A research opportunity in the federalization of corporate governance by deferred prosecution

09/12/2016

A research opportunity in the federalization of corporate governance by deferred prosecution

Back in 1982 Roberta Karmel published a classic article book, Regulation by Prosecution, the way the federal SEC was using prosecutions to regulate American business. As Mark Sargent summarized her argument:

Karmel concludes that this exaggerated emphasis on investor protection and corporate governance (each to be achieved primarily through prosecution of individual offenders) diverted the SEC from its other major task, the encouragement of capital formation.

Karmel expounds this general critique through case studies of the SEC's role in the corporate governance movement, its approach to the evolving national market system, its jurisdictional expansionism, and its tendency to erode materiality as a prerequisite to mandatory disclosure. Although a full summary of each of these case studies is be- yond the scope of this review, some of her specific criticisms deserve attention.

For example, Karmel's analysis of how the SEC used its control over the proxy rules to promote reforms in corporate governance, in overseas selling practices, and, generally, in the corporate sense of so- cial responsibility, points clearly to one unresolved contradiction in the agency's conduct. Specifically, the SEC would bring or threaten to bring enforcement actions against corporations which had paid foreign officials to secure contracts from their governments on the ground that such payments had not been adequately disclosed to the stockholders in a proxy statement or annual report. The corporation would ordinarily agree to a consent injunction through which the SEC would cause a restructuring of the board of directors or would apply other, ever more novel, forms of ancillary relief. The SEC would bring all of this about in the name of investor protection. The contradiction, however, is that most shareholders of those companies were not concerned with the illegality or immorality of foreign payments. Rather, those shareholders, like most shareholders, were primarily investors interested in tapping the corporation's income stream, thereby receiving a return on their investment. Thus, the relatively small amounts paid by management to receive lucrative foreign contracts were not matters of information material to the shareholders and, Karmel concludes, should not have been a basis for SEC action.

In addition, as Sargent recounts, Karmel objected to the SEC's creeping federalization of state corporate governance law:

The SEC's attempt to force preemption of state tender offer statutes would perhaps be more defensible if it had been the result of a careful, thorough, and open analysis of the regulatory alternatives, and not, as Karmel emphasizes, ad hoc litigation. The SEC's behavior in this episode appears even more reprehensible once it is realized that the tender offer statute ad- ministered by the SEC (the Williams Act) was not the product of careful study and policy formulation by the agency, but was an expedient political compromise. The SEC's preemptive strike on state takeover regulation thus seems more and more like institutional self-aggrandizement coupled with utter disregard for the effects of its actions on the traditions of federalism.

The more things change ....

Jennifer Arlen and Marcel Kahan have posted an interesting article on the latest twist in this story, which is the use of fevered prosecution agreements:

Over the last decade, federal corporate criminal enforcement policy has undergone a significant transformation. Firms that commit crimes are no longer simply required to pay fines. Instead, prosecutors and firms enter into pretrial diversion agreements (PDAs). Prosecutors regularly use PDAs to impose mandates on firms creating new duties that alter firms’ internal operations or governance structures. DOJ policy favors the use of such mandates for any firm with a deficient compliance program at the time of the crime. This Article evaluates PDA mandates to determine when and how prosecutors should use them to deter corporate crime. We find that the current DOJ policy on mandates is misguided and that mandates should be imposed more selectively. Specifically, mandates are only appropriate if a firm is plagued by “policing agency costs” — in that the firm’s managers did not act to deter or report wrongdoing because they benefitted personally from tolerating wrongdoing or from deficient corporate policing. Moreover, only mandates that are properly designed to reduce policing agency costs are appropriate. The policing agency cost justification for mandates that we develop thus calls into question both the extent to which mandates are used and the type of mandates that are imposed by prosecutors.

