Thanks to Erik Gerding for the opportunity to share some of my ideas on corporate criminal liability, Dodd-Frank, corporate influences on individual behavior and educating today's law students only three months into my new academic career. I appreciate the thoughtful and encouraging emails I received from many of you. I even received a request for an interview from the Wall Street Journal after a reporter read my two blog posts on Dodd-Frank conflicts minerals governance disclosures. We had a lengthy conversation and although I only had one quote, he did link to the Conglomerate posts and for that I am very grateful. 

http://online.wsj.com/article/SB10001424052970203733304577102412994084008.html?mod=WSJ_PersonalFinance_PF17#articleTabs%3Darticle

I plan to make this site required reading for my seminar students, and look forward to continuing to learn from you all.  

Best wishes for the holiday season and new year.  

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Time Magazine’s “person of the year” is the “protestor.” Occupy Wall Street’s participants have generated discussion unprecedented in recent years about the role of corporations and their executives in society. The movement has influenced workers and unemployed alike around the world and has clearly shaped the political debate.

But how does a corporation really act? Doesn’t it act through its people? And do those people behave like the members of the homo economicus species acting rationally, selfishly for their greatest material advantage and without consideration about morality, ethics or other people? If so, can a corporation really have a conscience?

In her book Cultivating Conscience: How Good Laws Make Good People, Lynn Stout, a corporate and securities professor at UCLA School of Law argues that the homo economicus model does a poor job of predicting behavior within corporations. Stout takes aim at Oliver Wendell Holmes’ theory of the “bad man” (which forms the basis of homo economicus), Hobbes’ approach in Leviathan, John Stuart Mill’s theory of political economy, and those judges, law professors, regulators and policymakers who focus solely on the law and economics theory that material incentives are the only things that matter.

Citing hundreds of sociological studies that have been replicated around the world over the past fifty years, evolutionary biology, and experimental gaming theory, she concludes that  people do not generally behave like the “rational maximizers” that ecomonic theory would predict. In fact other than the 1-3% of the population who are psychopaths, people are “prosocial, ” meaning that they sacrifice to follow ethical rules, or to help or avoid harming others (although interestingly in student studies, economics majors tended to be less prosocial than others). 

She recommends a three-factor model for judges, regulators and legislators who want to shape human behavior:

 “Unselfish prosocial behavior toward strangers, including unselfish compliance with legal and ethical rules, is triggered by social context, including especially:

(1)         instructions from authority

(2)         beliefs about others’ prosocial behavior; and

(3)         the magnitude of the benefits to others.

Prosocial behavior declines, however, as the personal cost of acting prosocially increases.”

While she focuses on tort, contract and criminal law, her model and criticisms of the homo economicus model may be particularly helpful in the context of understanding corporate behavior. Corporations clearly influence how their people act. Professor Pamela Bucy, for example, argues that government should only be able to convict a corporation if it proves that the corporate ethos encouraged agents of the corporation to commit the criminal act. That corporate ethos results from individuals working together toward corporate goals.

Stout observes that an entire generation of business and political leaders has been taught that people only respond to material incentives, which leads to poor planning that can have devastating results by steering naturally prosocial people to toward unethical or illegal behavior. She warns against “rais[ing] the cost of conscience,” stating that “if we want people to be good, we must not tempt them to be bad.”

In her forthcoming article “Killing Conscience: The Unintended Behavioral Consequences of ‘Pay for Performance,’” she applies behavioral science to incentive based-pay. She points to the savings and loans crisis of the 80's, the recent teacher cheating scandals on standardized tests, Enron, Worldcom, the 2008 credit crisis, which stemmed in part from performance-based bonuses that tempted brokers to approve risky loans, and Bear Sterns and AIG executives who bet on risky derivatives. She disagrees with those who say that that those incentive plans were poorly designed, arguing instead that excessive reliance on even well designed ex-ante incentive plans can “snuff out” or suppress conscience and create “psycopathogenic” environments, and has done so as evidenced by “a disturbing outbreak of executive-driven corporate frauds, scandals and failures.” She further notes that the pay for performance movement has produced less than stellar improvement in the performance and profitability of most US companies.  

She advocates instead for trust-based” compensation arrangements, which take into account the parties’ capacity for prosocial behavior rather than leading employees to believe that the employer rewards selfish behavior. This is especially true if that reward tempts employees to engage in fraudulent or opportunistic behavior if that is the only way to realistically achieve the performance metric.

Applying her three factor model looks like this: Does the company’s messaging tell employees that it doesn’t care about ethics? Is it rewarding other people to act in the same way? And is it signaling that there is nothing wrong with unethical behavior or that there are no victims? This theory fits in nicely with the Bucy corporate ethos paradigm described above.

