When the U.S. Department of Justice recently announced a renewed emphasis on the prosecution of individual directors and officers in instances of corporate misconduct, it raised the possibility that in the future we could see increased numbers of corporate officials prosecuted and convicted for actions they took as representatives of their company. There are times when popular sentiment rallies in favor of the prosecution of corporate officials – as, for example, was the case during and after the recent global financial crisis. And while there have been instances in the U.S. where corporate officials have in fact been convicted for criminal misconduct, it has been rare. I suspect that even under the new guidelines it will be only the unusual or egregious cases that will involve criminal prosecutions of individuals.
Of course, it is not preordained that criminal prosecutions of corporate individuals should be rare. In fact, there are places now where criminal prosecutions of corporate officials are more common. One of those places is China, as discussed in Steve Dickinson’s September 26, 2015 China Law Blog post entitled “China Company Directors and China Criminal Liability” (here). Dickinson’s discussion of these issues raises some interesting questions about the role of criminal law in policing director misconduct.
As Dickinson’s blog post notes, “director liability is a big issue in China.” However, the concept of director liability in China is very different than in the U.S., in part because in China, by contrast to the U.S., directors are “assumed to be directly involved in the day to day business operations.” Directors of Chinese companies are going to jail “not because they ‘should have known’ about crimes committed by the company, bur rather because they managed, promoted or supervised those crimes.”
It is important to understand that these criminally prosecuted Chinese directors are not being sued by shareholders for mismanagement; they are being prosecuted for crimes committed by the company itself – although in many cases their misconduct includes embezzlement, tax evasion and insider trading.
The fundamental difference explaining the prevalence of criminal prosecutions in China is that the director’s role in China itself is different. The directors are more directly involved in daily business operations than are directors of U.S. operations. The blog post doesn’t say this directly, but it seemingly implies that part of the reason for the frequency of criminal prosecutions in China is the absence of other mechanisms for shareholders and others to hold directors accountable, whether for mismanagement or for more blameworthy conduct, such as embezzlement or insider trading. There may also be a sense in China, by contrast to the U.S., that there is less of a legal separation between directors and their companies.
In the U.S., the new DoJ guidelines certainly hold out the possibility of more frequent prosecution of corporate directors. However, it arguably should be the case that the new guidelines should not necessarily result in more frequent prosecution of corporate directors, as opposed to corporate officers. Precisely because directors in the U.S. corporate model are not, by contrast the role of directors in the Chinese model, directly involved in the day to day business affairs of their company, prosecutions of corporate directors in the U.S, even after the issuance of the new DoJ guidelines, should remain infrequent and unusual.
The existence of criminal prosecutions in circumstances that in the U.S. would result shareholder actions rather than in criminal actions does underscore the perennial questions of to whom directors duties are owed in the first place.
In an interesting September 16, 2015 Forbes article entitled “The Real Duty of The Board of Directors” (here), Harvard Business School Professors Robert G. Eccles and Tim Youmans examine the proposition frequently stated (at least in the U.S.) that the board’s duty is to shareholders. However, the authors say, “contrary to this popular belief … a board’s real duty is to the interests of the corporation itself.” Shareholders, they note, don’t own the corporation; rather, they own shares in the corporation. Shareholders own a tradable set of rights: to vote, to claim residual assets, and to receive the profits of capital. Shareholders are temporary but the corporation is permanent, and the corporation is controlled not by the shareholders but by the board of directors.
These observations have important implications on the issue of disclosure and materiality, because , the authors contend, what may be material and what must be disclosed may vary depending on the interests involved.
Whether or not you subscribe to all of the disclosure implications of the authors’ analysis, their basic proposition that directors duties are owed to the corporation itself rather than to the corporation’s shareholders has some basis in the case law.
For example, as discussed here, in November 2013, the North Carolina Supreme Court reversed a lower court verdict in a director liability case on the grounds that directors’ duties generally are owed to the corporation itself rather than to the individual shareholders. Directors have duties to the act in good faith, with due care, and in a manner they reasonably believe to be in the interests of the corporation. If these duties are breached, a shareholder may sue the director – but in a derivative action only, on the corporation’s own behalf, not in a direct action (at least in the absence of a special duty to a particular shareholder).
This distinction about the focus of directors’ duties has practical implications. Among other things, it means that aggrieved shareholders can’t proceed directly against directors for their breach of duties, but may only proceed derivatively. Derivative actions are subject to a number of procedural safeguards (for example, the demand requirement) as well as to the defenses of the business judgment rule. The fact that directors duties are owed to the corporation rather than to shareholders may have important implications for the way in which corporate boards respond, for example, to shareholder proxy initiatives, particularly where the board believes the initiatives are not on the long-run interests of the corporation.
How the DoJ ultimately will implement its new prosecution guidelines remains to be seen. However, if it were to turn out that the prosecution of corporate directors becomes frequent and usual rather than infrequent and unusual, it should be asked whether the application of the guidelines is consistent with some of the basic premises of our system of corporate law. Prosecutions of directors are frequent in China, owing to the differences of the directors’ roles in their legal system. Prosecutions of directors in the U.S. should remain unusual and rare.