Trends in Corporate Liability

Fraud can be committed through many methods, such as mail, wire, phone, and the internet.  Acts that may constitute criminal fraud in a corporate setting include: (1) falsification of business records; (2) false billing; (3) forgery of documents or signatures; (4) embezzlement; (5) creation of false companies; (6) false insurance claims; (7) bankruptcy fraud; (8) investment frauds (such as Ponzi schemes); (9) tax fraud; and (10) securities fraud. 

Lengthy Sentences for Individuals Convicted of Corporate Fraud

Individuals convicted of federal corporate fraud offenses can face up to 30 years imprisonment per count, which can be either enhanced or departed from under the United States Sentencing Guidelines, depending on applicable aggravating and/or mitigating factors.  For example, former WorldCom CEO Bernie Ebbers, who was found guilty of securities fraud, conspiracy and false regulatory filings, faced up to 85 years in prison under the United States Sentencing Guidelines.  The fraud at WorldCom topped $11 billion and led to the country’s biggest bankruptcy filing in July 2002.  Nearly 17,000 employees lost their jobs as a result of the scheme to bury expenses and inflate revenue, according to a probation report.  Ebbers was ultimately sentenced to 25 years in July 2005, after agreeing to pay $5.5 million cash and to hand over his Clinton, Miss., mansion and other assets worth as much as $40 million to resolve claims filed by WorldCom shareholders who lost billions of dollars when the company collapsed.

Sentences for corporate fraud are lengthy in state court, as well.  In June 2005, Ex-Tyco CEO Dennis Kozlowski and Former Tyco CFO Mark Swartz were found guilty on 22 of 23 counts of grand larceny and conspiracy, falsifying business records and violating business law.  Both men received a sentence of 8-1/2 to 25 years in prison in September 2005 for their part in stealing hundreds of millions of dollars from the manufacturing conglomerate.   Kozlowski and Swartz were also ordered to pay $134 million back to Tyco, and Kozlowski was fined $70 million and Swartz $35 million—bringing total fines and restitution to $239 million.

The Ebbers, Kozlowski, and Swartz sentences have been identified as points of reference for future corporate convictions, and distinguished from the previous, much more lenient, sentences of individuals such as Ivan Boesky, a Wall Street financier who was sentenced to 3 years for insider trading in 1987 (he served 22 months); Michael Milken, “The Junk Bond King,” who was sentenced in 1990 to 10 years for the Drexel Burnham collapse (he served 22 months); and, Charles Keating, the banker responsible for the Lincoln S&L collapse, who was sentenced in 1993 to 12 1/2 years (he served 4 1/2 years).  The post-Enron trend is clear: executives are increasingly being held accountable for their actions, while corporate entities are being rewarded for cooperating with the government.

Deferred and Non-Prosecution Agreements for Corporate Entities

The trend for corporate entities, on the other hand, is for the dismissal of criminal charges, usually pre-indictment, in exchange for the corporation’s cooperation and production of evidence against executive wrongdoers vis-à-vis deferred and non-prosecution agreements.  Deferred and non-prosecution agreements gained popularity after the demise of Arthur Andersen in the wake of Enron.  In March 2002, federal prosecutors indicted Arthur Andersen for destroying tons of paper documents and other electronic information related to the Enron investigation.  Arthur Andersen went to trial and was found guilty of obstruction, although the Supreme Court overturned the conviction in 2005.  However, the negativity associated with Arthur Andersen’s reputation after its conviction destroyed the company, leading many advocates for big business to openly encourage the elimination of corporate criminal liability.

The government was virtually given the green-light to shift away from indicting and convicting corporate entities in 2003 with the Principles of Federal Prosecution of Business Organizations (the “Thompson memo”), written by former Justice Department official Larry Thompson which lays out nine factors that prosecutors should consider in deciding whether or not to criminally prosecute a corporation.  These factors include: (1) the nature and seriousness of the offense; (2) the pervasiveness of wrongdoing within the corporation; (3) the corporation’s history of similar conduct; (4) collateral consequences; and (5) the corporation’s willingness to cooperate.  While the ultimate decision of whether or not to indict a corporation remains in the discretion of the individual United States Attorney prosecuting the case, the effect of the Thompson memo has been for corporations faced with serious wrongdoing by corporative executives to accept full responsibility, discipline wrongdoers, establish institutional reform, and fully cooperate with the government.  If the corporation does that, it will more than likely escape indictment; if not, the corporation faces the risk of indictment, conviction, and corporate collapse.          

