Thanks so much to Gordon and the gang for inviting me to guest blog. 

As Gordon noted in his introduction, before I headed out onto the academic market, I was fortunate enough to participate in a Conglomerate Junior Scholars workshop on my job-talk paper, and it was extremely helpful.  Nowadays, I teach Corporations, Criminal Law and Criminal Procedure.  This works well for me because I was once a federal prosecutor with a focus on white-collar crime.  After my stint as a prosecutor, I headed over to Verizon for a little more than a year to see firsthand what it meant to be a Compliance attorney.  These were in the heady days following Sarbanes-Oxley, when everyone thought that beefed up compliance departments could do everything from improve corporate culture to implement complex internal policing schemes.  Hard work! 

For a number of reasons, I think most compliance departments are likely to tend towards the "policing" aspect of the job more than the "culture" aspect.  In a world of metrics and accountability, it is far easier to police (and show results from such policing) than it is to identify, agree upon and demonstrate an improvement in cultural norms.  In my most recent article, I argued that the focus on policing (encouraged in part by the federal government) fueled an adversarial culture within firms, which in turn undermined claims that corporate compliance was an example of "New Governance," which refers generally to the experimental and cooperative forms of regulation that scholars have been arguing for since at least the early 1990's. 

Nowadays, my interests have morphed from questions about corporate compliance to broader questions about how we should design and regulate law enforcement agencies; the role law enforcment agencies should play in regulating business entities; and law and economic analysis of certain law enforcement policies, such as cooperating with criminal defendants in exchange for leniency at sentencing.   Hopefully, I'll get the chance to blog about some of these topics over the next two weeks.

Thanks again for hosting me as your guest.  I look forward to hanging out on the Glom!

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Should law students care about business ethics? How about legal scholars?

Many of us here have written and taught about corporate social responsibility. Count me a skeptic on the potential role of law in improving corporate decision making, and my conversation yesterday with a business school professor at BYU only served to reinforce my skepticism.

This professor is serving on a committee to evaluate the Marriott School's success (or not) at inculcating business ethics in its students. The preliminary conclusion: students use ethical reasoning less as they advanced in their business training. They often become "single note" decision makers, meaning that they focus on shareholder wealth maximization as they progress.

This result is certainly not a function of legal constraints, unless business school professors are misunderstanding corporate law -- not that this would be unprecedented. Legal rules offer corporate managers lots of room to make "ethical" business decisions at the expense of shareholder wealth maximization. And this is why I often tell would-be corporate reformers that they should focus their efforts on business schools, not legal rules.

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These days we legal scholars are all a bunch of social science manques, yes, but sometimes vague memories of practice and naturally surly temperaments make reading good, old-fashioned evidence-based arguments really satisfying.  All of which is a a way of commending the following to you:

• Neil Buchanan goes after home-ownership.
• Mark Lange takes down the secret-fee-loving credit card industry.  (HT: Felix Salmon at Portfolio, always a good read itself).
• I'd include Steve Bainbridge on the Socratic Method, but Gordon already got there.

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Has the Department of Justice started hiring people based on their political affilation?  It's long been rumored, now the department's inspector general and office of professional responsibility have made their report:

We found that all 7 applicants [in 2002] who indicated that they were American Constitution Society members were deselected by the Screening Committee for interviews, while 2 of the 29 applicants who indicated that they were members of the Federalist Society were deselected
[snip]
The proportion of Democratic Party affiliated applicants deselected by the Screening Committee was significantly higher (70 percent, or 43 out of 61) than the proportion of Republican Party affiliated applicants (11 percent, or 5 of 46) or the proportion of neutral affiliated applicants (32 percent, or 259 out of 804) deselected by the Committee.

Goodness.  That's quite a change for an outfit that always claimed not to hire politically, but maybe those in charge felt that there had been years of invidious ideological discrimination that by golly would be rectified by reforming the hiring process in 2002.