Stout proposes modest, nonmaterial rewards such as greater job responsibilities, public recognition, and more reasonable cash awards based upon subjective, ex post evaluations on the employee’s performance, and cites studies indicating that most employees thrive and are more creative in environments that don’t focus on ex ante monetary incentives. She yearns for the pre 162(m) days when the tax code didn’t require corporations to tie executive pay over one million dollars to performance metrics.

Stout’s application of these behavioral science theories provide guidance that lawmakers and others may want to consider as they look at legislation to prevent or at least mitigate the next corporate scandal. She also provides food for thought for those in corporate America who want to change the dynamics and trust factors within their organizations, and by extension their employee base, shareholders and the general population.

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Massey Energy and Walmart made headlines last week for different reasons. Massey had the worst mining disaster in 40 years, killing 29 employees and entered into a nonprescution agreement with the Department of Justice. The DOJ has stated in the past that these agreements balance the interests of penalizing offending companies, compensating victims and stopping criminal conduct “without the loss of jobs, the loss of pensions, and other significant negative consequences to innocent parties who played no role in the criminal conduct, were unaware of it, or were unable to prevent it.”

Massey’s new owner Alpha Natural Resources, has agreed to pay $210 million dollars in fines to the government, compensation to the families of the deceased miners and for safety improvements (the latter may be tax-deductible). The government’s 972-page report concluded that the root cause was Massey’s “systematic, intentional and aggressive efforts” to conceal life threatening safety violations. The company maintained a doctored set of safety records for investigators, intimidated workers who complained of safety issues, warned miners when inspectors were coming (a crime), and had 370 violations. The mine had been shut down 48 times in the previous year and reopened once violations were fixed.  112 miners had had no basic safety training at all.  Only one executive has been convicted of destroying documents and obstruction, and investigations on other executives are pending. However, the company itself has escaped prosecution for violations of the Mine Safety and Health Act, conspiracy or obstruction of justice. Perhaps new ownership swayed prosecutors and if Massey had its same owners, things would be different. But is this really justice? The miner’s families receiving the settlement certainly don’t think so.

Walmart announced in its 10-Q that based upon a compliance review and other sources (Dodd-Frank whistleblowers maybe?), it had informed both the SEC and DOJ that it was conducting a worldwide review of its practices to ensure that there were no violations of the Foreign Corrupt Practices Act (“FCPA”).  Although no facts have come out in the Walmart case and I have no personal knowledge of the circumstances, let’s assume for the sake of this post that Walmart has a robust compliance program, which takes a risk based approach to training its two million employees in what they need to know (the greeter in Tulsa may not need in-depth training on bribery and corruption but the warehouse manager and office workers in Brazil and China do). Let’s also assume that Walmart can hire the best attorneys, investigators and consultants around, and based on their advice, chose to disclose to the government that they were conducting an internal investigation.  Let’s further assume that the incidents are not widespread and may involve a few rogue managers around the world, who have chosen to ignore the training and the policies and a strong tone at the top.

As is common today, let’s also assume that depending on what they find, the company will do what every good “corporate citizen” does to avoid indictment --disclose all factual findings and underlying information of its internal investigation, waive the attorney client privilege and work product protection, fire employees, replace management, possibly cut off payment of legal fees for those under investigation, and actively participate in any government investigations of employees, competitors, agents and vendors.

Should this idealized version of Walmart be treated the same as Massey Energy? (For a great compilation of essays on the potential conflicts between the company and its employees, read Prosecutors in the Boardroom: Using Criminal Law to Regulate Corporate Conduct, edited by Anthony and Rachel Barkow).  Should they both be charged and face trial or should they get deferred or nonprosecution agreements for cooperation? Do these NPAs and DPAs erode our sense of justice or should there be an additional alternative for companies that have done the right thing -- an affirmative defense?

A discussion of the history of corporate criminal liability would be too detailed for this post, but in its most simplistic form, ever since the 1909 case of New York Central & Hudson River Railroad Co v. United States, companies have endured strict liability for the criminal acts of employees who were acting within the scope of their employment and who were motivated in part by an intent to benefit the corporation.  As case law has evolved, companies face this liability even if the employee flouted clear rules and mandates and the company has a state of the art compliance program and corporate culture.  In reality, no matter how much money, time or effort a company spends to train and inculcate values into its employees, agents and vendors, there is no guarantee that their employees will neither intentionally nor unintentionally violate the law.