Piercing the Corporate Veil and Holding the Shareholders Responsible in Closely Held Corporations  

In addition to being a criminal act, corporate fraud is also embedded in the civil law as a tort.  Civil corporate fraud typically involves the act of intentionally making a false representation of a material fact, with the intent to deceive, which is reasonably relied upon by another person to that person’s detriment.   A “false representation” can take many forms, including: (1) a false statement of fact, known to be false at the time it was made; (2) a statement of fact with no reasonable basis to make that statement; (3) a promise of future performance made with an intent, at the time the promise was made, not to perform as promised; (4) a statement of opinion based on a false statement of fact; (5) a statement of opinion that the maker knows to be false; or (6) an expression of opinion that is false, made by one claiming or implying to have special knowledge of the subject matter of the opinion. “Special knowledge” in this case means knowledge or information superior to that possessed by the other party, and to which the other party did not have equal access.

Corporations exist in part to shield their shareholders from personal liability for the debts of a corporation.   Prior to the institution of the limited liability corporation in the 17th century, any partner in a general partnership could be held responsible for all the debts of the corporation.   As the capital needed to finance large projects grew, along with the necessity of raising money, investors were reluctant in becoming principals because of the risk involved in essentially guaranteeing the entire debt of the business entity.

Likewise, officers and directors of corporations, like other employees, are generally not held liable for the losses of the corporation.   In a similar manner, people would be less willing to serve as an officer or director if they were liable for the entire amount of the corporation’s losses.

For corporations with only one shareholder, officer and director (often the same person), individuals sometimes use the corporate entity to escape liability for their own misconduct by holding assets in the name of the corporation.   Historically, corporations with 10 or more shareholders are not likely to be affected by piercing the corporate veil.  This has generally held true under the logic that, in contrast to a large corporation where no individual shareholder could possibly obtain management authority over the corporation, a closely held corporation is tightly run by only a handful of shareholders.  

Courts are usually reluctant to rebut the presumption of limited liability and pierce the veil.  But, in some instances of civil fraud in a closely held corporation, the court will pierce the corporate veil and hold the shareholders liable.  Although courts will generally not hold a shareholder liable for actions that are legally the responsibility of the corporation, even if the corporation has a single shareholder, it will often do so if holding only the corporation liable would be especially unfair to the plaintiff, and the shareholder’s actions were clearly designed to attempt to pass personal liability off to the corporation.  In most jurisdictions, such a determination is made on a case-by-case basis.

The plaintiff typically has the burden of proving that the corporation was set up to commit a fraud, or at least show that the incorporation was merely a formality and that the corporation never held proper shareholder meetings to distribute profits as dividends.   This is quite often the case when a corporation facing legal liability transfers its assets and business to another corporation with the same management and shareholders.   It also happens with single-person corporations that are managed in a haphazard fashion.   In these instances, the court will pierce the veil upon consideration of the following factors: (1) the corporation is so grossly undercapitalized that fraud is likely; (2) there has been a failure to observe corporate formalities; (3) there is an intermingling of assets of the corporation and of the shareholder; (4) an individual treatment of the assets of corporation as his/her own; (5) failure to pay dividends; (6) siphoning of corporate funds by the dominant shareholders; (7) non-functioning corporate officers and/or directors; (8) concealment or misrepresentation of members; (9) absence of corporate records; (10) whether the corporation was being used as a façade for dominant shareholders’ personal dealings (the “Alter Ego Theory”); (11) failure to maintain an arm’s length relationship with related entities; (12) manipulation of assets or liabilities to consolidate the assets or liabilities; and (13) other factors the court finds relevant. 

It is important to note that not all of these factors need to be met in order for the court to pierce the corporate veil.  Courts generally look to the totality of the circumstances for three underlying principles, namely, unity of interest and ownership, wrongful conduct, and proximate cause.  Further, some courts might find that one factor is so compelling in a particular case that it will hold the shareholders personally liable.

Vicarious Liability for Officers of Large Corporations

Is the post-Enron shift from corporate to individual liability in the criminal arena indicative of an emerging trend in civil law as well?

Vicarious liability is a form of strict, secondary liability that arises under the common law doctrine of agency: respondeat superior, the responsibility of the superior for the acts of their subordinate, or, in a broader sense, the responsibility of any third party that had the “right, ability or duty to control” the activities of a violator.  Officers of a corporation exercise control over the daily and ongoing operations of corporate entities, and have direct control over many corporate activites.  It has been argued by some scholars that imposing vicarious tort liability on CEOs, CFOs, and other managing officers in a joint and several manner would be a means to retain the beneficial effects of limited shareholder liability, as well as reducing its social costs, thereby theoretically precluding corporate collapse, as the deferred and non-prosecution agreements have contemplated.