Since Enron's collapse in 2002, the federal government has stepped up its campaign against white-collar crime. In this timely book, John Hasnas reveals how the government's effort to enforce legal rules has created a Catch-22 legal environment in which businesspeople must either act unethically or illegally.

Trapped

WHEN ACTING ETHICALLY IS AGAINST THE LAWBy JOHN HASNAS

CATO INSTITUTE

Copyright © 2006 Cato Institute
All right reserved.
ISBN: 978-1-930865-88-4

Contents

1. Introduction............................................................................1Part I The Evolution of White-Collar Crime2. The Nature of White-Collar Crime........................................................113. Problems of Enforcement.................................................................154. The Solutions-Corporate Criminal Responsibility.........................................235. The Solutions-New Offenses..............................................................316. The Solutions-The Organizational Sentencing Guidelines..................................45Part II The Effect of the Federal Campaign Against White-Collar Crime7. Five Ethical Dilemmas...................................................................598. Organizational Justice..................................................................619. Privacy.................................................................................6510. Confidentiality........................................................................6911. Trust..................................................................................7512. Ethical Self-Assessment................................................................8113. Conclusion.............................................................................85Notes......................................................................................97Index......................................................................................117

Chapter One

Introduction

Before reading this book, please take the following multiple-choice quiz:

1. You are the chief executive officer (CEO) of Marsha Tudor Styles Inc., one of the country's largest retailers of products for homemakers. MTS is highly profitable and is closely identified with its founder and chair of the board of directors, Marsha Tudor, who also publishes a magazine and hosts a television show about homemaking. Recently, the Securities and Exchange Commission investigated Tudor for suspected insider trading for selling $1 million of stock in a company owned by a personal friend, just before a sharp decline in the price of that stock. In the course of her voluntary cooperation with the investigation, Tudor stated that she sold the stock pursuant to a pre-established stop-loss order. When news of the investigation became public, Tudor asserted her innocence of insider trading on a national news program. Although Tudor has not been charged with insider trading, she has been indicted for obstruction of justice for telling federal investigators that she sold her stock pursuant to a stop-loss order, as well as for securities fraud for attempting to prop up the value of MTS stock by falsely proclaiming her innocence to the public. You have known Tudor for many years and tend to believe that she is innocent of the charges, although you cannot be entirely sure. In this situation, which of the following constitutes the ethically appropriate action for you to take in your capacity as CEO?

a. Publicly support Tudor and offer whatever aid the corporation can give her in her effort to clear her name.

b. Take no action. This matter does not concern the corporation.

c. Consult with corporate counsel and immediately take steps designed to protect the corporation against any potential civil liability and to preserve its defenses against any potential criminal charges.

d. Ask Tudor to resign as chair of the board of directors until her legal troubles are resolved and cooperate with the government's criminal investigation of Tudor to the extent that doing so is consistent with preserving the company's legal defenses and respecting all promises of confidentiality, including those granted by corporate counsel under the attorney-client privilege.

e. Authorize the corporation to plead guilty to securities fraud and aid the government's criminal investigation of Tudor in every way, including waiving the corporation's attorney-client privilege and turning over records of all Tudor's appointments, phone calls, e-mails, and confidential consultations with the corporate counsel.

2. You are a senior executive at the Stone Fund, a large mutual fund company. The majority of investors in the Stone Fund are small investors, but the fund has several large investors as well as several institutional investors. Until recently, Gordon Gekko was one of the fund's most successful manager-brokers. He was responsible for acquiring most of the large investors in the fund. He apparently did this by allowing several of these investors to make trades after 4:00 p.m., which is illegal. Budd Fox, a junior broker who worked for Gekko, processed many of the late trades. Fox, who had been hired right out of business school, was not aware at first that he was doing anything wrong. Gekko's high status in the company, his forceful personality, and his assurance that the late trades were perfectly acceptable and were standard operating procedure in the industry led Fox to carry out Gekko's orders without qualm. Eventually becoming suspicious, Fox approached Stone Fund's corporate counsel in confidence to inquire about the legality of his actions. On learning of the late trades, Stone Fund immediately fired Gekko and reported his actions to the Department of Justice and the Securities and Exchange Commission. Which of the following constitutes the ethically appropriate action for you to take with respect to Fox?

a. Assign him to work with a broker who can serve as an ethical mentor, and use the legal resources of the company to help him defend himself against any criminal charges that may be brought as a result of his association with Gekko.

b. Allow him to continue working for the company, but do not use corporate resources to aid him in defending any criminal charges that are brought against him personally.

c. Fire him.

d. Fire him and recommend that the company report his activities to the Department of Justice and Securities and Exchange Commission.

e. Fire him and recommend that the company not only report his activities to the DOJ and the SEC but also offer to cooperate with the prosecutors in building a case against him by waiving the company's attorney-client privilege and turning over to the government any evidence that could possibly aid in establishing his guilt.

