Blog No. 167 

June 6, 2023 

Fixing America – Idea 29

By Mack W. Borgen

2023 Listee – Who’s Who in America, University of California at Berkeley (Honors, Economics); Harvard Law School; National Award-Winning Author.

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— “Fixing America” Series of Article —

Over the last three years, I have presented a wide range of ideas for “resetting” and “fixing” America. This blog presents Idea 29 in this his “Fixing America” series of articles.

The Need for Some Direct, Personal Liability

of Senior Management for Corporate Wrongdoing

Introduction   

In the 1986 movie Wall Street, Mike Douglas, in the character of Gordon Gekko, sought to convince his assembled audience that “greed is good.” As I have written before, it never crossed our minds that this movie line would become a corporate creed; the supposedly justifying ethos of many of America’s corporations.

But, to a large degree, it has. Some argue that it is a necessary evil — an almost unavoidable and necessary evil especially in the context of our now global economy. Others more humbly agree that it is regrettable, but they too insist that it is necessary in America’s highly competitive capitalistic economy. The more scholarly, or at least the more theoretically attuned, argue that the concept of greed, indeed the importance of greed, in our capitalistic society is merely the natural consequence of an economy which has for decades largely accepted Milton Friedman’s theories of capitalism in which corporations must and should follow a narrow, driven, blind-vision obligation to its shareholders – not to our society, not to its customers, not to its workers, and certainly not to some sense of vague ethical standards.

Regardless of the weak interplay between ethics and capitalism, there is no doubt that fines, penalties, judgments, and other civil and criminal liabilities are increasingly viewed by management as merely line-item entries in their corporate budget; as an almost unavoidable cost of doing business in our over-regulated and our country’s highly complex market.

Thus, with these perspectives the driving (and almost sole) obligation of corporate management is to maximize profits for its shareholders. Driven by that purpose, corporate management routinely uses lawyers to settle lawsuits (“with no acknowledgement of guilt or liability”), to negotiate deferred prosecution agreements, or to otherwise make bad things go away at a minimum cost.

What gets both conveniently and intentionally lost is that no matter what fines, penalties, or judgments are imposed, they are only entity obligations of the corporation. Except in rare circumstances, they do not become matters of personal liability for senior management. To a degree and with carefully designed guardrails, this premise should be re-considered.

Possibly the imposition of some degree of personal financial liability could be effectively used for two constructive reasons: (1) to punish management for gross or intentional neglect or wrongdoing, and (2) even more importantly, to better incentivize management to do better; to be more cautious; and to do the right thing.

Reflect upon even a few of the many well-known examples of management abuse, neglect, indifference, and wrongdoing. They are endless. For example, for many decades Sackler’s pharma business (and its management!) simultaneously triggered and profited from the opioid crisis resulting from its peddling of OxyContin. PGE (and its management!) paid out more than $5BB in dividends to its shareholders while at the same time failing to upgrade its aging high-voltage power lines. General Motors (and its management!) had no difficulty selling cars with faulty ignition switches for a decade before its 2014 recall. And it is almost impossible to keep track of the management-directed wrongdoing on the part of Wells Fargo’s marketing and false account programs.

The examples are endless, and corporate fines are just not enough. Silly, “no-acknowledgement-of-wrongdoing” settlements and deferred prosecution agreements are not enough. Even periodic hits to corporate balance sheets are not enough. Instead, direct – at least financial – liability has to be imposed upon those individuals, i.e., members of corporate senior management, who have the corporate power to make, to supervise, to correct, and to enforce minimum standards of their corporation’s behavior. These things, too, are what they should be paid for.

Thus, this article suggests that it is long past time for there to be change in the “who pays for what” rules.

America must – carefully and to a certain degree only – rethink when “corporate shields” should be “pierced.” Indeed, in some instances and with certain limitations and caps, direct, personal, financial liability should be imposed upon senior management when wrongdoing is discovered. In most instances, all or some of them (a) knew, (b) should have known; or (c) could have known about their corporation’s material wrongdoing. Possibly even more important, each of them can insist upon and monitor one another’s compliance with the laws. Exposed to potential personal liability, they, as members of senior management, can assure or at least improve corporate compliance because they have both the power and the responsibility to supervise, monitor, and implement necessary checks, balances, and changes.

The Continued Use of Business Entities

There are many appropriate reasons for conducting business in the name of a corporate or other entity (e.g., limited liability company or various forms of partnerships). In this article and for the sake of convenience, all such business entities shall be referred interchangeably “corporations” or “corporate entities.” Many people, and especially amongst the hundreds of thousands of small business in America, conduct their businesses in the form of sole proprietorships, but this is oftentimes, indeed usually, ill-advised because, at least this author, does not believe that people should be required to put all of their personal and familial assets at risk merely to commence a business. Nevertheless, because there is already a de facto direct personal liability in the context of sole proprietorships, the focus of this article is upon those businesses – both the large and the massive – which conduct business through the use of a corporate entity. And corporations, and especially the large corporate entities, comprise a huge proportion of America’s economy. A quick listing and summary of the largest ten (10) U.S. corporations is set forth at the end of this article.

