prosecutor’s preferred charges. 5.4 Summary Conviction for an offense may trigger an agency’s authority to exclude, whereas a DPA does not. A prosecutor’s decision to employ a DPA instead of a plea does not undermine agencies’ abilities to obtain an exclusion when they would otherwise have exercised discretion to exclude in the event of a guilty plea, however. First, the use of DPAs does not undermine the agency’s exclusionary authority when conviction would trigger permissive exclusion, because the agency also generally has full authority to exclude following a DPA should it conclude that exclusion is appropriate. Second, following both types of settlements, the agency may address any perceived future risk through mandates rather than exclusion. In addition when conviction would trigger mandatory exclusion that the agency is not free to waive, agencies may be better off under DPAs because DPAs enable the agency to seek exclusion only if exclusion serves its interests. Requiring pleas would then undermine the agency’s ability to achieve its objective, either by requiring it to impose an exclusion that does not efficiently serve its interests or by incentivizing it to seek adjustments to criminal settlements to avoid triggering mandatory exclusion. Accordingly, while a policy requiring prosecutors to favor a plea could cause more firms to be excluded, this would not occur through the reputational damage mechanism because such exclusions would not be undertaken by agencies seeking to avoid harm from future offenses.

6. CONCLUSION U.S. prosecutors entering into criminal settlements can either require a firm to plead guilty or offer to resolve the matter through a DPA. Prosecutors can impose the same formal sanctions through DPAs as through guilty pleas: the same charges, statements of fact, monetary sanctions, and mandates. Nevertheless, a debate has persisted over whether DPAs undermine deterrence by lowering the cost to firms of the reputational damage resulting from a criminal settlement. In this chapter, we undertook an assessment of the view that criminal settlement through a guilty plea causes firms to bear higher costs from reputational damage than does settlement through a DPA, holding all else constant. To assess this claim, we first identified the

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Does conviction matter?  139 types of qualitative information released by corporate criminal settlements that could lead interested outsiders—e.g., customers, suppliers and other c­ ounterparties—to anticipate an enhanced (or reduced) risk of harm from future dealings with the firm. This includes information about the crime, the corporation’s governance at the time of the crime, and post-crime reforms and mandates. We then explained that settlement through a plea could heighten the cost from reputational damage if it directly or indirectly leads interested outsiders to obtain information that the firm has a heightened risk of future misconduct that they would not obtain from a DPA settlement. We concluded that this requirement is not met after examining three channels through which pleas and DPAs might transmit disparate qualitative information about the firm’s future risk: direct revelation, prosecutorial selection, and managerial selection. Our conclusion that pleas and DPAs can impose similar costs on the firm—both similar formal sanctions and similar costs from reputational damage—raises the question of why firms care about whether they are required to plead guilty. Our answer is that firms are likely to care to the extent that a guilty plea would subject them to an enhanced risk of exclusion or delicensing by a federal, state, local or foreign government agency immediately or in the future. Pleas tend to present a greater risk of exclusion than do DPAs. The potential impact of guilty pleas on the risk of exclusion is not an independent reason to prefer them, however. Federal agencies can best serve their interests as interested outsiders by excluding or delicensing firms entering into criminal settlements when two conditions are met: first, the firm presents an enhanced risk of causing future harm to the agencies’ interests; and, second, this risk cannot be more efficiently addressed by mandated reforms instead of exclusion. Thus, agencies granted full discretion over exclusion would not exclude every firm—or even most firms—convicted of an offense. Instead, they would predicate exclusion on information about both the firm’s future risk of misconduct and on the availability of alternative means of reducing the risk, such as mandated reforms. Pleas do not promote agencies’ interests because pleas sometimes require exclusion when the agency would want not to exclude and, furthermore, agencies with exclusionary authority generally can exclude following a DPA based on their own findings. Moreover, those agencies required by law to exclude firms convicted of certain charges may better achieve their objectives as interested outsiders when prosecutors employ DPAs rather than pleas because DPAs leave them free to use permissive exclusion and enable them to exclude when appropriate. Finally, we have provided a framework for evaluating the effect of the form of settlement on the costs to the firm of reputational damage from a criminal settlement in terms of the reactions of interested outsiders to the qualitative information released at settlement, including information about reforms and mandates. We have done this by, first, identifying the types of information, including information about aggravating and mitigating circumstances, that may affect outsiders’ willingness to deal with the firm in the future, and, second, by specifying the channels through which the choice of settlement form—here guilty plea vs DPA but also potentially criminal and civil—would affect the cost of reputational damage by altering the information that is directly and indirectly available to interested outsiders about the risk of future misconduct. Finally, we distinguish the dynamic effects of reforms and mandates from other effects of settlement.

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Does conviction matter?  143 Uhlmann, David M. 2013. Deferred Prosecution and Non-Prosecution Agreements and the Erosion of Corporate Criminal Liability, Maryland Law Review, 72, 1295–1344. U.S. General Accountability Office. 2009. Preliminary Observations on the Department of Justice’s Use and Oversight of Deferred Prosecution and Non-Prosecution Agreements, GAO-09-636T (June 25). http://www. gao.gov/products/GAO-09-636T Velikonja, Urska. 2015. Waiving Disqualification: When Do Securities Violators Receive a Reprieve? California Law Review, 103, 1081–1138

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APPENDIX Illustration Using a Basic Model We extend the basic model of Darby and Karni (1973) to illustrate how the form of criminal settlement may affect the cost to a firm of reputational damage resulting from detected corporate crime.107 In the illustration, the interested outsider is a potential customer and the crime is fraud. In the basic model, the seller faces a cost of reputational damage from the misconduct. Our extension reveals how a settlement might enhance the cost of reputational damage and thus promote general deterrence. Consider a firm that sells a repair service, such as car repair, where the total amount of services provided is given by S. Assume that the producer knows the expected level of services that the consumer needs to achieve her objective (a repaired car), which is given by Se. The consumer benefits from services up to Se and derives no benefit from services over Se. We assume that production costs are given by C(S) where C'(S) > 0. Although the producer knows the level of service needed by the consumer, the customer does not. The customer can observe services provided and charged for, but does not know whether they exceeded the level, Se, needed to achieve the customer’s objective (e.g., having her car repaired). The firm thus can provide services over and above those that provide any value to the customer: S = Sd + Se. We normalize the customer’s preferred level of service to zero, so that Se = 0. As a result, S = Sd, and S denotes the delivery of excessive service. The only way to avoid the delivery of excessive service is to recommend, and provide, no service at all in this case. The seller charges a price PS, that is an increasing function of the recommended service level S. The customer accepts the offer. Fraud occurs when the firm knowingly overcharges the unsuspecting customer by providing services that are not needed to achieve the consumer’s stated objective (e.g., to repair the car). The harm to the customer is the over-payment that occurs relative to the payment that the seller would extract from a fully informed customer, and is given by PS. The customer cannot detect fraud ex ante but may detect it after the fact. For example, the customer may subsequently seek services from a new firm and learn about the fraud. The probability of detection is assumed to be a function of the magnitude of the fraud—the greater the excessive services the more likely the customer will seek additional information on the services provided and detect the fraud. Should the customer detect the fraud, she is unlikely to do business with the firm in the future. She may also tell other consumers. Absent legal sanctions for fraud, the firm’s incentive to engage in the fraud is constrained by the cost to the firm of the loss of future business should fraud be detected in addition to the cost of providing the excessive service. The cost to the seller of reputational

107   Dating back to Darby and Karni (1973), an extensive literature has emerged to explore the mechanism through which fraud and related bad-news events trigger a reaction by outsiders, along with the practical implications. For recent examples, see Board and Meyer-ter-Vehn (2013) and MacLeod (2007).

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Does conviction matter?  145 damage is the cost of the customer’s reaction to the detected overcharging. This includes both the loss of the victimized customer (purchaser) and the loss of business from other customers who learn about the fraud and react in the same way. The value of an individual purchaser’s future business that could be lost if the purchaser detects fraud is given by V. The total value of all business that could be lost is kV, where k = 1 if only the purchaser knows of the fraud and k > 1 if other consumers have access to the information, and knowledge of the fraud is more widely dispersed, as discussed below. In the Darby and Karni model, consumers can detect some frauds; the probability of detection is an increasing function of the magnitude of the fraud, S. The firm’s expected payoff from fraud is thus given by:

p 5 (PS − C(S)) 1 kV((1 − p(S|h))

where kV is the value of future business to the firm obtained if fraud is not detected, which occurs with probability (1 − p(S|h).108 Thus, kVp(S|h) is the firm’s ex ante expected cost of reputational damage from fraud of magnitude S. p(S|h) denotes the probability that consumers will detect the fraud and take their future business elsewhere, which is increasing in S, so that p/S > 0 (i.e., p' > 0) with p(0|h) 5 0. p(S|h) also depends on the quality of the information about the fraud that the consumer receives in the sense that p2/Sn > 0. Absent legal sanctions for fraud, it is assumed that the consumer only detects if S is large enough to cause him to investigate, or if some other defrauded consumer detected and informed him. Firms select the magnitude of deception at the point where the marginal cost of the enhanced risk of detection and related loss triggered by more deception equals the ­marginal benefit of the increased revenues. Firms defraud consumers because fraud is costly to detect and prevent in equilibrium (Darby and Karni 1973). In our extension of the model, we make explicit two channels through which criminal enforcement can affect the cost to firms of reputational damage from fraud.109 First, a criminal settlement can improve the quality of the information that consumers receive about the harm from the fraud (higher h) and thereby increase their willingness to take their future business elsewhere in response to those frauds that are relatively more harmful (higher p'). For example, a consumer who received a large bill can learn as a result of the criminal settlement either that his specific bill was for unnecessary services or that the firm charged other consumers for unnecessary services, thus increasing the probability that the high S the consumer was charged was for unnecessary services. The disclosure eliminates uncertainty about whether, by avoiding the firm, the consumer can avoid future harm (see Section 3.1 supra).

108   To the extent consumers view S as a signal of fraud then firms also will treat as a cost of fraud the reduction in the probability of selling the first unit resulting from a fraud large enough to lead consumers to decline the first unit on suspicion of fraud. In terms of the model, an increase in the magnitude of the fraud S can lead to a decline in the probability of completing the initial sale F(S), which we assume to equal one and be invariant to S. 109   In addition, criminal settlements can affect the cost of reputational damage by imposing mandates that affect outsiders’ expectations about the future risk of misconduct. See supra Section 3.4.

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146  Research handbook on corporate crime and financial misdealing Second, the criminal settlement can disseminate information more widely than would otherwise occur, represented here as an increase in k.110 For example, the criminal ­settlement for fraud may trigger discussion of the fraud in the media, disseminating the revelation of the firm’s practices to consumers nationwide or globally. The effect is to increase the cost of lost future business to the company (higher kVp'). To illustrate the effects of a change in the enforcement environment on the amount of fraud in equilibrium, we consider the case where p is convex in S and the choice is an interior optimum. The seller’s decision of what services to provide S* is characterized by the first-order condition of the model: p'(S*) 5 0. As Darby and Karni point out, the marginal return to overcharging must equal the cost of the resulting loss of sales, which is here limited to the expected loss in future sales. That is, if firms face only the threat of consumer reaction and no formal legal sanction from over-selling, we have:

p'(S*) 5 P − C' − kVp'(S*|h) 5 0

The incremental cost of reputational damage or stigma from the fraud is the last term in the above expression. It is the expected cost of the lost future sales that the seller anticipates from the increased chance that the purchaser (and other similar customers) will take their business elsewhere (higher p) upon detection of the fraud. p' > 0 is thus a necessary condition for the expected cost of reputational damage or stigma to deter the misconduct. The cost of the customer reaction depends on the value of the lost customer business to the seller (kV). In this model, the effect of the criminal settlement is to increase the expected cost of fraud by increasing the quality of information that the victim receives and thus the probability that the defrauded customer both detects the fraud and responds by refusing to deal in the future: p'(S)/h 5 2p/Sn 5 −V . 2p/Sn < 0. The settlement can further increase the cost to the firm by increasing outsider access to the fraud news and thus the number of other customers who learn about the crime and respond by taking their business elsewhere: p'(S)/h 5 2p/Sk 5 −Vp' < 0. These effects separately and together decrease the seller’s optimum level of fraud. That is, by application of the implicit function theorem at the optimum, dS*/dk, dS*/dh < 0. To summarize, using a simple model to illustrate, we have identified distinct channels through which information about an episode of misconduct can lead a firm to sustain a cost of reputational damage or stigma. A necessary condition in each instance is that the seller anticipates an increase in the probability of lost future business (or its expected amount) as a result. Interested outsiders who are prospective customers or c­ ounterparties must gain knowledge of the fraud and, based on this knowledge, be willing to take their future business elsewhere with some positive probability, as indicated in Section 3.2. p 5 (PS 2C (S) ) (1 2F (S) ) 1 g N1 Vi (12 pi (S 0 h) )   We introduce the parameter k (outsider access) to highlight the effect of increasing the number of interested outsiders who receive a signal of the bad act. For simplicity, we model the outsiders as having the same information and incentives as the initial purchaser. To explore heterogeneous r­ eactions across outsiders, one could alternatively write, p 5 (PS 2C (S) ) (1 2F (S) ) 1 g N1 Vi (12 pi (S 0 h) ) , thus letting k 5 [ N 2 g N1 Vi pi (S 0 h) ) /V (1 2p ( S 0 h ) ] . Allowing for such heterogeneity does not affect our conclusions, and we do not further explore it here. 110

k 5 [ N 2 g N1 Vi pi (S 0 h) ) /V (1 2p ( S 0 h ) ]

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Does conviction matter?  147 Accordingly, differences in enforcement regimes can, by influencing the information obtained by interested outsiders—through enhanced quality or access—cause differences in the cost of reputational damage or stigma to the offending firm.

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PART II PUBLIC ENFORCEMENT OF PUBLIC CORRUPTION AND SECURITIES FRAUD

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5.  Multijurisdictional enforcement games: the case of anti-bribery law Kevin E. Davis* 1

1. INTRODUCTION On December 15, 2008, Siemens AG, a German multinational corporation, publicly acknowledged that it had paid bribes totaling more than $1.4 billion to government officials in Asia, Africa, Europe, the Middle East and the Americas between 2001 and 2007. The acknowledgement was made as Siemens (along with three of its subsidiaries) pleaded guilty to violations of the U.S. Foreign Corrupt Practices Act (FCPA) and simultaneously settled proceedings brought by the U.S. Securities and Exchange Commission (SEC) and the Munich Public Prosecutor’s Office. The allegations subsequently led to settlements with the World Bank and governments or enforcement agencies in several other countries, including Greece, Italy, Nigeria and Switzerland. As the Siemens case illustrates, economic crime, along with the enforcement efforts mounted in response, can be a multinational phenomenon. The potentially global scale of economic crime complicates efforts to analyze interactions between potential wrong­ doers and law enforcement agencies. In simple models of crime and punishment a single representative actor decides whether or not to commit an offense, taking into account sanctions and enforcement practices established in advance by a single enforcement agency (see e.g. Becker 1968; Arlen and Kraakman 1997; Garoupa 1997; Polinsky and Shavell 2007). In reality, a heterogeneous set of firms and individuals choose whether to engage in misconduct based on their beliefs about how multiple enforcement agencies from multiple jurisdictions will decide to behave in the future. Sometimes these complications matter: enforcement or compliance strategies that are optimal in a world with a single enforcement agency that must commit to its strategy in advance might be far from optimal in a world with multiple enforcement agencies with distinct objectives, which can tailor their strategies to respond not only to one another’s enforcement strategies but also to observed patterns of misconduct. Despite the inherent challenges, there is considerable value in taking the time to understand and analyze enforcement and compliance in dynamic multijurisdictional settings. Regulation of foreign bribery is an important case in point. Since the turn of the century there has been a dramatic expansion in the number of countries that prohibit bribery of foreign public officials, with a corresponding increase in the number of agencies involved

*  Comments from Sanford Gordon, Paul Lagunes and Susan Emmenegger, as well as participants in a faculty workshop at NYU and the conference on corporate crime and financial misdealing are gratefully acknowledged. Mastewal Taddese provided excellent research assistance. Financial support from the Filomen D’Agostino and Max E. Greenberg Research Fund is acknowledged with thanks.

151

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152  Research handbook on corporate crime and financial misdealing in regulating this kind of misconduct—all 35 members of the OECD, along with at least six other countries, have enacted legislation of this sort.1 Moreover, the U.S., U.K., Germany and a handful of other countries have begun to enforce their prohibitions on foreign bribery quite vigorously. In addition, there is increased international cooperation between enforcement authorities—the largest penalties to date have resulted from joint enforcement actions, including the prosecution of Siemens by prosecutors in the U.S. and Germany ($1.6 billion in monetary penalties), and the prosecution of Odebrecht and Braskem by the U.S., Switzerland and Brazil (at least $3.5 billion). The emergence of this new regime has been widely celebrated (see e.g. Spahn 2013), but many questions about it remain unanswered. How will various countries enforce prohibitions on foreign bribery? Will they target both individuals and corporations? How will firms and individuals respond to multijurisdictional enforcement? Since enforcement practices can diverge from stated policies, what kinds of data should we collect to figure out which enforcement or compliance strategies have been adopted? The answers to these questions will help to determine whether the new anti-bribery regime represents a pathbreaking step toward reducing corruption or an unprecedented waste of enforcement and compliance resources. Similar questions can be asked about enforcement regimes aimed at many other kinds of transnational economic crime, ranging from email scams to money laundering to cyberattacks. Legal scholars often turn to game theory to analyze how firms and individuals who act strategically will respond to legal rules (see, e.g., Baird, Gertner and Picker, 1994; Benoît and Kornhauser 2002). At first glance, multijurisdictional law enforcement seems like a perfect setting in which to deploy game theoretic analysis. Law enforcement can be conceptualized as a dynamic multiplayer game involving various types of firms, individuals, victims, public officials and enforcement agencies, each of which has its own objectives and constraints and acts taking into account the actual and expected actions of others. Ideally, it would be possible to use this kind of analysis to formulate testable hypotheses about the outcomes of interactions between firms and enforcement agencies. Unfortunately, game theoretic analysis is unlikely to be a reliable source for these kinds of insights. There are too many factors that complicate the tasks of describing the structure of the game (i.e. players, objectives, sequences of actions and information structures), predicting how it will be played, finding empirical confirmation of those descriptions and predictions, and settling on normative criteria against which to evaluate outcomes. No tractable model can accommodate all these complicating factors. One of the main objectives of this chapter is to demonstrate the limits of models that ignore the various complications. The chapter focuses on the enforcement of laws against foreign bribery, but many of the arguments carry over to the enforcement of other laws. Section 2 describes two key elements of the law enforcement game, namely the players and the actions open to them. Section 3 discusses the objectives of the players. Section 4 describes the timing of the enforcement game. Conventional models are unrealistic 1   All of these countries are signatories to the Organisation for Economic Co-operation and Development, Convention on Combating Bribery of Foreign Public Officials in International Business Transactions. See, OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions: Ratification Status as of 21 May 2014, available online at http://www.oecd.org/daf/anti-bribery/WGBRatificationStatus.pdf

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Multijurisdictional enforcement games  153 because they ignore the fact that critical enforcement decisions generally are made after misconduct takes place. Section 5 discusses how the enforcement game is likely to be played, and points out several ways in which more realistic models might yield equilibrium outcomes that diverge from the predictions of conventional models. Section 6 discusses the challenges of observing and documenting either the structure of an enforcement game or how it has been played. Section 7 considers the normative criteria that should be used to evaluate outcomes of the enforcement process. Section 8 concludes.

2.  PLAYERS AND ACTIONS Who plays the enforcement game? On one side we have potential wrongdoers. Most economic crime occurs in organizational settings and sometimes we treat the organizations as players of the enforcement game: ‘Firm X paid bribes in five different countries’ or ‘Bank Y engaged in money laundering’. Sometimes though, it is helpful to identify individuals as the players (Arlen 1994): the sales manager who pays the bribe, or the account representative who turns a blind eye to warning signs in a client’s explanation of her source of funds. The situation becomes even more complicated if we take into account corporate subsidiaries and joint ventures, each of which may have its own organizational structure and senior managers. In the Siemens case, for instance, investigations were aimed not only at the German parent company, but also at several of its subsidiaries, joint ventures between Siemens and other companies, and several individual Siemens employees. Misconduct sometimes involves multiple wrongdoers, spanning organizational boundaries. In fact, some offenses necessarily involve multiple actors; bribery is a classic example since it requires both a payer and a recipient. Transnational bribery often also involves one or more third party intermediaries—consultants, attorneys, distributors, or financial institutions, and the like—who serve as conduits for bribes. A complete specification of any given law enforcement game should include all of these actors. Potential wrongdoers do more than simply decide whether or not to engage in misconduct; avoiding or preventing misconduct can entail many distinct actions. This is especially obvious in the case of organizational actors which act through multiple agents. For instance, a firm that wishes to prevent bribery can turn down opportunities to do business in high-risk countries, screen potential employees for honesty and integrity, train existing employees to refrain from unlawful payments or ensure that its incentive compensation scheme does not effectively award bonuses for bribery. Organizational actors must also choose whether and to what extent to gather information about their agents’ past misconduct through surveillance and audits. And both individual and organizational actors must decide whether and when to report past misconduct to various enforcement agencies (see Arlen and Kraakman 1997). Potential wrongdoers also must decide whether to devote resources to substitutes or complements for illegal activity. For instance, ­lobbying can serve as a substitute for bribery, while opaque accounting practices can serve as a complement. On the enforcement side of the game are public agencies that engage in monitoring, investigation, adjudication and sanctioning, as well as dissemination of information about these activities. (For present purposes I will assume that legal standards and the range of possible sanctions are established prior to enforcement and ignore actors such

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154  Research handbook on corporate crime and financial misdealing as legislatures which are involved in lawmaking but not law enforcement.) Those agencies include, at a minimum, police, criminal prosecutors and courts. Specialized regulatory agencies (e.g. securities regulators), as well as bodies such as legislative committees, also play a role sometimes. And thinking more broadly, officials charged with public procurement act as enforcement agencies to the extent they take violations of law into account when deciding whether someone is eligible to be awarded a public contract. Similarly, any government agency that serves the business community might play an enforcement role to the extent it receives and passes on information about suspected misconduct. To further complicate matters, because enforcement agencies are organizations, there is always the option of treating individuals within the agency—prosecutors, police officers, parliamentarians etc.—rather than the agency itself, as the players of the enforcement game. This will be appropriate if leaders of the organization find it difficult to induce individual employees or agents to keep their behavior in line with a coherent set of organizational objectives. And of course, these enforcement agencies and agents may be scattered across multiple countries. When a multinational enterprise like Siemens bribes a public official, any or all of these agencies can participate in the enforcement game (see, Davis, Jorge and Machado 2015a). The firm may be charged by criminal prosecutors in the jurisdiction where the official is located. The official’s government might also initiate civil proceedings in any jurisdiction where the firm or its assets are located to recover compensation for the harm it suffered (such as overpayment in public procurement) as a result of the bribe, or to compel disgorgement of a corrupt official’s ill-gotten gains. At the same time, if the case is sufficiently scandalous it might become the subject of a parliamentary investigation. Meanwhile, the U.S. Department of Justice (DOJ) may bring criminal charges for violations of the FCPA and the SEC might impose civil and administrative sanctions. These proceedings may unearth evidence of bribery in other jurisdictions, which might launch their own criminal, civil, administrative or legislative proceedings. Those proceedings might lead procurement officers in various countries to bar the firm from doing business with the government. Moreover, if the bribes were paid in connection with a project financed by an international financial institution such as the World Bank, that institution might bar the firm from working on future projects for a specified period of time. That debarment might lead other international financial institutions to debar the firm automatically pursuant to a formal cross-debarment agreement (see e.g. Agreement for Mutual Enforcement of Debarment Decisions, April 9, 2010). A complete model of the enforcement game would also include victims of misconduct and other private actors whose actions directly affect the impact of public law enforcement. Sometimes victims represent a discrete and easy to identify class of people—think of the victims of Internet scams. Sometimes the victims are more diffuse. For instance, in the case of foreign bribery, potential victims include the government as a whole, the specific agency impacted by the bribe, citizens who interact with that agency, and the general population in countries whose officials might be bribed as well as firms placed at a competitive disadvantage to the bribe-paying firm. Some victims initially influence the enforcement game by taking precautions, which typically make misconduct more difficult for at least some actors (see Søreide and Rose-Ackerman, Chapter 7 in this volume). After misconduct has occurred, victims can influence law enforcement by providing information to enforcement agencies (see Engstrom, Chapter 14 in this volume) and imposing

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Multijurisdictional enforcement games  155 their own sanctions, whether by legal or extra-legal means. For instance, competitors or shareholders might bring civil actions against firms or individuals who have engaged in bribery, and foreign governments might use evidence of bribery as a basis for escaping their obligations under tainted procurement contracts. Private actors other than victims can also play a role in the enforcement game. The most obvious examples are whistleblowers—people who provide information about misconduct to enforcement agencies (see Engstrom, Chapter 14 in this volume). Private actors who are not victims also sometimes sanction misconduct, such as when unions, NGOs or trading partners organize boycotts of firms that have a reputation for misconduct (Ayres and Braithwaite 1992). Victims and private actors are often ignored in models of law enforcement. It is common to assume that opportunities to commit crime and the rates at which crimes are reported are exogenously determined. This methodological shortcut is harmless so long as it is reasonable to assume that victims and other private actors do not behave strategically – that is to say, so long as victims do not adjust their behavior in response to beliefs about the actions of other players. But victims often do behave strategically. Firms might enter certain markets if, but only if, they believe that competitors will comply with prohibitions on foreign bribery. Similarly, victims and whistleblowers might report misconduct if they have confidence in law enforcement agencies, but not otherwise. 2.1  The Role of Legal Norms Legal norms obviously play a significant role in determining the players in the enforcement game and the actions open to them. In the case of enforcement agencies, jurisdictional rules, that is to say rules that determine which instances of wrongdoing or which actors the agency is allowed to pursue, play a crucial role in the analysis. In the international context, these rules are typically based on principles of either territoriality or nationality (although notable exceptions exist, including in the case of anti-bribery law). As a result, enforcement agencies are usually limited to investigating or prosecuting actors who either are nationals or who engage in misconduct within their territory. And when it comes to imposing sanctions, such as arrest or attachment, jurisdiction is typically limited to assets or individuals located within the territory of the relevant agency. Naturally, legal norms also determine agencies’ investigative powers and the types of sanctions they can request or impose. Those sanctions include not only direct fines and penalties but also corporate governance mandates (Arlen and Kahan 2017) and “collateral” sanctions such as being deprived of licenses or barred from bidding on public contracts. Legal norms can also grant agencies more or less discretion. For instance, in some jurisdictions, the legality principle prevents prosecutors from exercising discretion over which cases to prosecute and what charges to bring. By contrast, in the United States and other jurisdictions, enforcement agencies have broad discretion to engage in plea bargaining or charge bargaining (see Arlen 2016). Similarly, fines and penalties may either be left entirely within the discretion of the court or governed by mandatory rules. Law also governs the conduct of private actors in the enforcement process. This includes the extent to which firms can conduct private investigations of their employees and threaten to fire them if they fail to cooperate. In the United States, firms have broad latitude to investigate their employees and fire them if they fail to cooperate. In other

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156  Research handbook on corporate crime and financial misdealing countries that have not embraced the U.S. concept of employment-at-will, firms may find it difficult to wield the threat of termination. In the United States, firms also have broad authority to investigate their employees’ misconduct, review corporate documents and emails, and conduct interviews. By contrast, in other countries, firms do not have such leeway. For example, in China, private individuals retained by foreign firms have been imprisoned for conducting investigations, on the grounds that they have asserted powers that belong exclusively to the state (Barboza 2016). Law affects the conduct of whistleblowers in particularly distinctive ways. The U.S. SEC’s whistleblower program allows people who provide information about violations of the FCPA and other securities laws by publicly traded firms to recover up to 30 percent of sanctions collected from the firm. The law that creates the rewards program also protects whistleblowers from retaliation (U.S. Securities and Exchange Commission 2017). 2.2  Resource Constraints The actions open to enforcement agencies, potential wrongdoers and victims are determined in part by the resources available to them. On the enforcement side, skilled personnel, office space and information technology, as well as access to social networks and other media, are critical determinants of agencies’ abilities to investigate, monitor, prosecute, sanction and disseminate information (see e.g. Jackson and Roe 2009; Lohse et al. 2014). Private actors draw on the same kinds of resources to train, monitor, investigate and sanction agents who might engage in wrongdoing, as well as to avoid being victimized themselves. Some of these resources can be purchased in the marketplace, but access to social networks and know-how often can only be acquired over time and with experience.

3. OBJECTIVES 3.1  Objectives of Private Actors A critical step in game theoretic analysis is to specify the players’ objectives, or, more precisely, their preferences over possible outcomes of the game. It is conventional to assume that private actors’ preferences are driven by a desire to maximize expected financial returns. The implications for players’ decision-making processes are straightforward. Potential wrongdoers weigh the expected benefits of wrongdoing against the expected costs of sanctions (Becker 1968). Potential victims attend to the expected costs of being victimized, the costs of precautions, the costs of reporting, and the expected value of compensatory legal remedies. Meanwhile, for other private actors, the costs of participating in enforcement, including the costs of retaliation, are weighed against benefits such as the bounties offered to whistleblowers. Although the assumption that private actors are motivated primarily by financial incentives is fairly standard in the literature, common sense and an increasingly substantial amount of empirical literature suggest that other factors influence preferences in relation to compliance strategies. Some studies focus on cognitive factors, such as people’s tendencies to deceive themselves about whether their conduct is dishonest and to weigh short-term benefits more heavily than the relatively long-term consequences of being

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Multijurisdictional enforcement games  157 sanctioned. These tendencies vary from person to person. They can be exacerbated by factors such as stress or tiredness and past misconduct. Other studies focus on situational rather than individual factors, such as competition, cultural or professional identity and the perceived legitimacy of norms (Langevoort, Chapter 11 in this volume). 3.2  Objectives of Public Enforcement Agencies and their Agents Enforcement agencies also have preferences in terms of enforcement outcomes, including which cases are investigated and prosecuted and what sanctions are imposed. In the foreign bribery context, there are important questions about whether U.S. enforcement agencies should give priority to the prosecution of foreign as opposed to domestic firms, and whether they should focus on cases that involve corruption in countries with relatively weak anticorruption institutions. There is also controversy over whether fines, penalties, damages and forfeitures collected in foreign bribery cases should remain with the U.S. Treasury or be remitted to the governments who employed the corrupt officials. What should we presume about the preferences of enforcement agencies? First, like wrongdoers, some enforcement agencies care about their finances. Virtually every agency is subject to resource constraints and so, all other things being equal, some agencies will prefer to achieve any given outcome at the lowest possible cost. This assumption is not universally valid though. Agencies that seek to maximize their power and influence might wish to maximize the size of their budget. Perhaps more plausibly, agencies might also care about the financial benefits that flow from their actions. For instance, U.S. enforcement agencies arguably have an interest in enforcement strategies that yield large fines and penalties for the U.S. Treasury because total recoveries are an easily communicable way of demonstrating effectiveness to Congressional overseers (Lemos and Minzner 2014). At the same time, it is reasonable to presume that factors beyond financial returns play a role in shaping the preferences of public enforcement agencies. For starters, we should acknowledge that in well-functioning enforcement agencies, most individual agents are likely to care primarily about achieving the conventional objectives of law enforcement, namely prevention (which includes both deterrence and incapacitation), retribution or compensation. This still leaves considerable room for divergent preferences. Consider enforcement of the FCPA. If retribution is the objective, then at any given point in time the agency will assess outcomes by looking at whether sanctions for previous misconduct vary in accordance with defendants’ culpability, however conceived. By contrast, if prevention is the objective, the focus will be on how potential wrongdoers will behave in the future. Finally, if compensation is the objective, the focus will be on the welfare of victims (Davis 2015). An agency’s preferences over enforcement outcomes might also be influenced by its views on whether it ought primarily to serve the interests of nationals or foreigners. Again, consider enforcement of the FCPA by U.S. agencies. At one extreme, self-interested agencies will judge enforcement outcomes according to whether they respond to the concerns of U.S. nationals. This typically will mean focusing on the interests of U.S. nationals who are stakeholders—shareholders, creditors, employees, suppliers and customers, etc.—in firms that are economically disadvantaged by foreign bribery. (Those interests can be served by a variety of enforcement strategies, including targeting foreign rather than domestic firms, targeting domestic firms in order to give them a credible reason to

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158  Research handbook on corporate crime and financial misdealing “just say no to bribery,” or targeting any firm whose actions embarrass the United States in the eyes of allies.) At the other extreme, altruistic agencies will be concerned mainly about the people represented by the officials who have been bribed, especially if no other anticorruption institutions are capable of protecting them (Davis 2002). Alternatively, an agency might take an intermediate “cosmopolitan” approach and give equal weight to the interests of U.S. nationals and foreigners. The legislative history of the FCPA includes statements consistent with all of these viewpoints (Davis 2012; Choi and Davis 2014). Combining three distinct conceptions of the general objectives of law for enforcement and three conceptions of the objectives of FCPA enforcement yields at least nine distinct types of preferences: self-interested retribution, altruistic compensation, etc. In practice, of course, an agency may give weight to several motivations or objectives and pursue them simultaneously. This increases the number of possible types of preferences to include combinations such as “self-interested retribution and prevention, with greater weight given to retribution.” Another complication in analyzing enforcement objectives is that individual agents within an agency might have different objectives from those endorsed by the leaders of the agency. For instance, the preferences of individual U.S. prosecutors in FCPA cases might run towards easy high-profile cases (Lemos and Minzner 2014). Easy cases allow individual prosecutors either to earn more wins with the same amount of effort or to expend less effort. High-profile cases help individuals’ careers (Brewster and Buell 2017). Winning a high-profile case may be a good way for a prosecutor to earn a promotion. It may also be a calling card for an attorney who wants to leave government and go into private practice (although there is always the risk that prospective clients will take aggressive prosecution as a signal of implacable hostility to their interests). In the U.S. it is common for successful prosecutors to leave the government and obtain jobs with prominent law firms where they earn, literally, millions of dollars. A final complication is that the objectives of both enforcement agencies and individual agents (especially political appointees) might be shaped by the whims of individual political leaders to whom they report or, in the cases of democratically accountable actors, the vagaries of public opinion (Richman 1999; Gordon and Huber 2009). There is no reason to expect objectives shaped by such forces to be either well-defined or stable over time. For instance, agencies subject to political influence might pursue different objectives depending on the political clout of the prospective defendants.

4.  TIMING OF THE ENFORCEMENT GAME 4.1  The Single-Stage Game An enforcement strategy is an algorithm that specifies all the actions to be taken by an enforcement agency whenever it has an opportunity to act, over the course of the entire game. Those actions include establishing the range of possible sanctions, as well as monitoring, investigating and imposing sanctions on specific actors. An enforcement strategy can include specifications that certain actions should only be taken if the game to date has been played in a particular way (e.g., impose higher sanctions if, but only if, the defendant has failed to cooperate in the investigation). Similarly, a compliance strategy

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Multijurisdictional enforcement games  159 specifies actions to be taken when private actors have opportunities to engage in prevention, monitoring, investigation and reporting. As in other games, the strategies in the enforcement game can include both pure strategies and mixed strategies. A pure strategy identifies with certainty the action to be taken whenever an agent has the opportunity to act. By contrast, a mixed strategy identifies the probability with which each member of a set of actions should be taken (e.g. self-report 50 percent of the time when competitors are being investigated). When are enforcement and compliance decisions made? Ever since Becker’s (1968) pioneering contribution, and despite forceful objections from Tsebelis (1989, 1990, 1995), most economic analyses of law enforcement have assumed, often implicitly, that law enforcement is a two-stage game in which enforcement agencies move first and potential wrongdoers move second (see generally Garoupa 1997; Polinsky and Shavell 2007). In the case of economic crime, law enforcement appears to involve a different—and somewhat more complicated—sequence of moves. Before the enforcement process begins, legislators decide on a schedule of sanctions, setting out at least the range of possible sanctions. Then: 1. Organizations and potential victims decide what preventive measures to adopt. 2. Potential wrongdoers decide whether to engage in misconduct. 3. Wrongdoers and other private actors and enforcement agencies decide how to allocate their resources to collecting data on past misconduct through monitoring and investigation. 4. Wrongdoers and other private actors decide whether to report misconduct. 5. Enforcement agencies decide what sanctions to impose on detected misconduct. This sequence of moves differs from the sequence assumed in conventional models in one key respect: wrongdoers decide whether to engage in misconduct before enforcement agencies settle on their enforcement strategy. In other words, wrongdoers move before enforcement agencies. Following Graetz et al. (1986), compliance with tax law is often modeled in this way. Otherwise, few economic analyses of law enforcement, with the notable exception of Leshem and Tabbach (2012), have deviated from the conventional assumption that enforcement agencies are first movers (see also Spengler 2014 and Tsebelis 1989, 1990, 1995). The conventional model fits situations in which there is no opportunity for enforcement agencies to make decisions in response to observed misconduct. Classic examples are where the only way to enforce the law is to catch people red-handed, for example in the act of breaking into a car (see e.g. Di Tella and Schargrodsky 2004). In this scenario, the key enforcement decision is to ensure that agents arrive on the scene before the crime is completed. This means that the enforcement agency’s decision must be made before, or perhaps at roughly the same time as, wrongdoers choose their targets; unless the crime takes a long time to complete there is no opportunity to set an enforcement strategy in reaction to wrongdoers’ decisions. By contrast, the model outlined above presumes that agencies decide whether to initiate investigations and prosecutions after misconduct has occurred. This kind of reactive enforcement may or may not be common in cases of street crime—the situation is changing with the increased prevalence of video surveillance—but it is certainly common in cases of corporate misconduct, which often is not detected until well after the wrongful acts have been completed.

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160  Research handbook on corporate crime and financial misdealing The law clearly permits reactive enforcement. For example, in the United States, federal criminal law generally allows a defendant to be prosecuted so long as they have been indicted within five years after the commission of an offense (28 U.S.C. § 2462). And this five-year limitation period can be extended by agreement or in cases where the government requires evidence from a foreign country (18 U.S.C. § 3292). These lengthy limitation periods provide ample time for an enforcement strategy to change after a wrongdoer has engaged in misconduct, including as a result of changes in the availability of resources. Moreover, the combination of short budget cycles and broad prosecutorial discretion make it implausible for U.S. enforcement agencies to commit themselves to any particular enforcement policy until the expiry of the applicable limitation period. FCPA enforcement is a case in point. The U.S. ramped up enforcement beginning sometime around 2006, but the cases resolved in 2007 generally involved misconduct that began at least five years earlier. Why does it matter that decisions about prevention and misconduct typically are made before rather than after enforcement strategies are determined? In the first place, if enforcement takes place only after misconduct has occurred and involves no implicit commitment to make similar enforcement decisions in subsequent cases, then, virtually by definition, enforcement in and of itself has no deterrent effect. Potential wrongdoers might be deterred because they believe that the agency will use its enforcement powers to achieve objectives such as retribution, compensation or incapacitation, but the deterrent effects will be quite different from those suggested by conventional models (Leshem and Tabbach 2012). Alternatively, potential wrongdoers might be deterred if this sort of enforcement game is played repeatedly; they might believe that the agency will engage in enforcement after-the-fact in order to build or maintain a reputation that will form a deterrent in future periods. A second implication of the timing of enforcement decisions is that decisions about prevention and misconduct are often made in the face of profound uncertainty about what sanctions will be imposed. In other words, firms may face enforcement outcomes that are neither completely certain nor completely improbable. Moreover, the uncertainty will involve not just risk but also ambiguity. This means that agents may not be able to calculate the probabilities of outcomes with much confidence. Why the uncertainty? Prohibitions on retroactive lawmaking generally ensure that the range of potential sanctions can be determined by looking to the laws in force at any given time, but no comparable legal mechanisms bind enforcement agencies to specific enforcement strategies. Firms and individuals are forced to make predictions about whether their misconduct will be investigated or sanctioned by extrapolating from past enforcement actions and by interpreting speeches, hiring patterns, etc. to draw inferences about the preferences of enforcement agencies in future periods. Predictions based on these kinds of extrapolations are unlikely to be able to rule out many possibilities (which implies risk), and those predictions are also very likely to be wrong (which implies ambiguity). A third implication of the fact that enforcement decisions follow misconduct is that enforcement decisions can be conditioned on information that becomes available after the misconduct has occurred (Graetz et al. 1986; Leshem and Tabbach 2012; Arlen and Kahan 2017), including information about the prevalence of misconduct, the quality of the firm’s efforts in prevention and investigation, social harm or enforcement costs, and the actions of other enforcement agencies. For instance, instead of selecting firms

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Multijurisdictional enforcement games  161 at random to be investigated for foreign bribery, an agency might focus on firms that local press accounts have connected to documented instances of public sector corruption, especially when there are allegations that the corrupt acts have caused considerable harm to the public, involve multiple firms in an industry, or will be the subject of a local investigation. Allocating investigative resources on the basis of this kind of information is efficient because it allows resources to be concentrated on cases where the likelihood of detecting harmful wrongdoing is relatively high. This information also makes it possible for an agency to focus on cases in which the costs of any resulting enforcement actions are likely to be spread across several firms in an industry and shared with other enforcement agencies. From a firm’s perspective, the probability of being sanctioned for foreign bribery is significantly higher if it faces agencies that can draw on these kinds of information rather than agencies that pre-commit to random allocations of investigative resources. Having enforcement agencies condition their enforcement decisions on information obtained after misconduct has occurred often will tend to exacerbate the uncertainty faced by firms and potential wrongdoers. In order to calculate the probability of being sanctioned by any given enforcement agency a firm will have to take into account not just the extent to which its own wrongdoing will be observable to the agency, but also what the agency is likely to observe about the compliance decisions of other firms in its industry and enforcement strategies adopted by other agencies. It is quite possible that there will be multiple combinations of strategies those other players could reasonably pursue, in other words, the enforcement game might have multiple equilibria. In these circumstances, each player in the game will act in the face of uncertainty—so-called strategic uncertainty— about the consequences of its actions. Enforcement conditioned on post-misconduct information does not necessarily imply uncertainty for firms and potential wrongdoers. Nor does it necessarily mean that future enforcement decisions will be independent of past decisions. In principle, enforcement agencies might commit themselves in advance to strategies that rely on post-misconduct information yet still yield outcomes that are highly predictable. For instance, agencies might issue binding policy statements which leave little doubt that bribes paid to circumvent health or safety regulations in any sector where corruption is reputed to be widespread are highly likely to be sanctioned by one, but no more than one, agency. This approach to enforcement uses post-misconduct information to boost the efficiency of resource allocation—compared to having each agency select its targets randomly and independently—without divorcing future enforcement decisions from past decisions and without generating uncertainty. 4.2  Multi-Stage Enforcement Processes The process of deciding what sanction to impose can be modeled as a single stage of the enforcement game, but in fact it involves several distinct functional stages: monitoring, investigation, prosecution, adjudication and sanctioning. These functions are frequently performed by different organizations, working either in sequence or in tandem. Take the case of money laundering. Financial Intelligence Units monitor suspicious transactions. The police and agencies such as the U.S. Federal Bureau of Investigation investigate more credible allegations of wrongdoing. Attorneys-general conduct prosecutions that lead to adjudication by courts or administrative agencies. Finally, sanctions are administered

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162  Research handbook on corporate crime and financial misdealing by still other agencies, such as, in the U.S. federal system, the Marshals Service (which executes forfeitures) and the Bureau of Prisons. Ideally, information generated at each stage in the process serves as an input in later stages of the process. To further complicate matters, in some legal systems it is possible to bypass certain stages in the enforcement process. For instance, if a wrongdoer self-reports it is often possible to skip the monitoring and investigation stages. In the U.S., FCPA cases largely avoid adjudication. In recent years virtually all FCPA cases aimed at organizational defendants have been resolved through pre-trial agreements between prosecutors and the target firms, with very little oversight from the courts. 4.3 Coordination Another way to increase the realism of the enforcement game is to allow for the possibility of coordination among enforcement agencies or other actors. Coordination in this context can be defined as working together to achieve a common goal (Davis, Jorge and Machado 2015b). Working together involves sharing resources and information. Indicia of coordination are: acknowledgement of common goals; sharing of information required to pursue the common goals; provision of information about the effects of actions (feedback); adjustment of actions or objectives in response to feedback; and the adoption of rules or processes for assigning activities among various actors. These activities, in turn, generally require coordination mechanisms. These include organizations or social networks that establish channels for information flows and opportunities for face-to-face interaction, as well as protocols for making decisions or formulating rules. These organizations, networks or protocols can be established through hierarchical commands or adopted by explicit or implicit agreements, all of which may or may not be legally binding (Davis, Jorge and Machado 2015b). There are several prominent examples of coordination mechanisms among enforcement agencies. The more established mechanisms include: the doctrines of double jeopardy and ne bis in idem, together with jurisdictional rules, all of which serve to limit overlaps in jurisdiction; formal agreements such as Mutual Legal Assistance Treaties and memoranda of understanding (MOUs) among securities regulators; intergovernmental organizations such as the Financial Action Task Force or the OECD Working Group on Bribery in International Business Transactions; and a myriad of informal social networks. Enforcement agencies also create ad hoc coordination mechanisms to pursue specific cases, such as the arrangements between U.S. and German agencies that led to the Siemens settlement, or, in domestic contexts, interagency task forces. Among private actors, potential coordination mechanisms include: general purpose trade associations; specialized associations such as the Wolfsberg Group (an association of global banks concerned with anti-money laundering and related issues); and various forms of cartels, contracts or joint ventures. Few mechanisms exist, however, to coordinate the actions of private plaintiffs and public enforcement agencies (such mechanisms do exist in the U.S. qui tam process, see Engstrom, Chapter 14 in this volume). For the purposes of game theoretic analysis, when coordination is possible the extent of coordination should, ideally, be modeled as a choice—agencies might choose whether to conclude and abide by MOUs or firms might choose whether to join trade associations or cartels. The extent to which actors choose to coordinate will determine the extent to

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Multijurisdictional enforcement games  163 which it is appropriate to treat groups of individuals or organizations—whether or not they are formally constituted as organizations—as distinct players in subsequent stages of the game. Naturally, accounting for the possibility that actors will choose varying levels of coordination will make the analysis of a multijurisdictional enforcement game much less tractable. 4.4  Repeated Play An even more realistic specification of the enforcement game would allow for repeat play. In repeated games different actions can be adopted in different rounds. This allows for the possibility of using rewards and punishment to induce other players to pursue strategies that would be unattractive if the game was played only once. For example, an enforcement agency in Country A might target firms from Country B in an effort to encourage the enforcement agency in Country B to step up enforcement. There is some evidence that this kind of inducement can be effective. Kaczmarek and Newman (2011) found that countries whose firms were prosecuted for violations of the FCPA were twenty times more likely to enforce their own laws against foreign bribery. Similarly, an enforcement agency might abide by a publicly announced but legally unenforceable strategy of granting leniency to firms that self-report, even though it might be tempted to throw the book at them after hearing about their crimes, in order to reap the rewards of receiving self-reports in the future. Repeated games also allow players in the enforcement game to learn, both about other players and the environment (see e.g. Sah 1991; Pogarsky et al. 2004; Friehe 2008). For instance, a firm that makes a low investment in prevention in early rounds of the game might learn how prosecutors respond and adjust its levels of preventive effort accordingly in later rounds. Enforcement agencies can learn too. For example, investigators in a particular agency may become more adept at investigating complex economic crimes through learning-by-doing (Davis 2010). Under these conditions it might be rational for relatively sophisticated anticorruption agencies to limit extraterritorial enforcement in the early rounds of the enforcement game in order to allow less sophisticated agencies to acquire experience. A different strategy would be called for, however, if agencies learn best by example. That type of learning might be fostered by joint enforcement actions between more and less sophisticated agencies in early rounds of the enforcement game.

5.  POSSIBLE OUTCOMES In simple models of law enforcement, a single enforcement agency chooses its enforcement strategy in advance of any misconduct, in a one-shot game, with the aim of deterring a single representative wrongdoer. Higher penalties and/or probabilities of detection induce less misconduct, and induce firms to invest more in prevention. The agency’s optimal strategy involves setting the expected penalty facing wrongdoers at a level that equals or—in the case of acts whose harms are unquestionably greater than their benefits—exceeds, the social harm. This typically implies setting fines at the highest level feasible, supplementing those fines with more costly sanctions as necessary, and then choosing a level of enforcement effort that does not entail unduly high enforcement costs.

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164  Research handbook on corporate crime and financial misdealing In the standard model, players’ optimal strategies generally remain constant over time so long as no exogenous shocks alter fundamental parameters of the game (see generally, Polinsky and Shavell 2007; but see Arlen 1994; Arlen and Kraakman 1997). These results do not necessarily hold when we complicate the basic model. This is not the place to analyze all of the possible equilibria of dynamic multijurisdictional enforcement games. A few possibilities are worth highlighting though because they diverge from the predictions of the standard model and are likely to arise when there are multiple wrongdoers or enforcement agencies, or when enforcement strategies are chosen before compliance strategies, or when the enforcement game is played repeatedly. 5.1  Collective Action Problems among Wrongdoers We begin with a complication that is now reasonably well understood. Economic crime is often a collective activity. This is certainly the case for foreign bribery. At the very least it involves the actions of a bribe payer and a bribe recipient. Those actors may be individuals. But at least one of them, the recipient of the bribe, invariably represents an organization, and typically the bribe payer is acting on behalf of an organization as well. This means that many other individuals within the respective organizations are implicated in failing to prevent the misconduct and neglecting to detect or report it after the fact. Enforcement strategies can be crafted to create collective action problems among wrongdoers, that is to say, to induce them to pursue strategies that represent sub-optimal ways of pursuing the common objective of committing crime. The classic example is the enforcement strategy behind the famous prisoner’s dilemma—namely, imposing lower sanctions on wrongdoers who confess to a crime relatively early on. Selective grants of leniency can be used to induce leaders of firms to invest in monitoring that increases the risk of detecting wrongdoing or to self-report wrongdoing on the part of their employees or trading partners (see e.g. Arlen and Kraakman 1997; Basu 2011). As a result, the optimal enforcement strategy may involve penalties that are well below maximal levels. These strategies generally work on the assumption that there is no honor among thieves. If potential wrongdoers’ preferences include a disposition to be loyal to their peers then the prospect of leniency may not induce them to defect (see, e.g. U.S. Department of Justice, Antitrust Division 1993). 5.2  Collective Action Problems among Agencies Collective action problems can also arise among enforcement agencies, offsetting the potential benefits of redundancy among agencies (Ting 2003). When these problems arise the optimal enforcement strategy for any individual agency may involve either overenforcement or under-enforcement relative to situations in which either there is a single agency or a group of agencies are able to coordinate in pursuit of a common objective (Davis 2010). In the case of over-enforcement, agencies’ combined strategies result in more investigations or prosecutions, or greater sanctions than are required to achieve the common objective. In the absence of coordination this might occur because agencies free-ride unduly on one another’s efforts. If the objective is retribution, over-enforcement might entail sanctions that are disproportionately large in relation to the defendant’s culpability.

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Multijurisdictional enforcement games  165 Alternatively, regardless of the outcome, subjecting a defendant to the burden of being investigated or prosecuted multiple times might itself be viewed as a disproportionate sanction. Similarly, if the objective is deterrence, the concern is that multiplicity of proceedings will result in over-deterrence. One particularly troubling scenario occurs when a prosecution is based on information about wrongdoing that a firm has self-reported to an enforcement agency in another jurisdiction in return for a promise of leniency. This prospect undermines firms’ incentives to self-report. Under-enforcement, naturally, involves the opposite of over-enforcement. It can occur if agencies limit their enforcement to the point where enforcement is sub-optimal from a collective perspective. The most plausible concern is that agencies will delay enforcement in the hopes of free-riding on the actions of other agencies (see, e.g. Ting 2003). 5.3  Partial Enforcement and Displacement Sometimes an enforcement agency will choose a strategy that involves partial enforcement, meaning one that allows certain kinds of misconduct to go unpunished even though the benefits of targeting that misconduct for enforcement would exceed the costs. The most obvious explanation for partial enforcement is the presence of legal limits on the agency’s jurisdiction. International law generally frowns on efforts to sanction actors with no connection whatsoever to the country of the agency imposing the sanctions. Agencies may also choose partial enforcement for more practical reasons. For instance, a self-interested enforcement agency in Country A that is subject to even modest resource constraints may focus its efforts on bribery that places its firms at a competitive disadvantage and ignore bribes paid in markets where it has no economic interests. This strategy will be particularly effective if other enforcement agencies have difficulty detecting the misconduct tolerated by A’s enforcement agency (cf. Stephan 2012, pp. 66–67). Compliance strategies will tend to reflect the limits of agencies’ enforcement strategies. For example, suppose it becomes known that an anticorruption agency will refuse to sanction actors based overseas. Higher levels of enforcement effort will simply induce greater levels of bribery by actors located in foreign jurisdictions, assuming the foreign agencies’ enforcement strategies remain constant (Davis 2002). This is an example of the widely discussed phenomenon of crime displacement (see generally Broude and Teichman 2009; Johnson et al. 2014). The magnitude of displacement will depend in part on the extent to which actors are mobile, meaning that they can move from one jurisdiction to another or commit crimes while remaining beyond the reach of enforcement agencies of interested jurisdictions. 5.4  Non-Stationary Equilibria When an enforcement game is played repeatedly, equilibrium enforcement and compliance strategies may not entail identical behavior in each round of the game, even if there are no exogenous shocks that alter the basic parameters of the game. To begin with, the equilibrium might include mixed strategies. For example, it might make sense for an agency to randomly select crimes for investigation rather than consistently targeting the most socially harmful behavior. The intuition here is that a consistent pure strategy would allow a category of firms to evade prosecution consistently. Second, an agent’s optimal

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166  Research handbook on corporate crime and financial misdealing strategy might require that play in earlier rounds triggers reward or punishments in a subsequent round. For instance, U.S. FCPA enforcement strategy might entail reducing future enforcement in order to reward enforcement agencies in other countries for stepping up their level of enforcement in the past. It is also plausible that the parameters of the game will change over time as a result of endogenous factors. For instance, U.S. enforcement agencies might find it either more or less appealing to sanction firms that pay bribes in poor countries as local enforcement agencies in those countries learn from experience (depending on whether local enforcement serves as a complement to or a substitute for U.S. actions). 5.5  Uncorrelated Enforcement and Compliance Strategies In conventional models of law enforcement, current levels of enforcement are presumed to have a direct effect on current compliance decisions. This is not necessarily the case in a world in which enforcement agencies are second movers. In this kind of world, the ultimate consequences of compliance decisions made in the current period will be determined by the enforcement strategies that agencies pursue in future periods. The challenge for potential wrongdoers is to anticipate those strategies. However, if enforcement strategies are prone to change over time then strategies being pursued in the current period will not necessarily provide insight into those that will be pursued in the future. The recent history of FCPA enforcement demonstrates that an agency that is currently imposing light penalties and exerting little effort might dramatically increase both sanctions and effort in future periods. Similarly, current high levels of penalties and enforcement effort may say little about future enforcement strategies. For all these reasons, current enforcement strategies may play only a limited role in potential wrongdoers’ assessments of the consequences of their current compliance decisions. This in turn means that the compliance decisions of actors who are motivated primarily by fear of legal penalties will not necessarily be influenced directly by current enforcement practices.

6.  EMPIRICAL CHALLENGES So far we have discussed how one might in theory go about describing the structure and predicting the play of a multijurisdictional enforcement game. In practice, it can be extremely challenging to observe and document either the structure of such a game or how it has been played. As far as the structure of the game is concerned, it is generally straightforward to identify the players because formal legal norms normally identify the relevant enforcement agencies and define the class of potential wrongdoers. With this information in hand it is not likely to be difficult to identify potential victims or whistleblowers. However, the sheer number of players can make it difficult to manage the resulting data. It is not quite so straightforward to determine the strategies open to the various players. To some extent these are defined by legal norms, as in the cases in which a statute defines the sanctions an enforcement agency can impose. In other cases, however, the set of feasible actions will depend on actors’ resources and expertise. Both these parameters can be difficult to measure and are subject to change over time.

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Multijurisdictional enforcement games  167 An even greater challenge is to ascertain the preferences of all these actors. Even if we make the simplifying assumption that private actors are motivated primarily by financial considerations, we still have to specify the preferences of actors on the enforcement side. Enforcement agencies generally make only vague statements about their organizational objectives that are open to multiple interpretations. For example, the U.S. Department of Justice has embraced the following strategic goals (among others): ●

Objective 2.2: Prevent and intervene in crimes against vulnerable populations and uphold the rights of, and improve services to, America’s crime victims. ● Objective 2.3: Disrupt and dismantle major drug trafficking organizations to combat the threat, trafficking, and use of illegal drugs and the diversion of licit drugs. ● Objective 2.4: Investigate and prosecute corruption, economic crimes and transnational organized crime. ● Objective 2.6: Protect the federal fisc and defend the interests of the United States. (United States Department of Justice 2014, 10) Collecting data about the structure of an enforcement game becomes even more complicated when there is doubt about the appropriate units of analysis. For instance, on the enforcement side the default approach is to treat the enforcement agency as the appropriate unit of analysis. But if enforcement agencies regularly coordinate their actions then it may be preferable to treat the group of agencies as a single actor. For instance, in the FCPA context, the DOJ and the SEC have issued a joint statement on enforcement policy (Criminal Division of the U.S. Department of Justice and Enforcement Division of the U.S. Securities and Exchange Commission 2012), which suggests that they coordinate their actions enough to be referred to jointly as “U.S. enforcement agencies.” The same may be true of the major multilateral development banks to the extent their debarment actions are coordinated by their cross-debarment agreement (Agreement for Mutual Enforcement of Debarment Decisions, 2010). Unfortunately, less formal coordination mechanisms such as social networks may be much more difficult to observe. It can also be difficult to determine whether individuals within an organization are aligned with stated organizational preferences. If they are not, then the individuals may be the appropriate unit of analysis. The best response to the challenge of determining the structure of a complex multijurisdictional enforcement game almost certainly includes significant amounts of qualitative research, i.e. in-depth interviews and ethnography. Given the number of agencies and individuals involved in multijurisdictional enforcement this can be a daunting task (see e.g. Davis, Jorge and Machado 2015b). Collecting data on how enforcement games have been or are being played can also be challenging. In the typical situation, only the first and last steps of the game—namely, announcement of the range of sanctions and imposition of sanctions—are readily observable. Both firms and enforcement agencies tend to provide less than full information about other aspects of their behavior. As a result, prevention, wrongdoing, monitoring, investigation and self-reporting generally cannot be observed with confidence. It is also difficult to observe consequences associated with various outcomes. For instance, the extent to which the U.S. has an economic interest in the welfare of multinational

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168  Research handbook on corporate crime and financial misdealing firms is not always clear, and so it may be difficult to determine whether sanctioning any given firm is consistent with self-interested objectives. For all these reasons it can be very difficult to determine what compliance and enforcement strategies have been adopted at any given time. It is particularly difficult to use observable data from cases in which sanctions have been imposed to determine whether agencies are pursuing deterrence-oriented strategies. This is most obvious when the optimal deterrent strategy involves inconsistent behavior. The extreme case is when the agency wants to maintain or develop a reputation for pursuing an unpredictable enforcement strategy. Even if deterrence demands an enforcement strategy that is consistent over time, it is likely to include the practice of imposing higher sanctions for misconduct perceived to have a lower probability of detection. External observers will typically find it difficult to observe either the actual or perceived probability of detection. Recall that the probability of detection generally should not be regarded as an exogenous factor because enforcement agencies can decide which cases to investigate and prosecute after misconduct takes place. These obstacles have not kept scholars from trying to study the relationship between enforcement and compliance. Karpoff et al. (2015) make an ambitious effort to determine whether recent efforts to enforce the FCPA are sufficient to deter firms from committing foreign bribery (see also Hines 1995 and Cuervo-Cazurra 2008). They conclude that sanctions are too low based on estimates of the probability that a publicly traded bribe-paying firm will face bribery charges (6.4 percent), the average value of a contract procured through bribery (2.64 percent of market capitalization), and the average cost of fines, investigation costs and reputational losses associated with being prosecuted for foreign bribery (5.1 percent of market capitalization). These estimates are, however, rather crude. For instance, the estimate of the value of contracts procured through bribery seems likely to be biased upwards because it is based on changes in firm value that occurred when contracts were publicly announced. Firms probably only choose to make announcements of this kind for relatively large contracts. A more fundamental concern is expressed by Karpoff et al. (2015), who estimate the probability that a bribe-paying firm will be sanctioned by using a statistical model to identify the characteristics of firms caught paying bribes. They then, effectively, assume that the firms caught were randomly selected from all the firms in the population with similar observable characteristics. They calculate the probability of detection by examining the entire population of firms to determine what proportion of firms that have the characteristics of bribe payers were actually caught. There are two main difficulties with this approach. First, the assumption that firms that resemble those caught paying bribes also paid bribes may not be valid. What if enforcement agencies decide which firms to investigate and prosecute only after misconduct has taken place and then select firms based on information that is not observable to the researchers? Second, the implicit assumption that past rates of detection reflect future probabilities of detection is suspect because there is no guarantee that enforcement strategies will be consistent over time. To put this in more concrete terms, suppose that over a three-year period, out of 1,000 firms, five are sanctioned for paying bribes, and all five are large multinationals operating in the oil and gas sector. Suppose that another 95 large multinational oil and gas firms were not sanctioned. Is it reasonable for a researcher to infer that all or virtually all large

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Multijurisdictional enforcement games  169 multinational oil and gas firms paid bribes? And even if that is true, can we infer that the probability of detection at all relevant points in time is 5/100 = 5 percent? The answers to these questions are no and no. First, the enforcement agency may have received information unobservable to the researcher that allowed them to target the only five oil and gas firms that paid bribes, implying that the probability of detection, at least for oil and gas firms, was 100 percent. Imagine, for instance, that the agencies based their decisions about who to investigate on complaints from victims (including competitors). Second, the enforcement agency might have decided to focus its efforts in a single sector to take advantage of economies of scale in enforcement. This means that we cannot use the data on enforcement outcomes to draw any inferences whatsoever about whether firms outside the oil and gas sector paid bribes. For similar reasons, even if the probability of detection was 5 percent during the threeyear period, there is no reason to believe that figure reflects the probability of detection in future periods. There are many reasons why the enforcement strategy might shift in future periods: complaints from victims might cause the agency to identify foreign bribery in other sectors as sources of concern; it may target another randomly selected sector for enforcement in order to avoid predictability; or, local enforcement agencies may become more effective in sanctioning public officials for corruption in the oil and gas sector, thereby reducing the value of prosecuting firms for foreign bribery. Despite these challenges it is valid to draw certain types of inferences about enforcement strategies from observable outcomes. Several studies examine how FCPA sanctions vary across firms. The results suggest that firms incorporated outside the U.S. pay higher penalties than firms incorporated inside the U.S. in cases with similar observable characteristics (Garrett 2011; Choi and Davis 2014). Sanctions were also higher when the home country of the firm was wealthier, or had strong institutions or a regulator with whom U.S. agencies have a cooperative relationship (McLean 2012; Choi and Davis 2014). Meanwhile, analyses of how sanctions vary depending on the countries implicated in the misconduct, i.e. the countries in which bribes are paid, suggest that sanctions are higher when bribes are paid in relatively corrupt countries (Choi and Davis 2014). If we assume that agencies are motivated by retribution, which arguably implies that sanctions should be based primarily on publicly available information, then these variations shed light on the extent to which U.S. enforcement agencies are influenced by self-interest as opposed to cosmopolitanism or altruism.

7.  NORMATIVE CHALLENGES Suppose we overcome the empirical challenges described in the previous section and are able to map the structure of a particular enforcement game, identify the enforcement and compliance strategies adopted over a particular time frame, and describe the outcomes. At that point it would be useful to be able to evaluate the outcomes with a view to possible changes in strategy. For instance, in the area of foreign corrupt practices, it would be useful to answer questions such as: Are penalties being imposed on firms and individuals in proportion to their culpability? Does the current approach to regulation of foreign corrupt practices cause firms to make excessive investments in compliance? Or, does it reflect a waste of resources on the part of U.S. law enforcement agencies? Are the benefits

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170  Research handbook on corporate crime and financial misdealing of enforcement actions, in terms of either deterrence or financial recoveries, distributed equitably across affected countries? The answers to these kinds of questions depend on the answers to basic normative questions about the objectives of law enforcement. As we have already seen, there are several potentially conflicting points of view on these issues. The ways in which an analyst evaluates the outcomes of an enforcement game will depend on whether or to what extent he or she believes that law enforcement should aim at retribution, prevention or compensation, and where they fall on the self-interest–altruism continuum. To further complicate matters, evaluation of an enforcement regime might involve procedural criteria such as transparency and accountability, as well as the substantive criteria listed above. Evaluations based on these kinds of procedural criteria might conflict with those based on some of the other criteria we have mentioned. For instance, a highly transparent enforcement strategy might score low marks in terms of deterrence because it provides too much information to wrongdoers—it is not necessarily a good idea to tell the mice where the traps have been set. Similarly, an enforcement strategy that relies heavily on extraterritorial enforcement might be highly effective in terms of substantive outcomes, but deeply problematic in terms of accountability because the relevant enforcement agencies are not accountable to the people they purport to be protecting (Davis 2010). In a multijurisdictional setting, multiple answers to questions about the applicable evaluative criteria are not only possible, but probable. The mere fact that people have organized themselves into distinct political units and have different ways of life makes it quite plausible that they will arrive at different conclusions about how to evaluate law enforcement systems and their operations. As a result, issues such as whether a particular enforcement system is or is not effective, or whether reforms are warranted, may be hotly contested. And the differences of opinion seem likely to track jurisdictional boundaries.

8. CONCLUSION Efforts to analyze multijurisdictional dynamic law enforcement games face major challenges, some theoretical, some empirical, others normative. The theoretical challenge is to develop models that capture more of the complexity of the real world of law enforcement. Simple models that involve a single enforcement agency and a single potential wrongdoer are poor simulations of reality. That reality includes: wrongdoers who are members of complex organizations and often work through intermediaries; a multiplicity of enforcement agencies, operating both within and across jurisdictions; and, victims and whistleblowers who assist with enforcement. These actors all have complex objective functions. This is especially true of enforcement agencies, in which conventional motivations for enforcement, such as retribution, prevention and compensation, can interact in complex ways with attitudes toward foreign (as opposed to domestic) interests, as well as economic or political influences. Conventional models of the enforcement game also misrepresent real-life enforcement games by ignoring the possibility of reactive law enforcement. In the typical model, an enforcement agency commits to its enforcement strategy which shapes the subsequent behavior of potential wrongdoers. In reality, key aspects of enforcement strategy are crafted in response to perceived misconduct. This means that current enforcement deci-

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Multijurisdictional enforcement games  171 sions should have only an indirect impact on potential wrongdoers’ beliefs about future sanctions, that potential wrongdoers’ beliefs about future sanctions necessarily will be uncertain, and enforcement agencies can reap the benefits of being able to condition their enforcement strategy on information obtained after the misconduct has occurred. Models that incorporate these kinds of complications generate different predictions from conventional models. With multiple wrongdoers and multiple enforcement agencies come potential collective action problems, at least in the absence of coordination. Wrongdoers defect from collectively optimal strategies by reporting on one another. Enforcement agencies defect by engaging in levels of enforcement that are collectively either excessive or insufficient—that involve either piling on or holding back—compared to the optimal level. The fact that enforcement games are played repeatedly might mitigate the potential collective action problems associated with a multiplicity of players. For instance, the prospect of tit-for-tat-style retaliation in future rounds of a game might induce players to behave cooperatively. Wrongdoers are less likely to report one another’s misconduct, even in exchange for rewards or promises of leniency, if they expect to profit from future criminal collaborations. Similarly, enforcement agencies might contribute to their fair share of the costs of investigations and refrain from free-riding on other agencies’ efforts in the hopes of benefiting from future enforcement. Predictions about how repeated games will be played have to allow for the possibilities that coordination will fail to emerge, or will emerge and then unravel permanently, or will emerge and then be sustained by periods of uncooperative retaliation. Predictions about repeated games also have to account for the possibility of endogenous changes in key parameters of the game, such as when enforcement agencies acquire expertise through learning. The ultimate purpose of building models of law enforcement is to generate testable hypotheses, typically about the relationship between strategies for enforcement and compliance. Unfortunately, it is inherently difficult to test any hypotheses of this kind. When it comes to illicit behavior, it is generally difficult to observe what people do and why they do it. But without empirical tests it will be impossible to know whether we are making any theoretical progress. Therefore, the empirical challenges associated with research on corporate crime arguably are more pressing than the theoretical ones. There is also no consensus about the normative criteria that should be used to evaluate particular enforcement strategies and the outcomes they produce. Reasonable people can disagree about whether the success of law enforcement ought to be measured in terms of prevention, retribution or compensation, or perhaps transparency and accountability. In a divided world, these disagreements are almost certain to persist. So what kind of progress can we expect in game theoretic analyses of enforcement of laws against foreign bribery and other types of corporate crime? No single model can capture all the complexity of real-world enforcement practices. Therefore, in addition to developing more complicated models, it might be helpful to develop simple models that focus on complications that so far have been neglected in the literature. The empirical challenge will be to determine which of these models provide the most useful insights in any given context. Overcoming these theoretical and empirical challenges will require significant effort. But even if those efforts are successful it is unrealistic to expect consensus around the appropriate criteria for evaluating enforcement practices. As a result, uncontested conclusions about critical aspects of modern law enforcement may remain

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172  Research handbook on corporate crime and financial misdealing elusive. Still, theoretically coherent and empirically validated models of enforcement can ensure that these normative disagreements are at least well informed.

REFERENCES Arlen, Jennifer. 1994. The Potentially Perverse Effects of Corporate Criminal Liability, Journal of Legal Studies, 23, 833–867. Arlen, Jennifer. 2016. Prosecuting Beyond the Rule of Law: Corporate Mandates Imposed Through Pretrial Diversion Agreements, Journal of Legal Analysis, 8, 191–234. Arlen, Jennifer and Marcel Kahan. 2017. Corporate Regulation Through Non-Prosecution, University of Chicago Law Review, 84, 323–387. Arlen, Jennifer and Reinier Kraakman. 1997. Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes, New York University Law Review, 72, 687–779. Ayres, Ian and John Braithwaite. 1992. Responsive Regulation: Transcending the Deregulation Debate, New York: Oxford University Press. Baird, Douglas G., Robert Gertner and Randal Picker. 1994. Game Theory and the Law, Cambridge, MA: Harvard University Press. Barboza, David. 2016. Drug Giant Faced a Reckoning as China Took Aim at Bribery, New York Times, November 1. Basu, Kaushik. 2011. Why, for a Class of Bribes, the Act of Giving a Bribe Should Be Treated as Legal, Ministry of Finance Working Paper. Becker, Gary. 1968. Crime and Punishment: An Economic Approach, Journal of Political Economy, 76, 169–217. Benoît, Jean-Pierre and Lewis A. Kornhauser. 2002. Game-theoretic Analysis of Legal Rules and Institutions. In R. J. Aumann and S. Hart (eds.), Handbook of Game Theory with Economic Applications, 3, Amsterdam: Elsevier, 2229–2269. Brewster, Rachel and Samuel W. Buell. 2017. The Market for Global Anticorruption Enforcement, Law and Contemporary Problems, 80, 193–214. Broude, Tomer and Doron Teichman. 2009. Outsourcing and Insourcing Crime: The Political Economy of Globalized Criminal Activity, Vanderbilt Law Review, 62, 795–848. Choi, Stephen J. and Kevin E. Davis. 2014. Foreign Affairs and Enforcement of the Foreign Corrupt Practices Act, Journal of Empirical Legal Studies, 11, 409–445. Criminal Division of the U.S. Department of Justice and Enforcement Division of the U.S. Securities and Exchange Commission. 2012. FCPA: A Resource Guide to the U.S. Foreign Corrupt Practices Act (November 14, 2012). Cuervo-Cazurra, Alvaro. 2008. The Effectiveness of Laws Against Bribery Abroad, Journal of International Business Studies, 39, 634–651. Davis, Kevin E. 2002. Self-interest and Altruism in the Deterrence of Transnational Bribery, American Law and Economics Review, 4, 314–340. Davis, Kevin E. 2010. Does the Globalization of Anti-Corruption Law Help Developing Countries? In J. Faundez and C. Tan (eds.), International Economic Law, Globalization and Developing Countries, Cheltenham, UK and Northampton, MA: Edward Elgar Publishing. Davis, Kevin E. 2012. Why Does the United States Regulate Foreign Bribery: Moralism, Self-Interest or Altruism?, New York University Annual Survey of American Law, 67, 497–511. Davis, Kevin E. 2015. The FCPA Enforcement Model. In Susan Rose-Ackerman and Paul L. Lagunes (eds), Greed, Corruption, and the Modern State: Essays in Political Economy, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Davis, Kevin, Guillermo Jorge and Maíra Machado. 2015a. Transnational Anti-corruption Law in Action: Cases from Argentina and Brazil, Law and Social Inquiry, 40, 664–699. Davis, Kevin E., Guillermo Jorge and Maíra Machado. 2015b. Coordinating the Enforcement of Anti-Corruption Law: South American Experiences (unpublished). Di Tella, Rafael and Ernesto Schargrodsky. 2004. Do Police Reduce Crime? Estimates Using the Allocation of Police Forces After a Terrorist Attack, American Economic Review, 94, 115–133. Friehe, Timothy. 2008. On the Optimal Sanction Structure when Individuals Are Imperfectly Informed about the Probability of Apprehension. In Michael Pickhardt and Edward Shinnick (eds), The Shadow Economy, Corruption and Governance, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Garoupa, Nuno. 1997. The Theory of Optimal Law Enforcement, Journal of Economic Surveys, 11, 267–295. Garret, Brandon L. 2011. Globalized Corporate Prosecutions, Virginia Law Review, 97, 1775–1876.

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Multijurisdictional enforcement games  173 Gordon, Sanford C. and Gregory A. Huber. 2009. The Political Economy of Prosecution, Annual Review of Law and Social Science, 5, 135–156. Graetz, Michael J., Jennifer F. Reinganum, and Louis L. Wilde. 1986. The Tax Compliance Game: Toward an Interactive Theory of Law Enforcement, Journal of Law, Economics, & Organization, 2, 1–32. Hines, James R. 1995. Forbidden Payment: Foreign Bribery and American Business After 1977, NBER Working Paper 5266, National Bureau of Economic Research, Inc. Jackson, Howell E. and Mark J. Roe. 2009. Public and Private Enforcement of Securities Laws: Resource-Based Evidence, Journal of Financial Economics, 93, 207–238 Johnson, Shane D., Rob T. Guerette and Kate Bowers. 2014. Crime Displacement: What We Know, What We Don’t Know, and What it Means for Crime Reduction, Journal of Experimental Criminology, 10, 549–571. Kaczmarek, Sarah C. and Abraham L. Newman. 2011. The Long Arm of the Law: Extraterritoriality and the National Implementation of Foreign Bribery Legislation, International Organization, 65, 745–770. Karpoff, Jonathan M., D. Scott Lee and Gerald S. Martin. 2015. The Value of Foreign Bribery to Bribe Paying Firms, Working Paper, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1573222 Lemos, Margaret H. and Max Minzner. 2014. For-profit Public Enforcement, Harvard Law Review, 127, 854–913. Leroy, Anne-Marie and Frank Fariello. 2012. The World Bank Group Sanctions Process and Its Recent Reforms, Washington DC: World Bank. Leshem, Schmuel and Avaraham D. Tabbach. 2012. Commitment versus Flexibility in Enforcement Games, The B.E. Journal of Theoretical Economics (Contributions) 12, Article 18. Lohse, Tim, Razvan Pascalau, and Christian Thomann. 2014. Public Enforcement of Securities Market Rules: Resource-based Evidence from the Securities Exchange Commission, Journal of Economic Behavior & Organization, 106,197. McLean, Nicholas M. 2012. Cross-National Patterns in FCPA Enforcement, Yale Law Journal, 121, 1970–2012. Pogarsky, G., A. R. Piquero, and R. Paternoster. 2004. Modeling Change in Perceptions about Sanction Threats: The Neglected Linkage in Deterrence Theory, Journal of Quantitative Criminology, 20, 343–369. Polinsky, A. M. and S. Shavell. 2007. The Theory of Public Enforcement of Law. In A. M. Polinsky and S. Shavell (eds.), Handbook of Law and Economics, Amsterdam: Elsevier, 1, 403–454. Richman, Daniel C. 1999. Federal Criminal Law, Congressional Delegation, and Enforcement Discretion, UCLA Law Review, 46, 757–814. Sah, Raaj K. 1991. Social Osmosis and Patterns of Crime, Journal of Political Economy, 99, 1272–1295. Spahn, Elizabeth K. 2013. Multijurisdictional Bribery Law Enforcement: The OECD Anti-Bribery Convention, Virginia Journal of International Law, 53, 1–52. Spengler, Dominic. 2014. Endogenous Detection of Collaborative Crime: The Case of Corruption, Review of Law & Economics, 10, 201–217. Stephan, Paul. 2012. Regulatory Competition and Anticorruption Law, Virginia Journal of International Law, 53, 53–70. Stigler, George J. 1970. The Optimum Enforcement of Laws, Journal of Political Economy, 78, 526–536. Ting, Michael M. 2003. A Strategic Theory of Bureaucratic Redundancy.  American Journal of Political Science, 47, 274–292. Tsebelis, George. 1989. The Abuse of Probability in Political Analysis: The Robinson Crusoe Fallacy, American Political Science Review, 83, 77–91. Tsebelis, George. 1990. Are Sanctions Effective? A Game-Theoretic Analysis, Journal of Conflict Resolution, 34, 3–28. Tsebelis, George. 1995. Another Response to Gordon Tullock, Journal of Theoretical Politics, 7, 97–99. United States Department of Justice. 2014. Fiscal Years 2014–2018 Strategic Plan. United States Department of Justice, Antitrust Division. 1993. Corporate Leniency Policy. August 10. Available online at https://www.justice.gov/atr/file/810281/download (last visited May 16, 2017). United States Securities and Exchange Commission. 2017. Frequently Asked Questions, available online at: https://www.sec.gov/about/offices/owb/owb-faq.shtml (last visited May 16, 2017).