The DOJ has reiterated this 1909 standard in its policy documents. And because so few corporations go to trial and instead enter into DPAs or NPAs, we don’t know whether the compliance programs in place would have led to either the potential 400% increase or 95% decrease in fines and penalties under the Federal Sentencing Guidelines because judges aren’t making those determinations. The DPAs are now providing more information about corporate compliance reporting provisions, but again, even if a company already had all of those practices in place, and a rogue group of employees ignored them, the company faces the criminal liability. The Ethical Resource Center is preparing a report in celebration of the 20^th Anniversary of the Sentencing Guidelines with recommendations for the U.S. Sentencing Commission, members of Congress, the DOJ and other enforcement agencies. They are excellent and timely, but they do not go far enough.

A Massey Energy should not receive the same treatment as my idealized model corporate citizen Walmart. Instead, I agree with Larry Thompson, formerly of the DOJ and now a general counsel and others who propose an affirmative defense for an effective compliance program- not simply as possible reduction in a fine or a DPA or NPA.

While the ideal standard would require prosecutors to prove that upper management was willfully blind or negligent regarding the conduct, this proposed standard may presume corporate involvement or condonation of wrongful conduct but allow the company to rebut this presumption with a defense.

In the past decade, companies drastically changed their antiharassment programs after the Supreme Court cases of Fargher and Ellerth allowed for an affirmative defense. The UK Bribery Act also allows for an affirmative defense for implementing “adequate procedures” with six principles of bribery prevention. Interestingly, they too are looking at instituting DPAs.

I would limit a proposed affirmative defense to when nonpolicymaking employees have committed misconduct contrary to law, policy or management instructions. If the company adopted or ratified the conduct and/or did not correct it, it could not avail itself of the defense. The company would have to prove by a preponderance of the evidence that: it has implemented a state of the art program approved and overseen by the board or a designated committee; clearly communicated the corporation’s intent to comply with the law and announced employee penalties for prohibited acts; met or exceeded industry standards and norms; is periodically audited and benchmarked by a third party and has made modifications if necessary; has financial incentives for lawful and penalties unlawful behavior; elevated the compliance officer to report directly to the board or a designated committee (a suggestion rejected in the 2010 amendments to the Sentencing Guidelines); has consistently applied anti-retaliation policies for whistleblowers; voluntarily reported wrongdoing to authorities when appropriate; and of course taken into account what the DOJ has required of offending companies and which is now becoming the standard. The court should have to rule on the defense pre-trial.

Instead of serving as vicarious or deputized prosecutors, under this proposed standard, a corporation’s cooperation with prosecutors will be based on factors more within the corporation's control,rather than the catch-22 they currently face where if employees are guilty, there is no defense. And if the employees are guilty, this would not preclude the government from prosecuting them, as they should.

Responsible corporations now spend significant sums on compliance programs and the reward is simply a reduction in a fine for conduct for which it is vicariously liable and which its policies strictly prohibited. A defense will promote earlier detection and remedying of the wrongdoing, reduce government expenditures, provide more assurance to investors and regulators, allow the government to focus on companies that don’t have effective compliance program, and most important provide incentives for companies to invest in more state of the art programs rather than a cosmetic, check the box initiative because the standard would be higher than what is currently Sentencing Guidelines.

Perhaps only a small number of companies may be able to prevail with this defense.  Frankly, corporations won’t want to bear the risk of a trial, but they will at least have a better negotiating position with prosecutors. Moreover, companies that try in good faith to do the right thing won’t be lumped into the same categories as those who invest in the least expensive programs that may pass muster or worse, engage in clearly intentional criminal behavior.  If companies have the certainty that there is a chance to use a defense, that will invariably lead to stronger programs that can truly detect and prevent criminal behavior.

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David Smyth at the Cady Bar The Door blog has a pretty plausible take as to what prompted DOJ to indict Rajat Gupta well after the SEC's civil case against him had collapsed.  Here's some of the relevant analysis:

I think the delay in the criminal case against Gupta is explainable if one assumes two things are true:  First, that a criminal prosecutor would much rather go to trial in a case like this with incriminating taped conversations than without.  It makes sense; proving a case beyond a reasonable doubt is no easy trick.  Insider trading cases can be very hard to prove, and one can imagine that the prosecutors in the Southern District of New York would want to have the best evidence possible before walking onto that big stage.

The second key assumption is that prosecutors made a final run at trying to get Rajaratnam to flip on Gupta just before Rajaratnam was sentenced.  It’s hard to know if this is true, but Rajaratnam did recently submit to a wide-ranging interview with Newsweek magazine in which he revealed that prosecutors had asked again for his cooperation against Gupta....

To me, one of the interesting questions in this involves the lobbying of the prosecuting agency, DOJ, by the investigating agency, the SEC, to commit to a criminal case.  Once the SEC had lost on the administrative proceedings (which it may have begun because DOJ was unwilling to indict), it may have presented DOJ with something of an ultimatum.  We'll never know.  