However, even though the focus of this article is narrowed to corporate entities, any discussion and allocation of wrongdoing in the context of corporate wrongdoing is complicated. This is exactly because corporations are not “people” who can be incarcerated — even though corporations can be held criminally and civilly liable in the event of such wrongdoing. But the proverbial “rub” is who, if anyone, within the corporation should be held directly and personally liable.

Historically, there is no downstream liability. If large fines and penalties are paid, there may be an initial hit to the corporation’s balance sheet. However, the fine is eventually absorbed by the shareholders or eventually “paid” by the customers. There are sometimes consequential changes to management, but that is the extent of their liability. Even in the case of termination, the departure of senior management is frequently, if not usually, cushioned by severance contracts, buyouts, and other arrangements.

Lest it not be obvious, although corporations are not “people,” the corporation’s actions have serious consequences on people. Two dated, but well-known, examples of such conspicuous neglect and “knowing inactions,” occurred in the context of the decades-long affirmative concealment about the harmful effects of tobacco and the cold-hearted, cost/benefit analysis used to justify the continued manufacturing of the infamous Pinto. But more and more tragic examples occur every year – the marketing of Oxycontin, the knowing deferral of maintenance steps taken by PGE, and – I believe – the affirmatively concealed knowledge of major oil and other companies about the environmental harm caused by their products.

Since corporations are definitionally not “people,” corporate actions are conducted only by the direction or under the supposed supervision of humans – more precisely, senior management. However, there is no tight definition of “senior management,” and the titles vary from firm to firm. Nevertheless, “senior management” normally includes, among others, at least the President and CEO, CFO, CEO, CIO, and the Chief Legal Officer.

What is being proposed below is that when corporate wrongdoing is established, it is NOT enough to pass the consequential fines and penalties along to be absorbed by shareholders or to be paid by customers. Instead, in order to more strongly incentivize senior management to avoid wrongdoing, there are instances when some of the fines and penalties should be payable (ratably or otherwise) by the members of that senior management.

In summary, despite the corporate structure, personal financial loss should be imposed upon members of senior management for at least three (3) reasons.

First, these are the principals who are in supervisory roles. They have the greatest capacity to make major decisions and set the standards for both services and products.

Second, these principals should not be allowed to routinely incorporate civil liabilities or criminal fines as a mere cost-of-doing-business; as a mere line-item in their annual budgets.

Third, these are the principals who routinely (and to a degree appropriately so) claim both the reputational and financial rewards in the event of corporate successes. In a parallel fashion, these are the principals who should, again — at least to some degree, share in the payment of fines, penalties, judgments, and assessments (hereinafter “fines and judgments”) in the event of the corporation’s wrongdoing.

The Proposal

The proposal is straight-forward.

A designated percentage of the aggregate annual compensation of each member of senior management should be set aside and should remain “at risk” in the event of any judicial or regulatory fines and judgments which result (a) from a corporation’s wrongdoing, or (b) any private settlement with respect to such wrongful behavior or product liability.

There are many methods for calculating what “designated percentage” should remain at risk. For example, the at-risk amount could be a percentage of the total compensation paid by the corporation (either via monetary or stock equivalency compensation) to such individual over the last X years (e.g., three (3) years).

Any liability should be shared ratably among all members of senior management (up to their maximum at-risk exposure amounts). It is this author’s belief that such ratable liability will create a major incentive for each member of senior management to use their best (or at least better) efforts to avoid any corporate wrongdoing or liability.

Admitted, But Resolvable, Complications of Implementation

This proposal is, admittedly, substantial. However, it is necessary. But corporate law has gone through many machinations over the last 150 years. This is just another change – albeit an important and somewhat complicated change.

 

Fault-finding is oftentimes a waste of energy, but in this instance we lawyers have devised too many shields of protection that senior management feels, and indeed is, too immune from their own actions, failures, or neglect.

While there are obvious definitional challenges such as merely identifying which parties should be deemed members of “senior management,” this can be done – President, CEO, CFO, Chief Legal Officer, etc. Additional caution is necessary so that the ratable liability portions of the fines and judgments are imposed upon the “correct” members of senior management. If the fines and judgments result from actions or wrongdoing attributable to a date or period prior to the tenure of a member of a member of senior management, then such ratable liability should not be imposed. (NOTE: While it is far beyond the scope of this article, in the context of these prior-date fines and judgments, clawback laws could be used to allocate the ratable portion of the fines or judgments to the senior management in office during the date or dates of the wrongdoing. This would be neither difficult nor even greatly challenging, but a member of current senior management should not be held personally liable for matters occurring before he or she assumed their senior management position).

