Prosecuting in the Shadows

How Unsupported Fear of Collateral Consequences Impedes Corporate Prosecution

In the aftermath of the recent financial crisis, none of the major financial institutions at the heart of the mortgage crisis, nor any of their senior executives, faced criminal prosecution. When viewed against the vigorous response to the savings-and-loan crisis and the accounting frauds at the turn of the century, this lack of criminal sanction engendered substantial hand-wringing from the legal community and pundit classes. Some have argued that the lack of prosecution can be readily explained by the lack of any actual fraud. Others, like Judge Jed Rakoff in a widely-read New York Review of Books article, note that the prevailing view of numerous government officials is that the crisis contained outright financial fraud, and instead ascribe the failure to prosecute to the incentives facing individual line attorneys at the Department of Justice. Regardless of the underlying reason, the American public viewed the Obama administration’s response to the crisis to be decidedly lacking: in a survey conducted five years after the fall of Lehman Brothers, 53% of respondents thought the legal response was insufficient, against just 15% who were satisfied with the prosecutorial response.

While the failure to prosecute individuals associated with the financial crisis was perhaps surprising given past experience, the government’s inaction against the corporations associated with the activity is readily explained by DOJ guidance. Under long-established American legal principles, corporations are “legal persons” capable of committing crimes and being sued, and the DOJ has formally stated that corporations should face the same legal treatment as individuals irrespective of their “artificial nature”. However, the DOJ also instructs their attorneys to consider the “collateral consequences” associated with prosecuting corporations when considering whether to seek charges. Following the indictment and subsequent collapse of the accounting firm Arthur Andersen, federal prosecutors became excessively risk-averse, relying on the collateral consequences carve-out to justify an increasing reliance on alternative corporate prosecution agreements. This shift in practice was misplaced but predictable given the public backlash to Arthur Andersen’s prosecution and the DOJ’s lack of subject matter expertise in determining corporate systemic importance. To regain the public’s trust in equality before the law, the DOJ should divest its undue collateral consequences determination to an agency with the requisite expertise, and such a determination should be made formally and should be subject to public inspection.

The government’s ability to prosecute corporations for federal crimes long predates the present controversy surrounding the difficulty of bringing cases against large multinational institutions. As far back as 1909, the Supreme Court held in New York Central & Hudson River Railroad v. United States that corporations could be prosecuted based on the conduct of even a single employee. Under the doctrine of respondeat superior, corporations are criminally liable for the conduct of any employee or agent acting within the scope of their duties. At the turn of the century, the DOJ’s policies and practices in this area were codified in a series of charging memos issued by then deputy U.S. attorneys general Eric Holder and Larry Thompson. The Holder and Thompson memos reiterated the department’s long-held practice of seeking corporate criminal prosecutions when warranted, citing the “important public benefits” that result from corporate indictments. While reinforcing main Justice’s view that prosecution of corporations is an appropriate prosecutorial tool, the memos also articulated a set of factors to be considered when weighing the decision to prosecute, including the “pervasiveness of the wrongdoing”, “the corporation’s history of similar conduct”, and “collateral consequences, including disproportionate harm to shareholders, pension holders and employees not proven personally culpable and impact on the public arising from the prosecution”.[1]

The competing interests embodied in the Thompson and Holder memos came to a head with the indictment and failure of Arthur Andersen following the accounting scandals at Enron. The loss of some 85,000 jobs, accompanied by the Supreme Court’s reversal of the criminal conviction on procedural grounds, caused a tidal wave of criticism alleging overzealous charging practices within the DOJ. Brandon Garrett, in his carefully researched book Too Big to Jail: How Prosecutors Compromise with Corporations, argues that this criticism was a driving force in the DOJ’s shift toward deferred (DPA) and non-prosecution agreements (NPA) when addressing corporate criminality. While barely used before 2001, DPAs and NPAs, which lack the serious consequences associated with prosecutions, became the primary tool used by federal prosecutors to address corporate violations of the law. In certain cases, the alleged collateral consequences associated with prosecution were used as an explicit justification for declining to indict.

