This paper was given at the Mt. Pelerin Society meeting in Chattanooga, Tennessee, on September 21, 2003.
The Enron-era accounting scandals have resulted in new legislation, Sarbanes-Oxley, which imposes criminal liability on the CEO and CFO of corporations with incorrect accounting statements. This reform will have unintended consequences, as have previous reforms.
A case can be made that the recent scandals are themselves the consequences of past reforms. The emphasis on quarterly earnings is the result of reform that aimed to provide investors with more timely information about the profitability and financial condition of public companies. Stock options resulted from reforms that sought to tie executive compensation to shareholder return as measured by the company’s stock price. Another reform capped executive salaries at $1 million. Compensation above this amount must be paid from after-tax profits or justified by performance. The practice of giving executives large options whose value depends on driving up quarterly earnings (the measure of performance) came from this reform. In the early 1990s the S.E.C. itself launched fictional quarterly earnings reports when that agency changed Rule 16b. Previously, executives who exercised their stock options were required to purchase the stock at the option price and to hold it for six months before selling. The rule change permitted executives to sell the stock the minute they exercised their options, thus eliminating the executives’ exposure to the market.
Reform took its toll on the culture of accounting firms. In a judgmental era, loose dealings ruined reputations. Partners were paid according to seniority. The accounting industry operated under self-imposed bans on price competition and advertising. With charges that the absence of price competition was anticompetitive, the Federal Trade Commission and the U.S. Department of Justice destroyed this accounting culture during the 1970s. Competition on the basis of reputation and probity was replaced with price competition. Partners ceased to be paid by seniority. Instead, they were paid according to the business they brought to their firms. Accounting firms began consulting with the corporations that they audited, adding conflict of interest ingredients to the more accommodating stance toward clients that price competition had forced upon accountants. Price competition brought pressure to make the client happy. The need to make the client happy undermined the independence of the auditors.
Reformers assume that rules can substitute for character, and they ignore the unintended incentives created by rule making. An accounting culture based on probity was replaced by one in which sharp practices are acceptable as long as they comply with SEC rules.
By making top executives criminally liable for material errors, regardless of whether fraud is intended, Sarbanes-Oxley violates two protective principles of our legal system: mens rea (no crime without intent) and actus rea (evidence of a criminal act). Violating these legal principles is a far greater offense than accounting fraud.
We often hear that "the rule of law" is an advantage we have over our competitors, but the rule of law has been replaced with the discretion of regulators and prosecutors. Today Americans draw prison sentences for unknowingly violating vague regulations, the meanings of which are interpreted by the regulatory police who enforce the regulations. Americans are indicted on the basis of novel interpretations of criminal liability created by the indictment. When felony was ruled by intent, legal certainty was required in order that people could be aware of acts that constituted criminal violations. Now that intent is no longer required, certainly in law has lost its relevance.
The U.S. Department of Justice’s criminal indictment of Exxon for the Exxon Valdez oil spill and California’s criminal indictment of Lincoln Savings & Loan owner Charles Keating were path-breaking examples of criminalizing accidents and civil liability in order to interpret felony statutes without regard to intent (Roberts and Stratton, 2000).
It is absolutely certain that Exxon did not purposely run the Valdez oil tanker aground with the criminal intention of polluting the water and killing migratory birds without a license. Yet, the DOJ’s criminal indictment charged that Exxon did. The indictment interpreted oil worth $150 million as "refuse matter" that was "thrown, discharged and deposited" by Exxon without a permit. Exxon was also charged under the Migratory Bird Treaty Act for killing birds without a license. By threatening Exxon executives with prison, the DOJ guaranteed a big settlement.
In the Keating case, prosecutors with the connivance of Judge Lance Ito criminalized the civil tort doctrine of respondeat superior, which holds a "master" economically liable for wrongdoings by his "servant." This allowed Keating to be held responsible for alleged wrongdoings by employees.
Recently Paul Rosenzweig in a Heritage Foundation paper noted that accidents have become regulatory crimes that subject the innocent to criminal liability regardless of intent or even of fault (Rosenzweig, 2003). He illustrates the point with Edward Hanousek, a manager with a railroad in Alaska. A worker, at the worker’s own initiative, used a backhoe to move some rocks from a train track and accidentally ruptured an oil pipeline, causing a few thousand gallons to spill into the Skagway River. Mr. Hanousek, who was off-duty at the time, was imprisoned for failing to supervise the worker.