Legislation Dodd-Frank Wall Street Reform and Consumer Protection Act. Pub. L. No. 111-203, § 922, 124 Stat. 1376, C.F.R. § 80.7.1841-49. 2010. Foreign Corrupt Practices Act of 1977, Pub. L. No. 95-213, § 102,91 Stat. 1494, codified as amended at 15 U.S.C. §§78m(b), (d)(1), (g)–(h), 78dd-1, 78dd-2, 78dd-3, 78ff; amended by Foreign Corrupt Practices Act Amendment of 1988 (part of Omnibus Trade and Competitiveness Act of 1988), Pub. L. 100-418, 102 Stat. 1107, 1415 (1988), and International Anti-Bribery and Fair Competition Act of 1998, Pub. L. 105-366, 112 Stat. 3302 (1998).

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174  Research handbook on corporate crime and financial misdealing International Instruments Agreement for Mutual Enforcement of Debarment Decisions, April 9, 2010. Organisation for Economic Co-operation and Development, Convention on Combating Bribery of Foreign Public Officials in International Business Transactions, November 21, 1997, 37 I.L.M. 4 (1998). United Nations Convention against Corruption, in force 14 December 2005.

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6.  Beware blowback: how attempts to strengthen FCPA deterrence could narrow the statute’s scope Matthew C. Stephenson* 1

1. INTRODUCTION The U.S. Foreign Corrupt Practices Act (FCPA), enacted in 1977, has emerged as a powerful tool in the fight against transnational bribery. Although FCPA enforcement was relatively infrequent for the first three decades of the statute’s existence, enforcement surged starting in the mid-2000s, with scores of cases and hundreds of millions of dollars in penalties (Bixby 2010; Thomas 2010). Many in the business community and defense bar, along with some academic critics, think that the government is enforcing the statute too aggressively (Koehler 2010; Weissmann & Smith 2010). Yet many in the anticorruption advocacy community think that the U.S. government has not gone far enough, and that the expected costs of paying bribes abroad are still far too low to provide adequate deterrence (Mark 2012; Segal 2006). Indeed, though estimating the deterrent effect of a law like the FCPA is very difficult to do rigorously, some recent attempts have suggested that the expected benefits of foreign bribery still far exceed the expected costs (Cheung et al. 2012; Karpoff et al. 2014). For those who believe that under-deterrence of foreign bribery remains a more significant problem than over-deterrence (and I count myself in that group, although I acknowledge the evidence is not conclusive), it is natural to consider changes to FCPA enforcement practices that might give the statute more teeth. In addition to obvious measures like allocating more staff and budget to FCPA enforcement, some advocates have recommended more substantive legal or policy changes. Three such proposals are particularly notable: First, some have argued for amending the FCPA to add a private right of action, so that private plaintiffs can bring civil actions directly against defendants for FCPA violations (Lim et al. 2013; Mark 2012; Pines 1994). Second, many assert that the government should bring substantially more cases, especially criminal cases, against individuals, rather than focusing primarily on corporate liability (Bixby 2010; Koehler 2011). (The Department of Justice’s 2015 Yates Memo may signal a shift toward more focus on individuals, though it is too soon to tell how much of a practical difference the Yates Memo will make to FCPA enforcement.) Third, several critics have suggested that the government is too reluctant to employ certain remedies, such as debarment from future government contracting, in FCPA cases, and that greater use of such remedies would have a much stronger deterrent effect on corporate actors than conventional monetary sanctions (Bistrong 2014; Stevenson & Wagoner 2011). These three reforms—private civil enforcement, individual criminal liability, more *  I am grateful to Rachel Brewster and Jennifer Arlen for helpful comments on a draft of this chapter.

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176  Research handbook on corporate crime and financial misdealing ­ ainful corporate sanctions—have much to recommend them. Yet all three have a potenp tial drawback, which proponents of stricter FCPA enforcement sometimes overlook. The key to understanding this possible drawback is to recognize that although the FCPA contains a number of ambiguities, the government has been able to adopt and enforce an expansive reading of the statute, one that covers a broader range of actors and conduct. Although the government’s interpretations of the statute are plausible (indeed, I tend to agree with the government’s position on every major contested point regarding the FCPA’s meaning), they are certainly contestable. Many critics—and many of the targets of FCPA enforcement actions—believe that some of the government’s interpretations of certain key portions of the statute are simply wrong (Koehler 2010; Nayeri 2014; Westbrook 2010). It is possible that some judges might agree with them. But for the most part we do not know if that is the case because FCPA cases are rarely litigated to judgment (Alexander & Cohen 2015). The conventional explanation for this is that corporate defendants—the most frequent target of FCPA enforcement actions—have a strong preference for settling these cases (Brooks 2010; Koehler 2010). And there’s the rub. The three sorts of reforms outlined above (private enforcement, individual liability, harsher sanctions) would all tend, at least over the medium to long term, to produce more FCPA cases litigated to final judgment, including appeals in which the government’s interpretation of the statute is at issue. And the government might well lose some of those cases—not because its legal position is actually incorrect, but simply because litigation is unpredictable, and federal judges have sometimes exhibited quite a bit of sympathy for white-collar and corporate defendants. Losing a few cases is not by itself a big deal, but a government loss on an issue of the FCPA’s meaning would have significant collateral consequences, affecting both litigation and settlement negotiations in all other FCPA cases where the judicial determination in question is binding. What’s more, the three reforms considered here may also tend to generate cases in which the FCPA defendants appear more sympathetic than is true in a typical FCPA settlement today. This, in turn, may influence both judicial and congressional perspectives on the operation and enforcement of the statute. Indeed, even if the courts do not adopt narrower constructions of the FCPA, a perception that FCPA enforcement is “out of control” may give renewed impetus to the now-dormant efforts to weaken the statute through “clarifying” amendments. Thus, it is at least possible that some of the tools meant to strengthen FCPA enforcement, if adopted, might increase the risk that the statute’s substantive scope might be narrowed. Of course, there is no guarantee that this will occur—it is merely a risk, and one whose magnitude is difficult to gauge. Moreover, it might well be a risk worth taking if the increased deterrence associated with one or more of the proposed reforms outweighs any costs associated with a possible narrowing of the statute’s substantive scope. Yet this is nonetheless a genuine risk, and one that proponents of the three types of reforms discussed here tend to neglect.1

 1   There are other potential costs to these proposals as well. For example, private enforcement and harsher penalties could reduce corporate incentives to self-disclose violations to government enforcers (e.g. Arlen and Kraakman 1997). I do not pursue those issues here in order to focus on a distinct, and less widely recognized, cost.

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Beware blowback  177 To be sure, for those who think that the government is already overreaching by adopting implausible interpretations of the FCPA that are never tested in court, the possibility that these reforms might ultimately produce such clarification would count as a benefit rather than a cost. The positive argument developed in this chapter does not depend on one’s normative views on the FCPA. Yet for the most part, the perspective taken here will be that of the government enforcement agencies, or of anticorruption advocates interested in more robust deterrence of foreign bribery. From this perspective, although private enforcement, individual liability, and more stringent penalties all have distinct benefits, they are all also likely to increase the risk that the substantive scope of the FCPA (de jure or de facto) might be narrowed by judicial or congressional intervention. And that’s a risk worth taking seriously. Section 2 of this chapter will provide a brief overview of the FCPA—its history, basic provisions, potential ambiguities, and current enforcement practices. Sections 3–5 will discuss in turn each of the three proposals for reforms intended to strengthen deterrence of FCPA violations: Section 3 will focus on proposals to amend the FCPA to add a private right of action, Section 4 will focus on proposals to bring more criminal enforcement actions against individual FCPA defendants, and Section 5 will focus on proposals to employ more painful corporate sanctions, in particular debarment from government contracting. In each of these discussions, the chapter will explore how these reforms might have the unintended consequence of provoking more litigation and consequent narrowing of the FCPA’s substantive scope. A brief conclusion sums up the major arguments and discusses more general implications of the analysis.

2. THE FCPA’S AMBIGUITIES AND ENFORCEMENT PRACTICES The basic story of the FCPA­—its major provisions, its history, and the recent surge in enforcement—has been told countless times, and is likely familiar to most readers of this chapter. A succinct summary should therefore suffice to set the stage for the analysis that follows. In brief, the FCPA, enacted in 1977 and amended twice since then (in 1988 and 1998), contains two major sets of provisions. The anti-bribery provisions prohibit U.S. domestic concerns and issuers on U.S. exchanges, and their agents, as well as any person or entity within U.S. territory, from corruptly paying or offering to pay anything of value to a foreign public official for the purpose of obtaining or retaining business.2 The a­ nti-bribery

 2   See 15 U.S.C. §78dd-1(a)(1) (issuers), §78dd-2(a)(1) (domestic concerns), §78dd-3(a)(1) (persons other than issuers or domestic concerns “while in the territory of the United States”). The main text simplifies the language of the prohibition somewhat. The statutory language makes it unlawful for any issuer or domestic concern, or any officer, director, employee, agent, or stockholder acting on behalf of an issuer or domestic concern, “to make use of the mails or any means or instrumentality of interstate commerce or to do any other act in furtherance of an offer, payment, promise to pay, or authorization of the payment of any money, or offer, gift, promise to give, or authorization of the giving of anything of value to [] any foreign official for purposes of [] (i) influencing any act or decision of such foreign official in his official capacity, (ii) inducing

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178  Research handbook on corporate crime and financial misdealing provisions also prohibit any of these covered entities from transferring anything of value to a third party while knowing that this thing of value will in turn be given, offered, or promised to a foreign official for a corrupt purpose.3 The anti-bribery provisions, however, do not extend to so-called “facilitating or expediting payments” to secure “the performance of a routine governmental action.”4 Furthermore, actions under the FCPA’s anti-bribery provisions are subject to two affirmative defenses, one which applies when the payment or offer is legal under the written laws of the foreign official’s home country,5 the such foreign official to do or omit to do any act in violation of the lawful duty of such official, or (iii) securing any improper advantage; or [] inducing such foreign official to use his influence with a foreign government or instrumentality thereof to affect or influence any act or decision of such government or instrumentality, in order to assist such [issuer or domestic concern] in obtaining or retaining business for or with, or directing business to, any person[.]” (Although both the issuer provision and the domestic concern provision include “use of the mails or any means or instrumentality of interstate commerce” as part of the offense, this requirement does not apply to U.S. nationals, including U.S. corporations, when engaged in conduct that would violate the statute outside of the United States. See §§78dd-1(g), 78dd-2(i). The “means of interstate commerce” element would, however, still apply to non-U.S. agents of issuers or domestic concerns, when the relevant conduct takes place outside of the United States.) The provision for non-issuers that are not domestic concerns is similar except that it only covers conduct “within the territory of the United States,” and is not limited only to conduct making use of the mails or any means or instrumentality of interstate commerce, but also to “any other act in furtherance” of the offer or payment to foreign officials. In addition to the prohibition on payments or offers to foreign officials, the FCPA also prohibits such payments to any foreign political party or party official, or any candidate for foreign political office, for purposes of improperly influencing that official or inducing her to use her influence to affect a foreign government decision. See 15 U.S.C. §§78dd-1(a)(2), 78dd-2(a)(2), 78dd-3(a)(2).  3   See §§78dd-1(a)(3), 78dd-2(a)(3), 78dd-3(a)(3) (prohibiting issuers, domestic concerns, and other actors while within U.S. territory, respectively, from making “an offer, payment, promise to pay, or authorization of the payment of any money, or offer, gift, promise to give, or authorization of the giving of anything of value to . . . any person, while knowing that all or a portion of such money or thing of value will be offered, given, or promised, directly or indirectly, to any foreign official, to any foreign political party or official thereof, or to any candidate for foreign political office” for the same improper purposes that would apply to payments or offers made directly to the foreign officials, parties, or candidates themselves).  4   See §§78dd-1(b), 78dd-2(b), 78dd-3(b). The statute further defines “routine governmental action” as   only an action which is ordinarily and commonly performed by a foreign official in—   (i) obtaining permits, licenses, or other official documents to qualify a person to do business in a foreign country;   (ii) processing governmental papers, such as visas and work orders;   (iii) providing police protection, mail pick-up and delivery, or scheduling inspections associated with contract performance or inspections related to transit of goods across country;   (iv) providing phone service, power and water supply, loading and unloading cargo, or protecting perishable products or commodities from deterioration; or   (v) actions of a similar nature.   §§78dd-1(f)(3)(A), 78dd-2(h)(4)(A), 78dd-3(f)(4)(A). The Act’s definition of “routine governmental action” also makes clear that the term does not include a decision involving “whether, or on what terms, to award new business or to continue business with a particular party[.]” §§77dd-1(f)(3)(B), 78dd-2(h)(4)(B), 78dd-3(f)(4)(B). 5   See §§78dd-1(c)(1), 78dd-2(c)(1), 78dd-3(c)(1).

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Beware blowback  179 other of which applies when the things of value given to the foreign official can be fairly characterized as a reasonable, good faith expenditure directly related to the promotion or demonstration of products or services, or to the performance of a contract with a foreign government.6 In addition to the anti-bribery provisions, the FCPA also imposes so-called “accounting provisions,” which apply only to issuers on U.S. exchanges. The accounting provisions require that the issuer keep accurate books and records, and that the issuer maintain a system of internal accounting controls sufficient to ensure that all transactions are authorized by management and properly recorded.7 The focus of this chapter will be on the anti-bribery provisions rather than the accounting provisions, though many of the same basic arguments would apply in the latter context as well. Although the FCPA’s anti-bribery provisions are relatively straightforward, like virtually all laws they contain ambiguities and leave important questions unanswered. The U.S. Department of Justice (DOJ) and Securities and Exchange Commission (SEC), which share responsibility for enforcing the FCPA, have adopted aggressive readings of the statute’s scope. These interpretations are, in my view, both legally plausible and normatively attractive. I will not, however, defend that position here. The important point is that even someone who believes that the government’s expansive interpretation of the FCPA is correct (both as a matter of law and as a matter of policy) must acknowledge that on several key issues the government’s interpretations are at least contestable (on legal and/or policy grounds) and have been the target of sustained criticism. Consider some of the more prominent examples. First, the FCPA prohibits paying bribes to a “foreign official,” but the meaning of that term is not entirely clear, particularly in the context of state-owned enterprises (SOEs) or other parastatal organizations. The FCPA defines the term “foreign official” as including “any officer or employee of a foreign government or any department, agency, or instrumentality thereof,”8 but does not define the term “instrumentality.” The DOJ and SEC have taken the position that “[t]he term ‘instrumentality’ is broad and can include state-owned or state-controlled entities,” and that the determination as to whether a particular entity is an “instrumentality” of a foreign government “requires a fact-specific analysis of an entity’s ownership, control, status, and function” (DOJ/SEC 2012, p. 20). Furthermore, although the DOJ and SEC have asserted that an entity is “unlikely” to qualify as an instrumentality of a foreign government if that government does not control a majority of the firm’s shares, “there are circumstances in which an entity would qualify as an instrumentality absent 50% or greater foreign government ownership,” if other ­factors suggest the entity is in fact controlled by the foreign government (DOJ/SEC 2012, p. 21). This broad reading of “instrumentality” (and consequent broad reading of “foreign official”) has been vigorously contested by interest groups and scholars, who argue that it is inconsistent with the FCPA’s text, purpose, and history, and could lead to absurd results (Koehler 2010, 2011; Weismann & Smith 2010). Nonetheless, the critics have so far been unsuccessful in narrowing the scope of the bribe recipients covered by the statute.

  See §§78dd-1(c)(2)(A)–(B), §§78dd-3(c)(2)(A), §§78dd-3(c)(2)(A)–(B).   See §78m(b)(2)(A)–(B). 8  See §§78dd-1(f)(1)(A), 78dd-2(h)(2)(A), 78dd-3(f)(2)(A). 6 7

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180  Research handbook on corporate crime and financial misdealing Second, the FCPA’s anti-bribery provisions do not flatly prohibit all corrupt payments to foreign officials, but only those payments made “in order to assist [the bribe-paying entity] in obtaining or retaining business for or with, or directing business to, any person.”9 The government has interpreted this “business purpose” requirement broadly to include not only bribes to obtain government contracts, but also bribes “made to secure favorable tax treatment, to reduce or eliminate customs duties, to obtain government action to prevent competitors from entering a market, or to circumvent a licensing or permit requirement,” on the logic that these and similar bribes would all enable the bribe-paying firm to secure a “business advantage” (DOJ/SEC 2012, p. 13). The government’s position is generally consistent with one of the few Court of Appeals decisions on the FCPA’s meaning, United States v. Kay, in which the Fifth Circuit concluded that although the FCPA’s text is ambiguous on this point, the legislative history and the overall structure of the statute support the conclusion that paying bribes to lower a firm’s business costs can “provide an unfair advantage over competitors and thereby be of assistance to the payor in obtaining or retaining business” (359 F.3d 738, 749 (5th Cir. 2004)). The Kay court, however, was careful to emphasize that although bribes to evade duties or taxes “could fall within the purview of the FCPA’s proscription . . . this conduct does not automatically constitute a violation of the FCPA: It still must be shown that the bribery was intended to produce an effect . . . that would ‘assist in obtain or retaining business.’” (359 F.3d 738, 756) (emphasis in original). Critics argue that the government over-reads Kay by neglecting this latter qualification of the holding; more generally, critics emphasize that the Kay opinion is only one Court of Appeals decision. They assert that the government has interpreted the “business purpose” test in a way that is much more expansive than the FCPA’s text, structure, and purpose would support (Ballenger et al. 2010; Georgis 2012; Lu 2013). Third, the government has adopted a broad interpretation of what counts as an unlawful bribe. The government has done so by endorsing a sweeping construction of “anything of value,” while at the same time construing the “facilitating payments” exception quite narrowly. With respect to “anything of value,” the government has made clear, for example, that in its view a bribe can include a donation to an official’s favorite charity (even if it is a bona fide charity and none of the money is transferred to the official), so long as the donation was made with the corrupt intent to improperly influence the official’s decision (DOJ/SEC 2012, pp. 16–19). Furthermore, in recent government-enforcement actions based on hiring practices in the Hong Kong and China offices of JP Morgan, Bank of New York, and other financial institutions, the government has taken the position that offering a job to the adult relative of a foreign official can count as offering something of value to the foreign official, even if no money is transferred from the relative to the official. Critics have argued that this stretches the concept of offering “anything of value” to a foreign official past the breaking point (Chatterjee 2015). As for the “facilitating payments” exception, the government has interpreted this exception as covering only truly non-discretionary acts, and has refused to adopt any “safe harbor” for payments below a certain dollar amount (DOJ/SEC 2012, p. 25). Some have suggested that the government has construed the facilitating payments exemption so narrowly that in practice it is irrelevant. Although many would celebrate that fact (indeed, the OECD and numerous   See §§78dd-1(a)(1)–(3), 78dd-2(a)(1)–(3), 78dd-3(a)(1)–(3).

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Beware blowback  181 anticorruption activists have called for the elimination of the exception (Jordan 2011; Zervos 2006)), critics have argued that the government’s interpretation of the exception is unduly stingy, and inconsistent with the original intent and understanding of the FCPA (Jeydel 2012; Weinograd 2010). Fourth, the U.S. government has interpreted its jurisdiction under the FCPA broadly to authorize criminal enforcement actions even against foreign subsidiaries or foreign partners of U.S. issuers or domestic concerns—even when those companies do not themselves issue securities on a U.S. exchange (Ashe 2005; Wilson 2014). Critics argue that the U.S. government has adopted jurisdictional theories that go well beyond what a fair reading of domestic or international law would authorize (Leibold 2015; Ross 2012).10 That the FCPA contains numerous ambiguities regarding its scope is not particularly surprising. It is also unsurprising that the U.S. government agencies charged with enforcing the statute have adopted aggressive understandings of those ambiguous provisions. What is perhaps more unusual in the FCPA context (though certainly not unheard of) is the absence of significant judicial clarification of these ambiguous terms. The number of federal appellate court decisions on the statute’s meaning, throughout its over four decades in existence, can be counted on the fingers of two hands;11 the number of district court opinions is not much greater. Why is this? The conventional explanation (which I am inclined to accept, at least for present purposes) runs as follows. At least until recently, most (though not all) FCPA enforcement actions have been brought against corporate defendants. Sometimes the individuals who committed the violations are charged as well, but more often they are not. And most corporate defendants are extremely reluctant to go to trial, or even to be formally indicted, for FCPA violations. Of course, it is true that defendants in general prefer to avoid the risks of trial, and corporate defendants may be particularly anxious to avoid operating

10   Discussions of the U.S. government’s interpretation of its FCPA jurisdiction are sometimes confusing due to the fact that there are several different ways that a foreign party’s contacts with the United States might matter under the FCPA. First, in order for a non-U.S. individual or entity to be liable as an officer, employee, or agent of an issuer or domestic concern, the government must establish that this non-U.S. defendant made “use of the mails or any means or instrumentality of interstate commerce” in furtherance of the corrupt act (15 U.S.C. §§78dd-1(a), (g), 78dd-2(a), (i)). Second, in order for the government to impose liability for FCPA anti-bribery violations on an entity that is neither a domestic concern nor an issuer on a U.S. exchange, the government must establish that the defendant did “any . . . act in furtherance of ” the corrupt payment “while in the territory of the United States” (15. U.S.C. §78dd-3(a)). Third, though of less immediate relevance in the context of this chapter, for civil actions against non-U.S. persons, the Due Process Clause requires sufficient “minimum contacts” between the defendant and the United States (Brown 2001). These different requirements are sometimes conflated, occasionally leading to inaccurate statements regarding how the U.S. government in fact interprets these distinct requirements. But the main point stands: the U.S. has sometimes asserted FCPA jurisdiction based on contestable readings of the statutory text. 11   These cases are: United States v. Liebo, 923 F.2d 1308 (8th Cir. 1991); Stichting Ter Behartiging Van de Belangen Van Oudaandeelhouders In Het Kapitaal Van Saybolt Int’l B.V. v. Schreiber, 327 F.3d 173 (2d Cir. 2003); United States v. Kay, 359 F.3d 738 (5th Cir. 2004); United States v. Kay, 513 F.3d 432 (5th Cir. 2007); United States v. Kozeny, 541 F.3d 166 (2d Cir. 2008); United States v. Kozeny, 667 F.3d 122 (2d Cir. 2011); United States v. Esquenazi, 752 F.3d 912 (11th Cir. 2014); United States v. Duperval, 777 F.3d 1324 (2015).

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182  Research handbook on corporate crime and financial misdealing in the shadow of an unresolved criminal indictment. But, the conventional explanation runs, the incentives to avoid indictment, trial, and formal conviction, are especially pronounced for corporate defendants in the FCPA context. The reasons for this are not entirely certain, but numerous explanations have been hypothesized, including the alleged reputational damage (and consequent loss in firm value) associated with an FCPA conviction, possible collateral consequences of indictment (including suspension from certain lines of business), reluctance to proceed to formal discovery (which might bring to light further damaging information), and the enormous and potentially open-ended litigation expenses associated with defending against a criminal charge (Runnels & Burton 2012, Sivachenko 2013). Of course, the government is anxious to settle these cases as well. As a result, most criminal investigations brought by the DOJ against corporate defendants (other than those that result in no enforcement action at all) are concluded either with a plea bargain, or—more often—with a non-prosecution agreement (NPA) or deferred prosecution agreement (DPA), in which the corporation makes certain admissions, pays monetary penalties, and may also agree to other remedial actions as well, and the DOJ agrees not to pursue a formal prosecution against the corporation so long as the terms of the agreement are respected (Alexander & Cohen 2015; Warin & Boutros 2007). (SEC civil actions against issuers, which are often coordinated with DOJ enforcement, are often resolved in similar fashion, via settlement agreements.) In negotiating these settlements, the government’s principal source of leverage is the corporate defendant’s strong desire to avoid the costs of a pending criminal investigation. The government can, and likely does, amplify this leverage through judicious case selection—targeting corporations that are particularly anxious to settle, perhaps because the facts of the case are especially egregious, or perhaps because the corporation in question is particularly image-conscious or does a lot of business with the government that it cannot afford to jeopardize. To be sure, corporate defendants have important advantages as well, including the fact that they can hire small armies of talented and highly-paid lawyers, and the fact that the government depends to a considerable degree on the corporation’s cooperation in providing information about the underlying conduct. Nevertheless, corporations’ desire to settle FCPA cases gives the government an important advantage that allows the government to insist on its interpretation of the law. Even if a corporate defendant believes, for example, that the government’s case is based on an overly broad definition of “foreign official” or “anything of value,” or an overly narrow construction of “facilitating payment,” or that the government does not have FCPA jurisdiction because the company is a foreign non-issuer and the bribe payments lacked an adequate territorial nexus with the United States, the corporation is unlikely to want to litigate (or even to threaten to litigate) the issue. Indeed, the threat to litigate it might not be credible, given the considerations noted above, and threatening to litigate during negotiations might prove counterproductive. Thus, the government has been able to successfully impose monetary sanctions and other remedies on corporate defendants on the basis of interpretations of the FCPA, which, though in my view reasonable, are at least contestable. Yet many proponents of vigorous FCPA enforcement believe that the current enforcement regime, though undoubtedly an improvement over the anemic enforcement that characterized the FCPA’s first three decades, does not go nearly far enough. The main worries are that the government’s enforcement resources are spread too thin, and that

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Beware blowback  183 monetary sanctions on corporations (the usual remedy in most FCPA cases) do not provide sufficient deterrence. As noted in the introduction, supporters of more robust FCPA deterrence have advocated substantially increasing the probability of an enforcement action by authorizing private as well as public enforcement, and substantially increasing the severity of the penalties for FCPA violations, both by imposing more liability directly on individuals, and by employing corporate sanctions that are much more painful for the corporation than monetary penalties (in particular, debarment). These proposals have much to recommend them, but they also have a significant potential drawback: they might erode the government’s ability to insist on a broad reading of the statute without serious concerns about judicial or congressional intervention that would impose narrower limits on the substantive scope of FCPA liability. If such intervention occurs, the government may end up in a situation where more potential defendants escape FCPA liability altogether, although deterrence may be much stronger for those who are still covered. It’s not clear how one ought to resolve that trade-off, if it indeed exists, but it is at least worth taking seriously. The remainder of this chapter develops the argument that there might indeed be such a trade-off, considering in turn the possible effects of adding a private FCPA cause of action, increasing efforts to hold individuals liable for FCPA violations, and employing debarment more frequently as an FCPA sanction against corporate actors.

3.  A PRIVATE FCPA RIGHT OF ACTION The FCPA contains no provision providing for a private cause of action, and the statute has been interpreted not to imply any such cause of action.12 It is true that there are some indirect ways that private individuals can bring civil suits based on alleged FCPA violations, including shareholder derivative suits, civil suits under the Racketeer Influenced and Corrupt Organizations Act (RICO), and suits under the federal antitrust statutes or state unfair competition laws. But all these other mechanisms for private FCPA enforcement have significant difficulties (both legal and practical), and are particularly difficult to employ effectively in the absence of a prior or parallel government enforcement action (Lim et al. 2013; Mark 2012). Some proponents of vigorous FCPA enforcement consider the absence of a private cause of action to be a serious problem, and have advocated amendments to the statute that would add a private enforcement mechanism of some sort, although the details of the proposals differ somewhat (Lim et al. 2013; Mark 2012; Pines 1994). Although most of these proposals have not gotten much traction beyond the pages of scholarly journals, there have been a number of bills floated in Congress over the last few years, principally spearheaded by Representative Ed Perlmutter (D-CO), that would amend the FCPA to add a private right of action (Lim et al. 2013). Those proposals have not gone anywhere yet, but they are a signal that this reform proposal is worth taking seriously. An effective private civil remedy for FCPA violations would, in the view of its ­advocates,

12   See, for example, Lamb v. Philip Morris, Inc., 915 F.2d 1024 (6th Cir. 1990); Republic of Iraq v. ABB AG, 768 F.3d 145 (2d Cir. 2015).

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184  Research handbook on corporate crime and financial misdealing serve several important functions. The first two are familiar justifications for private remedies: compensation for victims whose injuries from unlawful action might otherwise go unredressed (including non-corrupt commercial competitors and citizens of the host country), and greater deterrence of wrongful conduct. This latter advantage, increased deterrence, occurs primarily because private enforcement substantially increases the resources available for enforcing the law—the private plaintiffs can act as a large group of “private attorneys general”—and because these private plaintiffs may sometimes be willing to pursue cases that the government enforcers would not (perhaps because they are “captured” by, or overly sympathetic to the interests of, a particular class of defendants) (Stephenson 2005). Interestingly, in the context of an FCPA private right of action in particular, at least some proponents have identified a third advantage: more private enforcement would produce more cases—and more cases litigated to final judgment—which would in turn produce substantially more judicial clarification of the FCPA’s meaning (Pines 1994). The logic of that argument is straightforward: although corporate defendants have strong incentives to settle enforcement actions (especially criminal actions) brought by the U.S. government, corporations have less of an incentive to settle civil suits brought by private plaintiffs, especially if the suits appear to the corporation’s lawyers to have a flimsy factual or legal basis. Of course, settlement will usually remain a more attractive, and economically rational, option than litigation to judgment (Friedman 1969; Priest & Klein 1984). Nonetheless, as a relative matter, corporations are likely more willing to litigate against a private plaintiff than a public enforcer, especially in the FCPA context. This tendency is compounded by a few additional considerations. While corporations may have an incentive for cultivating a reputation with government enforcers as cooperative, they may have the opposite incentive with respect to private plaintiffs: they may prefer, in that context, to develop a reputation for willingness to fight, even when it might seem economically rational to settle, in order to deter nuisance suits. Furthermore, government enforcers are more likely to carefully choose what enforcement actions to bring, focusing on those where the corporation is likely to settle (particularly where the corporation’s conduct looks especially bad); private plaintiffs, considered collectively, are more likely to roll the dice on more uncertain cases. The net result of adding an FCPA private right of action, therefore, would likely be more contested cases, more final judgments, and more judicial opinions (including more appellate opinions). Many of these opinions will likely focus on factual issues, but some are likely to include rulings on legal issues pertaining to the meaning of the statute’s substantive provisions (e.g., “foreign official,” “anything of value,” “facilitating or expediting payments,” etc.). As noted above, some proponents of private FCPA enforcement point to this fact—that private suits are likely to produce more judicial clarification of the statute’s ambiguous terms—as a good thing (Pines 1994). But from the perspective of the government, or proponents of vigorous FCPA enforcement more generally, it may not be. Consider what would happen if these private suits produce judicial rulings that substantially narrow (relative to the government’s current interpretation) the meaning of “foreign official” or “anything of value” or “for purposes of obtaining or retaining business.” Or suppose that such suits lead courts to adopt a more expansive understanding of the exception for “facilitating payments,” or a more restrictive understanding of what it means for a foreign entity to engage in conduct in furtherance of a corrupt act “within the territory of the

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Beware blowback  185 United States.” Such rulings would not only affect the private suit in question, but they would also bind the government (at least within the region subject to the jurisdiction of the appellate court that issues the holding) to that interpretation as well. And that likely would influence settlement negotiations between the government and potential FCPA defendants. Of course, corporate defendants would still be extremely reluctant to risk going to trial. Nonetheless, the dynamics of settlement negotiations would likely change dramatically if the corporation could make a plausible argument that, under settled law in the jurisdiction, its conduct simply did not qualify as an FCPA violation. Thus, if private lawsuits produce judicial opinions that “clarify” the FCPA by narrowing it, that would not necessarily count as a net win for proponents of aggressive FCPA enforcement. That judicial rulings might not go the government’s way was driven home by the recent District Court opinion in United States v. Hoskins, which held that Congress “did not intend to impose accomplice liability [for FCPA violations] on non-resident foreign nationals who were not subject to direct liability [under the FCPA]” (123 F.Supp.3d 316, 327 (D.Conn. 2015)). This holding limits the ability of the U.S. to charge non-U.S. residents with FCPA violations as accomplices or co-conspirators; while it’s only one ruling, from a trial court, it demonstrates that the U.S. government’s legal theories are not guaranteed to prevail. Of course, it is entirely possible that judicial clarification of the statute could go in the other direction—the courts might embrace the reading of the statute favored by the government (and the hypothetical private FCPA plaintiffs). After all, the government’s track record in defending its broad interpretation of the FCPA’s provisions in the courts of appeal is quite good. Maybe more litigation, spurred by private plaintiffs, would lead to more appellate rulings that clarify the FCPA in a direction that is favorable to the government. But there are two reasons why that possible upside is not something FCPA enforcement proponents should get terribly excited about. First, the settlement dynamics described earlier mean that the government is already able to insist on its interpretation of the law in negotiations with corporate defendants; judicial endorsement of the government’s view might be nice, and might marginally strengthen the government’s hand, but it would not add all that much. So even if courts are more likely to embrace the government’s view of the FCPA, the potential upside from a win is relatively small, while the potential downside from a loss is huge. Second, even on issues that are supposed to be pure questions of law, courts are likely swayed by the facts (and general atmospherics) of the case in front of them. The government can be, and almost certainly is, careful in selecting its cases, particularly when there is a decent likelihood the case might go to trial (which, again, is generally not the case for FCPA actions against corporations). Private plaintiffs are less discriminating. It is much more likely that private plaintiffs would pursue damages actions in contexts where the underlying conduct does not seem so bad, even where that conduct does appear to technically violate the statute on the understanding of the FCPA advanced by the plaintiff (and endorsed by the U.S. government in other cases). A natural response by a court confronted with such a case might well be to narrow the law (that is, to reject the more expansive reading of the statute)—and the court might do so in a way that has collateral consequences, perhaps unintended, for other cases with more egregious facts. So, we should be careful not to extrapolate too quickly from what the appellate courts have done with the FCPA cases that the government has litigated under the current regime to what

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186  Research handbook on corporate crime and financial misdealing appellate courts might do when confronted with the sorts of cases that private plaintiffs might bring, if permitted to do so. That latter point highlights another reason that a private FCPA right of action might lead to a narrowing of the substantive scope of the FCPA. The mechanism posited above is judicial: private enforcement means more cases litigated to judgment (possibly with more sympathetic defendants); more litigated cases means more appellate opinions interpreting the FCPA; more appellate opinions interpreting the FCPA means a higher risk of adverse opinions that narrow the scope of the statute, not only for private civil suits but for public enforcement actions as well. But judicial interpretation is not the only way that the FCPA’s scope might be rendered much narrower than the position currently favored by the DOJ and SEC. Congress might also get involved by formally amending the statute. The Chamber of Commerce, as well as its allies in the defense bar and the academic community, have been pushing for such amendments for a while now (Koehler 2010; Weissmann & Smith 2010), without much success. There are many reasons why this well-funded lobbying effort has not gotten more traction, but one reason is likely the fact that the Parade of Horribles that the Chamber of Commerce and its allies like to invoke is entirely hypothetical. There’s a lot of complaining to the effect that, given the DOJ and SEC’s interpretation of the law, the government could do this or could do that, or that a corporation might be liable in circumstances where liability seems absurd. But, as the DOJ, SEC, and their defenders are quick to point out, none of these outlandish hypotheticals describe any real cases. In fact, if you look at real FCPA cases, although reasonable people can disagree over the details, virtually all the settlements seem plausible in light of the conduct in question. And although FCPA critics have occasionally attempted to point to real cases that allegedly reveal out-of-control prosecutors running amok (Weissmann & Smith 2010), these examples have been quite easy to debunk as based on selective or inaccurate representations of the actual record (Kennedy & Danielsen 2011). Part of the explanation for this is that, as noted above, the government tends to be quite judicious (critics might say overly cautious) in its case selection. This selectivity is no doubt due in part to the government enforcement agencies’ own sense of what is in the public interest, but the DOJ and SEC have pragmatic, political incentives to be careful as well. Even when there is very little chance of an actual trial, the government has an interest in preserving its credibility and its reputation for reasonableness. One way that it does this is by not pursuing cases where, even though the underlying conduct might technically count as an FCPA violation in light of the government’s interpretation of the law, the case is not one where FCPA liability would seem appropriate. This will never convince hard-core opponents of aggressive FCPA enforcement that the DOJ and SEC are doing the right thing, but it likely helps to dissipate any broader momentum for the sorts of FCPA reform favored by the Chamber of Commerce and defense bar. Things might look quite different if large numbers of private FCPA plaintiffs were bringing FCPA suits, premised on aggressive interpretations of the law, in contexts where the defendant appears more sympathetic (or at least not especially unsympathetic). Such a development might substantially alter the political dynamics of the FCPA reform debate. Of course, even if a sufficiently large coalition in Congress were convinced that over-enforcement of the FCPA had become a genuine problem, there are a number of ways it might respond. It could, for example, simply eliminate the private cause of action, or at least impose significant limits (for example, procedural requirements) on private

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Beware blowback  187 enforcement suits. But it is also possible that a general perception that the FCPA was being over-enforced might lead in turn to a narrowing of the substantive scope of FCPA liability generally, in ways that would affect both private and public actions. For these reasons, proposals to add a private right of action to the FCPA might confront FCPA enforcement advocates with a difficult trade-off. Such private enforcement might effectively mobilize private resources to better enforce the statute, and might also secure compensation for victims of FCPA violations. At the same time, however, private enforcement is likely to produce more litigation, often over more marginal cases where the defendant appears more sympathetic, which might result in judicial and/or congressional narrowing of the statute’s substantive scope. This is not to say that, on balance, private enforcement is undesirable. Nor is it to say that there might not be ways to structure private enforcement mechanisms so as to minimize some of the potential disadvantages associated with unconstrained, unregulated private enforcement. For example, some have suggested adopting the qui tam model associated with statutes like the False Claims Act in the FCPA context (Carrington 2010, 2012). More generally, one might explore options that would create a role for private attorneys general but give the public enforcement agencies more authority to oversee, regulate, and potentially bar such private suits—either as a general matter or with respect to particular actions (Stephenson 2005). Nothing in this chapter should be taken as a general argument that private FCPA enforcement is a bad idea. Rather, the much more modest argument is that private enforcement carries with it the risk of adverse judicial or congressional action with respect to the substantive scope of FCPA liability, and that this factor ought to be taken into account when considering various proposals for creating a private FCPA cause of action.

4.  INDIVIDUAL FCPA LIABILITY The idea of adding a private cause of action to the FCPA is, up to this point, just a ­proposal—one with some academic and congressional supporters, but so far nothing more than that. Another widely-advocated method for strengthening FCPA deterrence— more aggressive enforcement against individual defendants—is already taking place. Indeed, senior officials at the DOJ have emphasized that holding individual executives liable is now a point of emphasis for its FCPA enforcement strategy (Krakoff et al. 2015; Nayeri 2014), a policy that has now been memorialized—not only for FCPA cases, but for corporate investigations more generally—in the Yates Memo. This greater focus on individual, as opposed to purely corporate, liability has been embraced by both supporters and critics of the government’s FCPA enforcement practices. Proponents of more aggressive enforcement assert that the imposition of monetary penalties on corporations does not have a sufficient deterrent effect; the only way to really deter corporate officers and employees from violating the FCPA (and similar statutes) is to start putting people in jail (Arlen 1994). And critics of the government’s approach to FCPA enforcement have long argued that it is inappropriate and unfair to hold a corporation criminally liable (on respondeat superior grounds) for the allegedly criminal conduct of the corporation’s employees if the government does not also hold those individual employees criminally liable (Koehler 2011).

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188  Research handbook on corporate crime and financial misdealing The argument that more individual liability (especially individual criminal liability) is likely to strengthen deterrence is compelling.13 But, as with the proposal to add an FCPA private right of action, the greater emphasis on enforcement actions against individuals may come at the cost of generating more trials, perhaps involving more sympathetic defendants, which could in turn produce more appellate judicial opinions which adopt interpretations of the FCPA that are unfavorable to the government, with collateral consequences for other FCPA enforcement actions. The logic runs as follows. As noted above, corporate FCPA defendants are widely presumed to have overwhelmingly strong incentives to settle cases quickly to avoid the costs of litigating an FCPA case, as well as the risks of a trial. Individuals also have a very strong incentive to settle—that’s one of the reasons why the vast majority of criminal charges, at all levels, are resolved by plea bargain—but as a relative matter, individual defendants are more likely than corporations to reject the government’s best settlement offer and proceed to trial. There are several reasons for this. For a corporation, the reputational and other collateral damage from an unresolved indictment may be considerable, while the damage from a DPA or NPA may be much more limited; for an individual, especially a white-collar defendant, a plea bargain may still be very damaging, especially if the government insists on jail time. Individuals may also be more susceptible to emotional or psychological factors that increase the propensity to insist on going to trial, even when settling might be the more rational thing to do. Corporations may be more likely to retain sophisticated counsel, often including former DOJ or SEC officials, who have a good working relationship with the government enforcers and who can negotiate a favorable settlement; by contrast, at least some individual FCPA defendants may be represented by less experienced and/or more aggressive defense counsel, entailing a greater likelihood of negotiation breakdown. These explanations may not be entirely satisfying, but as an empirical matter, it does seem to be true that cases involving individual defendants are more likely to be litigated, and to produce judicial opinions on the meaning of the law, than are cases involving corporate defendants, particularly in the FCPA context (Koehler 2013; Pollack & Billings 2010).14 Given that fact, consider the possible consequences if the DOJ follows through on its promise to substantially increase the number of cases brought against individuals. It is quite plausible that this strategy will result in more litigation, including litigation to final judgment. One straightforward cost of such a strategy, from an enforcement perspective, is that it will divert scarce government resources (especially prosecutors’ time) away from other valuable enforcement efforts. That issue is well-understood and I will not pursue it further here. A second, less widely-appreciated cost parallels that discussed in the previous

13   The argument that it is somehow unfair or inappropriate to hold a corporation liable without also charging the individual agents is, in my view, unpersuasive, but as that issue is not my main focus I will not pursue it further here. 14   Of the six FCPA cases that produced the eight appellate opinions on the statute’s meaning listed above in footnote 11, five involved individual defendants. Most of the recent FCPA cases to generate notable District Court opinions have also typically involved individual rather than corporate defendants. See, e.g., United States v. Hoskins, 123 F.Supp.3d 316 (D.Conn. 2015); United States v. Harder, 168 F.Supp.3d 732 (E.D.Penn. 2016); SEC v. Straub, 921 F.Supp.2d 244 (S.D.N.Y. 2013).

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Beware blowback  189 section on private FCPA enforcement: more litigation likely means more appellate judicial opinions interpreting the FCPA, and this entails a greater risk of appellate opinions that narrow the statute’s meaning, with consequences not only for the particular case at hand, but for all other FCPA enforcement actions, whether against individual or corporate defendants, within the relevant jurisdiction. This latter concern is likely to be compounded by another factor, again paralleling a consideration raised in the previous section on private enforcement. The practice of bringing FCPA actions against individual defendants is far from novel; the government has brought a number of such cases in the past. But the government has generally been quite careful in its case selection. For the most part, the cases against individual defendants have involved egregious misconduct, compelling evidence, or both. This is not universally true, and the government has suffered a few embarrassing defeats in cases brought against individuals, though none of them have yet resulted in adverse judicial rulings on the meaning of the law itself (Koehler 2013; Yockey 2013). But overall, the government seems to have judiciously exercised its prosecutorial discretion to select unsympathetic individual defendants, making it more likely that the government would prevail if the case were to go to trial—which in turn makes it more likely that these defendants, anticipating the probable trial result, will be willing to settle. Consider, then, the possible consequences of substantially increasing the number of individuals targeted for FCPA enforcement actions. Going after an additional one or two individuals per year probably won’t make much difference, but won’t have much impact on overall deterrence either. But suppose the government were to ramp up its targeting of individuals several-fold over the status quo. Not only would that mean more cases (and more litigated cases), but it would likely also mean more cases with sympathetic defendants. And, as noted above, even though judges are not supposed to consider such things when making general rulings on the meaning of law, in practice they are quite likely to do so. Indeed, it is widely recognized that judges sometimes (perhaps often) allow the facts of the particular case before them, and the desire to reach a particular outcome, to unduly influence their general legal rulings (Schauer 2006). If that is true, then a dramatic ramp-up in FCPA enforcement actions against individuals might lead to more judicial rulings on general issues of FCPA interpretation in contexts where the judges instinctively feel like the government is overreaching, and that the defendant before the court does not really deserve the punishment the government seeks to impose. The concern is that, in order to reach the result that the defendant is not liable, the court may issue a ruling on the meaning of the statute more generally—say, narrowing the definition of “foreign official,” or expanding the definition of “facilitating payment,” or adopting a more restrictive understanding of the requisite nexus with the United States—which implicates not only the case at hand, but numerous other cases as well, including those brought against corporate defendants (and less sympathetic individual defendants). To be clear, the above discussion is emphatically not an argument against seeking to hold individuals liable for FCPA violations. The statute expressly provides for individual liability, and such liability is likely crucial for adequate deterrence (e.g., Arlen 1994). The optimal level of FCPA enforcement against individuals is almost certainly greater than zero. The argument, rather, is that increasing the level of FCPA enforcement against individuals comes with costs (beyond the well-known resource costs), and that an appreciation of those costs might—might—imply that the optimal level of FCPA e­ nforcement

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190  Research handbook on corporate crime and financial misdealing against individuals is lower than one might think if those costs are neglected. The principal cost suggested here is that more enforcement against individuals implies more litigation, including more litigation against relatively sympathetic defendants, which in turn raises the probability of adverse judicial rulings on the meaning of the law. This potential cost is of course speculative—there’s no guarantee the government would lose if the cases were litigated and appealed, and indeed the government’s track record on legal interpretation of the FCPA is quite good so far. Moreover, the additional deterrence associated with enforcement against individuals might well outweigh any risk associated with the possibility of adverse legal rulings. Nonetheless, it seems worthwhile to at least take this risk into account, principally by maintaining what is presumably the government’s current practice of being careful and judicious in its selection of individuals to target for enforcement actions, focusing on the really bad actors where the legal violations are relatively clear and the evidence is strong.

5.  CORPORATE DEBARMENT While one way to strengthen deterrence would be to step up enforcement against individuals, another approach (certainly not inconsistent) would be to make the sanctions imposed on corporations substantially harsher. The most straightforward way to do that might be to increase the magnitude of the monetary penalties. There are other approaches as well, however. For example, the government could make more widespread use of an existing remedy—suspension or debarment of corporations from doing business with U.S. government agencies for some period of time (or, in an extreme case, permanently).15 Although debarment is sometimes an available remedy in FCPA cases, it is used quite infrequently (Stevenson & Wagoner 2011).16 The reasons for this are not altogether certain, but the most plausible hypothesis is that the collateral consequences of debarment are so severe that government enforcers are reluctant to include debarment as a condition of settlement, or to structure the settlement in such a way that it would trigger automatic debarment. These collateral consequences include the potentially devastating effects on a corporation (and its innocent shareholders and employees) that relies substantially on government contracting, and on the government purchasers that would be deprived of an important supplier. Critics have argued against this reluctance to employ debarment, and have suggested various ways to mitigate some of the adverse collateral consequences. The critics’ main argument is that debarment is a much more severe penalty than monetary sanctions (even large monetary sanctions), and consequently the threat of debarment would have a much

15   Although suspension and debarment are technically distinct, for the sake of economy I will refer in the text to “debarment,” even though the relevant category is broader, and would include suspension as well. 16   Another important issue here is that debarment is not intended as a punishment for wrongful conduct, but as a way to protect the government from an unreliable/risky supplier, such that deliberately increasing the use of debarment in order to increase deterrence would be inappropriate (Tillipman 2012). Here I acknowledge the point but set it to one side in order to focus on a different potential criticism of greatly expanding the use of the debarment remedy.

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Beware blowback  191 greater deterrent effect (Bistrong 2014; Stevenson & Wagoner 2011). Although this line of argument has appeared mostly in academic commentary, the idea that debarment should be employed more widely got a boost from the OECD’s 2014 Foreign Bribery Report, which noted the low rates of debarment and openly called for countries “to do more to ensure that those who are sanctioned for having bribed foreign public officials are suspended from participation in national public procurement contracting” (OECD 2014, p. 35). More widespread use of debarment might well increase deterrence of FCPA violations. Of course, debarment also has well-known costs, summarized above. In addition, even from the perspective of promoting more vigorous FCPA enforcement, more widespread use of debarment may entail certain risks, similar in kind to those associated with greater enforcement against individual defendants. The usual dynamic of settlement negotiations with corporate defendants is that although the corporation’s representatives will try to get the best deal they can, the corporation will generally be willing to accept even substantial monetary penalties in order to avoid an indictment, even if the corporation’s lawyers believe they have a plausible challenge to the government’s interpretation of the law. This calculus might well change if the government were to insist on debarment as part of the settlement agreement. After all, one of the reasons that corporations are often so desperate to avoid indictment is precisely because indictment might trigger (temporary) debarment or similar consequences, with a devastating impact on the corporation (Hughes 2013). The same reason that debarment proponents would like this remedy to be used more widely—its potentially devastating impact on the corporation, well beyond the consequences of even a large monetary sanction—means that insisting on this remedy might lead to significantly different settlement dynamics, even with corporate defendants, leading more of them to reject proposed NPAs/DPAs. If the government’s insistence on including debarment in a proposed NPA/DPA does lead more corporations to litigate rather than settle, this could have a number of adverse consequences for the government, and for FCPA enforcement more generally. These consequences closely parallel those discussed in the preceding sections on private enforcement and stepped-up enforcement against individuals. First, more corporate litigation means a greater resource burden on the government, diverting people and money away from other important enforcement priorities. Second, more litigation is risky, because it could result in adverse appellate rulings on the meaning of the FCPA more generally, with blowback effects for other, otherwise unrelated FCPA enforcement actions. This risk is compounded by the facts that a corporate defendant faced with potential debarment has an incentive to fight very hard, and a judge who recognizes that a ruling against the corporation might have devastating consequences, seemingly out of proportion to the alleged wrongdoing, might have especially strong incentives to find a way to avoid that result. Third, a dramatic corporate collapse triggered by the imposition of a debarment remedy—something akin to what happened to Arthur Anderson, though perhaps on a smaller scale (Giudice 2011; Yockey 2013)—might strengthen the perception in Congress that FCPA enforcement is out of control and needs to be reined in. While reform might take the form of limiting the remedies, there’s no guarantee of this, and dramatic examples of apparent over-enforcement could be leveraged by FCPA opponents (excuse me: FCPA “reformers”) to successfully push through legislative amendments to limit the statute’s substantive reach.

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192  Research handbook on corporate crime and financial misdealing As was the case in the preceding sections, it is important to emphasize that I am not arguing against the use of debarment in all FCPA cases; sometimes debarment is indeed an appropriate remedy. Nor does the discussion here have any direct implications for the use of debarment as a sanction in other contexts, for example in the case of multilateral development banks, where the above concerns either would not apply, or at least would not apply in the same way (Dubois 2012; Zimmerman & Feriello 2011). It might also be possible to craft more limited forms of partial debarment that would further some of the purposes of this remedy while avoiding some of the adverse collateral consequences, including the collateral consequences emphasized in this chapter (Bistrong 2014). Notwithstanding these qualifications, though, the central point remains: the tools that we might reasonably expect to increase deterrence of FCPA violations, including more severe sanctions such as debarment, are for that very reason likely to provoke more pushback, which could result in a more general narrowing of the statute’s scope.

6. CONCLUSION This main argument of this chapter is that in the FCPA context—and perhaps in other settings as well—some of the tools that could promote more robust, vigorous enforcement of the statute could also lead, indirectly, to narrowing of the statute’s substantive scope. When the statute is enforced primarily by government prosecutors, who select their cases judiciously and use their leverage to extract settlements in the vast majority of these cases, there is less motive and opportunity for significant judicial or congressional narrowing of the statute. Many of the measures that might substantially strengthen the statute’s deterrent force—expanding private enforcement, significantly increasing prosecutions of individual defendants, and insisting on qualitatively more severe penalties—could also produce more litigation, more cases brought against relatively sympathetic defendants, and more pressure on Congress to narrow the statute’s scope. This chapter has neither attempted to assess the severity of these risks nor conducted an all-things-considered cost-benefit analysis of various FCPA reform proposals. The more modest objective here is to raise these possibilities and to argue that they are sufficiently plausible that they ought to be taken seriously, and considered explicitly when evaluating measures intended to strengthen enforcement of the FCPA.

REFERENCES Alexander, Cindy R. & Mark A. Cohen. 2015. The Evolution of Corporate Criminal Settlements: An Empirical Perspective on Non-Prosecution, Deferred Prosecution, and Plea Agreements, American Criminal Law Review, 52, 537–593. Arlen, Jennifer. 1994. The Potentially Perverse Effects of Corporate Criminal Liability, Journal of Legal Studies, 23, 833–867. Arlen, Jennifer & Reinier Kraakman. 1997. Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes, New York University Law Review, 72, 687–779. Ashe, Daniel Patrick. 2005. The Lengthening Anti-Bribery Lasso of the United States: The Recent Extraterritorial Application of the U.S. Foreign Corrupt Practices Act, Fordham Law Review, 73, 2897–2945. Ballenger, J. Scott, Douglas N. Greenburg, & Nathan H. Seltzer. 2010. Reining in the Foreign Corrupt Practices Act: The Supreme Court Ignores a Perfect Opportunity, Criminal Law Bulletin, 46, 625–637.

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Beware blowback  193 Bistrong, Richard. 2014. The OECD Foreign Bribery Report: “To Big to Debar,” available at http://richardbis​ trong.com/oecd-foreign-bribery-report-too-big-to-debar/ (last visited September 9, 2015). Bixby, Michael B. 2010. The Lion Awakens: The Foreign Corrupt Practices Act—1977 to 2010, San Diego International Law Journal, 12, 89–146. Brooks, Allen R. 2010. A Corporate Catch-22: How Deferred and Non-Prosecution Agreements Impede the Full Development of the Foreign Corrupt Practices Act, Journal of Law, Economics & Policy, 7, 137–162. Brown, H. Lowell. 2001. Extraterritorial Jurisdiction Under the 1998 Amendments to the Foreign Corrupt Practices Act: Does the Government’s Reach Now Exceed Its Grasp? North Carolina Journal of International Law & Commercial Regulation, 26, 239–360. Carrington, Paul D. 2010. Enforcing International Corrupt Practices Law, Michigan Journal of International Law, 32, 129–164. Carrington, Paul D. 2012. Qui Tam: Is False Claims Law a Model for International Law?, University of Chicago Legal Forum, 2012, 27–40. Chatterjee, Shinjini. 2015. Dangerous Liaisons: Criminalization of “Relationship Hires” Under the Foreign Corrupt Practices Act, University of Pennsylvania Law Review, 163, 1771–1804. Cheung, Yan Leung, P. Raghavendra Rau, & Aris Stouraitis. 2012. How Much Do Firms Pay as Bribes and What Benefits Do They Get? Evidence from Corruption Cases Worldwide. NBER Working Paper No. 17981. Coffee, John C., Jr. 1983. Rescuing the Private Attorney General: Why the Model of the Lawyer as Bounty Hunter Is Not Working, Maryland Law Review, 42, 215–288. Department of Justice and Securities & Exchange Commission (DOJ/SEC). 2012. A Resource Guide to the U.S. Foreign Corrupt Practices Act, available at http://www.justice.gov/criminal-fraud/fcpa-guidance (last visited September 9, 2015). Dubois, Pascale Helene. 2012. Domestic and International Administrative Tools to Combat Fraud & Corruption: A Comparison of U.S. Suspension and Debarment with the World Bank’s Sanctions System, University of Chicago Legal Forum, 2012, 195–235. Friedman, Alan E. 1969. An Analysis of Settlement, Stanford Law Review, 22, 67–100. Georgis, Pete J. 2012. Settling with Your Hands Tied: Why Judicial Intervention Is Needed to Curb an Expanding Interpretation of the Foreign Corrupt Practices Act, Golden Gate University Law Review, 42, 243–282. Giudice, Lauren. 2011. Regulating Corruption: Analyzing Uncertainty in Current Foreign Corrupt Practices Act Enforcement, Boston University Law Review, 91, 347–378. Hughes, Alexander G. 2013. Drawing Sensible Borders for the Definition of “Foreign Official” Under the FCPA, American Journal of Criminal Law, 40, 253–279. Jeydel, Peter. 2012. Yoking the Bull: How to Make the FCPA Work for U.S. Business, Georgetown Journal of International Law, 43, 523–553. Jordan, Jon. 2011. The OECD’s Call for an End to “Corrosive” Facilitation Payments and the International Focus on the Facilitation Payments Exception Under the Foreign Corrupt Practices Act, University of Pennsylvania Journal of Business Law, 13, 881–925. Karpoff, Jonathan M., D. Scott Lee, & Gerald S. Martin. 2014. The Economics of Foreign Bribery: Evidence from FCPA Enforcement Actions. Working Paper. Kennedy, David & Dan Danielsen. 2011. Busting Bribery: Sustaining the Global Momentum of the Foreign Corrupt Practices Act, New York: Open Society Foundation. Koehler, Mike. 2010. The Façade of FCPA Enforcement, Georgetown Journal of International Law, 41, 907–1009. Koehler, Mike. 2011. Big, Bold, and Bizarre: The Foreign Corrupt Practices Act Enters a New Era. University of Toledo Law Review, 43, 99–149. Koehler, Mike. 2013. An Examination of Foreign Corrupt Practices Act Issues, Richmond Journal of Global Law & Business, 12, 317–391. Krakoff, David S., Lauren R. Randell, Veena Viswanatha, & Mehul N. Madia. 2015. Individual and Coordinated Prosecutions Accelerate—Along with the Challenges, Criminal Justice, 30, 26–31 & 46. Leibold, Annalisa. 2015. Extraterritorial Application of the FCPA Under International Law, Willamette Law Review, 51, 225–267. Lim, Delphia, Maryum Jordan, Patrick Kibbe, David Donatti, & Jose Vicente. 2013. Access to Remedies for Transnational Public Bribery: A Governance Gap, ABA Criminal Justice, 28, 35–45 & 51. Lu, Tiffany. 2013. The “Obtaining or Retaining Business” Requirement: Breathing New Life into the Business Nexus Provision of the FCPA, Fordham Journal of Corporate & Financial Crime, 18, 729–750. Mark, Gideon. 2012. Private FCPA Enforcement, American Business Law Journal, 49, 419–506. Nayeri, Rouzhna. 2014. No Longer the Sleeping Dog, the FCPA Is Awake and Ready to Bite: Analysis of FCPA Enforcements, the Implications, and Recommendations for Reform, New York International Law Review, 27, 73–91. Organisation for Economic Co-operation and Development (OECD). 2014. OECD Foreign Bribery Report: An Analysis of the Crime of Bribery of Foreign Public Officials.

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194  Research handbook on corporate crime and financial misdealing Pines, Daniel. 1994. Amending the Foreign Corrupt Practices Act to Include a Private Right of Action, California Law Review, 82, 185–229. Pollack, Barry J. & Laura Billings. 2010. After 30 Years of the FCPA, Will Courts Finally Get into the Act?, Champion, 34(Oct), 34–38. Priest, George L. & Benjamin Klein. 1984. The Selection of Disputes for Litigation, Journal of Legal Studies, 13, 1–55. Ross, Lauren Ann. 2012. Using Foreign Relations Law to Limit Extraterritorial Application of the Foreign Corrupt Practices Act, Duke Law Journal, 62, 445–485. Runnels, Michael B. & Adam M. Burton. 2012. The Foreign Corrupt Practices Act and New Governance: Incentivizing Ethical Foreign Direct Investment in China and Other Emerging Economies, Cardozo Law Review, 34, 295–327. Schauer, Frederick. 2006. Do Cases Make Bad Law? University of Chicago Law Review, 73, 883–918. Segal, Philip. 2006. Coming Clean on Dirty Dealing: Time for a Fact-Based Evaluation of the Foreign Corrupt Practices Act, Florida Journal of International Law, 18, 169–210. Sivachenko, Irina. 2013. Corporate Victims of “Victimless Crime”: How the FCPA’s Statutory Ambiguity, Coupled with Strict Liability, Hurts Businesses and Discourages Compliance, Boston College Law Review, 54, 393–431. Stephenson, Matthew C. 2005. Public Regulation of Private Enforcement: The Case for Expanding the Role of Administrative Agencies, Virginia Law Review, 91, 93–173. Stevenson, Drury D. & Nicholas J. Wagoner. 2011. FCPA Sanctions: Too Big to Debar?, Fordham Law Review, 80, 775–820. Thomas, Cortney C. 2010. The Foreign Corrupt Practices Act: A Decade of Rapid Expansion Explained, Defended, and Justified, Review of Litigation, 29, 439–470. Tillipman, Jessica. 2012. A House of Cards Falls: Why “Too Big to Debar” Is All Slogan and Little Substance, Fordham Law Review Res Getae, 80, 49–58. Warin, F. Joseph & Andrew S. Boutros. 2007. Deferred Prosecution Agreements: A View from the Trenches and a Proposal for Reform, Virginia Law Review in Brief, 93, 121–133. Weinograd, Charles B. 2010. Clarifying Grease: Mitigating the Threat of Overdeterrence by Defining the Scope of the Routine Government Action Exception, Virginia Journal of International Law, 50, 509–549. Weissmann, Andrew & Alixandra Smith. 2010. Restoring Balance: Proposed Amendments to the Foreign Corrupt Practices Act, Washington, DC: U.S. Chamber Institute for Legal Reform. Westbrook, Amy Deen. 2010. Enthusiastic Enforcement, Informal Legislation: The Unruly Expansion of the Foreign Corrupt Practices Act, Georgia Law Review, 45, 489–577. Wilson, Natasha N. 2014. Pushing the Limits of Jurisdiction Over Foreign Actors Under the Foreign Corrupt Practices Act, Washington University Law Review, 91, 1063–1087. Yockey, Joseph W. 2013. Choosing Governance in the FCPA Reform Debate, Journal of Corporation Law, 38, 325–380. Zervos, Alexandros. 2006. Amending the Foreign Corrupt Practices Act: Repealing the Exemption for “Routine Government Action” Payments, Penn State International Law Review, 25, 251–294. Zimmerman, Stephen S. & Frank A. Feriello, Jr. 2011. Coordinating the Fight against Fraud and Corruption, Agreement on Cross-Debarment among Multilateral Development Banks, World Bank Legal Review, 3, 192–204.

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7.  Corruption in state administration

Tina Søreide and Susan Rose-Ackerman*

1. INTRODUCTION Corruption can arise in any bureaucracy that has the authority to allocate benefits and impose costs. Program designers need to acknowledge and control such risks, but “best practice solutions” are seldom obvious. International development institutions propose long lists of anticorruption initiatives for state bureaucracies, hoping that at least some will be effective. But effective solutions in one context may be entirely ineffective in another.1 Nevertheless, general economic principles can help guide reform so long as they are interpreted in the light of each country’s particular situation. We turn for policy insight to models of bureaucratic behavior, especially the economic literature on asymmetric information and sanctions. In this literature, individuals are expected to make rational choices given their preferences and the limited information at their disposal. However, scholars often present these models abstractly without a discussion of how they interact with the law and with bureaucratic realities. We respond to that weakness by providing the intuitions behind the economic theories and discussing their practical value in anticorruption policy design. We show how insights from economic theory can elucidate efforts to deter corruption in administrative hierarchies. The chapter proceeds as follows. Section 2 shows how economic insights can contribute to understanding the nature and prevalence of corruption. Section 3 argues that economic principles can help reformers move from understanding to control of corruption. Section 4 discusses alternative policies to deter civil servants from engaging in corruption. Section 5 evaluates compliance regimes for state institutions and the available sanctions. A conclusion follows.

2.  EXPLAINING CORRUPTION Economists sometimes distinguish between capture or collusive corruption (where the civil servant and the client secretly collude for their common benefit) and extortive corruption (where the client feels compelled to make a bribe payment).2 In practice, it is difficult to   *  Jennifer Arlen, Paul Lagunes, and Linda Gröning made very helpful comments on earlier drafts, and we got useful feedback at the Conference on Corporate Crime and Financial Misdealing, New York University, April 2015, especially from discussant Jean Ensminger.  1   Grindle (2004) develops this point. See also Sandgren (2005) and Khan (2006). Transparency International (2012) provides a cross-country review of integrity mechanisms for state institutions in Europe.  2   See Rose-Ackerman (2010) for a review.

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196  Research handbook on corporate crime and financial misdealing draw the line between cases of collusive corruption and extortive corruption, especially because most bribe-payers prefer to portray themselves as victims of corruption (regardless of the benefits they obtain). A more neutral perspective considers the allocation of bargaining powers between the parties involved in the corrupt deal. The more important a decision is for a client or the greater the power of the civil servant, the lower is the bargaining power of the client and the higher the share of the gains that a corrupt official can appropriate in the form of a bribe, everything else being equal. The most extreme situation is one where the official is so powerful that he can threaten to harm the client through unlawful means unless paid off. Outside of such cases, however, corrupt deals tend to benefit both parties, typically at the cost of some government aim or function. These deals can range from pure extortion where the official behaves exactly as would an honest and competent official except that he is paid for his actions, to the opposite extreme, where a bribe is paid to get a benefit to which one is clearly not entitled or to avoid a legitimate cost, as when a bidder bribes to obtain a government contract that should have been awarded to someone else. We seek to explain what governments can do to deter corruption within their own ranks. To simplify and focus the discussion, we concentrate on a state institution with a hierarchy of employees who have the authority to allocate certain benefits to qualified clients. Although systemic corruption, of course, can penetrate state institutions, up to and including the top political level, we deal here with the intermediate case where the top management level seeks to promote integrity. An honest higher-level official has oversight responsibility—for example, a government minister who seeks efficiency and legality, consistent with publicly recognized goals. In this chapter, we concentrate on such bureaucracies, and we do not consider the background political environment or outside institutional checks. We also leave to one side the special case of publicly owned firms.3 Thus, we direct our contribution to high-level officials with a professional commitment to honest government who may gain insights from the economic analysis of reform alternatives. We emphasize two key loci of corruption—the allocation of scarce public benefits and the assessment of qualifications for receiving a benefit or for bearing a cost.4 2.1 Scarcity State administrations allocate scarce resources according to given rules and standards ostensibly designed to serve the public interest. Scarcity may arise in public health services, in access to schools, in the number of ships able to enter a port, in the number of production licenses for some good, and so on. If the benefit cannot legally be sold to the high bidders, a corrupt “market” may operate where the balance between demand and supply determines the bribe-price. If no official has significant bargaining power, the corrupt system may operate like a competitive marketplace that excludes the honest and the poor. A uniform bribe-price is likely because anyone charged too high a bribe  3   Much of the material in this section and the next summarizes arguments in Rose-Ackerman (1978, 1999). These sources also discuss some of the issues put to one side here.  4   A range of factors are relevant for understanding the individual propensity to engage in corruption. We have reviewed the literature in other publications, see Rose-Ackerman (1999), Rose-Ackerman and Palifka (2016), and Søreide (2016).

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Corruption in state administration  197 can approach another official for a better deal. Of course, even here the “market” is likely to diverge from the competitive model because of a lack of information about corrupt deals; they are kept secret not only from law enforcement authorities but also from other demanders. Nevertheless, the main beneficiaries will be those with a high willingness to pay who cannot be extorted to pay more than the equilibrium price. Clearly, other factors may influence the size of the bribe besides the underlying level of demand and supply. Honest officials and beneficiaries will not participate in corrupt transactions, shrinking the size of the corrupt market. Lobbying and other forms of persuasion can also influence officials’ choices and can substitute for illegal payoffs. If there is only one public official with de facto control over benefit allocation, he or she has monopoly power and might be able to negotiate bilaterally with each client with the bribes kept hidden from others. The official could then collect the clients’ whole “demand curve”—in the sense that those who obtain the benefits pay a bribe equal to their maximum willingness to pay. Those unable to pay enough, or unwilling to make illegal payments, do not obtain the benefit.5 There is no single, market-clearing bribe price. This result, of course, assumes—as in all analyses of price discrimination—that the benefit cannot be resold by the low bribers to those with high willingness-to-pay. The secrecy and illegality of payoffs is likely to mean that bribers have very poor information about the payoffs of others so that bribe-price discrimination can be stable. In such a situation, the single official can create shortages even if the benefits are not scarce by law. For example, even if there is space in the port for all ships to offload their cargoes, the official controlling the port (or customs clearance) may restrict the shipping firms’ entry to maximize bribes, just as a private monopolist restricts supply (Shleifer and Vishny, 1993). Thus, the source of bribery is not scarcity in the underlying program, per se, but rather the official’s monopoly control over the allocation of the benefit.6 That control permits the official to extract payoffs from demanders in accord with their willingness to pay bribes. 2.2 Qualifications Sometimes officials have discretion to judge who is qualified for a public benefit. Assume that anyone with certain qualifications should be able to obtain the benefit. Scarcity is not the problem, but bribery is possible because the allocation of the benefits is controlled by a gatekeeper who is able to deviate from the stipulated criteria without detection. The qualifi 5   Lui (1985) presents a theory showing how paying bribes for a better position in a queue serves as an efficient auction procedure. One problem with this result is that many public services are supposed to be free of charge. Corruption condoned because of efficiency concerns can easily undermine a program’s distributional goals (Rose-Ackerman, 1978, p. 106). Second, public officials’ efforts to avoid detection and arrest may add to the social costs of corruption. Third, informal payments typically trigger undesired externalities—such as an adverse selection of the unscrupulous into the state administration and a higher inclination of individuals to offer bribes to induce officials to deviate from formal rules.  6   Monopoly control can arise not only when one official misuses his or her authority, but also if several officials with similar or different responsibilities collude to share bribery receipts. For an illustrative case see Olken and Barron (2009) on corruption along trucking routes in Aceh, Indonesia.

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198  Research handbook on corporate crime and financial misdealing cation criteria are stipulated formally by a directive or law. With corruption, the gatekeeper alters the criteria, so that, informally, other criteria (such as bribe payments) apply. Consider for example the award of drivers’ licenses—which clearly should depend on a candidate’s qualifications, assessed through an exam that tests the candidate’s driving skills and knowledge of traffic rules. With corruption, the exam becomes irrelevant and the payment of a bribe determines award of a license. This is exactly what Bertrand et al. (2006) found when they used a field experiment to study corruption in the award of driving licenses in New Delhi, India.7 According to their study, bribery puts unsafe drivers on the road. Those who obtained their licenses in exchange for a bribe had lower driving qualifications. Those who refused to pay bribes were often found ineligible for a license, regardless of their skills, and many of those who offered bribes did not even have to take a driving test to get a license. Assessment of qualifications for benefits is a significant part of officials’ de facto discretionary authority.8 Building permit offices consider proposals in light of construction requirements, neighbors’ concerns, and urbanization plans. If the applicant pays a bribe, officials may set aside some criteria—possibly with the result that housing and city developments are not up to required standards and do not perform their expected functions. Similarly, teachers might allocate grades according to bribes paid instead of student qualifications. Safety inspections of industrial plants could be influenced by bribes, regardless of the actual safety level. Public procurement contracts create corrupt incentives that mix scarcity and the determination of qualifications. The number of contracts is limited, and tendering firms are assessed, not only on the offered price–quality combinations, but also on their integrity. If suspected or found guilty of certain forms of crime, suppliers can be excluded from participating in tenders—often called debarment. However, if the procurement agent is corrupt, the opportunity to exclude firms on a discretionary basis implies that the debarment rules themselves, introduced to promote higher integrity, may add to the decisions that can be bought with a bribe. Payoffs might, for example, eliminate an annoying competitor—excluded with the more or less legitimate excuse of suspected corruption on the other side of the globe.9 Bribes are also paid to induce civil servants to speed up the processing of requests or the issuance of licenses. Officials may strategically delay files as a device for extracting payoffs even if the applicant is clearly qualified. One way to delay allocations is to find fault with applications and to introduce trivial requirements. Sometimes the law itself helps the corrupt official by its very complexity. If access to the benefit is urgent for the client, the civil servant is obviously in a more powerful bargaining position to demand payoffs in return for speed.

 7   Peisakhin (2011) reviews field experiments on corruption, including the results from Bertrand et al. (2006). Banuri and Eckel (2012) present the insights and inconsistent results from lab experiments on corruption.  8   An official’s discretionary authority may follow de jure from the broad authority assigned to the specific position, or be the de facto consequence of the higher-level lack of oversight of the official’s performance.  9   Hjelmeng and Søreide (2014) criticize the EU Procurement Directive of 2014 for providing procurement agents with too much influence over debarment decisions.

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Corruption in state administration  199 Civil servants can also “sell” cost-cutting decisions. The civil servant has the authority to reduce a monetary burden—such as reducing the tax imposed on a category of clients or ignoring a client’s failure to pay a fine for some compliance failure. If corruption affects the performance of the judiciary, firms may avoid monetary penalties altogether. Other examples are firms offering bribes to cut health, safety, or environmental costs. This is very similar to the case of qualifying for a benefit. The firm or individual pays to avoid a cost rather than to obtain a benefit. Scarcity does not usually limit the discretion of officials unless he or she must collect a fixed quota of tax receipts. Rather, the bribe payer seeks an individual decision to limit his or her own costs. The bribe is likely to be higher the closer the purchased decision is to a criminal offense. The consequences of discovery are higher here than for other corrupt transactions; hence, the official must demand a bribe that exceeds the expected cost of detection and punishment. Furthermore, the official will likely also be able to bargain for a larger share of the benefits if he or she can credibly threaten to report the bribe offer. We would expect, for example, that a bribe paid to induce public authorities to ignore life-threatening pollution that is treated as a criminal offense ought to be higher than a bribe paid to overlook less harmful pollution. Likewise, the customs official who allows the importation of illegal goods (such as weapons or human organs) may demand higher corrupt payments than one who exempts importers from tariffs on legal products. In short, when the expected cost of detection and punishment is high, the minimum bribe acceptable to officials must exceed that cost. The actual level of the bribe then will depend upon the bargaining range between the minimum bribe acceptable to the official and the profits of the offender, taking into account the risks of detection and punishment for both actors. Those who are willing to pay bribes sometimes threaten violence to limit corrupt demands from officials—the famous choice between plata o plomo (silver or lead ­(bullets)). Mafia organizations have used this combination of bribes and threats of violence to influence public institutions’ decisions in their favor or to avoid arrest and prosecution. The threat of violence reduces the civil servant’s bargaining power. In the extreme, organized crime pays no bribes but rather operates through intimidation and threats that extend beyond civil servants to include law enforcement and the judiciary. Shelley (2014) explains that the most serious acts of terror since early the 2000s have used a mixture of threats and payoffs to obtain benefits. Without the necessary qualifications, terrorists have been given licenses, visas, bank accounts in false names, customs clearance for illegal goods, and access to areas with restricted entry. It is difficult to control this form of corruption with higher sanctions; both bribes and threats would simply increase to compensate for the added risk, and increased threats may be relatively inexpensive for criminal organizations.10 Corrupt officials have little bargaining power vis-à-vis such groups.

10   A government may reduce the incentives for such corruption by separately criminalizing the crime itself and the bribes paid to avoid detection—or to penalize bribe recipients more when their illegal conduct facilitates other criminal activity (Sanchirico 2006). However, this will not necessarily deter corruption if the criminal gains are very high or motivated by fanatic ideology.