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. . . ain't the hazard it used to be, at least not if you want to run Coca-Cola.  Coke just appointed Muhtar Kent as its president and COO, making him the No. 2 behind CEO Neville Isdell, as well as Isdell's likely successor.  Almost ten years have passed since Kent was fired from a senior position with Coca-Cola Amatil--a regional bottler based in Sydney--for shorting 100,000 of his own company's shares just hours before the company issued a serious profit warning that caused a drop of $2.5BB in the company's market cap, almost a 30% loss.  Kent had been managing director of the bottler's European division.  He apparently made about $324,000 from the sale.  After an investigation by the Austrialian Securities Commission, Kent coughed up the profits and another $30,000 to cover the costs of the investigation. 

This past October, Kent denied prior knowledge of the impending profit warning, calling it all a "bad coincidence."  The current official story from Coke is of the "dog ate my homework" variety:

Mr Kent was advised by his financial adviser to diversify his financial portfolio, which at the time consisted solely of KO stock and CCA stock options. . . . He accepted the proposal and left it to the financial adviser to execute. In doing so, he did not fully understand that it would involve a short sale or the elements of a short sale. As a result, he also did not know the specific timing of the transaction.

So he didn't know about the impending profit warning.   And he didn't know about the impending short.  Hmmm . . .  Sorta sounds like Martha Stewart's oral stop loss order.  I'm also not sure how short-selling diversifies his portfolio.  And why was he shorting his own company anyway??  When Kent was made president of Coca-Cola international in January, less than a year after rejoining Coca-Cola, it made Colin Barr's The Five Dumbest Things on Wall Street This Week at TheStreet.com.  Or you can watch the video.

In any event, CEO Isdell (declining to be interviewed) recently issued a written statement:  "Without doubt, Muhtar is a man of the highest integrity and deepest skills."

When Coke sneezes, Emory catches a cold.  So we tend to follow our local benefactor quite closely.

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Today we covered “puffery” in my Securities Regulation class, which is the notion that statements of corporate optimism in the face of a corporation’s seeming financial distress are not viewed as actionable misstatements because investors expect actors to be overly optimistic and “look on the bright side.”

I have always been troubled by this doctrine, and what it implies about the trustworthiness of corporate executives and directors. Intuitively it makes sense that you would expect officers and directors to project an image of confidence and optimism, particularly when the company may not be doing well. Indeed, studies suggest that officers of major corporations tend to be overly optimistic—it is one of the traits that apparently makes them successful.

My concern is that such a doctrine encourages investors to continually second-guess corporate statements, thereby encouraging a climate of distrust between investors and corporate actors. Thus, when I asked my students what they felt about the doctrine, most of them seemed to accept the puffery doctrine because it confirmed their impression that “executives lie.” To that end, the puffery doctrine facilitates a (growing) distrust of corporate executives.

I am also concerned about its impact on executives. Executives already tend to be overly optimistic. And at the very least, that optimism could lead them to turn a blind eye to the truth—we certainly see threads of this notion in the recent corporate scandals. The problem is that there is a fine balance. We certainly want executives to exude confidence, but we also want them to be able to provide a truthful and realistic assessment of their corporate environment. It is not clear that the puffery doctrine facilities the right balance.

In the end, I always tell my students that the puffery doctrine is like a used car salesman defense—that is, executive statements of optimism should be considered in the same light as statements made by used car salesmen. And who actually believes what a used car salesman has to say? Indeed, several surveys have suggested that used car salesmen represent the least trusted profession. If this analogy is accurate, the puffery doctrine suggests that corporate executives merit the same level of trust as used care salesmen. I find that troubling.

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Peter Henning has a post today about Larry Sonsini's spring-loaded options that he received while director and counsel for certain companies, including Novell.  Peter notes that the ABA issued an opinion in 2000 that taking equity in a client is not a per se violation of the ethical rules.  Certain other states, including New York, took this same position.  Wilson Sonsini has never been hesitant to take equity in a client.  In the 1990s, WS took equity in many start-up clients that they took to IPO.  In 1999, WS partners received $230 million in IPO shares.  The day that WS took VA Linux public in December 1999, the firm saw its 102,584 shares rise to a market value of $24.5 million.  (Compare that with a piddly "hours billed" fee for taking a startup to IPO!)  With Webvan, earlier that year, WS held $51 million by the end of the first day in trading.  Even in 2000, WS took Avanex Corp. public and saw its shares rise to $109 million one month later.  Although we don't know when the firm sold the shares, we can guess that they sold them fairly quickly after any lock-up period was over, and hopefully before the first two of these companies declared bankruptcy.