Law, once a shield of the innocent, has become a weapon in the hands of government. Today anyone can be criminally prosecuted for offenses created by the indictment. What William Blackstone defined as law — "the Rights of Englishmen" — has been lost.
In the Anglo-American legal system, law consists of a few basic principles: due process, the attorney-client privilege, equality before the law, the right to confront adverse witnesses, and the prohibitions against crimes without intent, bills of attainder, self-incrimination, retroactive law, and attacks against a person through his property. Each of these protective principles has been breached. Today prosecutors create bills of attainder by tailoring novel interpretations of law to fit the targeted defendant. A favorite tactic is to criminalize civil infractions. Clark Clifford and Robert Altman were indicted not for a statutory violation but on a prosecutor’s "novel theory" that two separate legal transactions comprised a "conspiracy." Accidents and mistakes in filling out government forms have been criminalized. The ancient legal principle of mens rea has been obliterated.
The New Deal laid the groundwork for destroying the tort/crime distinction and using criminal sanctions to achieve public welfare goals. An important feature of New Deal legislation was congressional delegation of lawmaking power to regulatory agencies. Delegation combined statutory authority and enforcement authority in the same hands. The bureaucrats’ ability to define criminal offenses by their interpretation of the regulations that they write gives regulatory police vast discretion. A cooperative "offender" may get off with a civil penalty, whereas a person who sticks up for his rights or a person who presents a high profile opportunity to an ambitious prosecutor may receive a criminal indictment. The bureaucrats’ ability to create criminal offenses spontaneously by interpretation makes law uncertain and incapable of fulfilling its purpose of commanding what is right and prohibiting what is wrong.
The Enron era scandals produced the Benthamite proposal that corporate lawyers be required to rat on their clients. Just as Hanousek’s case follows from the Exxon Valdaz, the proposal to breach the attorney-client privilege has its precedent in U.S. assistant attorney general Stuart M. Gerson’s indictment in 1990 of the blue-chip law firm Kaye, Scholer as "an abettor of crime" for not divulging to thrift regulators information pertaining to its client Charles Keating. The DOJ’s indictment of Kaye, Scholer was based on presumption as Keating was yet to be tried. But by freezing the law firm’s assets and the personal assets of the firm’s 400 partners, Gerson was able to force the law firm into a $41 million settlement. Such actions by the DOJ smell of robber barony, not of the rule of law.
Superfund took retroactive law back generations and placed liability on people and organizations that never contributed hazardous waste to a Superfund site. Child abuse cases violate due process and the right to confront one’s accusers. Anonymous allegations serve as grounds for seizing children and placing them in the hands of "therapists" who coax them into accusations. The DOJ and HUD have coerced neighborhoods into abandoning their rights under zoning ordinances to keep commercially operated halfway houses and drug treatment clinics out of residential areas.
The function of justice is to find the truth. This function has been destroyed by plea bargains. Plea bargains have corrupted the justice system by creating fictional crimes in place of real ones. The practice of having people admit to what did not happen in order to avoid charges for what did happen, or is alleged to have happened, creates a legal culture that elevates fiction over truth. By making the facts of the case malleable, plea bargains enable prosecutors to supplement weak evidence with psychological pressure. Prosecutors pile on charges, as in the Mike Milken case, until the defendant or his lawyers throw in the towel. Many innocent people cop a plea just to end their ordeal. Legal scholar John Langbein compares "the modern American plea bargaining system" with "the ancient system of judicial torture" (Langbein, 1978, 8). Confession and self-incrimination have replaced the jury trial in about 95 percent of felony indictments (Maguire and Pastore, 1995, 461—63, 483—86). Just as Bentham wanted, torture has been resurrected as a principal method of conviction. As this legal culture now operates, it permits prosecutors to bring charges in the absence of crimes.
How are firms to operate when managers face criminal liability for accidents committed by employees and for accounting mistakes in overseas subsidiaries? The criminalization of error has turned the justice system into a lottery that can assign criminal charges to anyone. To compensate for this liability, executives will be better remunerated. Operating expenses will rise as ever more accounting safeguards are implemented and audits are expanded. Corporate counsel will multiply as executives strive to establish that they have taken every step to prevent fraud and negligence. The vulnerability of firms to indictments will prevent any independence of voice as business executives seek political protection.