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3.  FORMS OF CORRUPTION CONTROL The control of corruption depends on the underlying mechanisms that produce corrupt deals. Without an understanding of how anticorruption controls affect both public officials and private individuals and firms, reforms may simply shift the distribution of corrupt gains between bribe payers and recipients, while corruption continues. With that in mind, we discuss the effect of controls on the supply and demand for bribes in a “competitive” corrupt market and next discuss how controls operate in collusive environments. 3.1  Reorganizing Service Delivery Corruption can be controlled by increasing the expected cost of corruption–that is, the risk of detection and punishment multiplied by the penalty.11 However, the exact impact of various forms of control is often difficult to predict, especially because civil servants will often adapt their corruption to the form of oversight. In theory, an increase in the frequency and intensity of controls ought to reduce propensities for corruption.12 However, even if the number of corrupt deals falls, some clients who can obtain the given benefit only through corruption (for example, because they would not qualify for honest allocations), may be willing to pay a higher bribe that compensates the official for the higher risk of being detected and punished. Hence the official may be able to maintain a high level of corrupt receipts despite the decrease in the total number of corrupt allocations. A simple illustration of this point is provided in Figure 7.1. Suppose that the underlying benefit is open to all who qualify, but that each applicant i must bear a qualification cost, ci, that might vary across applicants. This cost can reflect both measures taken to qualify, such as an educational credential for a person or the installation of safety measures in a firm, as well as the costs in time delays and fees of dealing with the state. In addition, willingness-to-pay can be a function of the risk of being caught times the penalty, which might vary with the size of the bribe. In the example, no one wants more than one unit of the public benefit, and applicants weigh the costs and benefits of corruption compared with qualifying honestly. For simplicity, assume that everyone could, in principle, qualify, but that some would have to bear very high costs to do so. Figure 7.1(a) then illustrates how clients’ demand (D) for corrupt decisions increases as the price (p = the bribe)

11   Tyler (2006, 2017) warns this is a simplified assumption and explains that norms do not always accord with formal rules and depend on the rules’ source and how they are enforced. Nevertheless, in our discussion we claim that the net benefit is important, especially for those decision makers who “are on the margin”—in the sense that they are nearly indifferent between committing the crime and staying honest. Compared to other forms of crime, corrupt actors in many cases fit the profile of rational strategic planners who are disinclined to act on shortsighted impulses. 12   A number of empirical studies confirm this point. See for example Lagunes (2012), who found that monitoring reduces the risk of bureaucratic corruption so long as detected corruption was followed by top-down sanctions. See also Sequeira (2013), who studied the impact of changes in tariff levels on tariff evasion in the context of clearing goods through international borders. A change of tariff levels reduced the risk of corruption, although it also resulted in other forms of tariff evasion. For the control of a completely different form of crime, see Ratcliffe et al. (2011), who find that foot patrols in violent crime hotspots can significantly reduce violent crime levels.

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(a) (b)

Figure 7.1  Forms of corruption control decreases. The quantity associated with each bribe-price, p, is the number of applicants who prefer corruption, with its attendant risk, to using the honest qualification process or simply doing without. The upward sloping supply curve, S, indicates that as the size of the bribe rises, more officials are willing to accept (or extort) payoffs. Even if expected penalties rise with the size of the bribe, the upward slope implies that in this case the net benefits of corruption increase with the size of the bribe. Alternatively, it is possible for costs to rise at a more rapid rate so that officials have a maximum bribe they are willing to accept. Now assume a “competitive” market for the service where a single bribe-price allocates the corrupt benefit because the officials cannot collude. This structure pushes the bribe to the level that clears the “market.” If an official demands too high a bribe, the client can simply turn to a different official. Increased controls on civil servants shift the supply curve to the left to S2. The change of slope is determined by the corruption elasticity—that is, how sensitive civil servants are to a change in controls. A shift from S1 to S2 will reduce the quantity (q) of corrupt decisions at any bribe-price and raises the equilibrium bribe to pB. The increased control has resulted in fewer corrupt decisions, but corruption is still a problem, and bribery revenues continue to reward civil servants for their corrupt behavior. In fact, those who remain in the corrupt column are likely to earn more than they did before the crackdown—the overall number of corrupt deals falls, but they are concentrated in the hands of those still willing or able to be corrupted. Figure 7.1(b) illustrates the case where controls are also placed on the clients who offer bribes in exchange for corrupt decisions. The demand curve shifts to the left from D1 to D2, and both the quantity demanded and bribe paid decrease.13 However, if combined with controls on the supply side, there is a combination of effects. Quantity falls but bribeprice could be above or below its level before the crackdown. In short, added controls may

13   Controls on the demand side that include a reward for self-reporting may also affect the supply side if self-reporting allows enforcement authorities to obtain evidence to charge the bribe recipient.

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202  Research handbook on corporate crime and financial misdealing reduce the number of corrupt decisions as honesty becomes relatively more attractive, but the net benefits of corruption will still be positive for some participants who will continue to pay and receive bribes. In both cases, there may be some honest officials and citizens or businesses. The figures represent the opportunistic actors who decide whether to accept or pay bribes on the basis of a profit and loss calculation. Those committed to honesty may complain about the corruption of the system but feel powerless to promote change. However, if a legal crackdown induces a new group of officials and citizens to shift into the honest camp, they may be especially likely to complain about others’ malfeasance. In Figure 7.1 individuals only interact through exchanging bribe payments for benefits. If, instead, corruption leads to long delays for the honest, this may be especially irksome for those who have decided to forgo bribery. If they can be granted an amnesty for past behavior, they can be potent allies in the anticorruption campaign. Government crackdowns against corruption are more effective if clients—both bribe payers and those who refused to pay—are willing to complain and report corrupt offers or demands. In an ordinary competitive market, trades are impersonal interchanges, but in a corrupt market officials need to identify those who will make payoffs. The official’s risk of detection will depend, first, on his or her ability to distinguish between those who will pay informally and those who will not, and, second, on the relationship between the delay experienced by the honest clients and the value of their time. Vicious and virtuous cycles can occur that our static equilibrium graphs cannot capture. For example, if those willing to pay and receive bribes cannot easily identify their counterparts, such dynamics may operate. As the share of bribe payers and recipients increases, there is a greater chance that a corrupt participant will interact with another dishonest one, making corruption less risky and inducing others to shift in the corrupt direction until all but an honest remnant are corrupt. Conversely, if few are corrupt, those willing to pay may find that it is too risky to offer or extort a bribe. Their shift to honesty induces even more to give up corruption in the next period, and so on until corruption becomes very rare.14 The analysis also suggests that if the benefit of corruption is access to a legal benefit, then competition for clients—between offices or between officers within a public office—will generally reduce the risk of corruption or at least lower the payoff levels compared to a case where individuals and firms are only allowed to interact with a single designated official who exercises a form of petty monopoly power (Rose-Ackerman 1978, pp. 137–150). The best case is one where the bribe that applicants are willing to pay falls below the minimum willingness-to-accept of the officials. Then if service delivery performance is observable, compensation schemes can depend on honest or efficient performance. Unfortunately, increased inter-official competition for clients is not always a viable option. A police officer will often be in a “monopoly situation” where his or her judgments and decisions go unchecked. In fact, because a police officer can initiate interactions with 14   See Bardhan (1997), Rose-Ackerman (1999, pp. 107–108, 124–125).These mechanisms depend on more than revenues and risk of detection. For some, ethnic belonging and loyalty may be more important than the risk of detection. Such aspects are parts of the broader set of costs and benefits associated with corruption, and their effect may well be consistent with the assumption of (fairly) rational decision makers.

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Corruption in state administration  203 almost anyone, he or she is free to exploit situations of petty monopoly power, even if the police force attempts to limit corruption risks.15 A small local government may not have the financial capacity to have several staff involved in sector or program decisions. Even if several officials in an office are equally able to make a particular decision, they may, in practice, consult with or defer to a colleague with more expertise or better political connections who may end up being able to monopolize the process. In some situations, however, it may be possible to introduce an element of shared authority. Instead of allocating responsibility to individual public officials according to certain geographical areas, segments, age groups, or whatever classification of clients applies, it may be possible to introduce overlapping jurisdictions in order to permit clients to consult an alternative official. As discussed by Tirole (1994), competitive pressures can promote better service delivery in different ways, including for control purposes. For example, instead of asking one group of civil servants to investigate the various options prior to an important investment decision, different groups can be given the task of investigating different options and eventually “compete” with each other in defending their case. Assuming a transparent process, such competition can be expected to secure a more informed assessment of options before important decisions are made. In addition, corruption becomes more difficult to carry out because more officials must be bribed and observers cannot so easily be fooled.16 These proposals for restructuring service delivery highlight the shortcomings of common anticorruption strategies that concentrate on law enforcement against officials or firms or both. Anticorruption campaigns and integrity reforms occur all over the world, but unless one studies the causes of weak performance, these efforts will not get at the roots of corruption. For example, firing civil servants suspected of corruption will have a limited effect if it simply reduces the number of officials willing to accept bribes. The result may be fewer corrupt deals but higher payoffs per corrupt interaction. One might count the decline in corrupt transactions as a success, but the most important decisions are still for sale, but for a higher price. Similarly, a policy that limits those willing to pay (demanders of public benefits in Figure 7.1) may have little effect if the government supply of benefits remains fixed. Bribe levels will indeed fall, but the quantity of the benefit allocated corruptly may not change. 3.2  Collusive Environments A key problem with competition between officials in the provision of public services is the risk of collusion by either those who pay or those who accept bribes. Public officials

15   In a study of police corruption in Kenya, Andvig and Barasa (2014) found that rotation of police officials—introduced to reduce the risk of corruption—had the opposite effect because officers could use their authority vis-à-vis strangers wherever they were located, and with the rotation, they could move on to new areas—easily avoiding the need to see their victims again. See also Fried et al. (2010) who studied police officers’ opportunities to take bribes and how they take into account their victims’ social status when demanding bribes. 16   Jean Tirole refers to the mechanism as indirect reward since those involved in providing information about options, performance or something else, are rewarded for the final decision, regardless of procedures, arguments or other forms of influence.

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204  Research handbook on corporate crime and financial misdealing can create “a cartel”—where those who deviate might be informally sanctioned by its members. If so, the situation is similar to a monopoly setting: If every official demands a bribe, an increase in the number of public officials making the same type of decision will not help to reduce either the incidence or the level of corrupt payments. For example, if those who operate a port collude, regardless of complaints from clients, it will be difficult to solve the problem through reorganization alone. Clients who dislike the corruption have to use an alternative port and accept the associated extra expenses—as occurred in a study of ports in South Africa and Mozambique (Djankov and Sequeira 2010). Similarly, a reduction in the number of bidders for a contract may simply raise suppliers’ offering prices or facilitate collusion between the remaining bidders. In the extreme, both those who pay and those who receive payoffs may collude to maximize their private gains at the government’s expense. Their relative bargaining power determines the division between payoffs and monopoly profits. If only the corrupt officials collude, they will take care to interact only with those who are willing to pay. Rather than the single market-clearing bribe-price that prevails when officials compete, officials tailor their bribe demands to firms’ ability to pay. Thus Svensson (2003), using data on Uganda, found that firms’ “ability to pay” for regulatory decisions and their “refusal power” explained a large part of the variation in bribes across graft-reporting firms. The firms in his study differed in their profitability and choice of technology, and probably also in their views on corruption, and the regulatory authority appeared to extract bribes depending on the firms’ position—much as a monopolist would do. In short, program designers need to ask if collusive behavior is likely to counteract the beneficial effects of competition. As Tirole (1986, p. 182) points out, collusion (perhaps facilitated by existing clans or cliques) must be anticipated at the organization design stage, but it is difficult to detect and combat, especially because it will often distort attempts to tie compensation to performance. Hence, an efficient strategy against corruption requires one to understand the risk of collusion not only between civil servants and firms that bid on contracts but also between the firms themselves who act as a cartel. For officials, the problem arises because, at a given level of decision making, they usually have an interest in exchanging favors (to solve tasks, help each other out, etc.). A benefit that one provides creates an expectation of reciprocity. There are efficiency-enhancing benefits and efficiency-distorting benefits. An example of the latter is an official who ignores a colleague’s laziness or small-scale theft, or reports favorably on a colleague, regardless of how he or she performs. Another such benefit could be collaboration on the manipulation of performance reports or audit information—or to make sure complaints from clients disappear—in order to make it look as if the unit has performed better than it really has. The exchange of benefits is a form of trade, and the exchanges are “covert transfers,” usually non-monetary—and they are difficult to prove. A cartel-resembling deal on sharing the benefits of corruption can easily develop in such an environment. Coalitions can develop horizontally within the same category of decision makers and vertically between controller and agent, and one official may collude with different parties depending on the issue. The difficult question for reformers is how to encourage reliable information and honest decisions from those who know the informal power structures and make decisions.

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Corruption in state administration  205 There is no clear way to discourage collusion and to encourage reliable, honest behavior.17 Tirole (1986) points to the importance of the corrupt relationship’s temporal length, so that a pattern of reciprocal favors builds up. (Because coalitions take time to develop, old organizations will typically have more coalitions than new.) It is possible to break up coalitions with new staff or staff rotation—or to use consultancy firms for certain tasks and limit discretionary decision making. These tools may also reduce efficiency-enhancing forms of collaboration, however, and, therefore, have other risks. Rewards for reporting deviant performance can encourage staff to reveal collusion, but the benefits of such rewards depend on the system. Whistleblowing programs may have a positive impact on an organization’s culture, but it is also possible that rewarding those who report on colleagues’ under-performance may distort the work environment in other ways, and, certainly, one cannot rely on these programs to prevent corruption up front. To some extent a benevolent superior can detect coalitions by looking at information coming from his or her unit. Reports that reflect poorly on official A, while not on official B are typically reported by B, and suggest that the two are not in a coalition. Reports that reflect positively on both A and B cannot necessarily be trusted. A and B may be colluding to deceive the boss. However, negative reports on others can be a way of enhancing one’s own career prospects, so they too deserve some skepticism. One important intuition coming out of this research is that assessments of service delivery ought to involve clients and society; controls for corruption in state administration cannot be totally internal.18 Beneficiaries of state programs and society at large must have safe places to report inadequate service, perceived infringements, or clear-cut demands for bribes.

4.  SANCTIONS AGAINST CIVIL SERVANTS So far we have treated punishment as a black box that is multiplied by the probability of detection and punishment to generate an expected cost of corruption. We turn now to consider the impact of alternative sanctions on corrupt incentives. Although internal organization and the design of control mechanisms are obviously important, the penalties levied may matter decisively for the level of integrity in state administration. Figure 7.2 presents the correlation between the absence of corruption (vertical axis) and the likelihood that government misconduct is sanctioned when disclosed (horizontal axis). The further away from the north-east corner a country is placed, the lower the sanctions levied on government corruption and the more problems with corruption are reported. This correlation, of course, is not sufficient to demonstrate causation. Severely dysfunctional governments can explain both the magnitude of corruption and the failure to sanction such crimes. Likewise, countries with low levels of corruption may have a culture and a political environment that are conducive to the

17   Many authors propose partial solutions; see, among others, the review by Laffont and Rochet (1997). 18   Beneficiaries of state programs and society at large must have safe places to report ­inadequate service, perceived infringements, or clear-cut demands for bribes.

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206  Research handbook on corporate crime and financial misdealing Corruption and Sanctions on Government Misconduct 1

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Sanctions on Government Misconduct

Figure 7.2 Correlation between corruption control and the likelihood that government misconduct is sanctioned when disclosed promotion of integrity through many routes besides the level of penalties. Nevertheless, the close relationship between estimated corruption control and the level of sanctions imposed on those found guilty of corruption highlights the potential importance of the penalties imposed by the state. 4.1  Administrative and Criminal Sanctions Corruption in state administrations can be sanctioned in many different ways. A reprimand, a letter criticizing an act, is among the milder sanctions against breach of duty. Nonetheless, being singled out as responsible for a more or less intended mistake may impose a significant cost on those who seek to maintain the image of an honest and committed civil servant. Relocation is used both formally, as a sanction for a certain breach of duty, or informally, without formal reference to a particular mistake. Relocation may mean that the civil servant loses his or her position or authority, or is physically relocated to some remote area where few other colleagues would like to work.19 Serious acts of corruption are normally addressed by the criminal justice system. If that system functions adequately, individuals can be sanctioned with a fine or imprisonment, or they can be disqualified for work in government institutions or dismissed from

19   As an informal sanction, relocation is also used against honest civil servants who refuse to be part of a corrupt scheme.

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Corruption in state administration  207 a ­government position. A sanction can be imposed both by an oversight institution, for example a ministry overseeing the performance of state administrative entities, or formally by law enforcement bodies through the criminal or the civil law. Criminal law normally sends a clearer signal of wrongdoing and will often hit harder than other sanctions. From an economic perspective, however, what matters is that there is a clear risk of some predictable sanction that civil servants find severe, annoying, and undesired. If the identity of the wrongdoers is uncertain, or even if there is a known individual, sanctions can target either the entire state institution or its top managers as individuals. The choice is not straightforward for institutions with severe problems. Sanctioning individuals only makes them scapegoats for deeper structural problems, but penalizing an institution may destroy its efficacy in a way that harms clients and those who have remained honest. Furthermore, a government that is responsible both for law enforcement institutions and for the performance of state institutions may not have the necessary independence or incentives to sanction parts of its own organization. How, then, can a government use­sanctions on state institutions to provide incentives to comply with anticorruption legislation? This section begins by discussing how economic sanctions can deter corruption among civil servants. Second, it asks whether sanctions can incentivize civil servants to report their own malfeasance. Section 5 addresses the sanctioning of state entities. 4.2  Deterring Corruption through Sanctions Imposed on Public Officials Sanctioning has multiple objectives including influencing the moral development of society, reducing the risk of private retribution which easily leads to an escalation of violence, and the general importance of protecting society against crime.20 Much weight is placed on the protection of offenders’ rights. Although some authors warn against using sanctions for the purpose of influencing other members of society, the deterrence of others is central to the economic analysis of crime.21 The economic rationality assumption postulates that a civil servant will sell decisions for bribes if his or her expected benefits exceed expected costs (Becker 1968), including the risks of being detected, reputational costs, and moral obstacles to committing crime. As long as the individual’s cost–benefit trade-off includes the risk of a sanction, a government can influence the choice through the expected level of sanctions—that is both the chance of being caught and convicted and the level of sanctions if convicted. The sanctions will not “steer” the behavior of all the civil servants because most people will stay honest without even considering the benefits or costs of being involved in corruption. Expected penalties are intended to influence civil servants “on the margin”— that is, those who are close to indifferent between staying honest or accepting bribes.22 The more responsive potential offenders are to the expected sanction, the more   Ashworth (2010) provides a useful review of criminal law perspectives on sentencing.   The case for a utilitarian perspective on criminal law sanctions was early defended by Cesare Beccaria (On Crimes and Punishments, 1764), thereafter rephrased by Jeremy Bentham (An Introduction to the Principles of Morals and Legislation, first printed in 1823), and later examined analytically by Becker (1968) and others. Becker and Stigler (1974) apply the framework to corruption involving the civil service. 22   Indirectly, a criminal law regulation and sanctions may well have long-run effects on larger 20 21

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208  Research handbook on corporate crime and financial misdealing important it is to set a sanction high enough to deter corruption. At the same time, the sanction imposed on a citizen should not be set higher than necessary for the intended deterrent effect. There are three problems. First, if offenders cannot be induced to self-report their crime, the probability of detection for white-collar crimes, such as corruption, is likely to be low so that deterrence requires sanctions that far exceed the harm caused by any particular corrupt act. That is the only way to set expected penalties (that is, the sentence times the chance of detection and conviction) above the expected benefit ex ante. Second, police and the courts make mistakes so that the marginal deterrent effect of any sanction needs to take such errors into account in calculating the expected ex ante cost. Third, holding individuals in prison when they could instead contribute productively in society is inefficient going forward, even if it is defended as an effective deterrent ex ante.23 These problems, taken together create a paradox. The harsh penalties that seem needed to deter ex ante, may delegitimize the state when they are imposed, making it seem brutal and repressive. Corruption may then seem a justifiable response to the illegitimacy of the state. Very severe penalties may also demotivate both potential whistleblowers from reacting against a colleague and juries from delivering a guilty verdict. They may easily feel empathy despite the person’s involvement in corruption. The basic problem is that the probabilities of arrest and punishment are far less than one for the crime of bribery. Thus, there is some tension between communicating the state’s respect for its citizens and using the criminal law to deter those who do make a rational calculation when deciding whether to demand or offer a bribe. Intuitively, a criminal act will likely be deterred if the expected benefit to the offender is less than the sanction multiplied by the risk of being detected and convicted (assuming risk-neutral potential offenders). Some argue that the expected penalty should equal the expected harm to society so that potential offenders are then induced to take the consequences of their act into account before they commit the crime (Becker 1968). One obvious problem with this approach is the difficulty of determining the harm to society. Corruption will typically have direct and indirect effects, and especially the latter is difficult to quantify. A second concern is that a sanction set to match the level of harm may not have the intended effect on the offender’s trade-off behind a decision to commit a crime. This is particularly clear in cases of corruption—because the briber and bribed can inflate the price (i.e. the bribe) as the sanction rises, while the decision in question is still illegally traded. Instead, to affect potential offenders’ decision-making process, it is necessary for the sanction to match or exceed the benefit obtained by the briber. The expected sanction for bribery should be tied to the value obtained by buying a civil servant’s decision. In other words, it should take account of the estimated risk of detection. The penalty levied on conviction should be a multiple of the corrupt benefit. For the civil servant the benefit obtained is reflected in the size of the bribe. These values multiplied by the risk of detection should determine the level of sanctions for those involved. If observers complain that the expected sanction

groups of civil servants’ moral concerns. Although such subtle effects are very important, we concentrate here on the direct effects. 23   Pager (2008) describes the personal consequences of imprisonment in the United States.

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Corruption in state administration  209 is too high relative to the social harm, then the state ought to rethink what it places in the criminal category.24 The link between deterrence and expected sanctions outlined here relies on an extreme simplification of actual decision-making processes. Many important factors determining an individual’s choice to accept or pay bribes are not known—possibly not even to the individuals involved. The economic logic generalizes about human behavior and motivation, while in real life individuals differ, including in their perceptions of the consequences of sanctions and their own ability to avoid detection. Even if the underlying simple assumptions are met, however, it is still difficult to set a sanction that is neither too harsh nor too mild for deterrence. In cases of corruption, the deterrent effect may be very different for different sanctions. For a wealthy and corrupt decision-maker, the payment of a fine may be a way of bribing one’s way out of the problem and not be seen or perceived as a real criminal penalty. A further concern is the need to adjust the sanctions’ level to achieve marginal deterrence. Thus, governments should impose small punishments for small offenses because they need room to levy additional sanctions for large violations. Even if a decision-maker is not fully deterred by the level of sanctions, he or she may still modify his or her conduct to avoid serious penalties. Therefore, sanctions should be scaled so that more harmful crimes are punished more severely than less harmful crimes. That strategy could, however, reduce very harmful corruption while low-level corruption remains undeterred or even increases as law-breakers shift from high- to low-sanction offenses. In principle, one could find a pattern of expected sanctions to deter both, but that may be difficult in practice, given limited law enforcement resources. If crimes with low social costs also provide low benefits to the corrupt—a plausible assumption—sanctioning systems can set expected punishments, that is, chance of detection times the punishment, to match the gain for those involved. If some very harmful crimes provide few benefits to offenders, rational criminals can be diverted to other lines of criminal activity. Of course, not all potential criminals react to economic incentives, but it seems plausible that most of those engaging in “grand” corruption are making profit and loss calculations. The deterrent effect on repeat offenders is another difficulty. From an economic perspective, it makes sense to let sanctions depend on the civil servant’s offense history—clearly, a higher penalty is needed to deter these offenders, while, for society, these civil servants are more important to deter, given the confirmed risk of repeated crime. For many forms of crime, such as violent crime, this concern may justify incarceration. In cases of corrupt civil servants, however, the need for protecting society will largely be met simply by excluding corrupt civil servants from government positions. The opportunity to disqualify civil servants from certain positions may deter some officials, but a comprehensive strategy still requires tougher reactions, including imprisonment, for some of the corrupt.

24   Rose-Ackerman (2010) provides a broader review and discussion of efficient sanctions for individuals involved in corruption.

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210  Research handbook on corporate crime and financial misdealing 4.3  Incentives for Self-Reporting Economists have studied white-collar crime prevention, not only for the purpose of deterring potential offenders, but also, to stimulate them to report their own crime after it has occurred (Arlen and Kraakman 1997). However, expecting civil servants to report their personal involvement appears inconsistent with the assumption that the crime is the result of rational choice, rather than accident or negligence. Civil servants work in bureaucracies that generally have formal monitoring mechanisms and seek to impart professional norms of honesty. However, corruption still occurs, and the economic literature can be of help here in suggesting ways to improve the effect of integrity systems in controlling corruption. Going beyond static rationality assumptions, it is possible that civil servants who engage in corruption feel such deep regret ex post that they want to report the incident. A reduced sanction for those who report their own crime, or an extra penalty for those who do not, will encourage these civil servants to disclose their wrongdoing. Those who self-report can also be rewarded for helping to locate other corrupt officials and private bribe payers (Kaplow and Shavell 1994). However, the offender should not be fully excused because otherwise an official could take bribes without risk as long as he or she reports them (Arlen and Kraakman 1997). Self-reporting is more likely the higher the reward for doing so, and it reduces enforcement costs substantially. There is a tension between incentivizing honesty and incentivizing self-reporting once bribery has occurred. From an economic perspective, there are at least two ways out of this dilemma. The first solution is to impose different penalties on those who report and on those who hide their crime but are detected by controls. Civil servants who fail to report may be found unqualified for positions of trust, leading to dismissal and loss of their pensions; those who report may keep their jobs but face fines, relocation, or extra controls on their actions. The second solution exploits the fact that there are two parties involved in corruption (sometimes more), and law enforcement officials can intensify the incentives to report by promising complete leniency to the party who reports the case first, while the other is punished.25 The parties will rarely trust each other 100 per cent, and a little bit of doubt may be sufficient to trigger a race in which each party tries to be the first to reach the prosecutor’s office. Several authors have discussed the effect of offering leniency in return for admitted corruption, but so far, the debate has circled around the bribe payer as the relevant party to reward with a reduced sanction. Basu et al. (2014) argue for excusing citizens who report their bribe payments in cases where they are legally qualified for the benefit obtained through a payoff. Under their proposal, not only is the briber not punished, but, in addition, he or she is given back the bribe payment. This scheme gives bribers a strong incentive to reveal corruption, and thus the crime will more easily be deterred. As the authors point out, however, the result depends on certain aspects of bureaucratic and legal institutions. The scheme will not work if the oversight institutions collude with the official who takes bribes. Moreover, the scheme is more likely to be effec-

25   This is a common strategy in antitrust and relevant also for corruption cases where players collude (Buccirossi and Spagnolo 2006).

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Corruption in state administration  211 tive for one-shot encounters and not for repeated interactions where, over time, official and citizen develop a trusting corrupt relationship from repeat play.26 Furthermore, the incentives to report can also apply to those who accept payoffs. The aim in both cases is to introduce a heightened risk of detection that will deter payoffs in the first place. That effect will operate if either of the two parties has an incentive to report the case. The situation is similar to cartel cases and investigations of organized crime, where the cartel member or Mafioso who reports first may avoid harsh sanctions, while the remaining participants are punished. In cases of corruption it does not matter which party is deterred, as long as one of them makes a report. In state administration with one monopoly decision-maker and many clients, however, it will often be more efficient to invest in efforts to deter the decision-maker, compared to convincing each of the clients (or firms).

5.  SANCTIONS AGAINST STATE INSTITUTIONS Some state institutions are permeated with systemic corruption that goes beyond the presence of individual bad actors. Here, one can draw lessons from the regulation of corporate criminal liability.27 This section begins with a discussion of duty-based sanctions applied to state administrative entities. Then, we consider institutional sanctions against agencies that fail to comply with rules against corruption and self-dealing. 5.1  Insights from the Regulation of Corporate Crime Many government jurisdictions are beginning to draw lessons from law enforcement efforts to encourage self-reporting and self-monitoring in the private sector. Such borrowing occurs most prominently in the United States, but other countries are now following suit. In the private sector, enforcement priorities increasingly give incentives to firms to report corruption and other crimes and to monitor their employees. If under suspicion, firms bear a large part of the expense associated with internal investigations of their business practices and employees’ behavior. Jennifer Arlen (2012) explains how to stimulate such incentives, given various law enforcement trade-offs and constraints. One strategy is to negotiate a deferred prosecution agreement with a firm instead of seeking a conviction and to reduce sanctions if the firm’s management or board reports malfeasance

26   Basu et al. claim that the leniency arrangement is primarily effective for “harassment bribes,” i.e. where the civil servant holds monopoly power or colludes with colleagues. In contrast, Dufwenberg and Spagnolo (2015) argue that the efficiency of a self-reporting program is higher for cases with larger bribes. They take into account the enforcement cost of verifying corruption, and this cost is high in an environment with high levels of corruption. They argue that for Basu et al.’s suggestion to be efficient in the societies where the corruption problem is widespread, it will require “a wider reform package that also fosters independence and accountability of the legal system” (2015, p. 837). 27   Oded (2013) provides a rich overview of the legal-historical development of compliance regimes and current solutions.

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212  Research handbook on corporate crime and financial misdealing (Arlen  2012). This strategy of “duty-based” corporate liability (Arlen and Kraakman 1997) has two parts. First, it places an expectation—or duty—on firms to assist enforcement authorities by adopting effective compliance programs, self-reporting, investigating, and cooperating. Second, the form and extent of criminal liability depends upon satisfying these duties. This strategy can both limit the expected benefit of bribery and ensure that the firm has adequate incentives to implement an effective compliance program. The individuals responsible for corrupt acts must also face sanctions (Arlen 2012).28 Duty-based sanction regimes encourage owners and top management to take steps to secure compliance because their organizations can largely escape criminal sanctions if they have a satisfactory compliance program in place. The duties must be listed explicitly—with details on self-reporting strategies for self-policing and a whistleblower system—and failure to comply with any one of them could trigger a sanction. However, according to Arlen and Kraakman (1997), if a case of corruption is disclosed by the firm, despite an apparently well-functioning compliance system, the firm still should face some form of sanction. This sanction—which they call strict residual ­liability—will strengthen firms’ motivation to undertake other prevention measures that are designed to deter misconduct, such as reforming compensation and promotion policy to remove excessive incentives to seek profits or sales at all costs. Given a combination of duty-based and residual liability sanctions, firms with strong compliance systems will only face the latter sanction. They are rewarded for having a good system in place but still bear a residual sanction that encourages them to do better. The impact of this regime is uncertain; some firms will have incentives to enact meaningless compliance systems that are mere window dressing, while they continue to profit from well-hidden bribery. However, once even a nominal compliance system is in place, it becomes more difficult for managers to avoid responsibility if cases are revealed. Hence, a compliance system can have a crime-deterrent effect even for those who intend to use it only for window-dressing so long as there is a risk that the firm’s corruption will be revealed by other means. To what extent can these elements from the criminal law regulation of firms apply to state administrations? Similar to firm managers and board members in the private sector, public sector managers are better placed than public law enforcers to know their institution-specific risks of corruption. They can more readily intervene if corrupt deals are being negotiated, and they are better able to identify those involved and react if cases come to light. In addition, like private sector leaders, public sector managers will be able to provide the evidence necessary for a court case or settlement at a much lower cost than public law enforcers. For these reasons, governments may be able to draw lessons from duty-based corporate liability regimes in the private sector. But would anticorruption incentive schemes for civil servants threaten public sector values? Public organizations should design compliance regimes that do not distort the way state institutions carry out their assignments, determine or meet their goals, or adapt to political signals. Instead, the regimes should promote compliance with the law, encourage

28   Problems arise when corporate liability is disconnected from individual liability, either because the responsible individual cannot be identified or because he is outside enforcement authorities’ jurisdiction.

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Corruption in state administration  213 well-functioning whistleblower systems, establish efforts to monitor the risk of corruption in the institution, and provide incentives to report cases once they are discovered, even if they involve top management. Most governments already encourage these integrity initiatives. The duty-based liability regime adds a clear anticorruption responsibility for the leaders of the public agency. The individuals most responsible for its functioning will see both that the agency faces penalties and that the leaders, themselves, will face predictable sanctions upon failure to comply with the regime. Sanctions are imposed regardless of what the top leader knew, giving him or her an incentive to monitor others’ behavior and making it more difficult for corrupt leaders to cover up their own personal benefits. These effects are largely consistent with an honest government’s goals for effective state administration. In various degrees, across countries and sectors, similar mechanisms are already in place. If corruption is revealed, there will often be an internal investigation and a reaction against the organization and those involved. If individual civil servants as well as top leaders are criminally liable, they can be prosecuted and sanctioned so long as independent prosecutors and judges exist. A duty-based compliance regime will emphasize managers’ responsibilities and the consequences of failing to fulfill them. It will add incentives for leaders to have a whistleblower program in place and to encourage their employees to use it. There will be a firmer push for maintaining integrity systems more generally, in accord with government’s anticorruption aims. Compared to the regulation of the private sector, however, a duty-based sanctions regime faces some distinctive challenges. Unclear and multiple performance targets combined with the discretion needed for civil servants to perform effectively, can permit collusive corruption to hide behind the façade of a compliance system. In the private sector the drive for profits and the benefits of paying bribes simplify the mapping of incentives, even if ambiguities arise in actual practice. In public institutions, high expectations, combined with ad hoc voter-friendly politics, often lead to multiple, vaguely defined objectives and performance criteria. With unclear performance targets, it becomes difficult to know if an organization is performing well or poorly. If the incentives and goals are blurred and in conflict, corrupt managers can deflect blame by claiming that neither they nor the government as a whole sought corrupt advantage and in fact did what they could to prevent it. Furthermore, rights-based service delivery and non-monetary values make it difficult for public institutions to develop efficiency-enhancing initiatives that could be triggered upon indicators of low performance, including corruption. At the same time, because public agencies and departments are responsible for implementing and enforcing political decisions, they do not have the same autonomy as private firms. They are exposed to popular pressures or unexpected budget constraints. A further essential difference between the public and the private is that firms may reach their business objectives sooner if their employees pay bribes to get procurement contracts or circumvent regulations and taxes; the acceptance of bribes by public officials usually distorts service delivery. For these reasons, a duty-based sanctions regime, introduced to promote compliance, may have a weaker effect in the public sector, compared to the private sector. Its impact on integrity will be stronger the clearer the state institution’s mandate. Because of the limits of integrity systems in the public sector, they should not entirely replace external controls. The two must operate together.

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214  Research handbook on corporate crime and financial misdealing 5.2  Sanctions for State Institutions and their Staff Sanctions for corrupt acts should match the offenders’ gains so that they deter future crime, and they should not be harsher than necessary to accomplish that goal. Sanctions are supposed to target those who cynically assess the expected gain from crime. At the same time, they signal to society that the state is determined to limit corrupt acts and to encourage norms of compliance with the law. Although the principles associated with duty-based sanctions in the private sector are also relevant for state institutions, the particular sanctions imposed on the private sector are not always appropriate for state institutions. As mentioned, levying a huge fine on a state institution makes little sense if the fine primarily harms the users of social services.29 However, the purpose of the ­sanction—that is, to raise the costs for those who ignore, accept, or are directly involved in corruption—may be achievable through alternative penalties, as we describe below. The effect of sanctions on decision making is difficult to foresee for both private and public entities. In either case, the principles associated with a duty-based sanction regime can be pragmatically implemented using penalties that need not be tied to the criminal law. As long as the specific compliance regime is clearly stipulated, implemented in the organizations, and enforced by an external control body, penalties will have their intended integrity-promoting effects if they are sufficiently severe, fairly predictable in their form, and imposed with a certain level of probability. However, sanctions should not be so severe that they harm the administrative unit’s service provision responsibilities. An across-the-board cut in the compensation level for a state institution’s employees ought not to be a substitute for ordinary fines targeted at venal individuals. Although monetary rewards for honest behavior may well have an encouraging effect, a general wage cut for a state institution involved in corruption may lead the employees to compensate for their loss by demanding more bribes.30 If corruption is pervasive, sanctions should avoid singling out scapegoats, who may just be the most junior hires or those who are politically suspect. Conversely, however, treating everyone as innocent because the “system: made them do it” will also be ineffective. There should be some combination of penalties against the organization as a whole and sanctions imposed on the responsible individuals in order to encourage compliance with the law. Given these various concerns and conditions, and the low applicability of standard criminal law sanctions on corporations; what are the applicable sanctions for state institutions? Relevant sanctions for managers include both the criminal law (for individuals) and

29   To some extent, this argument applies also to shareholders who innocently bear the cost when a huge fine is imposed on the company they own. However, a crucial difference between these private sector shareholders and the citizens and clients using public sector services is that shareholders receive higher returns when the firm is involved in profit-generating corruption. Their incentives are therefore more aligned with the incentives of the company management. When it comes to corruption in the public sector, corruption typically is damaging for citizens and clients— regardless of whether it is detected or not; a huge fine simply adds to the costs of corruption. 30   Benabou and Tirole (2003) explain why economists need to take into account the way positive rewards affect decisions differently than do payment cuts. (These changes will not necessarily have “clean inverse/opposite effects” on decisions.)

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Corruption in state administration  215 the milder penalties listed above in Section 4.1. For state administrative entities, where corruption is known to be entrenched but the identities of the individual offenders are not known, it makes sense to impose institutional reforms rather than to impose monetary fines. What might these sanctions be? In addition to the possible embarrassment associated with an investigation and blame-placing process, a number of sanctions are relevant for corrupt public institutions. First, intensified monitoring, as applied to private corporations, can be imposed as a reasonable sanction with external controllers investigating not only acts in the past but also overseeing the institution’s daily work—a penalty found annoying by many top managers and expensive for the government, yet reasonable given the gravity of the problems. More hard-hitting penalties are necessary in more serious cases. Strict sanctions may include reorganization of the relevant part of the bureaucracy, removing leaders from their positions, taking away responsibilities from the entity in question, disqualifying leaders who have completely failed to comply with the duties stipulated by the sanctions regime, and replacing a significant share of the staff. Victim compensation ought to be considered, but for a budget-constrained agency it cannot be integrated into the institutional sanction. The institution can, however, be requested to identify the victims of corruption and may be able to find ways of redressing their prior maladministration. The basic challenge is to both deter corruption and improve agency performance going forward. Thus, an outside monitor must not only seek to root out corruption but also find ways to help the agency serve its clients and its public goals better. Anticorruption reforms that simply scare officials and make them overly cautious about taking action can be counterproductive. Hence, it is possible to impose sanctions on agencies without relying on monetary fines and in ways that improve their performance. Given explicit guidance and sanction principles, a sanctions ladder reflecting the degree of negligence can make the law enforcement actions more predictable and serve as corruption deterrents while unmistakably signaling expected compliance. The principle of residual liability is applicable as well—meaning that the organization will face sanctions under any circumstance where corruption is known to have occurred and where the liability goes beyond those who are knowingly involved. Predictable enforcement combined with a certain risk of detection is a clear signal that the government expects compliance with the law.

6. CONCLUSION Anticorruption strategies for a state administrative institution should build on careful analyses of the underlying causes and consequences of corruption. Many integrity mechanisms are likely to have a corruption-controlling effect. Under resource constraints and given the risks of missteps that make the situation worse, reformers should be cautious about initiatives whose effects are highly uncertain or not understood. This chapter has presented an economic understanding of corruption as a trade in decisions that should not be for sale, where the size of the bribe and the consequences of corruption are functions of the bargaining powers of those involved. We have suggested ways to reorganize decision-making procedures to reduce the risks of corruption but have stressed the difficulty of breaking up entrenched collusive environments.

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216  Research handbook on corporate crime and financial misdealing Although proven corrupt acts should lead to criminal or administrative sanctions, the range of available penalties is not so obvious when it comes to public institutions and their staff. Compared to private organizations, state institutions have inherently different functions, and governments will often lack the distance needed for independent control and sanctioning. We ask if principles applied to the regulation of corporate liability are relevant for state institutions. Here it is important to distinguish between cases involving individuals found guilty of corruption, and cases where an institution “is corrupt.” Because common criminal law sanctions applied to private sector entities are less applicable to state institutions, we propose more appropriate penalties, including intensified external monitoring, the reorganization of authority, the disqualification of leaders, and the removal of service provision responsibilities. Oversight institutions can impose these sanctions. However, in cases of criminal law violations, internal administrative sanctions should normally be imposed in combination or collaboration with prosecuting authorities.31 We recognize that the corruption of some public entities is so pervasive that there are no reformers able to initiate change. Nevertheless, both history and contemporary experience suggests that such reformers do exist over time and space and that some end up in positions with the power to effectuate change. How to cultivate and support such leaders is an important topic for another day. In this chapter we have rather sought to provide some guidance to those who do face reform opportunities and need to think through what might be both feasible and efficacious.

REFERENCES Andvig, Jens and Tiberius Barasa. 2014. Grabbing by Strangers: Crime and Policing in Kenya. In T. Søreide and A. Williams (eds.), Corruption, Grabbing and Development: Real World Challenges, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Arlen, Jennifer. 2012. Corporate Criminal Liability: Theory and Evidence. In A. Harel and K. N. Hylton (eds.), Research Handbook on the Economics of Criminal Law, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Arlen, Jennifer and Reinier Kraakman. 1997. Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes, New York University Law Review, 72(4), 695–696. Ashworth, Andrew. 2010. Sentencing and Criminal Justice, New York and Cambridge, UK: Cambridge University Press. Banuri, Sheheryar and Catherine C. Eckel. 2012. Experiments in Culture and Corruption: A Review. In D. Serra and L. Wantchekon (eds.), New Advances in Experimental Research on Corruption, Bingley, UK: Emerald Group Publishing Limited, pp. 51–76. Bardhan, Pranab. 1997. Corruption and Development: A Review of the Issues, Journal of Economic Literature, 35, 1320–1346. Basu, Karna, Kaushik Basu, and Tito Cordella. 2014. Asymmetric Punishment as an Instrument of Corruption Control, Journal of Public Economic Theory, 18(6), 831–856. Becker, Gary S. 1968. Crime and Punishment: An Economic Approach, Journal of Political Economy, 76, 169–217. Becker, Gary S. and George J. Stigler. 1974. Law Enforcement, Malfeasance, and Compensation of Enforcers, The Journal of Legal Studies, 3, 1–18. Benabou, Roland and Jean Tirole. 2003. Intrinsic and Extrinsic Motivation, The Review of Economic Studies, 70(3), 489–520.

31   Recanatini (2011) describes experiences and challenges for government anticorruption agencies around the world.

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Corruption in state administration  217 Bertrand, Marianne, Simeon Djankov, Rena Hanna, and Sendhil Mullainathan. 2006. Does Corruption Produce Unsafe Drivers? NBER Working Paper 12274. National Bureau of Economic Research, Cambridge, MA. Buccirossi, Paolo and Giancarlo Spagnolo. 2006. Leniency Policies and Illegal Transactions, Journal of Public Economics, 90(6), 1281–1297. Djankov, Simeon and Sandra Sequeira. 2010. An Empirical Study of Corruption in Ports. Draft paper available at Social Science Research Network, SSRN no. 1589066. Dufwenberg, Martin and Giancarlo Spagnolo. 2015. Legalizing Bribe Giving, Economic Inquiry, 53(2), 836–853. Fried, Brian J., Paul F. Lagunes, and Atheendar Venkataramani. 2010. Inequality and Corruption at the Crossroads: A Multi-Method Study of Bribery and Discrimination in Latin America, Latin American Research Review, 45(1), 76–97. Grindle, Merilee S. 2004. Good Enough Governance: Poverty Reduction and Reform in Developing Countries, Governance, 12, 525–548. Hjelmeng, Erling and Tina Søreide. 2014. Debarment in Public Procurement: Rationales and Realization. In G. M. Racca and C. R. Yukins (eds.), Integrity and Efficiency in Sustainable Public Contracts, Brussels: Bruylant. Kaplow, Louis and Steven Shavell. 1994. Optimal Law Enforcement with Self-reporting of Behavior, Journal of Political Economy, 102(3), 583–606. Khan, Mushtaq M. 2006. Determinants of Corruption in Developing Countries: The Limits of Conventional Economic Analysis. In S. Rose-Ackerman (ed.), International Handbook on the Economics of Corruption. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 216–244. Laffont, Jean Jacques and Jean C. Rochet. 1997. Collusion in Organizations, The Scandinavian Journal of Economics, 99(4), 485–495. Lagunes, Paul F. 2012. Monitoring as a Democratic Imperative: A Study on Corruption and Accountability in Mexico (PhD dissertation), Yale University, New Haven. Lui, Francis T. 1985. An Equilibrium Queuing Model of Bribery, Journal of Political Economy, 93, 860–881. Oded, Sharon. 2013. Corporate Compliance: New Approaches to Regulatory Enforcement. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Olken, Benjamin and Patrick Barron. 2009. The Simple Economics of Extortion: Evidence from Trucking in Aceh, Journal of Political Economy, 117(3), 417–452 Pager, Devah. 2008. Marked: Race, Crime, and Finding Work in an Era of Mass Incarceration, Chicago: University of Chicago Press. Peisakhin, Leonid V. 2011. Field Experimentation and the Study of Corruption. In S. Rose-Ackerman and T. Søreide (eds.), The International Handbook on the Economics of Corruption, Vol. 2, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Polinsky, A. Mitchell and Steven Shavell. 2001. Corruption and Optimal Law Enforcement, Journal of Public Economics, 81(1), 1–24. Rainey, Hal G., Robert W. Backoff, and Charles H. Levine. 1976. Comparing Public and Private Organizations, Public Administration Review, 36(2), 233–244. Ratcliffe, Jerry. H., Travis Taniguchi, Elisabeth R. Groff, and Jennifer D. Wood. 2011. The Philadelphia Foot Patrol Experiment: A Randomized Controlled Trial of Police Effectiveness in Violent Crime Hotspots, Criminology, 49(3), 795–831. Recanatini, Francesca. 2011. Anti-corruption Authorities: An Effective Tool to Curb Corruption? In S. Rose-Ackerman and T. Søreide (eds), The International Handbook on the Economics of Corruption, Vol. 2, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Rose-Ackerman, Susan. 1978. Corruption: A Study in Political Economy, New York: Academic Press. Rose-Ackerman, Susan. 1999. Corruption and Government: Causes, Consequences and Reform, Cambridge, UK: Cambridge University Press. Rose-Ackerman, Susan. 2010. The Law and Economics of Bribery and Extortion, Annual Review of Law and Social Science, 6, 217–236. Rose-Ackerman, Susan and Bonnie J. Palifka. 2016. Corruption and Government: Causes, Consequences and Reform, 2nd edition, Cambridge, UK: Cambridge University Press. Sanchirico, Chris William. 2006. Detection Avoidance, New York Law Review, 81, 1331–2192. Sandgren, Claes. 2005. Combating Corruption: The Misunderstood Role of Law, The International Lawyer, 39(3), 717–731. Sequeira, Sandra. 2013. Displacing Corruption: Evidence from a Tariff Liberalization Program. LSE Research Online: The London School of Economics. Shelley, Louise. 2014. Dirty Entanglements: Corruption, Crime, and Terrorism, Cambridge, UK: Cambridge University Press. Shleifer, Andrew and Robert W. Vishny. 1993. Corruption, Quarterly Journal of Economics, 108(3), 599–617. Søreide, Tina. 2016. Corruption and Criminal Justice: Bridging Economic and Legal Perspectives, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing.

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218  Research handbook on corporate crime and financial misdealing Svensson, Jakob. 2003. Who Must Pay Bribes and How Much? Evidence from a Cross Section of Firms, Quarterly Journal of Economics, 118(1), 207‒230. Tirole, Jean. 1986. Hierarchies and Bureaucracies: On the Role of Collusion in Organizations, Journal of Law, Economics and Organization, 2(2), 181–214. Tirole, Jean. 1994. The Internal Organization of Government, Oxford Economic Papers, 46(1), 1–29. Transparency International. 2012. Money, Politics, Power: Corruption Risks in Europe, Berlin: Transparency International. Tyler, Tom R. 2006. Why People Obey the Law, Princeton, NJ: Princeton University Press. Tyler, Tom R. 2017. Procedural Justice and Policing: A Rush to Judgment?, Annual Review of Law and Social Science, 13, 2.1–2.25.

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8.  Securities law and its enforcers

Stephen J. Choi and A.C. Pritchard* 1

1. INTRODUCTION This chapter reviews work on enforcement by the Securities Exchange Commission (SEC) and explores avenues for deepening our current understanding of the work done by the agency. Some comparative work has been done in the field of securities regulation, trying to assess the role that enforcement plays in capital market development. In addition, there has been considerable empirical work looking at the external impact of enforcement actions brought by the SEC. Finally, empiricists have recently started to investigate enforcement by the SEC more systematically, looking for patterns in the SEC’s enforcement work, which might be thought of as the agency’s output. Largely missing to date, however, has been more granular investigation of the lawyers who conduct the SEC’s enforcement actions and their career patterns, a critical input to enforcement. We offer here some preliminary evidence on that topic. We proceed as follows. Section 2 surveys the prior literature relating to securities law enforcement, and in particular, the work of the SEC. Section 3 discusses questions not explored in the existing literature. Section 4 discusses our sample and conclusions that can be drawn from it. Section 5 provides a brief conclusion.

2.  PRIOR LITERATURE In this section we examine the existing literature on SEC enforcement. We split this survey into three categories that go from a very broad focus to a particular one. We start with comparative work examining the relation between securities law enforcement and capital market development. Next, we briefly survey existing empirical literature relating to the impact that securities law enforcement has on companies and officers that are the subject of its investigations and enforcement actions. Finally, we review studies that have attempted to find patterns in SEC enforcement. 2.1  Value of Enforcement Comparative work on the value of enforcement for capital markets is of relatively recent vintage. Based on a sample of 49 countries, La Porta et al. (2006), examining rules relating to public offerings, find no evidence that public enforcement of securities regulation

*  Thanks for helpful comments to participants at the Conference on Corporate Crime and Financial Misdealing sponsored by the NYU Program on Corporate Compliance and Enforcement, particularly our discussant, David Webber, and the editor, Jennifer Arlen.

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220  Research handbook on corporate crime and financial misdealing correlates with financial market development. Instead, they find that rules relating to private enforcement, including private causes of action for damages, are a much stronger predictor of robust capital markets (depth and liquidity). Putting aside endogeneity issues inherent in their approach, their findings suggest that the deterrent value of public enforcement may be limited. The work of La Porta et al. (2006) is subject to criticism, however, as it focuses on “law on the books”—that is, the formal legal powers provided by statute. If those powers are not actually exercised, perhaps because a country lacks the political will or resources to enforce a strong set of securities laws on the books, legal provisions are unlikely to make a difference on the ground. For example, Bhattacharaya and Daouk (2002) show that the actual enforcement of insider trading prohibitions is what matters, not formal authority. Many countries ban insider trading; far fewer have actually enforced those bans by imposing civil or criminal sanctions. In stark contrast to La Porta et al. (2006), Jackson and Roe (2009), focus on resources devoted to enforcement—annual staffing and budget. They conclude that public enforcement is strongly correlated with market liquidity. Of course, focusing on resources devoted to enforcement ignores how efficiently those resources are used, a much more challenging empirical inquiry. Tallying heads and counting dollars devoted to enforcement is relatively straightforward; measuring the deterrent impact produced is much more challenging. Even counting penalties imposed and wrongdoers jailed is likely to ignore a substantial portion of the impact of enforcement, which may manifest itself in the form of impaired reputation. 2.2  Impact of Enforcement Numerous studies have shown significant stock price reactions to the announcement of corporate wrongdoing, including potential disclosure violations (Kinney and McDaniel 1989; Palmrose et al. 2004). The magnitude of the impact varies with the target of the misrepresentation. For example, over the period 1981–1987 Karpoff and Lott (1993) examine frauds against customers, suppliers, employees, government and investors. They find that announcements of corporate fraud lead to an average decline of 2.39 percent of the stock price. The decline is much greater, however, for firms accused of fraud in their financial statements. Their findings are confirmed by Alexander (1999), who finds an abnormal stock price return of 22.84 percent for companies accused of a wide range of illegalities such as contract violations, bribes, fraudulent bids, FDA violations, safety violations, illegal antitrust practices, export violations and environmental and wildlife offenses. She also finds that companies can limit the impact of scandal through terminations and governance reforms. Perhaps because the SEC is focused on financial fraud, firms targeted by the SEC face large reputational penalties. Studies focusing specifically on SEC enforcement actions have found large abnormal stock price reactions to the revelation of an investigation by the SEC (Feroz et al. 1991; Nelson et al. 2009). That impact appears to have a substantial reputational component above and beyond expected sanctions. Karpoff et al. (2008b) look at U.S. firms sued by the SEC for financial misrepresentation between 1978 and 2002. These firms lost an average 41 percent of their market value when their misconduct was revealed. The actual penalty imposed by the SEC was a small component of this loss

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Securities law and its enforcers  221 of firm value. The SEC assessed an average penalty of $23.5 million, but the reputation penalty dwarfed the sum of all settlements paid in both government and private actions. They find that 24.5 percent of the equity loss can be attributed to market adjustment to reflect the correct fundamental value of the company’s financial situation, 8.8 percent can be associated with expected legal penalties and no less than 66.6 percent is due to a reputational penalty. Their results are subject to criticism, however, as they only aggregate the bad news relating to the misconduct, without accounting for the positive reaction to corrective measures, such as terminating the wrongdoing employee. Moreover, their measure of settlements may understate the expected value of those settlements at the time of the initial disclosure of the wrongdoing, which may tend toward the worst-case scenario. Looking at abnormal price reactions is a potentially noisy measure of the impact of enforcement. Finding a significant stock price reaction confirms the common-sense intuition that the discovery of potential fraud and facing a potential enforcement action are bad news for companies. The limitation of these studies is that stock price reactions cannot disentangle the reaction to possible disclosure violations—and the potential costs of dealing with an enforcement action—from reaction to a business setback, which is likely to be intertwined with the revelation of a disclosure problem (Arlen 2012). (Firms rarely resort to fraud to conceal good news (Arlen and Carney 1992).) Stock prices may be responding to problems revealed with the firm’s underlying business as much as to the loss of credibility flowing from the disclosure problem and enforcement-related costs. Those costs include both the direct costs of defending against the SEC and the distraction costs for management. Initial stock price reactions also may indicate that the market expects that the initial disclosures of problems may be followed by additional bad news about the company’s business (Arlen 2012). Finally, stock price reactions may also indicate that the market expects further related consequences from the enforcement action, including possibly follow-on regulatory or statutory changes, and potentially actions by others (such as the Department of Justice, private plaintiffs’ attorneys or foreign regulators). Alternative market measures have been used to assess the effects of potential fraud on a target company’s information environment. These measures are generally considered to be proxies for investors’ perceptions of information asymmetry in the market for a company’s common stock. For example, Dechow et al. (1996), studying a sample of companies charged by the SEC in accounting enforcement actions, find an increase in the bid–ask spread, a drop in analyst following, an increase in short interest, and an increase in the dispersion of analysts’ earnings forecasts. These findings are confirmed by later work using alternative measures of market confidence in disclosure. Murphy, Shrieves and Tibbs (2009) show that share price responses for firms accused of misconduct correlate with subsequent changes in the level of certainty about earnings. In addition, reputational harm can result in less investor confidence in earnings announcements (Nelson et al. 2008). Finally, institutional ownership declines significantly after a restatement (Burns et al. 2010). Taken as a whole, this work suggests that enforcement actions potentially send a signal to the market about the reliability of corporate disclosure that is separate from the expected costs of defending the action and any collateral private litigation. The consequences of financial fraud are not fully borne by shareholders in the form of diminished share value and liquidity. Karpoff et al. (2008a) find that over 90 percent of the individuals identified as responsible for fraud lose their jobs by the end of the enforcement proceedings. That level of individual accountability suggests that SEC

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222  Research handbook on corporate crime and financial misdealing enforcement is likely to produce substantial direct deterrence and some incapacitation. Officers terminated in connection with an enforcement action for fraud will likely find it difficult to secure similar employment in the future, so their likelihood of committing additional fraud on behalf of public companies is low. 2.3  Patterns of Enforcement Empirical work raises some question about the efficacy of SEC enforcement. Dyck et al. (2010) find that the SEC plays little role in detecting fraud; in their sample of 216 cases of fraud between 1996 and 2004, the SEC was responsible for uncovering the wrongdoing in only 7 percent of the cases. More important in detecting fraud were employees (17 percent of the cases), media (13 percent) and industry regulators (13 percent). Cox et al. (2005) examine SEC enforcement action characteristics. Their sample includes a substantial number of post-2001 actions in an effort to see if the financial scandals that came to light in the wake of Enron’s collapse in late 2001—at the time the largest public company in U.S. history to declare bankruptcy—changed the SEC’s targeting parameters. They find that the SEC targeted larger firms after 2001. This may well have been a response to a series of large market capitalization firms caught up in financial scandals, with WorldCom and Adelphia following quickly on the heels of Enron’s collapse. This focus is open to question, as larger firms are more susceptible to private enforcement through class actions. Those scandals attracted the attention not only of the media, but also Congress. Congress responded to the scandals by giving the SEC greater enforcement powers with the Sarbanes-Oxley Act and imposing more stringent internal controls on public companies, particularly the largest ones. From a policy perspective, this focus on larger companies is open to question. If the largest public companies have the most stringent internal controls, it stands to reason that the incidence of fraud will be correspondingly lower for these firms than for their smaller counterparts. Some studies focus more directly on the relation between media pressure and the SEC’s choices with regard to enforcement targets. Choi et al. (2013) study the SEC’s enforcement decisions relating to the backdating scandal of the mid-2000s. They find that the SEC shifted its mix of investigations significantly toward backdating and away from other accounting issues, which they attribute to media and political attention to the scandal. They also show, however, that the SEC may have pursued backdating cases beyond the point of diminishing marginal returns, as the stock market reactions to the initial disclos­ ure of backdating investigations declined over their sample period. (Likely backdating culprits were identifiable through publicly available information, so the possibility of an investigation should have been anticipated for most targeted companies prior to the actual announcement.) In addition, later backdating investigations resulted in less serious or no sanctions. Perhaps related, they find that the magnitude of the option-backdating accounting errors diminished over time relative to other accounting errors that drew SEC scrutiny. They suggest that the SEC may have turned toward lower-stake (but more salient) cases because of the popular attention drawn by the backdating scandal. In addition to media attention, the SEC may also respond to political pressure. Heese (2014) examines the relation between voter-driven political pressure and SEC enforcement decisions. Heese finds that labor-intensive firms are less likely to face an SEC

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Securities law and its enforcers  223 enforcement action—particularly in presidential election years if the firms are located in politically important states. He also finds evidence of weaker SEC enforcement against labor-intensive firms headquartered in the congressional districts of senior congressmen serving on committees that have oversight over the SEC. Correia (2014) finds that politically connected firms (as measured by campaign contributions and lobbying) are less likely to be involved in SEC enforcement actions. They also face lower penalties if they are prosecuted by the SEC. She further finds that contributions to politicians with influence over the SEC correlate with a lower probability of enforcement and penalties imposed. Finally, she finds that amounts spent on lobbyists with prior employment links to the SEC, and spent on lobbying the SEC directly, correlate with reduced costs in enforcement action. Gadinis (2012) finds a bias in SEC enforcement that works against smaller brokerdealers. This may reflect interest group influence by the largest financial firms. He finds that large firms were more likely to face exclusively corporate liability, with no individuals subject to enforcement action. Large firms also were more likely to be pursued in administrative proceedings, rather than in court, and faced less serious sanctions. These findings are open to question, however, as to whether the models Gadinis used adequately control for the evidence of wrongdoing and the quality of the compliance effort by the targeted firm. Both of these factors are likely to have an important influence on settlement negotiations, the former because it affects the SEC’s likelihood of prevailing at trial and the latter because it may relate to both the likelihood of recidivism and to potential bases of individual liability for failure to supervise. Other work reports a geographic bias in the SEC’s enforcement work. Kedia and Rajgopal (2011) find that the SEC is more likely to investigate firms located closer to their offices. They also find that firms located closer to SEC offices and in areas with more SEC enforcement activity are less likely to restate their financials, suggesting that these firms anticipate more stringent enforcement. SEC enforcement also may be skewed toward domestic issuers. Given the comparative work showing that stronger enforcement may lead to greater liquidity in capital markets, is it possible for firms to engage in regulatory arbitrage? The “bonding hypothesis” posits that foreign firms might overcome weak legal institutions in their home jurisdiction by listing their shares in the United States. By listing in the U.S., companies would voluntarily expose themselves to SEC enforcement, which would act as a pre-commitment to minority shareholders that controlling shareholders will not abuse their position (Coffee 2002). For this strategy to be credible, however, cross-listing would have to be accompanied by actual enforcement, rather than just the possibility. (It also assumes that self-dealing will be accompanied by misleading disclosure; fully disclosed misappropriation is not fraud.) Siegel (2005) finds that the probability of enforcement by the SEC against foreign firms cross-listing in the U.S. is low. Specifically, he looks at Mexican firms cross-listing in the U.S. and finds that cross-listing did not serve to deter self-dealing by controlling shareholders. This is perhaps not surprising, because over a six and a half year period, the SEC brought only 13 enforcement actions against cross-listed firms. Despite the limited prospect of enforcement, Siegel does find a reputational impact enforced by capital market consequences, as firms with better corporate governance enjoyed superior access to financing. Choi and Davis (2014) examine factors that explain how SEC and Department of

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224  Research handbook on corporate crime and financial misdealing Justice (DOJ) sanctions imposed in Foreign Corrupt Practices Act (FCPA) enforcement actions vary across firms and countries using a dataset of SEC and DOJ FCPA actions resolved from 2004 to 2011. They find evidence that the aggregate SEC and DOJ sanctions increase if the ultimate parent company of entities involved in the FCPA violation is foreign and if foreign regulators are involved in the action. They also find that the SEC and DOJ impose disproportionately greater aggregate sanctions for violations where the home country of the ultimate parent company of FCPA defendants has a greater gross national income per capita, stronger anti-bribery institutions, and a cooperation agreement with U.S. regulators. This pattern is consistent with the SEC (and DOJ) enforcing the FCPA more vigorously if the SEC can obtain information on the alleged FCPA violation from the home country of the ultimate parent company of FCPA defendants. Academic research has also investigated the relation between SEC enforcement actions and private securities class actions. Cox et al. (2003) examine targeting by the SEC compared with private plaintiffs’ attorneys in private class actions. Among other things, they find that the SEC tends to target smaller companies compared to private class actions alone during their sample period (1997–2002). They also find that private securities class actions with parallel SEC actions settle for significantly more than private class actions proceeding alone. Choi and Pritchard (2016) also compare targeting by the SEC with private class actions. Using disclosure violations attracting both SEC investigations and private class actions as their baseline, they find that investors in the market perceive greater information asymmetry following the public announcement of the underlying violation for class-action-only lawsuits compared with SEC-only investigations. They also find that the incidence of top officer resignation is greater for class-action-only lawsuits relative to SEC-only investigations. They conclude that their findings are consistent with private enforcement targeting disclosure violations at least as precisely (and perhaps more) than SEC enforcement.

3. SEC ENFORCEMENT AND ATTORNEY CAREER PATHS: OPEN QUESTIONS The empirical work discussed above looks at the outputs generated by the SEC’s enforcement work, focusing on sanctions imposed and consequences for companies and their officers when they are implicated in financial misconduct. Very little empirical attention has been paid to the attorneys who do the actual work of the Enforcement Division. This dearth may in part reflect the limited availability of relevant data. The SEC does not disclose its investigations until an enforcement action is filed. Even then the attorneys responsible for the case will only be revealed if the case is filed in court and the attorneys are required to enter an appearance. If the enforcement action is pursued in an administrative proceeding, the SEC’s enforcement release may or may not reveal the names of the attorneys responsible for the action. To date, the only substantial work on this topic is deHaan et al. (2015). They collect data on the career paths of SEC enforcement division lawyers involved in SEC cases involving accounting misrepresentations over the period 1990–2007. They find minimal differences in the enforcement outcomes for “revolving door” lawyers that eventually leave the SEC to join law firms relative to other lawyers. However, the lawyers that leave to join law firms

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Securities law and its enforcers  225 that specialize in defending clients against the SEC are associated with stronger enforcement effort, as proxied by higher damages collected, a higher likelihood of criminal proceedings, and a higher likelihood of charging the CEO. Overall, they conclude that the revolving door promotes more aggressive regulatory activity, rather than an attempt to curry favor with prospective employers. Their findings suggest that SEC attorneys are anxious to show their expertise to promote their job prospects. More work remains to be done, however, with respect to the attorneys in the Enforcement Division. Those attorneys are responsible both for conducting the investigations that lead to the filing of enforcement actions and for litigating those cases once they are filed. What are the incentives faced by those individuals? It is at least plausible that incentives facing enforcement attorneys influence the enforcement decisions that are ultimately made by the five commissioners who head the SEC. These individuals have not received much attention in the empirical literature to date. Who gets ahead at the SEC, and why? Who stays for the long run? How do they perform? Who leaves the SEC, and where do they go when they leave? Understanding the career patterns of SEC enforcement attorneys may shed light on their incentives and help explain the work of the Enforcement Division.

4.  SEC ENFORCEMENT ATTORNEYS To explore these questions, we collected data on attorneys employed by the SEC’s Division of Enforcement. Our sample consists of attorneys who worked in the SEC’s enforcement division in 2004. We obtained the names of the employees of the Enforcement Division from the SEC’s 2004 telephone directory. We supplemented this information with information about subsequent positions at the SEC through FOIA requests. These requests yielded employee names, job titles and postings, through 2014. We also collected pay grade information from federalpay.org, which reports data obtained from the U.S. Office of Personnel Management. We used this information to classify the attorneys based on their experience with the SEC, as well as hierarchically. To assess the impact of experience with the agency, we created two variables, Long Term2004, corresponding to attorneys with 15 years or more experience as of the end of 2004, and Short Term2004, corresponding to attorneys with five years or less experience at the SEC as of the end of 2004. Our initial (as of 2004) job categories were as follows: Staff Attorney2004 Employed by the SEC with title of staff attorney, attorney, or no listed title as of 2004. Trial Counsel2004  Employed by the SEC with title of Senior Trial Counsel, Assistant Chief Litigation Counsel, Trial Counsel, or District Trial Counsel as of 2004. Top Manager2004 Employed by the SEC with title of Assistant Director, Assistant District Administrator, or Assistant Regional Director, or higher as of 2004. We also distinguished among the various SEC offices. We coded attorneys as Regional2004 if they were employed in an office other than New York or Washington, DC, as of 2004. Given the concentration of the financial services industry in New York, and the

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226  Research handbook on corporate crime and financial misdealing c­ oncentration of the white-collar defense bar in Washington, attorneys in those offices may have had more attractive private-sector options than attorneys working in regional offices such as Fort Worth or Miami. Using publicly available information, we tracked the employment choices of the attorneys in our sample through June 2016. We collected background information on the attorneys through Internet searches, including the Martindale Hubbell dataset on LexisNexis, LinkedIn and Google. These searches yielded information on prior and subsequent employment and when the individual started at the SEC (if prior to 2004). We created an indicator variable for individuals still employed by the SEC as of June 2016 (SEC 2016). We also coded for the law school attended by the individual and their graduation year. We used the law school attended for our variable, Top Law School, which we defined as one of the top 18 law schools as ranked by U.S. News in 1992.1 We used the law school graduation year for our Experience2004 variable (which we define as 2004 minus the graduation year). We created an indicator variable, Female, so that we can assess the role of gender. We created indicator variables to reflect work experience prior to coming to the SEC: Prior NLJ 250 Partner is coded as 1 if the attorney was a partner at one of the 250 largest law firms in the U.S. before coming to the SEC. We conjecture that these attorneys are most likely to view experience at the SEC as adding a valuable credential. We also constructed an indicator variable for Prior Government experience. We posit that these attorneys are more likely to see government employment as a long-term career path. We also used the information produced by our searches to construct a number of variables relating to attorneys’ employment at the SEC, including: Award, which is an indicator variable coded as 1 if the individual received an award from the SEC related to their work at any point up to June 2016; Promotion, an indicator variable coded as 1 for individuals who received at least one promotion at the SEC between 2004 and 2014; and Top Promotion, an indicator variable coded as 1 for individuals who were promoted from a position below assistant director to assistant director or above at the SEC between 2004 and 2014. To help us understand how the work that these attorneys have done at the SEC influences their career patterns, we also collected the number of SEC civil enforcement cases against public companies in which these attorneys were involved from 2004 to 2015. Our source for this data was the complaints for SEC civil actions against public companies obtained from the SEC’s website, from Bloomberg Law or from the NYU Pollack Center SEED database.2 For each complaint, we recorded the names of the SEC attorneys listed at the bottom of the complaint. Our approach was under-inclusive in that we did not track SEC attorney involvement in actions involving private companies or in SEC administrative proceedings. Prior to 2010, the SEC did not regularly list the attorneys involved in SEC administrative proceedings. Our focus on public companies allowed us to focus on those attorneys that get the highest-profile cases at the SEC. The downside of 1   The law schools are Berkeley, Chicago, Columbia, Cornell, Duke, Georgetown, Harvard, Michigan, Northwestern, NYU, Penn, Stanford, Texas, UCLA, USC, Vanderbilt, Virginia and Yale. 2   The SEED database is located at http://www.law.nyu.edu/centers/pollackcenterlawbusiness/ seed

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Securities law and its enforcers  227 this approach is that it does not include cases such as insider trading and pump-and-dump schemes, which will primarily involve individuals. For the period 2004 to 2015, we collected detailed information about enforcement actions in which violations of Rule 10b-5 were alleged. For these actions, we counted the cases in which an attorney had been involved in which violations of Rule 10b-5 were alleged. We used that data to calculate the variable Average 10b-5, which is the average number of Rule 10b-5 cases against public companies per year in which an attorney was involved. As Rule 10b-5 requires proof of scienter, we posit that such cases are more serious violations. All else equal, a higher number for this variable suggests greater involvement enforcing against substantial fraud. We also created the variable Average Individual Actions, which is the average number of cases per year against public companies for each attorney in which an individual was also named as a defendant. Naming an individual may indicate a tougher stance in settling a potential enforcement action. Finally, we collected the total sanctions assessed in those cases, including disgorgement, prejudgment interest, and civil penalties for corporate defendants and individual defendants, which we used to calculate Average Sanction per case for each attorney. As an alternative measure of the impact of these cases, we collected the number of newspaper stories in LexisNexis mentioning an investigation and the number mentioning the enforcement action. We used this number to calculate two metrics for each attorney: Average News Stories—Investigations and Average News Stories—Enforcement. 4.1  Overall Sample We provide the means and medians for these variables for our sample in Panel A of Table 8.1. We see that working at the SEC is a substantial career choice for most attorneys at the SEC. Of the attorneys employed by the SEC in 2004, 47.2 percent were still employed by the SEC in June 2016 (SEC 2016). Long Term attorneys, measured in 2004, accounted for 12.7 percent of our sample and Short Term attorneys, measured in 2004, accounted for 47.2 percent of our sample. The relatively larger faction of Short Term attorneys may be due to the substantial increase in funding the SEC received after the collapse of Enron and WorldCom, which explains this influx as of 2004: more positions became available. The average lawyer had nearly 14 years of experience post law school in 2004. Women were slightly less than a third of the sample of SEC enforcement attorneys in 2004. Looking at the background of the enforcement attorneys, 45.6 percent graduated from top law schools. Only 6.6 percent had been partners at NLJ 250 firms, 17.4 percent came from other government agencies (Prior Government) and 43.9 percent were in regional or district offices. As noted above, we sorted the individuals into a rough hierarchy based on their position at the SEC in 2004. At the bottom were staff attorneys, who make up 37.1 percent of the sample (Staff Attorney2004). This is an entry level position for which individuals can be hired with minimal experience at a firm or other government agency. These attorneys do the bulk of the investigative work of the Division. Investigations that lead to enforcement actions are litigated by trial counsel who make up 22.2 percent of the sample (Trial Counsel2004). These are not entry-level positions; the SEC typically requires prior trial

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228  Research handbook on corporate crime and financial misdealing Table 8.1  Enforcement division attorneys in 2004 Panel A: Full sample Variable Experience2004 Close to Retire2004 Short Term2004 Long Term2004 Female NLJ 250 Prior Partner Prior Gov. Attorney Top Law School Regional2004 Staff Attorney2004 Trial Counsel2004 Top Manager2004 SEC 2016 Award Promotion Top Promotion Average 10b-5 Average Individual Actions Average Sanction Average News Stories—Investigation Average News Stories—Enforcement

N

Mean

Median

SD

406 406 417 417 417 362 362 410 417 410 410 410 413 417 406 406 417 417 417 153 157

13.889 0.039 0.472 0.127 0.307 0.066 0.174 0.456 0.439 0.371 0.222 0.229 0.472 0.168 0.416 0.239 0.081 0.099 15.188 57.345 43.421

13.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 35.000 33.125

7.169 0.195 0.500 0.333 0.462 0.249 0.380 0.499 0.497 0.484 0.416 0.421 0.500 0.374 0.494 0.427 0.169 0.202 47.859 61.420 35.371

Notes:  The following variables were determined as of 2004: Experience2004, Close to Retire2004, Short Term2004, Long Term2004, Female, NLJ 250 Prior Partner, Prior Gov. Attorney, Top Law School, Regional2004, Staff Attorney2004, Trial Counsel2004 and Top Manager2004. SEC 2016, Award, Promotion and Big Promotion were determined as of the end of 2015. The following variables were determined over the 2004 to 2015 period (or earlier if the attorney left the SEC prior to 2015): Average 10b-5, Average Individual Actions, Average Penalty, Average News Stories—Investigation, and Average News Stories—Enforcement.

experience for lawyers in these jobs. We also focus on those SEC attorneys at the top of the SEC enforcement hierarchy, including lawyers from the Assistant Director level up to the Director of the Division, who make up 22.9 percent of the sample (Top Manager2004). Looking at internal metrics of performance, 16.8 percent of the attorneys received some form of award from the SEC up to June 2016. Over 41 percent received at least one promotion during the 2004 to 2014 period (Promotion) and almost 24 percent of the attorneys were promoted from a position below Assistant Director to the Assistant Director or higher level between 2004 to 2014 (Top Promotion). With respect to cases, we computed each attorney’s average civil court cases per year from 2004 to 2015 (or earlier if the attorney left the SEC prior to 2015) against a public company that included a Rule 10b-5 allegation (Average 10b-5). On average, the SEC attorneys litigated a little over 8 percent of cases with a Rule 10b-5 allegation. We also computed each attorney’s average civil court cases per year from 2004 to 2015 (or earlier if the attorney left the SEC prior to 2015) that involved an action against an individual as well as a public corporation (Average Individual Actions). Almost 10 percent of the

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Securities law and its enforcers  229 Panel B: Male v. female enforcement attorneys Male N Experience2004 Close to Retire2004 Short Term2004 Long Term2004 Female NLJ 250 Prior Partner Prior Gov. Attorney Top Law School Regional2004 Staff Attorney2004 Trial Counsel2004 Top Manager2004 SEC 2016 Award Promotion Big Promotion Average 10b-5 Average Individual Actions Average Penalty Average News  Stories—Investigation Average News  Stories—Enforcement

Female

t-test

Ranksum

Mean Median N

Mean

Median p-value

p-value

282 282 289 289 252 252 285 289 284 284 284 282 287 289 282 282 289 289 289 110

14.270 0.046 0.467 0.135 0.063 0.190 0.435 0.415 0.349 0.239 0.077 14.270 0.422 0.194 0.394 0.220 0.097 0.114 19.184 59.545

13.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 13.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 40.000

124 124 128 128 110 110 125 128 126 126 126 124 126 128 124 124 128 128 128 43

13.024 0.024 0.484 0.109 0.073 0.136 0.504 0.492 0.421 0.183 0.040 13.024 0.587 0.109 0.468 0.282 0.046 0.065 6.166 51.719

12.500 0.000 0.000 0.000 0.000 0.000 1.000 0.000 0.000 0.000 0.000 12.500 1.000 0.000 0.000 0.000 0.000 0.000 0.000 31.000

0.107 0.297 0.746 0.471 0.746 0.213 0.198 0.145 0.164 0.202 0.156 0.107 0.002 0.034 0.164 0.175 0.004 0.022 0.012 0.485

0.251 0.297 0.745 0.470 0.746 0.212 0.198 0.145 0.164 0.201 0.155 0.251 0.002 0.034 0.163 0.175 0.008 0.073 0.068 0.423

113

42.843

33.000

44

44.905

37.000

0.744

0.425

Notes:  The following variables were determined as of 2004: Experience2004, Close to Retire2004, Short Term2004, Long Term2004, Female, NLJ 250 Prior Partner, Prior Gov. Attorney, Top Law School, Regional2004, Staff Attorney2004, Trial Counsel2004 and Top Manager2004. SEC 2016 and Award were determined as of June 2016. Promotion and Big Promotion were determined as of the end of 2014. The following variables were determined over the 2004 to 2014 period (or earlier if the attorney left the SEC prior to 2014): Average 10b-5, Average Individual Actions, Average Penalty, Average News Stories—Investigation, and Average News Stories—Enforcement.