Senior officials at the DOJ publicly extolled the benefits of DPAs and NPAs as an effective policy tool for deterring crime and reshaping corporate governance. In a speech to the New York Bar Association, then Assistant Attorney General for the Criminal Division Lanny Breuer stated that “in many ways, a DPA has the same punitive, deterrent, and rehabilitative effect as a guilty plea”. This assertion is belied by the simple fact that nearly every large corporation has chosen a DPA or NPA (often times multiple of them consecutively) when facing the prospect of criminal prosecution. These corporations have in turn absorbed DPA and NPA fines as a cost-of-doing-business: when Elizabeth Warren questioned whether JPMorgan was in violation of certain provisions of the Dodd-Frank Act, Jamie Dimon allegedly replied “So hit me with a fine. We can afford it.” The senior officials themselves gave the game away in a series of public comments following criticism of absence of significant prosecution of large financial institutions. Breuer, in the same speech to the New York Bar, revealed that DOJ officials were frequently “on the receiving end of presentations from defense counsel, CEOs, and economists who argue that the collateral consequences of an indictment would be devastating for their client”, and that such considerations “literally ke[pt] [him] up at night”. Similarly, in Senate testimony, then Attorney General Eric Holder acknowledged that the size of financial institutions was having “an inhibiting impact on our ability to bring resolutions that I think would be more appropriate”.

The Holder and Breuer Kinsley gaffes triggered a public outcry, and a rare bipartisan congressional response. Senators Chuck Grassley and Sherrod Brown issued a joint letter to Holder requesting clarification on whether financial institutions were too large to effectively prosecute, as well as the identity of any outside experts consulted in making prosecutorial decisions for particularly large institutions. Senator Grassley subsequently accused the Justice Department of being “aggressively evasive” after a receiving a tepid response letter confirming that “[n]o corporate entity, no matter how large, is immune from prosecution”, without answering any of the Senators’ substantive requests. This pointed exchange revealed a critical flaw in the government’s approach to corporate prosecutions: federal prosecutors are instructed to consider the collateral consequences of their decision while lacking the training necessary to credibly make such a determination. Considering the vociferous backlash facing any prosecutor who makes an adverse charging decision, the observed conservatism is understandable if misguided. Our justice system would be better-served directing federal prosecutors to focus on their particular expertise — proving with sufficient evidence whether a corporate criminal violation has occurred — while entrusting any ulterior consideration of collateral consequences to agencies with the requisite experience.

Conferring this authority to any of the relevant regulatory agencies would be an improvement on the status quo. The Federal Reserve, the Securities and Exchange Commission, and the Antitrust Division of the DOJ all employ economists who would be better situated to answer questions of systemic importance and collateral consequences. Another intuitive choice would be the Financial Stability Oversight Council (FSOC). Created through the Dodd-Frank Act, FSOC brings together the heads of the federal financial regulatory agencies under the chairmanship of the Secretary of the Treasury, with statutory authority to safeguard financial stability. Its present authorization includes the ability to designate systemically important financial institutions, propose enhanced regulatory standards for large institutions, and break up firms that pose a threat to overall market stability. While extending such authority to include the consideration of collateral consequences of corporate indictment would be a natural extension of its institutional mandate, commentators have accused FSOC of being hindered by political bias. Regardless of agency choice, any decision made regarding the presence or lack of collateral consequences should be made formally in writing and be subject to public inspection and critique.

To be clear this change will not solve the most challenging aspects of corporate prosecutorial discretion — namely what degree of collateral consequences justifies prosecutorial forbearance and what measures should be taken against management in cases where the collateral consequences require non-prosecution. However, the existing standard for prosecuting corporations is conceptually and practically ineffective; formalizing the standard and mandating the decision be publicly justified is at minimum a step in the right direction.

Andrew Baker

Stanford University

Twitter — “Andrew___Baker”

[1] Although outside the scope of this post, it’s my strong opinion that this notion of “innocent shareholders” fundamentally misconstrues the role of shareholders in public companies. As the residual claimants on a company’s cash flows, shareholders generally profit from malfeasance on behalf of the company, and, outside of the benefit accruing from limited liability, should otherwise be treated in the same terms as any other non-separated owner-managers. Moreover, public shareholders have the ability to select the board of directors which can, and should, curtail manager’s ability to engage in any illegal conduct in the first instance.

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