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Andrew Ross Sorkin today, in the NYT, brings up the age-old paradox of entity-level fines: if the SEC fines a corporation for lying to its shareholders, then the shareholders pay the fine. Interestingly, a federal district judge in the SDNY refused to approve an SEC settlement with BofA over omissions to shareholders because "'it propose[d] that the shareholders who were the victims of the bank’s alleged misconduct now pay the penalty for that misconduct.'" OK, let's dig in.

The conundrum is well-known to corporate law professors: Individuals at a corporation make bad choices, possibly illegal choices. The SEC, DOJ and attorneys for the shareholders get involved. The SEC may levy a fine or extract a settlement; private litigation may result in a settlement. Who pays? The corporation pays. The ultimate payor being the shareholder, who sees cash flow out of the corporation and fewer profits that quarter. The individuals who made the bad choices may or may not pay part of the fine or the settlement. And of course, this situation brings up questions that we've thought about before:

Why should the shareholders bear the loss? Well, they are the principals, and under various theories of vicarious liability, principals are responsible for the misdeeds of their agents. In theory, principals choose their agents in a mutually consensual relationship. In reality, shareholder-principals choose their investments, and take the management team as part of the package. If the team changes or loses its competence, shareholders sell the investment. But Sorkin wonders if this is (1) fair or (2) efficient for deterrence purposes. Two questions we ponder a lot here in the ivory tower.

Is it fair? I don't think it's unfair. We give shareholders limited liability, which is a big step up from the general partnership form and acknowledges that shareholder-principals in a corporation are not as close to the action as we might require for true vicarious liability. So, liability is capped at the amount of investment. Not too shabby, given the alternatives. Plus, the spectre of entity-level fines/settlements is a known factor and should be built into the price of a publicly-held corporation. Now, the market may not be great at pricing enforcement risk or litigation risk, but it is a known risk, just like the risk that your managers will lose money and harm your investment in a million other ways. So, the shareholders of Citigroup this week probably came on board sometime after the risk of enforcement was well-known, given turnover rates. Those shareholders probably got an investment at a discount.

But, Sorkin asks, is it fair in particular instances in which the bad choices of the corporation were to make false statements? Doesn't that rob the shareholder twice? Only if you really think these are the same shareholders, which I don't. Say individuals at Company A make false statements on Feb. 1, inducing new shareholders to buy inflated stock, then the stock falls on Oct. 1 when the real news comes out. Then 2 years later, Company A agrees to pay a fine or settlement amount. I'm not sure that most of the February shareholders were around in October, much less two years later. So, some shareholders make out like bandits when managers make false statements about the stock. (Think of the shareholders who bought in January and sold in April.) Others sell in between the revelation and the enforcement. The shareholders who were around for the whole saga are probably a small percentage, and they are holding with open eyes. Savvy investors know that these risks are out there: sometimes you're the windshield, sometimes you're the bug. If you believe in markets at all, this is priced.

Is it efficient? In other words, does fining a corporation really deter individuals in other corporations? I have no idea. Sorkin interviews Robert Khuzami, director of enforcement at the SEC. Khuzami says, from his pre-government experience, it does. But, he's the guy handing out fines, so he's probably going to say that. White-collar crime deterrence is a hard thing to measure because it is not a self-revealing crime: we can measure enforcement, but not incidence. But, if entity-level fines don't deter individuals at other corporations from making bad choices, then what does? Individual-level fines? (Note the teensy fines levied upon the individuals at Citigroup in comparison to their salaries.) Won't corporations just indemnify the individuals or provide insurance? Those costs, again, will be passed on to shareholders. Maybe the most efficient path would result in the "bad apples" losing employment, perhaps any industry future. That's a harder regulatory scheme to craft (think licensure).

I could cite to a barrelful of great law review articles on these topics, but I thought I would just point out that this is mainstream news today.

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Andrew Ross Sorkin today, in the NYT, brings up the age-old paradox of entity-level fines: if the SEC fines a corporation for lying to its shareholders, then the shareholders pay the fine. Interestingly, a federal district judge in the SDNY refused to approve an SEC settlement with BofA over omissions to shareholders because "'it propose[d] that the shareholders who were the victims of the bank’s alleged misconduct now pay the penalty for that misconduct.'" OK, let's dig in.

The conundrum is well-known to corporate law professors: Individuals at a corporation make bad choices, possibly illegal choices. The SEC, DOJ and attorneys for the shareholders get involved. The SEC may levy a fine or extract a settlement; private litigation may result in a settlement. Who pays? The corporation pays. The ultimate payor being the shareholder, who sees cash flow out of the corporation and fewer profits that quarter. The individuals who made the bad choices may or may not pay part of the fine or the settlement. And of course, this situation brings up questions that we've thought about before:

Why should the shareholders bear the loss? Well, they are the principals, and under various theories of vicarious liability, principals are responsible for the misdeeds of their agents. In theory, principals choose their agents in a mutually consensual relationship. In reality, shareholder-principals choose their investments, and take the management team as part of the package. If the team changes or loses its competence, shareholders sell the investment. But Sorkin wonders if this is (1) fair or (2) efficient for deterrence purposes. Two questions we ponder a lot here in the ivory tower.

Is it fair? I don't think it's unfair. We give shareholders limited liability, which is a big step up from the general partnership form and acknowledges that shareholder-principals in a corporation are not as close to the action as we might require for true vicarious liability. So, liability is capped at the amount of investment. Not too shabby, given the alternatives. Plus, the spectre of entity-level fines/settlements is a known factor and should be built into the price of a publicly-held corporation. Now, the market may not be great at pricing enforcement risk or litigation risk, but it is a known risk, just like the risk that your managers will lose money and harm your investment in a million other ways. So, the shareholders of Citigroup this week probably came on board sometime after the risk of enforcement was well-known, given turnover rates. Those shareholders probably got an investment at a discount.

But, Sorkin asks, is it fair in particular instances in which the bad choices of the corporation were to make false statements? Doesn't that rob the shareholder twice? Only if you really think these are the same shareholders, which I don't. Say individuals at Company A make false statements on Feb. 1, inducing new shareholders to buy inflated stock, then the stock falls on Oct. 1 when the real news comes out. Then 2 years later, Company A agrees to pay a fine or settlement amount. I'm not sure that most of the February shareholders were around in October, much less two years later. So, some shareholders make out like bandits when managers make false statements about the stock. (Think of the shareholders who bought in January and sold in April.) Others sell in between the revelation and the enforcement. The shareholders who were around for the whole saga are probably a small percentage, and they are holding with open eyes. Savvy investors know that these risks are out there: sometimes you're the windshield, sometimes you're the bug. If you believe in markets at all, this is priced.

Is it efficient? In other words, does fining a corporation really deter individuals in other corporations? I have no idea. Sorkin interviews Robert Khuzami, director of enforcement at the SEC. Khuzami says, from his pre-government experience, it does. But, he's the guy handing out fines, so he's probably going to say that. White-collar crime deterrence is a hard thing to measure because it is not a self-revealing crime: we can measure enforcement, but not incidence. But, if entity-level fines don't deter individuals at other corporations from making bad choices, then what does? Individual-level fines? (Note the teensy fines levied upon the individuals at Citigroup in comparison to their salaries.) Won't corporations just indemnify the individuals or provide insurance? Those costs, again, will be passed on to shareholders. Maybe the most efficient path would result in the "bad apples" losing employment, perhaps any industry future. That's a harder regulatory scheme to craft (think licensure).

I could cite to a barrelful of great law review articles on these topics, but I thought I would just point out that this is mainstream news today.

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