SEC attorney’s civil court cases involved actions against individuals as well as a public corporate defendant. The average total monetary sanction, including disgorgement, prejudgment interest, and civil penalties assessed against both corporate defendants and individuals in an SEC action, was $15.2 million (Average Sanction). The average investigation got 57 mentions in the news, with the announcement of an enforcement action yielding an average of 43. 4.2  Male v. Female Based on our conversations with enforcement division attorneys, we speculated that men and women may follow different career paths at the SEC. In particular, women may

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230  Research handbook on corporate crime and financial misdealing have greater family obligations early in their careers relative to men, which may make the relatively manageable hours of a government job attractive. Also some women may drop out of the labor market temporarily while their children are young, returning after they send their children to school. Their absence from the labor pool may affect their opportunities for advancement. To get a picture of the relative positions of men and women in the Enforcement Division, we divide the sample by gender and compare the means and medians for the two sub-samples in Panel B of Table 8.1. We see a handful of variables reflecting statistically significant differences between men and women. Women in the Enforcement Division average a little over one year less experience than men, a modest difference. Men were more likely to have previously been a partner in an NLJ 250 law firm, but this difference is not statistically significant. We see differences in the proportion of women employed at the bottom rung staff attorney position as of 2004 (18.3 percent of women, compared to 23.9 percent of men) but the difference is not statistically significant. Men are more likely to be found in upper-level management positions at the SEC as of 2004. In our sample, 14.3 percent of the men and 13.0 percent of the women held a Top Manager position, although this difference is not statistically significant. We do find a statistically significant difference in the incidence of an SEC Award up to June 2016, with 19.4 percent of the men having received one, and only 10.9 percent of the women. Our variables relating to cases are higher for men. In our sample, 9.7 percent of the cases for men involved a Rule 10b-5 allegation while only 4.6 percent of the cases for women involved a Rule 10b-5 allegation (difference significant at the 1 percent level). Similarly, 11.4 percent of the cases for men involved an individual defendant while only 6.5 percent of the cases for women involved an individual defendant (difference significant at the 10 percent level). And the average sanction was $19.2 million for men and only $6.2 million for women (difference significant at the 10 percent level). 4.3  Who Performs Well at the SEC? The statistics reported in Table 8.1 suggest that many enforcement attorneys will consider the SEC to be their long-time employment option, with nearly 60 percent of the employees in 2004 still employed by the agency in 2014. Notably, of the Enforcement Division attorneys who were employed at the SEC in 2004, 13 percent were also employed by the agency at the beginning of 1990. How do those long-term employees compare with attorneys hired more recently? Are they equally effective, more effective as a result of greater experience, or less effective because they have burned out? To shed light on this question, we compare the long-term attorneys with those who arrived later. For this purpose, we limit our sample to those who were at the bottom rung in 2004, i.e., classified as staff attorneys or trial counsel in 2004. These attorneys arguably have a level playing field in terms of moving up in the hierarchy. On the other hand, we conjecture that attorneys stuck in that position over the long run are likely to underperform, as they may have abandoned hope of advancement at that point. We label this conjecture the “dead wood” hypothesis. We compare eight performance metrics: (1) Award; (2) Promotion; (3) Top Promotion; (4) Average Rule 10b-5; (5) Average Individual Actions; (6) Average Penalty; (7) Average News Stories—Investigation; and (8) Average News Stories—Enforcement. Table 8.2

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Securities law and its enforcers  231 Table 8.2  Who performs well at the SEC? Variable Award Promotion Top Promotion Average 10b-5 Average Individual Actions Average Sanction Average News Stories—Investigation Average News Stories—Enforcement

Not Long Term

Long Term

p-value

0.122 0.416 0.224 0.069 0.077 19.058 60.928 47.912

0.000 0.182 0.091 0.072 0.068 5.823 55.798 24.917

0.083 0.033 0.147 0.911 0.757 0.300 0.856 0.137

Notes:  Sample here is limited to Staff Attorneys & Trial Counsel in 2004. Award was determined as of June 2016. Promotion and Big Promotion were determined as of the end of 2014. The following variables were determined over the 2004 to 2014 period (or earlier if the attorney left the SEC prior to 2014): Average 10b-5, Average Individual Actions, Average Penalty, Average News Stories—Investigation, and Average News Stories—Enforcement.

presents descriptive statistics comparing these metrics for Long Term attorneys with the non-Long Term attorneys. We do not find strong evidence to support the “dead wood” hypothesis. Long term attorneys are significantly more likely to have received an Award, which suggests that awards may reflect longevity as much as performance. With respect to advancement, only a handful of the long term attorneys received any promotion after 2004 (Promotion), while more than 41 percent of the newer arrivals did. The difference is significant at the 5 percent level. Long term attorneys are also less likely to receive a promotion to a Top Manager position (assistant director or higher) compared with shorter tenure SEC attorneys (Top Promotion). This difference however is not significant. Looking at case metrics, on average, long term attorneys are involved in more Rule 10b-5 cases but fewer cases that name individual defendants. Long term attorneys also correlate with cases that result in lower average monetary sanctions. We find a similar pattern with respect to news stories referring to both investigation and enforcement actions—long term attorneys correlate with cases that generate fewer news stories. None of the differences for our case metrics, however, rises to the level of statistical significance. 4.4  Who Leaves the SEC? We next look at who leaves the SEC by June 2016. We conjecture women may be more inclined to stay at the SEC relative to male counterparts because government work may offer a balance of interesting work and a manageable schedule. That balance may fit better with greater family caregiving obligations. We also conjecture that attorneys who perform well at the SEC, as measured by the significance of the enforcement actions that they are involved in, as well as internal metrics of awards and promotions, will be less likely to stay at the SEC because their outside employment options will be more attractive. This hypothesis contradicts the “revolving door” hypothesis, which posits that SEC attorneys will be inclined to pull their punches in bringing enforcement actions because it will enhance their job prospects when they depart for the private sector. We exclude from the

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232  Research handbook on corporate crime and financial misdealing Table 8.3  Who leaves the SEC? Variable Short Term2004 Long Term2004 Experience2004 Female Top Law School NLJ 250 Prior Partner Prior Government Regional2004 Staff Attorney2004 Trial Counsel2004 Top Manager2004 Award Promotion Top Promotion Average 10b-5 Average Individual Actions Average Penalty Amount Average News Stories—Investigation Average News Stories—Enforcement

Stay

Go

p-value

0.482 0.084 13.503 0.377 0.455 0.037 0.166 0.503 0.377 0.204 0.162 0.089 0.503 0.340 0.058 0.075 13.332 50.740 41.028

0.513 0.107 12.939 0.244 0.464 0.083 0.182 0.386 0.391 0.219 0.281 0.254 0.377 0.168 0.108 0.128 17.664 64.759 45.624

0.543 0.445 0.379 0.004 0.863 0.075 0.685 0.021 0.784 0.728 0.005 0.000 0.013 0.000 0.003 0.012 0.379 0.173 0.428

Notes:  The table compares attorneys in the Enforcement Division in 2004 who are still employed by the SEC in June 2016 with those who have left. p-value is from a t-test of the significance of the difference in means of the = 0 and =1 groups for each variable above. The following variables were determined as of 2004: Experience2004, Short Term2004, Long Term2004, Female, NLJ 250 Prior Partner, Prior Gov. Attorney, Top Law School2004, Regional2004, Staff Attorney2004, Trial Counsel2004, and Top Manager2004. Award was determined as of June 2016. Promotion and Big Promotion were determined as of the end of 2014. The following variables were determined over the 2004 to 2014 period (or earlier if the attorney left the SEC prior to 2014): Average 10b-5, Average Individual Actions, Average Penalty, Average News Stories—Investigation, and Average News Stories—Enforcement.

sample lawyers with more than 35 years of experience as lawyers, as their departures may be driven primarily by retirements. Table 8.3 presents descriptive statistics on our primary variables of interest. Among those attorneys who are not close to retirement, we do not observe any significant difference in the propensity of Short Term (as of 2004) or Long Term (as of 2004) attorneys to depart the SEC. We find that women are more likely to stay at the SEC compared with men. We see a number of markers which may correlate with greater attractiveness in the external job market. Individuals who were previously partners in NLJ 250 law firms are significantly more likely to go. The SEC appears to be just a stop along the way for those individuals. Working in a regional office is not associated with a higher rate of departure. These individuals may have fewer attractive options than attorneys practicing in Washington, which is generally regarded as the center for white-collar defense work, or New York, the home of the financial services industry. It is also possible that attorneys in the regional offices may get more substantial opportunities that make the SEC more attractive relative to private sector alternatives. Among the management ranks,

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Securities law and its enforcers  233 Table 8.4  Destination of attorneys who left the SEC by gender Post-SEC Destination

Male

Female

All

Private Practice—Non-Partner

15 10.1%

5 10.6%

20 10.2%

Private Practice—Partner

53 35.6%

11 23.4%

64 32.7%

Industry Position

45 30.2%

12 25.5%

57 29.1%

3 2.0%

5 10.6%

8 4.1%

Other Government

18 12.1%

9 19.2%

27 13.8%

Retired or Non-Law Self-Employed

15 10.1%

5 10.6%

20 10.2%

149 100.0%

47 100.0%

196 100.0%

Non-Profit

Total

Notes:  Chi2 test p-value = 0.084. Note that the table excludes 22 SEC attorneys who left the SEC but for whom we do not have information on their post-SEC position.

Top Managers (as of 2004) are much more likely to depart, suggesting that top-level experience is more marketable. Agency-centric metrics of contribution do seem to align with a greater likelihood of departure, as those receiving an Award, as well as those associated with a higher average number of Rule 10b-5 cases (Average 10b-5) and a higher number of actions with individual defendants (Average Individual Actions) are more likely to depart. These results seem inconsistent with the “revolving door” hypothesis; the SEC’s metrics of strong performance seem to correlate with the demand in the external job market. In contrast, those who receive any promotion while at the SEC (Promotion) as well as those who are promoted up to the Top Manager position (Top Manager) are less likely to depart the SEC.3 4.5  Where Do They Go? Our final set of comparisons looks at the destination of those who leave the SEC (Table 8.4). Here we look at all the SEC attorneys in our sample who left the SEC by June 3   Causality may be reversed in this relationship. It is possible that those who choose to stay at the SEC give themselves more opportunities for promotion within the SEC.

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234  Research handbook on corporate crime and financial misdealing 2016. We are interested to see if there are demographic patterns among those leaving. In particular, we assess whether women systematically differ from men in their destination upon leaving the SEC. We group the post-SEC destinations into six categories: private practice—non partner; private practice—partner; industry position (including compliance positions); non-profit position; other government position; and retired or self-employed in a non-law position. We find significant differences between the destinations for women compared with men who leave the SEC (significant at the 10 percent level). In particular, women are more likely to depart for another government position or a non-profit position (including academia). Men are more likely to take a position as a partner in a private law firm or take an industry position (for example as a compliance officer).

5. CONCLUSION This chapter looks at the role of enforcement by the SEC in the U.S. capital market, highlighted by the choices of the SEC and the impact generated by the agency’s enforcement actions. There is good reason to believe that the enforcement of disclosure obligations and prohibitions against fraud plays an important role in the development of liquid and robust capital markets. Investors will be more confident in taking on risk if they believe that risks are accurately disclosed and priced. The response of investors to potential disclosure violations and enforcement actions has consistently been found to be substantial. That response can be seen both with respect to abnormal stock price reactions to the revelation of a potential enforcement action, as well as in market measures of disclosure’s credibility. Markets demonstrate diminished trust in companies targeted by SEC enforcement actions, suggesting that investors perceive companies targeted by the SEC as less than truthful. Notwithstanding the weight that securities markets give to actions by the SEC, the empirical literature raises substantial questions with regard to how the SEC targets enforcement actions. In particular, researchers have found a number of patterns in the cases brought by the SEC that suggest that the agency responds to bureaucratic and political imperatives, rather than targeting the most egregious cases of fraud. The SEC targets larger firms and more salient scandals, suggesting that the quest for media and popular attention may drive some enforcement decisions. The agency also appears to be influenced by political pressure and interest-group lobbying. In addition, there appears to be a heavy emphasis on domestic companies and, in the FCPA-context, companies headquartered in jurisdictions that are open to cooperating with U.S. regulators. Finally, there is a developing body of literature comparing SEC enforcement with private class actions. Identifying these patterns is an important first step in understanding SEC enforcement. Explaining those patterns, however, will require researchers to dig deeper, looking inside the bureaucracy to untangle the incentives faced by the attorneys who do the actual work of investigating and prosecuting the SEC’s cases. Data issues make this work challenging, as information about investigations is hard to come by and SEC attorneys work in teams, making it difficult to identify the marginal contribution of any particular individual. Notwithstanding these difficulties, we offer some preliminary evidence on the career patterns of SEC enforcement lawyers in this chapter. One important takeaway from the

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Securities law and its enforcers  235 evidence presented here is that internal and external career incentives appear to be aligned. SEC metrics of performance (awards, promotion to top-level management positions) are also recognized by the private sector as markers of talent and expertise. Gender may also matter for the career progression of SEC attorneys. Much work remains to be done, however, to provide a complete picture of the enforcement work of the SEC and its enforcers.

REFERENCES Agrawal, Anup, Jeffrey F. Jaffe, and Jonathan M. Karpoff. 1999. Management Turnover and Governance Changes following the Revelation of Fraud, Journal of Law and Economics, 42, 309–342. Alexander, Cindy R. 1999. On the Nature of the Reputational Penalty for Corporate Crime: Evidence, Journal of Law and Economics, 42, 489–526. Arlen, Jennifer. 2012. Corporate Criminal Liability: Theory and Evidence. In Keith Hylton and Alon Harel (eds.), Research Handbook on the Economics of Criminal Law, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 144–203. Arlen, Jennifer and William Carney. 1992. Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, University of Illinois Law Review, 691–740. Bhattacharya, Utpal and Hazem Daouk. 2002. The World Price of Insider Trading, Journal of Finance, 57, 75–108. Bonner, Sarah E., Zoe-Vonna Palmrose, and Susan M. Young. 1998. Fraud Type and Auditor Litigation: An Analysis of SEC Accounting and Auditing Enforcement Releases, The Accounting Review, 73, 503–532. Burns, Natasha, Simi Kedia, and Marc Lipson. 2010. Institutional Ownership and Monitoring: Evidence from Financial Misreporting, Journal of Corporate Finance, 16, 443–455. Choi, Stephen J. and Kevin E. Davis. 2014. Foreign Affairs and Enforcement of the Foreign Corrupt Practices Act, Journal of Empirical Legal Studies, 11, 409–445. Choi, Stephen J. and A. C. Pritchard. 2016. SEC Investigations and Securities Class Actions: An Empirical Comparison, Journal of Empirical Legal Studies, 13, 27–49. Choi, Stephen J., A. C. Pritchard, and Anat Wiechman. 2013. Scandal Enforcement at the SEC: The Arc of the Option Backdating Investigations, American Law & Economics Review, 15, 542–577. Coffee, John C., Jr. 2002. Racing Towards the Top? The Impact of Cross-Listings and Stock Market Competition on International Corporate Governance, Columbia Law Review, 102, 1757–1831. Correia, Maria M. 2014. Political Connections and SEC Enforcement, Journal of Accounting and Economics, 57, 241–262. Cox, James D., Randall S. Thomas, and Dana Kiku. 2003. SEC Enforcement Heuristics: An Empirical Inquiry, Duke Law Review, 53, 737–779. Cox, James D., Randall S. Thomas, and Dana Kiku. 2005. Public and Private Enforcement of the Securities Laws: Have Things Changed Since Enron?, Notre Dame Law Review, 80, 893–908. Dechow, Patricia M., Richard G. Sloan, and Amy Hutton. 1996. Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC, Contemporary Accounting Research, 13, 1–36. deHaan, Ed, Simi Kedia, Kevin Koh, and Shivaram Rjgopal. 2015. The Revolving Door and the SEC’s Enforcement Outcomes: Initial Evidence from Civil Litigation, Journal of Accounting and Economics, 60, 65–96. Dyck, Alexander, Adair Morse, and Luigi Zingales. 2010. Who Blows the Whistle on Corporate Fraud?, Journal of Finance, 65, 2213–2253. Feroz, Ehsan H., Kyungjoo Park, and Victor S. Pastena. 1991. The Financial and Market Effects of the SEC’s Accounting and Auditing Enforcement Releases, Journal of Accounting Research, 29, 107–148. Fich, Eliezer M. and Anil Shivdasani. 2007. Financial Fraud, Director Reputation, and Shareholder Wealth, Journal of Financial Economics, 86, 306–336. Gadinis, Stavros. 2012. The SEC and the Financial Industry: Evidence from Enforcement against Brokerdealers, The Business Lawyer, 67, 679–728. Heese, Jonas. 2014. Government Preferences and SEC Enforcement. Harvard Business School Working Paper 15-054. Jackson, Howell E. and Mark J. Roe. 2009. Public and Private Enforcement of Securities Laws: Resource-Based Evidence, Journal Financial Economics, 91, 207–238. Karpoff, Jonathan, D. Scott Lee, and Gerald S. Martin. 2008a. The Consequences to Managers for Financial Misrepresentation, Journal of Financial Economics, 88, 193–215.

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236  Research handbook on corporate crime and financial misdealing Karpoff, Jonathan, D. Scott Lee, and Gerald S. Martin. 2008b. The Cost to Firms of Cooking the Books, Journal of Financial and Quantitative Analysis, 43, 581–612. Karpoff, Jonathan M. and John R. Lott, Jr. 1993. The Reputational Penalty Firms Bear from Committing Criminal Fraud, Journal of Law and Economics, 36, 757–799. Kedia, Simi and Shiva Rajgopal. 2011. Do the SEC’s Enforcement Preferences Affect Corporate Misconduct? Journal of Accounting and Economics, 51, 259–278. Kinney, W. and L. S. McDaniel. 1989. Characteristics of Firms Correcting Previously Reported Quarterly Earnings, Journal of Accounting & Economics, 11, 71–93. La Porta, Rafael, Florencio Lopez-de-Silanes, and Andrei Shleifer. 2006. What Works in Securities Laws? Journal of Finance, 61, 1–32. Murphy, Deborah L., Ronald E. Shrieves, and Samuel L. Tibbs. 2009. Understanding the Penalties Associated with Corporate Misconduct: An Empirical Examination of Earnings and Risk, Journal of Financial and Quantitative Analysis, 44, 55–83. Nelson, Christine, Sara Gilley, and Garrett Trombley. 2009. Disclosures of SEC Investigations Resulting in Wells Notices, Securities Litigation Journal, 19, 19–21. Nelson, Karen K., Richard A. Price, and Brian R. Rountree. 2008. The Market Reaction to Arthur Andersen’s Role in the Enron Scandal: Loss of Reputation or Confounding Effects?, Journal of Accounting and Economics, 46, 279–293. Palmrose, Zoe-Vonna, Vernon J. Richardson, and Susan Scholz. 2004. Determinants of Market Reactions to Restatement Announcements, Journal of Accounting & Economics, 37, 59–89. Siegel, Jordan. 2005. Can Foreign Firms Bond Themselves Effectively by Renting U.S. Securities Laws?, Journal of Financial Economics, 75, 319–359.

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9.  Corporate and individual liability in SEC enforcement actions Michael Klausner and Jason Hegland

1. INTRODUCTION Commentators have criticized the SEC for targeting and penalizing corporations for securities fraud while allowing the individuals who committed the violations to go unpunished.1 In this chapter we analyze this claim, using data on all SEC enforcement actions for disclosure violations from 2000 to 2014. Using the Stanford Securities Litigation Analytics database,2 we document the SEC’s enforcement practices with respect to imposing penalties on corporations and on the individuals who commit the violations with which corporations are charged. We find that the claim that the SEC is soft on individuals is untrue. Instead, we find the SEC frequently targets and penalizes individual officers, including for violations of Section 10(b) of the Securities and Exchange Act, Section 17(a) of the Securities Act, and the internal controls and books and records provisions of the Securities Exchange Act.

2.  THE DATA The data used in this chapter includes all SEC enforcement actions from 2000 to 2014 for alleged securities laws violations involving misstatements and omissions by publicly held companies. These include violations of Sections 10(b) and 13(b) of the Securities Exchange Act and Section 17(a) of the Securities Act. The data do not include the Foreign Corrupt Practices Act, insider trading cases or any other violation of the securities laws unless they also include a misstatement allegation. We refer to cases in this dataset as “misstatement” cases. We use the term “case” in this chapter to refer to a set of enforcement actions, in court or administrative proceedings or both, arising out of the same alleged misconduct. Sometimes the SEC files a single litigation or administrative action against a group of defendants—individual and corporate—together. More often, however, it brings separate actions against different defendants. For example, it may bring an administrative action against a corporate defendant, a separate administrative action against its comptroller 1   Gretchen Morgenson, Fining Bankers, Not Shareholders, for Banks’ Misconduct, New York Times, Feb. 6, 2016; Gretchen Morgenson, Ways to Put the Boss’s Skin in the Game, New York Times, March 21, 2015; Jed S. Rakoff, The Financial Crisis: Why Have No High-Level Executives Been Prosecuted?, New York Review of Books, Jan. 9, 2014 2   The Stanford Securities Litigation Analytics database contains data on all SEC enforcement actions, litigated and administrative, involving disclosure violations by public companies dating back to 2000 and maintained to remain current. It also includes data on all securities class actions from 2000 to today.

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Note:  *Includes all misstatement cases filed between 2000 and 2014, including those that remained unresolved as of the end of 2014.

Figure 9.1  Corporations and individuals named as defendants 2000–2014 (N = 672*) and an action in federal court against the CEO and CFO together. For purposes of this analysis, we group all these actions as a “case.”

3.  CORPORATE AND INDIVIDUAL DEFENDANTS Figure 9.1 provides the broadest perspective on SEC enforcement practices. It shows that, contrary to common assertions about SEC enforcement, the SEC names individuals in 88 percent of its enforcement actions involving misstatements. In 63 percent of its cases, the SEC names both a corporate defendant and individual defendants, and in 25 percent of cases, the SEC names just individuals. The same pattern is present if we look at who the SEC penalizes. We define “severe” penalties as all penalties other than injunctions and cease and desist orders. Severe penalties include disgorgement and monetary penalties for both corporate and individual defendants. For individual defendants, severe penalties also include temporary and permanent bars from serving as a director or officer of a public company. As shown in Figure 9.2, the SEC imposes severe penalties on individuals far more frequently than it does on corporations. It imposed severe penalties on individuals in 62 percent of cases and on corporations in 18 percent of cases during the time period covered in this chapter. The SEC imposed severe penalties on corporations without imposing severe penalties on individuals in only 4 percent of cases. Figure 9.3 provides a breakdown of penalties the SEC has imposed on corporations. This chart includes only those cases in which the corporation is named—75 percent of all cases, as shown in Figure 9.1. The SEC imposes monetary penalties or disgorgement on companies in 26 percent of cases in which the corporation is named. This comes to about 20 percent of all cases resolved during the 2000–2014 time period (26 percent times 75 percent).

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Corporate and individual liability in SEC enforcement actions  239

Notes:  *Includes cases that are fully resolved against all defendants named in a set of cases involving the same underlying allegations. For example, if there are three separate enforcement actions filed (in court or an administrative proceeding) against the company, the CEO and two other executives, this chart includes cases where all proceedings against all defendants are resolved. For corporations, severe penalty is defined as a monetary payment or disgorgement, and for individuals it is defined as a monetary payment, disgorgement and a bar from serving as an officer or director of a public company.

Figure 9.2 Severe penalties imposed on corporate and individual defendants 2000–2014 (N = 628*)

Note:  *Includes all cases in which the corporation is named and the action against the corporation is resolved.

Figure 9.3 Penalties imposed on corporations, 2000–2014 (N = 485*)

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Note: *Includes all cases for which market cap data is available from the Center for Research in Security Prices (CRSP).

Figure 9.4 Individual penalties by quartile of company market capitalization, 2000–2014 (N = 358*)

4. LARGE vs SMALL CORPORATIONS Those who perceive the SEC as soft on individual executives might be focusing on SEC actions against large corporations. It is true that executives who work for large corporations are named as defendants less often than executives at smaller corporations. Figure 9.4 shows that in cases against large market cap companies, the percentage of cases naming and penalizing individual executives is lower than in cases against smaller companies. For example, while the SEC penalized individuals in 86 percent of cases against companies in the smallest quartile of market cap, it did so in 62 percent of cases against companies in the largest quartile. Moreover, Figure 9.5 shows that half of those cases in which only the corporation is named (12 percent as shown in Figure 9.1) involve corporations in the largest quartile of market cap. These numbers suggest that there may be an issue with respect to holding executives of large companies responsible for disclosure violations, but not to a degree consistent with the rhetoric of some commentators who imply that individuals are almost never held to account.3 3   For example: “Life is not fair, I know, but this is getting ridiculous. Whenever a big corporation settles an enforcement matter with prosecutors, penalties levied in the case—and they can be

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Corporate and individual liability in SEC enforcement actions  241

Note:  *Includes all cases in which (i) the SEC named the corporation and no individuals and (ii) market cap data is available from the Center for Research in Security Prices (CRSP).

Figure 9.5 Cases in which only the corporation is named (no individuals), by market capitalization quartile, 2000–2014 (N = 50*)

5. SENIOR vs JUNIOR EXECUTIVES Even if, as we now see, individual executives do in fact incur severe penalties at the hands of the SEC, the question arises whether the most senior executives escape liability. This question assumes added importance in light of reforms, instituted by Sarbanes Oxley, designed to make it harder for the Chief Executive Officer and Chief Compliance Officer to deny knowledge of the contents of the financial statements they are filing. As Figure 9.6 shows, when we examine SEC enforcement actions against individuals, we find that CEOs and CFOs are regularly named and sanctioned. Indeed, CEOs are named and incur penalties more frequently than do other executives.

6.  HOW MUCH DO EXECUTIVES PAY? Finally, one might ask how severe individual penalties are. Monetary penalties are governed by statute and are low in comparison both to losses incurred by shareholders as a result of executive misconduct and to the compensation of executives. On the other hand, the SEC frequently imposes bars on individuals against serving as officers or directors of public companies in the future, and even without a bar, the vast majority of executives enormous—are usually paid by the company’s shareholders,” Gretchen Morgenson, Ways to Put the Boss’s Skin in the Game, New York Times, March 21, 2015.

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Figure 9.6 Individuals named as defendants and penalized, 2000–2014 (number of cases/ individuals = 672/1,116) that the SEC has charged with violations of the securities laws leave their jobs (Karpoff et al. 2008a). Finally, while criminal prosecution for securities fraud is much less frequent than SEC prosecution, the risk of criminal penalties for an individual executive is present. As shown in Figure 9.7, individuals incur severe penalties in 86 percent of cases settled on the basis of fraud charges, and 27 percent in cases settled on internal controls and books and records charges. Figure 9.8 shows that where the SEC settles Section 10(b) fraud charges against executives, those executives generally pay low statutory penalties. The top quartile penalties, however, get fairly large. The mean penalty is about $1.5 million—compared to a median of $118,000. Moreover, Figure 9.9 shows that director and officer (D&O) bars are imposed in over 60 percent of cases against executives. Often defendants incur both monetary penalties and D&O bars. In addition, criminal charges are filed in nearly 20 percent of cases that the SEC initially files. Mean and median criminal fines are $103 million and $1 million, respectively, and jail sentences range from 30 days to 25 years.

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Notes:  *Fraud cases are defined as those that settle based on Section 10(b) claims or Section 17(a). Section 17(a) includes subsections for which negligence is sufficient and therefore proof of fraud is not required. But often the SEC does not distinguish which subsection of 17(a) it is relying on. Non-fraud cases are those that settle based on books and records and internal control claims and no 10(b) claims. Severe penalties are defined as monetary penalties, disgorgement, and bars.

Figure 9.7 Severe penalties imposed on individuals: fraud vs non-fraud cases, 2000–2014 (number of fraud/non-fraud cases = 522/101*)

Note:  *Combines amounts designated as disgorgement and amounts designated as monetary penalty.

Figure 9.8  Fines & disgorgement in fraud cases, 2000–2014* (N = 404)

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Notes:  *Fraud cases are defined as those that settle based on Section 10(b) claims or Section 17(a). Section 17(a) includes subsections for which negligence is sufficient and therefore proof of fraud is not required. But often the SEC does not distinguish which subsection of 17(a) it is relying on. Non-fraud cases are those that settle based on books and records and internal control claims and no 10(b) claims.

Figure 9.9 Director and officer bars, 2000–2014* (number of fraud/non-fraud cases = 522/101)

7. CONCLUSION The bottom line is that executives frequently incur severe penalties in SEC enforcement actions—civil penalties, criminal penalties, and D&O bars. One could argue that the penalties should be higher—we have no view on that—but commentators who believe that executives are rarely punished are incorrect.

REFERENCES Arlen, Jennifer and William Carney. 1992. Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, University of Illinois Law Review, 691–740. Karpoff, Jonathan, D. Scott Lee, and Gerald S. Martin. 2008a. The Consequences to Managers for Financial Misrepresentation, Journal of Financial Economics, 88, 193–215. Karpoff, Jonathan, D. Scott Lee, and Gerald S. Martin. 2008b. The Cost to Firms of Cooking the Books, Journal of Financial and Quantitative Analysis, 43, 581–612.

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PART III ROLE OF PRIVATE ACTORS: COMPLIANCE, CORPORATE INVESTIGATIONS, AND WHISTLEBLOWING

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10.  An economic analysis of effective compliance programs Geoffrey P. Miller*

1. INTRODUCTION Many regulatory systems demand that organizations implement compliance ­programs—either as a direct regulatory requirement, or as a cost-effective means for avoiding or mitigating penalties for violations. To receive regulatory credit, such programs  must be “effective”—meaning, generally, that they must be reasonably designed and ­vigorously administered so as to deter and sanction violations of applicable norms. This chapter explores the economic meaning of “effective” compliance programs. I begin in Section 2 by discussing existing law on effective compliance programs, which takes the form of lists of various lengths and sorts. Section 3 undertakes a simple economic analysis of the concept of effective compliance; Section 4 examines some extensions of the basic analysis; and Section 5 concludes.

2.  EFFECTIVE COMPLIANCE PROGRAMS Internal compliance programs are a key weapon in the arsenal that the government deploys against violations. Compliance programs are mandated under a number of statutes and regulations including the Bank Secrecy Act’s anti-money laundering rules,1 the Dodd-Frank Act’s rules on swap dealers and futures commission merchants,2 SEC rules governing investment advisors3 and investment companies,4 bank regulations implanting the “Volcker

  *  I thank Emiliano Catan, Jeffrey Gordon, Sean Griffith, and Haynes Miller for helpful comments.  1   31 U.S.C. § 5318(h)(1) (requiring that “[i]n order to guard against money laundering through financial institutions, each financial institution shall establish anti-money laundering programs”).  2   7 U.S.C. § 6d(d) (requiring that “[e]ach futures commission merchant shall designate an ­individual to serve as its Chief Compliance Officer”), § 6s(k)(1) (requiring that “[e]ach swap dealer and major swap participant shall designate an individual to serve as a chief compliance officer”).  3   SEC Rule 206(4)-7(a), 17 CFR 275.206(4)-7 (requiring that investment advisors “[a]dopt and implement written policies and procedures reasonably designed to prevent violation, by you and your supervised persons, of the Act and the rules that the Commission has adopted under the Act”).  4   SEC Rule 38a-1, 17 CFR 270.38a-1 (requiring that investment companies “[a]dopt and ­implement written policies and procedures reasonably designed to prevent violation of the federal securities laws by the fund, including policies and procedures that provide for the oversight of

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248  Research handbook on corporate crime and financial misdealing Rule” against proprietary trading by banking firms,5 and rules of self-regulatory organizations such as FINRA6 and NASDAQ.7 In addition, government-imposed requirements to institute or upgrade compliance programs are often found in consent agreements with regulatory agencies,8 deferred prosecution agreements and non-prosecution agreements (Arlen and Kahan 2017; Garrett 2007; Kaal and Lacine 2014),9 settlements of shareholders’ derivative lawsuits,10 and class action litigation.11 Even when not legally required to do so, moreover, companies adopt compliance programs in order to enhance the chances that enforcement officials will refrain from

compliance by each investment adviser, principal underwriter, administrator, and transfer agent of the fund”).  5   Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Securities and Exchange Commission, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds Subpart D, 79 C.F.R. 5808 (January 31, 2014) [hereafter “Volcker Rule”] (requiring that banking agencies must develop and implement a program reasonably designed to ensure and monitor compliance with the prohibitions and restrictions on covered activities and investments).  6   Rule 3130 of the Financial Industry Regulatory Authority (FINRA) requires that each member firm must designate a chief compliance officer and further requires the chief executive officer to certify that the member “has in place processes to establish, maintain, review, test and modify written compliance policies and written supervisory procedures reasonably designed to achieve compliance” with applicable rules, laws and regulations.  7   Rule 3012 of the National Association of Securities Dealers (NASD) requires members to designate an officer responsible for establishing, maintaining, and enforcing a supervisory control system. Among other things, this system must test and verify that the member’s supervisory  practices are reasonably designed to comply with applicable rules, laws, and ­ regulations.  8   Hundreds of such settlements are available. For a sample, see United States Department of the Treasury, Comptroller of the Currency, In the Matter of RBS Citizens, N.A. (2013), available at http://www.occ.gov/static/enforcement-actions/ea2013-040.pdf; Corporate Integrity Agreement  Between the Office of Inspector General of the Department of Health and Human Services and Cephalon, Inc. (2008), available at https://oig.hhs.gov/fraud/cia/agreements/ cephalon.pdf; Board of Governors of the Federal Reserve System, In the Matter of Citicorp Inc. (2013), available at http://www.federalreserve.gov/newsevents/press/enforcement/enf20130326a1. pdf  9   Indeed, over three-quarters of the deferred and non-prosecution agreements contain a mandate affecting the firm’s compliance program. For substantive and procedural criticisms of the DOJ’s approach to employing these measures to effect corporate governance changes, see Arlen and Kahan (2017), Arlen (2016), Arlen (2011). An interesting recommendation that prosecutors  should consider corporate governance reforms early in the process, rather  than at the time of settlement, is found in Cunningham (2014). For an example of a deferred prosecution ­agreement with compliance obligations, see United States v. Aibel Group Limited, No. CR H-07-05 (LNH), United States District Court for the Southern District of Texas (2007). 10  E.g., In re Johnson & Johnson Derivative Litigation, 900 F.Supp. 2d 467 (D.N.J. 2012). 11  E.g., In re JP Morgan Chase & Co. Securities Litigation, 2009 WL 537062 (N.D. Ill. 2009).

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An economic analysis of effective compliance programs  249 charging ­suspected violations12 or will impose a lower sanction for violations that are established.13 Merely adopting a compliance policy is insufficient; it is necessary also that the policy be reasonably designed and faithfully implemented within the organization.14 But when is a compliance program “effective” in this sense? Government agencies provide guidance on this question in the form of lists of factors or required elements. A description of several leading formulations follows. 2.1  Bank Secrecy Act In one of the earliest efforts to identify desiderata for effective compliance, the Bank Secrecy Act of 1970 set out the following “minimum” requirements for an effective antimoney laundering (AML) program: (1) the development of internal policies, procedures, and controls; (2) the designation of a compliance officer; (3) an ongoing employee training program; and (4) an independent audit function to test programs.15 These four elements – internal controls, an internal compliance function, employee training, and independent validation – are sometimes referred to as the “four pillars” of AML compliance.16 These requirements are found in nearly all official formulations of effective compliance promulgated in later years. 12   See, e.g., United States Department of Justice, United States Attorneys’ Manual Principles of Federal Prosecution of Business Organizations § 9-28.300 (2013) [hereafter “U.S. Attorneys’ Manual”] (one factor for consideration in determining whether to bring charges is “the existence and effectiveness of the corporation’s pre-existing compliance program”); Criminal Division, United States Department of Justice & Enforcement Division, Securities and Exchange Commission, A Resource Guide to the U.S. Foreign Corrupt Practices Act (Nov. 14, 2012) [hereafter “FCPA Resource Guide”], p. 56 (in determining whether to bring charges and what charges to bring, the agencies will consider the adequacy of a compliance program, including “its design and good faith implementation and enforcement”); Securities and Exchange Commission, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions (available at http://www. sec.gov/litigation/investreport/34-44969.htm) (2001) (when deciding “whether, and how much, to credit self-policing, self-reporting, remediation and cooperation,” the SEC considers, inter alia, “[w]hat compliance procedures were in place to prevent the misconduct now uncovered? Why did those procedures fail to stop or inhibit the wrongful conduct?”). 13   Federal Sentencing Guidelines §8C2.5(f) (reducing guideline penalties “if the offense occurred even though the organization had in place at the time of the offense an effective compliance and ethics program”). Reductions of penalties for compliance programs are also common in civil cases. See, e.g., Environmental Protection Agency, Incentives for Self-Policing: Discovery, Disclosure, Correction and Prevention of Violations, 65 Fed. Reg. 19,6198 (2000); United States Department of Health & Human Services, Office of Inspector General, Updated OIG’s Provider Self-Disclosure Protocol (2013), available at https://oig.hhs.gov/compliance/self-disclosure-info/ files/Provider-Self-Disclosure-Protocol.pdf. 14   The Department of Justice’s Principles of Federal Prosecution of Business Organizations express the idea by admonishing prosecutors to “determine whether a corporation’s compliance program is merely a ‘paper program’ or whether it was designed, implemented, reviewed, and revised, as appropriate, in an effective manner.” U.S. Attorneys’ Manual § 9-28.800. 15   Bank Secrecy Act, 31 U.S.C. § 531(h). 16   See Federal Deposit Insurance Corporation, Supervisory Insights: Understanding BSA Violations, available at https://www.fdic.gov/regulations/examinations/supervisory/insights/siwin06/

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250  Research handbook on corporate crime and financial misdealing 2.2  U.S. Sentencing Guidelines The U.S. Sentencing Guidelines, another early formulation, require that in order to receive sentencing credit, organization defendants must “exercise due diligence to prevent and detect criminal conduct;” and “otherwise promote an organizational culture that encourages ethical conduct and a commitment to compliance with the law.”17 The Guidelines provide that in order to exercise due diligence, the organization must “establish standards and procedures to prevent and detect criminal conduct;” its governing authority must be “knowledgeable about the content and operation of the compliance and ethics program and [must] exercise reasonable oversight with respect to the implementation and effectiveness” of the program. The organization must use reasonable efforts “not to include within the substantial authority personnel of the organization any individual whom the organization knew, or should have known through the exercise of due diligence, has engaged in illegal activities or other conduct inconsistent with an effective compliance and ethics program;” must use reasonable efforts to conduct effective training regarding the compliance and ethics program; must take reasonable steps to ensure that the compliance and ethics program is followed; must take reasonable steps to ensure that it maintains mechanisms for anonymous and confidential reporting of violations or concerns; and must promote and consistently enforce the compliance and ethics program throughout the organization.18 In addition, the Guidelines impose further requirements on firms seeking to obtain sanction mitigation for an effective compliance program in situations where management was implicated in the crime.19 In this situation, the firm does not get credit for having an effective compliance program unless it both detected the misconduct offense before

article03_bsa.html. The U.S.A. PATRIOT Act, adopted in 2001, adds a fifth pillar: risk-based procedures that enable the institution to form a reasonable belief that it knows the true identity of its customers. See 31 U.S.C. § 5318(l). 17   Federal Sentencing Guidelines §8B2.1(a). 18   Sentencing Guidelines §8B2.1. 19   Sentencing Guidelines §8C2.5(f)(3).  (3) (A) Except as provided in subparagraphs (B) and (C), [the firm is not eligible for mitigation for a compliance program] if an individual within high-level personnel of the organization, a person within high-level personnel of the unit of the organization within which the offense was committed where the unit had 200 or more employees, or an individual described in §8B2.1(b)(2)(B) or (C), participated in, condoned, or was willfully ignorant of the offense.  (B) There is a rebuttable presumption, for purposes of subsection (f)(1), that the organization did not have an effective compliance and ethics program if an individual—   (i) within high-level personnel of a small organization; or   (ii) within substantial authority personnel, but not within high-level personnel, of any organization,   participated in, condoned, or was willfully ignorant of, the offense.   (C) Subparagraphs (A) and (B) shall not apply if—  (i) the individual or individuals with operational responsibility for the compliance and ethics program (see §8B2.1(b)(2)(C)) have direct reporting obligations to the governing authority or an appropriate subgroup thereof (e.g., an audit committee of the board of directors);  (ii) the compliance and ethics program detected the offense before discovery outside the organization or before such discovery was reasonably likely;

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An economic analysis of effective compliance programs  251 discovery outside the organization occurred or was reasonably likely and self-reported it to government authorities. In addition, the firm must have implemented a compliance program that granted the compliance officer direct line access to the governing authority or an appropriate subgroup thereof (e.g., an audit committee of the board of directors). Finally, no individual with operational responsibility for the compliance and ethics program can have participated in, condoned, or been willfully ignorant of the offense.20 2.3  DOJ Policy The U.S. Attorneys’ Manual (USAM) contains a provision on effective compliance and encourages prosecutors to take compliance into account in determining whether to seek a formal conviction, as opposed to an alternative form of resolution, such as a deferred prosecution agreement. Prosecutors’ assessment of the effectiveness of the firm’s compliance is also relevant to both the sanctions imposed (see above) and to the determination of whether a corporate governance mandate should be imposed (Arlen and Kahan 2017). The USAM provides that “the critical factors . . . are whether [a compliance] program is adequately designed for maximum effectiveness in preventing and detecting wrong­ doing by employees and whether corporate management is enforcing the program or is tacitly encouraging or pressuring employees to engage in misconduct to achieve business requirements.”21 The USAM lists key questions for prosecutors to ask: “Is the corporation’s compliance program well designed? Is the program being applied earnestly and in good faith? Does the corporation’s compliance program work?”22 In answering these questions, prosecutors are to consider “the comprehensiveness of the compliance program; the extent and pervasiveness of the criminal misconduct; and any remedial actions taken by the corporation, including, for example, disciplinary action against past violators uncovered by the prior compliance program, and revisions to corporate compliance programs in light of lessons learned.” Prosecutors may also examine corporate governance factors: do the corporation’s directors exercise independent review over proposed corporate actions rather than unquestioningly ratifying officers’ recommendations; are internal audit functions conducted at a level sufficient to ensure their independence and accuracy; and have the directors established an information and reporting system in the organization reasonably designed to provide management and directors with timely and accurate information sufficient to allow them to reach an informed decision regarding the organization’s compliance with the law.23

Moreover, prosecutors may consider whether the compliance program is “designed to detect the particular types of misconduct most likely to occur in a particular corporation’s  (iii) the organization promptly reported the offense to appropriate governmental authorities; and  (iv) no individual with operational responsibility for the compliance and ethics program participated in, condoned, or was willfully ignorant of the offense. 20   Sentencing Guidelines §8C2.5(f)(3). 21   U.S. Attorneys’ Manual §9-28.800. 22  Ibid. 23  Ibid.

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252  Research handbook on corporate crime and financial misdealing line of business.”24 In addition to assessing the structure of the program, the USAM directs prosecutors to determine whether the firm has sufficiently staffed and provided adequate resources to the compliance program. Finally, as part of the assessment of the compliance program’s effectiveness, the USAM directs prosecutors to consider the “promptness of any disclosure of wrongdoing to the government”—making it clear that from the government’s perspective effectiveness is measured not only by internal effectiveness but also by the degree to which compliance helps the government detect and deter crime. In 2014, Leslie Caldwell, the Assistant Attorney General of the Justice Department’s Criminal Division, issued a somewhat different set of hallmarks for effective compliance programs: (1) strong, explicit, and visible high-level commitment to the corporate compliance policy; (2) a clearly articulated and visible corporate compliance policy memorialized in a written compliance code; (3) periodic evaluation of compliance codes on the basis of a risk assessment addressing the individual circumstances of the company; (4) assignment of responsibility to senior executives for the implementation and oversight of the compliance program; (5) training and guidance designed to ensure that the compliance code is effectively communicated to all directors, officers and employees; (6) an effective system for confidential, internal reporting of compliance violations and concerns; (7) an effective process with sufficient resources for responding to, investigating, and documenting allegations of violations; (8) implementing mechanisms designed to enforce the compliance code, including appropriately incentivizing compliance and disciplining violations; (9) periodic reviews and testing of the compliance code to improve its effectiveness.25 In February 2017, the Fraud Section of DOJ’s Criminal Division issued a guidance document on this topic. While the Section indicated that it does not use any “rigid formula” for assessing the adequacy of compliance programs, it indicated that it would ask certain common questions. Topics covered by these questions include: (1) analysis and remediation of the underlying misconduct; (2) the behavior of senior and middle management; (3) autonomy and resources of the program; (4) the institution’s compliance-related policies and procedures; (5) the institution’s risk assessment methodology; (6) training and communications; (7) confidential reporting and investigation; (8) incentives and disciplinary measures; (9) continuous improvement through periodic testing and review; (10) management of vendors and other third parties; (11) situations involving mergers and acquisitions.26 2.4 FCPA The Department of Justice and the Securities and Exchange Commission have published a joint guide, the Resource Guide to the U.S. Foreign Corrupt Practices Act, that articulates their approach to FCPA actions. Compliance programs are relevant to FCPA actions  Ibid.   Remarks by Assistant Attorney General for the Criminal Division Leslie R. Caldwell at the 22nd Annual Ethics and Compliance Conference, October 1, 2014, available at http://www.justice.gov/opa/ speech/remarks-assistant-attorney-general-criminal-division-leslie-r-caldwell-22nd-annual-ethics 26   U.S. Department of Justice, Criminal Division, Fraud Section, Evaluation of Corporate Compliance Programs, available at https://www.justice.gov/criminal-fraud/page/file/937501/download 24 25

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An economic analysis of effective compliance programs  253 for two reasons. First, the existence of an effective program affects the seriousness of the sanctions imposed by the Fraud Section for bribing a foreign official. Second, certain forms of ineffective compliance can be an independent basis for liability. The “accounting provisions” of the FCPA require SEC-reporting firms to make and keep books, records, and accounts that, in reasonable detail, accurately and fairly reflect an issuer’s transactions and dispositions of the issuer’s assets.27 The “internal controls” provision requires issuers to devise and maintain a system of internal accounting controls sufficient to assure management’s control, authority, and responsibility over the firm’s assets.28 The Resource Guide articulates an elaborate set of criteria for programs designed to ensure compliance with the Foreign Corrupt Practices Act. The Guide recognizes that there is no “one-size-fits-all” effective program,29 but goes on to list the following elements as emblematic: (1) commitment from senior management and a clearly articulated policy against corruption;30 (2) code of conduct and compliance policies and procedures;31 (3) oversight, autonomy, and resources;32 (4) risk assessment;33 (5) training and continuing advice;34 (6) disciplinary measures and incentives;35 (7) third-party due diligence and payments;36 (8) confidential reporting and internal investigation;37 (9) continuous improvement: periodic testing and review;38 and (10) pre-acquisition due diligence and post-acquisition integration in mergers and acquisition transactions.39 2.5  Financial Institutions The banking agencies’ regulation implementing the “Volcker Rule” against proprietary trading by banking institutions lists the following components of an effective compliance program for mid-sized institutions: (1) written policies and procedures reasonably designed to document, describe, monitor, and limit regulated activities; (2) a system of internal controls reasonably designed to monitor compliance;  (3) a management framework that clearly delineates responsibility and accountability for compliance; (4)

  15 U.S.C. § 78m(b)(2)(A).   15 U.S.C. § 78m(b)(2)(B). 29   FRCA Resource Guide p. 57. The Department of Justice commonly includes many or all these factors as requirements in deferred prosecution agreements. See, e.g., Non-Prosecution Agreement, In re Lufthansa Technik AG (Dec. 21, 2011), available at http://www.justice.gov/sites/default/files/ criminal-fraud/legacy/2012/03/19/2011-12-21-lufthansa-npa.pdf; Non-Prosecution Agreement, In re RAE Sys. Inc. (Dec. 10, 2010), available at http://www.justice.gov/criminal/fraud/fcpa/cases/ rae-systems/12-10-10rae-systems.pdf; Non-Prosecution Agreement, In re Paradigm B.V. (Sept. 21, 2007), available at http://www.justice.gov/sites/default/files/criminal-fraud/legacy/2011/02/16/0921-07paradigm-agree.pdf 30   FRCA Resource Guide 57. 31  Ibid. 32   Ibid. at 58. 33  Ibid. 34   Ibid. at 59. 35  Ibid. 36   Ibid. at 60–61. 37   Ibid. at 61. 38   Ibid. at 62. 39   Ibid. at 62. 27 28

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254  Research handbook on corporate crime and financial misdealing independent testing and audit of the effectiveness of the compliance program; (5) training for trading personnel and managers, as well as other appropriate personnel, to effectively implement and enforce the compliance program;  and (6) making and keeping records sufficient to demonstrate compliance.40 In addition, the Comptroller of the Currency rates banks’ compliance with consumer protection and civil rights statutes and regulations and the adequacy of its operating systems. Factors to be considered include the nature and extent of compliance with consumer protection and civil rights statutes and regulations; the commitment of management to compliance and their ability and willingness to assure continuing compliance; and the adequacy of operating systems, including internal procedures, controls, and audit activities, designed to ensure compliance on a routine and consistent basis. To receive the highest rating, a bank must convince the regulators that: (1) management is capable of and staff is sufficient for effectuating compliance; (2) an effective compliance program, including an efficient system of internal procedures and controls, has been established; (3) changes in consumer statutes and regulations are promptly reflected in the institution’s policies, procedures, and compliance training; (4) the institution provides adequate training for its employees; (5) if any violations are noted, they are minor and easily corrected; (6) there is no evidence of discriminatory acts or practices, reimbursable violations, or practices resulting in repeat violations; and (7) violations and deficiencies are promptly corrected.41 2.6 Conclusions As these and other statements demonstrate, there is no universally accepted definition of an effective compliance program, even though there is substantial overlap among the examples. We can observe also a certain evolution of thinking towards increasing complexity (from the four requirements of the Bank Secrecy Act to the considerably more elaborate recent Justice Department statement) and inclusion of different factors (note the focus in the Justice Department statement on assignment of responsibility, risk assessment, and attention to business partners and agents). The lack of uniform standards may not be problematic for those working in a particular field, where the governing standard is the only one that really matters. But the profusion and complexity of pronouncements, important and useful as they are, does suggest that current thinking has not penetrated to the core of the issue. The following section investigates whether economic analysis can offer insights on this question.

3.  A SIMPLE ECONOMIC ANALYSIS OF COMPLIANCE I now turn to a simple economic analysis of effective compliance programs. Assume that employees in a rational, profit-maximizing, risk-neutral firm engage in random illegal

40   See 12 CFR Part 44.20 (Program for Compliance; Reporting) and Appendix B (Enhanced Minimum Standards for Compliance Programs). 41   Comptroller of the Currency, Comptroller’s Handbook, Bank Supervision Process 73 (2007).

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An economic analysis of effective compliance programs  255 on-the-job conduct. The government imposes a fine f on the firm for proven violations, which is administered with probability p. The firm experiences a sanction pf for violations. For the moment, assume that the government’s enforcement efforts are costless. The firm spends an amount C on activities such as setting an appropriate “tone at the top,” screening employees, conducting training programs, maintaining mechanisms for confidential reporting of misconduct, operating surveillance and reporting procedures, sanctioning employees for violations, and so on. As a result of these activities the firm avoids the sanction pf with probability z. The probability z increases with the firm’s compliance spend, but at a decreasing rate: z'(C) > 0, z''(C) < 0. With compliance, the firm’s cost of violations is:

(1 − z) (pf) + C

The firm will engage in compliance if the cost of sanctions with compliance is less than or equal to the cost of sanctions without compliance:

(1 − z) (pf) + C ≤ (pf)

This is equivalent to the proposition that the firm will spend on compliance if the cost of compliance is less than or equal to the cost of sanctions avoided:

C ≤ z(pf)

As shown in Figure 10.1, the firm will expend resources up to the point C1 where the marginal cost of compliance equals the marginal cost of sanctions avoided. As compared with the situation without compliance, C1 generates a benefit for the firm equal to:

z(pf) − C1

z(pf)

C1

C

Figure 10.1  Firm’s compliance expenditure

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z(pˆ f)

Ĉ

C

Figure 10.2  Optimal compliance Now let us use this framework to investigate when a compliance program can be considered effective in an economic sense. To determine a first approximation of an optimal compliance program, assume that the government sets the sanction for violations at their social cost: k



pf 5 pf

k

Setting the expected sanction equal to the social cost of violations causes the firm to internalize the cost of its activities. In response, the firm will be able to adopt a socially ˆ as shown in Figure 10.2. optimal level of compliance expenditure C, Cˆ is socially optimal as a first approximation in that it maximizes the surplus generated by compliance expenditures. Accordingly, we can define an effective compliance program ˆ an effective compliance program is the set of policies and procedures that a in terms of C: rational, profit-maximizing firm would establish if it faced an expected sanction equal to the social cost of violations. Let us now consider the impact of different values of p and f. Many combinations of p and f can generate the optimal expected fine pf. The particular values of p and f are not of concern if we assume that enforcement is costless and firms are risk-neutral. But these considerations matter when we relax these assumptions. If firms are risk-averse, they will experience a low-probability/high-fine regime as more costly than a high-probability/low-fine regime because the former is riskier. Accordingly, risk-averse firms will expend more resources on compliance when fines are high and the probability of detection is low than when fines are low and the probability of detection is high. On the other hand, governments expend fewer resources on law enforcement when the probability of detection is low and fines are high than they do when the probability of detection is high and fines are low. The reason is that it is usually more costly for the government to detect violations than to impose fines for violations once detected. The optimal values for p and f minimize the sum of the firm’s compliance costs C and the government’s enforcement cost E. These two costs tend to offset one another, but prob-

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An economic analysis of effective compliance programs  257

(E + C)

pˆ

p

Figure 10.3  Optimal probability of detection ably not completely. For low levels of p, it is probable that the government’s cost savings in enforcement are more than offset by the firm’s increased compliance spend. For high levels of p, likewise, it is probable that the firm’s cost savings are more than offset by the government’s enhanced enforcement spend. This suggests that the social optimum is an intermediate level of enforcement and fine, as shown in Figure 10.3. This trade-off between government enforcement and internal enforcement through compliance programs should be a function of comparative costs. The government should expend money on enforcement so long as the firm cannot perform the same task at a lower cost. Optimally, both the government and the private sector will be involved in compliance.42 The foregoing suggests an interesting footnote to the economic theory of punishment. As noted by Becker and others, government can save on resources by adopting a low probability of detection/high-fine enforcement policy (Becker 1968; see Polinsky and Shavell 1992, pp. 133–148). Conventionally, the limits on this strategy are conceived as flowing from the defendant’s solvency constraint and the public’s unwillingness to tolerate high punishments for minor offenses. The theory of compliance suggests another constraint.43 The government’s choice between policy instruments not only affects the government’s

42   For example, firms have superior access to information and thus can detect violations at lower cost than the government, which must rely on formal legal processes (Arlen 2012; Arlen and Kraakman 1997). On the other hand, firms may have an incentive not to perform the compliance function vigorously because they may have to pay for violations discovered, unless liability is structured to eliminate this disincentive (Arlen 1994). Compliance programs may also lack the threat value of government investigations and therefore may sometimes be less effective at smoking out instances of misconduct. 43   Additionally, if employees tend to discount a low probability of detection to zero, then enhancing the probability of sanction may be more important than the sanction magnitude (Arlen 2012). Compliance can not only enhance the probability of sanction but can also take actions to make the risk of sanction more salient, for example by providing notice to employees about detected deviations from the firm’s norms and their consequences.

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z(pf)

C1

Ĉ

Figure 10.4  Compliance expenditures when sanctions are too low

costs; it also affects the firm’s compliance response. If the government spends lightly on enforcement and relies on high fines to deter misconduct, the firm increases compliance spending in order to reduce the risk of having to pay a substantial fine. The efficiencies claimed for low-detection high-fine enforcement strategies may be overstated unless the costs of compliance are taken into account. We now consider situations in which the firm will not engage in optimal compliance expenditures. Consider the case where the expected sanction for violations is too small. In such a case, as shown in Figure 10.4, the firm will spend too little on compliance. With an inefficiently low expected fine, the firm both engages in too many violations ˆ Inefficiencies also result if the and institutes compliance expenditures of C1 <  C. ­government imposes an expected sanction for violations larger than their social cost. As shown in Figure 10.5, when the expected sanction is too large, the firm institutes ˆ The firm engages in too little of the activity which compliance expenditures of C2 <  C. generates the risk of violations, and also spends too much rather than too little on compliance activities. So far we have considered the situation where the government imposes a fine for violations. The compliance response, however, provides an additional policy tool. Even if a low sanction (or no sanction) is imposed for the underlying violation, the firm will behave optimally if it spends C   ˆ on compliance. Thus when fines are too low, the government may be able to achieve optimal behavior by mandating an effective compliance program. This strategy confers advantages as compared with policing the underlying conduct. To incentivize the firm to adopt an effective compliance program, the government does not need to impose a fine equal to the social cost, but only a penalty of sufficient magnitude such that it is cheaper for the firm to institute an effective compliance program than not to do so. This lower penalty is likely to encounter reduced public resistance. Moreover, although the government must expend resources to supervise the compliance program, it is probably cheaper to mandate an effective compliance program than to police the

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An economic analysis of effective compliance programs  259

z(pf)

C1

Ĉ

C2

Figure 10.5  Compliance expenditures when sanctions are too high underlying conduct. Unlike primary misconduct, which is usually hidden from view, large parts of the compliance program are easy to observe. The option of mandating a compliance program thus holds promise for improving the cost-effectiveness of regulation. However, there is also a danger associated with this approach. Governments have an incentive to require firms to overspend on compliance programs. The reason is that regulators do not pay the costs of the program, but obtain benefits by appearing “tough on crime” and by deflecting blame for violations. This situation is shown in Figure 10.6. The firm’s optimal compliance expenditure is  Cˆ but the government requires C1. Even though C1 is socially ­inefficient, regulators may avoid criticism by observing that it reduces the rate of violations.

4. APPLICATIONS The definition of an effective compliance program suggested in this chapter—the program that a rational profit-maximizing firm would adopt if faced with an expected fine equal to the social cost of violations—cannot easily be translated into concrete elements of actual programs. It is couched at too abstract a level and requires an assessment of costs that are difficult or impossible to quantify. As a practical matter, therefore, list-type criteria for effective compliance programs are necessary and appropriate. Nevertheless, the economic approach has the virtue of clarifying thinking. Beyond this, the economic approach does offer certain guides for interpretation in practical cases. The fact that firms have an incentive to adopt compliance programs, even in the absence of government compulsion, suggests that the government could usefully examine the policies and procedures voluntarily adopted by firms as guidance for the elements of a government-mandated program. To be sure, the utility of examining private sector models is limited by two considerations. First, the pervasive influence of government mandates

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z(pf)

Ĉ

C1

Figure 10.6  Excessive compliance requirement has made it nearly impossible to identify a pure private sector solution, since nearly all private sector compliance programs are adopted against the background of government requirements. Second, the reliability of private solutions must be assessed in light of the fact that companies facing regulatory requirements may face incentives to violate the law, so may not voluntarily adopt effective programs. These qualifications suggest caution, but do not nullify the value of examining private sector models for effective compliance. In fact it is likely that the evolution of government thinking on the elements of an effective compliance program has been informed by an active dialog with the private compliance sector. The government should not micromanage the requirements for an effective program. Since companies have different characteristics, histories, and cultures, any attempt to specify the ingredients of an effective program at a granular level will likely generate poor results. No regulator or prosecutor can hope to know more about the internal workings of an organization than the existing managers who spend their professional lives there. Thus regulatory requirements for compliance programs, if articulated at an excessive level of detail, are doomed to be unwieldy, inefficient, and insensitive to the particular circumstances and unique culture of any given organization. The better approach is for the government to identify key components and general principles and then allow the regulated entity to design the details. Courts should generally defer to an agency’s judgment about the effectiveness of an organization’s compliance program. The agency will ordinarily be familiar with the policies underlying the laws being enforced, and often has knowledge of conditions in the industry and in the regulated firm. On the other hand, as noted above, governments face a temptation to demand more in compliance than is socially optimal. For this reason, even while exercising deference, a court should scrutinize the program in order to assure itself that it is not unreasonably designed and not administered in an irrational or unfair manner.

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An economic analysis of effective compliance programs  261 A final issue concerns the legal consequences that follow if a regulated entity commits a violation even though it has an effective compliance program in place. On the one hand, as demonstrated above, an effective program can achieve the socially optimal level of violations. Moreover, recognition of an effective program as a defense reduces a firm’s risk by providing a “safe harbor” against liability. These considerations might suggest that an effective compliance program should provide an absolute defense against liability. Other considerations counsel against an affirmative defense. It is often hard to determine whether a compliance program is actually effective—either because it is difficult to assign values or weigh the impact of different components, or because the firm presents the program as effective when in fact it is not. This means that there is substantial room for error in the determination of an effective program. The fact that a violation occurred, while not establishing the ineffectiveness of the program, might nevertheless lead a reviewer to revise the assessment she might otherwise make: other things being equal, it is more probable, given a violation, that the compliance program under review was ineffective. The possibility of error in the determination of whether a program is effective suggests that an affirmative defense might not represent the best social policy. In addition to the possibility of error, there are activity levels to consider. In the presence of an affirmative defense, a firm that has an effective compliance program in place will tend to engage in more of the activities that create a risk of compliance violations. The reason is that the firm gets a benefit from these activities but does not pay for violations that occur even with an effective program in place. In consequence, an affirmative defense for effective compliance programs may lead to inefficiently high activity levels and resultant harm to the public (Arlen and Kraakman 1997). For these reasons, it appears most appropriate for the law to recognize the presence of an apparently effective compliance program as a substantial factor in mitigating the penalty or tipping the balance in favor of non-enforcement, but not as an absolute defense to liability.

5. CONCLUSION This chapter has offered a simple economic description of an effective compliance program: the set of policies and procedures that a rational, profit-maximizing firm would establish if it faced an expected sanction equal to the social cost of violations. Firms that operate effective programs minimize the net social costs of violations. In any given case, the firm’s compliance expenditures will be a function of the government’s enforcement strategy: if the government opts for a low-detection, high-fine approach, a risk-averse firm will expend more on compliance than if the government adopts a high-detection, low-fine strategy. If the government can require firms to adopt effective compliance programs, the result will be efficient even if budget or political constraints prevent the government from imposing an optimal fine. But offsetting the government’s cost saving here is the need to ensure that the firm does in fact operate an effective program. Courts should generally defer to the government’s determination that a firm has or has not implemented an effective program; but the deference should be qualified by the fact that the government’s incentives are not fully aligned with those of the public: governments face a temptation

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262  Research handbook on corporate crime and financial misdealing to impose compliance requirements that in some cases may reduce rather than increase social wealth. Strong policy arguments can be developed both in favor of and against the creation of an affirmative defense for effective compliance programs. All things considered, it is probably preferable for the government not to provide an affirmative defense, but rather to give substantial credit for effective compliance programs in connection with matters such as charging, settlements, and sentencing.

REFERENCES Arlen, Jennifer. 1994. The Potentially Perverse Effects of Corporate Criminal Liability, Journal of Legal Studies, 23, 833–867. Arlen, Jennifer. 2011. Removing Prosecutors from the Boardroom: Deterring Crime Without Prosecutor Interference in Corporate Governance. In Anthony Barkow and Rachel Barkow (eds.), Prosecutors in the Boardroom: Using Criminal Law to Regulate Corporate Conduct, New York: New York University Press. Arlen, Jennifer. 2012. Corporate Criminal Liability: Theory and Evidence. In Keith Hylton and Alon Harel (eds.), Research Handbook on the Economics of Criminal Law, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Arlen, Jennifer. 2016. Prosecuting Beyond the Rule of Law: Corporate Mandates Imposed Through Pretrial Diversion Agreements, Journal of Legal Analysis, 8, 191–234. Arlen, Jennifer and Marcel Kahan. 2017. Corporate Governance Regulation through Nonprosecution, University of Chicago Law Review, 84, 323–387. Arlen, Jennifer and Reinier Kraakman. 1997. Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes, New York University Law Review, 72, 687–779. Becker, Gary S. 1968. Crime and Punishment: An Economic Approach, Journal of Political Economy, 76, 169–217. Cunningham, Lawrence A. 2014. Deferred Prosecutions and Corporate Governance: An Integrated Approach to Investigation and Reform, Florida Law Review, 65, 1–85. Garrett, Brandon L. 2007. Structural Reform Prosecution, Virginia Law Review, 93, 853. Kaal, Wulf A. and Timothy Lacine. 2014. The Effect of Deferred and Non-Prosecution Agreements on Corporate Governance: Evidence from 1993–2013, The Business Lawyer, 70, 61–120. Miller, Geoffrey P. 2015. Risk Management and Compliance in Banks: The United States and Europe. In Danny Busch and Guido Ferrarini (eds.), The European Banking Union, Oxford: Oxford University Press, 200–216. Miller, Geoffrey P. 2017. The Law of Governance, Risk Management and Compliance, 2nd edition, New York: Wolters Kluwer Law & Business. Miller, Geoffrey P. forthcoming. The Compliance Function: An Overview. In Jeffrey N. Gordon and Georg Ringe (eds.), Oxford Handbook of Corporate Law and Governance, Oxford: Oxford University Press. Orland, Leonard. 2006. The Transformation of Corporate Criminal Law, Brooklyn Journal of Corporate, Financial and Commercial Law, 1, 45–85. Polinsky, A. Mitchell and Steven Shavell. 1992. Enforcement Costs and the Optimal Magnitude and Probability of Fines, Journal of Law and Economics, 35, 133–148.

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11.  Behavioral ethics, behavioral compliance Donald C. Langevoort

1. INTRODUCTION The design of an effective legal compliance system for an organization fearing prosecution for white-collar crime or regulatory violations requires skill at predicting human behavior. The surveillance portion of compliance involves estimates about who is most likely to misbehave, and when. The communicative aspect—training and guidance—requires thinking about what kinds of messages and incentives are most effective. Forensics and resolution are about, at least in part, learning from the experience and applying the lessons to future activity. It is entirely plausible to use the economist’s simplifying assumptions of rational choice and pecuniary self-interest in making these predictions. But the realism of these assumptions has been under attack for decades now (see Kahneman 2011), suggesting that we should at least consider more nuanced behavioral possibilities when designing and implementing compliance programs. Psychologists observe that people tend to cheat less than they might get away with, even when assured of no possibility of detection and a sure financial gain. At the same time, they cheat more than they should as an ethical matter, for reasons that are a complex mix of dispositions, cognitive frames and situational influences. A rapidly growing body of cognitive research is shedding light on when, how and why wrongdoing occurs. At the same time, sociologists stress the cultural dimension to compliance-related behavior, urging that we look outside the individual mind for what drives compliance or noncompliance with the law. To be sure, all of this makes compliance-related predictions much more contingent and messy, especially since there is no simple model to invoke and the research is very much a work in progress.1 The hope, however, is that these insights can make the predictions more accurate. The label “behavioral compliance” can be attached to the design and management of compliance that draws from this wider range of behavioral predictions about individual and organizational behavior.2 Like conventional economics, it understands that incentives matter. Indeed, a core portion of work in the psychology of ethical choice explains how and why people can behave selfishly or cheat but do not construe their own behavior as bad or wrong. For if that is so, their (or their team’s) moral compass becomes unreliable as a matter of self-regulation, a particularly frustrating insight in the compliance realm: good people doing bad things. This chapter surveys some of the contemporary research in what has become known as  1   In a recent book I extend this analysis to the task of securities regulation generally (Langevoort 2016).  2   In the interests of limited time and space, this chapter leaves to others discussions of structural sources on blind spots in compliance, such as the diffusion or “siloing” of information. For a broader perspective, see Miller and Rosenfeld (2010).

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264  Research handbook on corporate crime and financial misdealing behavioral ethics,3 and its relevance to compliance. This connection is by no means new: for the last twenty-five years or so, researchers interested in managerial and organizational behavior have tapped into the psychology of good and bad moral choices to suggest how companies might manage their legal and reputational risks. By now, they seem to have agreed that ethics is an essential building block for both legal compliance and enterprise risk management. Lawyers have taken note (Killingsworth 2012).

2.  BEHAVIORAL ETHICS AND COMPLIANCE Research in behavioral ethics uses “cheating” as its key word to describe what good ethics is not, and treats illegal behavior as an especially troubling form of cheating. Many of the field’s insights relate directly to legal matters. Furthermore, the line between law and ethics is very fuzzy, so that good ethics are a worthy goal within compliance regardless of how a prosecutor or defense lawyer might characterize some accusation. In that sense, behavioral ethics research is perfectly in synch with compliance programs that seek to be values-based (see Tyler et al. 2008; Tyler, Chapter 1 in this volume), rather than command and control. The connections between ethics and compliance are also important to the debate about the optimal balance of emphasis between law and ethics and on which corporate actors (e.g., lawyers or compliance officers) have ultimate authority over these matters (Treviño et al. 1999, p. 146; Langevoort 2012, pp. 499–502). We know from surveys of compliance officers that ethics is a potentially uncomfortable subject in organizations (Treviño et al. 2014b). People tend to think of themselves as ethical, and consider that ethical dispositions have been formed via religion, education and the broader culture. That provokes some level of defensiveness when the subject comes up in the workplace. One of the eye-openers in using behavioral ethics is how easily people take to psychological explanations when analyzing the riskiness of other peoples’ unethical behaviors, before it then gradually dawns on them that they could not possibly be immune to the same forces. That is key to ethical self-awareness, in compliance and otherwise. To repeat the punch line for behavioral ethics: people cheat less than they could get away with, but more than they should. The first part of that insight is heartening. There is indeed a great deal of pro-social behavior—loyalty, cooperation, conscientiousness— because people want to think of themselves in such a light, and want others to think of them similarly. Whether this is biological or learned behavior is strongly disputed. Certainly there are evolutionary advantages in species that suppress selfishness, and economists have long pointed out the value of a reputation for trustworthiness. No complex organization could work well without a baseline of mutual trust, and much of the theory of corporate culture involves taking advantage of these inclinations to build loyalty at the group level (Akerlof and Kranton 2005). For most people, it is good to be part of a team, something bigger than oneself (Kluver et al. 2014). From a compliance standpoint, however, that is a mixed blessing. Precisely the same

 3   For book-length treatments of behavioral ethics for a general audience, see Ariely (2012) and Bazerman and Tenbrunsel (2011). There are many literature reviews for academics; e.g., Bazerman and Gino (2012) and Treviño et al. (2014a).

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Behavioral ethics, behavioral compliance  265 forces that create internal bonding make it more likely—especially in the face of competition and rivalry—that the cohesion will work to displace empathy and justify aggressive behavior against perceived outsiders (Cikara et al. 2014). In business, those “others” can not only be competitors, but the government, customers and even other units within the firm that are viewed as threats to the group’s interests and identity. One of the most potent incentives to cheat is in service of others: altruistic cheating (Ariely 2012, pp. 222–223). Corporate agents have ample room to rationalize compliance failures in the name of loyalty. That also happens on an individual cognitive level, and takes us to the dark side of the punchline: in general (but with many exceptions) people cheat more than they should. There are now many psychology experiments built on a simple platform, testing the inclination to cheat in circumstances where detection and punishment are impossible. A common form is to give subjects a somewhat challenging matrix-based computation test (Ariely 2012, pp. 11–22). The test is given to a control group and is externally graded, thus giving investigators the ability to see what honest performance is over a large number of subjects. The same test is then given to subjects who grade themselves. These subjects are told to shred their exams immediately after grading and report the score to an administrator, who will give (real) money based on the number of questions that were correct. The control group scores on average around four out of ten. Under non-detection conditions, self-graders claim around six. An obvious question, among others, is why not ten, which maximizes utility? There are different possible answers (e.g., people would feel ashamed when observed claiming ten, because that seems like obvious cheating), but this at least illustrates some form of ethical self-control. But then why not be completely honest? One common interpretation is that people will cheat out of temptation, but only up to a point where they can maintain a self-image as a non-cheater. If the mind can somehow rationalize the act as acceptable (e.g., I wrote down the wrong digit, or I knew the right answer, or I’m really better at math than this), it self-justifies the cheating. While the shredder tests are fairly objective, you can see how much more easily this could occur in the face of subjective standards for right and wrong. The basic insight is that motivated inference allows people to maintain self-image while pursuing self-interest more aggressively—but to a limit. From there, behavioral ethics asks when, why and how this sort of rationalized self-interest occurs. Experimentally, what manipulations might make cheating more or less likely? That is where the most interesting results come in terms of compliance, because answers that describe real-life behaviors in the field might give compliance officials a better opportunity to predict and deter lawrelated cheating behaviors where such forces might be especially likely. We will turn to these stress points shortly. But within this research program, one major question dominates and is not yet fully understood (Feldman 2014). How much of this cognitive activity is unconscious? For the shredder experiments, the “excuses” listed above seem fairly conscious ones, designed to justify the cheating. We are all familiar with our own (sometimes pathetic) efforts to resolve guilt via excuse-making, which sometimes work to normalize the activity but not so as to make awareness of the troubling act or omission disappear entirely. What the research suggests is that self-serving inference results from cognitive activity that operates along a broad spectrum. Some is perceptual, so that we may not see the

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266  Research handbook on corporate crime and financial misdealing problem (we see only what we want to see). Some is interpretive, so that we fail to perceive ethically relevant cues. Hence, the ethical or legal risks are simply not processed as such. As we move further along the spectrum, we start coming to something that might be described as awareness, but is still subject to interpretation and shading that deflect the sense that something is seriously wrong—the more familiar sort of rationalization or normalization. In other words, there are cognitive buffers that delay awareness of what is ethically or legally problematic, and maybe prevent it from ever fully being realized. Timing is key. Consequences flow from the unlawful or unethical actions or omissions, and those choices may be made without sufficient awareness or appreciation of the risk. If so, neither carrots nor sticks work as we would hope or expect because the person is not aware that the action taken falls within the category of unlawful or unethical conduct to which the reward–penalty system applies. And once the crucial steps are taken, responsibility is locked in. If the person later comes to sense that what was done was wrong, the psychological reaction is defensive bolstering or cognitive dissonance (adjusting beliefs to justify the action), or a more active cover-up. To use a phrase from a classic in social psychology relating to the escalation of commitment, when adequate awareness comes the person is already “knee deep in big muddy” (Staw 1976). Max Bazerman and Ann Tenbrunsel (2011, Chapter 4) describe this temporal dimension to wrongdoing in three phases. The first is anticipatory, and is the domain of good intentions. People genuinely intend and expect to behave well. But people are notoriously bad at self-prediction. At the time of temptation, the mind goes to work in the ways just described: blurring, misperceiving, reconstituting, so that the preferred outcome is privileged. Some call this “ethical fading” (Tenbrunsel and Messick 2004), because the ethical dimension to the choice is deflected and put out of awareness. After the act the mind restores the original self-image, through rationalization, motivated forgetting, compensation or other mechanisms. What we are describing is hardly unfamiliar; these are “blind spots” in which ego (or greed, fear, desire, etc.) gets in the way of good judgment. Scientific progress—today heavily focused on neuroscience—lies in understanding how and why blind spots thrive and persist. That is an evolutionary question, and gets us to whether and why this tendency might be adaptive. There are a number of intriguing hypotheses. Robert Trivers (2011) has long argued that success (survival) within species depends to some extent on the ability to deceive others who pose threats. But precisely because of the frequency of deception, others learn to detect it from small, subtle “tips and tells” like shifty eyes, etc. A person can avoid providing these signals if he has distorted the truth in his own mind sufficiently to believe that he is not being deceptive or otherwise unethical. To deceive others, in others words, we first deceive ourselves. Self-deception, in turn, often takes the form of excessive confidence or optimism. Biologists have developed fairly intricate explanations for why each of these is a survival trait in large populations, even though the dangers might be self-evident (Johnson and Fowler 2011; Sharot 2011). From a compliance perspective, this raises the uneasy possibility not only that selfdeception as to legal and ethical risk is commonplace, but that it might be especially common among the most successful people in the organization—the survivors of the

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Behavioral ethics, behavioral compliance  267 Darwinian promotion tournaments that operate as the pathways to influence and power. If strong ethics and compliance initiatives are resisted in many organizations—which seems to be the perception among compliance professionals—that may be one reason why. Compliance norms threaten beliefs, behaviors and cultural tropes that are instinctively success-producing. We will come back to power issues later in the chapter; for now at least be aware of one researcher’s claim that power itself makes people better liars (Carney 2010).

3.  CHEATING MORE The experimental studies described in the prior section set in motion wide-ranging inquiries into what dispositional or situational factors make cheating more or less likely. In the laboratory, this can be tested by manipulating one potential factor while holding everything else constant, and the volume of such studies is now large (Bazerman and Gino 2012). But contemporary research is hardly limited to that particular experimental design, especially because it has become recognized that ethics can be viewed as a form of risk-taking, and judgment and decision making in the face of risk is a much larger project in psychology, from and to which insights might be derived. For legal compliance, it is especially noteworthy that self-serving inference is indeed facilitated by ambiguity, either in the situational context or the ethical demand. This strongly suggests that compliancerelated distortion will occur especially easily when the law is subjective rather than bright-line (Feldman and Teichman 2009), as it so often tends to be. This section will review some of the influences said to make cheating behaviors more likely. Because this field is large and growing larger, we have to be both brief and selective. Readers wanting more can consult any of a number of literature reviews and metaanalyses (e.g., Treviño et al. 2014a, and studies cited therein). Consistent with the primacy of psychology in behavioral ethics research, we will focus first on individual-level insights, even though it is generally agreed that social forces are almost always at work in serious instances of organizational misbehavior. 3.1  Loss Aversion In studies of risky choice, one of the most famous insights is referred to as loss aversion, part of the Kahneman–Tversky heuristics and biases research under the heading of prospect theory (Kahneman 2011). To be sure, rational people are generally risk-averse. Loss aversion suggests that people become more risk-preferring when faced with a threatened loss of what they have, as compared to when faced with the opportunity to gain something of equal value. This is so even where the loss versus gain is simply a matter of framing— whether a given outcome is viewed as a loss or a gain depends on the decision-maker’s reference point outcome. A famous illustration found different risk attitudes for a risky medical intervention based solely on whether the effort was described as avoiding deaths or saving lives. Importantly, aspiration levels can divide the two domains, so that falling short of expectations is usually processed as a risk of loss. This leads to a fairly intuitive prediction that goals and quotas—commonplace in many phases of a business—can distort judgment especially when the goal is close but still out of reach. Researchers have described this effect under the title “goals gone wild” (Ordóñez et al. 2009).

