The KPMG decision

I was otherwise engaged in the Netherlands over the last few days, so only caught up with Judge Kaplan's opinion in the KPMG case 8 miles over the Atlantic yesterday. Although I'm late to the party (see, e.g., White Collar Crime here and here and Dave Hoffman), I feel compelled to dissent from the dismissive view of the opinion I see from Hoffman, as well as from Steve Bainbridge, who endorses Dale Oesterle's view that the opinion "contribute[s] to the fallacy" that the constitution is "some granddaddy protection against all that is unfair." I think this significantly understates Judge Kaplan's accomplishment and the broader implications of the case.

In a nutshell, the court held that the Thompson memo and the prosecution's other conduct, by bludgeoning KPMG to deny advancement of expenses to KPMG employees, unconstitutionally denied defendants a fair trial and right to counsel.

To begin with, it is worth recalling that the Thompson memo was generated by the same post-WorldCom summer 2002 panic that brought us SOX. It was a time of regulatory madness when, as the court notes in n. 13, the second highest ranking lawyer in the government could say publicly that employees “don’t need fancy legal representation” if they don’t think they’re criminals. Soon after, this official gave the instructions to his lawyers that led in this case.

The court showed in detail how KPMG was subjected to intense pressure to deny the payment of expenses to which the court found that the employees were contractually entitled, and how this prevented the employees from presenting an effective defense in this very extensive case.  Because dismissing the indictment would be too drastic, and just letting KPMG rethink the denial of fees with a deferred prosecution agreement hanging over its head probably ineffective, and with the government protected by sovereign immunity, the court held that it could use its ancillary jurisdiction to order KPMG to pay the fees. Since KPMG is not yet before the court, the defendants will have to sue it.

So far this seems pretty straightforward at least if one accepts the implied contract finding, which is at least arguable.

One might argue that the court could have dispensed with the whole constitutional part of the opinion and skipped right to the end – that is, to the suggestion that the defendants sue KPMG. So is the court converting a contract claim to a constitutional claim?  I don't think so.  Without the constitutional part of the opinion, what would have happened in the employee's suit against KPMG? Even if the court found a contractual right to advancement, would it hold that this right trumped the Thompson memo?  Would the government really say that it’s ok to (in its view) encourage the defendants to resist prosecution as long as the employees have a civil judgment? If so, why wouldn’t the contract alone be enough to justify the fees?  After all, the government didn't seem to care at all about the existence of any such contracts. 

So the likely result of the employees' civil suit would be that the parties would be where Judge Kaplan found them – with the government effectively ordering KPMG not to pay the fees without regard to its contractual obligations. The whole problem is that the government didn't give a damn about the contract.

This gets to the very heart of the matter. My basic problem with criminalization of agency costs is precisely that it ignores internal corporate arrangements. The complex set of contracts and incentive devices that comprise a corporation simply doesn't fit with the sort of moral condemnation that criminal penalties necessarily involve. The nuances of an agency contract are the proverbial square peg in the round hole of criminal law.

But Judge Kaplan emphasizes that indemnification serves an important function in an agency contract: If directors and other agents are over-exposed to liability, they simply won’t work for the firm. One might add that even if they do work for the firm, they won’t take the risks that are necessary to maximize shareholder value and to make capitalism work. Corporate criminal liability essentially seeks to reengineer the firm to change incentives so that agents are no longer maximizing profits, but attempting to root out fraud at all costs.

The fundamental importance of this case is that Judge Kaplan is telling the government that the contract matters, even if it gets in the way of prosecution. By doing this, Judge Kaplan is re-reengineering the firm to make it, once again, a profit-maximizing entity rather than a government agent.

So what now? Dave Hoffman suggests that “potentially vulnerable firms will draft by-laws or contracts that exclude indemnification absent cooperation, to make clear that the government has the right to demand cooperation from employees.” This essentially assumes that the opinion didn’t happen, that the Thompson memo is entirely valid, and that the government will simply go on bludgeoning defendants.

I think it’s more likely the opposite will happen. The government will get the message that the next time something like this happens, a court, emboldened by Judge Kaplan’s opinion, will decide that throwing out the indictment really is necessary. The only qualification is that not every court will agree with Judge Kaplan that a contractual entitlement can be based on mere “expectations.” Accordingly, partners will demand and likely get more explicit protection.

Of course this one case isn’t going to solve all of the problems of corporate criminal liability. Corporate defendants will face the basic problem that it is hugely burdensome to defend these cases, which gives the government considerable leverage. The case's precise implications for other uses of government leverage are unclear. But by saying that there is a limit to what the government may do in criminalizing agency costs, the judge has taken an important first step. I predict the opinion will be a landmark.

Comments

[Jake]

Prof. Ribstein's comment above assures that, in the event North Korea lays waste to California with a thermonuclear-tipped ICBM, we can at least blame agency costs for the catastrophe.