There would also need to be certain structural challenges. For example, neither the corporation nor the individual members of senior management should be allowed (a) to enter into any form of indemnity or reimbursement agreements with the corporation, or (b) to procure any form of personal liability insurance to cover these matters. At first blush, this may seem unreasonable. However, I respectfully suggest that there are at least two adequate responses to any suggestions of over-reaching. First, the exposure of direct, pro rata liability will institutionally increase tighter standards of behavior amongst all corporate departments. Secondly, the entire decision to become a member of senior management remains with the individual. Corporations with “bad” liability and fines track records would, indeed, have more difficulty in hiring the better individuals. But even this merely creates more incentive for assuring that the corporation does not continue to break the laws, to mislead its customers, or to sell worthless or dangerous products.

Some would argue that it is inappropriate to assign personal liability with a “broad brush” to all of senior management. Indeed, possibly the wrongful conduct resulted from the production division of the company without any knowledge, for example, of the CFO or the Chief Legal Counsel. This is true. That will occur. But exactly because of the broad-brush senior management liability, all members of senior management will, consciously or subconsciously, more zealously insist upon lawful compliance and dutiful behavior from the other members of senior management and the other many divisions of the company. In other words, the mere risk of potential liability imposed upon senior management will create a powerful incentive for monitoring and compliance.

Additional complexities will arise from finalizing some cap on the personal liability of members of senior management. In other words, it is certainly not here suggested that any single member of senior management should have unlimited personal liability in the event of proven corporate wrongdoing. To a degree, the corporate shield should remain, and it is recognized that liabilities could arise which are beyond the actual province or actual knowledge of a member of senior management. Thus, some cap on personal liability would be appropriate. An example of such a liability cap would be that an imposed penalty recovery could not be more than X (e.g., 50%) of all monies (e.g., salary, benefits, and stock) received by any subject corporate officer over the last Y (e.g., three (3)) years. In this manner, a hit of personal liability by one corporate officer due to the wrongdoing (or willful blindness or gross negligence) of another corporate officer would be meaningful, but not open-ended. So long as the cap is not too low, the punitive and deterrent objectives could be achieved even with such a cap.

 

The last major hurdle arises from the fact that corporations are formed in different states. For a wide myriad of reasons, many corporations elect to incorporate in Delaware due to its historically-favorable and protective environment for management and directors. Sometimes, corporations will select another state, such as Virginia, due to its prohibitions upon class action lawsuits. And on and on. However, even these state-of-incorporation issues could be resolved by merely allowing each state to require — as a condition for a corporation’s products to be sold or services to be provided in its state — that the corporation accept these senior management pro rata liability provisions.

Sometimes, states like and choose to be “corporate-friendly,” but that is not what is at stake here. As proposed, a corporation would have to preclude doing business in an entire state merely to protect its senior management’s pro rata liability for corporate wrongdoing. I suggest that few corporations and even few shareholders would want a corporation to so narrow its customer base and market share merely to “protect” senior management salaries.

Confession and Apology

I confess that this is a somewhat complicated idea. I confess that because it is complicated, I have long deferred proposing this change in our capitalist corporate environment. And I apologize, because the subject is kind of technical — and “technical” is usually just a fancy word for boring.

But things must change. PGE. Wells Fargo. Fox News. Sackler’s Purdue Pharma. GM. And on and on. The proverbial bottom-line: Our “free-market” capitalism has to be reined in, and senior management “from the inside” is in a far better position to improve our products and assure lawful compliance than our government’s various departments and agencies.

Remember – no liability, and no one pays. However, sloppy management or sloppy product or deceitful advertising or violation of laws, and then yes, senior management should pay some ratable and meaningful share of the fines, judgment, and awards. Personally.

ADDUNDUM

The Largest U.S. Corporations

Rank      Name                            Industry                        Revenue               No. of Employees                                         

(In MMs)

1            Walmart                        Gen merchandise              $573.8MM                  2,300,000

2             Amazon                        Retail                                  $469.8MM                  1,608,000

3            Apple                             Electronics                         $365.8MM                     154,000

4            CVS Health                  Healthcare                          $292.1MM                    258,000

5             UnitedHealth             Healthcare                          $287.6MM                    350,000

6             Exxon Mobil               Petroleum                          $285.6MM                       63,000

7             Berkshire Hathaway Conglomerate                    $276.1MM                     372,000

8             Alphabet                      Technology                        $257.6MM                    156,000

9           McKesson Corp            Health                                 $238.2MM                     67,500

10          AmerisourceBergen   Pharmaceutical                  $214.0MM                     40,000

                                                                    TOTAL:          $3.26Billion           5,368,500 employees

  

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Copyright 2023 by Mack W. Borgen. All rights reserved. No part of this article may be reproduced or transmitted in any form or by any means, electronic or mechanical, except in the case of brief quotations embedded in critical articles or reviews, without prior written permission by the author.