Just as many defense attorneys are former prosecutors and many corporate lawyers come from backgrounds in regulatory agencies, future business executives might be drawn from the ranks of regulatory bureaucrats as protection of the firm and its management from indictment becomes an important goal.
The vagueness of laws and undefined crimes, such as insider trading, make it easy for prosecutors to bring charges and coerce monetary settlements. Alan Reynolds noted in the Washington Times (May 25, 2003) that New York prosecutor Elliott Spitzer managed to shake down Merrill Lynch without developing any real evidence of fraud. Spitzer’s settlement agreement with Merrill Lynch was reached without "the court making any findings of fact or conclusions of law." Nothing in the settlement "may be deemed or used as an admission of, or evidence of, the validity of any alleged wrongdoing or liability." As Reynolds puts it, "the case against Merrill is officially one with no accusation of fraud, no admissible facts, no legal findings and no evidence of wrongdoing."
It is amazing that people still believe that the U.S. is a country where property rights are protected. In torts, what formerly were dismissed by judges as "nuisance suits" are now settled for large sums. Asset freezes and forfeitures have exploded. The Racketeer Influenced Corrupt Organizations Act (RICO), which was supposed to be targeted toward the mafia, has found its way into divorce cases. Asset confiscations, which were supposed to be targeted toward drug lords, take their daily toll on a large number and wide range of totally innocent parties. Grandparents lose their homes because police suspect that grandchildren brought drugs into the house. Elderly disabled people are evicted because their care providers bring drugs on their premises. People are confiscated of cash because police surmise that the amounts imply drugs. Motels, cars, boats, and airplanes have been confiscated as a result of police surmise that they facilitated the commission of a crime or because renters or passengers (including hitchhikers) possessed drugs or premises were used for prostitution or to solicit prostitution. California multimillionaire Donald Scott lost his life, because Los Angeles deputy sheriff Gary Spencer planned to confiscate his 200-acre Malibu estate on the basis of false allegations that marijuana plants were growing on his land.
In our book, The Tyranny of Good Intentions, Larry Stratton and I devote a chapter to asset confiscations. I have not kept up with forfeiture since the book was published in 2000. According to the latest information we had at that time, the 1984 forfeiture provision, which targeted drug trafficking, had been expanded to cover 140 other federal criminal offenses. Scores of similar state and local forfeiture laws have been added to the books. According to former House Judiciary Committee Chairman Henry Hyde, Florida, Texas and other states permit civil forfeiture for any criminal activity. New Jersey allows forfeiture for any alleged criminal activity.
The innocent owner’s defense is extremely weak. Police and prosecutors have taken advantage of it. Levy reports that in 80% of forfeiture cases no charges are filed against owners of confiscated property (Levy, 1996). In other words, the confiscations acknowledge that the owners whose properties were seized are innocent of the alleged criminal activity for which their property was confiscated. As Rep. Hyde said, Americans face "endless possibilities to be caught in the snare of government forfeiture" (Hyde, 1995, 10).
The Patriot Act and follow-up proposals are destroying habeas corpus and permitting warrentless searches and spying. Supposedly, these police state measures are directed toward terrorists, but they are certain to expand, just as asset freezes and forfeitures expanded. On May 21 of this year the Washington Post reported that the Justice Department acknowledged in a 60-page report to the House Judiciary Committee that it has used many of the anti-terrorism powers granted in the wake of September 11 to pursue defendants for crimes unrelated to terrorism, including drug violations, credit card fraud and bank theft. Some people say police and prosecutors will protect the innocent by exercising careful discretion. If asset forfeiture is the example of police discretion, 80% of those incarcerated under the new anti-terror laws will be innocent.
The grand jury is supposed to determine that a crime has occurred and that an indictment of an individual is justified. The trial jury is supposed to determine the innocence or guilt of the indicted party. Just as the trial jury has been displaced by the coerced plea bargain, the grand jury has lost its function. A recent Cato Institute paper shows that the federal grand jury is "a stalking horse for prosecutors to bypass the constitutional rights of individuals and organizations. . . .In truth, the government has been using the facade of the u2018grand jury process’ to subvert the Bill of Rights — especially the Fourth Amendment’s ban on unreasonable seizures of private papers and the Fifth Amendment’s ban on compulsory examination under oath" (2003, 1, 4).