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An article in today's Life section of USA Today titled Movies tap into anger at Wall Street describes how 3 movies in current release mirror public angst over economic inequalities and inequities: Tower Heist, In Time, and the already mentioned in 2 Glom blogs, Margin Call.

This autumn's documentary Chasing Madoff recounts Harry Markopolos’ multi-year crusade to expose the multi-billion dollar Ponzi scheme perpetrated by Bernie Madoff. Alleged victims of this massive fraud include the celebrity couple of Kyra Sedgwick (star of The Closer on TNT) and Kevin Bacon (of the original Footloose (1984) fame). The Dodd-Frank Wall Street Reform and Consumer Protection Act included a broad set of whistleblower provisions under which the Securities and Exchange Commission adopted specific rules and procedures to incentivize potential whistleblowers by way of cash rewards and protection from retaliation.

There is also a 2009 documentary about the subprime mortgage fiasco, which is now available on DVD, American Casino. 2001 economics Nobel laureate Joseph Stigltiz described it as being "a powerful and shocking look at the subprime lending scandal. If you want to understand how the US financial system failed and how mortgage companies ripped off the poor, see this film." 

This May, the HBO Films production of Too Big to Fail, based on the book of the same name with the subtitle of The Inside Story of How Wall Street and Washington Fought to Save the Financial System--and Themselves depicted the autumn 2008 U.S. financial crisis and the sequence of (less than intertemporally consistent) policy responses by the Treasury department, the Federal Reserve, and other financial regulators.

Last autumn's Inside Job made a compelling argument in five parts about how the American financial services industry systematically and systemically corrupted the United States government and in so doing brought about changes in banking practices and legal policies that led directly to the Great Recession.

Although the documentary Client 9: The Rise and Fall of Eliot Spitzer focused primarily on the interaction of ego, hubris, power, scandal, sex, and politics, it also touched upon Wall Street and efforts by Spitzer to reform its excesses.

Of course, no list of movies related to the recent financial crises would be complete without including documentary film-maker Michael Moore's 2009, Capitalism: A Love Story, which criticizes the current American economic system in particular and capitalism in general. At one point, it asks if capitalism is a sin and whether Jesus would be a capitalist, who wanted to maximize profits, deregulate banking, and have the sick pay out of pocket for pre-existing conditions via clips from Jesus of Nazareth. Moore asks if one could patent the sun and questions how the brightest American youth are drawn towards finance and not science. He proceeds to Wall Street asking for non-technical explanations of derivative securities in general and credit default swaps in particular. Both a former vice-president of Lehman Brothers and current Harvard University economics professor Kenneth Rogoff fail to clearly explain either term. Moore thus concludes that our complex economic system and its arcane terminology exist simply to confuse people and that Wall Street effectively has a crazy casino mentality. 

Finally, the PBS Nova episode, Mind Over Money, which originally aired on April 26, 2010 asks whether markets can possibly be rational when people clearly are not. In other words, is there a version of the efficient markets hypothesis that can be true in a world populated by at least some boundedly rational actors? In posing this question, the show offers an entertaining, yet quite informative survey of elements of behavioral economics and finance. Its companion website provides additional resource materials concerning the role of emotions in financial decision-making. The debate which it depicts between the University of Chicago school of economics and the behavioral economics approach (including scenes of Dick Thaler playing pool) is a bit overdone and perhaps unintentionally comical, but it raises the question of whether it matters for law and policy how people make their financial judgments and decisions? Of course, the natural follow-ups of if so, then how and if not, then why not, are questions about which business law professors, Glom readers, and policy makers are likely to have perhaps quite strong and certainly divergent opinions.

A television program that has become quite popular is the USA network's original dramatic series White Collar, which is based upon the premise of an F.B.I. agent solving white collar crimes with the assistance of consultant who is a former (and current?) art thief and con man extraordinaire. Episodes have featured a black widow, baby selling, bank robbery, black market kidneys, bond theft, collusion, corporate espionage, derivatives, financial fraud by a Wall Street brokerage firm, identity theft, and political corruption.  

It is reminiscent of the 1960's campy, classic, and tongue-in-cheek television series, It Takes A Thief.

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Apparently, part of the answer to David's question regarding the timing of the arraignment of Raj Gupta's arraignment was Gupta's desire to surrender on Diwali, the Indian festival of lights.  The WSJ quotes a childhood friend Anand "Bill" Julka: "He believes he is innocent and the gods will protect him if humans fail." 

Apropos of Diwalki, this image has been making the Facebook rounds, captioned "India during Diwali NASA."

