Commentary: Punishment for Corporate Fraud? How Radical

Financial penalties for executives would, at least, spread the pain

By Mike France

Executives almost never go to jail for cheating shareholders. That's not news. What is surprising is how rarely they face financial penalties. White-collar wrongdoers often manage to walk away from corporate disasters without paying a dime.

Treasury Secretary Paul H. O'Neill has floated some surprisingly radical proposals to redress this problem. Among other things, he wants to force CEOs to certify the accuracy of their companies' financial statements, make it easier for the government to punish executives, and reduce the ability of officers and directors to insure themselves against fraud claims.

Despite public outrage about the collapse of Enron Corp., these ideas are getting a mixed reception. Some, such as having CEOs vouch for their 10Ks, may survive. Others are already all but dead. One of the casualties appears to be the notion of giving directors and officers some financial liability for shareholder fraud. Critics warn that if companies can't fully indemnify executives and board members from financial penalties, they could have trouble attracting candidates, especially in industries prone to securities litigation such as finance and technology. "It's a crazy idea," says B. Kenneth West, a corporate governance consultant for TIAA-CREF, the teacher's pension fund often at the forefront of calls for increased management accountability.

While the concerns are valid, the idea of limiting corporate indemnification would have one enormous benefit: It would create an effective disincentive by making executives who mislead shareholders bear some of the pain caused by their misdeeds. That's all too rarely the case these days. And nothing else the Bush Administration is considering will make much of a difference if most executives can count on a big Director & Officer insurance policy to bail them out of trouble.

The system isn't meant to work that way. Executives at companies suspected of engaging in financial shenanigans are often sued by the Securities & Exchange Commission and aggressive plaintiffs' law firms. But charges of fraud are exceedingly difficult to prove. That's a big reason why the SEC and private lawyers often settle. Without a finding of fraud, however, the D&O policies shield executives from any financial liability. So most directors and officers who have committed financial malfeasance get away essentially scot-free financially. "It is absolutely necessary to find some way of creating a sting for executives without sending them to jail," says Georgetown University securities law expert Donald C. Langevoort.

In the absence of any real prospect of financial loss, much less time behind bars, executives face a distorted set of incentives. While the risk of punishment from exaggerating a company's performance is low, the reward can be tens or hundreds of millions of dollars. For many executives, the math couldn't be more clear: All of the benefits of cooking the books are private, while the costs are held largely by the company and its investors.

To be sure, threatening executives with unlimited personal liability is a bad idea. It would make them too cautious and discourage many--particularly university professors, community representatives, and others of more modest means--from ever serving on boards. But this problem might be managed by limiting the liability to, say, one or two years' worth of compensation. The key would be in striking the right balance. "You would want to increase the tension to the point where people were more careful, but not so much that it would drive away every candidate," says University of Texas School of Law professor Henry T.C. Hu.

Nobody pretends that this would be easy. Any new laws would have to be crafted to prevent execs from sidestepping the rules. They would, for example, have to prevent them from buying their own private insurance against fraud liability and then getting their companies to compensate them for the premiums. Closing such loopholes would be difficult, if not impossible. But it is worth the effort to try. As would be making executives face direct liability for shareholder fraud. It's a worthy alternative for a system in need of serious reform.

France follows securities law from New York.

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