If you are interested to know more about this topic, see my article Counselor, Gatekeeper, Shareholder, Thief:  Why Atorneys Who Invest in Their Clients in a Post-Enron World Are "Selling Out," Not "Buying In.

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In the wake of new disclosures about his involvement with the investigations of fellow directors, HP CEO Mark Hurd is promising to "give as much clarity as we can to these matters" at a press conference tomorrow. The latest revelations describe a sting operation apparently approved by Hurd:

Dawn Kawamoto, a reporter for Cnet.com, wrote a fairly straightforward article on Jan. 23 outlining the firm's long-term strategy after a board retreat.

Determined to ferret out the source's identity, HP senior counsel Kevin Hunsaker, who led the HP investigation ordered by Dunn, and an HP colleague in Boston created a fictitious persona, "Jacob," who would pose as a disgruntled HP "senior level executive" and cultivate Kawamoto by saying he was "an avid reader of your columns."

The idea, evidently, was to induce Kawamoto to open an e-mail attachment with a "tracer" in it that would allow them to see who she forwarded it to. They hoped it would pinpoint board member Keyworth as her source, according to the documents.

Both Hurd and Dunn have been beating on the ethics drum to justify their investigation of the leaks. This is from Hurd:

The HP Standards of Business Conduct are our foundation of ethical leadership, and encompass the basic principles that govern our ethical and legal obligations to HP.

The leaking of company confidential information violates our Standards of Business conduct which applies to all employees and Board members.

The HP Standards of Business Conduct contains the following statements regarding privacy and employee misconduct:

HP is committed to protecting the personal information of its customers, channel partners, suppliers, other business partners and employees. Personal information includes data related to a person who can be identified or located by that data. To create an environment of trust and to comply with applicable local law, you are required to follow HP privacy policies and data protection practices in using online and offline systems, processes, products and services that involve the use, storage or transmission of any personal information....

Misconduct In general, misconduct is an illegal or harmful activity that involves or affects HP and its employees. Misconduct includes, among other things, violation of the provisions of these Standards of Business Conduct, theft, records falsification, involvement with unlawful drugs, unauthorized use of alcohol, violence, threats, harassment, possession of weapons and insubordination. If you engage in misconduct, you are subject to immediate termination of employment.

Luckily for Hurd, the privacy policy does not extend to directors or reporters.

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While browsing the Craig's List "wanted" section for Milwaukee, I noticed this very interesting posting entitled "Letter from a Marquette alumn[sic]=Free application?"

I recall hearing somewhere that with a letter from a Marquette alumnus, the application fee is waived. I am looking to apply to Marquette's MBA program and would prefer to skip the $40 application fee. Is this true? If so, can you help me out? I would gladly buy you a drink.

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A few of our blog friends have been riffing on the usury law meme and each other.  See Matt B. here, Kate at Ideoblog, ProfB starting it all and responding to Kate and Matt.  I have defended usury laws before, and Paul Gowder's comment to Kate's post explains why.  Although the law may have no interest in stopping fully informed individuals from binding themselves or their entities to a high rate of interest that compensates the lender for a particular risk, the law realizes that in many cases the borrowers aren't fully informed of their bargain.  Unfortunately, many lenders and vendors seem to have a business plan that hinges on individuals legally binding themselves to obligations they don't understand.  Because the law is not very effective at making sure that borrowers are clear on their obligations, usury laws (interest rate caps) ensure that at least those caught in sharp business practices won't be damaged too bad.  Obviously, reasonable minds differ here, but I want to discuss something else.

I wanted to specifically respond to Kate's point, which seems to be that "usurious" interest rates can't be unethical if they are market-driven.  Kate makes the point that she doesn't want an "ethics tsar" determining what interest rates are unethical.  Of course, Kate is responding to ProfB's post on the Pope's discussion of usurious lending rates as unethical.  My seminar, the Ethics of Business, discusses just this intersection of what is ethical, what is legal, and what is good business practice.  Merely because a practice is good business or the product of a free market does not mean that I have to think it is ethical.  Ethical philosophies exist beyond utilitarianism, beyond what is the greatest good for the greatest number.  One might determine what is ethical based on the incentives of the actor or the values embodied in the action.  One might also determine what is ethical based on an intuitive sense of right or wrong that may or may not come from a belief in a supernatural being.  And at some point, one's sense of ethics may deviate from the workings of the free market.