Which makes it seem like India is all lit up at night during Diwali, which is pretty cool.  According to Business Insider, though, that's not quite right:

The photo is an overlay of shots highlighting India's burgeoning population over several years. The white lights were the only illumination visible before 1992. The blue lights appeared in 1992. The green lights in 1998. And the red lights appeared in 2003.

Current speculation suggests the lights are a result of the Hindu celebration Diwali, or the celebration of lights, held from mid-October to mid-November, but NASA was unable to confirm what time of year the shots were taken.

For his sake, hopefully Gupta's story holds up better than the picture...

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The real question about the Gupta charge is: what took the SEC so long?

• The incidents raised in the complaint - calling Rajnaratam after a P&G board meeting, and calling him after hearing about Warren Buffett's investment in Goldman Sachs, inter alia - aren't new.
• The SEC dismissed its prior, administrative case against Gupta after Judge Jed Rakoff suggested that it violated Gupta's equal protection rights, given that everyone else was getting a criminal indictment, and therefore the broad discovery obligations that such an indictment imposes on the United States (I find this pretty ludicrous, by the way, the idea that being threatened with a fine and a trading ban has constitutional implications for Gupta, given that everyone else is facing bigger fines and jail time ... but it did get the SEC off the schneid, I guess).
• Andrew Ross Sorkin speculated that the SEC didn't have smoking gun phone tap evidence then.
• But the complaint certainly suggests it is willing to go with simple phone record inference now.  When Gupta was a board member at Goldman Sachs, he called Rajnaratnam 16 seconds after hanging up on a board teleconference about Buffett's investment, the complaint alleges.  And Rajnaratnam traded into Goldman Sachs later that day.  Which looks really bad - it would look even worse if they could quote the content of those calls, though, and the complaint doesn't do that.
• Still no quotes from the phone calls that I could see in the complaint, though, and once again, the incidents being charged are the same as they were in the administrative case.
• I'm not seeing the reason for the change of heart, unless there was an issue with getting DOJ to indict back then, but now that they've won against Rajnaratnam, maybe they're feeling braver.  It's quite mysterious.

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When the story of Kweku Adoboli, UBS's "rogue trader" who incurred 2.3 billion in losses for the Swiss bank, broke this weekend, my reaction probably mirrored that of many: "Really?  Haven't we heard this story before?"  For all demonization of SOX's Section 404, haven't most companies put some internal controls in place to prevent this?  And if the Achilles' heel of generals and regulators alike is that they always fight the last war, well Societe Generale handed banks a modern rogue trader's battle plan: start in the back office, learn the risk controls, then move to the front office and evade them. 

Here's Forbes' Francine McKenna:

Kerviel and Adoboli were both veterans of the back office. That gave them, according to their accusers, an advantage over most traders.  They actually understood and could appreciate the purpose of risk management and control mechanisms that were supposed to be in place. They weren’t the kind of traders who are deaf, dumb, blind, and angrily resistant to checks and balances, reports and circuit breakers, and requests for information and explanations.

They were smarter.  They knew how to bypass the controls.

I think a ban on moving smarter, more aware back office and middle office professionals onto the trading floor is an insult to traders.  And wrongheaded.  What was missing in both cases is supervision and enforcement of controls.

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Yesterday’s Wall Street Journal ran a story (password required) on federal prosecutors using the “responsible corporate officer” doctrine to impose personal liability on the officers and directors of drug companies for violations of food & drug laws.

This revives an obscure doctrine that I wrote about a few years ago (see here, pages 313-318) for a book that compared director liability for corporate actions across countries. The responsible corporate officer is understandably extremely worrying for corporate boards and executives because it means civil and even criminal liability when a corporation violates a law absent a director or officer knowing about the violation.

It is important to note that the scope of the doctrine is limited. It sprang forth in the 1943 Supreme Court case U.S. v. Dotterweich which interpreted the Federal Food, Drug and Cosmetic Act. The Court upheld the application of the doctrine to the same statute in 1975 in U.S. v. Park. In the 2003 case Meyer v. Holley, the Court revisited the doctrine and stated that Congress must be fairly explicit in a statute that it intends the doctrine to apply. And the current Supreme Court is unlikely to reverse course on this. The responsible corporate officer doctrine is unlikely to apply to new statutes absent explicit Congressional language.

Even so, the doctrine does apply to more than one federal food & drug statute. I list a number of federal cases in that book chapter I mention above. Moreover, state legislatures and courts have also applied the statute to state laws (and Meyer v. Holley does not necessarily constrain the ability of state courts to apply the doctrine to state statutes more liberally). So this dormant doctrinal strain should only give pause to boards and executives in certain heavily regulated industries that are subject to certain statutes. The doctrine is more limited, but potentially vastly more powerful – because lack of knowledge is not a defense -- than other sources of liability for directors that have been much more analyzed in recent years (for example, securities laws and Disney/Caremark/Stone v. Ritter).

