Corporate crime and deterrence.

• Author: Hamdani, Assaf

INDEX OF FIGURES AND TABLES INTRODUCTION I. RESPONDEAT SUPERIOR AND COLLATERAL CONSEQUENCES A. Collateral Consequences 1. The "corporate death penalty" 2. Delicensing, exclusion, and debarment 3. Market reaction 4. The existing regime II. PROFESSIONAL FIRMS A. Organizational Liability and Member Incentives B. Can Lenient Regimes Enhance Deterrence? 1. Civil fines 2. The pervasiveness standard 3. Taking stock III. MONITORING AGAINST MISCONDUCT A. Firms' Monitoring Incentives 1. Criminal liability: the existing regime 2. Civil fines 3. Criminal liability: pervasiveness B. When Will Corporate Criminal Liability Fail? 1. Monitoring technology 2. Personal gain from wrongdoing 3. Firm size and structure 4. Enforcement policy IV. IMPLICATIONS: CRIMINAL LAW AND BEYOND A. The Case for Purely Monetary Penalties B. Reforming Entity Criminal Liability 1. Top management involvement 2. Negligence 3. Pervasiveness 4. Personal liability 5. The KPMG affair C. Unlimited Liability of Professional Firms V. CONCLUSION APPENDIX: MEMBER INCENTIVES IN PROFESSIONAL FIRMS A. The Threshold B* Under the Existing Criminal Liability Regime B. The Threshold B* Under Civil Fines C. The Threshold B* Under the Pervasiveness Standard INDEX OF FIGURES AND TABLES Table 1. The Strategic Decision Under Criminal Liability Figure 1. The Effect of Probability of Conviction on Deterrence Table 2. The Strategic Decision Under Civil Fines of 80 Table 3. The Strategic Decision Under the Pervasiveness Standard Figure 2. Comparing Deterrence Under Alternative Regimes Table 4. Employee Misconduct and Monitoring Table 5. The Professional Firm Misconduct Game: Criminal Liability Table 6. The Professional Firm Misconduct Game: Civil Fines Table 7. The Professional Firm Misconduct Game: Pervasiveness Standard INTRODUCTION

The doctrine of corporate criminal liability is notoriously controversial. For decades, scholars have argued that imposing criminal liability on business entities is both ineffective and inconsistent with the fundamental principles of individual culpability and moral condemnation underlying criminal law. (1) It is therefore not surprising that the federal government's post-Enron campaign against corporate crime has reignited debate over the proper use of criminal law to target business entities. (2)

Critics of corporate criminal liability often invoke the disastrous impact of a criminal conviction on firms, employees, suppliers, and other innocent third parties. (3) Consider the case of Arthur Andersen LLP. Formerly one of the "Big Five" accounting firms, Arthur Andersen was convicted in 2002 of obstruction of justice for its destruction of Enron-related documents. (4) The conviction forced the firm to go out of business, thereby making 28,000 employees in the United States lose their jobs. (5) Not surprisingly, Arthur Andersen's tragic fate has sparked calls for sharply limiting the prosecution of business entities. (6)

But while the dramatic consequences of corporate liability occupy a prominent role in the ongoing policy debate, the deterrence effect of these harsh consequences remains largely unexplored by legal academics. (7) This omission is troubling, as the predominant justification for corporate criminal liability is its effectiveness as a necessary tool for combating organizational misconduct.

Commentators typically assume that harsh corporate penalties, including the threat of going out of business, provide firms with powerful incentives to contain wrongdoing. (8) Some find these incentives to be excessive, (9) while others posit that only the threat of going out of business can effectively deter organizational misconduct. Yet, the prevailing view is that prosecutors should balance the need to deter corporate crime against a conviction's dire consequences for employees and other innocent stakeholders. (10)

In this Article, we show that subjecting business entities to criminal liability carrying severe collateral consequences might, in fact, undermine deterrence. Indeed, purely financial penalties could contain misconduct more effectively than the threat of going out of business. To be sure, severe corporate penalties might produce powerful compliance incentives in some cases. As we shall explain, however, such penalties are likely to fail precisely when entity liability is vital from a deterrence standpoint, i.e., in decentralized organizations where individual wrongdoers are difficult to identify.