One particular point we discuss in class is sharp business practices.  I may have a legal obligation to disclose some things and not others, but my personal ethics may tell me to disclose others.  My business sense may incentivize me not to disclose anything or selective things.  My religious beliefs may tell me to refrain from activity that may be legal and that may also be rational in a free market.  A religious leader may extol followers to also refrain from an activity that may be legal and that may also be rational in a free market.  This teaching may create individual inconvenience, such as not spending money one day a week, or may create huge obstacles, such as not lending money or not lending money at a high rate of interest.

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For some reason it seems to have passed with little fanfare (at least in my rarefied circles), but recently the Electronic Frontier Foundation (EFF) announced a startling discovery:  The government, in conjunction with printer manufacturers (or is it the Rand Corporation, in conjunction with the reverse vampires?)  have for some time been tracking computer printer output.  Details are sketchy, but it looks like the government has been working with printer manufacturers to embed coded messages in every document produced on certain color laser printers (indicating the serial number of the printer and the time and date of printing) in an effort to assist enforcement against counterfeiters.  According to this article, the technology has been employed by some manufacturers for decades.

EFF does some decent work (cracking this code, for example, would have to qualify), but unfortunately it’s also a group of fear mongers — not that just because they’re paranoid there isn’t anyone following them.  It’s just that they have limited credibility when this is their take:

Even worse, it shows how the government and private industry make backroom deals to weaken our privacy by compromising everyday equipment like printers. The logical next question is: what other deals have been or are being made to ensure that our technology rats on us?

Look guys — as Posner would tell you (and so would any other economist) it’s about trade-offs.  Do you think counterfeiting is a problem?  Should the government use any resources to combat it?  Now, if so, how can you be sure that this is not, in fact, the best way to do so, even though it entails a cost?  What doesn’t?  The next logical question is hardly “how else has private industry colluded with the government to screw us over?”  The actual next logical question is, “is this the most cost-effective way to deal with the problem of counterfeiting, given the potential cost?”  Now, how hard was that?  Let’s not assume our conclusions before we even ask the questions, shall we?

By the way — here’s what I think really ought to be the next question:  “How on earth was this kept secret for so long?”  I mean — there had to be dozens if not hundreds of folks in on this, in both industry and government.  How did the secret not get out?  How is it possible that not a single programmer involved in the project at Xerox leaked the news?  Or — did they?  Was this known to the counterfeiting community long ago?  (And, of course, if so, question one — was this a good idea? -- becomes a little easier to answer).

Relatedly, what kind of protections could EFF want in the future? Disclosure? That would immediately defeat the purpose, and, again, assume the conclusion of the very question being asked. So what, realistically, should be done?

Also, I note that, according to the EFF itself, the tracking dots are used only in color laser printers. Maybe this is itself a decent compromise position. If the government really wanted secretly to monitor subversive organizations like Greenpeace and the ACLU through their printed output, wouldn't it make more sense to target the black and white printers?  Or are these organizations printing strictly in color these days?

Finally, my real beef with EFF is not that it is wary of government; there's plenty to be wary of. My real problem is that it seems not to discriminate between potential government violations of one's privacy and anonymity on the one hand, and private sector incursions on the other. This, by the way, is a problem it shares with one of the organization's intellectual godfathers, Larry Lessig (see here).

The point seems obvious, but there is an enormous, qualitative difference between the threat posed by Leviathan reading your emails and that posed by your boss doing it. If you don't like your boss doing it enough, you work someplace else (or contract with your boss to stop). If you don't like it that Sony encodes intrusive DRM software on its CDs, you buy another label's CDs. If enough people share your aversion to these incursions in the private sphere, the market will induce the violators to respond and/or it will provide alternatives. But we can't say the same for Leviathan, and the democratic process is hardly a reliable system for inducing the government to respond, even to the preferences of the majority.

