Thursday, August 5, 2010

Should Shareholders Pay for Corporate Misconduct?

The U.S. SEC’s settlement last week with Citigroup has revived the debate about the efficacy of payments by way of settlements, fines and penalties by companies as a consequence of breaches of law. Under this settlement, Citigroup is required to pay $75 million for making “misleading statements about the extent of its holdings of assets backed by sub-prime mortgages in earnings calls and public filings”, thereby affecting the interests of its shareholders. SEC also settled with two of Citigroup’s officers – Gary Crittenden who has been penalized to the extent of $100,000 and Arthur H. Tildsley, Jr. $ 80,000 – sums which are trifling in the context of the overall settlement.

New York Times’ Andrew Ross Sorkin asks whether it is fair to expect the shareholders to bear the burden of the payment when they themselves have been victims of the lack of proper disclosures. In other words, would shareholders not suffer a double-whammy – once when they were kept in the dark and next when they bear the impact of the fine paid by the company? Others find merit in the approach that involves penalizing the company and not just its directors or officers – using a blend of legal and economic analysis.

Similar issues arise under corporate law and governance in India as well. For example, one of the key deterrents used by SEBI and the stock exchanges against breaches of corporate governance norms is the threat of delisting (which has also been exercised on occasion). Even here, it is the shareholders who suffer due to the loss of liquidity in their shares although they are they are not involved in the breach. Similarly, under principles of corporate criminal liability, it may not serve as adequate deterrent merely for the company to be held liable, but it would be necessary for directors and officers responsible for the misconduct to be made liable too. However, there is some evidence in practice to indicate that responsible individuals tend to go scot free, while the companies bear the burden of fines and penalties. The problem may get compounded if the companies plunge into bankruptcy, as they often do in the aftermath of an epochal crisis afflicting it, which makes any recovery difficult, if not impossible.


Mandar Kagade said...

On the first take, it does appear that shareholders get a raw deal when the settlement monies flow from corporate coffers than the misfeasing managers. On a closer look, sorkin's claim about it being unfair for shareholders, seems an overstatement.

This is firstly because, Even though the Corporation is made to pay the fine, limited liability and portfolio diversification mean that the per capita loss to shareholders is miniscule. In fact, outside shareholders deem monitoring of corporate affairs costly and choose diversification as an alternative.

Secondly, the corporate that pays the fine may clawback the monies expended from the corporate managers on the grounds of misfeasence-- instances where duty of care violation is argued, might admittedly be difficult in the light of the business judgment rule; nonetheless, the counter-force of hindsight bias that affects ex post decision maker may help the plaintiffs pleading for clawback. Arguments for clawback are stronger for claims about violation of duty of loyalty in any event.

So, in a nutshell, Sorkin's compliant appears very naive.

Similar arguments could be made about the indian scenario too- in fact, in the indian context where controlling shareholder is dominant and holds concentrated interest, such fines may hit it where it hurts most and actually serve the purpose of deterrence. The outside shareholders are dispersed and therefore per capita losses for them 'd be lower than what Sorkin 'd have us believe.

So far as forced delisting is concerned, the other side of the coin I think is equally arguable-- If the delisting happens at a fair price allowing the outside shareholders to exit at fair price plus a premium, that might be a far better deal than the incremental agency costs they might otherwise incur by staying invested in a corporate that routinely flouts corporate governance norms.

Sacha Singh said...

I’ll go a little further..

Shareholders must pay for the mangers’ misconduct; do they not feel entitled to benefit from the managers’ brilliant performance? If they do not have stomach for it they should move into bonds.

And yes, investors seek to minimize the firm specific risks (such as a drunk trader trading away the firm’s net worth) by diversification.

But what really beats me is Mark Hurd getting away with a severance package of US$ 50 million. There is a nexus / old boys’ network, call it whatever you wish, that is determined to protect teh managers vis-a-vis the shareholders.