CLS Blue Sky Blog

Why Prosecuting Executives for Securities Fraud Is So Difficult

In a new essay, I examine public company wrongdoing by focusing on securities fraud.

In general, there are two main reasons why companies commit wrongful acts. The first is that managers have incentives to further their own interests. They may steer the corporation towards illegality to preserve their jobs or increase their compensation. Corporate misconduct thus reflects agency costs where an agent (the manager) betrays a principal (the company). The second reason is that public companies typically aim to maximize shareholder wealth. Corporate managers thus decide to sacrifice the interests of stakeholders and society to increase corporate profits because they view that as necessary for the corporation to prosper and even survive.

When corporate misconduct reflects agency costs, enforcement cases against individual executives are much easier to justify. A desire to enrich oneself can provide the basis for establishing fraudulent or criminal intent. In contrast, when a manager violates the law to further corporate policy, a viable case against that individual is often more difficult. It may be unfair to single out executives who contribute only partly to a corporation’s wrongful acts. The costs of establishing such liability may also be significant relative to the benefits.

The question of whether corporate wrongdoing tends to reflect agency costs is thus critical in assessing criticisms that enforcers do not bring enough cases against executives. If there are clear examples of individuals not being held accountable for enriching themselves, then the problem could be explained by factors such as prosecutors’ aversion to risk.

The reality is that managerial decisions reflect a mix of personal and corporate motivations. Executives who are responsible for corporate misconduct may be motivated to maximize their personal stock holdings, but because of the strong corporate incentive to maximize shareholder wealth, there will often be an argument that such wrongdoing was also meant to benefit the corporation. When corporate wrongdoing is meant to bolster financial performance, which increases or maintains a company’s stock price (at least in the short-term), it is difficult to argue that it was primarily a scheme to benefit just a few individuals. Without a distinct motivation to violate the law, it is more difficult for enforcers to establish the intent necessary to bring a compelling case against a manager.

As for securities fraud, corporations can deceive investors by issuing misleading disclosures relating to their financial performance or condition. Hundreds of allegations of such fraud are filed against U.S. corporations each year, typically asserting claims under SEC Rule 10b-5. One view of securities fraud is that it mainly reflects the agency-costs view of corporate wrongdoing. Managers inflate the stock price to increase the value of their own holdings so they can sell them before the market learns the truth.

But securities fraud emerged even before managers were paid mostly in stock. While allegations were prominent in the 1990s that a material misrepresentation permitted managers to benefit through insider trading, that theory has not always been dominant and is no longer prevalent. Securities fraud is a complex problem that cannot be addressed solely by targeting executive compensation policies. It is a broader structural problem that threatens most public corporations that are pressured to maximize shareholder wealth.

There are high-profile cases of securities fraud that can be tied to the incentive of individual executives to inflate the company’s stock price. But there are also many cases where there are no such allegations. Because drafting disclosure documents and financial statements necessarily involves groups of employees, it may be unfair to hold just one or two executives responsible for a material misstatement in such disclosures. Even when a particular fraudulent misstatement can be linked to a high-level executive, absent evidence of deceptive intent, it can be difficult to justify imposing strong sanctions on that executive.

In some ways, shareholders want corporate managers to take risks that may trigger allegations of corporate misconduct. Because a significant percentage of the public holds stock, many of us are complicit in a system that tends to sacrifice other corporate stakeholders to generate profits. There is no easy solution to the problem of corporate misconduct because it rests on a system that encourages efficiency, growth, and innovation. Addressing problems like securities fraud requires relying on a diverse range of measured efforts by enforcers as well as ex ante regulation.

This post comes to us from Professor James J. Park at UCLA Schools of Law. It is based on his recent essay, “Shareholder Wealth Maximization and Securities Fraud,” available here.

Exit mobile version