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Oct 31, 2009

In the line of fire

  • Corporate officers and management no longer immune from prosecution
  • Prosecutors more aggressive in their pursuit of corporate wrongdoing
  • Officers increasingly taking out additional insurance against liability
  • SEC intent on disallowing insurance policies to cover settlements
  • Success of prosecutions hinges on funding and resources

One of the most overused lines in the corporate world is: ‘It’s not personal, it’s just business.’ Try telling that to any one of dozens of high-profile business people currently cooling their heels in prison. This decade has seen no shortage of corporate scandal and accompanying high-profile prosecutions and, in some cases, directors and officers of the companies have found themselves on the wrong side of the defendant’s table.

Mostly, when a company is caught doing something wrong, it is the firm that is prosecuted; directors and officers have largely been protected from liability. This is changing, however. Both government and private prosecutors are increasingly moving away from trying corporations and are instead turning their attention to the individuals behind the companies.

Many people, looking at the list of disgraced and jailed business executives, believe it could never happen to them. But it can, and it does: in 2007, for the first time in the US, a chief compliance officer was sent to prison in Illinois. That same year saw the start of a seemingly endless parade of general counsel and other executives being tried for options backdating.

General counsel and corporate secretaries are increasingly in the sights of government prosecutors, and leading plaintiff firms are preparing cases that include the names of many people who thought they were safe from harm. It’s a natural extension: as board members are being held to a higher standard, so too are the professionals who serve the directors. And while criminal prosecutions remain relatively uncommon, the same cannot be said for civil cases.

Most people expect a string of civil and criminal cases to be brought as the reasons for the global market meltdown become better understood. One of the leading plaintiff lawyers in the US, based in Washington, DC and who requested not to be named because he is ‘about to bring dozens of cases against individual corporate officers’, says a lot of people are in for an unpleasant surprise. ‘There is a definite attitude among shareholders and other stakeholders that we should make the bastards pay,’ he adds.

Not unexpected

This shouldn’t come as a surprise. What officers do need to be aware of, though, is the growing trend toward making officers and directors pay out of their own pockets. David Seide, partner in the DC office of Curtis Mallet-Prevost Colt & Mosle, points to the SEC’s action against Bank of America Merrill Lynch for alleged impropriety in the paying of bonuses to senior Merrill executives before the merger.

‘This case was going to be settled by the SEC with a payment of around $30 million,’ he says. ‘The decision was sent before Judge Rakoff in the Federal District Court in Manhattan; he rejected the proposed arrangement of a company-only settlement, saying that others needed to be held to account. The implication is that those others are the individual corporate officers who made the decisions. The case suggests a trend where individuals are increasingly held accountable, and their personal assets targeted.’

Seide isn’t alone in this opinion. ‘There is no question the Department of Justice, particularly in the Foreign Corrupt Practices Act arena, is focusing on pursuing individuals as well as corporate entities,’ says Lee Stein, partner at Perkins Coie Brown and Bain.

So why are we seeing this shift toward greater individual action against corporate officers? ‘You are seeing more aggression against corporations and executives, more aggression in who you go after and the theories used to go after them, more aggression in the financial penalties being sought and the length of sentences being imposed on executives,’ notes Mike Kendall, partner at McDermott Will & Emery. ‘Why is this happening? Firstly, it appeals to popular desire – even though that sometimes obscures the fact that often these are technical, regulatory issues. Secondly, there is bureaucratic inertia toward continuing aggressiveness by prosecutors – you never hear of penalties becoming less onerous, do you? It is always more, more, more.’

And there are other, more fundamental reasons for the onslaught, according to Stein. ‘It has generally been a hallmark of criminal prosecution to hold the people responsible for the act personally liable,’ he says. ‘Also, it is one thing to pursue a company, but quite another when executives see other executives being held personally responsible in a criminal context. That delivers a far more powerful message and really has the ability to modify behavior. There is nothing like seeing an individual being prosecuted for a violation to cause people to change their practices, or at least be mindful of them.’

