A story in today’s Wall Street Journal (sub. req.) about the continuing troubles at Bristol-Myers raises troubling questions about the government’s use of strong-arm tactics to extract corporate governance and other concessions from firms under threat of litigation-induced firm death.
In the aftermath of the demise of Arthur Andersen, firms are especially leery about the possibility of being indicted. As the Andersen case makes clear, the risk from indictment is enormous, and even exoneration by the Supreme Court isn’t enough to bring back the dead. It was in the wake of Andersen that the US Attorney’s Office for the District of New Jersey negotiated a so-called “deferred prosecution agreement” (DPA) with Bristol-Myers to settle allegations that the firm engaged in deceptive inventory practices to meet quarterly earnings estimates. DPAs, which are adapted to the corporate crime context from the pre-trial diversion programs used to monitor juvenile and drug offenders, have been used in 43 corporate crime and fraud cases since 1993. These agreements raise issues about privilege waiver and corporate versus individual accountability, but the Bristol-Myers case highlights the danger of governance reform aspects of these agreements.
In over half of the DPAs to date, the government has required that the firm under investigation agree to install a government-appointed “monitor” to oversee the board and other aspects of the firm, and has required substantive changes to firm governance, such as appointing new directors or putting in place internal control systems or personnel. In the Bristol-Myers DPA, the parties agreed to split the role of Chair and CEO, and have a former federal judge, Frederick Lacey, effectively monitor the board and the firm’s compliance with the DPA and general norms of good governance. The judge also filed regular reports on the firm and its conduct to the US Attorney, Christopher Christie. According to the WSJ, the power of Judge Lacey and Christie is so unbridled that when they learned about conduct by the CEO that might be in violation of the DPA, they called a special session of the board and recommended firing the CEO. The board, which was planning a board meeting the next day to discuss the future of the CEO, is expected (surprise!) to follow the monitor’s advice, lest they face revocation of the DPA and indictment. Lest we think the board can actually exercise its own independent judgment, the story assures us that “[t]he board’s only recourse if it disagrees with Mr. Lacey’s recommendation is an appeal to Mr. Christie”. This is a fruitless course, however, since Christie conferred with the judge’s recommendation even before he went into the boardroom.
There are many troubling aspects to this: First, these are the wrong people to be instituting governance reforms. Judge Lacey and Mr. Christie are not experts in corporate governance, nor are they familiar with the ways that firms operate or the tradeoffs inherent in making governance decisions. The DOJ offers no guidelines for governance aspects of DPAs nor any experts to help attorneys decide what choices to make. How can Mr. Christie justify his choice that separating the role of Chair and CEO is beneficial for shareholders or even society? He can’t, and individual government prosecutors should not be in the business of telling firms, even misbehaving ones, how to set up internal governance.
Second, this practice is likely to destroy shareholder value. Putting government spies in the boardroom is bound to lead to less effective firm performance, as executives and board members are constantly second guessing the risk taking that is essential to value creation. The worry might be the leakage of confidential business data—Judge Lacey attended every board meeting—or that run-of-the-mill risk taking might be viewed as illegal. Every firm engages in conduct that might technically violate the Sherman Act or someone’s ethical standards of corporate conduct, not all of which are illegal or even undesirable from a shareholder and societal perspective. Having the judge sitting in the corner may cause firms to pass up these opportunities or simply not discuss them at the board level.
Third, this is the wrong way to achieve effective corporate governance reforms. There is already a variety of ways of instituting governance changes, ranging from voluntary adoption to shareholder recommendation or takeover to changes in state law, SEC rules, or stock exchange listing standards. In each of these cases, firms and other interested parties are given the opportunity to be heard and present evidence of the impact of governance changes on their businesses. In the DPA context, however, changes are unilaterally imposed by government agents without reasoning, deliberation, or support. Whatever the merits of the deliberative model, coercion is unlikely to yield superior results. This is especially true since the litigation approach has an alternative mechanism that gives firms incentives to design effective governance models: the government can extract monetary fines from firms, thus causing them to internalize the costs of fraud or other misconduct. Firms can then choose how to best minimize the risks of fraud going forward, whether it is from governance reforms, business model or personnel changes, or other means.
Fourth, the DPA model of governance gives other firms not covered by the agreement a disincentive to adopt even beneficial reforms. Suppose that a firm believes that it can improve its governance by splitting the Chair and CEO role, but it knows that there is a chance that it may face an investigation by the US Attorney for the District of New Jersey. The firm, or more likely individual executives, may withhold the reform, preferring instead to have it as a bargaining chip to reduce the threat to the firm or to individual executives from any potential investigation.
Finally, DPA agreements allow for government agents to extract private benefits from firms. In the Bristol-Myers case, the firm agreed to endow a chair at Seton Hall Law School for the study of business ethics. This isn’t just odd, it is deeply disturbing because, you guessed it, Mr. Christie is a graduate of Seton Hall Law School! The potential for abuse is not limited to such silliness, as other DPAs have been used to force firms to follow the policy preferences of the government in ways that would be more difficult to achieve through actual negotiation or the political process. For example, in a settlement of alleged tax fraud by the New York Racing Association, the US Attorney for the Eastern District of New York required NYRA to install video lottery terminals at their tracks.
The trend is clearly towards greater use of this device: 36 of 43 DPAs have been since 2001. While more work needs to be done to expose the faults of this approach to governance reform, the Brisol-Myers case should serve as a cautionary tale.