Grand juries do not determine whether a crime has occurred. They merely accept the prosecutor’s word for it, who, in turn, accepts the police’s word. In two Arlington, Virginia, child sex abuse cases that I investigated, no evidence was ever presented that an offense occurred. The same detective and prosecutor simply lied to the grand jury that offenses had occurred. Once they had the indictment, they proceeded to convict the defendants.
In one case parents, concerned about the relationship of their underage daughter with an older woman in their apartment building, insisted on chaperoning their meetings. To continue the relationship, the daughter accused her father of sex abuse. No investigation was ever made by the police. Child Protective Services stepped in and forced the mother to abandon her husband or lose custody of the child to CPS. This isolated the father. The detective lied to the grand jury that the father had confessed. Isolated and indicted, the father was forced into a deal.
In the other case a skateboard coach took his team to New York City for a competition. One of the boys wanted to purchase drugs. Fearful that any rumor of drugs would destroy parents’ confidence, the coach threatened to tell the boy’s parents. The boy struck first by accusing the coach of sex abuse. Again, no investigation was made. The skateboard team came to testify as to what really happened. The trial judge, suspected by a clean government group of being under the prosecutor’s thumb, jailed one of the young witnesses on a trumped-up technicality. This served both to intimidate the young witnesses and to cast aspersion on the credibility of the witnesses.
The reason that the vast majority of felony cases are settled with a plea bargain and the vast majority of civil suits are settled out of court is that no one has any confidence in the justice system.
This lack of confidence should tell us something about the fate of entrepreneurs and executives when criminal sanctions are used in order to obtain "public welfare" goals.
When felony no longer requires intent, criminal conviction loses its moral condemnation. When error is criminalized and third party criminal liability assigned, people can be found guilty of felonies of which they have no knowledge or personal connection. When law is morally arbitrary, unknown and uncertain, prosecutors escape all restraint.
Former U.S. attorney Robert Merkel says that prosecution "is a result-oriented process today, fairness be damned." Merkle says prosecutors are pressured to justify budgets with convictions, "and that causes them to prosecute absolutely bogus cases to get those statistics" (Moushey, 1998, 3—4). Former deputy U.S. attorney general Arnold I. Burns wrote in the Wall Street Journal that "it is time for a sober reassessment of the power we have concentrated in the hands of prosecutors and the alarming absence of effective checks and balances to prevent the widespread abuse of that power" (Burns, 1998, A23). A law school textbook, Prosecutorial Misconduct, is evidence that the problem is not going away on its own.
In 1998 the Pittsburgh Post-Gazette summed up its investigative reports of prosecutorial misconduct as follows:
Hundreds of times during the past 10 years, federal agents and prosecutors have pursued justice by breaking the law. They lied, hid evidence, distorted facts, engaged in cover-ups, paid for perjury and set-up innocent people in a relentless effort to win indictments, guilty pleas and convictions. Rarely were these federal officials punished for their misconduct. . . . Perjury has become the coin of the realm in federal law enforcement (Moushey, 1998, 40).
The traditional prosecutorial ethic required prosecutors to give the defendant the benefit of the doubt and to strive for a fair trial. This ethic has been lost. Today prosecutors strive for conviction at all costs. Prosecutors try defendants in the media, not in the courtroom. They overdraw charges in order to elicit a plea. They withhold exculpatory evidence.
A recent case of withholding exculpatory evidence was reported by Alexander Cockburn in the Los Angeles Times (May 26, 2003). Ed Rosenthal was designated by the City of Oakland to be the legal supplier of medical marijuana under the terms of California’s Compassionate Use Act of 1996. Federal agents arrested Rosenthal under federal anti-marijuana law. At Rosenthal’s trial in U.S. District Court in San Francisco, the prosecutor presented Rosenthal as a major drug dealer. Judge Charles Breyer (brother of the U.S. Supreme Court justice) prevented Rosenthal’s attorneys from introducing the fact that he was supplying medical marijuana to the City of Oakland under the terms of a California state law. Misled by judge and prosecutor, the jury convicted Rosenthal. When the jurors learned that they had been deceived, they protested in front of the U.S. courthouse. Do we want people who will intentionally mislead jurors in order to obtain a conviction serving as prosecutors and judges?