Part I begins our analysis by providing necessary background concerning both the doctrine of corporate criminal liability and its collateral consequences. The prevailing respondeat superior doctrine holds entities criminally liable for every offense committed by an agent within the scope of employment. (11) At the same time, a conviction can deal corporate defendants a fatal blow even when courts impose relatively modest penalties. Firms may thus unravel due to a variety of non-criminal sanctions triggered by a conviction, such as delicensing, exclusion from government contracts, and irreparable damage to reputation. Indeed, the most telling evidence of the fatal consequences associated with a conviction is the growing success of prosecutors in compelling companies under investigation to assist them in bringing charges against their own employees and officers. (12)

Our analysis then focuses on two distinct channels through which entity liability affects compliance. Part II considers professional firms. As the Arthur Andersen case demonstrates, holding a professional firm criminally liable would most likely trigger its demise. (13) Unlike shareholders of a corporation, members of professional firms are both part-owners and potential wrongdoers. This overlap is commonly believed to strengthen compliance incentives. Penalties imposed on professional firms, the argument goes, would not only encourage hierarchical monitoring, (14) but also directly penalize members to the extent of their equity investment, (15) thereby discouraging them from committing misconduct.

We demonstrate, however, that holding professional firms criminally liable might undermine this unique deterrence effect. When a conviction triggers the firm's demise, members decide whether to commit misconduct in a strategic setting: there are many potential wrongdoers within the firm, but liability can be imposed only once before the firm unravels. When other members of the firm are likely to commit misconduct, each member expects to bear her share of the loss associated with the firm's demise regardless of her own actions. The risk of going out of business due to others' wrongdoing thus undercuts the deterrence power of the firm's liability.

Part III considers the second channel--monitoring against misconduct--which applies to all types of business organizations. The threat of going out of business appears to provide firms with powerful monitoring incentives. Most modern firms, however, cannot realistically expect to eliminate wrongdoing even when they implement adequate compliance measures. (16) Under the prevailing entity-liability regime, a firm might unravel even for an isolated violation that took place notwithstanding the firm's compliance effort.

When they cannot eliminate misconduct, firms might respond to the threat of harsh sanctions by reducing their monitoring effort. After all, if the firm is about to unravel regardless of its investment in compliance, then why bother? More precisely, the marginal reduction in expected liability might be too low to justify additional monitoring efforts. Entity-level criminal liability can therefore undermine incentives to implement costly compliance measures when such measures merely reduce--but do not eliminate--misconduct.

Our analysis gives rise to several insights concerning corporate liability and collective sanctions. (17) First, as a matter of theory, we demonstrate that harsh penalties could undermine deterrence in group settings. Law and economics scholars recognize that subjecting offenders to severe penalties might fail to produce optimal deterrence. (18) Yet, this Article offers a novel framework to analyze the deterrence effect of harsh penalties imposed on business entities or other groups.

Second, as a matter of enforcement policy, we caution against subjecting firms to harsh sanctions--whether criminal, administrative, or other--that can be imposed only once.

Third, as a matter of criminal law doctrine, we offer a deterrence-based justification for targeting firms only for pervasive wrongdoing. While legal economists generally believe that the respondeat superior doctrine provides firms with optimal incentives, (19) our analysis shows that this regime might fail when the defendant entity is unlikely to survive a conviction. A pervasiveness standard, however, can provide both firms and their members with adequate compliance incentives. Interestingly, the federal guidelines for prosecuting business organizations require that prosecutors consider the extent to which wrongdoing is pervasive within the organization. (20) Our analysis thus lends support to this element of the guidelines.

Fourth, our analysis sheds a new light on the debate about unlimited liability for professional firms. Professional firms were traditionally prohibited from incorporating as limited liability entities. In recent years, however, lawmakers have allowed such firms to enjoy the shield of limited liability, by organizing as an LLP, for example.

While critics argue that reinstituting unlimited liability for professional firms is vital for enhancing deterrence, (21) our analysis questions the deterrence value of unlimited liability. Under a regime of unlimited liability, each partner could suffer a severe financial penalty even for wrongdoing by a single, rogue member of the firm. In modern, large professional firms--where members cannot fully eliminate wrongdoing--subjecting members to such potential liability might dilute their...