3. You are the new CEO of Endrun Inc., a very troubled corporation. Acting without the knowledge of Endrun's former CEO, Kevin Lie, the company's chief operating officer (COO) and chief accounting officer (CAO) had been using improper accounting practices to disguise the size of the company's debt and inflate the company's profits. When this fraud came to light, Endrun was forced to restate its earnings for the past several years, causing the company to suffer serious losses in the third and fourth quarters as well as a sharp decline in the price of its stock. The COO and CAO have since pled guilty to securities and wire fraud, and Lie resigned as CEO. You stepped in to try to staunch the bleeding and revive the company. You have just learned that Lie has been indicted for wire fraud for statements he made at an "All Employee Meeting" video teleconference. At that meeting, Lie said:

"The third quarter is looking great. We will hit our numbers. We are continuing to have strong growth in our businesses, and I think we are positioned for a strong fourth quarter."

"I have strongly encouraged our officers to buy additional Endrun stock. Some, including myself, have done so over the past couple of months, and others will probably do so in the future. My personal belief is that Endrun stock is an incredible bargain at current prices."

"Liquidity is fine. As a matter of fact, it's better than fine-it's strong."

The indictment claims that these statements constitute a scheme and artifice to defraud Endrun and its shareholders of their intangible right to Lie's honest services because:

With regard to the first statement, Lie knew that Endrun was about to announce a quarterly loss for the third quarter and was aware that lowering the previous earning statements was going to adversely affect the company.

With regard to the second statement, Lie deliberately created the impression among Endrun employees that his confidence in the company's stock was such that he had increased his personal ownership of Endrun stock in the "past couple of months," when, in fact, he had purchased approximately $4 million in Endrun stock but sold $24 million in Endrun stock in response to margin calls during that period. The sales were concealed from Endrun employees and the rest of the investing public.

With regard to the third statement, Lie knew that the only readily available source of liquidity was the $3 billion corporate line of credit, which, if drawn, would signal the dire straits of Endrun's finances.

Lie claims that none of his statements were false, that at the time he made them he genuinely believed Endrun could overcome its problems, that he was acting responsibly as CEO to maintain employee morale in a time of crisis, and that the charges against him are driven by political pressure to find a scapegoat for employee and investor losses on the stock market. Which of the following constitutes the ethically appropriate action for you to take as CEO?

a. Publicly support Lie, offer whatever aid the corporation can give him in defending himself against the charges, and honor the company's policy of reimbursing the legal expenses of corporate officers who incur such expenses as a result of their activities on behalf of the corporation.

b. Honor the company's legal expense reimbursement policy, but take no other action with regard to Lie's case.

c. Honor the company's legal expense reimbursement policy, consult with corporate counsel to determine the extent to which Lie's situation creates the risk of civil or criminal liability for the corporation, and take appropriate steps to defend against such liability.

d. Honor the company's legal expense reimbursement policy but cooperate with the government's criminal investigation of Mr. Lie to the extent that doing so is consistent with preserving the company's legal defenses and respecting all promises of confidentiality, including those granted by corporate counsel under the attorney-client privilege.

e. Do not honor the company's legal expense reimbursement policy for Lie, authorize the corporation to plead guilty to wire fraud, and aid the government's criminal investigation of Lie in every way, including waiving the corporation's attorney-client privilege, turning over all corporate documents that may bear on the case, and attempting to recover and turn over any corporate documents that Lie may have in his personal possession.

Thank you for taking the quiz. The purpose of this book is to explore how federal efforts to combat white-collar crime bear on the answers to these and similar questions.

Specifically, I intend to examine how the federal standard for corporate criminal responsibility, the requirements of several of the federal statutes used to combat white-collar crime, and the incentives created by the U.S. Sentencing Commission's Federal Sentencing Guidelines for Organizations influence the decisions of businesspeople confronted with difficult ethical dilemmas. I will suggest that, in the context of federal criminal law, there are many ways in which compliance is not ethical and ethical behavior is not compliance. As a result, the current federal campaign against white-collar crime frequently undermines, rather than enhances, the efforts of businesspeople to behave ethically.

The predominate response to the recent corporate scandals within the business community has been to call for renewed efforts to ensure that businesspeople behave more ethically and obey the law. This response reflects two assumptions that businesspeople often accept uncritically: that the law commands only ethical behavior and that businesspeople who behave ethically have nothing to fear from the law. Although those assumptions may generally be true, they patently are not true in an increasing number of cases that can produce achingly poignant situations for businesspeople who act in naive reliance on them.

