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August 11, 2006

Throw them all in the clink

As noted earlier here and here, the practice of backdating stock options is fundamentally a disclosure issue. However, that has not stopped federal prosecutors from criminalizing the practice as new indictments are now announced almost daily.

In this typically lucid post, Larry Ribstein wonders where this current spike in criminalizing a perhaps unfortunate but nevertheless common corporate practice will end:

The question is where to draw the line between criminal and civil liability for these violations. Are we going to throw a significant fraction of corporate America in jail? . . . backdating could become the Rubicon of criminalizing agency costs.[. . .]

The line-drawing problem becomes particularly clear in light of the news just yesterday that the vaunted Pixar apparently had its own backdating problem, and that one of the grants was to its guiding creative spirit, John Lasseter. So, again, how far are we going to go? Should we say that it’s ok to jail the heretofore little known Kobi Alexander, but draw the line at the famous John Lasseter, or Steve Jobs, Pixar’s co-founder and board chair?

Or is the key that Jobs himself didn’t receive options but Alexander did? But, then, how distinguish Brocade, discussed in my first post on criminalizing backdating, where the indicted ceo apparently also did not gain?

Or is the distinction that the board may have authorized the options in Pixar, but the indicted Comverse agents apparently tricked their board? But the board apparently approved the Brocade options.

Also, the evidence of who did, and knew, what may get a little tricky. A member of the Comverse board’s compensation committee was Alexander’s sister. And note that a lot of this evidence of a coverup is based on affidavits by Comverse board members, who appointed the internal review committee.[ . . .]

In the Pixar case, the WSJ story implies but doesn’t say that the board was in on the scheme. It notes that one compensation committee member was Jill Barad, former Mattel ceo, who also served on Microsoft’s compensation committee while Microsoft was backdating. Another director was famed lawyer Larry Sonsini, who was also on the Brocade board and had long advised Apple and Jobs. . .

But what difference should it make whether the insiders fooled the board, and therefore the shareholders, or the board was in on the scheme? Is it, again, just that we don’t want to send the likes of Barad and Sonsini to jail, but it’s ok to catch the small fry? And can we be sure who was in on what?

Or should the key distinction as to criminalization be whether the insiders lied to the auditors, as may have happened in Comverse? If so, why is it worse to lie to the auditors than to your board?

This whole business of fixing responsibility within large organizations, or even not so large, is part of the problem of criminalizing agency costs. As I’ve said in my short paper The Perils of Criminalizing Agency Costs:

Disciplining agents also requires pinning responsibility for corporate failure on particular people in the organization. If someone should be criminally responsible for obscuring Enron's financial condition, who should it be – the midlevel executives who designed the misleading structures, the executive officers who signed off on them, the independent directors who failed to object, the lawyers, accountants, banks and other executives who enabled them, anybody who knew about them and didn’t speak up, the whistleblower who told only those within the organization, or all of the above?

Elsewhere on the criminalization of business front, the publicly-owned company BetOnSports -- whose CEO David Carruthers was yanked off a plane while changing planes and arrested a couple of weeks ago (previous posts here) and which has provided a recreational service enjoyed by millions of Americans (online betting) -- announced yesterday that it was shutting its operations down and "refocusing" its business on the Asian markets. The development represents the first time that I can recall that a publicly-traded company on the London Stock Exchange has shut down its operations under pressure from United States prosecutors.

So, what's next? Shut down all the popular online Fantasy Football operations? That would be absurd, you say. Well, maybe not. At least the statistics don't appear to be the property of the professional sports leagues.

Federal prosecutors assert that offshore Internet casinos such as BetOnSports violate the Federal Wire Act of 1961, but that legal theory is wholly untested except arguably in the area of sports betting. BetOnSports raised over $100 million when it went public on the London Exchange in July 2004 and its market cap immediately before the arrest of Carruthers was about $235 million. Some of the company's largest institutional shareholders are funds controlled by major American investment houses, such as Goldman Sachs, Merrill Lynch and Morgan Stanley.

So, if BetOnSports is truly guilty of racketeering, then does that mean that Goldman Sachs, Merrill Lynch and Morgan Stanley are also criminally responsible for helping to finance that racketeering?

Don't bet against it.

Update: Christine Hurt over at the Conglomerate provides these related insights into the enormous cost of prosecutorial overreaching.

Posted by Tom at August 11, 2006 05:19 AM

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