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I'm not sure there is much to be learned, in a professional responsibility sense, from what went wrong with former AUSA Paul Bergrin's criminal defense practice, but the New York article on it is a good read.

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The last two weeks have witnessed dramatic victories against two very different lawbreaking networks. First the death of Bin Laden removed the leader of al Qaeda. Second, the conviction of Raj Rajaratnam represented a major victory for prosecutors against the so-called expert insider trading networks. Although the two lawbreaking networks have a multitude of differences – in terms of social harm, motivations, and structure – they also have important similarities.

For one thing, both terror networks and insider trading networks present an opportunity to study social networks in a rigorous manner. “Networks” are more than just loose metaphor, but instead the subject of the emerging field of network theory that borrows from and links computer science, sociology, economics and a host of other fields. “Emerging” does not mean new: some of the germinal research stretches back over four decades. For example Granovetter’s work on “weak ties” in sociology. Mark Lemley and David McGowan authored a wonderful piece on network effects and law over 10 years ago and the legal literature continues to blossom (from Aviram to Zaring). Network theory has arrived.

And it is being put to use. A number of years ago, media reports suggested that the U.S. intelligence agencies were seeking to use network theory to crack Al Qaeda (see here for a law review article by Christopher Borgen on network theory and terrorism). The extent to which financial regulators and prosecutors have done the same with respect to insider trading is not clear, although scholars have recently suggested new potential approaches.

We may not know for a long time the extent to which network theory is influencing law enforcement. You can understand that intelligence and law enforcement would be unwilling to disclose the methods they use to catch bad guys. But the secrecy means that their methods do not enjoy the benefits – one could even say network effects – of being subject to the scrutiny of a larger community. Observers could help answer vital questions, such as “how effective are these efforts against lawbreakers?” and “could they be improved?” According to Linus’s Law: “given enough eyeballs, all bugs are shallow.” Aside from questions about efficacy, there are lingering and legitimate concerns about the implications of national security surveillance over internet communications.

But even the information we have learned about the two recent victories against anti-social networks leads to some interesting, if tentative observations. First, the ultimate value of these government operations is not in traditional deterrence alone, but in disrupting networks. In other words, successful operations against networks rely not only on crude deterrence of criminal behavior by scaring off would-be criminals. After all, it isn’t clear that a jihadist will be sobered by Bin Laden’s fate. By contrast, one thing that does disrupt networks is interfering with their capacity to send signals. Driving bad guys off the net seriously interferes with their ability to conduct business. From news reports, it doesn’t look like Bin Laden was all that successful in managing operations without an internet connection or a phone line. (Some reports suggest that the one time he did use a phone contributed to his location by U.S. intelligence.) Of course, government surveillance is thwarted not only by encryption, but by the daunting task of finding a needle in a haystack of data. Old-fashioned informants will still prove a critical tool.

Indeed media reports suggest that the government is heavily relying on informants in cracking the expert insider trading networks. From the perspective of law enforcement, this is important not only because it may lead to prosecutions, but also because it might disrupt the thing that these networks most rely on: trust.

So network theory suggests that we pay more attention to the marginalia of the Rajaratnam story. It is not the conviction alone that matters. It also argues for looking at other policy tools – such as a use of bounties in corporate crime – in another dimension, namely engendering distrust and thwarting the development of illegal networks. Of course, bounties for corporate crime and promoting snitching can create their own perverse incentives and pernicious effects. (Eleanor Brown penned an interesting essay on snitching, immigration, and terrorism that uses network theory.)

Another problem with a broader use of these tools is that they don’t always yield headline grabbing successes. No one sees the insider trading or terror attacks or law breaking that didn’t happen. The political economy of deterrence rewards prosecutors for victories in the courtroom, not necessarily for crime prevented.

Still, the events of the last week should give new life to study of network theory. There is evidence that network theory has become white hot. Consider this graph (from Google’s nifty Ngram tool) that plots the rising use of “network effect” compared to “deterrence effect” in books from1970 to mid 2007. 

One can now also see a lot of those neat network graphs (see below) in news reporting. 

 
Source: Wikipedia /Author: DarwinPeacock/Created with Guess software/See wikimedia commons for license terms 

Of course, the popularization of theory also threatens to reduce the intellectual rigor. Let’s hope the network effects of this line of inquiry are positive.