The sole professional obligation of federal prosecutors is to punish and, to whatever extent possible, prevent violation of federal criminal law. In most cases, businesspeople, too, have an obligation to ensure that members of their firms do not violate federal law, but this obligation is not their only, or even their primary, one. In current business terminology, businesspeople have obligations to their stakeholders. They have a fiduciary duty to their principals, the stockholders, to use the stockholders' resources only as authorized and to advance the purposes for which the firm was organized. They have contractual, as well as informal customary, obligations to their employees, customers, and suppliers. Furthermore, they have their ordinary ethical obligations as human beings to honor their commitments and to deal honestly with others. Those obligations can, and to an increasing extent do, conflict with the obligation to take the most effective steps to comply with federal law. When the law provides incentives to violate one's ethical duties to others, businesspeople face a difficult choice. Federal prosecutors do not. Businesspeople must decide the extent to which they can ethically expose their firm to the risk of legal liability in order to meet their other obligations. Federal prosecutors, whose only obligation is to the law, need only judge the level of the firm's legal compliance. Simply expressed, businesspeople's ethical dilemmas are not the federal prosecutors' problem.

In this book, I intend to explore the ethical difficulties this divergence of interests poses for those engaged in business. In Part I, I will introduce what is perhaps an idiosyncratic definition of "white-collar crime" to distinguish the efforts of the federal government to combat business-related crime from traditional state-level criminal enforcement. I will then identify the special difficulties that the traditional rules of criminal law pose for federal efforts to police business activity and will detail the substantive and procedural innovations that were introduced into federal criminal law to surmount these difficulties. In Part II, I will identify five areas in which these legal innovations create difficult ethical dilemmas for the conscientious businessperson. Specifically, I will argue that these innovations make it more difficult for businesses to realize organizational justice, to properly respect employees' privacy, to maintain needed confidentiality, to engender trust within the organization, and to engage in ethical self-assessment. Finally, I will provide an explanation for the divergence between ethics and compliance and will suggest that the solution to the problem of white-collar crime may not lie in using harsher measures to crack down on white-collar criminals, but in restraining the power of federal prosecutors to do so at all.

Chapter Two

The Nature of White-Collar Crime

White-collar crime can be defined in many ways. It has been defined as crime committed by a person of respectable or high social status or in the course of one's occupation, as crime that involves deceit or a breach of trust, as nonviolent crime undertaken for personal gain, as crime that involves a combination of these factors, and simply as business crime. None of these definitions specifies the class of offenses that I wish to address in this book, however. I intend to restrict my focus to federal law, and then even more narrowly to the particular subset of federal law that is designed to police the behavior of those engaged in business for honest dealing and compliance with regulatory requirements. Because all of the above definitions include state offenses, and many include nonbusiness-related crime as well, none of them correspond to the class of offense that I am interested in. Accordingly, for purposes of this book, I will employ the phrase "white-collar crime" in a somewhat idiosyncratic manner to refer exclusively to behavior that is the object of federal efforts to ensure honest dealing and regulatory compliance in business.

Under this stipulative definition, white-collar criminal law constitutes a discrete subset of American criminal law. It is distinct from state criminal law, which is directed against actions that either directly harm or violate the rights of others or constitute what is regarded as inherently immoral activity-the so-called morals offenses or victimless crimes. This traditional understanding of crime, which is the subject of the typical first-year law school course in criminal law, covers offenses such as murder, rape, kidnapping, and theft, as well as prostitution, the use of illegal narcotics, and, somewhat famously, taking a girl under the age of 16 out of the care of her parents without their consent. White-collar crime is also distinct from much of federal criminal law, which, in addition to prohibiting offenses of purely national concern such as treason or counterfeiting, prohibits "traditional" criminal activity when that activity transcends state boundaries. As used in this book, the term white-collar crime refers exclusively to the class of federal offenses designed to police business behavior that do not fit within those categories.

The distinction between ordinary and white-collar criminal law is perhaps best illustrated by a comparison of what constitutes fraudulent behavior under each. State law criminalizes fraudulent conduct when it amounts to larceny by false pretenses. To establish the offense of false pretenses, "the prosecutor was required to prove that [the] defendant obtained title or possession of money or personal property of another by means of an intentional false statement concerning a material fact upon which the victim relied in parting with the property." False pretenses criminalizes dishonest behavior only when it is intended to obtain and is effective in obtaining property on the basis of a representation of fact that is known to be false and that the other party actually relies upon. This interpretation depends on a fairly strict set of requirements that punishes dishonesty only when it causes significant harm to others.

(Continues...)

Excerpted from Trappedby JOHN HASNAS Copyright © 2006 by Cato Institute. Excerpted by permission.
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