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268  Research handbook on corporate crime and financial misdealing More generally, Rick and Loewenstein (2008) claim that “people who find themselves ‘in a hole’ from which they perceive that dishonest behavior provides the only apparent means of escape, a wide range of evidence suggests, are more likely to cheat, steal, and lie,” which they refer to as hypermotivation. A business professor has collected 58 instances of corporate fraud consistent with a prospect theory account in the face of weak internal controls, including the infamous “London Whale” fiasco suffered and then mishandled by J.P. Morgan Chase (Abdel-khalik 2014; see also Arlen and Carney 1992, identifying a similar explanation for securities fraud). Perhaps when we observe some person or team hitting “stretch” goals period after period, it should be a compliance red flag, not just the cause for celebration and reward payouts that it is in so many firms. 3.2  Conflicts of Interest and Truth-Telling Conflicts of interest create the incentive to act opportunistically notwithstanding some pre-existing obligation (ethical or legal) to another, and so are of special interest in both law and behavioral ethics. Regulation often seeks to dampen such conflicts, and a common legal strategy is required disclosure of the conflict, on the assumption that there will be more cautious assessment of the discloser’s behavior. Researchers, however, have found two unintended consequences (Loewenstein et al. 2011). Under certain circumstances, the rate of opportunism in laboratory experiments went up after disclosure, not down. This seems to be motivational: more unconscious “moral wiggle room” (Dana et al. 2007) to justify the opportunism because the victim has fairly been warned of its likelihood. Compounding the problem is that the victims became more trusting, not less (although this varied depending on how the disclosures were structured). One theory is that when there is a pre-existing relationship between the parties so that trust is present, the potential victim overcompensates in response to the disclosure to assure the sender that the trust remains. Patterns of communication can produce unethical behavior in other ways as well. Perhaps reflecting the common moral intuition that acts of omission are less blameworthy than acts of commission (on which there is plenty of supporting psychology research), studies of what lawyers would call half-truths—and what the researchers called “artful paltering” (Rogers et al. 2014)—showed that people are more willing to cheat via saying something technically true but misleading than to lie affirmatively. 3.3  Depletion, Stress and Time One of the most interesting findings is that, cognitively, being ethical is hard work. As a result it is subject to depletion over time (e.g., Welsh and Ordóñez 2014). Such forces as stress and tiredness (so common in the business setting) weaken the ability to resist, as can repetitive acts of goodness. The assumption here is that being selfish is the more automatic process, which deliberation has to override, and that takes a cognitive toll. Another commonly noted bias involves overweighting present benefits over future costs, which can be seen as a simple failure of will power but also as a cognitive distortion. This “hyperbolic time discounting” has familiar effects of impulsivity, procrastination and an excessive focus on immediate rather than delayed consequences—all associated

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Behavioral ethics, behavioral compliance  269 with the potential for wrongdoing when the threat of punishment is both uncertain and distant.4 3.4  Slippery Slopes Another of the fairly intuitive predictions is that the inclination to cheat grows one step at a time (e.g., Welsh et al. 2015). In studies of criminal behavior and business disasters, we keep being reminded that so many stories of corrupt wrongdoing begin with something fairly small and relatively innocent. This fits with much of what we have already covered. If people are willing to step over the line only a bit, that line moves so that when another temptation comes along, the next small step over takes them further away from the baseline. And so on. Rationalizations that aided and abetted the original opportunism recursively become part of a new normal. Note the connection between the first steps down the slippery slope and some of what we covered earlier. A study of how companies get into trouble for accounting fraud discovered, not surprisingly, that one can trace backwards from the sizable falsifications that eventually led to detection to much smaller deceits earlier on (Schrand and Zechman 2012). But more interestingly, the study found that those early steps correlated with indicators of managerial overconfidence and over-optimism. That is to say, managers who were genuinely convinced of the company’s good prospects made more unrealistic judgments in accrual matters, presumably believing that this best captured the fair value of the company. But once there was a lock-in to that optimism, the managers resisted disconfirming information (self-serving inference) and so escalated their commitment to the rosy picture. Gradually that became impossible to carry out within the bounds of accounting discretion and so became accounting fraud. The slippery slope also sheds light on the temporal dimension to wrongdoing, how early on there may not even be full recognition of an ethical or legal issue—even as the first fateful steps are taken. Only later, if ever, is awareness of the misconduct able to break through the blind spots and rationalizations. It need not be innocent at the beginning, however. Interviews with white-collar criminals do often describe a slippery slope but identify the first step as a moment of weakness—being pressured by a friend or colleague into a small (and thus easily rationalized) act of wrongdoing, unaware of how that one step makes it so much harder to say no when asked again (Free and Murphy 2015, p. 44). In broker-dealer regulation, for example, one common problem is forged client signatures on transactional or account paperwork. Note how easy this is to start—you’re actually saving the client the time and hassle of signing the papers—and how readily a year or two later this can turn into forged signatures that misappropriate funds from the client’s account and into the broker’s hands.

 4   In legal scholarship, Manuel Utset has done a great deal to show how these time-­inconsistency biases generate unlawful behavior; e.g., Utset (2013); see also Baer (2014).

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270  Research handbook on corporate crime and financial misdealing 3.5 Competition That intense competition produces unethical behavior is another non-surprising finding. Competition produces both the excitement of potential gain as well as the fear of loss, and so cheating goes up as the goal gets closer but you are a step behind. Cheating is more likely when the competitor is a well-known rival, both because of the personal emotions and the ease by which rationalizations can go to work—they would do it to us if they could, or it is just the way the game is played (e.g., Pierce et al. 2013). Many people have noted the common invocation of sports or military imagery in such settings. Risk-taking of all sorts—ethical and otherwise—is associated with a cluster of traits that enhance competitive fitness, including a taste for excitement, a desire to dominate and a strong ego (Malhotra 2010). It is easy, then, to speculate about a link to testosterone, which recent research in neuroscience tries to chase down. In the investment world, there have been a number of studies on the dynamics between hormones and risk-taking on trading floors (Coates 2012). A study of corporate fraud found a positive correlation with evidence that the CEO had the facial structure typical of high testosterone individuals (Jia et al. 2014). Ethically, high testosterone leads to a more utilitarian, ends-justify-the-means stance (Carney and Mason 2010). One obvious implication of all this is with respect to gender diversity, which is well studied in both risk-taking and behavioral ethics research. On average, women are less competitive, less inclined toward risk, and less likely to cheat than men. Many researchers thus believe that gender diversity in upper echelons of organizations and other locations of economic power is a crucial step toward better ethics and responsibility (van Staveren 2014). This raises the much-debated problem, however, of whether women who self-select into highly competitive fields are substantially different from men along these dimensions. A research paper in the Proceedings of the National Academy of Sciences studied the testosterone levels of MBA students at the University of Chicago, and found the expected differences between men and women (Sapienza et al. 2009). But that small segment of women who chose investment banking as a career had somewhat higher relative testosterone levels than even the men who were going into investment banking. Hopefully, successful efforts at diversity would alter the desirability of entering such occupations, and gradually change the cultural dynamics and expectations that today treat ­hypercompetitive fields as the domain of alpha males. 3.6  Cultures and Conformity As noted earlier, one of the big interdisciplinary battles in the study of business wrongdoing is between psychologist and economists, on the one hand, and sociologists on the other. The latter tend to reject highly individualized explanations for good and bad behavior, in favor of memes, norms and culture. According to sociologists, people act with consciousness constrained by cultural belief systems, and immense pressures to conform, which sometimes promote group-level wrongdoing (Greve et al. 2010). Social psychology mediates between the individual and collective extremes (Darley 2005), and some conventional research psychologists are taking a greater interest in the neuroscience of “groupishness” (Kluver et al. 2014). We have known for some time that groups moderate some cognitive biases, and exacerbate others. Identities can strengthen

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Behavioral ethics, behavioral compliance  271 in group settings, enhancing competitiveness, aggression and the inclination to cheat. Earlier, we discussed studies finding that cheating increases when done for the betterment or protection of someone else. It is not hard to see how the bonds of loyalty and team cohesion can embolden someone to take ethical risks that he or she might not undertake out of pure self-interest. Perhaps the most classic experimental study in all of social psychology came from Stanley Milgram, who found a higher-than-expected willingness of subjects to inflict pain on others simply out of obedience to the orders of an authority figure. There are many forces potentially at work here—denial of responsibility, conformity, escalation etc.—and many disturbing lessons to be considered as applicable in hierarchical organizations. Cheating is contagious; observing it by others makes it more likely the observer will then cheat too (Ariely 2012, ch. 8). In social networks, which are of special interest in business settings, well-positioned actors can amplify, via retransmission, what is observed into what seems normal. Another cross-cutting idea of importance to ethics is legitimacy. In terms of the willingness of people to obey the law in settings of relatively weak detection and prosecution, evidence suggests that people assess the legitimacy of the legal demands (Tyler et al. 2008). If either individually or by reference to the prevailing corporate culture, those legal demands are denigrated rather than respected, compliance rates drop. We can hypothesize that those beliefs are adaptive, enabling aggressive risk-taking with a lesser burden of doubt. I have long believed that in highly regulated industries, the tendency of employees to view regulatory demands as imposed by mindless bureaucrats running amok is a defense mechanism that lets business get done, at the price of higher compliance risk. Cynical cultures therefore can be particularly dangerous from a compliance standpoint. Even without cynicism, the inclination within organizational cultures to interpret the law in a self-serving fashion increases compliance risk (Feldman 2014).5 Consistent with the survey evidence that the legitimacy of a compliance and ethics program is heavily contested within many organizations (Treviño et al. 2014a), a similarly pernicious form of self-serving inference about internal compliance demands could be at work. 3.7  Identity and Environment We have already tied much of the research in behavioral ethics to identity maintenance. Identity issues are well researched in both psychology and sociology, with even inroads into economics (Akerlof and Kranton 2005). There is great utility in a positive identity, individually and organizationally. But with strong professional identity comes heavy baggage. Recently, some well-respected European researchers gave a version of the standard cheating experiment to large-firm bankers, divided into two groups. In one, their identities as bankers were primed (i.e, the experimental conditions pointedly reminded them of their profession). In results reported in the prestigious scientific journal Nature (Cohn et al. 2014), the level of cheating was normal except in the priming condition, where it was higher. The bankers’ identity itself, in other words, was the motivator to cheat.

 5   How organizations (including compliance and human resource personnel) interpret the law is a distinct and fruitful subject of research in sociology as well; e.g., Edelman and Suchman (1997).

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272  Research handbook on corporate crime and financial misdealing Much could be going on here, of course. The results are reminiscent of a series of experiments that measure pro-social and anti-social behavior (including cheating) by framing the experiments so as to prime certain attitudes or emotions. In particular, the trappings of money and wealth—expensive cars, for example—will, when made salient, increase the likelihood of opportunism (Kouchaki et al. 2013). “Banker” may trigger similar feelings, or simply bring to mind a workplace where ample cheating had recently been observed. Apart from cultural or professional identity, researchers have identified other effects in multi-person settings. We have already seen the ability of loyalty to drive unethical behavior. Not surprisingly, people cheat more if they can do so indirectly, as by having an agent cause the harm (Paharia et al. 2009). Acting through agents (or other institutions) also mutes responsibility, thereby diminishing both guilt and third-party blame over acting selfishly (Bartling and Fischbacher 2012), as well as regret over the negative outcomes of risky decisions (Arlen and Tontrup 2015). Motivated inference also affects monitors, who may have incentives to avoid seeing trouble—so they miss the danger signs. Ethical misbehavior that occurs on the slippery slope is not only more likely to grow, but is harder for others to detect precisely because it evolves so slowly (Gino and Bazerman 2009). These latter observations also make the important point that research in behavioral ethics is relevant to the compliance function not only in the ways described above but because compliance monitors themselves have blind spots.

4.  BEHAVIORAL COMPLIANCE Most people find all the foregoing interesting and more or less intuitive. The question is whether it is useful to those seeking to build a successful compliance program. There are a variety of potential concerns with relying on this research when designing a compliance program. Some are methodological, such as whether one can rely on experiments using ordinary people (or students) as subjects to design a compliance program for those in business. This is a fair concern, because lab results can easily be misconstrued and are sometimes misleading (researchers have their own behavioral biases and self-interests, after all). I will leave these challenges to literature reviews, and simply note the volume of this work and that, increasingly, it involves professional subjects in the laboratory and field studies to confirm or refute experimental predictions. All social science must be used cautiously, this included, in formulating practice and policy. The increasing interest in adaptive biases also helps justify using this learning in sophisticated business settings. We know that heuristics and biases do not always translate well when applied in settings that reward skill and savvy when mistakes are costly and there is opportunity to learn from experience. But again, without undertaking to prove the point here, the case has been made in the best peer-reviewed journals that certain biases help people compete and win. Anecdotal observation suggests that the business world has more than its share of blind spots. So if you are a compliance officer and want to take this learning seriously, how would you do so? This question connects to the subject of organizational correctives, which has

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Behavioral ethics, behavioral compliance  273 been of interest for some time.6 Many companies have shown an awareness of the risks of self-serving bias, and there are tactics to combat it. Perhaps the best-known example is the practice of banks removing authority from the original loan officers to renegotiate or work out arrangements when a large borrower is nearing default. Otherwise, the loan officer is subject to an escalation of commitment, driven by the desire to justify the original decision. As this example shows, all organizational correctives are based on the particular challenge in question, compliance included. For now, we’ll have to generalize, which is dangerous because compliance challenges vary greatly. The template for a smart antitrust compliance program focused on potential cartel activity (Sokol 2014) poses different problems from the one a brokerage firm worried about financial advisers pushing unsuitable securities on naïve customers might put in place. 4.1 Communication Compliance begins with effective communication (Killingsworth 2012), and many people—lawyers in particular, I think (other than trial lawyers)—are poor communicators even when their diction is exquisite. They assume that others will understand and process what they mean to say, as long as they are clear enough. But communication research stresses that what people hear and think is often very different from what the speaker says or intends. Compliance messages are apt to be filtered through eyes, ears and brains that are skeptical, resentful or merely uninterested— and adept at self-serving interpretation. A case study from the management literature illustrates (MacLean and Benham 2010). A financial services firm was increasingly concerned that its insurance brokers might be churning policies—substituting a new one for an old one for a customer just to generate fees. Regulators were making threatening noises about the practice, so it was a salient compliance issue. The executive team sent reminders and notices, and to make clear its seriousness, instituted a heightened compliance review of policy substitutions within 90 days. That was presumably well intentioned. But the message as received was completely different. The firm’s brokers were churning to some extent. Performance and compensation expectations were fixed on that level of productivity, and so the brokers were threatened by these new compliance demands. When the brokers saw the 90-day procedure, they decided management was not really serious, and soon, the churns were done in 91 days. They were convinced among themselves that headquarters did not really want the profitable practices stopped given that their “solution” was such an easily evadable compliance procedure. The brokers interpreted the whole situation as management winking: mere window-dressing designed to appease the regulators but not cut into productivity. They acted accordingly, no doubt with an added dose of cynicism about regulators, as well. The rate of churning went up. Perhaps they were right, and management was not serious. But this story doesn’t seem far-fetched as describing a poorly executed compliance initiative, and one that ultimately cost the firm greatly in legal costs and penalties.  6   Philip Tetlock (2000) notes in a fascinating article that there are wide variations in organizations regarding the validity of behavioral predictions and explanations, varying based on the political ideology and cognitive style of the observer. More conservative managers have less tolerance for complicated behavioral assessments, preferring a more authority-based assessment of blameworthiness.

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274  Research handbook on corporate crime and financial misdealing Communication also involves timing, which is very tricky. Remember that most people in the firm see themselves as ethical and responsible, without the intention to misbehave. Ethical warnings and lessons delivered well in advance of temptation will be met with the mental mute button. Behavioral ethics stresses the need to intervene very close to the time of the act or omission, but by no means after, and to offer constructive courses of action, not just warnings. As to good intentions alone, there should be candid recognition that they can, indeed, line the road to hell. There is a fascinating illustration of good and bad timing. Certifications are commonplace in the business world: promises that what was or is about to be said is true and complete. One wouldn’t think that there would be much difference as to when, but psychologists hypothesized that there was—that there would be more honesty when people promise to be truthful than when, after the fact, they promise that they have been truthful (Ariely 2012, pp. 48–51). The intuition is that the advance certification (think about a witness being sworn in at trial) is a reminder in advance of ethical demands, and therefore more efficacious. If the person is inclined to lie, confronting them after the fact with the need to promise that there were no lies will just produce more lying. The researchers were able to convince an insurance company to do a randomized test with its customers, who were asked once each year how many miles they had driven (useful in rate-setting because of the risk associated with additional miles). The only difference was the before or after certification instruction. When forms came back that year, those who signed before-the-fact reported, against interest, significantly (15%) more miles traveled than the after-signers. Encouraging whistleblowing is a common strategy within compliance, and notoriously difficult to incentivize (see Engstrom, Chapter 14 in this volume). Norms of loyalty are immensely powerful, as we’ve seen, and self-serving inference will often cut against forming the impression that a colleague is cheating. Tone at the top and peer support seem crucial; as one set of commentators put it, “it takes a village” to have the right support and incentives for whistleblowers to act (Mayer et al. 2013). And any whistleblower has to anticipate that the inferences from the message may be processed in a self-serving way, so that the rejection of the complaint is deemed justified (Sumanth et al. 2011). More constructively, research on the psychology on whistleblowing has found that the countervailing pressure generally comes from fairness outrage, which may give hints on how to frame the outreach programs to better elicit these acts (Waytz et al. 2013). 4.2 Surveillance Another core aspect of compliance is internal surveillance. Advances in information technology allow extraordinarily sophisticated real time and retrospective observation of activity within a firm, albeit at substantial cost. Both hard data and soft clues—scrubbing email traffic for words and phrases of a particular tone—can yield valuable compliance intelligence. Although we are still distant from this point, it is not hard to imagine the modern-day compliance version of Jeremy Bentham’s prison “panopticon,” which sees everything without being seen.7   The compliance-based reference to Bentham’s idea comes from James Fanto (2014, p. 1148).

 7

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Behavioral ethics, behavioral compliance  275 Short of that, all surveillance is necessarily risk-based, and behavioral ethics research can help inform what to look for. Here again one size never fits all, and each compliance issue must be analyzed by breaking down the choice architecture of any sensitive decision to see who makes it, under what circumstances, when and how. We can then put the behavioral learning to work, looking for particular temptations (goals gone wild), especially in the form of loss frames. Once again, sequentially high levels of success can be a red flag, especially if you can’t figure out how they did it. This suggests that the use of big data analytical tools may permit compliance departments to predict misbehavior, based on the large-scale analysis of prior failures and their precursors. Such efforts indeed seem to be on the horizon.8 Given the rapidly growing body of research on the correlates with fraud and other forms of wrongdoing, one can readily imagine a behaviorally attuned program that seeks to identify markers as they point toward more intense motive and opportunity. MIT economist (behavioral and otherwise) Andrew Lo (2016) has suggested that a linear factor model could eventually be constructed for each executive that estimates risk appetite at any given time, and which in the aggregate might depict the taste for risk in the firm as a whole, or in individual sub-units. Three cautionary points have to be made. First, as Lo points out, such artificial intelligence—surely helpful in at least allowing the centripetal processing of all available information about people and situations—would have to have the capacity to learn and evolve (Lo 2016). People surely do, as the 91-day rule experience noted earlier shows. What happened in the past to produce misbehavior was the function of a set of interpersonal and situational forces that may be gone by the time the model is built. The value-at-risk models in investment banks in the time leading up to the financial crisis did poorly precisely because the data inputs were from a time when housing prices rose consistently, because that had been the only available prior experience. Second, any predictive software will inevitably generate a large number of false positives (and false negatives), which may lead to behaviors by those in charge of responding that are not optimal and leave hiding places, about which people in the field gradually learn. The third is a bigger point. One of the central insights in behavioral economics is that people react poorly to close monitoring (Falk and Kosfeld 2006). Heavy surveillance is a signal of distrust, which may produce less trustworthy behaviors in response to expectations. Control has the ability to crowd out the kind of autonomy that invites ethical behavior,9 and can make people less entrepreneurial and productive (Tenbrunsel and Messick 1999). Imagine a bank with a perfect panopticon. Though I concede the experiment would be an interesting one, I would wager that over time its productivity and competitive position would lag behind peers with less surveillance intensity, even if its compliance record might be better (Langevoort 2002). And given the capacity of complex human systems to frustrate even the best of plans, I’m not even sure about the compliance superiority.  8   “J.P. Morgan Knows You’re a Rogue Trader before You Do,” Bloomberg Business, April 8, 2015.  9   Related to this is the phenomenon whereby both promised rewards and threatened sanctions are “priced” and lead to more calculative behaviors where integrity is called for. See Gneezy and Rustichini (2000).

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276  Research handbook on corporate crime and financial misdealing Values-based compliance and risk management are important, by most accounts, to success (Treviño et al. 1999; Tyler et al. 2008). If so, the best systems invite intraorganizational trust, even though the trust will sometimes be abused. (I wish prosecutors and regulators understood this better, but suspect that the induced evolution of surveillance, technology-driven and otherwise, will steadily be in the direction of more intensity and less trust.) 4.3  Goals, Quotas and Compensation The kind of work in behavioral ethics we have been surveying meshes with orthodox economics in agreeing that incentives matter. Thus, it is probably safe to say that most compliance failures happen because incentives pushed or pulled in that direction. The main difference between the psychologists and the economists on this is that the former see compliance choices as mediated by a state of mind that obscures perception and judgment in pursuit of self-interest, while the latter see the actor as a nimble Bayesian updater responding precisely to changing incentive cues. As we have seen, that difference complicates the tasks of compliance and ex ante risk management. The common ground on the matter of incentives means that conventional economic analysis of the incentive structure relating to any compliance setting is a good starting point, as a matter of parsimony if nothing else. (My sense is that many compliance programs ignore both good economics and good psychology.) From that base can be added the psychological and organizational twists to see how messages might be distorted in transmission or reception. One of the famous examples in the compliance literature involves Sears and the financial and reputational penalties for overcharging customers for auto repair work (Bazerman and Tenbrunsel 2011, p. 106). Sears had been a leader in auto work, and had a good reputation for that and other customer services. But firms like Wal-Mart and K-Mart destabilized the retail marketplace via cost cutting, and Sears suffered a loss of revenue. To compete (perhaps to survive) Sears ­instituted more ­rigorous ­profitability targets that matched others in the industry. Apparently to its surprise—but not to the surprise of any economist or psychologist—the shop-floor reaction read that as a directive to ignore good customer service. On the shop floor, the redesigned incentive structure likely led to “seeing” more problems with customers’ cars than previously, and a lower perceptual threshold for when repairs were thought necessary. The optimal design of compliance-sensitive incentives is well beyond the scope of this chapter. There is a school of thought among some behavioralists that aggressive incentives and quotas are not only dangerous and less important to productivity than commonly assumed, they crowd out conscientiousness. Others contest that and consider those arrangements efficient, even as they acknowledge the compliance risk when they are baked into the organization’s strategic plan (for a review, see Kamenica 2012). Given the time lag between revenue (now) and a compliance sanction (later if ever), attention to the former is fairly natural and increases all the more in the face of hyperbolic discounting of the future over the present. Executive contracts might be designed to address this through deferrals, clawbacks and the like, though that is certainly a contested topic. But much of the motivation for wrongdoing is not entirely top down. As Chuck Whitehead and Simon Sepe (2015) point

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Behavioral ethics, behavioral compliance  277 out, risk often comes from the up-and-coming strivers, for whom mobility is important, and hence incentive structures have to be short-term to attract the best talent. I confess some pessimism that entrenched incentive structures will ever make compliance a priority in settings that are perceived internally as hypercompetitive, or that there is a particularly productive way to do this by external regulatory fiat. The genetic structure of firms seems to understand that survival and success come first, and that optimal compliance is about the organization’s taste for risk. Given what we said earlier about biases that promote competitiveness, both regulation and compliance will usually be chasing the greased pig from behind (Langevoort 2016, p. 160). That goes for human resources as well. It is probably right that good compliance is heavily influenced by who gets hired and who gets promoted. And it is self-evident that most competitive firms don’t hire at seminaries or schools of social work in order to seek out the most ethically sensitive. Nor do they seek out sociopaths, of course. But how many consider the compliance implications of hiring practices that, say, seek out college-level athletes or fraternity/sorority presidents? That may seem merit-based and innocent enough, and probably not a bad heuristic in predicting employment success, but the firm is also raising its aggregate testosterone level, plus whatever other traits correlate with such résumés. Researchers have noted how sought-after characteristics in the business world like energy, self-confidence and the need for achievement and independence, can have evil twin pairings: aggressiveness, narcissism, ruthlessness and irresponsibility (Miller 2015). Promotion practices are another subtle source of frustration. Economists have modeled the internal promotion tournament at competitive firms and noted how they reward the overconfident risk-taker (Goel and Thakor 2008). If we assume that risk-taking includes compliance risks with a significant economic upside, we can see how the path to the top may favor those with an extra willingness to push against regulatory demands. If regulatory demands are under-enforced, either systematically or at a particular time (e.g., when the economy is booming), the lottery wheel tilts even more in favor of the legal risk-takers (Langevoort 2012, pp. 504–506). If so, no matter what the official rhetoric, the tone at the top can degrade audibly to anyone listening carefully enough. 4.4  Constructive Interventions The pessimism of the last subsection is sobering, and I do fear that the compliance function has to work hard—and use all the economic and behavioral tools at its disposal—even to moderate the temptations to take excessive legal risks, much less eliminate them. But compliance efforts are crucial, in that without them, things would surely be worse. Behaviorally, organizational correctives are sorely needed. Earlier, we said that there is much research which is trying to tease out when cheating becomes more likely than the baseline. It also looks for the opposite, interventions that lessen cheating. There are some amusing findings. Pictures of eyes in the room, or posting the Ten Commandments (even for non-believer subjects), reduce cheating (Ariely 2012, ch. 2). Behavioral ethicists urge the display of ethical reminders as close to the time of temptation as possible, which is behind the intuition noted earlier that an oath or certification just before making a statement can be helpful. Another effort looks to the choice

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278  Research handbook on corporate crime and financial misdealing architecture inside the firm to see if nudges will work—making the ethically more risky course of action require affirmative effort rather than being the default.10 These are low-powered interventions, to be sure. But they do help give content to something often invoked but otherwise ill-defined: tone at the top. Tone can be viewed in terms of the bad—where senior management give off signals of disinterest or hypocrisy,11 saying one thing but doing another. (Ostentatious displays of wealth don’t help, or overclaiming business travel privileges on the company jet.) But more positively, persistently addressing ethics and values offers the same kind of close-to-the-moment reminder opportunity. How senior management and the board of directors interact with the ethics and compliance function, in terms of both frequency and expression, will be noticed, too. And to stress a point, Tom Tyler (Tyler et al. 2008) has persistently emphasized in his research that fair treatment of employees is key not only to good morale but any perception that management’s compliance expectations have legitimacy (see also Tyler, Chapter 1 in this volume). Organizational processes may also be addressable from a compliance and ethics perspective. Decision making usually tries to be as nimble as possible, and bureaucratic roadblocks—repetitive committee approvals—can be deadening. That said, a psychologically savvy look at decision process and decision speed can be helpful at points where compliance risks lurk.12 But being more specific than this requires that we hone in on the particulars of the legal subject in question, the competitive context and many other factors, beyond what we can profitably explore here. Miriam Baer (2014) offers a useful sketch of architectural and policing strategies that a company might employ to target time-inconsistency-driven misbehavior, a search for pre-commitment devices that better align employees’ present and future selves.

5. PERSPECTIVE So in the end, what is behavioral compliance? To be clear, it is not some new or different brand of compliance design, but rather an added perspective. Just as compliance requires good economics skills, it requires psychological savvy as well, to help predict how incentives and compliance messages will be processed, construed and acted upon in the field. All compliance functions and challenges should be deconstructed and thought through rigorously to anticipate responses and counter-responses, an effort at game theory in both its classical and behavioral (Camerer 2003) forms. The behavioral approach to compliance offers some concrete interventions to consider, but is mainly about doing conventional things (communication, surveillance, forensics) better. Behavioral compliance also demands self-reflection. As we saw, one research agenda in behavioral ethics looks at how people observe and react to cheating by others, and the role of motivations, biases and blind spots in all this. People in the compliance field should

10   For an experimental study showing some promise in nudging greater awareness of the effects of conflicts of interest, see Feldman and Halali (2015). 11   Even if the hypocritical CEO genuinely believes his own sanctimony, which is not unlikely. 12   On the benefits of delay from a cognitive perspective, see Partnoy (2012).

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Behavioral ethics, behavioral compliance  279 appreciate that their own efforts are potentially biased, too. Compliance is very hard, and often frustrating. It has to fight for its own internal legitimacy, against pushback both blatant and subtle. Finding wrongdoing inside the firm is painful in terms of hard choices about self-reporting that might bring on penalties, the political difficulties of assigning blame, and institutional shame and anger. Those conditions can easily prompt self-serving or self-protective construals within the compliance function, not just outside it. Given how important the job is, that risk has to be confronted openly, too, lest the function devolves into defensive routines and habits that make it the merely cosmetic touch-up critics have long feared (Krawiec, 2003).

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Behavioral ethics, behavioral compliance  281 Paltering: The Risks and Rewards of Using Truthful Statements to Mislead Others. Available at http://papers. ssrn.com/sol3/papers.cfm?abstract_id=2528625 Sapienza, Paulo, Luigi Zingales, and D. Maestripieri. 2009. Gender Differences in Financial Risk Aversion and Career Choices are Influenced by Testosterone, Proceedings of the National Academy of Sciences, 106, 15268–15273. Schrand, Catherine and Sarah Zechman. 2012. Executive Overconfidence and the Slippery Slope to Financial Misreporting, Journal of Accounting and Economics, 15, 311–329. Sharot, Tali. 2011. The Optimism Bias, Current Biology, 21, R941–945. Sokol, Daniel. 2014. Policing the Firm, Notre Dame Law Review, 91, 785–848. Staw, Barry. 1976. Knee Deep in Big Muddy: A Study of Escalating Commitment to a Chosen Course of Action, Organizational Behavior and Human Decision Processes, 16, 27–44. Sumanth, John J., David M. Mayer, and V. S. Kay. 2011. Why Good Guys Finish Last: The Role of Justification Motives, Cognition, and Emotion in Predicting Retaliation Against Whistleblowers, Organizational Psychology Review, 1, 165–184. Tenbrunsel, Ann and David Messick. 1999. Sanctioning Systems, Decision Frames and Cooperation. Administrative Science Quarterly, 44, 684–707. Tenbrunsel, Ann and David Messick. 2004. Ethical Fading: The Role of Self-Deception in Unethical Behavior, Social Justice Research, 17, 223.Tetlock, Philip E. 2000. Cognitive Biases and Organizational Correctives: Do Both Disease and Cure Depend on the Politics of the Beholder?, Administrative Law Quarterly, 45, 293–328.  Treviño, Linda Klebe, Niki A. den Nieuwenboer, and Jennifer Kish-Gephart. 2014a. (U)nethical Behavior in Organizations, Annual Review of Psychology, 65, 635–660. Treviño, Linda Klebe, Niki A. den Niewuwenboer, Geln E. Kreiner, and Derron Bishop. 2014b. Legitimating the Legitimate: A Grounded Theory Study of Legitimacy Work Among Ethics and Compliance Officers, Organizational Behavior and Human Decision Processes, 123, 186–205. Treviño, Linda Klebe, Gary Weaver, David Gibson, and Barbara Toffler. 1999. Managing Ethics and Legal Compliance: What Works and What Hurts. California Management Review, 41, 131–151. Trivers, Robert. 2011. Deceit and Self-Deception: Fooling Yourself the Better to Fool Others, New York: Allen Lane. Tyler, Tom, John Dienhart, and Terry Thomas. 2008. The Ethical Commitment to Compliance: Building Valuesbased Cultures, California Management Review, 50, 31–51. Utset, Manuel. 2013. Corporate Actors, Corporate Crime and Time Inconsistent Preferences. Virginia Journal of Criminal Law, 1, 265–328. van Staveren, Irene. 2014. The Lehman Sisters Hypothesis, Cambridge Journal of Economics, 38, 995–1014. Waytz, Adam, James Dungan, and Liane Young. 2013. The Whistleblower’s Dilemma and the Fairness–Loyalty Tradeoff, Journal of Experimental Social Psychology, 49, 1027–1033. Welsh, David and Lisa Ordóñez. 2014. The Dark Side of Consecutive High Performance Goals: Linking Goal Setting, Depletion and Unethical Behavior. Organizational Behavior and Human Decision Processes, 121, 79–89. Welsh, David, Lisa Ordóñez, Deirdre Snyder, and Michael Christian. 2015. The Slippery Slope: A Selfregulatory Examination of the Cumulative Effect of Minor Ethical Transgressions, Journal of Applied Psychology, 100, 114–127. Whitehead, Charles and Simon Sepe. 2015. Paying for Risk: Bankers, Compensation and Competition, Cornell Law Review, 100, 655–702.

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12.  An analysis of internal governance and the role of the General Counsel in reducing corporate crime Vikramaditya Khanna*

1. INTRODUCTION There is a great deal of interest in understanding what factors contribute to the likelihood of corporate wrongdoing or fraud (Soltes 2016). Lately, scholarly attention has focused on internal factors such as Board and Audit Committee composition, executive compensation, and a host of other matters. The increased attention is also mirrored in greater regulatory and sentencing interest in internal governance.1 This chapter examines this literature and explores a feature of internal governance that has recently garnered greater research interest—the role of the General Counsel. This chapter also offers some early thoughts on a topic generating a great deal of debate: whether, and when, hiving off compliance from the General Counsel’s office  is  likely  to  be beneficial in terms of reducing fraud and enhancing firm performance.2 Recent attention to the General Counsel’s office seems to flow from the fact that traditionally one of its key responsibilities has been to prevent and address corporate wrongdoing. Consequently, how this office operates may hold important insights for understanding and reducing fraud. Much of the extant analyses explore how the General Counsel must balance potentially conflicting roles—specifically, strategic advising, compliance, and monitoring—and its impact on fraud. Less attention has been paid to how information relevant to the General Counsel’s tasks reaches her office and whether that might influence the likelihood of fraud and the firm’s performance. This chapter begins examining this issue and notes that the design of the General Counsel’s office (and what tasks are kept in it and which are sent elsewhere) is likely to influence internal information flows. This, in turn, impacts how effective various internal players are likely to be in reducing fraud and enhancing overall firm performance. In particular, I argue that often dividing the tasks traditionally associated with the General Counsel’s office between the Chief Compliance Officer (who reports to the Board) and the General Counsel may impose costs on the firm. These costs include weaker information gathering and duplication of effort (in many instances), as well as   *  I thank Jennifer Arlen, Alexander Dyck, Geoff Miller, and J. J. Prescott for very helpful comments and discussion, and Stephanie Balitzer, Don Blevins, Sarah Jaward, Lilliana Lim, Trisha Parikh, Joe Piligian, and Sarah Scheinman for excellent research assistance.  1   See §8C2.5(f)(3)(C)(i), Chapter 8, United States Sentencing Guidelines, United States Sentencing Commission. Available at: http://www.ussc.gov/guidelines-manual/2014/2014-chap​ ter-8; Rules 38a-1, 206(4)-7, 204-2 and Part 1, Schedule A, Item 2(a) of Form ADV. Discussion available at: http://www.sec.gov/rules/final/ia-2204.htm  2   See, e.g., Heineman (2010) and Tabuena (2006).

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An analysis of internal governance and the General Counsel  283 the potential for even greater wrongdoing. For example, some employees may be more reluctant to share their information with an independent compliance officer than with the General Counsel for a variety of reasons (that I discuss in this chapter), including, but not limited to, because conversations with the General Counsel are more likely to fall within the firm’s privilege than conversations with compliance. This reluctance, which is little discussed in the literature, could result in an increase in fraud incidence and weaker firm performance, amongst other things. These costs would need to be balanced against the potential gains from having compliance run by an officer who reports directly to the Board and is thus more independent of top management. Which way this balance comes out may vary across firms and sectors, but it is an important inquiry. This chapter then discusses some of the key factors that may influence this balance as well as ways in which one might ameliorate these concerns to some extent.3 It also suggests that greater empirical inquiry may prove fruitful and provides some early indicia about how such an empirical inquiry may be carried out. The chapter begins, in Section 2, by sketching out the pre-existing literature on corporate wrongdoing with a focus on the more recent scholarship examining internal governance and corporate wrongdoing. Section 3 narrows the focus to the corporate player of greatest interest in this chapter—the General Counsel—and lays out the research to date on the General Counsel and fraud incidence. Section 4 examines whether separating compliance from the General Counsel’s office is likely to prove beneficial for the firm in terms of fraud reduction and overall firm performance. Section 5 describes how one may begin to explore this question empirically. Section 6 concludes.

2.  LITERATURE ON CORPORATE CRIME Corporate wrongdoing has generated a great deal of scholarly interest. Since the 1930s, the study of “White Collar Crime” or “Corporate Crime” has fascinated scholars from multiple disciplines (e.g., sociology, law, economics, accounting, finance, management) and occupied an important place in both political and business discussions as well as in the general zeitgeist.4 The economically oriented discussion initially focused on questions related to the structure of corporate and individual liability regimes.5 Issues considered included: When might corporate liability be desirable?;6 When, if at all, is it desirable to impose criminal, rather than civil, liability on corporate  3   This may involve making other adjustments to internal operations to address concerns associated with some employees’ potential reluctance to share information. This may involve, for example, staggering roles (compliance does something first then the GC’s office takes it from there) or enhanced whistleblowing through the compliance department or greater use of technology in compliance.  4   Edwin Sutherland is credited with coining the phrase “White Collar Crime”. See Sutherland (1983).  5   By no means should the focus on economically oriented discussion in this paper indicate that other types of research do not examine white collar crime or corporate crime. For a sampling see Orland (1995), Braithwaite and Fisse (1993), and Laufer (2008).  6   See, e.g., Kraakman (1984) and Sykes (1984).

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284  Research handbook on corporate crime and financial misdealing entities?;7 When are criminal sanctions on individual executives desirable?;8 What kinds of liability standards—strict liability, mens rea, negligence, or composite regimes—should apply to corporations?;9 When, if ever, should prosecutors impose governance mandates on firms?;10 What role should top management play in the ­sanctions  faced  by  corporations?;11 When might liability on third parties be appropriate?;12  What procedural protections should a corporation receive?;13 What insights can one gain from the political economy of corporate crime legislation?;14 and many more. There has also been a recent proliferation of empirically oriented scholarship examining both the costs of corporate wrongdoing (to firms, managers and society)15 and the factors that may influence the likelihood of fraud and its detection. Although much of the recent scholarship seems to have been influenced by the enactment of the SarbanesOxley Act ((Coates and Srinivasan 2014) provide an excellent review of this work), some of the earlier work was focused on the more general question of why might firms commit corporate crime? In the following discussion where papers provide strong evidence of causal inference that is discussed in the text. A number of papers argue that corporate crime and fraud are largely the result of agency costs (Alexander and Cohen 1999; Arlen and Carney 1992; Arlen 1994, 2012; Macey 1991). For example, Alexander and Cohen (1999) find that firms whose management owns more shares have a lower frequency of crime. This, the authors suggest, indicates that corporate crime primarily reflects an agency cost that might be reduced with careful monitoring by top management. The focus on agency costs underscores the fact that people (i.e., employees or management) commit crimes, not corporations per se (see Macey 1991; Arlen 1994).16 That, in turn, leads our focus to be on what sorts of factors might encourage or discourage management (or employees) from engaging in fraud? I explore this question by dividing the literature into (i) factors external to the firm and (ii) factors internal to the firm. Of course, the division between external and internal is not as clean as it sounds because internal factors can influence external ones and vice versa. For example, studies have found that firm size and leverage can influence fraud incidence because larger firms

  See, e.g., Coffee (1981), Khanna (1996), Fischel and Sykes (1996), and Buell (2009).   See, e.g., Arlen and Carney (1992), Polinsky and Shavell (1993), Arlen (1994, 2012), and Khanna (2007).  9   See, e.g., Arlen (1994), Arlen and Kraakman (1997), and Khanna (1999). 10   See, e.g., Arlen and Kahan (2017) and Khanna and Dickinson (2007). 11   See Khanna (2003). 12   See, e.g., Kraakman (1986) and Coffee (2006). 13   See Khanna (2005). 14   See Khanna (2004). 15   For excellent discussions of the costs of corporate crime see Anderson (1999), Dyck, Morse, and Zingales (2013), and Coates and Srinivasan (2014). For exploration of the costs of wrongdoing for the firm see Karpoff, Lee, and Martin (2008a) and Agrawal, Jaffe, and Karpoff (1999) and for the costs to managers see Karpoff, Lee, and Martin (2008b). 16   Corporate fraud arises in other countries too where managerial agency costs are smaller and controller–minority conflicts are larger (e.g., Parmalat (Italy) and Satyam (India)). See Ferrarini and Giudici (2006), Coffee (2005), and Khanna (2009).  7  8

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An analysis of internal governance and the General Counsel  285 and more leveraged firms receive more scrutiny from outsiders. This scrutiny increases the likelihood of detection thereby reducing the incentive to engage in fraud (Wang, Winton, and Yu 2010). Although one could say these factors are internal to the firm, the primary mechanism through which they are influencing fraud incidence is by triggering monitoring by external actors. 2.1  Studies on External Factors Influencing Fraud Incidence Studies seeking to identify the external factors that influence firms to commit fraud have tended to focus on business conditions around the time of the fraud. Wang, Winton, and Yu (2010) investigate the role of investor’s beliefs about industry business conditions in influencing a firm’s incentive to commit fraud while going public. Their starting point is the notion that investors monitor for fraud, and if managers wish to engage in fraud they would presumably prefer to do it at times when investor monitoring (or any third-party monitoring) is not high.17 The authors then note that when industry conditions are bad, investors are likely to monitor carefully which makes fraud less attractive to managers.18 When industry conditions are good, investors are likely to monitor less because firms are on average performing better.19 Finally, when industry conditions are great, investors may think poor performance is temporary and hence fund even poor performers, leading to a lesser incentive to engage in fraud by management. Thus, fraud incidence may have an inverted-U shape with respect to investor perceptions about industry conditions. This would suggest that we might expect to see more frauds during good times, which are then revealed as the market gets weaker and investor monitoring increases. Wang, Winton, and Yu (2010) provide empirical evidence that is consistent with these theoretical predictions. In addition to a focus on investor perceptions about industry conditions, there have been a host of studies exploring what other external factors may matter to fraud incidence and detection. For example, a number of studies provide evidence that monitoring by institutional investors can play a critical role in deterring fraud (see e.g., Hartzell and Starks 2003; Cremers and Nair 2005; Kim and Lu 2011), as can monitoring by analysts (e.g., Hong, Lim, and Stein 2000; Chang, Dasgupta, and Hilary 2006; Kelly and Ljungqvist 2012). Relatedly, firms in industries that have a higher level of litigation intensity are more likely to be subject to monitoring because investors and law enforcers appear to focus their monitoring efforts on certain industries over time (see Wang et al. 2010). Moreover, 17   Note that this study is primarily focused on the incentives of investors to monitor rather than directly on manager’s incentives (which is addressed more in Section 2.2). 18   The authors’ proxy for investor beliefs by relying on median industry Tobin’s Q, median annual industry earnings per share growth forecast, and the inverse of the industry median IPO book-building time. 19   Of course, the plausibility of this story depends on the type of fraud and how likely it is that misconduct will eventually be detected. Managers in good times should expect to retain their jobs if they remain lawful. The net present value of this stream of income would be lost should the manager commit fraud and get caught. This could provide a powerful incentive not to commit fraud. For this reason, Arlen and Carney (1992) postulated that fraud is more likely when managers are in a last period, either because the firm is in trouble or the firm is underperforming compared to others in the industry.

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286  Research handbook on corporate crime and financial misdealing Yu and Yu (2011) find that corporate lobbying is associated with reduced fraud detection likelihood.20 Indeed, a number of studies (including Choi and Pritchard, Chapter 8 in this volume) examine the types of factors that might influence government enforcers. Of course, investors and enforcement agencies are not the only people who might be monitoring for fraud. Dyck et al. (2010) explore which parties are most responsible for detecting and reporting corporate fraud. Detecting fraud requires effort and hence is not costless. Consequently, identifying the parties most likely to detect fraud may help us understand the incentives to engage in fraud. The authors gather data on all reported instances of fraud at large firms between 1996 to 2004 and find that the primary detectors of fraud are the media and employees rather than investors, regulators, or auditors. They suggest that monetary incentives are significant for employee whistleblowing, and reputational incentives appear to matter only for the media in large cases. It is noteworthy that both the SEC and auditors increased their fraud detection after the enactment of Sarbanes-Oxley.21 2.2  Studies on Internal Factors Influencing Fraud Incidence Internal factors also influence the likelihood of fraud. Much corporate wrongdoing is the result of coordinated activity at the firm or a failure of coordination at the firm. In light of this, exploring factors internal to the firm becomes important. Literature in this area has been growing at quite a brisk pace over the last few years, with a number of studies examining how internal governance is likely to have an impact on the incidence of fraud. Factors considered include internal features affecting the ways in which fraud might benefit management—such as firm performance and executive compensation—as well as the ways in which internal monitors, such as the Board and Audit Committees, affect the cost management faces in deciding whether to go forward with fraud. 2.2.1  Firm performance and managerial incentives A number of studies indicate that poor firm performance is associated with an increased likelihood of fraud. For example, Arlen and Carney (1992) develop a model for understanding fraud-on-the-market cases and find that these types of cases are generally ­unattractive for managers unless the firm (or the manager) is near its last period. The authors report evidence in support of their model which suggests that fraud-on-the-market cases are more likely towards the end of a firm’s life cycle.22 Relatedly, Alexander and 20   The underlying notion is that lobbying may influence the likelihood of detection (and perhaps delay detection). The authors test this by gathering data on corporate lobbying and large frauds between 1998 to 2004 and find that lobbying firms have a lower chance of being detected and their detection is delayed by over 100 days compared to firms that do not lobby. 21   As Coates and Srinivasan (2014) note, this study and others related to it do not provide tests to show causal inference. 22   Their analysis leads the authors to suggest that for fraud-on-the-market cases liability of the firm simply results in a transfer of wealth from one set of innocent investors to another. Because this serves little useful function, they suggest scrapping corporate liability and relying solely on agent liability with the possibility of criminal sanctions against those agents. See Arlen and Carney (1992).

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An analysis of internal governance and the General Counsel  287 Cohen (1996) find a statistically significant negative correlation between environmental crimes and pre-crime sales growth rates.23 Firm performance may also influence managers even when a firm is not about to fail. Managers may have an incentive to misreport earnings when they believe it enables them to obtain better terms for their firm to raise capital for new ventures (Bebchuk and Bar-Gill 2002). This kind of misreporting may not be done to stave off bankruptcy, but to try to enhance firm performance by raising capital through misreporting the firm’s performance. 2.2.2  Executive compensation In addition, a number of studies have explored how executive compensation may influence managements’ incentives and thus the incidence of fraud. Some of the theoretical treatments of this issue merit attention before discussing the empirical studies. Peng and Roell (2008b), Benmelech et al. (2010), and Bebchuk and Bar-Gill (2002) examine the impact of equity compensation on incentives to misreport earnings. They describe how equity-based compensation can incentivize corporate executives to engage in behavior that would cause the stock price to move up in the short run (thereby profiting management) even when the behavior is otherwise value reducing for the firm. Benmelech et al. (2010) rely on a dynamic rational expectations model, with asymmetric information, to show that equity compensation can induce managers to misreport (and invest sub-optimally to support that misreporting). Peng and Roell (2008b) develop a model where stock prices account for the possibility of misreporting, but do not do it fully because of uncertainty surrounding managers’ ability or willingness to engage in misreporting. This has effects on the optimal contract, which now has a lower equilibrium level of effort. Bebchuk and Bar-Gill (2002) develop a model where even when managers cannot sell their shares (i.e., equity compensation is not at issue) they may have incentives to misreport if that might entail better terms for their company to raise capital for new ventures. These papers are complemented by a series of empirical papers. Peng and Roell (2008a) examine the impact of equity-based compensation on private securities litigation and find that options-based pay largely drives the incentives of management to focus on short-term price movements. Burns and Kedia (2006) discuss the effect of CEO equity compensation on misreporting and find that the stock option compensation delta (i.e., the sensitivity of the CEO’s option portfolio to stock price) is positively and significantly related to the likelihood of misreporting. This effect is limited to stock options because other aspects of the CEO’s compensation (e.g., salary, restricted stock) do not appear to impact misreporting. The authors argue that this is because stock options generate convexity in CEO wealth, which creates stronger incentives to misreport (by limiting the downside risk if misreporting is detected).

23   Note also that somewhat analogous results are found in Alexander and Cohen (1999). The studies noted in this section are focused on the incentives of managers to engage in fraud rather than on whether investors or others change their monitoring of managers (a matter discussed in Section 2.1).

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288  Research handbook on corporate crime and financial misdealing Efendi et al. (2007) find the chance of misreporting is positively and significantly related to when the CEO has large amounts of in-the-money stock options and that this also leads managers to take non-value-enhancing steps to support stock price movements. They focus on the spate of financial statement fraud at the end of the 1990s and also find (consistent with Bebchuk and Bar-Gill (2002)) that firms raising new debt or equity are also more likely to engage in misstatements. Indeed, there are a host of other studies that also find equity compensation related to the risk of fraud and misreporting.24 Most of these also find that stock option compensation is more likely to induce misreporting than stock compensation, as noted in Burns and Kedia (2006). 2.2.3  Board and Audit Committee structure Board and Audit Committee structure have long been thought to be relevant to policing fraud. Given the central role of the Board and Audit Committee in monitoring management (and producing financial reports) and their increasing independence from top management, this is not surprising. However, empirical studies have not always spoken with a consistent voice on their effectiveness and generally have difficulty establishing causal inference or overcoming endogeneity. One of the earliest studies on internal governance and corporate fraud is Beasley (1996). He examines whether firms with more independent boards and audit committees have a lower likelihood of financial statement fraud. His key finding—relying on a logit regression of 75 fraud and 75 no-fraud firms—is that no-fraud firms have boards with a significantly greater percentage of outsiders on the Board. Moreover, as the outside direct­ors own more shares and stay on the Board longer, the likelihood of financial statement fraud declines. In spite of these findings, Beasley does not find that the presence of an independent Audit Committee affects fraud likelihood significantly.25 Later studies have only partially confirmed some of these results. Agrawal and Chadha (2005) study a sample of 159 firms with restatements (and another 159 industry-size matched firms without restatements) and find that independent boards and audit committees had little impact on the likelihood of earnings restatements. However, they did find that if either the Board or the Audit Committee has an independent director with financial expertise then the likelihood of fraud is lower. Relatedly, Xie, Davidson, and DaDalt (2001) find that Audit Committee members and Board members with corporate or financial experience are associated with less earnings management or discretionary current accruals. These findings suggest that directors and committee members with financial expertise can be useful monitors when it comes to deterring restatements. Klein (2006) studies whether the number of independent members of the Audit Committee or the Board has an impact on earnings management. A critical finding is that committees that are entirely staffed by independent directors have no significant effect 24   See, e.g., Bergstresser and Philippon (2006) and Denis, Hanouna, and Sarin (2006) finding that equity compensation induces misreporting and fraud; Morse et al. (2011) concluding that performance measures are often rigged; and Aboody and Kasznik (2000) finding that equity compensation can influence the timing of option grants. 25   This study and many others in this section are not directly addressing causal inference. Moreover, many do not address the partial observability problem discussed in Wang, Winton, and Yu (2010) and Khanna, Kim, and Lu (2015).

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An analysis of internal governance and the General Counsel  289 on earnings management, but committees with slightly less than a majority of independent directors are negatively and significantly related with the likelihood of earnings management. Klein also obtains a number of other important findings, including that CEO shareholdings are negatively related to fraud (again underscoring the agency cost perspective) and that steps that make boards and committees more independent of the CEO tend to reduce earnings management (e.g., the CEO not sitting on the compensation committee, a large outside shareholder on the Audit Committee).26 This latter finding, when combined with the finding that a wholly independent board does not reduce the likelihood of earnings management, suggests that independence can have costs that make a wholly independent board not as attractive as one where only part of the Board is independent from the perspective of deterring or preventing corporate wrongdoing. A number of other papers examine yet different attributes of board functioning and their association with fraud. For example, larger boards appear associated with weaker board monitoring (Lipton and Lorsch 1992; Jensen 1993; Yermack 1996), and more numerous board meetings appear associated with better monitoring (Vafeas 1999). In addition, board independence may not always reduce fraud incidence due to enhanced board monitoring before a fraud, but may influence the likelihood of fraud because independent boards are more likely to dismiss a CEO once poor performance is revealed (Weisbach 1988). The ex post threat of dismissal may be sufficient to deter some CEOs from engaging in fraud. 2.2.4  The “softer side” of internal governance Although the Board and Audit Committee structure plays an important role in monitoring management, recent studies have started exploring the “softer side” of internal governance. These studies focus on the kinds of relationships and connections people within the firm may share with each other and what impact that may have on fraud incidence and detection. Khanna et al. (2015) examine the role of the CEO’s connections with other corporate leaders, built up through appointments decisions, in influencing the incidence of fraud. They hypothesize that the CEO’s considerable “soft” influence over firm behavior is likely to be amplified if the CEO has strong connections with other executives and directors. This, in turn, is likely to impact fraud incidence and detection. Moreover, at a conceptual level, this could either increase or decrease the likelihood of fraud.27 The article then empirically examines this question by focusing on different sources of connections that a CEO may develop with other corporate leaders—in particular, the connections arising from the CEO appointing (or being involved in the appointment of) other corporate

26   In a similar vein, Mustafa and Meier (2006) examine the role of Audit Committees in policing for misappropriation of assets (not just financial misreporting). Their study relies on 81 misappropriation firms and two control samples of 81 firms. The proportion of independent Audit Committee members is significantly and negatively related to the likelihood of misappropriation. 27   Strong CEO connections could increase the risk of fraud if other executives or directors are inclined to help the CEO cover up fraud or to keep quiet once they discover fraud. On the other hand, close connections could help reduce fraud if it results in other corporate leaders counseling the CEO not to engage in fraud or if the CEO uses her connections to detect and hence reduce fraud. See Khanna et al. (2015) and Khanna (2003).

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290  Research handbook on corporate crime and financial misdealing leaders, and then the connections that arise from the CEO and other corporate leaders sharing similar educational, professional, and social network ties. The key findings are that the appointment-based connections increase the likelihood of fraud and decrease the likelihood of detection. The primary measure of appointmentbased connections is the fraction of the top five executives (or board members) appointed during the CEO’s tenure. Moreover, the effects on the likelihood of fraud and its detection appear to occur through at least three channels—reducing the likelihood of detection (and delaying it) by helping to cover up frauds, reducing the likelihood of the CEO being terminated once fraud is uncovered, and reducing the costs of coordinating wrongdoing. The authors find that moving from none of the top executives (board) being appointed during the CEO’s tenure to all of them being appointed during the CEO’s tenure increases the likelihood of fraud by 20 percent (19 percent) and decreases the likelihood of detection by 12 percent (14 percent). On the other hand, connections based on social network ties do not appear to have similar effects, underscoring that the influence and loyalty obtained through appointment-based connections is important in understanding fraud. In addition to the focus on the “softer” elements of internal governance, this article discusses some key concerns in empirical studies of fraud. First, the data one relies upon in studying fraud often includes suits that may not be instances of fraud (either because they are frivolous or mistaken) and excludes actual cases of fraud that were not discovered or prosecuted. The former problem is often addressed (as in Khanna et al. 2015) by putting in place screens to cull out mistaken or frivolous suits. The latter problem—partial observability—is not often addressed. Khanna et al. (2015)—relying on steps taken in other recent studies of fraud—use the bivariate probit estimation to generate estimates both for the likelihood that fraud is detected and then for the incidence of fraud given detection.28 A second issue this article discusses is identification—how does one gain confidence that the results obtained here suggest a causal relationship? In particular, why might we be confident that causation is running from the CEO’s connections to fraud incidence? This article addresses this issue by relying on an instrumental variables regression where the instrument is the death of the CEO or other corporate leaders. The death of a corporate leader mechanically leads to the CEO appointing new people to the vacated positions (thereby increasing the fraction of corporate leaders appointed during the CEO’s tenure), but is unlikely to be related to the underlying fraud. Other instruments are also used in the article and the main results are robust—indicating a strong case for causal inference. A growing number of other articles also explore these softer connections. Fracassi and Tate (2012) identify external network ties between directors and CEOs and find that CEO–director ties reduce firm value (especially if there are few other governance checks). Further, firms with stronger CEO–director ties seem to have more unprofitable acquisitions. Their study finds that network ties seem to weaken the intensity of board monitoring. Other articles examine whether: (i) social and professional network ties impact fraud incidence (Chidambaran et al. 2012); (ii) social networks serve as important mechanisms

28   For a more detailed description of the bivariate probit model and its key assumptions as used in fraud studies, see Wang, Winton, and Yu (2010).

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An analysis of internal governance and the General Counsel  291 for information flow into asset prices in the mutual fund context (Cohen et al. 2008); (iii) connections to the CEO are associated with divisional managers receiving more capital (Duchin and Sosyura 2013); and (iv) connections between board members of different firms (e.g., board interlocks) are associated with earnings management contagion (Chiu et al. 2013),29 amongst other issues. Although these studies tend to focus on the negative side of connections between key players in the corporate hierarchy (due to the interest in fraud), a number of studies find positive effects of closer connections on other measures of firm performance (outside the fraud context). For example, Edmans, Goldstein, and Zhu (2013) find that closer connections can enhance the CEO’s productivity.30 Finally, although the discussion here has focused on the connections CEOs have with other key corporate players, one should note that even without these kinds of connections, the CEO can have a substantial impact on firm behavior. Many studies find that CEO characteristics matter for a range of important firm behaviors and policies (Bertrand and Shoar 2003; Bennedsen et al. 2006; Cronqvist et al. 2012; Jenter and Lewellen 2015; Graham, Harvey, and Puri 2013). Taken together these studies indicate that connections between the key players in the corporation (especially with the CEO) can have a significant impact on the incidence of fraud. Indeed, scholars have begun to explore what other sorts of connections within the firm, and what other sorts of players, may have an impact on fraud incidence.31

3. ROLE OF THE GENERAL COUNSEL OR TOP LEGAL OFFICER Given the central role of the General Counsel’s office in managing the legal affairs of the firm, it is not surprising that it has become a locus of considerable attention. Morse et al. (2016) examine how changes in the General Counsel’s (GC’s) compensation impact the GC’s various tasks. They begin by relying on DeMott (2012) for a description of the multiple roles that the modern GC fulfills at the firm. These include: (i) strategic advising and mitigating the legal risks of innovation; (ii) compliance with relevant regulations (e.g., insider trading); (iii) monitoring for wrongdoing (e.g., shareholder suits for securities

29   They find that a firm sharing a director with another firm engaged in earnings management is more likely to manage earnings itself. In particular, they find evidence in support of the notion that earnings manipulation can spread through private social networks (like interlocked boards). 30   It is also noteworthy that even without connections or other external governance constraints CEOs may still take into account what other non-shareholder members of the firm may think. Acharya, Myers, and Rajan (2011) develop a model of how a CEO may be influenced in her decisions by the presence of others. In particular, they show that when the firm’s future cash flows depend on the efforts of these others then the CEO may be reluctant to take measures—even without external governance constraints—that leave these others with little incentive to engage in efforts to generate cash flows. One can imagine this applying to corporate fraud as well, although it may be more muted to the extent that fraud is occurring in the firm’s (or CEO’s) last period. 31   For example, Jiang, Petroni, and Wang (2010) find that earnings management is associated with the equity incentives of CFOs, and these may be more important than the effect of the equity incentives of CEOs on earnings management.

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292  Research handbook on corporate crime and financial misdealing fraud, options backdating); and (iv) supervising the work of the legal department (e.g., contract drafting). Given these multiple roles, one can imagine a GC adjusting the time spent on these activities to reflect their own reputational concerns and compensation incentives. Morse et al. then suggest that as the GC’s stock and option compensation changes (specifically the relevant compensation deltas) then they would expect the GC to adjust the time spent on various aspects of her work (e.g., more time on strategy and less on monitoring). To test this they engage in a two-step inquiry. First, they examine the fixed effects of the GC and find that GCs do impact measures for strategy (e.g., investment (proxied by Capex/PPE) and R&D/assets) as well as impacting proxies for compliance and monitoring. Overall, GCs appear to influence firm value. Second, they divide GCs into those hired from a law firm and those hired from another firm. The goal is to use the different backgrounds as an identification strategy, relying on sociological studies that find the different backgrounds are likely to influence how the GC performs in his new role (at least for the first few years). The authors hypothesize that law firm hires probably have less experience with strategy in a business context and hence may hew more closely to compliance and monitoring tasks. The authors then examine what impact changes in stock and option compensation delta have on these two types of GCs. They find that changes in delta are accompanied by payoffs on the strategy role and fewer payoffs on the monitoring role—in other words that there is a trade-off between strategy and monitoring. In particular, they find that a one standard deviation change in delta is associated with an unwinding of 67 percent of governance improvements and a 22 percent increase in the likelihood of securities fraud. This is particularly interesting because a similar trade-off does not appear to be present with compliance and strategy, indicating that GCs prioritize compliance (perhaps for reputational reasons). Further, the trade-offs are more muted when GCs receive stock as opposed to options, which is consistent with the more general findings on the impact of executive compensation on fraud incidence. Although the article makes a number of important contributions, one wonders about the distinction drawn between compliance and monitoring. Both rely in some measure on misreporting (one concerns misreporting according to GAAP and the other misreporting according to the federal securities laws), but the degree of overlap is palpable and seems in need of further discussion. In addition, the identification strategy of separating GCs based on where they were hired from right before becoming a GC may require a little more elaboration and discussion. For example, it is not obvious that the choice of where to hire a GC from (law firm or in-house) is random—one would expect that firms hiring GCs with no prior in-house experience (i.e., only from a law firm) might have some special attributes that made this decision worthwhile versus a firm that wanted a GC who had prior experience working in-house (i.e., selection issues). Moreover, the extent to which a GC hired from a law firm has had prior in-house experience affects the identification strategy used in Morse, Wang and Wu (2016), making it more debatable. Other studies examine the impact of the GC on fraud incidence. Hopkins et al. (2014) examine whether highly compensated General Counsels (as measured by being in the top five highest compensated officers of the firm) are associated with lower quality financial reporting. They posit that highly compensated GCs might compromise their professional

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An analysis of internal governance and the General Counsel  293 judgment. The authors find that firms with such highly compensated GCs tend to have lower quality financial reporting and more aggressive accounting practices. Yet, these same GCs appear to keep the firm in compliance with GAAP and thereby avoid letting the aggressive accounting behavior rise to the level of a violation of the securities laws. This result is consistent with Morse et al. (2016) in the sense that GCs who are paid more are likely to substitute away from tight monitoring, but not to compromise their compliance obligations. Avci and Seyhun (2016) explore the question of why GCs do not appear to be the ones who openly blow the whistle on corporate fraud (Dyck et al. 2010). The authors examine insider trading patterns of GCs and find they tend to match those of top management, which the authors contend suggests that GCs do not blow the whistle because they, like top management, appear to profit from the fraud. Although the results are interesting, the authors do not address whether GCs might be preventing fraud in the first place (rather than blowing the whistle after it occurs which carries reputational and other risks for the GC) or how the partial observability problem (i.e., some frauds are not detected and hence looking at alleged detected fraud may only tell us so much about the population of frauds). Kwak et al. (2012) find that firms with the GC in top management are more likely to issue forecasts, and those forecasts are more likely to be accurate and less optimistic, than firms whose GC is not a member of senior management. Moreover, they find that the market response to these firms’ forecasts is stronger than for other firms, suggesting that the market considers these forecasts more accurate. Finally, a pair of recent papers examines the value of having other corporate leaders with legal training and expertise (i.e., not the GC per se). Litov et al. (2014) examine the value of having lawyers on the Board. They suggest that firm value increases substantially when there are lawyer-directors and they attribute this to a number of factors. First, as the corpus and complexity of regulation has increased, the value of having a senior corporate official with legal knowledge and training has similarly increased. Second, firm value may increase as the amount of risk-taking decreases once a lawyer is on the Board. Finally, the value of the advice provided by lawyer-directors may also contribute to the increase in firm value (e.g., in strategizing about intellectual property rights). They present a substantial amount of empirical evidence in support of these points and conclude that lawyer-directors’ effects on firm value and risk-taking occur “primarily through changes in CEO compensation and how litigation is managed”.32 Henderson, et al. (2017) explore the value of CEOs who have legal training and experience. They find that firms where the CEO has legal expertise are associated with less corporate litigation and a lower proportion of lost and settled litigation (conditional on litigation). These results are robust to many alternative specifications. The authors also explore identification by using an instrumental variable (i.e., the potential pool of executives within a 50-mile radius) and by doing event studies of firms as the Sarbanes–Oxley Act was in the enactment process. They find that firms with lawyer CEOs experienced a positive market reaction relative to firms that did not have CEOs with legal expertise. Although the instrument being used is subject to concerns over selection, the paper provides intriguing results as well as channels through which those results may be occurring (e.g., lawyer CEOs have more board   Litov, Sepe, and Whitehead (2014), at 472.

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294  Research handbook on corporate crime and financial misdealing members with legal expertise (following Litov et al. 2014), and these firms appear more cautious in earnings management).

4. SHOULD THE TRADITIONAL TASKS OF THE GENERAL COUNSEL BE SPLIT BETWEEN THE GENERAL COUNSEL AND THE CHIEF COMPLIANCE OFFICER? The most recent studies of the role of General Counsels increasingly recognize their multiple, and often conflicting, roles. These studies, in turn, raise a number of questions that can be explored more carefully. For example, the conflict in the GCs’ roles has led many to suggest that these roles should be split up amongst multiple corporate players.33 Suggestions include leaving the strategic role, contract drafting, and some monitoring tasks at the GC’s doorstep, and moving compliance and some monitoring tasks to a separate official—the Chief Compliance Officer (CCO)—who can then report directly to the Board or Audit Committee.34 Proponents claim that this separation reduces the conflicts faced by the GC amongst these tasks (making it easier for her to focus on strategy) and enhances the independence of the person in charge of compliance, thereby improving the compliance outcomes as well. The desire for greater independence seems motivated, in part, by recent cases where the GC appears to have been involved in, or aware of, the wrongdoing and did little to stop it, or was prevented from stopping it by other senior corporate executives.35 Making the CCO a direct report to the Board may help to reduce such concerns. By contrast, many in the GC community argue that having a CCO report to the Board is likely to create duplicative efforts and lead to turf wars between the CCO and the GC, with both officers often looking at the same things and each trying to determine which one decides an issue. This is likely to be counterproductive.36 Moreover, splitting the tasks amongst two roles is likely to generate responses from people within the firm that require careful thought. Removing the CCO from the GC’s office also might negatively impact investigations, for example by moving CCO investigatory work out from under the protection of the attorney–client privilege. This suggests that an analysis of the effects of splitting the traditional tasks of the GC between the GC and the CCO is merited. This section embarks on such an analysis by focusing on two scenarios: where all the tasks of the GC are integrated into one official (the GC) and where some tasks are kept with the GC and some are given to the CCO, who reports to the Board and not the GC. Although there are many different ways in which

33   See, e.g., Heineman (2010) and Tabuena (2006). The SEC requires the CCO to report to the Board or the Audit Committee for Investment Advisors and Investment Funds (see supra note 1) and the U.S. Sentencing Commission provides a sentence reduction if this is a feature of a firm’s compliance program (see supra note 1). 34   In this sense the CCO may be akin to the internal audit function, but for the broader compliance-based obligations. 35   See Kim (2005). 36   See Heineman (2010) and interview with Stasia Kelly, Co-Managing Partner of DLA Piper (Americas) and former GC of AIG and Worldcom.

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An analysis of internal governance and the General Counsel  295 these tasks could be divided and how organizational reporting lines and hierarchies might be designed, this section does not attempt to examine all the permutations and combinations. Rather it examines what factors may lead one to prefer splitting tasks between officers versus integrating them under one officer. This section then focuses on how splitting the GC’s tasks between two officers may impact the incentives to gather and use information on legal and compliance matters. The impact on information is critical because for any corporate officer to be effective at her job, she must be able to obtain relevant information. However, gathering information usually takes effort and is costly, which means that the amount gathered is substantially influenced by the incentives and institutional structures officers face (e.g., how the officer’s tasks are allocated). In other words, information gathering is largely endogenous and as such careful attention needs to be paid to how one divides tasks amongst agents. Of course, information collection is also impacted by the incentives of those with the information to provide it (i.e., the other employees and officers). Much of the extant literature does not address this latter point—which is something this section takes up. In addition, gathering information about legal and compliance matters is not only relevant to fraud incidence, but may also impact firm performance more generally. Further, attempts to enhance independence within executive suites may generate responses that affect hiring in ways that might worsen outcomes. Given all these considerations this section examines the likely effects on information gathering in five sub-sections. Although these five effects may not exhaust all possible effects, they provide a useful starting point for analysis. They are: (i) information gathering by the officers at issue (i.e., the GC and CCO); (ii) the ability of these officers to gather information from other employees in the firm; (iii) the impact of this on the firm’s operating performance; (iv) the effects of making the CCO more independent on the selection of other officers or corporate leaders in the firm; and (v) what kinds of incentive and institutional structures might ameliorate some of the concerns raised in the four points above. Although the present analysis is distinctive in focusing on how the tasks of the GC and CCO are divided, it is connected to at least two other important literatures. First, the present analysis is connected to the literature examining the impact of incentive structures, the assignment of tasks, and institutional structures on the gathering and use of information in both private firms and public institutions (Lambert 1986; Lewis and Sappington 1997; Stephenson 2011; Tirole 1986). It contributes to this literature by beginning an exploration of how splitting tasks may influence not only information gathering by the GC and CCO, but also the likely responses of employees from whom the GC and CCO may try to gather information (point (ii) above). Second, the analysis here is connected to a long-standing debate about whether the primary role of the Board should be strategic advising, monitoring, or both (Adams and Ferreira 2007; Adams et al. 2010; Lorsch and Clark 2008; Lorsch and MacIver 1989). In that debate the discussion about whether one organ can perform both tasks effectively bears some similarity to the inquiry here. However, there are some important differences. First, board members are often not full-time employees of the firm (e.g., independent directors), whereas the GC and the CCO are full-time employees. As a result, the GC and CCO possess detailed knowledge of the firm, which independent directors may not. This should enable them to play both

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296  Research handbook on corporate crime and financial misdealing strategic and monitoring roles. Second, the discussion often sets up the contrast between the GC and the CCO as being similar to the contrast between inside and independent directors, which is not an entirely apt comparison. Both the CCO and the GC are full-time employees of the firm and receive their primary source of income from the firm. Thus, they are not independent in the traditional sense of “independent” directors who have no significant financial interests in the firm besides their sitting fees. Further, until quite recently the GC and the CCO were selected by top management and could be removed by them. It is only in the last decade or so that it has become more common for the CCO to be selected by the CEO, but to be subject to removal only with board action. This makes the CCO somewhat less dependent than the GC on top management, and in that sense they might be thought to be more independent. 4.1  Effects on Information Gathering by the Officers The prior literature generally examines ways in which splitting tasks between agents might be desirable from the perspective of information gathering by those agents. For example, Lewis and Sappington (1997) argue that if the firm is primarily concerned about moral hazard issues then integrating tasks in one officer might be beneficial from the perspective of economies of scope, but might make it difficult to motivate both optimal information gathering and the optimal use of that information. They show that splitting the tasks allows for incentive contracts to be written that motivate both optimal information gathering and the optimal use of that information without creating extreme contractual arrangements. Separating tasks however does sacrifice whatever existing economies of scope may arise from task integration. However, if the firm is primarily concerned with adverse selection issues then task integration may be preferable to separating tasks (Baron and Besanko 1992; Gilbert and Riordan 1995). For example, assume that a firm can make a product either through two separate divisions or in a single division, and that each division has private information about its costs. In this situation, the firm would face a problem akin to double marginalization associated with the information if it separated tasks, but not if the tasks were integrated.37 Thus, depending on whether moral hazard or adverse selection are the key concerns, and what the extent of economies of scope are, one might lean towards one type of structure or the other. There are, however, yet other concerns too. Splitting tasks amongst the GC and the CCO also impacts the interaction between the GC and the CCO. This is likely to affect the amount of information gathered. First, to the extent that the tasks of the GC and CCO overlap there is the risk that there would be duplicative efforts in gathering information (Stephenson 2011). This is a cost to the firm. 37   Double marginalization (or the problem of successive monopoly) refers to when two independent firms making complementary products have monopolies. Each firm sets the price and quantities at the monopoly level thereby imposing a larger deadweight loss than a single firm producing both products (because the two independent firms do not take account of the negative externality their pricing is imposing on the other). A typical example is when you have multiple owners of a toll road—the tolls charged are thought to be higher than when there is one owner of the toll road. See Spengler (1950).

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An analysis of internal governance and the General Counsel  297 Moreover, to the extent that the GC (CCO) perceives the CCO (GC) as encroaching on his territory there is the risk of a turf war developing. The competition between them can stymie the effective operation of the firm (Chen 2003; Garicano and Posner 2005; Wilson 2000). In addition, when there are multiple agents gathering information simultaneously there is a risk of free riding where neither agent tries to gather some information thinking that the other will do so (i.e., information “slipping through the cracks”) (Stigler 1961; Persico 2004). This is more likely when the information each agent may gather is at least a partial substitute for the other’s information gathering. If they are complementary then this concern is somewhat mitigated (Stephenson 2011). Nonetheless, this puts a premium on carefully thinking through the assignment of tasks and information flows. For example, one might split the tasks in a manner where the CCO conducts the initial investigation and then it goes to the GC’s office if the investigation results in some indication of a problem. One concern with such an approach is that investigations typically serve multiple objectives—asking if there is a problem, working out how to correct it, and then positioning the firm most favorably for dealing with law enforcement. A separate CCO may design their process to address the first objective (is there a problem?), but that might hurt the ability of the firm to position itself with respect to law enforcement. On the other hand, a combined GC–CCO office may stop an investigation too early because it can see problems with enforcement in the offing. Perhaps a simpler way to put it is that assigning tasks requires careful thought. 4.2  Effects on Obtaining Information from Other Employees Even though the information-gathering activities of the GC or CCO are important, they are not the only significant players. Other employees and executives may possess much information of relevance to the GC or CCO and it is useful to examine what effect separating the GC’s roles between two officers may have on the incentives of these other employees to provide information. Information about legal and compliance issues is complex for a number of reasons: it comes from multiple sources in the firm (e.g., employees or processes), from different levels of employees (e.g., top management or non-top management), and from different settings (e.g., formal or informal/social and strategic versus non-strategic information). To simplify the analysis this sub-section examines the effects of splitting tasks on obtaining information from non-top management employees and then obtaining information from top management employees. 4.2.1  Non-top management employees and information gathering Employees who fall outside the ranks of senior management may view sharing information with the CCO as quite different from sharing with the GC. For example, some employees might be more reluctant to share information with the CCO than the GC because they view the GC as “friendlier” to the interests of the firm. They may perceive the CCO as having a more singular focus on compliance and ethics and to be less beholden to management. This perception is likely related to the fact that in most large firms the GC is now in the cadre of top management, often has a seat in Board meetings and highlevel strategy sessions (which the CCO may not always have), and can be appointed and removed by the CEO without Board approval. The GC is also the firm’s lawyer and in

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298  Research handbook on corporate crime and financial misdealing that sense it is the GC’s job to protect the interests of the firm (making her appear more “friendly” to the firm’s interests). In addition, information provided to the GC’s office generally should be privileged, whereas information provided to the CCO’s office (if it is not part of the GC’s office) likely will not be.38 The combination of these features would probably make some employees more reticent about sharing potentially incriminating evidence with the CCO.39 This concern is likely to be most pressing when the employee is knowingly involved in wrongdoing or when the underlying law is sufficiently unclear that the employee has some uncertainty about whether his information might implicate him or other people he may care about. In such situations the employee may either be unwilling to share the information or only share it with someone who is thought of as “friendly” or sympathetic (e.g., the GC) rather than with someone perceived to be more interested in compliance per se (e.g., the CCO). Moreover, this is likely to be more pronounced when information is conveyed in informal settings as opposed to formal ones (where records may be kept of communications). Indeed, a recent survey conducted by LRN found that firms that combined the GC and CCO roles tended to have higher scores on the effectiveness of their compliance programs than firms with just an independent CCO (LRN 2015). Measures of effectiveness included having fewer negative compliance outcomes, more employee adoption of the company code of conduct (suggesting employees were more likely to support the efforts of the GC/CCO than just the CCO) and more support from senior executives for the GC/ CCO than just the CCO.40 This latter point seemed related to higher levels of trust of the GC. This suggests that the concern identified above is quite real. However, those employees who observe potential issues but are not directly implicated in misconduct may prefer to share information with someone perceived to be less connected to the firm and top management—such as the CCO. In such situations, an employee who takes the risk to share suspicions may be more concerned that her information will not be acted upon if provided to the GC (who may be thought to be more beholden to management) or that she will face retaliation for having reported something. This suggests a more independent officer is likely to get more information from such individuals than a more connected officer. Of course, if the CCO is part of senior management then that CCO may also not get this kind of information easily. Furthermore, there are other relatively independent players in the firm besides the CCO that an employee may approach, such as internal auditors, independent directors and some Audit Committee members, but the general point remains that sometimes an independent officer (like the CCO or an 38   Not everything communicated to the GC’s office will attract privilege (e.g., business matters obtain no privilege), but the chance of obtaining privilege is higher for communications to the GC’s office than to the CCO. Of course, the greatest chance of privilege attaching is to communications to outside law firms, which may be an important reason motivating some firms to “outsource” certain legal matters. See Fox and Martyn (2009) and Miller (2014). 39   The degree of this is likely to depend on many things, including how integrated compliance is within a firm—is it in its own silo or is it integrated throughout? Does compliance also handle corporate ethics (which may correlate with integration of compliance)? 40   Note that having fewer detected negative outcomes might be a result of better compliance or poor detection. Similarly, the significance of this depends on what is being detected—trivial or serious matters. Nonetheless, their results are interesting.