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From the Madoff front:

1.  Irving Picard is moving to begin making disbursements to qualified Madoff investors, specifically about $222,000 to each of over a thousand accounts, for about $272 million.  This is in addition to about $795 million in SIPC funds that has been approved and is being disbursed.  Though Picard has collected almost $10 billion through legal actions against big Madoff investors, much of that is subject to appeal at this time and must be kept in reserve.  In addition, the Second Circuit is reviewing an appeal of the bankruptcy court's determination of how to determine a "net loser" for purposes of having a valid liquidation claim.  Should the Second Circuit reverse, then Picard will need money for those claims.  In other words, investors being paid now will be paid less so as to reimburse "net winner" investors.

How does this outcome compare with other Ponzi schemes?  Most Ponzi schemes are small, and I would assume that most victims see little compensation at all as smaller amounts might be frittered away for consumables or depreciating assets like cars, furniture, etc.  Madoff's scheme was large enough for him to invest funds in real estate, jewels, etc. that were auctioned off.  But most of the money is coming from clawbacks from those investors who were probably complicit.  Carlo Ponzi's victims ultimately received about 37% of funds invested, in small amounts over ten years.  That case makes the Madoff case seem easy.  Ponzi didn't manage money for decades.  He sold basically notes, payable at a stated amount in ninety days.  Calculations of losses were easy.  For Madoff investors to be as successful, $2.5 billion (37% of $6.9 billion) will ultimately have to be returned by the end of 2018 or so, or about ten times what Picard is disbursing now.

2.  Diana Henriques, the New York Times reporter who chronicled there the Madoff saga, has now published a book called The Wizard of Lies:  Bernie Madoff and the Death of Trust.  Though several rushed books out quickly after the collapse of BLMIF, this book should have the advantage of more careful research over the past two years.  In addition, Henriques has had time to interview the major players, including Madoff from prison.

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I lead a pretty sheltered life.  What I know about crime comes from the movies and the news.  From the movies I learn that crime is hard work (Oceans's 11, heist movies generally), you have to pick your associates with care (Heat), and that you should trust no one (The Godfather II).  From real life, I learn that criminals are dumb.  It occurs to me that I can use all of these lessons next year to introduce my BA class to agency costs.

Yesterday's WSJ article exposed Kenneth T. Robinson as the middleman between Matt Kluger, BigLaw associate, and Garrett Bauer, NY stock trader.  (You may remember I have a personal interest in this story.)  The insider trading scheme was simple. Kluger had access to inside information on mergers, but he couldn't trade without immediately drawing suspicion on himself.  Bauer, the trader, could and did trade on the information; his "lucky" bets roused lots of suspicion, but there was nothing to tie him to any source of illegal information because Kluger used Bauer as an intermediary, communicating via payphones and disposable cell phones to prevent tracing. 

So what went wrong?  Assume Kluger is the principal, who has valuable information the law prevents him from cashing in on.  He relies on 2 agents, Robinson and Bauer.  The plan worked perfectly for 15 years.  But...

Agency cost #1: Throwing money around: Bauer began paying cash for million-dollar homes in Manhattan and Florida. 

Agency cost #2: Being dumb.  Robinson traded on his own account, making nearly $200,000 trading on information about HP's acquisition of 3Com.  Says Robinson "It didn't seem like it would raise eyebrows when it wasn't millions of dollars."  Huh.  The SEC knew Robinson and Bauer were friends, so they zeroed in on him.

Agency cost #3: Crumbling at the prospect of jail. When confronted, Robinson turned on his friends.  This is probably close to inevitable, but not entirely--cf. Barry Bonds' trainer, who went to jail rather than testify.

There you have it, folks.  Moral of the story?   People are dumb and hard to trust.  Crime may pay for a while, but there's no avoiding agency costs. 

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Dear Ethicist,

I am the general counsel at a federal agency.  This agency, while I was not employed there, somehow missed the largest Ponzi scheme in U.S. history, even though there were red flags.  Now, the agency is involved in the bankruptcy/liquidation proceeding, which is attempting to round up funds (sometimes from other participants in the Ponzi scheme) and distribute it equitably among the participants who lost money.  In all likelihood, claims will not be satisfied in full.  My agency is going to take a position on how to calculate participants' losses -- i.e., who is a "net winner" and who is a "net loser" -- which will affect how much each participant will be able to claim (if any amount at all).  Here's the thing -- my mother was a participant, though she surely did not suspect that the investment fund was a Ponzi scheme.  She died several years ago, prior to the fund's collapse, but during the time that it was operating as a Ponzi scheme, and her account balance (just over $2 million), reflecting principal and capital gain, was liquidated and became part of her estate.  I was the executor of the estate and an heir.  There is only the tiniest probability (in my mind) that I would be sued or asked to disgorge any amounts.  Do I have a conflict of interest?