The mendacity of prosecutors knows no bounds. In Stigler, Oklahoma, prosecutor Ron Boyer is prosecuting 32-year-old Shannon Denney for the crime of "outraging public decency and public morals." Denny is guilty of nursing another woman’s 3-month old baby while caring for her in a daycare center. The baby could not stop crying and refused the offered bottle, so Denny, who was nursing her own baby, offered the distressed infant her breast. For this act of kindness, Denny faces up to a year in jail.
The prosecution of Denny epitomizes the complete destruction of law. Denny had no notice that her act of kindness constituted a crime. Indeed, how could wetnursing — a normal activity for thousands of years prior to the invention of the baby bottle and infant formula — be construed as a crime? Actus rea and mens rea are absent, and normal human behavior with an ancient tradition has been criminalized without notice.
Martha Stewart’s indictment by U.S. attorney James B. Comey is another example of crimes invented by prosecutors. Stewart is not charged with felony "insider trading," but with felony obstruction of justice for allegedly trying to cover up evidence that might be construed as insider trading (if a person without a fiduciary relationship with the firm, ImClone, whose stock she sold can be guilty of insider trading). How can a person be indicted for covering up a crime for which one is not accused?
In addition, Stewart is charged with felony "securities fraud" for declaring her innocence publicly. According to the prosecutor’s "new legal twist," her declaration of innocence constitutes an illegal manipulation of the stock of her own company, Martha Stewart Living Omnimedia. By declaring her innocence, the prosecutor says, she was attempting to prevent her indictment from driving down the shares of her company, which depends on her leadership. The prosecutor’s invented charge ignores that in our legal system a person is innocent until proven guilty. At the time she declared her innocence, Stewart had neither been tried nor found guilty.
Many people have the misconception that justice is a function of the size of the pocketbook. In actual fact, it is easier to frame a white-collar defendant than to frame a poor member of a minority group. The common law crimes associated with the poor — theft, assault, and murder — are well defined. Frame-ups for such crimes require prosecutors to suborn perjury, suppress exculpatory evidence, and coerce false confession. To frame a white-collar victim, a prosecutor need only interpret an arcane regulation differently or with a new slant.
As a result of past reforms, the bulk of executive compensation depends on performance-related bonuses. It is easy for employees to become dependent on bonus income and to be tempted to fudge results when profits turn down. To hold a CEO and CFO criminally liable for accounting misstatements that cannot be detected in advance is tyranny.
Many justifications have been used for past tyrannies. We now have tyranny in the name of corporate governance and the prevention of accounting fraud.
Burns, Arnold J. 1998. What By-the-Book Prosecutors Can Get Away With. Wall Street Journal, March 23, A23.
Dillard, W. Thomas, Stephen R. Johnson, and Timothy Lynch. May 13, 2003. A Grand Facade: How the Grand Jury Was Captured by Government. Policy Analysis. Washington, D.C. Cato Institute.
Hyde, Henry. 1995. Forfeiting Our Property Rights: Is Your Property Safe from Seizure? Washington, D.C.: Cato Institute.
Langbein, John H. 1978. Torture and Plea Bargaining. University of Chicago Law Review 46 (October), 3-22.
Levy, Leonard W. 1996. License to Steal: The Forfeiture of Property. Chapel Hill: University of North Carolina Press.
Maguire, Kathleen, and Ann L. Pastore, eds., 1995. Sourcebook of Criminal Justice Statistics 1994. U.S. Department of Justice, Bureau of Justice Statistics. Washington, D.C.: U.S. Government Printing Office.
Moushey, Bill. 1998. Win at All Costs. Pittsburgh: PG. Stories reprinted from the November 22, 23, 24, 29, and 30, and December 1, 6, 7, 8, and 13 issues of the Pittsburgh Post-Gazette.
Roberts, Paul Craig, and Lawrence M. Stratton. 2000. The Tyranny of Good Intentions. Roseville, Calif.: Prima Publishing.
Rosenzweig, Paul. April 17, 2003. The Over-Criminalization of Social and Economic Conduct. Legal Memorandum. Washington, D.C.: Heritage Foundation.
Dr. Roberts [send him mail] is John M. Olin Fellow at the Institute for Political Economy and Senior Research Fellow at the Hoover Institution, Stanford University. He is a former associate editor of the Wall Street Journal and a former assistant secretary of the U.S. Treasury. He is the co-author of The Tyranny of Good Intentions.