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An analysis of internal governance and the General Counsel  299 independent director) may obtain more information from some employees than an officer thought to be very close to top management or likely wrongdoers. Thus, the impact of splitting the GC’s tasks on obtaining information from non-top management employees depends on which type of employees are more likely to provide information about potential misconduct to the firm: those who are not involved in wrongdoing and quite certain they cannot be implicated or employees concerned about information that may turn out to be incriminating. This is likely to vary with the firm, but is also likely to vary with the industry: more heavily and vaguely regulated industries are more likely to have employees who are uncertain about whether their information might trigger negative consequences for them, and in these situations splitting the tasks might reduce their willingness to share information. Given the increasing level of regulation in the U.S., this deleterious effect on gathering information from other employees merits attention.41 Indeed, the LRN survey noted above seems to reflect this in some measure (LRN 2015). However, other considerations also impact on information collection. First of all, employees are not the only source of information within a firm. Most firms have processes operating that keep track of information that may be relevant to legal and compliance issues. This type of information can be particularly valuable in detecting wrongdoing, assessing its causes, and examining useful responses. Often this may be the kind of information provided by internal control processes, compliance programs, and risk management systems. If these programs are largely automated (i.e., subject to little interference from the typical employee) then they are less subject to the kinds of deleterious effects discussed above. If employees cannot directly influence the information in such systems then the perceptions of employees about who is “friendlier” become less significant.42 When might such processes be more common or more significant? This is a difficult question to answer, but one suspects that these processes are more in the bailiwick of the CCO than the GC (because a significant part of the CCO’s “calling card” is these programs). Thus, one might expect that if the CCO had the authority to report directly to the Board (rather than to the GC) then that CCO may have a larger budget and more space in which to design systems that may be more comprehensive. If so, that suggests that the CCO with direct access to the Board may obtain more process-based information from non-top management employees than the GC. 4.2.2  Top management employees and information gathering Obtaining information from top management raises many of the same issues noted above (e.g., top management is more likely to share information with officers they think

41   One might also believe that when all of top management is involved in wrongdoing then there is little advantage to telling the Board or Audit Committee (they may be reluctant to believe it or may be collegial with top executives) and then it may be better to encourage the employee to take the information to law enforcement, either through use of a bounty or by providing protection against whistleblower retaliation. 42   Of course, even with automation one expects someone will have overall authority to decide when to escalate matters further—thus, discretion is not entirely removed (just reduced). It is conceivable with more artificial intelligence that even these decisions could be partially a­ utomated— although that does not seem like something that is going to happen soon.

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300  Research handbook on corporate crime and financial misdealing are “friendlier” to the firm and management; internal control processes are potentially important). However, there are a couple of additional points worth noting. First, top management may have greater apprehension of communicating information to the CCO than non-top management employees because their bases of liability and reputational harm are likely larger than non-top management employees. They also may be better informed about likely legal consequences than other employees. Second, top management generally has access to strategic information which non-top management does not. If top management is less willing to share strategic information with the CCO than the GC (for reasons noted already) then that leaves the CCO in a particularly problematic position because now she is trying to monitor behavior and enhance compliance at the firm without the benefit of understanding the key strategic moves the firm is making. This makes it more difficult to place whatever information the CCO does receive in an appropriate context, thereby weakening the CCO’s ability to achieve her key goals. Of course, in firms that make the CCO a member of the senior management team, this concern is reduced. Yet it is not eliminated because some important strategic information is provided in less formal settings where the GC’s greater perceived trust level could be important. Given the various considerations at play, it may prove useful to summarize the key points on obtaining information from other employees in the firm. The CCO who directly reports to the Board is likely to gather less information from other employees relative to an integrated GC and compliance officer if: (i)

employees are more likely to either have been knowingly involved in wrongdoing or be uncertain about whether their information incriminates them or others in whom they have an interest (e.g., in heavily and vaguely regulated industries); (ii) if there are weak internal controls, compliance or risk management systems; and (iii) if there is substantial strategic information held by top management that is not communicated to the CCO. 4.3  Information Gathering and Operational Effects The discussion thus far has noted the potential effects on information gathering from splitting the GC’s tasks amongst multiple officers and suggests that if less information is gathered then the likelihood of fraud might increase. However, lesser amounts of information are likely to hurt the firm’s operational decisions too. For example, if employees are reluctant to communicate with the CCO they may also be reluctant to communicate with other employees who may be approached by the CCO for information. If this is a frequent occurrence then employees may start hoarding information and become more secretive. This would make operational decisions more challenging because it is difficult to engage in coordinated action if employees have a greater level of mistrust with each other. This, of course, is fine if the coordinated action is illegal. But when the law is vague (as it often is in the corporate crime area) the distinction between acceptable behavior and wrongdoing is murky, which may lead employees to avoid sharing information even for behavior that is, in the end, legally acceptable. This could have negative consequences for firm value beyond those associated with increased risk of wrongdoing because it would chill desirable behavior and perhaps lead to weaker firm performance. Moreover, if the

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An analysis of internal governance and the General Counsel  301 firm were to perform poorly then prior studies have found that the risk of fraud is likely to be higher (Alexander and Cohen 1996; Arlen and Carney 1992; Bebchuk and Bar-Gill 2002). Of course, one might counter that the potentially increased risk of fraud associated with splitting tasks should be balanced against the possibility that the GC will perform her remaining tasks better without the inconvenience of having to manage compliance and monitoring. This is of course possible, but it is subject to the caveat that the GC’s other tasks may be performed more poorly if they are not informed by compliance and monitoring information. 4.4  Influence on the Selection of Other Corporate Players Splitting the tasks of the GC amongst multiple players may not only influence the amount of information gathered and operational performance as noted above, but also may influence who is hired into certain positions at the firm. By requiring some tasks to be undertaken by officers who are perceived to be more independent than the GC (or not as beholden to top management), there is the possibility that management will select executives for other positions who are even more beholden to senior management than before. For example, pushing for a more independent compliance officer (with a direct report to the Board) may induce the CEO to appoint a GC or CFO who is even more beholden to the CEO than before to counter-balance the CCO. Although this might sound far-fetched, there is increasing evidence that when the demands for board independence grew around the turn of the millennium, CEOs started appointing other senior executives who were even more connected and beholden to the CEO than the insiders selected previously (Kim and Lu 2017). Moreover, as prior research notes, increasing CEO connectedness (e.g., the fraction of the top executives appointed by the current CEO in her tenure) increases the risk of wrongdoing (Khanna et al. 2015). 4.5  Incentive Structures and Institutional Design The analysis in this sub-section suggests that splitting the tasks of the GC into two roles—the GC and the CCO—may have some advantages (i.e., the independence of the top compliance officer from top management), but some disadvantages too (e.g., lesser amounts of information being provided, duplicated effort, and the possibility for poorer operational decisions). Which of these sets of effects is likely to triumph in the end may depend on context (or the wrongdoing in question). However, the extant literature on internal structures at private firms and in the public sector suggests that changes made to the institutional design and incentive structures within the firm or entity can help to reduce some of the concerns associated with splitting roles. This suggests that even if one were to conclude that in most instances splitting tasks might result in less information, more wrongdoing and weaker operating performance, we might still be able to make the split in tasks desirable by adjusting incentive structures and institutional designs. For example, in firms that split the GC and CCO we might witness the staggering of an investigation first through the CCO’s office, and, if it seems serious, then to the GC’s office. Although this has some advantages, it raises some concerns, as noted earlier. The broader topic of this kind of institutional design and adjustment is left for later work, but I flag

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302  Research handbook on corporate crime and financial misdealing it here because the concerns noted in this section are not faits accomplis—organizational designers and regulators can put in place some measures (e.g. veto rights, supermajority votes, evidentiary burdens) that might reduce some of the concerns noted in this section.

5.  EMPIRICAL INQUIRY Because the effects of splitting the traditional tasks of the GC between the GC and the CCO depend on context, that suggests this may be an area ripe for empirical inquiry. Although an empirical inquiry is beyond the scope of this chapter, one can examine the kinds of issues that would need to be addressed in conducting such a study. In order to test the effects of separating the traditional tasks of the GC between two officers we would need a way to divide firms into those that have all the functions under one department and those that have separated out compliance from these other functions (i.e., a CCO who can report directly to the Board or Audit Committee, not to the GC). This data is not that easy to obtain because it requires getting access to some kind of organizational chart for each firm or survey data, which is not often available publicly. For example, the LRN study, which is based on survey responses, finds that in their sample about 42 percent of all firms have the CCO report to the GC, 28 percent have the CCO report to the CEO, and 14 percent have the CCO report to the Board (LRN 2015). Once this kind of data is obtained for a large enough sample then we would need to compare fraud incidence in these two groups (along with good control variables and so forth). This approach is likely to have a number of problems, ranging from data collection (self-selection in the firms that respond to the survey and incomplete survey responses that undermine researchers’ ability to draw a useful organizational chart) to the more conceptual issues—the way firms divide their internal organization is endogenous, which complicates empirical inquiry. One approach—following some of the other corporate fraud studies—might be to generate a matched sample (or some type of propensity matching). For example, code the internal structure at firms accused of fraud as well as firms that are their industry and size-matched peers (but not accused of fraud) and try to assess the impact of the internal structures. Although potentially informative on some dimensions, such a study is unlikely to convincingly show causal inference and does not by itself address the partial observability concern (i.e., not all fraud is detected so looking at detected fraud as a proxy for all fraud may be misleading). However, one might be able to do better if it were possible to provide an exogenous reason for why firms may differ in their decision to split GC functions into multiple offices, or some other reason for thinking we can create useful treatment and control groups. It seems unlikely that a random experiment would be practical in this context (e.g., where all firms in an industry whose name ends with “m” adopt one internal structure and all the other firms adopt a different practice), and thus we need to explore alternatives. It appears that the SEC requires investment advisors and investment funds to have a CCO (separate from the GC) who reports to the Board or Audit Committee.43 This forced

43   See Rules 38a-1, 206(4)-7, 204-2 and Part 1, Schedule A, Item 2(a) of Form ADV. Discussion available at: http://www.sec.gov/rules/final/ia-2204.htm

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An analysis of internal governance and the General Counsel  303 separation by law tends to create uniform practices/structures in this industry. However, it may be that some other industries share many of the same/similar characteristics to investment advisors, but would not be required to follow this rule (e.g., “shadow” investment advisor industries). Examples might include insurance firms, broker/dealers, other financial institutions and so forth.44 Although these sectors are not identical to investment advisors or funds (and have different regulatory structures), they do share some similarities that might make them a useful control group in a study.45 These are plausible future studies one could conduct to examine the question of whether separating out compliance from the GC’s other tasks is likely to reduce the incidence of fraud (or otherwise impact the firm). I leave that inquiry for future work.

6. CONCLUSION The empirical study of corporate fraud and wrongdoing has grown dramatically over the last two decades, with a host of studies identifying a number of factors related to the likelihood of fraud and its detection. In the last five years, scholars are increasingly focusing on internal governance and the roles of specific players in the corporate hierarchy. In particular, the spotlight is shining on the General Counsel or Top Legal Officer, whose responsibilities usually include preventing or reducing illegalities at the firm. One of the most important issues affecting the General Counsel’s office is whether the General Counsel should remain responsible for compliance, or whether the traditional tasks of the General Counsel should be divided between the General Counsel and a Chief Compliance Officer (who reports directly to the Board). The implicit, and often explicit, rationale for this is that the General Counsel has other duties that may conflict with compliance, and hence it may be desirable to have more independent officers, who report to the Board, in charge of compliance. Although independence is often thought to be valuable in reducing wrongdoing, in this context it is likely to come with some additional costs that may make gathering information on wrongdoing more difficult. Moreover, this analysis underscores that greater attention to understanding the effects of reforms on information gathering within the firm may be critical to obtaining a better understanding of what may be most effective in reducing wrongdoing. In particular, we must gain a better understanding of how other employees and officers in the firm may respond to attempts to gather information by the GC or the CCO. Indeed, it may well be the case that having the Chief Compliance Officer report directly to the Board and not the General Counsel could result in increased

  See Kelly interview, supra note 36.   An alternate approach would be to look at firms that were required as part of settlements or court sanctions to ensure that their CCOs did not report to any of the top executives (but instead reported to the Board or Audit Committee). This appears to be a fairly common term in many deferred prosecution agreements (DPAs). One might consider a study comparing firms subject to such DPAs with other matched firms (again either by industry-size or a propensity score match such as Dechow, Ge, Larson, and Sloan (2011)) to explore what the effects might be. However, without some good explanation for why the firms with DPAs are roughly similar to other firms, such an inquiry raises many of its own questions. 44 45

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304  Research handbook on corporate crime and financial misdealing wrongdoing and weaker operating performance in some instances and better outcomes in others. This chapter begins the inquiry into what factors may drive the likely outcomes and also suggests that, given these potentially conflicting effects, empirical inquiry into this question is likely to be valuable. This chapter suggests some ways in which future research might then explore this question.

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13.  When the corporation investigates itself Miriam H. Baer* 1

1. INTRODUCTION The internal corporate investigation, once viewed with a certain level of distaste, has become a mainstay of the corporate enforcement landscape. Corporations investigate their employees for a variety of reasons: to protect themselves from employee-directed misconduct; to assure their shareholders that the company has in place effective internal controls; and, finally, to preserve the corporation’s ability to seek leniency from government enforcers who might otherwise hold the entity strictly liable for its employees’ violations of law. No longer a one-time or strictly episodic event, the investigation has become an integral component of the firm’s compliance department. Corporations invest considerable resources—in some cases hundreds of millions of dollars—in the identification and reconstruction of wrongdoing that has occurred within the firm (Griffith 2016). Government prosecutors and regulators, in turn, encourage and rely upon their corporate counterparts’ information-generating activities (O’Sullivan 2007). No wonder, then, that as the legal services industry emerges from its recession, the corporate investigation business continues to generate substantial revenues (Weisselberg and Li 2011). Simply put, the investigation business is booming. The corporate investigation also now attracts a fair amount of scholarly inquiry. Analytically, the literature divides into three strands. The first revolves around the question of inducement: Which rules most effectively prompt corporations to investigate themselves? The second is more doctrinal and practical, involving the corporation’s day-to-day implementation of its policing powers and its consequent relationship with its employees. The third directs attention to matters of institutional design, and attempts to identify the type of relationship between corporate investigators and external enforcers that produces optimal results. It is tempting to view these literatures separately, arising as they do at chronologically distinct points in time and in different contexts. We worry about inducement in the abstract and before any investigation has actually occurred; the investigation’s effect on employees when investigations actually take place; and institutional design questions in the aggregate. There is a common theme, however, that binds the three categories together, and it is the problem commonly referred to as detection or punishment avoidance. Individuals who knowingly engage in wrongdoing go to great lengths to evade detection and punishment (Sanchirico 2006; Tabbach 2010; Nussim and Tabbach 2009). These

  *  I thank Jennifer Arlen and Sean Griffith for their generous feedback on this project as well as Jennifer Arlen’s invitation to write this chapter, and Geoff Miller for his helpful commentary on several of the issues discussed in this chapter.

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When the corporation investigates itself  309 efforts generate challenges not just for external enforcers, but also for corporate investigators, particularly corporate attorneys who operate according to a complex set of norms, professional rules, and well-guarded legal privileges. As a result, the policies and rules that purport to induce corporate investigations generate a number of unintended and undesirable consequences, all of which potentially undermine the corporate investigator’s relationship with her government counterpart on the one hand, and her relationship with the firm’s employees on the other. Imagine an adversarial contest between government enforcers and a corporate firm’s employees. In the middle of this fight stands the corporate investigator, who is expected to develop relationships with both factions, even though she nominally represents the firm. To gain the government’s trust, the corporate investigator must be willing to relay information provided to her by her firm’s employees. And to gain the trust of her firm’s employees, the investigator almost certainly will be forced at times to push back when government enforcers articulate various requests. Moreover, while mediating these relationships, the investigator must internalize increasingly voluminous laws that govern workplace relationships and privacy. Thus, if one is to understand the corporate investigation’s inducement, implementation and design challenges, one must first grapple with the investigator’s challenge of reconciling her competing obligations to the government on one hand, and her firm’s employees on the other. That trilateral relationship, in turn, is dominated by actual and perceived detection avoidance—by both the firm itself as well as its managers and lower-level employees. This chapter proceeds as follows. Section 2 briefly describes the internal investigation. Section 3 traces the origins of the firm’s legal obligation to self-police, articulated by, among other things, a series of memoranda issued by the Department of Justice and eventually memorialized in its United States Attorneys’ Manual. Section 4 explores the three major questions raised by corporate internal investigations, namely inducement, implementation and institutional design. Section 5 analyzes the ways in which detection avoidance shapes and ultimately undermines the relationship between government enforcers and corporate investigators. Finally Section 6 contrasts two new developments likely to impact corporate investigations: the government’s latest announcement of its policy on corporate cooperation (i.e., the Yates Memo) and the law’s increasing interest in ensuring workplace privacy. These competing developments portend an uncertain and somewhat unstable backdrop for corporate investigations as their volume and relevance continues to increase.

2.  CORPORATE INVESTIGATION DEFINED A corporate investigation is an inquiry performed by employees or agents acting on the corporation’s behalf to determine whether the firm—i.e., the firm’s employees or contractors—has violated the law. It is distinct from a purely operational or strategic review. Because the investigation is implemented and directed by the corporation, and not a government prosecutor or regulator, it is a subspecies of self-policing, representing the government’s quasi-delegation of enforcement power to the firm itself (Stafford 2011, p. 2296). Although small firms investigate instances of wrongdoing on an ad hoc basis, most

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310  Research handbook on corporate crime and financial misdealing publicly held corporations now host free-standing functions, often referred to as “compliance departments,” devoted to ensuring the firm’s regulatory and legal compliance (Miller 2014). This is true as well of privately held investment firms, such as hedge funds. The compliance function vests a certain number of executives with the responsibility for initiating, overseeing, and communicating the results of such investigations (Miller 2014, Chapter 10 in this volume; Griffith 2016). The obligation to investigate employees may reside within the corporation’s compliance department or within the general counsel’s office, or be executed by members of both departments, as well as outside counsel ­contracted by the corporation (DeStefano 2014a, 2014b; Khanna, Chapter 12 in this volume). An investigation can be episodic, in that it responds to a specific allegation of wrong­ doing, or periodic, in that it occurs periodically on a scheduled basis. It can be proactive or reactive; it is often the subject of attorney supervision, although not always; it may extend globally and therefore trigger concerns about different sovereigns’ laws (Dervan 2011). Corporate investigators provide valuable information to the corporation’s management, including the board of directors or relevant committee tasked with investigating serious allegations of fraud or similar wrongdoing (Bennett et al. 2006). Corporate investigators also play an important signaling role throughout the firm, as they communicate to employees the company’s views regarding legal and ethical compliance.1 At the same time, investigations serve as a signal to outside enforcement agencies of the corporation’s interest in ferreting out wrongdoing (Bennett et al. 2006). Corporate investigations have become, over the past several decades, a lucrative source of business for Wall Street law firms, accounting firms with forensic investigation units, and standalone boutiques (Weisselberg and Li 2011; Baer 2009). Many of those who make up the private investigator workforce have prior experience working for the federal government, either as prosecutors or regulatory enforcement attorneys (Weisselberg and Li 2011; Zaring 2013). Not all investigators are attorneys, however, and the line between “legal” and “compliance” activity tends to blur, particularly when both departments play a role in the corporate investigation (DeStefano 2014b; Rostain 2006; Khanna, Chapter 12 in this volume). Investigations fall within three general categories. The first and most common type of investigation emerges from the corporation’s auditing function, wherein the corporation follows up on concerns flagged by an auditor. Policing of this sort occurs at all levels, may be conducted primarily by non-lawyer corporate employees (although some may have received legal training (DeStefano 2014b)), and occurs before any serious specific allegation of wrongdoing has surfaced. The second is a firm-initiated investigation in response to specific allegations that the firm has violated the law. The investigation may concern solely the firm’s employees, or it may extend to firms and individuals with whom the corporation does business. Attorneys are more likely to direct this type of investigation, and the firm may hire outside counsel skilled in white-collar matters. If the matter concerns the corporation’s accounting,

 1   Investigations thus alleviate the “credibility problem” that arises when employees ignore their firms’ threats to sanction misconduct because they assume their respective employers would just as soon ignore the misconduct and sweep it under the rug (Arlen and Kraakman 1997).

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When the corporation investigates itself  311 auditing or internal controls, the investigating attorneys generally report their findings to the corporate board’s audit committee (Bennett et al. 2006). The third and final type of investigation, which often serves as the backdrop for scholarly discourse, is the high-stakes internal investigation that arises either in response to or in tandem with a full-blown government investigation. Investigations of this sort already presume the knowledge and indirect participation of enforcement officials, such as the SEC’s Enforcement Division (SEC), a state attorney general, the Criminal Division of the Department of Justice (DOJ) or one or more United States Attorneys’ Offices. This third species is consistently spearheaded by attorneys, and includes the corporation’s board and audit committee, and quite often outside counsel from law firms who are not intimately associated with the defendant corporation’s day-to-day business and who are expected to initiate and manage communications with government investigators and attorneys (Bennett et al. 2006). ­

3.  THE LEGAL OBLIGATION TO INVESTIGATE Many firms would rationally monitor their employees to prevent entity-wide harm, regardless of the law’s mandate. Crimes such as embezzlement, theft, and misuse of corporate resources benefit the employee at the expense of the employer. Other crimes erode the corporation’s reputation with customers (see Alexander and Arlen, Chapter 4 in this volume). Thus, firms retain strong economic and reputational incentives to identify and punish some employee misconduct, regardless of any outstanding liability rule. Some criminal acts, however, benefit not just the employee, but also the corporation itself, at least over the short run. Moreover, within the publicly held company, criminal behavior such as fraud often benefits the corporation’s managers at the expense of its owners, the public shareholders (Arlen and Carney 1992). Prior to detection, fraud props up the corporation’s stock price, benefits officers and directors, and even helps those shareholders savvy or fortunate enough to sell stock while the fraud remains undetected (Coffee 2006, p. 1560). To overcome management’s inclination to ignore or promote illegal behavior, numerous legal regimes command or strongly encourage the corporation to investigate and report instances of wrongdoing (Stafford 2011; Arlen and Kraakman 1997). Some mandates are general and directed at all “organizations,” whereas others impose specific legal obligations on members of a particular industry. The backdrop for this evolving obligation is federal criminal law’s broad rule of respondeat superior liability (Garrett 2014, pp. 35–36; Khanna 1996, pp. 1488–1490). Under this rule, the corporation can be held liable for its employees’ misconduct provided the employee has acted within the scope of his employment and with at least a partial purpose to aid the corporation2 (Alexander and Cohen 2015, p. 543). Combined with an extensive federal criminal code that criminalizes most willful violations of regulatory law, the respondeat superior standard ensures technical liability for a wide array of corporate actors. Federal prosecutors could, if they wished, fill their federal criminal docket with   New York Cent. & Hudson River R.R. v. United States, 212 U.S. 481, 493–494 (1909).

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312  Research handbook on corporate crime and financial misdealing c­orporate charges for violations of the federal securities, anti-bribery, environmental, banking, and health care laws, among others. The collateral costs of indicting or convicting a publicly held entity or financial institution, however, render criminal convictions undesirable, at least with regard to financial and accounting firms, as well as corporations conducting business in highly regulated industries that rely strongly on licensing schemes (Baer 2009; Gilchrist 2014).3 For all these reasons, prosecutors tend not to indict most publicly held corporations for offenses that could trigger such consequences (Alexander and Cohen 2015).4 Instead, the government chooses from a sliding scale of responses and corresponding penalties. When the company alerts authorities and freely shares the results of its investigation, the government may, depending on the presence or absence of other factors, reward such forthrightness by declining to take any negative action towards the company. The Department of Justice’s treatment of Morgan Stanley, which reported its investigation of one of its managing directors who had violated the Foreign Corrupt Practices Act, is often used as an example of how the government rewards corporate self-policing.5 If, instead of cooperating with authorities, the company actively undermines the government’s investigatory efforts or conducts a sham compliance program, the government may demand a guilty plea, either from the company itself or one of its subsidiaries (Alexander and Cohen 2015). The subsidiary indictment, although harsh in its own right, differs substantially from an all-out indictment of the corporate parent in that the subsidiary charge effectively shields the parent from the effects of its subsidiary’s conviction (Golumbic and Lichy 2014).6 For the remaining offenders (i.e., those who fall within the middle of the spectrum), the government may choose a deferred or non-prosecution agreement (DPA or NPA) (Alexander and Cohen 2015; Garrett 2014). The former involves the filing of a criminal

 3   Some scholars are more skeptical of the collateral costs argument and contend that more corporate defendants could weather formal federal charges without unleashing significant or systemic harms (Garrett 2014; Markoff 2013).  4   By contrast, Alexander and Cohen (2015) find that both the Antitrust Division and the Environmental Division favor formal conviction over alternative resolutions (such as DPAs), even for publicly held firms, although even here, the formal conviction may be limited to a subsidiary entity, mutually agreed upon by the subsidiary’s parent and government prosecutor.  5   For examples of speeches by DOJ officials to this effect, see Lanny A. Breuer, American Conference Institute’s 28th National Conference on the Foreign Corrupt Practices Act, 2012 WL 5784942 (discussing the prosecution of Morgan Stanley’s managing director and subsequent decision to decline the prosecution of Morgan Stanley); Marshall L. Miller, Remarks at the Advanced Compliance and Ethics Workshop, 2014 WL 4978800 (same); James M. Cole, Government Enforcement Institute at the University of Texas School of Law, 2014 WL 2111105 (contrasting Morgan Stanley’s good behavior with Credit Suisse’s obstructive conduct).  6   It should be noted that none of these are true “indictments” since an indictment would require the government to bring its case before a grand jury and secure a “true bill.” In reality, even the “subsidiary indictment” reflects the filing of an “information,” a legal document filed by the government that initiates the case in federal court and that cannot be filed absent a defendant’s waiver. See Fed. R. Crim. Proc. 7(b). Accordingly, even the subsidiary “indictment” reflects a settlement process between government and corporate attorneys (Golumbic and Lichy 2014, pp. 1332–1333).

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When the corporation investigates itself  313 information (the legal equivalent of an indictment, absent the necessity to present the case before a grand jury) against the corporate entity, as well as an agreement deferring further prosecution of the corporation. In some instances, the government has charged and demanded a guilty plea from a corporate subsidiary while simultaneously executing a DPA or NPA with the corporate parent (Alexander and Cohen 2015). Whereas the DPA involves a court filing and a formal deferral of prosecution pursuant to the Speedy Trial Act, the NPA includes no formal charges and is characterized solely by the execution of an agreement between the government and the offending actor (Alexander and Cohen 2015). DPAs and NPAs ordinarily require the payment of some fine or restitution; the admission of certain facts establishing guilt; promises of remediation, in some instances aided or verified by some third-party monitor; and cooperation in the identification and prosecution of guilty individuals (Garrett 2011, 2014; Alexander and Cohen 2015; Arlen and Kahan 2017). The Federal Principles of Prosecution of Business Organizations, which have been incorporated into the United States Attorneys’ Manual, set forth the various factors prosecutors are expected to consider when deciding among the alternatives of seeking an indictment, entering into a DPA or NPA, or declining prosecution entirely.7 These factors include, among others: the pervasiveness of wrongdoing; the presence of an effective compliance program (including the monitoring and discipline of wayward employees); and the extent to which the corporation disclosed information to authorities and cooperated in the government’s investigation of wrongdoing (Baer 2008).8 Individually and in the aggregate, the Federal Principles all but require the publicly held corporation’s implementation of a compliance function (Arlen and Kahan 2017), which includes the corporation’s internal investigations unit. In the event federal prosecutors do in fact seek criminal charges, the corporation can benefit at the sentencing stage from its internal investigatory efforts. Under Chapter Eight of the now-advisory United States Sentencing Guidelines (commonly referred to as the “Organizational Sentencing Guidelines” or OSG), a corporation can receive reductions in its “culpability score” by demonstrating the presence of an “effective compliance and ethics program.”9 Self-reporting and remediation, as well as cooperation with the government merits additional reductions in sentence (Schipani 2009). Many other laws directly or indirectly encourage corporations to investigate themselves. The Sarbanes-Oxley Act of 2002 obligates publicly held companies to maintain and certify adequate “internal controls” for financial reporting, although this requirement  7   Department of Justice, United States Attorneys’ Manual, Criminal Division Manual, Title 9-28.300, available at http://www.justice.gov/usao/eousa/foia_reading_room/usam/title9/28mcrm. htm#9-28.300  8   In September 2015, the Department of Justice announced a change in its charging policy for corporate organizations. I discuss this new policy infra in the final section of this chapter.  9   USSG 8B2.1 (defining compliance program); 8C2.5 (f) (providing a three-point reduction for the presence of a compliance program, provided the organization did not delay the reporting of wrongdoing to “appropriate governmental authorities”). Section 8C2.5’s reduction may not apply if high-level personnel “participated in, condoned, or [were] willfully ignorant” of the charged offense. 8C2.5(f)(3) (creating a rebuttable presumption that the organization lacked an effective program).

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314  Research handbook on corporate crime and financial misdealing has been rolled back somewhat for smaller, less capitalized firms.10 The Foreign Corrupt Practices Act requires that corporations keep adequate “books and records” of employees’ expenditures in order to deter and detect bribery.11 Many federal agencies (such as the Environmental Protection Agency, the DOJ’s Antitrust Division, the Department of Health and Human Services) offer corporations varying levels of leniency (from reduced sanctions to outright immunity) in exchange for information gleaned through internal investigations (Stafford 2011). Finally, Delaware law itself has recognized the corporate director’s fiduciary duty to “attempt in good faith to assure that a corporate information and reporting system . . . exists.”12

4. THE STUDY OF CORPORATE INVESTIGATIONS: THREE QUESTIONS As the corporate investigation has become more commonplace, legal scholars have begun to consider its wide-ranging implications. Relevant questions cluster within three separate categories: the first focuses on the optimal liability rule for inducing self-policing; the second on the rights and privilege issues that arise out of the investigation’s implementation; and the third on the relationship between the internal corporate investigator and the public prosecutor or regulator (“enforcer”). 4.1  Inducing Investigations The early literature on corporate criminal liability does not focus so much on the content of investigations, but rather on the optimal liability rule for inducing them. Scholars have long debated which type and standard of liability best induces corporate compliance. The variables include criminal versus civil liability (Fischel and Sykes 1996; Khanna 1996); collective versus individual liability (Khanna 1999); and negligence versus strict liability (Arlen and Kraakman 1997). Arlen and Kraakman’s seminal contribution demonstrates the benefits of a two-tiered “composite” liability system, whereby the corporation is subject to a more lenient sanction if it meets some level of “care” in policing its employees and reporting wrongdoing, and a much harsher sanction if it declines to engage in such self-policing (Arlen and Kraakman 1997). Arlen and Kraakman dub this scheme “composite liability” because it incorporates characteristics of both strict and fault-based liability schemes (Arlen and Kraakman 1997). The arguments in favor of composite liability arise out of Arlen’s previously articulated insight that strict liability creates perverse incentives for corporations (Arlen 1994). Although the strict liability rule encourages prevention efforts, it discourages internal 10   Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 302, 116 Stat. 745, 777–778 (2002) (codified at 15 U.S.C. § 7241 (2000)). Pub. L. No. 107-204 § 906(a), 116 Stat. at 806 (codified at 15 U.S.C. § 1350). Ibid. § 404, 116 Stat. at 789 (codified at 15 U.S.C. § 7262). 11   Foreign Corrupt Practices Act (FCPA),  Pub. L. No. 95-213, Title I, 91 Stat. 1494 (1977) (codified as amended at 15 U.S.C. §§ 78dd-1 et seq.).  12   In re Caremark Int’l, Inc. Derivative Litig., 698 A.2d 959, 970 (Del.Ch.1996).

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When the corporation investigates itself  315 policing because policing tends to reveal employee crimes for which the corporate employer is strictly liable (Arlen 1994; Arlen and Kraakman 1997). To the extent that a corporate self-policing program detects wrongdoing after the fact, the program increases the corporation’s liability costs without any corresponding benefit (Arlen 1994). Fault-based liability, on the other hand, unleashes a different set of problems. Because it excuses the firm that has otherwise complied with its duty to self-police, it fails to internalize fully the corporate actor’s harms; moreover, it is subject to judicial error (Arlen and Kraakman, 1997). In addition, it eliminates the firm’s incentive to avoid the implementation of policies (e.g., compensation or promotion tournaments) that induce fraud or similar misconduct among employees. In response to these two poles, Arlen and Kraakman’s composite liability concept erects a hybrid two-tier model that, on one hand, incentivizes self-policing and reporting, and on the other hand, internalizes the costs of wrongdoing, thereby ensuring efficient activity levels among corporations (Arlen and Kraakman 1997). The firm that adequately selfpolices and voluntarily discloses wrongdoing still pays a penalty, but it pays a substantially lesser penalty than it would have had it dispensed with self-policing and disclosure. The argument for composite liability dovetails quite nicely with Robert Innes’ work on leniency and its positive effect on organizational self-policing (Innes 1999, 2000, 2001). Composite liability also overlaps to some degree with the theory of governance known as “responsive regulation,” a type of regulation first theorized and then promoted by John Braithwaite and Ian Ayers that advises under-resourced regulators to calibrate their enforcement responses, particularly when corporations self-report violations of law (Ayers and Braithwaite 1992). Much of the early inducement literature appears to rest on the unstated presumption that courts will serve as the ultimate arbiters for deciding whether a given corporation qualifies for harsher or more forgiving treatment (Khanna 2000, p. 1272). As we now know, courts rarely decide this question, as few cases even reach the indictment stage (Garrett 2014). Instead, prosecutors do much of the work. Accordingly, later waves of scholarship have explored the questions of both prosecutorial incentives and prosecutorial-driven agency costs (Ribstein 2011), and have advanced normative arguments for constraining prosecutorial discretion by shifting remedial decisions to courts (Garrett 2014). 4.2  Implementing Investigations: Rights and Privileges It is one thing to induce corporate investigations. It is quite another to execute them in a way that accords with the law. This subsection deals with the implementation of corporate investigations, which focuses primarily on the corporation’s rights and privileges, as well as those of its employees. As this subsection demonstrates, these issues underscore the broader struggle over who controls the flow of information: the government, the corporation, or the individual corporate employee. 4.2.1  The corporate attorney–client privilege Of all the legal issues stemming from the corporate investigation, the corporate attorneyclient privilege has attracted the greatest and most sustained attention from jurists, practitioners and scholars. The debate is fairly straightforward. Ex ante, a broad privilege encourages clients to

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316  Research handbook on corporate crime and financial misdealing consult attorneys on transactions of doubtful legal provenance; consultation, in turn, reduces the likelihood of criminal wrongdoing (Kaplow and Shavell 1989). Ex post, the analysis grows more complicated (Kaplow and Shavell 1989). A narrow privilege (and the availability of waiver) eases access to communications made in the course of an internal investigation; reduces the government’s investigatory burden; and enables the government enforcer to confirm the corporation’s claim that it has met its investigatory burden. A broader privilege, by contrast, vests within the corporation exclusive control over the flow of communications between its employees and its lawyers. At the very least, a robust privilege increases the government’s independent investigatory burden, and at its worst, it masks corporate management’s complicity. Although scholars recognize the ways in which privileges can be counterproductive (Arlen and Kraakman 1997; Richman 2008; O’Sullivan 2008b), neither the legal community nor jurists have indicated any willingness to part with them. On the contrary, whenever the corporate privilege appears threatened, the defense bar heatedly warns of its demise and its deleterious effect on the American adversarial system (Zornow and Krakaur 2000). Whether the tenacious adherence to privilege reflects deep-seated feelings about the attorney–client relationship, or distinct but related concerns against corporate self-incrimination (O’Sullivan 2007), or is instead a more cynical manifestation of the corporate manager’s interest in avoiding punishment, are questions best reserved for later. For now, it is helpful to consider the corporate privilege’s modern doctrinal evolution. Most contemporary analyses begin with the Supreme Court’s 1981 decision in Upjohn v. United States, an early foreign bribery case in which a corporate parent conducted an internal investigation of one of its subsidiaries.13 After the corporate parent voluntarily disclosed its subsidiary’s wrongdoing to the SEC and the IRS, the government initiated its own investigation and sought access to written questionnaires that the corporation’s counsel had drafted and distributed to employees, as well as notes and memoranda of interviews conducted with said employees. Citing privilege and work product protection, the company declined to produce them.14 Addressing a percolating circuit split, the Supreme Court clarified that the corporation’s privilege was not limited to communications between corporate counsel and the high-level employees (the so-called “control group” test), but applied generally to communications (regardless of the speaker’s position within the firm) in which the corporation was either seeking or receiving legal advice.15 Following Upjohn, the privilege continued to serve as a source of contention among corporate defense attorneys, government prosecutors and third-party plaintiff attorneys. Throughout the 1990s and 2000s, prosecutors and SEC enforcement attorneys attempted to work around the doctrine by seeking privilege waivers from corporate defendants seeking lenient treatment (Schipani 2009; O’Sullivan 2008a). Although the DOJ stopped short of imposing waiver as a formal condition (Buchanan 2004), individual prosecutors threatened recalcitrant attorneys that they would indict their organizational defendants,

  449 U.S. 383 (1989).   Upjohn, 449 U.S. at 386–388. 15   Ibid. at 386. 13 14

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When the corporation investigates itself  317 and a widely criticized “culture of waiver” arose among corporations and their attorneys (Schipani 2009; O’Sullivan 2008a). In the years following a 2008 change in DOJ policy, wholesale corporate privilege waivers have become rare (Kaal and Lacine 2014). Nevertheless, government and private attorneys continue to grapple with the privilege’s effect on corporate investigations. Prosecutors say they are entitled to, and continue to demand, the firm’s full disclosure of all relevant “facts” (O’Sullivan 2008b). At the same time, documentation of those facts may well be embedded in communications the corporation claims to be privileged (O’Sullivan 2008b, p. 1262). Thus, the corporation’s lawyer must walk a tightrope; he must assure the prosecutor that he has in fact conveyed all relevant information to the government, but he must also do so in a manner that preserves the corporation’s privilege, assuming the corporation wishes to preserve it. Moreover, if corporate investigators wish to preserve the privilege at all, they must pay attention to how they structure and staff their investigations at the outset. As noted earlier, investigations embrace several types of inquiries and can be performed by a mix of personnel. Given the multiple types of “investigations” that arise within the corporate context, no single doctrinal rule cleanly resolves the issue. Instead,  ­several  ­heuristics dominate. A routine audit performed by a non-attorney and conducted for no ostensible legal advice-giving purpose receives no protection. Confidential communications between the corporation’s attorney and employee, and undertaken for the primary purpose of securing legal advice, are certainly privileged (O’Sullivan 2008b, p. 1262). Between these two poles, uncertainty—and consequently, litigation—prevails. The D.C. Circuit’s decision in In re Kellogg Brown & Root16 reflects the difficulty inherent in distinguishing an “ordinary audit” from a protected legal investigation. In a qui tam suit brought under the False Claims Act, the defense contractor, Kellogg Brown and Root (KBR), asserted a privilege claim over documents it had created in the course of its internal investigation of over-billing allegations.17 The district court reasoned that KBR’s records were not entitled to privilege protection because the company had instigated the investigation pursuant to Department of Defense contracting regulations that required KBR to maintain a compliance program, “rather than for the [primary] purpose of obtaining legal advice.”18 Recognizing the lower court’s “purpose” test would effectively eviscerate the privilege for most corporate investigations, the D.C. Circuit granted KBR’s writ of mandamus and vacated the lower court’s order and opinion.19 Specifically, the D.C. Circuit found that KBR’s assertion of privilege “was materially indistinguishable” from Upjohn; because KBR had initiated and conducted its investigation in order to “gather facts and ensure compliance with the law after being informed of potential misconduct” the materials produced during its investigation were protected by the attorney–client privilege.20 That the investigation simultaneously served regulatory or strategic concerns was irrelevant. So long as a “significant” purpose of   In re Kellogg Brown & Root, Inc., 756 F.2d 754 (D.C. Cir. 2014).  Ibid. 18   U.S. Ex. Rel. Barko v. Halliburton Co., 37 F.Supp.3d 1, 5–6 (D.D.C. 2014). 19   In re Kellogg Brown & Root, Inc., 756 F.3d 754, 757 (D.C. Cir. 2014). 20  Ibid. 16 17

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318  Research handbook on corporate crime and financial misdealing the investigation was to secure legal advice, KBR’s communications with its employees were privileged.21 Meanwhile, during roughly the same time period, the Delaware Supreme Court affirmed the Chancery court’s ruling that a shareholder-plaintiff pension fund was entitled to documents created in the course of Wal-Mart’s internal investigation of Foreign Corrupt Practices Act (FCPA) violations by its subsidiary, WalMex.22 The pension fund, the Indiana Electrical Workers Pension Trust (IBEW) sought Wal-Mart’s internal investigation records pursuant to a “books and records” request filed under Section 220 of the Delaware Code23 for the purpose of investigating possible fiduciary violations by Wal-Mart’s officers and directors.24 Wal-Mart argued the documents were protected by the attorney–client privilege and work product doctrines.25 IBEW premised its entitlement to the otherwise privileged documents on the fiduciary exception to the attorney–client privilege set forth in Garner v. Wolfinbarger.26 Garner had held that when shareholders file derivative suits claiming fiduciary violations, courts can dispense with the corporate privilege provided the shareholders could show “good cause” for production of materials in question.27 In a very narrow opinion, the Chancery court in Wal-Mart agreed that limited production was appropriate under Wolfinbarger.28 Wal-Mart appealed the Chancellor’s decision and lost; the Delaware Supreme Court explicitly adopted Garner and affirmed its application to proceedings conducted under Section 220.29 The reaction to the case was certainly more muted than the reaction to the lower court’s decision in KBR. The lower courts in KBR and Wal-Mart each employed what one might call a ­“de-privileging” device. The device adopted by the district court in KBR was blunt and threatened to destroy the privilege for most corporate investigations. By contrast, the fiduciary exception featured in Wal-Mart was context-specific and narrow. It should come as no surprise, then, that the D.C. Circuit tossed out the broad rule while the Delaware Supreme Court approved the narrower one. There are, of course, other factors that distinguish the two cases, including the negative publicity that had already attached to Wal-Mart’s bungled investigation by the time IBEW sought the relevant documents. Together, the two cases demonstrate the judiciary’s inclination to uphold the privilege 21  Ibid. at 760. Although the Supreme Court rejected the relator’s subsequent petition for certiorari in January 2015, U.S. ex rel. Barko v. Kellogg Brown & Root, Inc., 135 S.Ct. 1163 (2015), the lower court judge presiding over the case eventually identified additional grounds for stripping KBR’s investigation materials of the privilege and work product protections. KBR again sought mandamus, which the D.C. Circuit again granted. In re Kellogg, Brown & Root, Inc., 796 F.3d 137 (D.C. Cir. 2015). 22   95 A. 3d 1264 (2014). 23   8 Del §220. 24   Wal-Mart, 95 A.3d at 1268. 25  Ibid. at 1269. 26   430 F.2d 1093 (5th Cir. 1970). 27   Garner v. Wolfinbarger, 430 F.2d 1093, 1103-04 (5th Cir. 2970). 28   Wal-Mart, 95 A.3d. at 1270. The Chancery Court simultaneously “ordered Wal-Mart to produce documents protected by the attorney work-product doctrine” (ibid.). The facts that establish “good cause” under Garner should ordinarily establish the same claim to documents otherwise deemed attorney work-product. 29   8 Del. 220(b).

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When the corporation investigates itself  319 overall, paired with a willingness to dispense with it when its true beneficiaries (the corporation’s shareholders) show good reason to doubt corporate management’s good faith. Taking a step back, one cannot help but view with some skepticism the corporate defense bar’s reflexive embrace of the privilege. For every corporate investigation, two potential bottlenecks restrict the flow of information: the first pertains to the movement of information from rank-and-file employees to corporate management.30 The second concerns the flow of information from the corporation itself to the government enforcer. While purporting to solve the first bottleneck problem, Upjohn invariably worsens the second. Even under a regime that obligates the corporation to disclose all relevant “facts” to a government prosecutor, the corporation can still withhold, under the guise of privilege and work product protection, the very documentation that would most easily confirm the veracity of its disclosures. Moreover, it is unclear how well Upjohn cures the first bottleneck. There is little direct empirical support for the supposition that a corporate privilege causes individual employees to report more information to the corporation’s investigator-attorneys, particularly information relating to prior misconduct (Sexton 1982, pp. 466–467; but see Khanna, Chapter 12 in this volume, suggesting it should). Khanna argues that employees who have engaged in wrongdoing may be more comfortable advising the corporation’s attorney of their situation (Khanna, Chapter 12 in this volume), but it is difficult to understand why they would be so enamored of a privilege over which they have no control. As white-collar practitioners well know, Upjohn’s legacy is the so-called Upjohn warning, wherein the corporation’s attorney advises the employee-interviewee that the attorney represents the corporation and that it is the corporation, and the corporation alone, that maintains the discretion to hold or waive the privilege (Giesel 2010).31 Certainly, the more worldly employees who comprehend this warning understand that Upjohn offers them no incentive to talk to corporate counsel, since the corporation can hand-deliver their information to the government.32 Thus, if the Upjohn corporate privilege enhances internal information flows within the firm, it does so either because individual employees misunderstand the privilege (Podgor and Green, 2013), or are supremely confident in the belief that their employer will vigorously defend its entity-level privilege rights. Such   For more on internal information gathering, see Khanna, Chapter 12 in this volume.   Admittedly, not every employee will comprehend the Upjohn warning (Podgor and Green, 2013), and some attorneys may obfuscate the matter by softening it. Nevertheless, the mainstream view is that attorney-investigators should warn employees that the privilege resides solely with the corporation. See e.g. In re Grand Jury Subpoena: Under Seal, 415 F.3d 333, 340 (4th Cir. 2005) (warning AOL attorneys not to issue “watered down” Upjohn warnings, as they present “a potential legal and ethical minefield”). 32   The corporate privilege debate highlights Kaplow and Shavell’s seminal comparison of legal advice before and after an individual undertakes an action: ex ante, legal advice may persuade rational actors to conform their behavior with the law; ex post, the same advice may result in the shielding of relevant information from fact-finders (Kaplow and Shavell 1989, p. 597). The corporate investigation occupies an odd space between “ex ante” and “ex post.” For the corporation’s board members, the investigation and the advice accompanying it are prospective, as they relate to future conduct such as remediation and self-reporting. At the same time, and particularly for an individual employee, the investigation is retrospective; it relates to events that occurred in the past. Accordingly, the social desirability of legal advance may be more ambiguous than most commentators are willing to admit. 30 31

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320  Research handbook on corporate crime and financial misdealing c­ onfidence, if it in fact exists, cannot help but appear extremely naïve. In many instances, the firm’s interests will diverge from that of the employee who admits wrongdoing (Laufer, 1999). Thus, if we assume most employees in fact understand the difference between a personal privilege and a corporate one, not to mention the many other downsides of admitting wrongdoing to their employer, it is difficult to believe the “corporate privilege” strongly improves information flows across the firm, particularly in regard to wrongdoing that has already occurred. If the corporation really wants to obtain information from its employees (and that “if ” is admittedly a big sticking point), the corporation’s most reliable tool for eliciting information from recalcitrant employees is not the specious carrot of a corporate-wide privilege, but rather, the blunt stick of employee-termination (Buell 2007). Given the termination threat’s importance, it is difficult to say that Upjohn uniquely facilitates communication between employees and corporate management. Even when it does, it forms a barrier between corporate management and anyone else who decides to sue the company in regard to its wrongdoing. Admittedly, government investigators are free to perform their own investigations by interviewing witnesses or serving subpoenas for documents. But this final point undermines the entire basis for a self-policing regime. If one of the purposes of the corporate investigation is to save the government time and resources (O’Sullivan 2007), one can only be skeptical of claims that the corporate privilege furthers this goal. 4.2.2  Employee confessions Apart from organizational privilege issues, internal investigations trigger concerns regarding the corporate investigator’s interaction with lower and mid-level employees. In considering this issue, it is helpful to divide the employee population into two categories: those sophisticated enough to recognize the risks inherent in speaking to a corporation’s investigator, and those who reflexively and inaccurately treat the corporation’s investigator as their agent. The corporate investigator’s interaction with the unsophisticated employee differs little from the ordinary police interrogation: despite warnings by corporate investigators that they represent the corporation as a whole and not the individual employee, corporate employees often fail to comprehend the magnitude of risk inherent in speaking freely with a corporate investigator (Podgor and Green 2013). When employees misunderstand Upjohn warnings, they become more likely to reveal incriminating information, because they mistakenly believe their information will remain confidential (Podgor and Green 2013). The corollary to this critique is that intense or deceptive forms of questioning at the hands of the corporate investigator may cause an otherwise innocent employee to admit conduct she has not in fact committed.33 In addition to questioning the accuracy and fairness of confessions, critics argue that underhanded investigatory tactics may erode the corporate workforce’s sense of “procedural justice,” thereby leading employees to distrust the firm, and, quite ironically, comply less often with internal codes and external laws (Tyler 2005). Notwithstanding

33   Saul Elbin, When Employees Confess, Sometimes Falsely, New York Times, March 8, 2014 (describing false confessions by employees in the context of corporate investigations).

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When the corporation investigates itself  321 these prudential concerns, those who criticize the power imbalance between corporate investigator and employees have yet to offer a coherent argument why investigators and employees should be on some idealized “equal” footing, particularly when such equity is notably absent in government investigations. As Buell points out, the corporation benefits from the overly talkative employee in much the same manner that a police officer benefits from the suspect who duly ignores his Miranda warnings (Buell, 2007). But what about the sophisticated employee, who either refuses to meet with interrogators at all, or demands that he be permitted to bring his counsel to such meetings? For this type of employee, the police interrogation analogy is inapt. Whereas the police cannot compel a confession from an in-custody defendant who requests an attorney, the corporate investigator operates outside the Fifth Amendment’s privilege against self-incrimination. Accordingly, except where he appears to be acting at the direction of government officials, the corporate investigator can threaten recalcitrant employees with termination (Buell 2007).34 Some scholars have criticized this set-up, arguing that the “speak-or-we-will-terminate” threat unduly forces the corporate employee into a revised version of the so-called cruel trilemma of perjury, self-accusation, or contempt (Podgor and Green 2013, pp. 87–88).35 In the corporate context, the three options instead appear to be “lie to the investigator,” self-accusation, or termination for failing to cooperate with investigators (Podgor and Green 2013). Curiously, this choice does not arise when the government is itself an employer conducting its own internal investigation. There it is bound by the Garrity case, which renders it a violation of the Fifth Amendment to threaten a government employee with termination if he fails to cooperate in an investigation.36 Some contend that Garrity immunity ought to extend to private employees (Griffin 2007). Others scholars, however, are less sympathetic to this view: “It is hard to imagine a single investigation of wrong­doing committed in a firm progressing past square one under a regime that [tells] employees: ‘You may refuse to answer questions in any internal inquiry and no penalty will follow’” (Buell 2007, p. 1678). A final concern relates to the corporation’s effort to control the employee’s subsequent conduct by conferring confidentiality status on the contents of the employee’s interview with the firm’s attorneys. Kellogg Brown and Root (KBR), whose legal woes were discussed at length in the preceding section, directed its employees not to disclose the contents of their in-house interviews with anyone outside the company. The SEC’s Enforcement division interpreted KBR’s direction as an attempt to muzzle potential whistleblowers and directed KBR to amend its confidentiality agreements and to pay a $130,000 penalty.37

34   For the rare example of a case in which a district court found the threat of termination to constitute state action, see United States v. Stein, 440 F.Supp.2d 315 (SDNY 2006). 35   Murphy v. Waterfront Comm’n, 378 U.S. 52 55 (1964) (articulating the trilemma in regard to an individual defendant). Buell criticizes the direct application of Murphy’s trilemma in the corporate context, where the defendant faces, at worst, termination from employment (Buell 2007). 36   Garrity v. New Jersey, 385 U.S. 493, 496 (1967). 37   SEC: Companies Cannot Stifle Whistleblowers in Confidentiality Agreements, April 1, 2015, http://www.sec.gov/news/pressrelease/2015-54.html

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322  Research handbook on corporate crime and financial misdealing 4.2.3  Privacy and related concerns Corporate investigators do more than interview employees. They also monitor employees and social media (sometimes surreptitiously) and review mountains of documents and electronic data. All of this activity raises privacy concerns, not only for rank-and-file employees but also for middle managers and even top executives and board members. To what extent can a corporate investigator comb through the employee’s emails, search his  computer files, or look through the documents at his workstation when he is not present? As an initial matter, the internal corporate investigation ordinarily has little to do with the Constitution. Neither the Fifth nor Fourth Amendments regulate purely private activity.38 So long as the corporate investigator acts independently, and not as an agent of the government (i.e., fails to engage in “state action”), he need not worry that he has transgressed constitutional boundaries.39 Nevertheless, the investigator is still subject to a patchwork quilt of statutes and regulations promulgated by the particular jurisdiction in which the employee’s workspace is located (Fink 2014). Certain state statutes, such as Connecticut’s for example, forbid an employer’s search of an employee’s emails without prior notice (Ciocchetti 2011).40 Accordingly, covert investigations, the bread and butter of federal enforcement agencies, may be particularly difficult (if not i­mpossible) for the corporate investigator to execute without potentially transgressing various laws. If the company does business abroad, the headaches multiply. Foreign regulations such as the European Union’s Directive on Data Privacy require the corporate investigator to pay far closer attention to the manner in which data is accumulated and held, as well as how (if at all) it is transferred back into the United States (Gurkaynak and Durlu 2013; Dervan 2011; George et al., 2001). Moreover, some foreign nations place many more restrictions on the corporation’s ability to interview its employees, particularly if a government investigation has already commenced (Dervan 2011, p. 380). Finally, if the corporation reports the results of its investigation to authorities, in some states it must also contend with possible defamation claims (Ladd 2014). Although the Texas Supreme Court recently confirmed that statements contained in a corporation’s report to the DOJ arising out of an FCPA investigation were absolutely privileged from

38   City of Ontario v. Quon, 130 S.Ct. 2619, 2630 (2010) (private employer’s search of employee’s email or pager data not implicated by Fourth Amendment). 39   See, e.g., Burdeau v. McDowell, 256 U.S. 465 (1921). State action ordinarily does not arise simply because a company conducts an internal investigation following a government agency’s service of a subpoena or request for documents. Rather, state action arises when the private investigator’s “specific” conduct becomes “entwined” with that of the government. See United States v. Stein, 541 F.3d 130, 147 (2d Cir. 2008) (explaining the nexus requirement as it applies to corporate actions undertaken in the shadow of a government investigation). See also Blum v. Yaretsky, 457 U.S. 991, 1004 (1982) (explaining the strict nexus requirement to ensure that “constitutional standards are invoked only when it can be said the State is responsible for the specific conduct of which the plaintiff complains”). 40   See Conn Gen Stat § 31-48d(3)(b) (requiring employers who engage in “any type of electronic monitoring” to give “prior written notice to all employees who may be affected,” which can be accomplished by a public notice posted in a conspicuous place). For a state-by-state analysis of workplace laws and electronic monitoring, see, e.g., Mark W. Robertson and Anthony DiLello, State By State Employee Monitoring Laws, LAW 360 (April 17, 2009).

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When the corporation investigates itself  323 defamation claims,41 the uncertain contours of that privilege (which is qualified in other states) leaves ample room for vexatious and expensive litigation (Egozi 2016). 4.3  Optimizing the Relationship between Public Enforcers and Private Investigators Having successfully induced corporations to investigate themselves and to navigate the various legal issues that accompany the investigation’s implementation, a policymaker must also decide how best to structure the investigator’s relationship with the public enforcer.42 After all, the investigation is valuable only if the corporation conveys its information to the appropriate authorities. Thus, we come to the final question: which relational structure optimally facilitates the sharing of information between private investigators and public enforcers? This public–private question has begun to attract greater attention among scholars, albeit not directly in regard to corporate investigators and public enforcers. Scholars have theorized the optimal relationship between public regulators and private plaintiffs’ attorneys in civil litigation (Rose 2010). Scholarship examining whistleblowing and qui tam regimes also theorizes the optimal relationship between public and private enforcers (Engstrom 2014, Chapter 14 in this volume; Casey and Niblett 2014; Rose 2014). Finally, Stephenson has carefully analyzed the various ways in which sequential and competitive models affect multiple agents in their acquisition of information (Stephenson 2011). None of the foregoing, however, explicitly addresses the design issues inherent in directing the relationship between a private corporate investigator and a public government enforcer. Accordingly, with these analogous discussions in mind, this section briefly sketches the problem. Three models could plausibly describe the relationship between a public enforcer (i.e., a prosecutor or SEC enforcement attorney) and a corporation’s private investigator. For ease of exposition, the section refers to them as sequential, cooperative, and competitive. Each presents a unique mix of benefits and drawbacks; for reasons that will be explained below, the competitive model has gradually become the model that best describes today’s investigatory climate, although some may conclude it includes characteristics of the other two models. ●

The sequential model: Under the sequential model, the corporation is responsible in the first instance for detecting, gathering evidence of wrongdoing, and then disclosing that information to a prosecutor or regulator for further action and development. Similar to the relay runner who passes a baton to his teammate after he has completed his leg, the corporate investigator passes his findings and analysis on to the government agency, whose agents are tasked with continuing and finishing the so-called race. ● The cooperative model: Under a cooperative model, public and private investigators

  Shell Oil Co. v. Writt, 464 S.W.3d 650 (Tex. 2015).   For the purposes of this chapter, the term “private investigator” refers to the point person  the  corporation designates to lead the investigation and report its contents to outside authorities. 41 42

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324  Research handbook on corporate crime and financial misdealing concurrently investigate wrongdoing and freely share information. They leverage each other’s competencies, pool resources, and decide jointly how to proceed, although, as described below, one “partner” inevitably takes direction from the other. ● The competitive model: Finally, under the competitive model, the two investigators work independently, with the recognition that they are, to some extent, adversaries. Each side races to be the first to develop evidence of corporate wrongdoing, knowing that such early knowledge conveys a distinct advantage. Resources, competencies and incentives drive the choice of model. If the corporation is best positioned to collect and interpret early signals of wrongdoing, and the government best situated to discipline and sanction employee-wrongdoers, then a sequential, batonpassing model quickly emerges as the optimal one since it best leverages each institution’s comparative advantages. Corporate investigators can detect and remediate early instances of wrongdoing, and, like the experienced relay runner, hand over evidence of serious wrongdoing to federal regulators and prosecutors. The problem with the sequential model is primarily one of trust. The government does not trust the corporation to provide timely or complete information. Moreover, even in those instances where trust is not an issue, the public enforcer sometimes prefers to direct the investigation from the very beginning, in part because it wishes its investigation to remain covert or seeks evidence of industry-wide malfeasance. Thus, the sequential model of investigations has its limits. Given the foregoing, the parties might instead adopt a cooperative model, wherein the government and corporate investigator share information freely from the earliest stages of the investigation. The unstated assumption underlying this model is that the corporate investigator effectively reports to or takes directions from the public investigator (First 2010). To the extent the corporate investigator is an attorney or directed by one, this model most explicitly challenges the traditional conception of the attorney as the client’s ethical but zealous representative; if the corporation’s attorney defers too easily to the public enforcer (particularly by becoming some sort of junior investigator), she cannot possibly render anything close to “zealous” representation. Aside from ethical implications, the cooperative model is further hampered by the Constitution’s distinction between private and state action. When the corporate investigator works in tandem with the government enforcer (i.e., interviews witnesses jointly, searches emails and documents together), the corporate investigator’s searches and interrogations morph into state action, and therefore become subject to Fourth and Fifth Amendment protections. To put it simply, the government and private investigators can do less when they act together than when they act independently. Accordingly, private and  public  investigators maintain ample reason to conduct their affairs semi-independently. When the sequential and cooperative models become practically unworkable, the competitive model emerges by default. This third and final model treats public and private investigations as time-bound adversaries: whoever uncovers wrongdoing first “wins.” If the private investigator uncovers and voluntarily discloses wrongdoing to the government, her employer preserves the opportunity for leniency and the lesser sanction

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When the corporation investigates itself  325 that accompanies it.43 If, however, the public enforcer beats the private investigator to the punch, the public enforcement agency obtains the upper hand in ensuing negotiations. The competitive model’s presumptive advantage is its effect on corporate investigators. When the corporate investigator is the only game in town, she can pick and choose the tips as she wishes and she can bide her time. The presence of an eager and willing competitor, however, compels the corporate investigator to work harder and investigate reports of wrongdoing more expeditiously. Working harder, however, can translate into more aggressive, intrusive tactics by the corporate investigator, triggering the various workplace issues described earlier in this chapter. By the same token, the corporate investigator’s desire to wrap everything up quickly may cause her to jump to inaccurate conclusions, thereby resulting in the wrongful termination (or worse) of employees who have done nothing wrong. Variants of this argument have surfaced in response to the memorandum issued by Deputy Attorney General Sally Yates (known as the Yates Memo), which amplifies the corporation’s obligation to investigate and identify errant employees.44 Temporally pressed investigators, Yates Memo critics contend, will become more aggressive in identifying (i.e., scapegoating) wrongdoers, even if those wrongdoers are factually innocent (Joh and Joo 2015). These critics echo previously articulated warnings that overly aggressive investigations may cause employees to become disaffected and (ironically) more prone to committing or acquiescing in their co-workers’ misconduct (Baer 2008; Tyler 2005). An additional drawback of the competitive model is that in many instances, it sets the company up for failure. When it comes to investigative ability, the corporation and the government are not equals. Those who demand “more” of the corporate investigator tend to assume a level of omniscience among company personnel that, at least in the context of the large organization, is largely unrealistic. Corporate investigators certainly benefit from the employee’s incentive and natural inclination to report information internally (Feldman and Lobel 2010). There are limits, however, to the corporate investigator’s ability to secure information from its employees. For example, the corporation cannot promise the limited immunity that prosecutors extend witnesses as part of their government proffer sessions (Buell 2007). Nor can the corporation easily pay employees a special earmarked bounty for information regarding wrongdoing. Granted, the corporation can promise promotions and a better career trajectory for internal reporters, but it cannot implement the same, cash-for-information program that has become the hallmark of the SEC’s whistleblowing program (Engstrom 2014). Were a corporation to do so—that is, to bluntly offer cash bounties for information provided to its compliance officer—it would undermine the very notion that all of its

43   This voluntary disclosure premium has grown in importance following the DOJ Fraud Section’s announcement of its 2016 Pilot Program for violations of the Foreign Corrupt Practices Act. U.S. Dept of Justice, Criminal Division, Fraud Section, The Fraud Section’s Foreign Corrupt Practices Act Enforcement Plan and Guidance, April 5, 2016, available at https://www.justice.gov/ opa/file/838386/download 44   Deputy Attorney General Sally Quillian Yates Delivers Remarks at New York University School of Law, Sept. 10, 2015, at https://www.justice.gov/opa/speech/deputy-attorney-general-sallyquillian-yates-delivers-remarks-new-york-university-school; Sally Quillian Yates, Memorandum, Individual Accountability for Wrongdoing, September 9, 2015, available at http://www.justice.gov/ dag/file/769036/download

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326  Research handbook on corporate crime and financial misdealing employees are obligated, as a matter of law and ethics, to report wrongdoing and cooperate with internal inquiries. Moreover, were a corporation to offer such a bounty, it would have to contend with the expressive effects of its payout. Too low a payout would suggest the corporation does not care about reducing crime; too high a payout would convey the corporation’s fear that it is riddled with crime. Either way, the payout’s expressive effects could undermine its informational benefits. Then again, if the most useful information resides with the employee who has participated in the underlying corporate fraud, then the bounty question becomes largely moot. The SEC’s whistleblowing program stops short of rewarding the convict who reports his own fraud (Pacella 2015), and, in any event, most rational fraudsters value their liberty far more than an uncertain government payout (Baer 2017). Accordingly, with regard to inducing confessions from guilty employees, the focus ought to be on the respective abilities of the corporate and government investigator to promise immunity from prosecution or reduced penalties. And with respect to quelling the guilty employee’s fear of imprisonment, the government is the unquestioned champion (Baer 2017). The government can immunize employees from individual prosecution; and it can promise fines instead of jail time or at least the opportunity for a vastly reduced sentence of imprisonment. The corporation, by contrast, can promise none of these things. On the contrary, to secure the organization’s leniency, the corporation must noisily communicate its willingness to ferret out wrongdoing and identify wrongdoers (or even suspected wrongdoers) to government investigators and prosecutors. In other words, the very rule intended to induce corporate self-reporting pairs organizational leniency with individual intolerance (Baer 2009). The corporation must adopt a strict, take no prisoners attitude with its own employees if it is to save its organizational skin. The government, by contrast, can choose from a mix of carrots and sticks depending on the situation; it can afford the luxury of dispensing mercy in strategically valuable situations. Savvy employees aware of this distinction (or advised by competent attorneys) will therefore “sell” their information to the highest and most flexible bidder: the government.

5. CORPORATE INVESTIGATIONS AND DETECTION AVOIDANCE The preceding sections demonstrate the profound difficulty in investigating corporate crime, particularly financial fraud, which is likely to be covert in the first instance. Much of the difficulty stems from what others have referred to as “detection avoidance” or “punishment avoidance” (Sanchirico 2006; Nussim and Tabbach, 2008, 2009). Employees who desire not to be caught red-handed can destroy documents on the one hand, or claim privacy violations and legal privileges on the other (the latter reflecting a form of “non-regulable” avoidance) (Nussim and Tabbach 2008). Regardless of its form, detection avoidance limits the investigator’s access to information and delays her ability to act. The previous section’s discussion underscores avoidance’s elusive nature: the efforts to eliminate or reduce organizational avoidance can unwittingly create problems at the individual employee level, which in turn undermines the relationship between internal investigators and external enforcers. No matter how faithfully a prosecutor follows the composite liability prescription, or how doggedly the corporate investigator monitors

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When the corporation investigates itself  327 corporate employees, some employees will likely commit crimes and those employees will retain an ample incentive to engage in both legal and illegal forms of detection avoidance. Thus, for both corporate investigator and external enforcer, uncertainty will often rule the day. Still, most corporate investigators are more knowledgeable about their companies than the external prosecutors and agents with whom they interact (Arlen 2012). Legal doctrines such as the corporate attorney privilege exacerbate this asymmetry. The company knows more about itself than the external enforcer tasked with evaluating the company’s investigative efforts. Some companies, moreover, will find it more profitable to short-change or dress up sham investigations rather than engage in real ones. The familiar lemons problem arises when good faith corporate investigators pool with window-dressers (Akerlof, 1970). Prosecutors and regulators, who lack complete information about firms and assume assurances of self-policing is just “cheap talk” will rationally discount the value of the information they receive. As a result, the government will pay increasingly “less” for the product it distrusts. Organizational leniency will therefore become, over time, less generous. Akerlof’s seminal paper on the market for lemons illuminates the earlier fights over corporate privilege waivers that arose in the early 2000s. First, prosecutors, who distrusted the corporate bar’s claims of self-policing, sought privilege waivers. Waivers, in turn, permitted the government cheap verification of the corporate investigator’s claims and also operated as a costly credible signal. That is, the corporation gave up something valuable in order to signal its bona fides. Nevertheless, even as it received waivers, the government continued to devalue the information it received, complaining that companies had engaged in insufficient investigation of wrongdoers. Corporate lawyers began to portray the privilege waiver as a stripping of rights and not as a precursor to securing a better deal. In sum, waivers failed to solve the lemons problem, and arguably sent negative signals to corporate employees. Accordingly, the corporate bar vigorously complained and the government eventually backed down on its waiver requests. Apart from waivers, how else might the “good faith” corporation overcome the lemons problem? Wealthier corporations can signal their sincerity by hiring former prosecutors to head up internal compliance offices and conduct investigations. The signaling tactic works to the extent current prosecutors trust former ones. But to maintain that trust, former prosecutors-turned-investigators must approach the corporation’s employees as potential liars and criminals. Add to this milieu a fair amount of turnover within the Department of Justice and the United States Attorneys’ Offices, and one winds up with an unstable signal. With this backdrop in mind, one can now comprehend why the focus on individual rights has risen to prominence within this field. Because it distrusts the corporation, the government discounts corporate self-policing; to signal that their self-policing is genuinely better than the pack, some corporations react by aggressively monitoring and investigating their own employees. In response to such aggression, the corporation’s employees (who may be rationally fearful of scapegoating (Laufer 1999, 2002)) increasingly seek protection in privacy and workplace statutes, as well as legal ethics doctrines. Notice, then, that the corporate compliance officer or general counsel (or whoever is in charge of corporate investigations) must navigate two pooling problems. She must find a way to signal to government prosecutors and regulators that hers is the “good” type of corporate citizen; one that responds to red flags and diligently investigates all plausible

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328  Research handbook on corporate crime and financial misdealing leads. At the same time, she must also contend with the corporation’s employees, whose indignant privacy claims may be genuine, amount to little more than a spirited attempt to save one’s skin, or something in between. Investigators are thus placed between a rock and hard place. If the corporate investigator credits the workforce’s concerns too much, government regulators may conclude that the corporation is interested in only the most superficial of compliance efforts (Krawiec 2003). If, on the other hand, the corporate investigator ignores privacy concerns, she may perversely erode, among the corporation’s rank and file employees, the intrinsic desire to comply with law (Tyler 2005). Thus, the detection avoidance angle helps explain why corporations aggressively seek protection under attorney–client privilege and yet hire expensive white-collar law firm departments to conduct extensive investigations. It explains as well why some companies increasingly embrace privacy protections for employees and consumers while also insisting that they can be trusted to monitor and promptly disclose wrongdoing. The same angle also explains why government prosecutors promise leniency for corporate monitoring on the one hand, and yet, on the other hand, seem so keen to develop their own channels of information through whistleblowing programs and more intrusive measures such as wiretaps. Ultimately, detection avoidance elucidates the weaknesses underlying one of the key premises of corporate self-reporting. Corporate investigations are prized because the corporation supposedly has a leg up on the government investigator in ferreting out wrongdoing and figuring out who did what, who knew what, and who stood by and looked the other way (Buell 2007; Arlen and Kraakman 1997). In a world where employees are fully aware of the corporation’s incentives to investigate them (and one in which laws increasingly favor workplace privacy and fairness), detection avoidance may well subvert these informational advantages. Knowing that this dynamic exists, how should we structure the relationship between corporate investigators and government enforcers? Arguably, caution is the best policy for now. The competitive model that currently describes the relationship between prosecutors and SEC enforcers on the one hand, and private corporate investigators and attorneys on the other, is probably the best and only one we will have for the time being. But at some point, pressure on corporate investigators to be the “first” to come forward may become counterproductive. By the same token, corporate defense attorneys might wish to consider their reflexive reliance on the corporate attorney–client privilege. To the extent the privilege keeps information outside the hands of federal prosecutors, those prosecutors are likely to discount the value of corporate investigations. Discounts, in turn, further undermine the leniency-for-self-policing regime. Years from now, the most exciting anti-fraud developments may arise from outside the corporation, from the expansion or emergence of new whistleblower programs, to the DOJ’s use of undercover tools formerly reserved for narcotics and street crime prosecutions (Barkow 2014). That is, even as agencies stress the value of self-policing to corporate investigators and attorneys, they may eventually develop alternative methods for securing evidence of wrongdoing (Joh and Joo 2016). Meanwhile, corporations will continue to police themselves, if for no other reason than that policing has become an embedded norm.

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When the corporation investigates itself  329

6. CONCLUSION This chapter traces the corporate investigation’s evolution and challenges, and describes the difficult relationships the corporate investigator must navigate, as she attempts to prove her trustworthiness to both corporate employees and government prosecutors and regulators. Detection avoidance drives much of this story: to demonstrate the corporate firm’s bona fides, the corporate investigator must investigate aggressively and disclose gratuitously. But this demeanor has the potential to drive information further underground, as corporate employees recognize the increasing importance of evading detection. Two recent developments further affect this analysis. First, the Department of Justice announced on September 10, 2015 yet another revision to its Principles of Federal Prosecution of Business Organizations.45 The new policy, which as of this date has received much fanfare but has yet to be applied negatively to any particular corporate offender, warns corporate organizations that in order to receive any cooperation “credit” from the federal prosecutors, the corporate offender must cooperate fully in the government’s investigation. Although the Department’s initial announcement of the policy suggested “full cooperation” might serve as a threshold requirement for any leniency (Joh and Joo 2016), later announcements make clear that the Yates Memo’s reach is quite modest. The Department has kept in place the multi-factor rubric that has long described prosecutorial discretion, and now separately rewards “voluntary disclosure” under a newly added factor (Baer 2017). Thus, the corporation that discloses wrongdoing but fails to follow through completely on its cooperation may still receive credit, albeit under a different provision of the Principles of Federal Prosecution. If the Department’s intention was to attract attention by shaking a big, but perhaps illusive, stick, the Memo has achieved its purpose. It has received substantial attention from the press, as well as practitioners and scholars; as a result, corporate compliance departments are likely to respond by investing greater effort and financial resources in internal investigations. If the dynamic laid out in this chapter is accurate, however, we should expect employees to react by expending ever more effort in evading detection. The second development arises in contravention to the first, which is the emergence of the strong argument for privacy within the workplace. Traditionally, privacy has served as shorthand for the insecurity and offense borne by citizens upon learning that government agents have entered their homes and tapped their telephone calls. Today, that anxiety extends to the corporate investigator who examines an employee’s email inboxes with only the most notional form of consent. As the workplace becomes, for many employees, the equivalent of a second (or first) home, privacy discourse will surely expand and become more salient. If privacy and compliance are visualized as two trains, they appear to be barreling towards each other at bullet speed, with the corporation’s compliance officer standing firmly in the middle. To confuse the matter even more, the “right of privacy” may extend beyond the 45   Deputy Attorney General Sally Quillian Yates Delivers Remarks at New York University School of Law, Sept. 10, 2015, at http://www.justice.gov/opa/speech/deputy-attorney-general-sallyquillian-yates-delivers-remarks-new-york-university-school; Sally Quillian Yates, Memorandum, Individual Accountability for Wrongdoing, September 9, 2015, available at http://www.justice.gov/ dag/file/769036/download

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330  Research handbook on corporate crime and financial misdealing i­ndividual employee to the entity itself (Pollman 2014). As the for-profit corporation attains greater respect as a holder of constitutional rights, scholars have begun to debate  whether the corporation is deserving of privacy rights (Orts and Sepinwall 2015) or whether those rights reside exclusively in the corporation’s employees (Pollman  2014).  Either way, privacy’s rise in importance may impact the corporate investigation in far-reaching and unforeseen ways, particularly if it impacts social norms and the general populace’s views of what a corporate investigator should or should not see. Who benefits the most from this instability? Surely not the corporation’s shareholders; they will pay, one way or another, for their entity’s excessive self-policing and their managers’ claims to privacy. At least for the time being, the corporate investigation’s most prominent beneficiary is likely to be the white-collar defense lawyer, whose expertise and signaling value can only continue to accrete.