I'm no ethicist, but I think I would have said "yes" or at least "maybe, so let's think of some way to avoid the appearance of impropriety."  Apparently, though, when David Becker, general counsel of the SEC, posed this question to an ethics officer (one he supervised), the ethics officer pondered the question for up to 25 minutes before replying by email "no."    Chairman Mary Schapiro regrets this now.  Just to get the facts out, Becker re-joined the SEC in 2009 for a two-year stint, which is almost over.

On December 11, 2009, the SEC filed a Memorandum of Law prior to a February 2, 2010 hearing in the Madoff SIPC liquidation that Madoff investors be able to claim the principal amounts that they had invested (less withdrawals) plus interest calculated to reflect inflation (a "constant dollars" approach).  (For example, if Mrs. X invested $100,000 in 1983, then her claim would be for basically the same amount but in 2008 dollars.)  This filing was signed by Katherine Gresham, assistant general counsel.  Remember that SIPC was taking the position that the claim would be just for the $100,000, and the other Madoff investors were arguing that the claim would be for $100,000 plus the "phantom returns" that their monthly balances purported to show.  (SIPC won in bankruptcy court and now the issue is in front of the Second Circuit.)  The SEC's position seems like a (very)reasonable one, and not one against the interest of the other Madoff investors.  However, this position might be a pro-Becker position.  The Complaint against Becker states that his withdrawal from BLMIS contains at least $1.544,494 of fictitious profits that must be clawed back, suggesting that the principal amount might have been $500,000.  Under SIPC's position, Mrs. Becker's estate has only a $500,000 claim.  However, if that principal was deposited many years (or decades) ago, then the time value of that money may be fairly substantial.  This position may help other similarly situated investors, but it could definitely be in Becker's interest as well.

My colleague Larry Ribstein was all over this last week.  I'm a little late to the party.

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Hardly a news cycle (if there is such a thing anymore) goes by without a news article about Bernie Madoff and the congoing SIPC liquidation proceeding.  In case you've been busy reading memoirs about unconventional (or ultra-conventional?) parenting styles like me, here's a quick catch-up:

Madoff and the Banks:  The Madoff Trustee, Irving Picard (the "accidental Pecora"), has filed clawback suits against several banks for fraudulent profits.  In addition, this month the complaint against Citigroup was unsealed.  Though Citigroup did not invest with Madoff, the bank was its banker.  The complaint speaks to a loan that Citi made to a feeder fund, then terminated, and swap agreements that Citi contemplated with another feeder fund.  During these transactions, Citi officers became very suspicious of Madoff and how Madoff's fund worked.  Harry Markopoulos even paid them a visit.  Because of these suspicions, the complaint asks for funds to be returned (fees, and repayment of a loan from funds disbursed by Madoff's fund.  A complaint against JP Morgan Chase was also unsealed, which asks for even more money to be clawed back from that bank.  Chase not only invested in Madoff funds (though it had reduced its investments considerably due to suspicions), it was also the holder of Madoff's bank accounts, which would not have held up to comparison with the financial statements that Madoff was sending to clients.  What does Madoff have to say?  Madoff gave his first interviews from prison this month, to the NYT's Diana Henriques, and responded tellingly "They [the banks] had to know."

Madoff and the Mets:  I love baseball, but I have not been following closely enough the Madoff/Wilpon mess that is taking shape in the Sports section.  Here's the highlight reel:  Fred Wilpon and his brother-in-law own Sterling Capital, which had almost 500 Madoff accounts.  Sterling Capital owns the Mets.  Picard wants to claw back $1 billion from Sterling Capital.  If Picard wins, someone else would almost have to purchase all or part of the Mets.  The nonsports issue is that Sterling is both a Ponzi winner and a Ponzi loser here.  Sterling withdrew $1 billion, which is probably $300 million phantom gain.  But, Sterling also had open accounts of $500 million ($160 million principal) with Madoff at the time of the fund's collapse.  So, Sterling's argument is "take my $300 million gain, minus my $160 principal loss, and I'll write you a check for $140 million."  So, the first response is there is no "wash" here.  Sterling should give back the $300, then get in line with everyone else for your $160 loss.  Furthermore, Picard wants the full $1 billion because he says that Wilpon and crew should have known they were in a Ponzi scheme sometime in the last three decades.  As to his friends, Madoff responds, "They knew nothing."

Madoff and the S.E.C.:  The latest clawback suit to get prime time attention is a suit against David Becker, general counsel of the SEC, as executor of his mother's estate.  Mary Becker had been an investor in BLMIS prior to her death in 2004.  At that time, her $2 million and change account was liquidated, representing $1.5 million in phantom profits.  The cookie-cutter complaint seems to indicate that all withdrawals in the six years prior to December 11, 2008 are being clawed back, but I had not thought that was going to be the strategy.  Anyway, if Picard is going to use any discretion, it cannot be to the benefit of the general counsel of the SEC. 

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