Arlen, Jennifer and Kahan, Marcel, Corporate Governance Regulation Through Non-Prosecution (September 2016). University of Chicago Law Review, Forthcoming; NYU School of Law, Public Law Research Paper No. 16-38; NYU Law and Economics Research Paper No. 16-31. Available at SSRN: http://ssrn.com/abstract=2833902

What the Arlen & Kahan article lacks, however, is a focus on the federalism issues raised by the use of these agreements to impose mandates that effectively federalize some aspect of corporate governance traditionally within the state's purview. Somebody ought to write that article.

Posted at 09:54 AM in Law | Permalink

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Karmel concludes that this exaggerated emphasis on investor protection and corporate governance (each to be achieved primarily through prosecution of individual offenders) diverted the SEC from its other major task, the encouragement of capital formation.

Karmel expounds this general critique through case studies of the SEC's role in the corporate governance movement, its approach to the evolving national market system, its jurisdictional expansionism, and its tendency to erode materiality as a prerequisite to mandatory disclosure. Although a full summary of each of these case studies is be- yond the scope of this review, some of her specific criticisms deserve attention.

For example, Karmel's analysis of how the SEC used its control over the proxy rules to promote reforms in corporate governance, in overseas selling practices, and, generally, in the corporate sense of so- cial responsibility, points clearly to one unresolved contradiction in the agency's conduct. Specifically, the SEC would bring or threaten to bring enforcement actions against corporations which had paid foreign officials to secure contracts from their governments on the ground that such payments had not been adequately disclosed to the stockholders in a proxy statement or annual report. The corporation would ordinarily agree to a consent injunction through which the SEC would cause a restructuring of the board of directors or would apply other, ever more novel, forms of ancillary relief. The SEC would bring all of this about in the name of investor protection. The contradiction, however, is that most shareholders of those companies were not concerned with the illegality or immorality of foreign payments. Rather, those shareholders, like most shareholders, were primarily investors interested in tapping the corporation's income stream, thereby receiving a return on their investment. Thus, the relatively small amounts paid by management to receive lucrative foreign contracts were not matters of information material to the shareholders and, Karmel concludes, should not have been a basis for SEC action.

In addition, as Sargent recounts, Karmel objected to the SEC's creeping federalization of state corporate governance law:

The SEC's attempt to force preemption of state tender offer statutes would perhaps be more defensible if it had been the result of a careful, thorough, and open analysis of the regulatory alternatives, and not, as Karmel emphasizes, ad hoc litigation. The SEC's behavior in this episode appears even more reprehensible once it is realized that the tender offer statute ad- ministered by the SEC (the Williams Act) was not the product of careful study and policy formulation by the agency, but was an expedient political compromise. The SEC's preemptive strike on state takeover regulation thus seems more and more like institutional self-aggrandizement coupled with utter disregard for the effects of its actions on the traditions of federalism.

The more things change ....

Jennifer Arlen and Marcel Kahan have posted an interesting article on the latest twist in this story, which is the use of fevered prosecution agreements:

Over the last decade, federal corporate criminal enforcement policy has undergone a significant transformation. Firms that commit crimes are no longer simply required to pay fines. Instead, prosecutors and firms enter into pretrial diversion agreements (PDAs). Prosecutors regularly use PDAs to impose mandates on firms creating new duties that alter firms’ internal operations or governance structures. DOJ policy favors the use of such mandates for any firm with a deficient compliance program at the time of the crime. This Article evaluates PDA mandates to determine when and how prosecutors should use them to deter corporate crime. We find that the current DOJ policy on mandates is misguided and that mandates should be imposed more selectively. Specifically, mandates are only appropriate if a firm is plagued by “policing agency costs” — in that the firm’s managers did not act to deter or report wrongdoing because they benefitted personally from tolerating wrongdoing or from deficient corporate policing. Moreover, only mandates that are properly designed to reduce policing agency costs are appropriate. The policing agency cost justification for mandates that we develop thus calls into question both the extent to which mandates are used and the type of mandates that are imposed by prosecutors.