REFERENCES Akerlof, George. 1970. The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, Quarterly Journal of Economics, 84, 488–500. Alexander, Cindy A. and Mark Cohen. 2015. The Evolution of Corporate Criminal Settlements: An Empirical Perspective on Deferred Prosecution, Non-Prosecution and Plea Agreements, American Criminal Law Review, 52, 537–591. Arlen, Jennifer. 1994. The Potentially Perverse Effects of Corporate Criminal Liability, Journal of Legal Studies, 23, 833–867. Arlen, Jennifer. 2012. The Failure of the Organizational Guidelines, University of Miami Law Review, 66, 321–362. Arlen, Jennifer. 2016. Prosecuting Beyond the Rule of Law: Corporate Mandates Imposed Through Pretrial Diversion Agreements, Journal of Legal Analysis, 8, 191–234. Arlen, Jennifer H. and William J. Carney. 1992. Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, University Illinois Law Review, 1992, 691–734. Arlen, Jennifer and Marcel Kahan. 2017. Corporate Governance Regulation Through Non-prosecution, University of Chicago Law Review, 84, 323–387. Arlen, Jennifer and Reinier Kraakman. 1997. Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes, New York University Law Review, 72, 687–779. Ayres, Ian and John Braithwaite. 1992. Responsive Regulation, New York: Oxford University Press. Baer, Miriam H. 2008. Insuring Corporate Crime, Indiana Law Review, 83, 1035–1096. Baer, Miriam H. 2009. Governing Corporate Compliance, Boston College Law Review, 52, 949–1019. Baer, Miriam H. 2011. Cooperation’s Cost, Washington University Law Review, 88, 903–967. Baer, Miriam H. 2017. Reconceptualizing the Whistleblower’s Dilemma, UC Davis Law Review, 50, 2215–2280. Barkow, Rachel. 2014. The New Policing of Business Crime, Seattle University Law Review, 37, 435–473. Bennett, Robert, Alan Kriegel, Carl S. Reich, and Charles F. Walker. 2006. Internal Investigations and the Defense of Corporations in the Sarbanes-Oxley Era, Business Lawyer, 62, 55–88. Buchanan, Mary Beth. 2004. Effective Cooperation by Business Organizations and the Impact of Privilege Waivers, Wake Forest Law Review, 39, 587–611. Buell, Samuel W. 2007. Criminal Procedure Within the Firm, Stanford Law Review, 59, 1613–1670. Casey, Anthony J. and Anthony Niblett. 2014. Noise Reduction: The Screening Value of Qui-Tam, Washington University Law Review, 91, 1169–1217. Ciocchetti, Corey A. 2011. The Eavesdropping Employer: A Twenty-First Century Framework for Employee Monitoring, American Business Law Journal, 48, 285–359. Coffee, John C., Jr. 2006. Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation, Columbia Law Review, 106, 1534–1586. Cunningham, Lawrence A. 2004. The Appeal and Limits of Internal Controls to Fight Fraud, Terrorism, Other Ills, Journal of Corporation Law, 29, 267–336. Dervan, Lucian E. 2011. International White Collar Crime and the Globalization of Internal Investigations, Fordham Urban Law Journal, 39, 361–389.

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When the corporation investigates itself  331 DeStefano, Michele. 2014a. Compliance and Claim Funding: Testing the Borders of Lawyers’ Monopoly and the Unauthorized Practice of Law, Fordham Law Review, 82, 2961–2994. DeStefano, Michele. 2014b. Creating a Culture of Compliance: Why Departmentalization May Not Be the Answer, Hastings Business Law Journal, 10, 71–174. Egozi, Joseph. 2016. Qualified Privilege from Defamation: Cracking the Absolute Corporate Shell in DOJ Investigations, The University of Chicago Legal Forum, 2016, 711–737. Engstrom,  David Freeman. 2014. Whither Whistleblowing? Bounty Regimes, Regulatory Context, and the Challenge of Optimal Design, Theoretical Inquiries in Law, 15, 605–633. Feldman, Yuval and Orly Lobel. 2010. The Incentives Matrix: The Comparative Effectiveness of Rewards, Liabilities, Duties, and Protections for Reporting Illegality, Texas Law Review, 88, 1151–1210. Fink, Jessica K. 2014. In Defense of Snooping Employers, U. Pa. J. Bus. L., 16, 551–597. First, Harry. 2010. Branch Office of the Prosecutor: The New Role of the Corporation in Business Crime Prosecutions, North Carolina Law Review, 89, 23–98. Fischel, Daniel R. and Alan O. Sykes. 1996. Corporate Crime, Journal of Legal Studies, 25, 319–349. Garrett, Brandon L. 2007. Structural Reform Prosecutions, Virginia Law Review, 93, 853–954. Garrett, Brandon L. 2011. Globalized Corporate Prosecutions, Virginia Law Review, 97, 1775–1875. Garrett, Brandon L. 2014. Too Big to Jail, New York: Belknap. George, Barbara Crutchfield, Patricia Lynch, and Susan J. Marsnik. 2001. U.S. Multinational Employers: Navigating through the “Safe Harbor” Principles to Comply with the EU Data Privacy Directive, American Business Law Journal, 38, 735–783. Giesel, Grace M. 2010. Upjohn Warnings, the Attorney-Client Privilege and Principles of Lawyer Ethics: Achieving Harmony, Miami Law Review, 65, 110–168. Gilchrist, Gregory M. 2014. The Special Problem of Banks and Crime, University of Colorado Law Review, 85, 1–52. Golumbic, Court E. and Albert D. Lichy. 2014. The “Too Big to Jail” Effect and the Impact on the Justice Department’s Corporate Charging Policy, Hastings Law Journal, 65, 1293–1344. Griffin, Lisa Kern. 2007. Compelled Cooperation and the New Corporate Criminal Procedure, NYU Law Review, 82, 311–382. Griffith, Sean J. 2016. Corporate Governance in an Era of Compliance, William and Mary Law Review, 57, 2075–2140. Gurkaynak, Gonec and Derya Durlu. 2013. Harmonizing the Shield to Corporate Liability: A Comparative Approach to the Legal Foundations of Corporate Compliance Programs from Criminal Law, Employment Law, and Competition Law Perspectives, International Lawyer, 47, 99–121. Hamdani, Assaf and Alon Klement. 2008. Corporate Crime and Deterrence, Stanford Law Review, 61, 271–310. Innes, Robert. 1999. Remediation and Self-Reporting in Optimal Law Enforcement, Journal of Public Economics, 72, 379–393. Innes, Robert. 2000. Self-Reporting in Optimal Law Enforcement When Violators Have Heterogeneous Probabilities of Apprehension, Journal of Legal Studies, 29, 287–300. Innes, Robert. 2001. Violator Avoidance Activities and Self Reporting in Optimal Law Enforcement, Journal of Law, Economics and Organization, 17, 239–256. Jensen, Michael C. and William H. Meckling. 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics, 3, 305–360. Joh, Elizabeth E. and Thomas W. Joo. 2015. The Corporation as Snitch: The New DOJ Guidelines on Prosecuting White Collar Crime, Virginia Law Review Online, 101, 51–59. Joh, Elizabeth E. and Thomas W. Joo. 2016. Third Party Harms in Undercover Police Operations, Southern California Law Review, 88, 1309–1355. Kaal, Wolf A. and Timothy Lacine. 2014. The Effect of Deferred and Non-Prosecution Agreements on Corporate Governance: Evidence from 1993–2003, Business Lawyer, 70, 61–119. Kaplow, Louis and Steven Shavell. 1989. Legal Advice about Information to Present in Litigation: Its Effects and Social Desirability, Harvard Law Review, 102, 565–615. Kaplow, Louis and Steven Shavell. 1994. Optimal Law Enforcement with Self-Reporting of Behavior, Journal of Political Economy, 102, 583–606. Khanna, Vikramaditya S. 1996. Corporate Criminal Liability: What Purpose Does it Serve, Harvard Law Review, 109, 1477–1534. Khanna, Vikramaditya S. 1999. Is the Notion of Corporate Fault a Faulty Notion? The Case of Corporate Mens Rea, Boston University Law Review, 79, 355–414. Khanna, Vikramaditya S. 2000. Corporate Liability Standards: When Should Corporations Be Held Criminally Liable? American Criminal Law Review, 37, 1239–1283. Krawiec, Kimberly D. 2003. Cosmetic Compliance and the Failure of Negotiated Governance, Washington University Law Quarterly, 81, 487–544.

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332  Research handbook on corporate crime and financial misdealing Ladd, Alyssa. 2014. The Catch-22 of Corporate Cooperation in Foreign Corrupt Practices Investigations. Houston Law Review, 51, 947–979. Lasprogata, Gail, Nancy J. King, and Sukanya Pillay. 2004. Regulation of Electronic Employee Monitoring: Identifying Fundamental Principles of Employee Privacy Through a Comparative Study of Data Privacy Legislation in the European Union, United States and Canada, Stanford Technology Law Review, 2004, 4–121. Laufer, William S. 1999. Corporate Liability, Risk Shifting and the Paradox of Compliance, Vanderbilt Law Review, 52, 1343–1420. Laufer, William S. 2002. Corporate Prosecution, Cooperation and the Trading of Favors, Iowa Law Review, 87, 643–667. Markoff, Gabriel. 2013. Arthur Andersen and the Myth of the Corporate Death Penalty, University of Pennsylvania Journal of Business Law, 15, 797–836. Miller, Geoffrey. 2014. The Law of Governance, Risk Management and Compliance, New York: Walters Kluwer. Nussim, Jacob and Avraham D. Tabbach. 2008. (Non)regulable Avoidance and the Perils of Punishment, European Journal of Law and Economics, 25, 191–208. Nussim, Jacob and Avraham D. Tabbach. 2009. Deterrence and Avoidance, International Review of Economics, 29, 314–323. Orts, Eric and Amy Sepinwall. 2015. Privacy and Organizational Persons, Minnesota Law Review, 99, 2275–2323. O’Sullivan, Julie Rose. 2007. The DOJ Risks Killing the Golden Goose Through Computer Associates/ Singleton Theories of Obstruction, American Criminal Law Review, 44, 1447–1479. O’Sullivan, Julie Rose. 2008a. The Last Straw: The Department of Justice’s Privilege Waiver Policy and the Death of Adversarial Justice in Criminal Investigations of Corporations, DePaul Law Review, 57, 329–363. O’Sullivan, Julie Rose. 2008b. Does DOJ’s Privilege Waiver Policy Threaten the Rationales Underlying the Attorney-Client Privilege and Work Product Doctrine? A Preliminary “No”, American Criminal Law Review, 45, 1237–1296. Pacella, Jennifer. 2015. Bounties for Bad Behavior: Rewarding Culpable Whistleblowers Under the Dodd-Frank Act and Internal Revenue Code, University of Pennsylvania Journal of Business Law, 17, 345–392. Podgor, Ellen S. and Bruce A. Green. 2013. Unregulated Internal Investigations: Achieving Fairness for Corporate Constituents, Boston College Law Review, 54, 73–126. Pollman, Elizabeth. 2014. A Corporate Right to Privacy, Minnesota Law Review, 99, 27–88. Raskolnikov, Alex. 2014. Irredeemably Inefficient Acts: A Threat to the Market, Firms and the Fisc, Georgetown Law Journal, 102, 1133–1189. Ribstein, Larry. 2011. Agents Prosecuting Agents, Journal of Economics and Policy, 7, 617–643. Richman, Daniel. 2008. Decisions about Coercion: The Corporate Attorney-Client Privilege Waiver Problem, DePaul Law Review, 57, 295–328. Root, Veronica. 2014. The Monitor-Client Relationship, Virginia Law Review, 100, 523–585 Rose, Amanda M. 2010. The Multi-Enforcer Approach to Securities Fraud Deterrence: A Critical Analysis, University of Pennsylvania Law Review, 158, 2173–2231. Rose, Amanda M. 2014. Better Bounty Hunting: How the SEC’s New Whistleblower Program Changes the Securities Fraud Class Action Debate, Northwestern University Law Review, 108, 1235–1300. Rostain, Tanina. 2006. The Emergence of “Law Consultants,” Fordham Law Review, 75, 1397–1428. Rubin, Edward L. 2005. Images of Organizations and Consequences of Regulation, Theoretical Inquiries in Law, 6, 347–390. Sanchirico, Chris William. 2006. Detection Avoidance, New York University Law Review, 81, 1331–1399. Schipani, Cindy A. 2009. The Future of the Attorney-Client Privilege Corporate Criminal Investigations, Delaware Journal of Corporate Law, 34, 921–963. Sexton, John E. 1982. A Post Upjohn Assessment of the Corporate Attorney-Client Privilege, New York University Law Review, 57, 443–520. Short, Jodi L. and Michael W. Toffel. 2010. Making Self-Regulation More Than Merely Symbolic: The Critical Role of the Legal Environment. Administrative Science Quarterly, 55, 361–396. Stafford, Sarah L. 2011. Outsourcing Enforcement: Principles to Guide Self-Policing Regimes, Cardozo Law Review, 32, 2293–2323. Stephenson, Matthew C. 2011. Information Acquisition and Institutional Design, Harvard Law Review, 124, 1422–1483. Tabbach, Avraham D. 2010. The Social Desirability of Punishment Avoidance, Journal of Law, Economics and Organization, 26, 265–289. Toffel, Michael W. and Jodi L. Short. 2011. Coming Clean and Cleaning Up: Does Voluntary Self-Reporting Indicate Effective Self-Policing?, Journal of Law and Economics, 54, 609–649. Tyler, Tom R. 2005. Promoting Employee Policy Adherence and Rule Following in Work Settings: The Value of Self-Regulatory Approaches, Brooklyn Law Review, 70, 1287–1312.

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When the corporation investigates itself  333 Weisselberg, Charles D. and Su Li. 2011. Big Law’s Sixth Amendment: The Rise of Corporate White-Collar Practices in Large U.S. Law Firms, Arizona Law Review, 53, 1221–1298. Zaring, David. 2013. Against Being Against the Revolving Door, University of Illinois Law Review, 2013, 507–549. Zornow, David M. and Keith D. Krakaur. 2000. On the Brink of a Brave New World: The Death of Privilege in Corporate Criminal Investigations, American Criminal Law Review, 37, 147–161.

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14.  Bounty regimes

David Freeman Engstrom* 46

1. INTRODUCTION Whistleblower bounty schemes that pay individuals a cash reward for surfacing information about illegal conduct have rapidly gained public and scholarly attention, fueled in part by recent efforts to deploy a bounty approach in the regulation of corporate crime and financial misdealing. This chapter offers a theoretical and empirical overview of these “bounty regimes” in three steps. The first part (Section 2) briefly catalogues existing bounty regimes and compares the structure and workings of two of its most prominent exemplars: the “cashfor-information” scheme established by the recent Dodd-Frank Wall Street Reform and Consumer Protection Act, and the False Claims Act’s (FCA) more elaborate qui tam scheme in which whistleblowers are vested with independent enforcement authority via a private right of action. The second part (Section 3) surveys the small but growing scholarly literature on bounty regimes, with particular attention to a trio of recurrent design challenges: how to incentivize an optimal quantity and quality of information revelation; how to harmonize bounty regimes with internal corporate compliance systems to achieve an optimal mix of internal and external whistleblower reports; and how to weigh efficiency and democratic-control trade-offs in choosing between a cash-for-information and a qui tam bounty approach. The third part (Section 4) aims to advance theory on a further aspect of the regulatory design puzzle that has thus far eluded systematic scholarly inquiry: how the organizational structure of wrongdoing (e.g., organizational complexity, the degree to which the misconduct is centralized or compartmentalized, and the like) presents opportunities and challenges in the design of bounty regimes. In particular, the analysis compares the organizational structure of wrongdoing both across industry sectors and regulatory contexts and in the corporate crime and financial misdealing arena. The chapter closes by suggesting further avenues for research.

2.  BOUNTY REGIME OVERVIEW A bounty regime is a regulatory program that incentivizes individuals or entities other than those who have suffered cognizable harm to surface information about wrong­ doing. The approach is primarily motivated by the recognition that, in many regulatory areas, wrongdoing is hard for regulators operating at a remove from regulated parties to

  *  Thanks to Jennifer Arlen, Kathleen Clark, and Marcia Miceli for insightful feedback, and to Conor Beckerman for tireless research assistance.

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Bounty regimes  335 detect. A paradigmatic example is corporate crime, where scholars have long noted that government actors cannot, operating alone, detect significant amounts of wrongdoing without paying high information costs (Arlen 2012; Dyck et al. 2010). Beyond this core commonality, however, bounty regimes are a varied bunch. Table 14.1 (Engstrom 2014b, p. 611) attempts a succinct overview by summarizing six design dimensions along which bounty regimes can vary. These are: (i) the bounty amount; (ii) the degree of regulator discretion in determining that amount and the institutional actor (agency or court) who wields such discretion; (iii) whether a whistleblower can exercise independent enforcement authority and, if so, the degree to which public regulators exercise residual control over the exercise of that authority; (iv) retaliation protections, including guaranteed anonymity or sanctions for retaliatory acts; (v) limitations on whistleblower standing, including provisions that exclude particular whistleblower types (counsel, compliance officers, organizational outsiders or others who lack firsthand knowledge of the wrongdoing) from participation; and (vi) filing prerequisites, including the requirement that a whistleblower first report wrongdoing internally before making an external report to a regulator. To show how some of these design features fit together, Table 14.1 compares two realworld examples. First, the recently expanded Dodd-Frank bounty scheme pays “cash for information” by guaranteeing a whistleblower who provides information to the Securities and Exchange Commission (SEC) an automatic reward of 10 to 30 percent of any monetary sanctions in excess of one million dollars obtained in a successful SEC-initiated judicial or administrative enforcement action.1 Note, however, that the SEC retains near-total control over the system, exercising full discretion over whether to initiate an enforcement action in the first place and also in determining the precise amount of the bounty to be paid (so long as within statutory bounds).2 Finally, whistleblowers enjoy robust anti-retaliation protections, including a private right of action in federal court3 and an assurance of anonymity if represented by counsel4 (17 C.F.R. § 240.21F–4(b)(4)(v)(C)). By contrast, the FCA’s qui tam system entitles whistleblowers to a bounty of 15 to 30 percent of any monetary recovery. However, in a critical departure from the Dodd-Frank scheme, the FCA vests whistleblowers with independent enforcement authority by granting them a right of action to pursue claims on the government’s behalf even where the government refuses to intervene in the action.5 In turn, the FCA grants the United States Department of Justice (DOJ) substantial control rights, including the authority to control the litigation where it intervenes. The DOJ also possesses the power to veto private settlements or even terminate private actions outright where it does not intervene.6 Courts,

  15 U.S.C. § 78u-6(b)(1).   15 U.S.C. §§ 78u-6(c)(1)(A), 6(f). This differs from the SEC bounty regime in its previous incarnation, which made bounty awards entirely discretionary on the part of the SEC. The resulting uncertainty helps explain why the system generated so few tips (Ferziger and Currell 1999, p. 1144).  3   15 U.S.C. § 78u-6(h)(1)(C).  4   15 U.S.C. § 78u-6(d)(2); 17 C.F.R. §§ 240.21F-7(b)(1), 240.21F-9(c).  5   31 U.S.C. § 3730(b)–(d).  6   Interestingly, the DOJ only rarely asserts its right to dismiss lawsuits out from under whistleblower plaintiffs, even where it declines to intervene. This tendency may be a reaction to concerns among legislators who drove enactment of the modern, post-1986 version of the FCA  1  2

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336  Research handbook on corporate crime and financial misdealing Table 14.1  Bounty regimes at a glance Design Dimensions

Real-World Examples Dodd-Frank Bounty Regime

Qui Tam Provisions of False Claims Act

Bounty amount

10–30% of sanctions exceeding one million dollars

15–25% of recovery where DOJ intervenes; 25–30% where DOJ declines to join

Degree of regulator discretion in making or calculating awards

Tipper guaranteed at least 10%; but SEC retains unappealable discretion to set amount within statutory bounds

“Relator” guaranteed at least 15%; court determines ultimate bounty amount within statutory bounds

Whether whistleblower wields independent enforcement authority— and the degree of residual public control over private enforcement actions

No—SEC alone decides whether to pursue enforcement action

Yes—but DOJ wields full “gatekeeper” powers, including ability to control or terminate private actions

Retaliation protections

Anti-retaliation private right of action and SEC-imposed sanctions; anonymity guarantee where represented by counsel

Anti-retaliation private right of action, but no anonymity guarantee

Limits on whistleblower eligibility

Excludes government agency employees and limits tipsters who obtained information pursuant to legal or accounting engagement or as part of internal compliance process; information must be “original” (i.e., derived from whistleblower’s “independent knowledge or analysis”)

“Relator” must be the “original source” of the information upon which the fraud claim is based where previously “publicly disclosed”

Filing prerequisites (e.g., must the bountyseeker first report the wrongdoing internally?)

None, but SEC implementing regulations incentivize (and, for compliance personnel, require) initial internal report

None

however, determine the precise amount of the ultimate bounty payout.7 Finally, while the FCA offers whistleblowers anti-retaliation protections similar to those enjoyed by SEC about insufficiently aggressive government prosecution of fraud as a result of regulatory capture or agencies’ reluctance to admit to having been defrauded (Engstrom 2013).  7   31 U.S.C. §§  3730(c)(2)(B)–(C) (termination and settlement authority); § 3730(b)(1) (veto over private settlements); §§  3730(c)(1), 3730(c)(2)(C) (intervention and control authority). Engstrom (2013) catalogues the DOJ’s oversight powers under the FCA.

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Bounty regimes  337 whistleblowers, including a private right of action, it does not protect whistleblowers’ anonymity.8 Of course, the Dodd-Frank bounty scheme and the FCA’s qui tam mechanism do not exhaust the universe of bounty regimes, whether real or proposed. Two other prominent, and increasingly controversial, cash-for-information bounty programs include the IRS’s longstanding “Informant Claims Program” for tax cases (substantially revised and revived in 2006),9 and the federal Financial Institution Reform, Recovery and Enforcement Act of 1988 in the banking law area.10 More importantly, all signs point toward increased adoption of a bounty approach. A potent mix of factors—among them the seeming success of qui tam litigation under the FCA (Engstrom 2013); a legislative preference for off-budget, privatized regulatory tools in times of fiscal austerity (Engstrom 2014b, pp. 608–609); and recognition that the growing organizational complexity of regulated entities makes information prohibitively expensive for regulators to unearth themselves (Bucy 2002a)—has spurred calls to install bounty regimes across a wide range of regulatory areas. These range from ­workplace safety (Gonzalez 2010), environmental protection (Bucy 2002b; Thompson 2000), and civil rights (Mensz 2010), to political corruption (Petty 2006), immigration (Manns 2006), and antitrust (Crumplar 1975; Kovacic 2001). Congressional debate, too, regularly features bills with bounty provisions.11 This suggests that bounty regimes now occupy a place on the standard menu of tools legislators consider in crafting regulatory responses to social and economic problems (Rapp 2013). As a final prefatory note, this chapter intentionally ignores two types of regimes that share characteristics of bounty regimes but are distinct in key respects. The first are regulatory regimes—including securities, antitrust, and job discrimination—in which legislators vest individuals who have themselves suffered compensable harm with the power to bring representative suits (e.g., class actions) to vindicate a mix of public and private rights. Because such plaintiffs have a preexisting instrumental motivation to seek redress, these regimes pose design challenges that overlap with, but differ from, the bounty regimes addressed herein. The second are criminal amnesty programs, such as the DOJ Antitrust Division’s Corporate Leniency Policy, which grants amnesty to the first member of a price-fixing cartel to defect and expose the conspiracy to regulators. The focus of this analysis is civil bounty regimes and this section thus omits consideration of bounty   31 U.S.C. § 3730(h).   26 U.S.C. § 7623; 26 C.F.R. 301.7623-1. The 2006 “revival” took the form of a congressional amendment making rewards automatic, thus eroding what was previously the Service’s near-total discretion over whether to make awards and in what amount. For an account, see Internal Revenue Service (2015). For an account of the IRS program’s recent growth, including payouts of $125 million in 2012 after a four-year span during which total payouts did not exceed $23 million, see Internal Revenue Service (2012). 10   12 U.S.C. § 4205. 11   In response to revelations about defective General Motors ignition switches, a bill (S. 2949, 114th Cong., 2015) is currently working its way through Congress that would permit employees and contractors of automakers, parts suppliers, and car dealerships to recover up to 30 percent of penalties resulting from a federal enforcement action totaling more than $1 million. For analysis, see David Morgan, Andre Grenon, and Leslie Adler (2015).  8  9

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338  Research handbook on corporate crime and financial misdealing regimes on the criminal side of the regulatory state.12 Because the amnesty-seeker’s reward is not an affirmative monetary payout but rather a reduction or elimination of criminal sanctions, including non-monetary ones, amnesty policies raise distinct questions from those addressed herein.13

3.  THREE CHALLENGES OF BOUNTY REGIME DESIGN The rising use of bounty regimes in the procurement, securities, and tax contexts, as well as mounting calls to export the bounty model to still other regulatory contexts, have spurred increasingly rich debate among academics, policymakers, practitioners, and judges. A foundational fault line in that debate is whether bounty regimes, by pitting citizen against citizen, impose solidarity and demoralization costs that overwhelm any welfare gains from increased regulatory compliance. Detractors thus seek to revive the view— more common in past decades but continuing into the present day—that whistleblowers of all sorts, including the bounty-seeking variety, are “snitches” who threaten to fray the social fabric (Brown 2007; Miethe 1999).14 Another foundational concern is whether a qui tam mechanism would pass constitutional muster if exported beyond the FCA’s unique government procurement context. While the Supreme Court long ago held in Vermont Agency of Natural Res. v. U.S. ex rel. Stevens (529 U.S. 765 [2000]) that Congress can constitutionally assign its own proprietary claim to a private actor via a qui tam provision, it is possible that a qui tam regime in which a litigant’s only stake is the collection of a statutory fine separate from the government’s proprietary interest would not satisfy Article III’s requirement for a concrete and redressable injury.15 12   The current incarnation of the Corporate Leniency Program dates to 1993, when DOJ beefed up its amnesty program in various respects. For the announcement and a summary of the policy, see Department of Justice (1993). 13   Moreover, amnesty seekers are by definition involved in the wrongdoing, raising important game-theoretic and other questions that are not developed at length herein. Christopher Leslie (2006) offers theoretical analysis. Interestingly, a recent DOJ announcement suggests that federal prosecutors have begun using whistleblower reports from existing bounty programs to seed criminal actions, thus raising questions, such as how to structure bounties where a criminal fine or restitution is not sought, that are not addressed herein. For an account, see Fernandez and Alpert (2015) at 12. 14   The pariah treatment of many whistleblowers is colorfully illustrated by a statement from the otherwise liberal Senator Harry Reid (D-NV) in 1998 (141 Cong. Rec. S4397-401, 1998) referring to the IRS bounty program as the “Snitch Program” and “Reward for Rats Program.” As Colin Grant (2002) notes, the Enron scandal may have marked a turning point in the American public’s perception of whistleblowers, as exemplified by TIME Magazine naming a trio of whistleblowers its “Persons of the Year” for 2002 (Kelly 2002). 15   Qui tam’s constitutionality beyond the government procurement or other proprietary context is in considerable doubt following the Supreme Court’s decision in Spokeo, Inc. v. Robins (136 S. Ct. 1540 [2016]). In that case, the Court held that Article III’s “case or controversy” requirement bars plaintiffs from bringing damages actions in federal court under the Fair Credit Reporting Act where the plaintiff sues on a plain statutory violation (viz., publication of factually incorrect information about the plaintiff on the defendant’s website), but cannot point to any injury. Of particular relevance, while the Spokeo majority restated Justice Kennedy’s assertion in Lujan v.

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Bounty regimes  339 While these concerns are important ones, the bulk of recent research on bounty regimes has instead taken a narrower, policy-analytic tack. Three questions predominate. One is how to incentivize an optimal quantity and quality of bounty-seeking tips. A second is how best to reconcile bounty regimes with internal corporate compliance systems. A third is how, in choosing between a cash-for-information and a qui tam bounty approach, to balance the benefits of harnessing private entrepreneurialism and access to information against the need to maintain democratically accountable control over the enforcement and elaboration of legal mandates. The remainder of this section surveys existing theory and evidence on each question. 3.1  The Goldilocks Challenge: Optimizing Tip Quantity and Quality A central challenge in designing bounty regimes is what has previously been termed the “Goldilocks” challenge: optimizing the quantity and quality of whistleblower tips in a manner that weighs the deterrence and other social benefits that flow from surfacing highquality information about wrongdoing against the costs of investigating and adjudicating low-quality and even frivolous accusations (Engstrom 2014b, p. 613). A standard rational-choice economic account holds that bounty-seeking whistleblowers gamble both the expected cost of assembling credible information on misconduct and the expected personal and professional cost of reporting misconduct against expected payouts (Engstrom 2014a; Heyes and Kapur 2009; Miethe and Rothschild 1994). These costs, particularly the risk of career derailment and ostracism, are considerable. As a result, where rewards are too low or uncertain, or anti-retaliation protections too anemic, bounty-seeking whistleblowers may not come forward at all (Ferziger and Currell 1999, p. 1172). However, incentives or protections that are too robust may open the door to excessive reporting or misuse. In particular, extremely high bounties could encourage employees to report the slightest suspicion of wrongdoing and thus risks overwhelming an agency tasked with sifting good and bad tips (Ferziger and Currell 1999, pp. 1158–1159). The institutional design challenge, then, is not just coaxing whistleblowers with highquality information into the system—the challenge is doing so without also unleashing a torrent of low-quality information.16 This swamping risk is substantial at least in part because whistleblowers may hold

Defenders of Wildlife (504 U.S. 555 [1992]) that Congress “has the power to define injuries . . . that will give rise to a case or controversy where none existed before,” it was also careful to note that this language from Lujan “does not mean that a plaintiff automatically satisfies the injury-in-fact requirement whenever a statute grants a person a statutory right and purports to authorize that person to sue to vindicate that right. Article III standing requires a concrete injury even in the context of a statutory violation.” A fair reading of this dictum, when combined with the Court’s earlier decision in Stevens, is that only cash-for-information regimes along Dodd-Frank lines, but not a qui tam whistleblower mechanism, will survive judicial review on Article III grounds outside the FCA’s unique procurement or other proprietary (e.g., government “purchase” of health care services via the Medicaid or Medicare programs) context. Of course, this analysis applies only at the federal level; treatment of the issue under state constitutions will vary. 16   In economic terms, policymakers should thus increase bounties and other incentives until the marginal cost to the agency of sorting tips exceeds the tips’ marginal regulatory value (Ferziger and Currell 1999, p. 1172).

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340  Research handbook on corporate crime and financial misdealing moral and ethical views that are stronger and less flexible than average and so they may be more predisposed to see conduct as wrongful than others might be (Miceli and Near 1992, p. 104; Jos, Tompkins, and Hays 1989; Glazer and Glazer 1989). Some whistleblowers may also use reports instrumentally as part of a broader workplace dispute (Gobert and Punch 2000), or to trigger retaliation protections to avoid discharge or discipline for poor performance (Near and Miceli 1996, p. 509). Section 4 returns to research on the individual and situational determinants of whistleblowing behavior in assessing how institutional architects can take account of regularities in the organizational structure of wrongdoing in designing bounty regimes. But the concern at the heart of the Goldilocks challenge is not just higher administrative expenses that push the social cost of enforcement beyond its benefit—rather, it is a deeper, and perhaps counterintuitive, one. A budget-constrained agency that receives additional tips must either ignore some of them, using a triage approach to focus its efforts on a subset of tips, or else allocate fewer investigative resources to examining each tip, thus degrading the agency’s screening accuracy. Paradoxically, a bounty regime with a robust mix of incentives and protections that yields more whistleblower reports may overwhelm the agency. By reducing the likelihood that the agency detects and sanctions misconduct, such a regime may yield less overall deterrence compared to a regime with a less robust mix of incentives and protections (Engstrom 2014b, p. 613; Casey and Niblett 2014, p. 1196).17 3.1.1  Structuring payout magnitudes A number of tools are available to regulatory architects in meeting the Goldilocks challenge. Perhaps the most obvious way to optimize tip quantity and quality is by manipulating payouts. As noted previously, the Dodd-Frank program conditions a bounty payout on a minimum recovery of one million dollars in order to stem the flow of tips reporting small-fry wrongdoing for which the social cost of enforcement exceeds any possible gain. Regulators can deploy a similar strategy at the other end of the harm spectrum: FCA critics, among them Hutt et al. (2013), have called for a graduated schedule of bounty percentages as damages increase, thus reducing the likelihood that whistleblowers will swing for the fences by targeting potentially large but highly speculative frauds.18 17   This claim extends from the theory advanced by Louis Kaplow and Steven Shavell (1994) that lower adjudicatory accuracy, whether false positives or false negatives, lowers deterrent effects by making sanctions less certain. Note, however, two caveats. First, the theory that additional tips will yield lower deterrence assumes that there is a point at which additional tips will decrease the likelihood that a firm’s misconduct will be accurately identified and sanctioned more than they increase the probability that the firm’s misconduct is the subject of a tip at all. This is a plausible but by no means ironclad assumption. Second, from a social planner’s perspective, the more important concern here may be the social optimality of the deterrence additional tips yield. This is because additional tips may, by reducing the accuracy of an agency’s decision to enforce, create social loss by deterring socially productive (i.e., legal) activity, offsetting welfare gains from deterred misconduct. 18   Less compelling is the claim of Marsha Ferziger and Daniel Currell (1999, p. 1197) that regulators should offer “low, fixed-percentage bounties [of 1 to 2 percent] with no nominal cap” as a way to ensure that “(1) the violation is factually and legally clear, and (2) it involves substantial money.” While such an approach would clearly chill whistleblower reports of small-scale ­wrongdoing, it is unclear why such an approach would incentivize only high-quality reports. Closer to the mark is the conclusion of Yuval Feldman and Orly Lobel (2010, p. 1207), after reviewing

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Bounty regimes  341 Other available tools for optimizing tip flow leverage heterogeneity within the pool of potential whistleblowers. The most direct means is categorical exclusion of certain classes of individuals from participation who are deemed less likely to surface high-quality information. The FCA’s “public disclosure/original source” bar offers a ready example: where information about a fraud has been publicly disclosed in a government or press report, a qui tam relator must be an “original source” of the information—that is, have “firsthand” knowledge of the wrongdoing.19 One effect of this provision is to deter pure outsiders, who are likely to have systematically lower-quality information about wrongdoing, from coming forward and taxing agency resources. A more flexible means of shaping the bounty-hunter pool is raising or lowering bounty percentages for certain whistleblower types who have different underlying propensities to report wrongdoing. Business competitors are an obvious candidate because of the concern that they will use tips for anticompetitive purposes, perhaps yielding systematically lower-value information.20 Though the estimates of underlying reporting propensities necessary for such an approach will be informationally demanding, one can nonetheless imagine a highly variegated schedule of payouts pegged to different whistleblower types as a way to optimize tip flow. 3.1.2  Who incurs the cost of and controls the litigation? An important further question explored by Anthony Casey and Anthony Niblett (2014) is whether cash-for-information and qui tam approaches differ systematically in their ability to deliver an optimal quantity and quality of tips. The core claim is that a qui tam mechanism requires bounty hunters to make a private, loss-contingent cost commitment that screens out low-quality tips. Among these loss-contingent costs are the expense of preparing and filing a civil lawsuit, the increased litigation costs a qui tam relator pays when she goes it alone after DOJ declines to join the lawsuit, and the FCA’s reverse feeshift for “clearly frivolous” claims.21 But questions remain. Experience thus far implementing the Dodd-Frank bounty program does not suggest that cash-for-information and qui tam regimes differ in the degree of whistleblowers’ pre-filing or pre-submission efforts. Indeed, whistleblowers in both regime types have strong incentives to conduct a careful pre-filing or pre-submission inquiry to distinguish them from the pack, and they will often employ counsel to do so (Engstrom 2014b, p. 614 n. 25). Along with the Dodd-Frank program’s guarantee of a whistleblower’s anonymity where represented by counsel, this may explain why the FCA qui tam and securities plaintiffs’ bars quickly flooded the Dodd-Frank cash-forinformation scheme and have become central to its operation (Rose 2014). Nor is there a good reason why an agency that oversees a cash-for-information regime along Dodd-Frank lines cannot be granted authority, like trial judges under the FCA, the literature on whistleblower incentives, that “no one-size-fits-all policy design exists, but rather, policy makers must evaluate the full scope of psychological and situational factors in order to design the most efficient incentive structures.” 19   37 U.S.C. § 3730(e)(4). 20   Antitrust scholars such as Steven Salop and Lawrence White (1986) have long applied a similar logic in suggesting that business competitors should not be able to recover treble damages. 21   31 U.S.C. § 3730(d)(4).

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342  Research handbook on corporate crime and financial misdealing to fine whistleblowers who submit frivolous tips (Engstrom 2014b) or even require whistleblowers to post a bond along with their tip.22 In the end, the theory may reduce to higher relator litigation costs where the DOJ declines to intervene—which may itself be questionable given the government’s ability to free-ride on relator efforts and demand that relators contribute substantial resources, even in intervened cases (Depoorter and De Mot 2006; Engstrom 2013, p. 1728). 3.1.3  Extrinsic considerations: morality of the misconduct A final consideration in optimizing tip flow arises out of an emerging literature exploring the complex interaction of material and moral incentives to report wrongdoing. Common sense, backed by a growing body of research, suggests that whistleblowers are motivated by a mix of intrinsic and extrinsic rewards (Feldman and Lobel 2010).23 One straightforward implication is that the potency of bounties in convincing whistleblowers with actionable information to come forward may vary in the degree to which the wrongdoing is perceived as serious or morally or ethically problematic (Engstrom 2014b; Miceli and Near 2005, p. 104; Near and Miceli 1996, p. 511). In regulatory areas where the harm is concrete and “direct”—for instance, worker safety and health, where victims are identifiable and suffer physical as opposed to financial injury—providing bounties may merely raise program costs without substantially increasing tip flow, because whistleblowers already have strong moral or ethical reasons to report wrongdoing (Engstrom 2014b). By contrast, in areas like corporate financial misdealing, where the regulatory harm is more diffuse and does not result in direct bodily harm, bounties may be necessary to generate an appreciable number of tips, since moral and ethical concerns may not be enough to compel would-be whistleblowers to come forward.24 A second, more complicated implication extends from the idea, which enjoys at least some empirical support, that material rewards may “crowd out, or suppress, internal moral motivation” to take action (Feldman and Lobel 2010, p. 1155).25 More specifically, the commodification of whistleblowing via the provision of bounties may render would-be whistleblowers less likely to come forward by reducing the moral valence of the wrongdoing. This might be especially true where bounties are relatively small, because low-grade commodification not only reduces the moral valence of misconduct but also signals that the misconduct is not severe enough to warrant a substantial payout (Feldman

22   Casey and Niblett (2014, p. 1204) respond that “[a]llowing the SEC to fine the whistleblower for a failed investigation when the whistleblower had no control over the investigation introduces complex moral hazard problems,” but do not elaborate on the point. 23   Other commentators unhelpfully trade in stylized, unidimensional types (see, for example, Cunningham 2007). 24   More specifically, Engstrom (2014b, p. 621) theorizes that the moral incentive to report wrongdoing may be greater where regulatory harm is “direct”—defined as “affect[ing] a relatively small number of identifiable people based on characteristics unique to the group.” 25   Richard Titmuss (1971) provides the classic economics analysis. Carl Mellstrom and Magnus Johannesson (2008) offer an updated and more skeptical view.

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Bounty regimes  343 and Lobel 2010, p. 1155).26 It follows that, in some regulatory areas, the best way to achieve an optimal amount of information revelation may be not to offer bounties at all. 3.2  Harmonizing Bounty Regimes and Internal Compliance Systems A second core design challenge also takes the form of a Goldilocks-like optimization problem—how to harmonize bounty regimes with internal corporate compliance systems to achieve the “right” mix of internal and external whistleblower reports. Much of the debate on this issue has centered on whether bounty regimes should require that a bounty-seeker first report wrongdoing internally, to management or compliance officers, before reporting “out” to regulators. A core claim among critics, as explored more fully below, is that bounty regimes that lack an internal exhaustion requirement will impair and erode internal compliance systems (see, for example, Kovacic 1996, p. 1831; Vega 2012).27 For many such critics, bounty regimes tend to be all stick and no carrot (Hutt et al. 2013). An internal reporting mandate, it follows, effects a salutary shift away from ex post sanctions and toward ex ante prevention. By contrast, defenders of bounty regimes warn that an internal exhaustion mandate will chill whistleblowers from coming forward at all. Defenders further note that the threat of external reporting may have a beneficial effect, inducing firms to strengthen internal compliance systems rather than eroding them (Miralem 2011). Perhaps the best way to bring needed clarity to this debate is to isolate possible mechanisms, particularly those underpinning the critical claim that the availability of external bounties impairs internal compliance systems. While most treatments of the topic leave those mechanisms woefully under-specified, they tend to cluster around a pair of theoretical possibilities. One is that external bounty systems inefficiently displace internal compliance efforts. The other goes further and holds that external bounties erode internal compliance systems. Displacement concerns are built around two basic premises. The first is that the lack of an internal exhaustion requirement will have a “diversion effect,” inducing whistleblowers to make external reports of wrongdoing that would otherwise be resolved by firm managers in response to internal reports.28 Worse, whistleblowers may adopt a “‘wait-and-see’

26   Janet Near and Marcia Miceli (1996, p. 513) offer a contrary view: “To the extent that legal changes seem to support whistle-blowing, for example, by providing monetary rewards for wrongdoing, they provide symbolic support for the notion that whistle-blowing is the loyal and ethical behavior to take. . . .” 27   Such was the position of much of the financial services industry during the notice-andcomment period preceding the SEC’s promulgation of regulations implementing the Dodd-Frank bounty program. See Securities Whistleblowers Incentives and Protections, 76 Fed. Reg. 34,000, 34,324 (June 13, 2011) (collecting industry comments) [hereinafter Dodd-Frank Rulemaking]. For a survey of industry thinking, see U.S. Securities and Exchange Commission (2010). William Kovacic (1996, p. 1831) offers an academic view that bounty programs undermine internal compliance. 28   Dodd-Frank Rulemaking at 34,360. For other claims about diversion, see U.S. Senate Commission on Banking, Housing, & Urban Affairs (2011), in which former SEC chair Harvey Pitt notes that the Dodd-Frank implementing rules “create overwhelming financial incentives to bypass internal reporting mechanisms and requirements, and go directly to the SEC with

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344  Research handbook on corporate crime and financial misdealing attitude,” allowing embryonic wrongs to ripen into fully fledged ones, and may even further delay making an external report once wrongdoing is fully ripe in order to run the meter and maximize the bounty award (Vega 2012, p. 511; Depoorter and De Mot 2006, p. 156). The second premise is subsidiarity: compliance efforts are most efficient and effective when conducted by the smallest and least centralized competent authority (Vega 2012, p. 536). On this view, corporate or even sub-corporate internal compliance efforts are preferable to external regulatory efforts because they carry lower transaction and socialpsychological costs (Arlen 1994, p. 836; Arlen and Kraakman 1997, p. 692; Dworkin and Callahan 1991, p. 306; Kelsey and Krause 2008, p. 119). Internal compliance efforts might also prove superior because internally devised remedies will be better tailored to the distinctive features of the firm’s structure or culture than remedies imposed by external regulators. The mechanisms that lead to erosion, as against displacement, of internal compliance systems are more diffuse and less easily specified. One possible mechanism is that bounty regimes that lack an internal exhaustion requirement degrade the “moral legitimacy” of whistleblowers (Vega 2012, p. 524). Collateral consequences include an increase in the likelihood of retaliation and, with it, a decrease in the willingness of whistleblowers to come forward in the first place (Vega 2012, p. 487, 513). More generally, commodification of whistleblowing without parallel efforts to preserve the primacy of internal compliance systems can erode a company’s “moral DNA” (U.S. Securities and Exchange Commission 2003) and generate a creeping, organization-wide version of moral crowd-out. Research on organizational behavior and management suggests that people behave based on social cues and, more specifically, their expectations about how others will act in similar circumstances (Stout 2011, pp. 247–248; Eisenberg 1999, pp. 1273–1274). The result could be a kind of feedback, or increasing returns, process: as commodification erodes a firm’s ethical culture of compliance, whistleblowers will progressively resort to external, profitseeking reports, further degrading the firm’s compliance culture, and so on. A more concrete erosion mechanism is that bounty regimes without an internal exhaustion requirement disrupt the information flows on which internal compliance systems depend. For instance, bounty opportunities disrupt the vertical flow of information within firms by making lower-level employees with knowledge about misconduct less forthcoming or cooperative when contacted by directors, managers, or internal compliance personnel conducting internal investigations. They can also disrupt lateral information flows by leaving directors and managers less able to solicit advice from legal counsel and compliance officers out of concern that those advice givers might in turn make external, bounty-seeking reports. This might be true even in regimes that formally bar lawyers or compliance personnel from collecting bounties [­ whistleblower] tips. As a result, they may effectively deny companies the opportunity to detect and take prompt remedial action in response to internally reported tips from employees. . . . By diverting tips and complaints from internal compliance and legal channels to the SEC, the whistleblower provisions paradoxically may result in violations continuing and becoming more serious.” See also U.S. Chamber of Commerce (2011): “[W]histleblowers will go straight to the SEC with allegations of wrongdoing and keep companies in the dark. This leaves expensive, robust compliance programs collecting dust, while violations continue to fester, eroding shareholder value.”

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Bounty regimes  345 save in exceptional circumstances that resemble fraud-related exceptions to a lawyer’s duty of confidentiality.29 Indeed, concern about leakage via side agreements between ineligible and eligible whistleblowers can leave firms’ decision makers less likely to seek professional advice, reducing the efficacy of internal compliance systems.30 A useful question to ask is which of the two mechanisms of impairment—displacement or erosion—is more worrying. One way to gain some purchase on the issue is to note that displacement costs accrue only where a whistleblower forgoes an internal report and instead files an immediate external report. Displacement costs do not accrue, however, where a whistleblower first lodges an internal report, even if she ultimately makes an ­external report.31 Erosion, by contrast, imposes pervasive costs. By degrading whistleblowing’s moral legitimacy and moving whistleblowers to report “out” rather than “in,” erosion exacerbates diversion effects and leads to higher cost resolution upon external whistleblower reports. In addition, by compromising internal information flows, erosion reduces the likelihood that firm decision makers will discover and resolve wrongdoing in response to an internal whistleblower report. Crucially, erosion thereby generates costs anytime an internal report is made or could have been made, even where no external report follows. Of course, an ultimate judgment as to whether displacement or erosion is more ­worrying will turn on the frequency of the above scenarios and the magnitude of the costs generated by each. These costs will surely vary across firms and regulatory contexts.32 The degree of displacement and erosion will also turn on structural factors beyond whether a bounty regime mandates internal exhaustion. Among these are the relative strengths of retaliation protections for internal and external whistleblowing, an issue that has long divided policymakers and courts (Pacella 2014; Recent Legislation 2011),33 and whether a firm’s self-disclosure of misconduct to regulators prior to a whistleblower’s report

29   Under the Dodd-Frank bounty program, an attorney can qualify for bounties so long as she would be permitted to disclose the information under applicable state attorney conduct rules, under the SEC’s earlier SarBox regs or otherwise (17 C.F.R. s. 240.21F-4(b)(4)(i) and 4(b)(4)(ii)). This includes situations, as Kathleen Clark and Nancy Moore (2015) and Jennifer Pacella (2015) explain, in which the attorney believes disclosure is necessary, among other things, to “prevent the issuer from committing a material violation” of the securities laws in which the attorney’s services were used. 30   Interestingly, and though the FCA is unclear regarding attorneys’ bounty eligibility, Clark and Moore (2015) report that only a handful of cases have been brought by counsel who acquired information during legal representations. 31   In such a case, a rational, profit-maximizing firm will either resolve the misconduct internally or else reject it, based on the likelihood and amount of an agency-imposed sanction in the event of a subsequent external report. The strong, simplifying assumption here is that internal resolution forecloses the possibility of an external report. 32   As explored further in Section 4, the organizational structure of wrongdoing, particularly whether the misconduct originates at the subunit level or at the highest levels of management, will be an important factor. 33   For examples of the judicial split, compare Asadi v. G.E. Energy (USA), LLC (720 F.3d 620 [5th Cir. 2013]) with Murray v. UBS Securities, LLC, (No. 12 Civ. 5914 [JMF], 2013 WL 2190084, at *7 [S.D.N.Y. May 21, 2013]); Genberg v. Porter (935 F. Supp. 2d 1094, 1105–07 [D. Colo. 2013]); Kramer v. Trans-Lux Corp. (No. 3:11CV1424 [SRU], 2012 WL 4444820, at *4–5 [D. Conn. Sept. 25, 2012]); Nollner v. S. Baptist Convention, Inc. (852 F. Supp. 2d 986, 997 [M.D. Tenn. 2012]).

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346  Research handbook on corporate crime and financial misdealing forecloses a bounty payout, as some have advocated in the FCA context (Hutt et al. 2013, pp. 17–20). A provision of the latter sort has the potential to swamp all other factors and may even produce unintended and undesirable effects by making it more, rather than less, likely that whistleblowers will report “out” rather than “in.” To that extent, a bar on bounty payouts upon firm self-disclosure can only work as part of a broader suite of design features, perhaps including an internal exhaustion requirement. Even if displacement and erosion costs vary by context, the broader question of which type of cost is apt to be greater is relevant because regulatory designers possess a wide range of tools to mitigate displacement costs beyond conditioning bounty payouts on an initial internal report. By contrast, there are few obvious ways to mitigate erosion effects.34 An example of a displacement-mitigating mechanism is the Dodd-Frank regulation that renders a whistleblower ineligible for a bounty payout where the SEC has already initiated an investigation or enforcement action, unless the information “significantly contribute[s] to the success of the action.”35 While primarily designed to prevent “parasitic” reports that piggyback on government actions already in progress, this provision also mitigates displacement by making running the meter on wrongdoing a risky whistleblower strategy.36 Other provisions of the SEC’s Dodd-Frank implementing regulations likewise mitigate displacement concerns, including: (i) a rule providing for a 120-day “look-back” period that dates a whistleblower’s tip to the moment of an internal company report for the purposes of determining whether the tip predated an SEC investigation or enforcement action,37 and (ii) a rule permitting the SEC, in calculating the bounty amount, to consider a whistleblower’s initial filing of an internal report as a “plus-factor,” and a whistleblower’s interference with internal compliance functions as a “minus-factor.”38 These types of provisions also highlight the potential downside of an internal exhaustion requirement—and so help to fill out the mechanisms on the other side of the cost–benefit ledger. As noted previously, the most obvious drawback is that conditioning bounties on a prior internal report may expose whistleblowers to an undue risk of retaliation, especially at firms that lack credible compliance systems, thus chilling whistleblowers

34   Feldman and Lobel (2010, p. 1200) offer one of the few proposals for restructuring bounty regimes that would counter erosion: mandating internal reporting and then imposing fines for failure to do so. Even this proposal, however, points up a possible paradox: Any effort to counter erosion of a firm’s ethical culture that commodifies whistleblowing—whether by imposing fines or by providing internal bounties to rival those offered by government regulators—risks further erosion. 35   17 C.F.R. § 240.21F-4(c)(2). 36   The FCA’s “first to file” provision similarly disciplines whistleblowers in this regard (31 U.S.C. § 3730[b][5]). In fact, FCA critics, harking back to the work of William Landes and Richard Posner (1975, p. 34), raise the opposite concern, warning that first-to-file rules yield immature, not over-ripe, reports of wrongdoing by fostering a “race to the courthouse.” 37   Dodd-Frank Rulemaking at 34,365; 17 C.F.R. § 240.21F-4(c)(3). The SEC’s implementing regulations also permit the SEC to reduce the bounty amount for any unreasonable reporting delay to counter the “meter-running” concern (17 C.F.R. §§ 240.21F-6[b][1]–[3] [2012]). 38   Dodd-Frank Rulemaking at 34,329, 34,360; 17 CFR § 240.21F-6(a)(4) (specifying that the SEC “will assess whether, and the extent to which, the whistleblower and any legal representative of the whistleblower participated in internal compliance systems”); ibid. at 34,308 (minus-factor).

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Bounty regimes  347 with actionable information from coming forward at all (Miralem 2011).39 The SEC’s decision to incentivize rather than mandate internal reporting followed from its conclusion that the individual whistleblower was “in the best position” to weigh the risks and benefits and decide whether an internal report would be futile or otherwise expose her to an unreasonable risk of retaliation.40 Another reason to reject an internal exhaustion requirement is that, far from eroding internal compliance systems, the threat of purely external reports may provide salutary incentives for firms to improve and strengthen those systems (Miralem 2011). Even simple displacement costs—including the higher cost of external regulatory intervention relative to internal resolution, or the possibility that bounty-hunting employees will permit wrongdoing to ripen rather than lodge an immediate internal report—will be borne, at least in part, by regulated entities themselves. It thus seems reasonable to assume that firms will respond to the creation of a bounty regime by strengthening internal compliance processes and making internal reports more attractive, thus reducing the likelihood of a costly external report.41 This further complicates the case in favor of an internal reporting requirement. Unfortunately, empirical evidence on questions regarding the optimal mix of internal and external reporting is sparse and likely to remain that way. The main reason is that internal whistleblower reports are typically not observable by the analyst and so, like much of the empirical literature on whistleblowers, rely on unvalidated self-reporting (Miceli and Near 1992, p. 99; Miceli and Near 2005, pp. 124–128). This precludes direct measurement of displacement or erosion effects. Nor are analysts able to generate reliable estimates of the proportion of individuals who acquire actionable information but, perhaps out of fear of retaliation in a regime with an internal mandate requirement, choose not to blow the whistle at all. Faced with these challenges, a growing body of research has instead begun to work around the edges of the core policy questions. One potentially fruitful line of research seeks to estimate the proportion of external whistleblowers who lodge an internal report before reporting “out.” A reliable answer to that question would help policymakers gauge the value added of an internal exhaustion requirement. A frequently made claim is that whistleblowers overwhelmingly report misconduct internally before lodging external reports (National Whistleblowers Center 2010; Kesselheim, Studdert, and Mello 2010; Miceli and Near 1994; U.S. Merit Systems Protection Board 2011). However, many such studies are of questionable utility because of sampling and other problems. The National Whistleblowers Center study (2010), which finds an unusually high internal reporting rate of nearly 90 percent, is especially 39   So argued a number of commenters during the rulemaking comment period. Ibid. at 34,324 (collecting comments). 40   Ibid. at 34,360–62 & n. 462. 41   As with the prior discussion on the determinants of the magnitude of displacement and erosion costs, the degree to which firms will respond to the presence of a bounty regime by improving internal compliance will turn on structural features of the regime beyond the presence or absence of an internal reporting mandate. One of the most potent factors will be whether self-disclosure to regulators entitles a firm to a lower sanction, as appears to be the case in many regulatory contexts (Files, Martin, and Rasmussen 2015). Ian Ayres and John Braithwaite (1992, p. 47) offer a useful general discussion of the ways in which self-regulation depends on “the spectre of sanctions in the background.”

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348  Research handbook on corporate crime and financial misdealing vulnerable because it examines only FCA cases in which qui tam relators also asserted retaliation claims—an obvious and fatal case of selecting on the dependent variable.42 Similarly, Aaron Kesselheim, David Studdert, and Michelle Mello (2010) consider only whistleblowers who achieved large, marquee recoveries against pharmaceutical companies, raising obvious (but often unacknowledged) generalizability concerns.43 A broader problem is that rigorous research on the individual and situational determinants of whistleblowing predates Dodd-Frank and the FCA’s maturation as a litigation regime and so focuses on regulatory contexts without bounties at all (see, for example, Miceli and Near 1992), or else pools data on whistleblower reports across regulatory regimes with and without bounty programs (see, for example, Dyck, Morse, and Zingales 2010; Ethics Resource Center 2012).44 It remains an open question how well empirical findings derived from non-bounty or mixed bounty/non-bounty contexts transfer to the pure bounty context. The end result is a surprising lack of evidence on even basic questions relating to optimal bounty regime design. A second potentially useful but still developing line of scholarly inquiry interrogates the relationship between the strength of a firm’s internal compliance system and external whistleblower reports. For instance, Bowen, Call, and Rajgopal (2010) offer the most rigorous study to date and find no statistical relationship between the likelihood of an external report and either the strength of a firm’s internal controls or the clarity of its internal communication channels. But they also find that firms that experienced external whistleblowing events were more likely to make subsequent improvements in corporate governance, including reductions in board size and in the proportion of insider board members. However, the study suffers from methodological problems, including questionable sampling techniques—e.g., a sample that only includes whistleblower reports that drew press coverage, and a control group that only includes firms targeted in securities class action lawsuits—and, as with the accounting and finance literature more generally, decidedly crude proxies for the strength of a firm’s internal compliance structures.45 As

42   More specifically, the sample includes only cases in which the relator asserted a claim for retaliation under 31 U.S.C. § 3730(h). This is problematic because a qui tam relator who files a complaint cannot typically assert retaliation in response to an external report until after she has filed her lawsuit, typically in an amended complaint. It follows that many or most of the cases included in the sample alleged retaliation in response to internal reports. 43   Another promising study of a large sample of federal employees reports the percentage of employees who reported to each of several types of internal superiors (e.g., “immediate supervisor”; “higher level supervisor”; “higher level agency official”; etc.) (U.S. Merit Systems Protection Board 2011). However, it does not report the proportion of employees who made any internal report to at least one type of superior. As a result, the study can only support a finding that the internal reporting rate was between 33 percent and 68 percent among employees who believe they observed wrongdoing. Nor does the study report the percentage of employees who made immediate external reports or went on to make external reports following internal reports. 44   As an example, the Ethics Resource Center’s (2012) annual “National Business Ethics Survey” asks respondents whether they observed and reported any of 33 different types of misconduct, only a small fraction of which fall within a regulatory area with a bounty program such as Dodd-Frank or the FCA. 45   For example, Bowen, Call, and Rajgopal (2010) operationalize their variable for the strength of a firm’s internal compliance system using an index measure that includes a number of firm attributes, including firm size and age, the presence of negative earnings, and the number of operat-

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Bounty regimes  349 a result, we only have mostly anecdotal evidence on how firm-level characteristics shape rates of external whistleblowing or, framing causation in the other direction, on the effect of external whistleblowing on firm compliance structures.46 A final line of research makes the important point that employers who seek to reduce the risk of external whistleblowing have a variety of tools at their disposal beyond strengthening internal compliance systems. A recent unpublished study by Call, Kedia, and Rajgopal (2012) finds that stock-option grants depress the incidence of external whistleblowing, suggesting that employers might use option grants—or, alternatively, equity-based compensation and profit-sharing programs—to buy employees’ silence about wrongdoing by tying their compensation to firm stock price or performance.47 Contracting offers another tool employers can use to moderate external whistleblowing, and some warn of increasing use of non-disclosure provisions in employment contracts, as well as more narrowly tailored provisions requiring employees to provide internal notice before making external reports and severance agreements waiving an employee’s right to file a qui tam lawsuit (Project on Government Oversight 2014).48 Growing use of these contractual provisions is also suggested by a rising tide of case law examining their enforceability,49 as well as SEC enforcement actions imposing a cease and desist order

ing and geographic segments. This latter variable is designed to capture communication difficulties, among other things. 46   Emily Chasan (2011) suggests that some firms responded to Dodd-Frank by incentivizing employees to make internal rather than external reports, including offering internal bounties to compete with those offered by the SEC. 47   The theory here is that employees with knowledge of wrongdoing will not make external reports to the press or regulators out of fear that doing so will depress firm value. Of course, it is also possible that revelation of information will be seen by whistleblowers as a way to boost firm value over the mid or long term, particularly if an external report, even if it leads to an initial drop in stock price, catalyzes changes in management personnel or priorities that ultimately improve performance and profitability. 48   As an example, Scott Higham and Kaley Belval (2014) report that some employment lawyers see an increase in the use of highly restrictive non-disclosure agreements. 49   Case law is in considerable flux. Courts typically find non-disclosure agreements invalid under the FCA (U.S. ex rel. Ruhe et al. v. Masimo Corp., Case No.: CV 10-08169 [2012]; U.S. ex rel. Grandeau v. Cancer Treatment Centers of America, 350 F. Supp. 2d 765 [2013]). However, other courts have left potential openings for defendants, enforcing non-disclosure and confidentiality provisions where a qui tam relator’s appropriation of company documents is overbroad and “indiscriminate” (U.S. ex rel. Cafasso v. Gen. Dynamics C4 Sys., Inc., 637 F.3d 1047 [9th Cir. 2011]), or where the defendant company’s claim does not depend on a finding of liability under the FCA (Cell Therapeutics, Inc. v. Lash Group, Inc., 586 F.3d 1204 [9th Cir. 2009]). Another line of decisions concerns employment contracts with internal-reporting requirements and severance agreements waiving qui tam causes of action. Thus, in U.S. ex rel. Wilhirt v. AARS Forever Inc., et al. (2013 WL 5304092 [N.D. Ill. Sept. 19, 2003]), the district court found that the defendants could make out a claim for breach of a contractual provision requiring employees to acknowledge “no known suspect practices” within the company by showing “a causal relationship between Relators’ failure to report [internally] and their filing of the qui tam action.” Similarly, the Fourth Circuit recently upheld a severance agreement waiving the right to bring a qui tam action where the government had already begun an investigation of the matter (U.S. ex rel. Radcliffe v. Purdue Pharma L.P., 600 F.3d 319 [4th Cir. 2011]), thus joining an earlier Ninth Circuit decision chipping away at the more general refusal of courts to enforce pre-filing waivers of subsequent qui tam suits of any kind (United States ex rel. Hall v. Teledyne Wah Chang Albany, 104 F.3d 230 [9th Cir. 1997]).

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350  Research handbook on corporate crime and financial misdealing against firms that use confidentiality agreements with “improperly restrictive language” (U.S. Securities and Exchange Commission 2015, 2016a, 2016b).50 Harder to gauge are employer motives in deploying such tools. On the one hand, a long line of research finds a relationship between equity-linked compensation and financial misreporting (see, for example, Peng and Roell 2008; Johnson, Ryan, and Tian 2009; Efendi, Srivastava, and Swanson 2007; Burns and Kedia 2006), and thus lends at least some credence to the notion that option grants are a cynical managerial effort to silence would-be whistleblowers.51 A more charitable view is that option grants and even contractual provisions mandating internal reporting are a sincere tool of good governance, sharpening employees’ focus on value-generating—and value-reducing—activities in ways that bolster, rather than erode, internal compliance systems (following from Hochberg and Lindsey 2009). Future research could better adjudicate between these competing accounts, thus developing our understanding of whether and how regulated entities can bolster or subvert bounty regimes. 3.3  The Efficiency–Control Trade-Off A final design challenge facing regulatory architects is specific to the choice between a cash-for-information approach and an FCA-like qui tam mechanism: how to weigh the complex efficiency and control trade-offs in deciding the degree to which whistleblowers are vested with independent enforcement authority. Part of this analysis parallels a longstanding debate about the merits and demerits of public and private enforcement as regulatory modes. Thus, a qui tam approach may prove superior to a cash-for-information approach because profit-minded private enforcers are more cost-effective and nimbler than weakly incentivized or sclerotic public enforcement bureaucracies (Stewart and Sunstein 1992, p. 1298). By contrast, a cash-for-information approach may prove superior where public enforcers leverage scale economies that private, decentralized qui tam enforcers cannot (Polinsky and Shavell 2000, p. 46), or because profit-motivated qui tam enforcers engage in wasteful and duplicative enforcement efforts by piggybacking on public enforcers or each other (Stephenson 2005; Engstrom 2012). Viewed through this narrow efficiency lens, the choice between a cash-for-information and a qui tam approach will turn at least in part on an empirical judgment as to which generates a chosen level of enforcement effort—and, with it, a desired quantum of ­deterrence—more cheaply and efficiently. Yet regulatory architects must also weigh a complex set of agency costs in choosing

50   These agreements, the SEC first found in In the Matter of KBR, Inc., run afoul of Rule 21F17, which provides: “No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.” 51   It is worth noting that Call, Kedia, and Rajgopal (2012) attempt to control for the possibility that option grants are a tool of good governance rather than a cynical managerial tool by including proxies for good governance, including “the GIM index, board characteristics and ease of internal communication channels.” But as noted previously, the proxies used are crude. For instance, the proxy for the clarity of “internal communication channels” is an index measure that includes firm age and Herfindahl-Hirschman scores for the firm’s geographic and business segments.

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Bounty regimes  351 among bounty approaches. One type of agency cost is private and profit-based. For example, profit-motivated qui tam enforcers will target misconduct whenever the prospective payout exceeds the cost of bringing suit, even where the social costs incurred—e.g., litigation costs or costs imposed on affected communities—exceed any benefit (Shavell 1997; Kwok 2013). The resulting lack of prosecutorial discretion, in addition to undermining the possible benefits of overbreadth in regulatory statutes (Buell 2008), should be especially concerning in regulatory areas where enforcement efforts implicate unique sensitivities, such as diplomatic concerns, that may also have a constitutional dimension given the President’s enumerated powers in the foreign policy space. Private enforcement actions also may undermine the government’s efforts to use prosecutorial discretion to induce firms to self-report and cooperate to provide evidence against individual wrong­ doers (Arlen 2012). Thus, in the Foreign Corrupt Practices Act (FCPA) context, anything beyond a cash-for-information regime, including recent proposals to install a qui tam mechanism (O’Sullivan 2016), may be a non-starter. Vesting profit-seeking enforcers with a qui tam cause of action yields other agency and control costs as well. Qui tam regimes transfer substantial lawmaking powers to private litigants who have powerful incentives to relentlessly press law’s boundaries in ways that courts, agencies, and even the legislature itself can only imperfectly police (Engstrom 2014b). As a result, qui tam regimes may, relative to cash-for-information regimes, exhibit substantial statutory “drift” away from legislative purposes as qui tam enforcers push the law in new and democratically unaccountable directions. This risk may be especially high where statutory mandates are highly indeterminate, as with the FCA’s open-ended anti-fraud prohibition (Engstrom 2014b). The second type of agency cost is public and politics-based: the risk that purely public enforcement upon receipt of whistleblower tips, as in a cash-for-information regime, will yield socially inefficient regulatory gaps. One reason is the standard concern with regulatory capture (Kovacic 1996; Carpenter and Moss 2013). Others arise from a more pedestrian set of bureaucratic pathologies. Thus, we might worry that a politically conscious agency charged with sifting good and bad tips in a cash-for-information regime will seek to burnish its reputation and curry favor with legislative overseers by pursuing a mix of high-value, marquee cases and low-value, easy-to-win cases, leaving a swath of under-deterred misconduct in between (Engstrom 2014b, p. 618). An agency might also seek to suppress a valid whistleblower report to hide its own lax oversight (Engstrom 2013, p. 1715). In such situations, the addition of a qui tam mechanism can serve as a salutary “failsafe” mode of enforcement that fills in what would otherwise be socially inefficient gaps in regulatory effort, whether directly or by threatening to embarrass an agency inclined to shirk (Coffee 1983). Mapping competing agency costs in this way shows that a key institutional design challenge is how much public control to inject back into a bounty scheme. A qui tam regime coupled with strong or even absolute public control may merely relocate the point in the regulatory process at which capture or other bureaucratic pathologies take hold and thus prove little different from a cash-for-information approach. Too little control and qui tam enforcement efforts can impose substantial efficiency costs because of failures of prosecutorial discretion, while also steering the elaboration of statutory mandates down democratically unaccountable pathways. Getting the balance right may once more turn on empirical judgments. In regulatory

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352  Research handbook on corporate crime and financial misdealing areas where regulatory capture is likely to be pervasive, a qui tam mechanism may bring enforcement efforts closer to the legislative bargain. Where capture or other bureaucratic pathologies are less concerning, a qui tam mechanism may merely exacerbate statutory drift and legislative infidelity with little countervailing benefit.

4. THE ORGANIZATIONAL STRUCTURE OF WRONGDOING AND OPTIMAL BOUNTY REGIME DESIGN This final section aims to advance thinking on a further aspect of the regulatory design puzzle that has thus far eluded systematic scholarly inquiry: how regularities in firm complexity and the organizational structure of wrongdoing present opportunities and challenges in constructing bounty regimes. The analysis will proceed in two steps. The first subsection advances a series of descriptive claims about firm complexity and its relationship to the organizational structure of wrongdoing. The second subsection uses these more descriptive insights to sketch a set of prescriptions regarding optimal bounty regime design. Some of these prescriptions concern core design challenges, assessed above, such as how to generate an optimal quantity and quality of tips, and how to achieve an optimal mix of internal and external reporting. In addition, the analysis will consider whether certain types of corporate crime and financial misdealing are more or less conducive to a bounty approach, as compared to other regulatory areas. The aim throughout is to offer a conceptual framework and highlight opportunities for future research rather than arrive at authoritative conclusions. 4.1  Firm Complexity and the Organizational Structure of Wrongdoing Standard organizational theory holds that firms vary in complexity along at least three dimensions. One dimension is vertical: whether firms are characterized by more or fewer management layers (Daft 1992). A second is horizontal: more complex firms tend to be “multi-divisional,” or “M-form,” in their structure and are typically characterized by semi-autonomous subunits that have their own unitary structures and are responsible for their own production and profits (Williamson 1985). A third dimension is related but distinct: firms vary in the degree of skill differentiation within employee ranks. Some firms’ employees are relatively uniform in skill areas or levels. Others may exhibit substantial differentiation, with employees possessing a disparate set of financial, technical, or other specific skill sets. Organizational complexity is relevant to regulatory design because it predictably shapes both the amount of wrongdoing and its point of origin within the firm. To begin with, a long line of research holds that organizational complexity correlates with firms’ under­lying propensity to commit wrongdoing. Vertical layers mean more agency costs and “agent opportunism,” as firm employees internalize benefits at the firm’s expense (Alexander and Cohen 1999; Williamson 1985; Coffee 1977; Baysinger 1991; Macey 1991). Horizontal complexity, particularly when expressed through semi-autonomous subunits with profit-center responsibility, creates further incentives to cheat by linking compensation and access to firms’ resources to unit performance (Baysinger 1991), while also increasing the probability that cultures of noncompliance can take root and persist.

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Bounty regimes  353 Finally, complexity compromises firms’ capacity to monitor and police wrongdoing (Baucus and Near 1991, p. 14; Bushman et al. 2004, p. 175). Vertical and horizontal complexity attenuates communication channels (Arrow 1974; King 1999) and will also often entail geographic dispersion (or “spatial complexity,” Daft [1992]), thus increasing the cost of monitoring while decreasing its efficacy. Whatever the precise mechanisms, we might plausibly expect that, all else being equal, more organizationally complex firms will generate higher levels of wrongdoing. Perhaps more importantly, as organizational complexity increases, a greater proportion of wrongdoing will originate at the subunit level within firms, and it will also be less likely to involve direct participation by upperlevel (non-subunit) managers. Of more direct relevance to bounty regimes, variation in organizational form will also yield systematic differences in the observability of wrongdoing by insiders. In more organizationally complex firms, vertical management layers and the operational independence of subunits can prevent employees within one part of the firm from learning about actions taken in another part—a version of the “elephant and the blind men” problem (Baucus and Near 1991, p. 14). In fact, wrongdoers within more complex firms can deliberately distribute tasks among siloed subunits in order to mask the overall scheme. As an example, the multiple transactions required to implement an illegal tax-avoidance scheme can be distributed across multiple subunits, thus reducing the probability that employees will be able to connect the dots and identify the illegal scheme as such. Skill differentiation can have a further obfuscating effect by creating translation problems: finance and accounting personnel may be less able to accurately identify wrongdoing perpetrated by mechanical engineers, and vice versa. As a final preliminary, firm complexity and the organizational structure of wrongdoing will not just vary by firm but may also systematically vary by industry or regulatory area. A range of evidence suggests that firms have generally grown more complex during the postwar era, due in part to the rise of multinational and transnational corporations (Buckley and Casson 2002). But substantial variation remains, as evidenced by a small empirical literature tracking other trends in corporate forms (see, for example, Rajan and Wulf 2006). As a result, we might expect that industries dominated by large manufacturing concerns will exhibit greater organizational complexity than industries dominated by small or mid-sized operations (Baucus and Near 1991). Similarly, we might expect that firms regulated under the FCPA—which are almost by definition multinational corporations—will exhibit greater average organizational complexity than firms regulated under the FCA, which run the gamut from large, multinational corporations to small physicians’ offices. As discussed in more detail below, if industries or regulatory areas exhibit regularities along such lines, then regulators may be able to tailor bounty regime designs accordingly. 4.2  The Organizational Structure of Wrongdoing and Optimal Bounty Regime Design Regularities in the organizational structure of wrongdoing present both challenges and opportunities for regulators designing bounty regimes. For instance, the few studies of whistleblowing that have considered the relationship of organizational structure to whistleblowing predict that firm complexity, by attenuating and even obscuring communication channels, will encourage external over internal reporting (King 1999, p. 324;

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354  Research handbook on corporate crime and financial misdealing Miceli and Near 1992, p. 157). As a result, regulators with jurisdiction over industries or regulatory areas characterized by greater organizational complexity may thus field more tips at a given level of payouts and protections than in industries or regulatory areas characterized by lower organizational complexity. A second and more salient implication of the prior section’s analysis is that, as organizational complexity increases, fewer would-be whistleblowers will have a sufficiently synoptic view of organizational activities to observe and accurately identify wrongdoing. Consequently, in more complex firms, whistleblowers with high-quality information should be a smaller proportion of firm employees, and they should also be disproportionately found within managerial ranks (Miethe and Rothschild 1994, p. 332). This is borne out in empirical research finding that management-level qui tam relators tend to win more often than underling qui tam relators (Engstrom 2012, p. 1296). On the one hand, these dynamics help highlight a central challenge of bounty regime design. Research on the individual and situational determinants of whistleblowing suggests that higher-ups within a firm’s managerial hierarchy, while possessing more reliable information about wrongdoing, may also be less likely to make external whistleblowing reports when confronted with wrongdoing compared to underlings (Rothschild and Miethe 1999).52 The most common explanation is that higher-ups tend to be more organizationally embedded and, because they are more likely to possess firm- and industryspecific human capital and vested benefits (e.g., sick leave, delayed remuneration), also have more to lose in the event of retaliation than underlings or newcomers (Miethe and Rothschild 1994; Miceli and Near 2005). This same line of research also suggests that higher-level employees, because of their greater sense of self-efficacy and organizational commitment, may also be more likely than underlings to lodge internal reports (Miethe and Rothschild 1994).53 Still, the end result is something of a paradox from the perspective of bounty regime design: firm insiders with better information about wrongdoing are also less likely to provide it to external regulators. This paradox should become more pronounced as organizational complexity within an industry or regulatory area increases and the pool of employees with high-quality information shrinks. Of course, if regulators wish to generate more management-level tips, they can always increase payouts in an effort to overcome the higher professional and personal costs managers face in lodging external reports. But the Goldilocks problem noted previously imposes limits: raising payouts should also draw more tips into the system from employees at all levels within the firm, including those with less reliable access to information. It follows that as firm complexity increases within an industry or regulatory area, a bounty system may more quickly reach the overload point, where the cost to a supervising agency of sifting the marginal tip exceeds its regulatory value before the system generates

52   Interestingly, while Joyce Rothschild and Terance Miethe (1999) report finding “no substantial differences” in whistleblowing propensities based on “supervisory position,” their data show that 53 percent of internal whistleblowers held a “supervisor position” as against 46 percent of external whistleblowers, a non-trivial difference. 53   Marcia Miceli and Janet Near (2005) offer a more recent summary of research and are careful to note key studies finding that whistleblowing correlates with age, years of service, education,  pay,  and organizational commitment, alongside conflicting studies finding no such relationships.

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Bounty regimes  355 substantial high-quality information. Thus, some industries or regulatory areas may be more conducive to a bounty approach than others. While these dynamics suggest substantial design challenges, they also present some design opportunities, including a potentially valuable, if partial, solution to the Goldilocks problem. In particular, if higher-ups are more likely to possess firm- or industry-specific skills, they should also be more sensitive to shifts in anti-retaliation protections—­ including anonymity guarantees—than lower-level employees, whose more fungible skills may make them more employable in other industries and thus less vulnerable to blackballing. This suggests that regulatory architects may be able to coax more highquality tips into the system by strengthening anti-retaliation protections rather than by raising bounties (Engstrom 2014b, p. 615). Put another way, a bounty regime with strong anti-retaliation protections—especially guaranteed anonymity—but lower payouts might generate systematically higher-quality information than a system with weak antiretaliation protections and higher payouts. Future research might further develop theory and evidence on how regulators can better modulate tip flow by leveraging heterogeneity within the whistleblower pool, whether by strategically substituting between payouts and protections or otherwise. More ambiguous are the implications of regularities in the organizational structure of wrongdoing for a second design puzzle reviewed earlier: whether to impose an internal reporting mandate. On the one hand, a high degree of firm complexity should reduce the value of an internal exhaustion requirement because, as noted previously, higher-ups with the best information about wrongdoing are already more likely than underlings to make internal reports (although also less likely to make external ones). This suggests that mandating internal reporting may not materially increase the amount of high-quality information that is channeled to internal compliance officers, even as it deters some whistleblowers from coming forward at all. And yet, high complexity also means that more wrongdoing will originate below senior managerial ranks, especially within subunits. An internal reporting mandate could thus plausibly reduce diversion costs in firms with good-faith, but under-utilized, compliance systems. Less obviously, by disproportionately chilling whistleblowing among lower-level employees who might otherwise move immediately to an external report, an internal reporting mandate may work to filter out whistleblowers with less reliable access to information about wrongdoing. Interestingly, one of the main arguments for an internal reporting requirement is modulating external tip flow by discouraging whistleblowers with lowerquality information, not bolstering internal compliance systems. Future scholarly work may seek to improve our understanding of these competing dynamics in order to arrive at a  firmer set of conclusions about the costs and benefits of an internal reporting mandate. A final question remains: Assuming that regularities in the organizational structure of wrongdoing translate into clean design prescriptions, are industries and regulatory areas sufficiently distinct such that regulatory designers can plausibly implement those prescriptions? As already noted, some industries or regulatory areas are readily categorized. Thus, the multinational companies subject to the FCPA are likely to exhibit greater average organizational complexity than the near-infinite variety of entities subject to the FCA. Privileging protections over payouts could therefore pay significant dividends were Congress to install a full-scale bounty program within the FCPA, as advocated

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356  Research handbook on corporate crime and financial misdealing by O’Sullivan (2016).54 Experts in specific regulatory areas may be able to offer further sectoral generalizations, which can also be tested empirically. For instance, the finance literature commonly uses the Herfindahl-Hirschman Index to estimate the degree of business-line and geographic concentration/diversity of firms and industries (see, for example, Bushman et al. 2004). The goal would be to work up a series of cross-sectoral judgments about which industries or regulatory areas are most conducive to a bounty approach. An intriguing question given the focus of the volume to which this chapter contributes is how to characterize the organizational structure of wrongdoing among firms subject to securities regulation—perhaps the principal means of policing financial misdealing. On the one hand, any publicly traded firm operating within any industry can commit securities fraud, thus foiling clean generalizations about firm structure. And yet, some have argued that securities fraud is a distinctive regulatory area, because most wrongdoing is public—that is, someone at the top of the firm usually must speak—and is also typically “committed with the involvement or acquiescence of the entire management group” (Langevoort 1997, pp. 111–112). To that extent, the organizational structure of wrong­ doing in the area of securities regulation may resemble that in industries or regulatory areas with a high degree of organizational complexity—such as the FCPA—at least in the concentration of actionable information among higher-level managers. Interestingly, by maximizing protections via guaranteed anonymity for represented whistleblowers but limiting payouts to frauds totaling at least one million dollars, the SEC has optimized tip flow consistent with the account presented herein. Less clear is whether the SEC was right in refusing to impose an internal reporting mandate. As noted previously, such a mandate can confer benefits, including the modulation of external tip flows by chilling whistleblowers with lower-quality information.