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Professor William Black (Texas, criminology) has posted an interesting comment on one of my prior posts, A Case Study in the Ethics of Financial Engineering.  An excerpt:

Fourth, like most white-collar criminologists I rarely use the word "evil," because it is so subjective a phrase and generally adds little value to the discussion. I wonder, however, why you were so quick to agree that the senior insiders, including Fastow, who destroyed Enron were NOT "evil." How can any of you know this? And what is your conception of "evil"? You seem to (implicitly) reject the concept that it could be banal. Fastow has confessed to actions that you know from your reading involved scores, probably hundreds, of acts of deceit in order to get even more wealthy. He betrayed everyone he had a duty to protect. He had no need to do so.

I should also add that Mitt Regan (Georgetown) has a great paper on Enron.  I will post to it when it's on-line.

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Immortal??  I don't even have tenure. 

Meanwhile, having admitted unlawful conduct, KPMG is fighting back.  My instincts are with KPMG on this one -- I find it a little hard to believe that the shelter consumers didn't know what they were buying.

Calvin Johnson's analysis of the shelters can be found through Paul Caron here.
 

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Bainbridge links to Tom K's coverage of KPMG.  Both refer to it as the "criminalization of agency costs." 

If the KPMG partners are the agents, who are the principals?  I assumed the phrase "criminalization of agency costs" (a clever turn of phrase that I believe originated with Larry Ribstein) referred to the use of the criminal law to protect shareholders -- the implication being that the protection is unnecessary and a problem for shareholders and managers to work out among themselves.  Markets, not the government, should police accounting fraud, theft of corporate assets, etc.  I disagree, but I think I understand the argument. 

At least I thought I did.  Now I'm not so sure.  Tax fraud is not an agency costs problem.  KPMG, an advisor, sold its clients tax shelters for the benefit of the clients' shareholders.  Accounting gimmicks shift value away from creditors and long-term shareholders.  Tax gimmicks shift value away from the government.  The public, not the clients' shareholders, got hurt.  How is this an agency costs problem?

Pre-cooked phrases should not substitute for thought.  "Criminalization of agency costs," once it loses its substantive meaning, becomes as useless a phrase as "witch hunt" or "inquisition" or "corporate greed."  Sloppy writing is a sin I am sure I am guilty of as well, and I hope you will call me on it too.

In any event, the KPMG memo is good reading, as is Tanina Rostain's article on KPMG. 

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As I prepare to teach Deals again this fall, I have been reading Eichenwald's account of the Enron meltdown, Conspiracy of Fools.  It's a very good read if you find Enron endlessly intriguing.  I do.  For the more casual reader, I suspect Eichenwald's tendency to include what seems like every source and every memo might become a little tiresome.  But for a scholar, it's great. 

One theme I find challenging to teach in my deals course is the ethics of financial engineering.  Where should we draw the line between ethical and unethical, criminal and legal?  Should there be two lines or one?  Why?

One argument for having a clear line between criminal and non-criminal conduct is that a fuzzy line may deter socially productive behavior as well as socially undesirable behavior. 

But what, exactly, is socially productive about financial engineering?  A fuzzy line may be okay if the legal behavior it deters doesn't create much social value.

This is a long post, so I'll summarize the key points in advance:

1.  Financial engineering, unlike most deal lawyering, does not create value.  It merely shifts value around.

2. A fuzzy line between legal and illegal conduct deters some legal conduct. 

3.  Overdeterrence is less problematic, though, if the legal conduct it deters is not socially productive.

4.  Criminalizing the business purpose doctrine may be the best (only?) way to draw a line between legal and illegal financial engineering.

Financial engineering, as I use the term, refers to exploiting the gap between the economics of a transaction and its treatment for legal, regulatory or accounting purposes.  While transaction-cost-engineering (the primary role of the deal lawyer) creates value by allocating risk to the party who can best bear the risk, financial engineering is typically a zero sum game.  Value is shifted, not created.  Improving the tax treatment of a transaction creates value for the client, but usually at the expense of the government.  Improving the accounting treatment of a transaction pleases management and increases the short-term value of their stock, but usually at the expense of long-term shareholders or nonadjusting creditors. 