Protecting yourself

This trend is encouraging many corporate officers to take on additional insurance coverage. It is not uncommon for a traditional D&O insurance policy to be exhausted before executives at the level of general counsel or corporate secretary have fully defended their cases, explains Kendall.

‘The problem is that the total coverage under the policy applies to both the legal fees and any monies that can be used in settlement,’ he says. ‘So if you have to pay some money in settlement but the coverage is being eroded by the legal fees, there will be a lot of pressure on how to allocate funds.’

Taking on more insurance is a good safety net, but it may not be all that helpful. Stein explains that the SEC has been quite active lately with respect to pursuing individuals. It has also adopted a policy of not allowing insurance polices to pay for people’s settlements because the commission wants payment to come from their personal resources. What’s more, insurance may not cover all conduct; in cases of intentional wrongdoing or fraud, it definitely won’t.

Playing a better game

‘Increasingly, you can see the government alleging behavior that would not be covered by insurance,’ notes Stein. ‘You see individuals having to reach into their pockets and find other resources to defend themselves, even in the civil cases.’ The motivation for all this, he adds, ‘started with that Duke Cunningham matter in California, where we saw corruption at work and the public really wanted to see the people involved punished. Then we had Abramov, and now with Madoff you see the public wanting to see individuals being held responsible for their own conduct, not hiding behind a corporate shell or having penalties paid by insurance companies.’

Even with an increased appetite for targeting individuals, it remains extremely difficult for the government to try these cases. ‘I think lawyers, general counsel and governance-related employees are tougher to prosecute than other executives, especially those in sales and financial reporting,’ says Kendall. ‘This is because, by their very nature, lawyers are being consulted on decisions and will give advice and a range of options, but they are not usually the central people carrying out a challenged business strategy.’

‘To prosecute a corporation, you have to establish corporate guilt,’ adds Seide. ‘If a company issues a false statement, you don’t need to figure out who in the company signed off on the final release – all you have to do is say the company issued it and should have known better based on the collective knowledge of the corporation. It becomes more difficult at the individual level because there may be multiple people who can say, I didn’t really have final sign-off. I relied on the advice of others.’

How successful, then, will the government be in bringing these cases? ‘It is less about how open the courts are and more about what resources are committed on the prosecutorial side,’ suggests Seide. ‘If more prosecutors are hired and the SEC boosts the number of enforcement officers, more cases will be brought. The SEC has asked for – and is likely to get – a significant increase in its power and funding. That is likely to lead to more criminal referrals to the Department of Justice.’

Documents and processes

What can be done to stay out of trouble? ‘Scrupulous adherence to correct process is the best advice,’ says Kendall. ‘Boards have a lot of discretion in how to make judgments, and there may be different results that can be justified as long as the basic touchstones of good governance are applied: appropriate disclosure, experience, expertise and independence. People can usually go after the board not by challenging the result of a decision but by challenging the process.’

Seide believes the main question facing corporate secretaries and general counsel is: have they been good gatekeepers? As the professionals with that oversight function, they are expected ‘to have good procedures, and that is the standard they will be held to.’ He proposes several questions investigators will ask: have you looked at compliance processes lately? Have you thought about them and conducted audits of internal processes? Have you consulted outside counsel for advice on creating or updating policies? Are they adequate and appropriate, and what are you doing to correct deficiencies if and when they are discovered?

Usually a general counsel becomes accountable when he or she ignores red flags. Going to jail is the last step in a long line of things a general counsel needs to worry about; the first is damage to personal reputation and employment prospects. Do you want to preside over some major governance investigation you could have headed off?

Having good controls in place can turn out to be cost-effective for many companies, particularly those that operate in an industry with a history of problems or investigations. There is some tendency to be penny-wise and pound-foolish, however. You can save on compliance dollars up front, but you will spend a lot more on the back end if you fall prey to a government or criminal investigation.

Brendan Sheehan

Brendan Sheehan is the former Executive Editor at Corporate Secretary magazine, and is a leading expert in public company governance and compliance. He regularly lectures on cutting edge governance, risk and compliance issues and is a regular...