5. CONCLUSION The purpose of this chapter has been to survey the small but growing academic literature on bounty regimes and to synthesize some of the principal challenges facing regulatory designers who deploy them. While much valuable work has already been done, there is a critical need for at least two kinds of inquiry going forward. One line of inquiry is more formal theoretical work that moves toward a more unified framework for weighing competing design choices. Key to such efforts is corralling the many complexities regarding the individual and situational determinants of whistleblowing, including the differing propensities of whistleblower types to engage in internal versus external whistleblowing. Of equal importance is modeling the relationship between external reporting and internal compliance systems using a carefully specified set of mechanisms that plausibly explains when and how external reporting may impair, rather than improve, internal compliance efforts.

54   Currently, only FCPA violations trained on securities “issuers” are bounty-eligible under the Dodd-Frank whistleblower program, as jurisdiction over actions against other entities and individuals rests with the DOJ.

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Bounty regimes  357 The other fruitful line of inquiry is empirical work testing key theoretical premises. Importantly, this work should focus narrowly on the bounty context rather than on whistleblowing behavior more generally—a plain shortcoming of much of the existing literature. Given the challenge of collecting real-world data on whistleblowing, some of the clearest research opportunities here may be experimental in nature, along the lines of Feldman and Lobel (2010) and Daniel Martin (2013), and as advocated by Anthony Heyes and Sandeep Kapur (2009, p. 180). Both of these lines of inquiry offer far more abundant research opportunities than are available in other, more crowded sectors of the scholarly literature on corporate crime and financial misdealing. But they are not just low-hanging fruit. Indeed, bounty regimes are likely to become an ever more prominent feature of the regulatory landscape, particularly as the present era of fiscal austerity makes bounty regimes attractive policy tools from the perspective of budget-conscious legislators and regulators. This makes it all the more concerning that public and political interest in bounty regimes may have outstripped rigorous theoretical and empirical work analyzing their workings.

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358  Research handbook on corporate crime and financial misdealing Carpenter, Daniel and David A. Moss (eds.). 2013. Preventing Regulatory Capture: Special Interest Influence and How to Limit It, Cambridge: Cambridge University Press. Casey, Anthony J. and Anthony Niblett. 2014. Noise Reduction: The Screening Value of Qui Tam, Washington University Law Review, 91, 1169–1217. Chasan, Emily. July 29, 2011. CFO Report: Companies Adjust to Looming Whistleblower Rule, The Wall Street Journal, retrieved from http://blogs.wsj.com/cfo/2011/07/29/companies-adjust-to-looming-whistleblower-rule/ Clark, Kathleen and Nancy J. Moore. 2015. Financial Rewards for Whistleblowing, Boston College Law Review 56, 1697–1775. Coffee, John C., Jr. 1977. Beyond the Shut-Eyed Sentry: Toward a Theoretical View of Corporate Misconduct and an Effective Legal Response, Virginia Law Review, 63, 1099–1278. Coffee, John C., Jr. 1983. 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An Economic Model of Whistle-Blower Policy, The Journal of Law, Economics, and Organization, 25, 157–182. Higham, Scott and Kaley Belval. June 29, 2014. Workplace Secrecy Agreements Appear to Violate Federal Whistleblower Laws, The Washington Post, retrieved from http://www.washingtonpost.com/investigations/

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Bounty regimes  359 workplace-secrecy-agreements-appear-to-violate-federal-whistleblower-laws/2014/06/29/d22c8f02-f7ba11e3-​8​a​​a9-dad2ec039789_story.html Hochberg, Yael V. and Laura Lindsey. 2010. Incentives, Targeting and Firm Performance: An Analysis of Non-Executive Stock Options, Review of Financial Studies, 23, 4148–4186. Hutt, Peter, Anna Dolinsky, David W. Ogden, and Jonathan Cedarbaum. October 2013. Fixing the False Claims Act: The Case for Compliance-Focused Reforms, retrieved from http://www.instituteforlegalreform.com/ uploads/sites/1/Fixing_The_FCA_Pages_Web.pdf Internal Revenue Service. 2012. Fiscal Year 2012 Report to the Congress on the Use of Section 7623, retrieved from http://www.irs.gov/pub/whistleblower/2012%20IRS%20Annual%20Whistleblower%20Report%20to%20 Congress_mvw.pdf Internal Revenue Service. February 20, 2015. History of the Whilstleblower/Informant Program [sic], retrieved from http://www.irs.gov/uac/History-of-the-Whilstleblower-Informant-Program Johnson, Shane A., Harley E. Ryan, and Yisong S. Tian. 2009. Managerial Incentives and Corporate Fraud: The Sources of Incentives Matter, Review of Finance, 13, 115–145. Jos, Phillip H., Mark E. Tompkins, and Steven W. Hays. 1989. In Praise of Difficult People: A Portrait of the Committed Whistleblower, Public Administration Review, 49, 552–561. Kaplow, Louis and Steven Shavell. 1994. Accuracy in the Determination of Liability, Journal of Law and Economics, 37, 1–15. Kelly, James. December 30, 2002. The Year of the Whistleblowers, TIME, retrieved from http://content.time. com/time/magazine/article/0,9171,1003967,00.html Kelsey, Sean and Thomas R. Krause. 2008. Leading with Ethics: The Cooperative Model and the Example of Workplace Safety. In Samuel Gregg and James R. Stoner, Jr. (eds.), Rethinking Business Management: Examining the Foundations of Business Education, Princeton, NJ: Witherspoon Institute, 118–128. Kesselheim, Aaron S., David M. Studdert, and Michelle M. Mello. 2010. Whistle-Blowers’ Experiences in Major Fraud Litigation against Pharmaceutical Companies, New England Journal of Medicine, 362, 1832–1839. King, Granville III. 1999. The Implications of an Organization’s Structure on Whistleblowing, Journal of Business Ethics, 20, 315–326. Kovacic, William E. 1996. Whistleblower Bounty Lawsuits as Monitoring Devices in Government Contracting, Loyola Los Angeles Law Review, 29, 1799–1857. Kovacic, William E. 2001. Private Monitoring and Antitrust Enforcement: Paying Informants to Reveal Cartels, George Washington Law Review, 69, 766–797. Kwok, David. 2013. Evidence from the False Claims Act: Does Private Enforcement Attract Excessive Litigation? Public Contract Law Journal, 42, 225–250. Landes, William M. and Richard A. Posner. 1975. The Private Enforcement of Law, Journal of Legal Studies, 4, 1–84. Langevoort, Donald C. 1997. Organized Illusions: A Behavioral Theory of Why Corporations Mislead Stock Market Investors (and Cause Other Social Harms), University of Pennsylvania Law Review, 101, 105–172. Leslie, Christopher R. 2006. Antitrust Amnesty, Game Theory, and Cartel Stability, Journal of Corporation Law, 31, 453–488. Macey, Jonathan R. 1991. Agency Theory and the Criminal Liability of Organizations, Boston University Law Review, 1991, 315–340. Manns, Jeffrey. 2006. Private Monitoring of Gatekeepers: The Case of Immigration Enforcement, University of Illinois Law Review, 2006, 887–973. Martin, Daniel E. 2013. Whistle Blowing, Religiosity, Spirituality and Integrity: Understanding the Impact of Social Dominance Orientation and Environmental Context, Journal of Organizational Moral Psychology, 2, 99–116. Mellstrom, Carl and Magnus Johannesson. 2008. Crowding Out in Blood Donation: Was Titmuss Right? Journal of the European Economic Association, 6, 845–880. Mensz, Jan P. 2010. Citizen Police: Using the Qui Tam Provision of the False Claims Act to Promote Racial and Economic Integration in Housing, University of Michigan Journal of Legal Reform, 43, 1137–1174. Miceli, Marcia P. and Janet P. Near. 1992. Blowing the Whistle: The Organizational and Legal Implications for Companies and Employees, New York: Lexington Books. Miceli, Marcia P. and Janet P. Near. 1994. Whistle-Blowing: Reaping the Benefits, Academy of Management Executives, 8, 65–72. Miceli, Marcia P. and Janet P. Near. 2005. Standing Up or Standing By: What Predicts Blowing the Whistle on Organizational Wrongdoing, Research in Personnel and Human Resources Management, 24, 95–136. Miethe, Terance D. 1999. Whistleblowing at Work: Tough Choices in Exposing Fraud, Waste, and Abuse on the Job, Boulder, CO: Westview Press. Miethe, Terance D. and Joyce Rothschild. 1994. Whistleblowing and the Control of Organizational Misconduct, Sociological Inquiry, 64, 322–347.

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360  Research handbook on corporate crime and financial misdealing Miralem, Iskra. 2011. Comment, the SEC’s Whistleblower Program and Its Effect on Internal Compliance Programs, Case Western Reserve Law Review, 62, 329–346. Morgan, David, Andre Grenon, and Leslie Adler. February 26, 2015. Senate Panel OKs Auto Industry Whistleblower Incentive, Reuters, retrieved from http://www.reuters.com/article/2015/02/26/autos-whistleblo​ wer-idUSL1N0W02WV20150226 National Whistleblowers Center. 2010. Impact of Qui Tam Laws on Internal Compliance: A Report to the Securities Exchange Commission, retrieved from http://www.whistleblowers.org/index.php?option=com_conte​ nt&task=view&id=1169 Near, Janet P. and Marica P. Miceli. 1996. Whistle-Blowing: Myth and Reality, Journal of Management, 22, 507–526. O’Sullivan, Julie R. 2016. “Private Justice” and FCPA Enforcement: Should the SEC Whistleblower Program include a Qui Tam Provision?, American Criminal Law Review, 53, 67–115. Pacella, Jennifer M. 2014. Inside or Out? The Dodd-Frank Whistleblower Program’s Anti-Retaliation Protections for Internal Reporting, Temple Law Review, 86, 721–761. Pacella, Jennifer M. 2015. Advocate or Adversary? When Attorneys Act as Whistleblowers, Georgetown Journal of Legal Ethics, 28, 1027–1067. Peng, Lin and Ailsa Roell. 2008. Executive Pay, Earnings Manipulation and Shareholder Litigation, Review of Finance, 12, 141–184. Petty, Aaron R. 2006. How Qui Tam Actions Could Fight Public Corruption, University of Michigan Journal of Law Reform, 39, 851–888. Polinsky, A. Mitchell and Steven Shavell. 2000. The Economic Theory of Public Enforcement of Law, Journal of Economic Literature, 38, 45–76. Project on Government Oversight. August 8, 2014. Whistleblowers Silenced by Non-Disclosure Agreements, retrieved from http://www.pogo.org/blog/2014/08/20140808-whistleblowers-silenced-by-nondisclosure-agree​ ments.html Rajan, Raghuram G. and Julie Wulf. 2006. The Flattening Firm: Evidence from Panel Data on the Changing Nature of Corporate Hierarchies, The Review of Economics and Statistics, 88, 759–773. Rapp, Geoffrey C. 2013. Four Signal Moments in Whistleblower Law: 1983–2013, Hofstra Labor and Employment Law Journal, 30, 389–403. Recent Legislation: Corporate Law – Securities Regulations – Congress Expands Incentives for Whistleblowers to Report Suspected Violations to the SEC. 2011. Harvard Law Review, 124, 1829–1836. Rose, Amanda. 2014. Better Bounty Hunting: How the SEC’s New Whistleblower Program Changes the Securities Fraud Class Action Debate, Northwestern University Law Review, 108, 1289–1302. Rothschild, Joyce and Terance D. Miethe. 1999. Whistle-Blower Disclosures and Management Retaliation: The Battle to Control Information about Organization Corruption, Work and Occupations, 26, 107–128. Salop, Steven C. and Lawrence J. White. 1986. Treble Damages Reform: Implications of the Georgetown Project, Antitrust Law Journal, 55, 73–94. Shavell, Steven. 1997. The Fundamental Divergence between the Private and the Social Motive to Use the Legal System, Journal of Legal Studies, 26, 575–612. Stephenson, Matthew C. 2005. Public Regulation of Private Enforcement: The Case for Expanding the Role of Administrative Agencies, Virginia Law Review, 91, 93–173. Stewart, Richard B. and Cass R. Sunstein. 1992. Public Programs and Private Rights, Harvard Law Review, 95, 1193–1322. Stout, Lynn. 2011. Cultivating Conscience: How Good Laws Make Good People, Princeton: Princeton University Press. Thompson, Barton H., Jr. 2000. The Continuing Innovation of Citizen Enforcement, University of Illinois Law Review, 2000, 185–236. Titmuss, Richard M. 1971. The Gift Relationship: From Human Blood to Social Policy, New York: Pantheon Books. U.S. Chamber of Commerce. May 24, 2011. U.S. Chamber Warns New SEC Whistleblower Rules Will Undermine Corporate Compliance Programs [Press Release], retrieved from https://www.uschamber.com/ press-release/us-chamber-warns-new-sec-whistleblower-rule-will-undermine-corporate-compliance U.S. Merit Systems Protection Board. 2011. Blowing the Whistle: Barriers to Federal Employees Making Disclosures, retrieved from http://www.usda.gov/oig/webdocs/Blowing_The_Whistle.pdf U.S. Securities and Exchange Commission. May 8, 2003. Speech by SEC Chairman: Remarks Before the Economic Club of New York, retrieved from http://www.sec.gov/news/speech/spch050803whd.htm U.S. Securities and Exchange Commission. December 17, 2010. Letter from Alexander M. Cutler, Chairman and C.E.O. of Eaton Corp, to Elizabeth M. Murphy, Sec’y, SEC, retrieved from https://www.sec.gov/comments/ s7-33-10/s73310-142.pdf U.S. Securities and Exchange Commission. 2015. Order Instituting Cease-and-Desist Proceedings Pursuant to

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Bounty regimes  361 Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order (File No. 3-16466), retrieved from http://www.sec.gov/litigation/admin/2015/34-74619.pdf U.S. Securities and Exchange Commission. 2016a. Order Instituting Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order (File No. 3-17739), retrieved from http://www.sec.gov/litigation/admin/2016/34-79607.pdf U.S. Securities and Exchange Commission. 2016b. Order Instituting Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order (File No. 3-17736), retrieved from http://www.sec.gov/litigation/admin/2016/34-79593.pdf U.S. Senate Commission on Banking, Housing, & Urban Affairs. July 12, 2011. Written Testimony of Harvey L. Pitt, Remarks Before the United States Senate Banking Committee on “Enhanced Investor Protection After the Financial Crisis,” retrieved from http://banking.senate.gov/public/index.cfm?FuseAction=Files. View&FileStore_id=25ebf00f-03ca-481c-941b-4f42b14b76f2 Vega, Matt A. 2012. Beyond Incentives: Making Corporate Whistleblowing Moral in the New Era of DoddFrank Act “Bounty Hunting,” Connecticut Law Review, 45, 483–547. Williamson, Oliver E. 1985. The Economic Institutions of Capitalism, New York: The Free Press.

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Index accomplice liability 70, 185 accountability 47, 55, 61, 158, 170–71, 253, 339 individual 51, 53–6, 221 accounting 163, 221, 283, 310, 348 aggressive practices 293 firms 310, 312 fraud 47, 64, 70, 72, 269 provisions 179, 253 actionable information 342, 347, 356 actors 28, 66, 78, 153–5, 158, 162–7, 170, 176 corporate 6, 66, 175, 183, 264, 311 organizational 153 actus reus 73–6 administrative entities 207, 211, 215 administrative proceedings 223, 226, 237 administrative sanctions 154, 216; see also collateral sanctions; reputational damage clawbacks 56, 276 debarment, see debarment delicensing, see delicensing director/officer bars 239, 241–3 exclusion, see exclusion impact of choice of guilty pleas vs DPAs 133–8 admissions 2, 65, 81, 92–4, 96, 110, 182, 313 affirmative defenses 178, 261–2 affirmative misrepresentation 71 agencies 4, 90–92, 120–21, 127–39, 154–69, 335–6, 339–41, 351 budget-constrained 215, 340 enforcement 4, 70, 151–71, 286, 310, 322 federal 90–91, 97, 118, 124, 127–8, 131, 135, 139 government 124, 128, 132, 135, 139, 181, 190, 227 interests 91, 129–31, 133–4, 136–7 agency costs 66–7, 105, 124–5, 284, 289, 315, 350–52 agents 153–4, 157, 159–60, 177–8, 295–7, 320, 322–3, 327 multiple 153, 297, 323 aggravating factors 103, 106–7, 139 aggressive accounting practices 293 agreements 43–5, 47–8, 50, 55, 89–90, 92–6, 109–10, 120 corporate integrity 106, 128, 130–31, 133

criminal settlement 94, 97, 104, 109, 112, 115, 117, 124 non-prosecution 2–3, 40–41, 45–7, 50, 55, 182, 253, 312–13 plea 45–6, 54–5, 88–9, 92–3, 95–7, 109–10, 119–20, 124 settlement 88, 92, 104, 106–7, 111–12, 123, 126, 130 aiding and abetting 77 allegations 65, 151, 161, 228, 230, 239, 252, 310 altruism 158, 169–70, 265 ambiguities 160, 176–7, 179, 181, 213, 267 American criminal law 73–4, 76, 78, 80 amnesty 202, 337–8 anonymity guarantees 335–7, 341, 355–6 anti-bribery law 4, 49, 151, 155, 177–80, 312; see also FCPA anticorruption institutions 157–8 anticorruption strategies 203, 215 anti-money laundering compliance 43, 249 anti-money laundering efforts 42–4, 162, 249 anti-retaliation protections 335–6, 339–40, 345, 355 Antitrust Division 51, 53, 114, 164, 314 antitrust violations 82, 93, 102, 114, 337 anything of value 180, 182, 184 appellate opinions 184–6, 188–9 arrest 23, 32, 155, 199, 208 assets 42, 52, 68, 154–5, 253 assistant director level 225–6, 228, 231 asymmetric information 195, 287 attorney career paths 224 attorney-client privilege corporate 6, 315–20, 327–8 waivers 316–17, 327 attorneys 53, 55, 224–35, 310–11, 317, 319, 323–4, 328 career paths 224–5 corporate defense 316, 328 enforcement 225, 225–34, 310, 316, 323 leaving SEC 231–4 private 187, 317 staff 225, 227, 230 audit 96, 153, 254, 317 Audit Committees 65, 282, 286, 288–9, 294, 298, 302, 311

363

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364  Research handbook on corporate crime and financial misdealing auditors 286, 310 internal 298 austerity, fiscal 337, 357 authorities, regulatory 13–14, 24, 204 autonomy 213, 252–3, 275 backdating investigations 222 bad faith 126 Bank Secrecy Act 42–4, 50, 247, 249, 254 bankers 271–2 bankruptcy 222, 287 banks 40, 42–5, 50, 64, 67, 78, 273, 275 international 22, 40, 50 investment 50, 275 multilateral development 167, 192 bargaining powers 5, 196, 199, 204, 215 bars, director/officer 239, 241–3 baton-passing model 324 behavioral compliance 5, 263, 272–9 behavioral economics 11, 275 behavioral ethics 5–6, 263–79 biases 11, 27, 31, 223, 267–8, 270, 272–3, 277–8 bid-rigging 102 blind spots 266, 269, 272, 278 blowback effects 191 boards of directors Caremark duty 74 independence 288–9, 301 meetings 289, 297 members 72, 212, 288, 290–91, 293, 295, 322, 348 monitoring 289–90 Stone v Ritter 126 bonuses 44, 56, 64, 66 bounty regimes 6–7, 156, 325–6, 334–57; see also whistleblowing bounty amounts 335–6, 346 design 7, 334, 338–56 Dodd-Frank 335–6 efficiency–control trade-off 350–52 Goldilocks challenge 339–43 and internal compliance systems 343–50 and organizational structure of wrongdoing 352–6 overview 334–8 payouts 336, 340, 346 bounty-seekers 336, 339, 343–4 BP 61–3, 68, 70, 73, 75, 80 bribery 65, 153–5, 164–6, 168–9, 180, 196–204, 207–10, 212–15; see also FCPA anti-bribery law 4, 49, 151, 155, 177–80, 312 bribe-prices 196–7, 201, 204 demands for bribes 200, 205

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foreign 151–2, 154–5, 157, 161, 163–4, 168–9, 171, 175 payers/bribers 71, 164, 168, 196–7, 199–200, 202, 208, 210 payments 182, 195, 198, 202, 210 recipients 164, 179 broker-dealers 223, 269, 303 budgets 157, 175, 220, 261, 299 burden of proof 136 bureaucracies 195–6, 210, 215, 234 business purpose requirement 65, 180 capital 78, 287, 291 human 354 social 14 capital markets 219–20, 223, 234 capital punishment 16, 78 capitalization, market 81, 168, 240–41 Caremark duty 74; see also individual liability cartels 114, 162, 204, 211 price-fixing 53, 337 cash-for-information 325, 334, 337, 339, 341, 350–51 causal relationships 74, 290 causation 62, 205, 233, 290 causes of action, private 183, 186–7 CCOs (Chief Compliance Officers) 6, 241, 282, 303 and GC (General Counsel) 294–302 cease and desist 238, 349 CEOs (Chief Executive Officers) 77, 80, 238–9, 241, 288–91, 293, 296–7, 301–2 certifications 44, 274, 277 CFOs (Chief Financial Officers) 46, 77, 238, 241, 301 cheating 263–5, 267–72, 274, 277–8, 352 altruistic 265 factors promoting/discouraging 267–72 Chief Compliance Officers, see CCOs Chief Executive Officers, see CEOs Chief Financial Officers, see CFOs children 33, 73–4, 101, 230 China 77, 156, 180 churning 273 civil actions 155, 175, 182, 226, 228–9 civil enforcement 41, 54, 70, 78, 175, 226 against individuals 54 civil liability 1–2, 60, 69, 314 civil penalties 227, 229, 244 civil sanctioning 66–9 civil servants 195–6, 198–201, 212–13 sanctions against 205–11 claims, false 131–2, 136 class actions 222, 224, 234, 248, 337 clawbacks 56, 276

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Index  365 Clean Water Act, see CWA clients 42, 81, 98, 195–205, 211, 215, 315, 324 coalitions 204–5 coercion 3, 12, 18, 22, 24, 26 coercion-based variables 22–3 coercive models 3, 11–12, 14, 21, 26, 33–5 collaboration 34, 204–5, 216 collateral sanctions 115, 117–18, 120–21, 124, 127, 188, 190, 192; see also debarment; disqualification disqualification 5, 215–16 exclusion, see exclusion collective action problems 164–5, 171 collusion 102, 195, 201, 203–5 collusive corruption 195–6, 213 collusive environments 5, 200, 203, 215 command and control 14, 17, 23, 29, 35, 264 commitment 14, 30, 250, 253–4, 266, 269, 273 commodification 342, 344 communications 14, 71, 268, 273–4, 278, 311, 316–17, 320 channels 63, 348, 353 communities 11, 13–14, 18–19, 21, 28–9, 32, 351 compensation 1–2, 66–8, 75, 157–8, 160, 170–71, 184, 187 equity 66, 287–8 equity-based 66, 287–8, 349–50 equity-linked 350 executive 67, 241, 282, 286–7, 292 system 64, 66, 104 competence 26–7, 33 illusions of 26, 28, 33 competition 157, 202–4, 265, 270, 297 competitive disadvantage 154, 165 competitive markets 196, 201–2 competitive model 197, 323–5, 328 competitiveness 271, 277 competitors 99, 155, 159, 169, 180, 184, 265, 270 complaints 84, 169, 204, 226, 274, 344 complex firms 352–4 complexity 170–71, 198, 254, 293, 352–3, 355–6 horizontal 352–3 organizational 7, 334, 337, 352–6 compliance 11–16, 212–15, 250–58, 263–5, 276–9, 282–3, 291–4, 300–303; see also CCOs behavioral 5, 263–79 effective programs 1–2, 5, 41, 212, 247, 249–62, 313

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employees 42, 44, 64 internal compliance systems 7, 334, 339, 343–5, 347–50, 355–6 and bounty regimes 343–50 legal 121–2, 264, 267, 310 messages 6, 273, 278 optimal 256, 258–9, 277 policies 56, 249, 252–3 risks 6, 271, 276–8 strategies 151–2, 156, 158, 164–6, 169 systems 7, 24, 212–13, 334, 339, 343, 346, 355 voluntary reforms 88–9, 94, 100, 106, 109, 122, 130, 134–5 complicity 59, 61, 90, 125–6, 316 composite liability 314–15, 326 concessions 88, 99, 102, 120 confessions 320–21, 326 employee 320–21 confidentiality 317, 321, 345 conflicts 18, 129, 170, 213, 268, 294, 303 internal 13 Congress 68, 76–8, 183, 185–6, 191–2, 222, 338–9, 355 conscientiousness 264, 276 consensual approaches 3, 11–12, 24 consensus 66, 68, 79, 85, 171 consent 11, 13–14, 18–20, 22, 24, 329 consent-based regulation 21–3 conspiracy 70, 72–3, 337 conspirators 59, 78 consumers 101, 144–6, 328 continuous improvement 252–3 contracts 123, 162, 168, 198, 204, 287, 292, 294 employment 31, 349 procurement 155, 198, 213 control 1–2, 27–9, 179, 195, 197, 199–201, 254, 335–6; see also command and control corruption 195, 200–206 external 18, 213 illusions of 29 internal 222, 237, 242, 249, 253, 308, 311, 313 public 336, 351 social 33, 35 control groups 265, 302–3, 316, 348 convictions 3, 46–7, 72, 80, 85, 87–147, 208, 211 exclusion or delicensing 128–38 felony 133, 136–7 formal 2, 182, 251 cooperation 6, 19, 21, 32, 52–5, 115, 119, 121–2

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366  Research handbook on corporate crime and financial misdealing coordination 124, 162–3, 171, 286 absence of 164, 171 mechanisms 162, 167 corporate attorney-client privilege 6, 315–20, 327–8 corporate civil liability, see civil liability corporate convictions 88, 92, 110, 126–7 corporate cooperation, see cooperation corporate crime, see detailed entries corporate criminal liability 42, 52, 59–60, 66–70, 73, 80–85, 211, 314; see also corporate prosecutions composite 314–15, 326 and Department of Justice 82–4 and managers 81–2 optimization of second-best instrument 84–5 Yates Memo 6, 41, 51, 53–5, 175, 187, 325, 329 corporate criminal settlements 2–3, 48–9, 51, 88, 92–4, 105–7, 114, 125–6 declinations 110 DPAs (deferred prosecution agreements) 4, 40–41, 43–7, 54–5, 88–97, 107–25, 127–39, 312–13 Holder Memo 82 pleas 40–4, 45–6, 54–5, 88–97, 107–14, 116–20, 122–7, 129–39 Thompson Memo 82 corporate culture 3, 14, 53, 61, 264, 271 corporate debarment 4, 190–92 corporate defendants 176, 181–2, 184–5, 188–9, 191, 227, 229, 237–8 corporate employees, see employees corporate fraud 53, 220, 268, 270, 288, 293, 302–3, 326 corporate governance 24, 66, 139, 155, 223, 251, 348 corporate integrity agreements 106, 128, 130–31, 133 corporate investigations 2–3, 5–6, 53, 65, 187, 211, 213, 308–30 definition 309–11 and detection avoidance 326–8 implementation 315–23 legal obligation to investigate 311–14 liability rule for inducing 314–15 rights and privileges 315–23 corporate investigators 6, 308–10, 314, 317, 320–30 corporate liability 1–2, 175, 212, 216, 223, 283; see also civil liability; corporate criminal liability; liability duty-based 212 respondeat superior 311

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corporate malfeasance, see corporate misconduct corporate management, see management corporate managers, see managers corporate misconduct 1, 3, 6–7, 59–61, 67–8, 100–101, 282–4, 286 organizational structure 7, 334, 340, 352–6 corporate policing 2 corporate privilege 316, 318–20 waivers 317, 327 corporate prosecutions 3, 41–2, 45–9, 51–3, 56, 114 goals 52–4 reform proposals 54–6 corporate reforms, and mandates 94–6 corporate regulation 3, 23, 60–61, 74 corporate reputation, see reputational damage corporate self-policing 312, 315, 327 corporate settlements, see corporate criminal settlements corporate wrongdoing, see corporate misconduct corrupt acts 161, 184, 208, 212, 214, 216 corrupt incentives 198, 205 corrupt officials 157, 199, 204, 210 corrupt transactions 197, 199, 203 corruption 1, 4–5, 157, 161, 167, 169, 195–6, 198–216; see also bribery; corporate criminal liability; FCPA; OECD absence of 205–6 benefits 201–2, 204 collusive 195–6, 213 control 195, 200–206 expected cost 200, 205 explanation 195–9 extortive 195–6 risks 5, 202–3, 212–13, 215 sanctions against civil servants 205–11 sanctions against state institutions 211–15 in state administration 4, 195–216 systemic 196, 211 costs 91–2, 95–100, 102–4, 107–10, 137–9, 144–6, 188–91, 199–201 agency 66–7, 105, 124–5, 284, 289, 315, 350–52 and benefits 4, 32, 51–2, 200, 355 enforcement 160, 163, 210, 221, 256 expected 97–8, 103, 105–6, 109, 145–6, 156, 175, 199 investigation 168, 171 litigation 117, 341–2, 351 loss-contingent 341 of reputational damage 88, 90, 97–107, 114, 126–30, 135, 139, 144–7 social 5, 18, 67, 209, 256, 258–9, 261, 340

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Index  367 counterparties 88, 139, 146 indirect 90 courts 72–3, 154–5, 161–2, 184–5, 189, 260–61, 315, 335–6 federal 40, 46, 62, 72, 238, 335 co-workers 19, 30, 325 credible threat of punishment 20, 32, 35 Crime Victims Rights Act 55 criminal behavior 16, 24, 52, 103, 269, 311 criminal charges 44, 99, 111, 131, 154, 182, 188, 242 Criminal Division 85, 167, 252, 311 Fraud Section 110, 114, 119, 252–3 criminal enforcement 3–4, 70, 128, 145, 177, 181 criminal investigations 51, 106–7, 182 criminal law 60, 66, 70, 72–5, 77–9, 84–5, 207–8, 214 American 73–4, 76, 78, 80 criminal liability 3, 41, 60–62, 68–9, 71–5, 78–9, 82, 212 corporate 42, 52, 59–60, 66–70, 73, 80–85, 211, 314 individual 60, 65, 70–81, 83, 85, 175, 188 criminal prosecutions 45, 54, 67, 70, 78, 81, 242 criminal sanctions/penalties 59, 66–8, 71, 76, 79, 206, 242, 244 sentences 23, 33–4, 46, 55, 93, 262, 313 criminal settlements 2–4, 88, 90–103, 105–7, 111–14, 128–30, 138–9, 145–6 agreements 94, 97, 104, 109, 112, 115, 117, 124 choices of form 89–92, 108, 111–13, 116, 119–20, 123, 126, 133–6 documents 103–6, 113 illustration using basic model 144–7 criminally bad management 3, 59–85 and corporate criminal liability 80–85 and criminal law 66–70 and individual criminal liability 70–80 nature of problem 60–65 cross-debarment agreements 154, 167 cross-listing 223 culpability 53, 55, 61, 63, 80, 157, 164, 169 culture 22, 30, 61, 65, 260, 264, 270, 344 corporate 3, 14, 53, 61, 264, 271 ethical 18, 31, 35, 344 internal 17, 19, 21 organizational 30, 250, 271 customers 18, 99–102, 115, 117–18, 128–31, 144–6, 273–4, 276 potential 101, 144 customs clearance 197, 199 CWA (Clean Water Act) 62, 72, 77

M4468-ARLEN_9781783474462_t.indd 367

dealings 71, 73, 88–9, 91, 98–103, 105–9, 127–8, 130–31 expected cost 97, 105, 109, 130 death penalty 16, 52, 77 deaths 63, 70, 73, 78–9, 120, 290 debarment 54, 117–20, 122, 129, 175, 183, 190–92, 198 automatic 190 corporate 4, 190 use 191–2 deception 27, 145, 266 declinations 110 defendants 55, 71–3, 76–9, 157–8, 186–7, 189, 237–40, 242 corporate 176, 181–2, 184–5, 188–9, 191, 227, 229, 237–8 sympathetic 4, 186, 188–90, 192 defense bar 81, 175, 186, 226, 316 defenses affirmative 178, 261–2 mistake-of-law 71 deference 12–14, 21–3, 68, 260–61 deferred prosecution agreements, see DPAs delicensing 70, 89–91, 97, 115, 117–20, 128–39 Department of Justice (DOJ) 46–8, 56, 81–4, 117–19, 167, 179, 186–8, 335–6 Antitrust Division 51, 53, 114, 164, 314 and corporate criminal liability 82–4 Criminal Division, see Criminal Division policy 55, 93, 126, 251, 317 Deputy Attorneys General 51, 84, 126, 325 design challenges 309, 334, 337, 355 institutional 301, 308–9, 339, 351 regulatory 7, 83, 334, 352 detected misconduct 90, 108, 117, 121, 129, 159 detection 6, 15, 121, 145–6, 168, 208–9, 284–5, 289–90 avoidance and corporate investigations 326–8 probability of 34, 144–5, 163, 168–9, 208–9, 256, 285, 290 deterrence 1–4, 11–35, 88, 90–92, 170, 183–4, 189–90, 207–9 approaches 17, 24, 33 effectiveness of 3, 16, 20, 26, 52 effects 14–17, 20–21, 25 general 117, 144 importance of corporate policing 2 magnitude of 15–16 marginal 208 organizational 52–3 over-deterrence 77, 165, 175

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368  Research handbook on corporate crime and financial misdealing strengthening 4, 175–92 through external sanctions 15–17 deterrent effects 16–17, 97, 100, 160, 175, 187, 191, 208–9 directors, see also boards of directors assistant 225–6, 228, 231 independent 94, 107, 125, 288–9, 295–6, 298–9 disclosure violations 5, 220–21, 224, 234, 237, 240 disclosures 51, 71, 221, 223, 268, 315, 317, 319 discretion 83–4, 90–91, 93, 116–17, 128–31, 136–7, 155, 335 exercise of 92, 131, 138 prosecutorial 84, 160, 189, 315, 329, 351 regulator 335–6 disgorgement 154, 227, 229, 238–9, 243 displacement 165, 343–7 costs 345, 347 disqualification 5, 215–16 D&O bars 242, 244 Dodd-Frank bounty scheme 336–7, 341 Dodd-Frank Wall Street Reform and Consumer Protection Act 247, 334, 339, 341, 346 DOJ, see Department of Justice double jeopardy 162 DPAs (deferred prosecution agreements) 4, 40–41, 43–7, 54–5, 88–97, 107–25, 127–39, 312–13 drug use 18, 21 due care 79 due diligence 42, 250, 253 duplicative efforts 294, 296, 350 duty-based corporate liability 212 duty-based sanctions 211–14 earnings management 288–9, 294 economic analysis 4–5, 11, 61, 68, 196, 207, 247, 254 of effective compliance programs 5, 247–62 economic crime 111, 151–3, 159, 163–4, 167 economists 84, 195, 210, 263–4, 270, 275–7 effective compliance programs 1–2, 5, 41, 212, 247–62, 313 efficiency–control trade-off 350–52 e-mails 19, 152, 156 embezzlement 132, 311 empirical evidence 11–12, 25, 41, 285, 293, 347 empirical inquiry 6, 220, 283, 302, 304 empirical literature 5–6, 156, 219, 225, 234, 347, 353 employee behavior 17, 22, 30, 56 employee confessions 320–21

M4468-ARLEN_9781783474462_t.indd 368

employees 1–3, 17–23, 29–32, 41–50, 297–300, 308–11, 314–22, 325–30; see also management full-time 295–6 high-level 23, 316 immunization 53, 326 lower-level 50, 56, 60, 73, 103–4, 309, 355 non-top management 297, 299–300 training 25, 96, 250, 252–4, 263, 293 employers 311, 319–20, 324, 349 employment 66, 87, 104, 222, 226, 311 contracts 31, 349 enforcement 151–4, 156–61, 165–6, 168–72, 219–20, 222–5, 227–32, 256–8 agencies 157, 166–7, 169 attorneys 225, 225–34, 310, 316, 323 authorities 2, 60, 152, 212 independent 334–6, 350 civil 41, 54, 70, 78, 175, 226 costs 160, 163, 210, 221, 256 criminal 3–4, 70, 128, 145, 177, 181 decisions 5, 153, 160–61, 222, 225, 234 FCPA Pilot Program 114, 119 federal policy, USAM (U.S. Attorneys’ Manual) 82, 96, 110, 113–16, 119–20, 251–2, 309, 313 games, see multijurisdictional enforcement games impact 5, 220–22 internal 56, 257 multijurisdictional 152, 167 outcomes 157, 160, 169, 224 over-enforcement 164–5, 186, 191 patterns 5, 51, 54, 222–4 powers 160, 222, 309 private 176–7, 183–4, 186–7, 189, 191–2, 220–22, 335–6, 350–51 public 3–5, 157, 162, 183, 186–7, 219–20, 325, 350–51 reactive 159–60, 170 under-enforcement 164–5 value 219–20 Enforcement Division 167, 224–5, 230, 232, 311, 321 Attorneys 228–9 enforcers 221, 223, 225, 227, 229, 231, 233, 235 external 308–9, 326–7 government 6, 184, 188, 190, 308–9, 316, 319, 323–4 public 6, 184, 323–4, 350 securities law 219–35 enhanced risk 4, 88–9, 109, 112–13, 124, 128–30, 137, 139 Enron 35, 69, 72, 78, 222, 227

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Index  369 environmental crimes 77, 83, 101–2, 107–8, 287 reputational damage 102 equilibrium 145–6, 165 equity 288, 321 equity-based compensation 66, 287–8, 349–50 erosion 344–7 escalation 207, 266, 271, 273 ethical behavior 22, 30, 275 ethical culture 18, 31, 35, 344 ethical risks 266, 271 ethics 5–6, 44, 264, 267, 271, 278, 297, 326 behavioral 5–6, 263–79 programs 250–51, 271, 313; see also compliance, programs evidence 2–3, 16, 24–5, 103, 110, 112–13, 223–4, 324 empirical 11–12, 25, 41, 285, 293, 347 exclusion 4, 89, 91, 97, 115, 117–22, 128–39 agency approach if granted full discretion 130–31 decisions 91, 129, 133, 135 and guilty pleas or DPAs 133–8 laws constraining authority to exclude 131–3 mandatory 91, 131, 133, 136–8 permissive 4, 118, 121, 131–5, 138–9 risk 124, 138 exclusionary authority 132, 134, 138–9 executive compensation 67, 241, 282, 286–7, 292 executives 5, 43–4, 239–42, 244, 289, 293, 297, 301 individual 51, 187, 240–41, 284 junior vs senior 241 expected costs 97–8, 103, 105–6, 109, 145–6, 156, 175, 199 expected harm 102, 105, 208 expected penalties 163, 201, 207–8 expected risk 4, 89–91, 99, 112, 125 expected sanctions 5, 207–9, 220, 256, 258, 261 expected value 101, 156, 221 experience 25, 27, 163, 225–6, 228, 230, 232, 292–3 expertise 6, 166, 171, 203, 225, 235, 288, 293–4 external bounties, see bounty regimes external controls 18, 213 external enforcers 308–9, 326–7 external monitors 107, 123–4 external reports 335, 343–5, 347–8, 354–5 external sanctions, deterrence through 15–17 external whistleblowing 334, 343, 345, 347–9, 354, 356 extortive corruption 195–6 extradition 47, 49–50

M4468-ARLEN_9781783474462_t.indd 369

facilitating payments 182, 184, 189 fairness 30–31, 274, 320, 328 false claims 131–2, 136 False Claims Act, see FCA FATF, see Financial Action Task Force fault-based liability 314–15 FBI, see Federal Bureau of Investigation FCA (False Claims Act) 7, 187, 334–41, 346, 348, 351, 353, 355 FCPA (Foreign Corrupt Practices Act) 4, 48–9, 156–8, 224, 252–3, 318, 351, 355–6 ambiguities and enforcement practices 177–83 cases 48–9, 158, 162, 175–6, 182–3, 185–8, 190, 192 corporate debarment 4, 190–92 defendants 176–7, 185, 188, 224 deterrence 175–92 enforcement 158, 160, 166, 175–6, 181–9, 191 private 183, 187, 189 facilitating payments 182, 184, 189 individual liability 183, 186–90 meaning 176, 180, 184 Pilot Program 114, 119 private right of action 183–7 reforms 4, 186 violations 175, 177, 181, 183, 185, 187, 191–2, 224 FDCA (Food, Drug, and Cosmetic Act) 76–7 federal agencies 90–91, 97, 118, 124, 127–8, 131, 135, 139 Federal Bureau of Investigation 161 federal courts 40, 46, 62, 72, 238, 335 federal prosecutors 40–41, 43–5, 81, 83, 114, 116, 311, 328–9 feedback 162, 195, 308, 334, 344 fees 53, 68, 200, 273, 296 felonies 72, 76, 78–9, 91, 111, 133, 136–7 fiduciary duties 79, 90, 314 Financial Action Task Force (FATF) 162 financial fraud 5, 75, 220–21, 326, 350 financial institutions 43, 51, 54, 78–9, 93, 153, 303, 312 international 154 Financial Intelligence Units 161 financial misdealing, see detailed entries financial misreporting/misrepresentation 5, 75, 220, 350 financial services industry 225, 232; see also financial institutions financial statements 49, 64, 71, 220, 241, 288 fines 5, 52, 155, 157, 163, 214–15, 256, 258 firms, value 168, 182, 221, 290, 292–3, 300 fiscal austerity 337, 357

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370  Research handbook on corporate crime and financial misdealing Food, Drug, and Cosmetic Act (FDCA) 76–7 force-based approaches 24, 34–5 foreign bribery 151–2, 154–5, 157, 161, 163–4, 168–9, 171, 175; see also FCPA Foreign Corrupt Practices Act, see FCPA foreign governments 124, 139, 155, 178–9 foreign officials 65, 125, 178–80, 182, 184, 189 foreign regulators 221, 224 forfeitures 157, 162 for-profit organizations 13, 35, 77, 330 fraud 47–9, 71, 99–102, 131–2, 144–6, 220–23, 284–93, 301–3 corporate 53, 220, 268, 270, 288, 293, 302–3, 326 financial 5, 75, 220–21, 326, 350 health care 107, 133, 136 incidence 222, 283, 285–7, 289–92, 295, 302–3 likelihood 282, 284, 286, 288–90, 300–301, 303 and reputational damage 101–2 securities 2–5, 48–9, 64, 77, 80, 237, 242, 356 Fraud Section 110, 114, 119, 252–3 fugitives 47, 49–50 game theoretic analysis 152, 156, 162, 171, 278 gatekeepers 128–9, 197–8, 336 GC (General Counsel) 6, 54, 63, 282–304, 327 and CCOs 294–302 empirical inquiry 302–3 highly compensated 292–3 role 291–4 gender 226, 230, 233, 235, 270 General Counsel, see GC Germany 151–3, 162 GM (General Motors) 62–3, 68, 70, 75, 79–80, 111 goals 1, 3, 11–15, 26, 42, 212–14, 267, 275–6 primary 1, 3 Goldilocks challenge 339–43 good faith 179, 251, 314, 319, 327 governance 15, 284, 290, 315 corporate 24, 66, 139, 155, 223, 251, 348 good 350 internal 6, 104–5, 107, 110, 124–5, 134, 282–304 reforms 95, 107, 220 government agencies 124, 128, 132, 135, 139, 181, 190, 227 government contracting 134, 175, 177, 180, 190, 196 government enforcers 6, 184, 188, 190, 308–9, 316, 319, 323–4

M4468-ARLEN_9781783474462_t.indd 370

government interpretations 176, 179, 181, 186, 191 government investigations 82, 119, 311, 313, 321–2, 329 government investigators 89, 122, 311, 320, 326, 328 government misconduct 205–6 government officials 5, 151–2, 169, 191, 200, 203–4, 207, 213 grand juries 70, 313 guarantees, anonymity 335–7, 341, 355–6 guilt 50, 92, 110, 265, 272, 313 guilty pleas 40–41, 88–91, 93–4, 107–13, 116–19, 122, 124–6, 133–9 harm 89–91, 98–105, 107–9, 112–13, 118–22, 124–6, 130–31, 135–9 enhanced/heightened risk of 88, 98, 101, 109, 113, 124, 130, 135 expected 102, 105, 208 risk of 88–9, 91, 104–7, 113–14, 120, 122–4, 130, 132 Health and Human Services, see HHS health care fraud 107, 133, 136; see also debarment heightened risk of detection 211 of future misconduct 91, 139 of harm 98, 101, 109, 113, 120, 122, 135 heterogeneity 146, 341, 355 heuristics 27, 267, 272, 317 HHS (Health and Human Services) 132–3, 135, 314 hidden information 90, 109, 112–13, 115–16, 119–20, 122, 124 hierarchies 195–6, 227, 230, 271, 291, 295, 303, 354 high risk of future harm 17, 42, 69, 114, 123, 125–6, 128, 137 high-quality information 339, 341, 354–5 hiring 56, 66, 94, 160, 180, 277, 327 Holder Memo 82 honesty 153, 196, 202, 210, 274 horizontal complexity 352–3 hot spots policing 15, 31 HSBC 3, 40–5, 50, 55–6, 111 too big to jail 42–5 identification 14–15, 19, 22–3, 290, 293, 308, 313 identity, professional 157, 271–2 IEEPA (International Emergency Economic Powers Act) 42, 50

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Index  371 illusions of competence 26–8, 33 of control 29 of moral superiority 28 psychological benefits 28–9 immigration 49–50, 337 immunity 314, 325 immunization, employees 53, 326 impact of enforcement 5, 220–21 implementation 24, 35, 250, 252, 308–9, 313–15, 323 implementing regulations 336, 346 imprisonment 16, 32–4, 45–8, 76–9, 84, 187–8, 208–9, 326 incapacitation 16, 52, 157, 160, 222 incarceration, see imprisonment incentives 1–2, 17–18, 65–6, 210–13, 225, 259–60, 285–7, 295 corrupt 198, 205 internal 12, 17–18 managerial 67, 286 perverse 73, 314 reputational 66, 286, 311 strong 118, 136, 184, 188, 191, 210, 341 structures 276–7, 295, 301, 341 whistleblower 274, 341 independence 6, 207, 251, 277, 289, 294–5, 301, 303 board 288–9, 301 independent directors 94, 107, 125, 288–9, 295–6, 298–9 independent enforcement authorities 334–6, 350 independent review 110, 251 indictment 81–3, 182, 188, 191, 312–13 individual accountability 51, 53–6, 221 individual and corporate criminals 3, 40–56 individual criminal liability 60, 65, 70–81, 83, 85, 175, 188 Yates Memo 6, 41, 51, 53–5, 175, 187, 325, 329 individual employees 45, 53–4, 104, 154, 187, 319–20, 330 individual liability 1, 3, 5, 176–7, 237, 239, 241, 243; see also individual criminal liability FCPA (Foreign Corrupt Practices Act) 183, 186–90 responsible corporate officer doctrine 54, 76–7 supervisory liability 54, 59 Yates Memo 6, 41, 51, 53–5, 175, 187, 325, 329

M4468-ARLEN_9781783474462_t.indd 371

individual prosecutions 3, 41, 45–53, 80, 115, 125–6, 326 accompanying federal deferred and nonprosecution agreements 45–50 reform proposals 54–6 individuals 1–3, 40–43, 46–51, 53–6, 151–5, 188–91, 225–7, 237–43 civil enforcement against 54 inferences 28, 113, 160, 169, 274 motivated 265, 272 self-serving 265, 267, 269, 271, 274 information actionable 342, 347, 356 asymmetric 195, 287 available 65, 113, 169, 226, 275 flows 162, 291, 297, 315, 319–20, 344 internal 282, 319, 345 lateral 344 hidden 90, 109, 112–13, 115–16, 119–20, 122, 124 high-quality 339, 341, 354–5 lower-quality 341, 355–6 private 112, 130, 296 qualitative 88, 91, 97, 138–9 reliable 109–10, 204, 354 sharing 297–300, 324 injunctions 238 in-role behavior 13, 22 insider trading 220, 227, 237, 291, 293 institutional culture 54, 84 institutional design 301, 308–9, 339, 351 institutions 66, 78, 207, 213, 215–16, 250, 252, 254 legal 11, 21, 60, 68, 70, 210, 223 oversight 207, 210, 216 state 5, 195–6, 207, 211, 213–14, 216 instrumentalism 24–35 motivations for holding instrumental beliefs 26–9 shaping values 29–31 instrumentality 178–9 insurance companies 50, 274, 303 integrity systems 210, 213 intensified monitoring 5, 215–16 intent 1, 51, 71–2, 104 corrupt 180 original 181 interested outsiders 88, 96–8, 112, 139 interests 4, 90–91, 128–31, 133, 138–9, 157–8, 273–4, 297–8 agencies 91, 129–31, 133–4, 136–7 public 126, 133, 138, 186, 196 internal and external regulation 12–15

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372  Research handbook on corporate crime and financial misdealing internal compliance systems 7, 334, 339, 350, 355–6 and bounty regimes 343–50 internal controls 222, 237, 242, 249, 253, 308, 311, 313 internal corporate investigations, see corporate investigations internal exhaustion requirement 343–7, 355 internal governance 6, 104–5, 107, 110, 124–5, 134, 282–304 internal incentives 12, 17–18 internal investigations 211, 213, 309, 311, 313–14, 316–18, 320–21, 329 internal motivations 19, 26, 342 internal reporting requirement 347, 355 internal reports 336, 343, 345–7, 354–5 international banks 22, 40, 50 International Emergency Economic Powers Act, see IEEPA international sanctions 40, 42–3 interpretations 179, 182, 185–6, 188, 259, 266 broad 180, 185 government 176, 179, 181, 186, 191 investigations 40–42, 53–5, 158–61, 224–5, 227–32, 308–12, 316–18, 320–24 corporate, see corporate investigations costs 168, 171 criminal 51, 106–7, 182 government 82, 119, 311, 313, 321–2, 329 internal, see corporate investigations investigators 63, 163, 265, 309–10, 321–2, 328 corporate 6, 308–10, 314, 317, 320–30 government 89, 122, 311, 320, 326, 328 investment banks 50, 275 investors 53, 64, 67, 220–21, 224, 234, 285–6 issuers 177–9, 181–2, 223, 253 jail time, see imprisonment joint enforcement actions 152, 163 joint ventures 153, 162 JP Morgan 50, 64–5, 68, 70, 75, 80, 180 judges 12–13, 25–7, 43–4, 54–6, 83, 110, 189, 191 judgments 22, 47, 176, 184, 186, 202, 267, 276 final 176, 184, 188 judicial clarification 181, 184–5 judicial opinions 184–5, 188–9 judicial review 55, 339 juries 62, 64, 69, 89, 110, 208 Justice Department, see Department of Justice KBR (Kellogg Brown and Root) 317–18, 321 K-Mart 276 knowledge 51, 64, 71–2, 145–6, 198, 241, 335, 344; see also information

M4468-ARLEN_9781783474462_t.indd 372

laboratory experiments 267–8, 272 law enforcement, see enforcement law firms 82, 158, 224, 226, 232, 311 law schools 76, 87, 226–9, 232 leaders 26–7, 33, 35, 154, 158, 164, 213, 216 corporate 12, 289–90, 293, 295 legal advice 316–18 legal authorities 11–12, 14, 18–19, 21, 24–5, 27, 30, 32 legal compliance 121–2, 264, 267, 310 legal institutions 11, 21, 60, 68, 70, 210, 223 legal obligations 71, 73, 309, 311 to investigate 311–14 legal risks 81, 266, 277, 291 legal tools 80–81, 83 legality 20, 155, 196 legitimacy 11–12, 14, 21–4, 26–7, 30–32, 34, 271, 278 moral 344–5 leniency 114, 121, 163–5, 171, 308, 314–15, 324, 329 organizational 326–7 leverage 51, 59, 70, 83, 182, 192, 284, 324 liability 1–4, 67–8, 70, 73–7, 186–7, 189, 261, 283–4 accomplice 70, 185 civil 1–2, 60, 69, 314 composite 314–15, 326 corporate 1–2, 175, 212, 216, 223, 283 criminal, see criminal liability fault-based 314–15 FCPA (Foreign Corrupt Practices Act) 183, 186–90 felony 72, 79 individual 1, 3, 5, 176–7, 188–9, 237, 239, 241 omission 74, 77 personal 2, 90, 126 residual 212, 215 rule best suited to inducing corporate investigations 314–15 strict 75–80, 212, 284, 314 supervisory 54, 59 licenses 81, 127, 155, 198–9 limitations, statutes of 54, 73 liquidity 220–21, 223 literature on corporate crime 15–16, 21, 83, 283–91, 357 litigation 4, 45, 176–7, 184–5, 187–92, 293, 335, 341 costs 117, 341–2, 351 lobbying 153, 197, 223, 234, 286 London Whale 64–5, 80, 268; see also JP Morgan loss 99, 144–6, 185, 210, 214, 220–21, 267, 270

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Index  373 loss-contingent costs 341 loyalty 13, 18, 74, 264–5, 271–2, 274, 290 malfeasance 59, 84, 202, 207, 324 corporate 59–61, 67–8, 81, 211 management 60–61, 65–6, 79–84, 90, 124–5, 250–52, 283–5, 319–20 corporate 61, 66, 72, 80–81, 251, 316, 319–20 criminally bad 3, 59–85 earnings 288–9, 294 failure 60–61 non-top 297, 300 responsibility 60, 65, 70, 80 role in corporate crime 70 managerial selection 4, 90, 109, 124, 126, 139 managers 1–3, 22, 30–32, 59–85, 125, 212–14, 284–8, 343–4; see also executives and corporate criminal liability 81–2 middle 46, 252, 322 mandated reforms 89, 91, 94–6, 122, 124, 132–3, 135–7, 139 mandates 92 and corporate reforms 94–6 mandatory exclusion 91, 131, 133, 136–8 manslaughter 62, 78–9 marginal deterrence 208 markers 232, 235, 275 market capitalization 81, 168, 240–41 markets 64, 68, 77, 81, 127–31, 196–7, 221, 224 capital 219–20, 223, 234 competitive 196, 201–2 corrupt 197, 200, 202 marquee cases 348, 351 media 111, 146, 156, 222, 234, 286 attention/coverage 45, 111, 222 mens rea 54, 69, 71–3, 75–6, 78, 284 mental state 61, 71, 78 mergers 22, 252–3 middle managers 46, 252, 322 misconduct 88–91, 98–101, 103–7, 109–13, 121–5, 129–36, 151–7, 159–61 corporate 1, 3, 7, 92, 100–101, 125, 159 detected 90, 108, 117, 121, 129, 159 financial 24, 132, 224 government 205–6 past 153, 157, 159 risk of 89–90, 100, 104, 106, 126, 128, 130, 134 misdemeanors 54, 76–7, 80, 137 misreporting/misrepresentation 220, 287–8, 292 affirmative 71 financial 5, 75, 220, 350 misstatements 237–8, 288

M4468-ARLEN_9781783474462_t.indd 373

mistake-of-law defenses 71 monetary sanctions 92–4, 96, 117–18, 182–3, 190–91, 229, 238, 241–3 money laundering 40, 42–4, 71, 93, 111, 152–3, 161–2, 249 monitoring 14–15, 19, 158–9, 161–2, 164, 285–6, 291–3, 295 intensified 5, 215–16 roles 292, 296 monitors 44, 92, 94–5, 130–31, 133–4, 156, 213, 285 external 107, 123–4 monopoly power 197, 202–3 moral legitimacy 344–5 moral superiority, illusions of 28 moral values 19, 21, 30 morality 21, 28, 32, 73, 342 motivated inferences 265, 272 motivations 12–13, 16, 25–6, 28, 32, 34, 275–6, 278 internal 19, 26, 342 pre-existing instrumental 337 value-based 19, 30 multijurisdictional enforcement games 4, 151–72 conventional models 152–3, 159–60, 166, 170–71 empirical challenges 166–9 normative challenges 169–70 objectives 156–8 players and actions 153–6 possible outcomes 163–6 timing 158–63 multilateral development banks 167, 192 multinational enforcement, see multijurisdictional enforcement games multiple agents 153, 297, 323 Mutual Legal Assistance Treaties 162 ne bis in idem 162 negligence 74–5, 78–9, 210, 215, 243–4, 284, 314 negotiations 28, 83, 92, 110, 117, 119, 182, 185 network ties 290 networks, social 156, 162, 167, 271, 290 neuroscience 266, 270 New York Central & Hudson River Railroad v United States 87, 311 Nigeria 105, 151 non-cooperation 55, 122 non-prosecution agreements (NPAs) 2–3, 40–41, 45–7, 50, 55, 182, 253, 312–13 non-top management employees 297, 299–300 normative analysis 4, 66, 84–5

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374  Research handbook on corporate crime and financial misdealing normative criteria 152–3, 171 NPAs, see non-prosecution agreements

over-enforcement 164–5, 186, 191 oversight institutions 207, 210, 216

obligations 19, 71, 73, 133, 155, 310–11 legal 71, 73, 309, 311 observability 353 partial 290, 293, 302 obstruction 62, 65, 72 OECD (Organisation for Economic Cooperation and Development) 152, 162, 180, 191 offenders 100, 102, 104, 130, 133, 199, 207–10, 214 potential 207–8, 210 offenses 78–9, 88–9, 97–8, 100–107, 110–11, 124–7, 129–39, 251 environmental 77, 83, 102 officials 154, 158, 188, 197–9, 201–4, 209 corrupt 157, 199, 204, 210 foreign 65, 125, 178–80, 182, 184, 189 government 5, 151–2, 169, 191, 200, 203–4, 207, 213 honest 197, 202 oil 61–2, 67, 70, 168–9 omission liability 74, 77 omissions 63, 71, 73, 75–6, 237, 265–6, 268, 274 operating performance 6, 295, 301, 304 opportunism 268–9, 272 optimal compliance 256, 258–9, 277 optimal quantity and quality of tips 334, 339, 341, 352 options, stock 287–8, 349 Organisation for Economic Co-operation and Development, see OECD organizational behavior 6, 263–4, 344 organizational complexity 7, 334, 337, 352–6 organizational correctives 272–3, 277 organizational cultures 30, 250, 271 organizational deterrence 52–3 organizational leniency 326–7 organizational prosecutions 41–2, 51, 53 Organizational Sentencing Guidelines 93, 121, 313 organizational structure of wrongdoing 7, 334, 340, 352–6 organized crime 73, 83, 167, 199, 211 outsiders 88–91, 96–109, 111–13, 118–20, 122–8, 133–5, 137–9, 146–7 expectations 98–9 interested 88, 96–8, 112, 139 reactions 98–9, 103–4 overcharging 144–6, 276 over-criminalization 75, 84 over-deterrence 77, 165, 175

panopticon 274–5 parent companies 119, 137–8, 153, 224, 312–13, 316 partial observability 290, 293, 302 PATRIOT Act 250 payments 144, 178, 180, 198, 209, 253, 313 facilitating 182, 184, 189 payoffs 197–9, 201–2, 204, 210–11, 292 expected 124, 145 payouts 326, 340–42, 351, 354–6 affirmative monetary 338 penalties, see sanctions perceptions 16, 27, 29, 267, 276, 278, 297, 299 performance 178–9, 204, 207, 228, 231, 285, 287, 289 permissive exclusion 4, 118, 121, 131–5, 138–9 personal benefits 90, 213 personal liability 2, 90, 126 pervasiveness of wrongdoing 115, 251, 313 pharmaceutical companies 49, 54, 72, 77, 81, 83, 136, 348 Pilgrim’s Pride 50 Pirate of Prague 49 plausible assumptions 124, 209 pleas 40–41, 45–6, 54–5, 88–97, 107–14, 116–20, 122–7, 129–39 police forces 13–14, 18, 34, 203 police interrogation 320–21 police officers 12, 27, 31, 154, 202, 321 policing 15, 20, 70, 258, 310, 314–15, 328, 356 political economy 83, 284 political pressure 34, 222, 234 pollution 76, 199 positions of authority 3, 24–5, 28 potential whistleblowers 208, 321, 341 power 24–9, 69, 216, 220, 267–8, 335, 337, 339 use of 15, 26, 29 predictions 152–3, 160, 164, 171, 263, 272 intuitive 267, 269 prejudgment interest 227, 229 press conferences 53, 110 press coverage 93, 100, 348 pressure 6, 33, 53, 105, 192, 270, 328 political 34, 222, 234 situational 32 pre-trial agreements 162 price-fixing cartels 53, 337 prison, see imprisonment privacy 309, 322–3, 327–30 workplace 6, 309, 328 private actors 3, 5, 154–6, 159, 162, 167, 338

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Index  375 private enforcement 176–7, 183–4, 186–7, 189, 191–2, 220–22, 335–6, 350–51 class actions 224, 234 plaintiffs 162, 175, 184–6, 221, 224, 323 settlements 335–6 private investigators 310, 323–5 and public enforcers 323–6 private sector 211–14, 231–2, 235, 257 privilege 278, 315–19, 323, 328 corporate, see corporate privilege probability of detection 20, 34, 144–5, 163, 168–9, 208, 256 procedural justice 30, 320 procurement contracts 155, 198, 213 public 154, 198 productivity 11, 20, 273, 275–6, 291 professional identity 157, 271–2 profitability 13, 204, 276 profit-maximization 5, 254, 256, 259, 261 profits 1, 61, 64, 171, 199, 202, 212–13, 233 promotion 158, 179, 206, 226, 228–33, 235 policies 2, 103, 105, 212 proof 62, 64, 69–73, 76, 227 burden of 136 proprietary trading 248, 253 prosecutions corporate 3, 41–2, 45–9, 51–3, 56, 114 criminal 45, 54, 67, 70, 78, 81, 242 individual 3, 41, 45–53, 56, 80, 115, 125–6, 326 organizational 41–2, 51, 53 prosecutorial decisions 89, 113, 121–2, 129, 135 prosecutorial discretion 84, 160, 189, 315, 329, 351 prosecutorial selection 4, 89, 108, 112–24, 127, 139 candidate factors affecting 113–16 focal criteria 116–20 necessary conditions 113 and possible hidden information about future risk of harm 120–22 and possible impact of reforms 122–4 prosecutors 40–46, 48–56, 80–4, 87–96, 108–26, 129–34, 136–9, 323–9 choices 90, 112–14, 116, 120, 123 decisions 89, 113, 122, 129, 135 federal 40–41, 43–5, 81, 83, 114, 116, 311, 328–9 government 192, 308–9, 316, 319, 327–9 protections 207, 271, 294, 317, 327–8, 339–40, 354–5 anti-retaliation 335–6, 339–40, 345, 355 privilege 316, 319

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retaliation 335–6, 339–40, 345, 355 work product 316, 319 psychological benefits 3, 12, 24, 26, 28 psychology 3–35, 263–4, 267, 270–71, 274, 276 social 19, 266, 270–71 public companies 5, 45, 96, 222, 226–8, 238–9, 241 public control 336, 351 public enforcement 3–5, 157, 162, 183, 186–7, 219–20, 325, 350–51 public enforcers 6, 184, 350 and private investigators 323–6 public interest 126, 133, 138, 186, 196 public officials, see government officials public procurement 154, 198 public sector 161, 212–13, 301 public services 203 public statements 48, 113, 115, 120, 126 punishment 15–25, 30, 32–5, 51–2, 54, 59–60, 199–200, 208–9; see also sanctions risk of 17, 21, 23, 30, 35 severity of 16, 18, 23 threat of 20, 26, 32, 269 purchasers 128, 145–6 pushback 192, 279 qualifications 5, 180, 192, 196–9, 260 qualitative information 88, 91, 97, 138–9 qui tam 162, 187, 317, 323, 334–9, 341, 348–52, 354; see also bounty regimes quotas 267, 276 Racketeer Influenced and Corrupt Organizations Act, see RICO rational choice 11, 195, 210, 263 rationalizations 265–6, 269–70 reactive enforcement 159–60, 170 recidivism 16, 24, 34, 223 recklessness 71–2, 74–5, 78–9 red flags 63–4, 72, 103, 268, 275, 327 reformers 59, 191, 204, 215–16 reforms 2, 4, 92, 94–5, 97, 99–100, 122, 175–7 effective 107, 124 impact 122–4 mandated 89, 91, 94–6, 122, 124, 132–3, 135–7, 139 voluntary 88–9, 94, 100, 106, 109, 122, 130, 134–5 regulated entities 260–61, 337, 347, 350 regulated industries 54, 271, 299, 312 regulation consent-based 21–3 corporate 3, 23, 60–61, 74 internal and external 12–15 securities 59, 71, 219, 356

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376  Research handbook on corporate crime and financial misdealing regulators 4, 13–14, 106–7, 259–60, 273, 308–9, 327–9, 353–5 discretion 335–6 external 344, 354 foreign 221, 224 government 13–14, 24, 204, 308, 327–9 securities 154, 162 regulatory design 7, 83, 334, 352 relators 336, 342 qui tam 341, 348, 354 reliability 109–10, 112, 120, 122, 124–5, 204, 221, 260 relocation 206, 210 remedial actions 115, 182, 251, 344 remediation 119, 121, 252, 313, 324 reorganization 5, 204, 215–16 reports external 335, 343–5, 347–8, 354–5 internal 336, 343, 345–7, 354–5 reputational damage 3–4, 88, 90–91, 97–100, 102–4, 107–9, 125–7, 138–9 aggravation and mitigation of outsider response 103–7 antitrust offences 102–3 conviction and risk of future offense 126–7 conviction vs DPA 107–27 cost 88, 90, 97–107, 111–12, 114, 126–30, 138–9, 144–7 and criminal settlement 99–100 direct revelation 109–12 environmental crimes 102 fraud 101–2 and management selection 124–6 offense type and interested outsiders 100–103 and outsiders’ expectations 98–9 and prosecutorial selection 112–24 weight accorded to information released at settlement 109–12 reputational incentives 66, 286, 311 residual liability 212, 215 resource constraints 20, 156–7, 165, 215 resources 13, 15, 17–18, 20, 26, 31–4, 220, 255–8 importance 20 sufficient 20, 252 respondeat superior 311 responsibility 33, 35, 61–2, 71–2, 75–6, 212–13, 252–4, 270–71; see also liability management 60, 65, 70, 80 responsible corporate officer doctrine 54, 76–7 restitution 55, 115, 313 retaliation 156, 171, 298, 344, 346–7, 354 retribution 1, 52, 157–8, 160, 164, 169–71, 207

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review independent 110, 251 judicial 55, 339 revolving door hypothesis 224, 231, 233 RICO (Racketeer Influenced and Corrupt Organizations Act) 70, 73, 183 risk 78–9, 89–91, 104–8, 110–13, 124–8, 130–33, 135–9, 187–92 assessment 79, 132, 252–4 of collusion 203–4 of corruption 5, 202–3, 212–13, 215 of detection 199–200, 208, 215 enhanced 4, 88–9, 109, 112–13, 124, 128–30, 137, 139 firms 111–12, 119, 130–31, 134, 136, 261 of fraud 288, 301 of harm 88–9, 91, 104–7, 113–14, 120, 122–4, 130, 132 high 17, 42, 69, 114, 123, 125–6, 128, 137 legal 81, 266, 277, 291 low 94, 103, 113, 120–21, 136 of misconduct 89–90, 100, 104, 106, 126, 128, 130, 134 of punishment 17, 21, 23, 30, 35 Rule 10b-5 cases 227–33 rule of law 24, 27 safety 62–3, 76, 80, 161, 198–200, 220 sanctions 11–13, 15–21, 67–70, 155–7, 159–61, 164–9, 205–16, 222–4 administrative, see administrative sanctions against civil servants 205–11 against state institutions 211–15 average 221, 227–32 cease and desist 238, 349 clawbacks 56, 276 collateral 115, 117–18, 120–21, 124, 127, 188, 190, 192 criminal 59, 66–8, 71, 76, 79, 206, 242, 244 disgorgement 154, 227, 229, 238–9, 243 duty-based 211–14 expected 5, 163, 201, 207–9, 220, 256, 258, 261 FCPA (Foreign Corrupt Practices Act) 65, 169, 183 fines 5, 52, 155, 157, 163, 214–15, 256, 258 forfeitures 157, 162 formal 4, 92, 138–9 imprisonment 16, 32–4, 45–8, 76–9, 84, 187–8, 208–9, 326 injunctions 238 monetary 92–4, 96, 117–18, 182–3, 190–91, 229, 238, 241–3 reputational 52, 69, 220–21, 276

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Index  377 for state institutions and staff 214–15 threatened 3, 17–20 Sarbanes-Oxley Act 35, 222, 241, 284, 286, 313 scandals 18, 60–61, 65, 76, 220, 222 scapegoats 40, 207, 214, 325, 327 SEC (Securities and Exchange Commission) 4–5, 64–5, 156, 179–80, 186, 335–6, 344, 346–7 attorney career paths 224–5 attorney performance 230–31 corporate and individual defendants 238–40 and corporate and individual liability 237–44 enforcement 219–35, 237–44 enforcement attorneys 225–34 Enforcement Division 167, 224–5, 230, 232, 311, 321 executive penalties 241–4 large vs small corporations 240–41 leaving patterns 231–4 senior vs junior executives 241 securities 4–5, 64, 151, 156, 335, 337–8, 344, 350 fraud 2–5, 48–9, 64, 77, 80, 237, 242, 356 laws 5, 76, 156, 219–35, 237, 242, 248, 292–3 enforcers 219–35 regulation 59, 71, 219, 356 regulators 154, 162 Securities Act, Section 17(a) 237, 243–4 Securities and Exchange Commission, see SEC Securities Exchange Act 76, 237 Section 10(b) 237, 242–4 Section 13(b) 237 selection managerial 4, 90, 109, 124, 126, 139 prosecutorial 4, 89, 108, 112–13, 116, 123, 127, 139 self-accusation 321 self-competence, perceived 26 self-confidence 27, 277 self-image 265–6 self-incrimination 316, 321 self-interest 25, 28, 100, 169–70, 263, 265, 271–2, 276 self-policing 5, 212, 309, 314–15, 320, 327–8 corporate 312, 315, 327 excessive 330 self-regulation 248, 263 self-reporting 2, 52, 114–15, 117, 119, 121–2, 162–5, 210–12 self-serving inference 265, 267, 269, 271, 274 sellers 99, 144, 146 senior management 63–5, 69–70, 72–4, 125–6, 228–33, 283–4, 293, 296–301

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sentences 23, 33–4, 46, 55, 93, 262, 313 sentencing guidelines 30, 52, 55, 82, 93, 121, 250, 313 service delivery 200, 202–3, 205, 213 settlement 82–3, 88–91, 93–4, 96–100, 107–14, 124–30, 138–9, 221 agreements 88, 92, 104, 106–7, 111–12, 123, 126, 130 corporate 40, 48–9, 51, 53, 56, 114, 126 form 89, 112, 114, 117, 120 choice of 89–92, 108, 111–13, 116, 119–20, 123, 126, 133–6 negotiations 125, 176, 185, 191, 223 private 335–6 time of 94, 104 shared values 21–2 shareholders 1, 69, 155, 157, 221, 223, 241, 318–19 short termism 66–7 shredder tests 265 Siemens 49, 82, 151–4, 162 signals 89–90, 101–2, 104, 107–8, 112–14, 116, 121–6, 327 negative 98, 107, 109, 125, 327 reliable 120, 122, 124–5 situational factors 15, 17, 267, 340–41, 348, 354, 356 skills 6, 27, 198, 263, 278, 355 social control 33, 35 social costs 5, 18, 67, 209, 256, 258–9, 261, 340 social harms 160, 163, 209 social networks 156, 162, 167, 271, 290 social psychology 19, 266, 270–71 Social Security Act 132–3 South Africa 35, 204 Spain 64 Speedy Trial Act 54–5, 313 staff attorneys 225, 227, 230 Stanford Securities Litigation Analytics 237 state administration, corruption in 195–216 state institutions 5, 195–6, 207, 216 sanctions against 211–15 statements of facts 43, 88, 93, 104, 110, 117, 138 financial 49, 64, 71, 220, 241, 288 public 48, 113, 115, 120, 126 statutes of limitations 54, 73 stigma 4, 88, 97, 107, 127, 146–7; see also reputational damage stock options 287–8, 349 stock price reactions 220–21, 234 Stone v Ritter 126 strategies, enforcement 151, 157–61, 163–6, 168–71, 258, 261 street crime 21, 52, 61, 159, 328

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378  Research handbook on corporate crime and financial misdealing strict liability 75–80, 212, 284, 314 subsidiaries 45–6, 104–5, 137, 151, 153, 312–13, 316, 318 subsidiarity 344 substantive scope 176–7, 183, 186–7, 192 supervisors 3, 22, 30, 42–4, 50, 90 supervisory liability 54, 59 suppliers 4, 88, 98, 102, 139, 157, 198, 204 Supreme Court 71, 74, 76, 316, 338 surveillance 11, 13–15, 17, 19–20, 24, 26, 32–5, 274–6 video 14, 19, 159 sympathetic defendants 4, 186, 188–90, 192 systemic corruption 196, 211 targets, performance 213 taxes 21, 75, 114, 180, 199, 213 termination 156, 220, 321, 325, 336 terrorism 31, 42, 61, 73, 199 testosterone levels 270 Thompson Memo 82 tips 325, 340–42, 344, 346, 354–5 bad 339, 351 optimal quantity and quality of 334, 339, 341, 352 tone at the top 105, 255, 274, 277–8 top management, see senior management training 25, 96, 250, 252–4, 263, 293 transactions 42, 55, 72, 179, 316 corrupt 197, 199, 203 transparency 85, 100, 170–71 trial 46–7, 80, 92–3, 108, 124, 181–2, 185–6, 188–9 trial counsel 225, 227–32 trust 19–20, 22, 210–11, 268, 276, 309, 324, 327 trustworthiness 264, 329 under-enforcement 164–5 underlings 73, 354–5 unethical behavior/conduct 13, 22, 32, 264, 266, 268, 270, 272 United States, see detailed entries USAM (US Attorneys’ Manual) 82, 96, 110, 113–16, 119–20, 251–2, 309, 313 utilitarian approach 24–9, 31–4, 270 in organizational context 31–5 value, firms 168, 182, 221, 290, 292–3, 300 value-based motivations 19, 30 values moral 19, 21, 30

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shaping 29–31 shared 21–2 values-based approach 22–3 victims 1, 71, 73, 130–31, 152, 154–7, 169–70, 268 of corruption 196, 215 potential 154, 156, 159, 166 video surveillance 14, 19, 159 violent crime 15, 19, 199, 207, 209 Volcker Rule 247, 253 voluntary disclosure, see self-reporting voluntary reforms 88–9, 94, 100, 106, 109, 122, 130, 134–5 waivers, privilege 316–17, 327 Walmart 65, 68, 70, 75, 80, 82, 276, 318 whistleblowers 5, 155–6, 166, 170, 274, 334–48, 350, 354–5 chilling 343, 346, 355–6 potential 208, 321, 341 whistleblowing 3, 5, 340, 342, 344, 348, 353–4, 356–7; see also bounty regimes anti-retaliation protections 335–6, 339–40, 345, 355 external 334, 343, 345, 347–9, 354, 356 internal 56, 345, 347 programs 156, 205, 213, 325–6, 328 qui tam 162, 187, 317, 323, 334–9, 341, 348–52, 354 white-collar crimes 16, 52–3, 70, 82, 208, 263, 269 window-dressing 212, 273, 327 witnesses 274, 301, 320, 325 Wolfsberg Group 162 women 227, 229–32, 234, 270 work environment 17, 30, 205 work organization 11, 19, 30 work settings 11, 17, 19, 28, 30 workplace 14, 19, 22, 30–31, 264, 272, 329 privacy 6, 309, 328 World Bank 151, 154 Worldcom 35, 46, 69, 72, 222, 227 wrongdoers 2, 108, 133, 157, 159–60, 163–4, 170–71, 325–7 multiple 153, 164, 171 potential 151, 153, 156–7, 159–61, 164, 166, 170–71 wrongdoing, see corporate misconduct Yates Memo 6, 41, 51, 53–5, 175, 187, 325, 329

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