Not all financial innovation is zero sum.  Sometimes new deal structures carve up risk in a useful way that lowers the cost of capital.  New financial products may improve the liquidity of markets.  But where deal structures are tweaked to improve the tax, accounting or regulatory treatment without changing economic risk, there is little social utility.  Lawyers are no longer shifting risk or reducing transaction costs -- they are merely reducing regulatory costs for the client at the expense of other parties (shareholders, creditors) or the public at large.

Perhaps there is some social value to financial engineering.  Involving lawyers in deals usually encourages a culture of compliance.  In other words, when lawyers push transactions to the line without crossing it, at least it suggests that the line matters.  Blatantly fraudulent transactions may be prevented.

Also, transactions that expose badly-designed regulations (i.e. where economically identical transactions receive different legal treatment) may encourage better line-drawing by regulators. 

But most financial engineering, as I've defined it, has little or no social value.  A transaction that allows a company to book income on its financial reports that bears no relationship to the economic substance of the deal is not socially productive.  A transaction that allows a company to avoid income on its income tax return without facing any economic consequences is not socially productive.  I see nothing wrong with using the criminal law to deter such transactions IF we can do so without deterring transactions that are socially productive. 

So how might we distinguish between the two?  It's tough. 

I am becoming resigned to the notion that the only practical way to distinguish between socially productive and socially destructive transactions is some sort of "business purpose" test similar to what is used in tax.  If a transaction is motivated by a business purpose, then tweaking the structure to obtain a better legal, accounting, or regulatory treatment is okay.  If, however, the transaction has no business purpose but is, instead, engineered to improve the balance sheet or reduce tax liability, then the transaction should be prohibited.

In an ideal world, we might expect the government, in advance, to craft perfectly clear regulations in tax, accounting, securities, environmental law, etc. --- which would then allow us to say that any transaction that fits within the literal four corners of the regs is perfectly legal.  But this is unrealistic.  Regulations are imperfect and fuzzy and always will be.  Even when they are clear, lawyers and bankers will develop a new structure that suddenly makes the old rules less clear.

This leads me to the conclusion that criminalizing the business purpose doctrine (and extending it from tax to accounting) might be the right solution.  In other words, where the government can prove that a transaction lacked any cognizable business purpose (in light of all the relevant facts and circumstances), then not only is the transaction unethical, it is illegal.  If the transaction has some business purpose but mostly a financial engineering purpose, then the transaction might be unethical but not illegal.  If the transaction primarily has a business purpose, then it is both legal and ethical.

The obvious problem is that figuring out business purpose is itself a difficult task.  And it is easy for lawyers to manipulate through careful drafting of board minutes and the like.  How much business purpose is enough?  Not clear.  Doctrine would have to develop through case law and Congressional guidance.  We would also have to sort out such questions as whether improving one's credit rating is a legitimate business purpose. 

Criminalizing the business purpose doctrine might discourage some transactions that have a little bit of a business purpose and a lot of financial engineering purpose.  Many securitizations and structured finance transactions, for example, would be suspect.  Is that so bad?  I'm not sure.  If I am right that financial engineering has little social utility, then the over-deterrence problem isn't such a problem after all.

I am okay with deterring some socially productive behavior if it also discourages a lot of socially destructive behavior.  Given limited resources for enforcement of ethical and legal rules, using the criminal law as a backstop (and to express our social expectations) makes a lot of sense.

Is there a better way to criminalize the business purpose doctrine without deterring socially productive behavior?   

Or is relying on the purpose or intent of the deal-makers the wrong path to pursue?  How else could we draw the line? 

Criminalizing the business purpose doctrine has LOTS of potential problems, but I am finding it hard to find a better solution.  I don't see how the status quo -- where fraudulent transactions are sometimes criminal, sometimes not, and no one knows what "fraud" is -- is better. 

I should stress that my thoughts here are preliminary and not targeted at KPMG, the Nigerian barge case or anyone case in particular.  My goal here is to start putting some thoughts on paper, and perhaps I will try to apply them to specific facts later.  As it is, the only theory of the ethics of financial engineering that we have is the "smell test," and it has not served the country well.  The smell test is the sort of test that increases the cost of doing business without actually preventing socially undesirable conduct.  I certainly hope we can do better, and this post is an attempt to move my own thinking along. 

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