Corporate Fraud: Where Should the Buck Really Stop? Corporate Fraud Perspective 2002

Corporate Fraud: Where Should the Buck Really Stop? Corporate Fraud Perspective 2002

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More than a decade after he got his big break in Hollywood, Gordon Gecko, the head tycoon in the 1987 Oliver Stone movie "Wall Street," has finally become a fixture in corporate board rooms across the country. Perhaps the best news Enron has received in the last year is that on July 21, 2002, WorldCom became the largest corporate bankruptcy in U.S. history, a title that Enron previously held when it filed in December. In the wacky world of bankruptcy, just as in real life, misery loves company. With a "new kid on the block," the focus of national ire related to massive corporate fraud may shift—partly, or temporarily—away from Enron.

But Enron's worries, or, more accurately, the worries of Enron's former executives, are far from over. In August, federal prosecutors persuaded Michael Kopper, a former Enron executive, to plead guilty to at least two felonies, which means that eyes have turned to his superiors: Kenneth Lay, the energy-trading giant's former chairman; Jeffrey Skilling, its former chief executive; and Andrew Fastow, its former chief financial officer.2 Fastow was charged on Oct. 2, 2002, with securities, wire and mail fraud, money laundering and conspiring to inflate Enron's profits and enrich himself at the company's expense.3

Lower-level employees also are finding themselves called on the carpet for corporate fraud. In September 2002 David Myers, former WorldCom controller, pleaded guilty to securities fraud charges...saying he was instructed by "senior management" to falsify records in what became the largest corporate accounting scandal in U.S. history.4 "I combined with assist in the commission of fraud," said the former executive.5

The Enron and WorldCom scandals may be the biggest, but they are not the only examples of the corporate malfeasance of the late '90s. Earlier this year, Global Crossing filed for bankruptcy protection, later facing accusations that it used sham transactions to increase revenue and that it misled investors about its financial health. The accusations include dishonest accounting, fraudulent swapping of assets and liabilities, and the enrichment of top executives as lower-level employees lost millions.6

Another chapter 11 corporation facing serious charges is Adelphia Communications. A federal prosecutor recently stated in filing a 24-count fraud indictment that seeks to recover $2.5 billion that the Rigas family created a towering facade of false success and lined their pockets with shareholder dollars. The action came two months after the family members were arrested at their apartment and accused of running the nation's sixth-biggest cable TV company like a personal piggy bank.7 "The defendants used many of the most sophisticated tricks in the corporate fraud playbook," said U.S. Attorney James Comey, who called the alleged scheme "one of the most elaborate and extensive corporate frauds in U.S. history. There have been plenty of contenders for that unwelcome distinction lately amid a flood of massive corporate scandals...but the Adelphia indictment is full of colorful detail and impressive scale."8

In the Corporate Food Chain, How Low Do You Go?

Enron, WorldCom, Global Crossing and Adelphia are headline-grabbers because of their size. Most corporate fraud never makes the news. If corporations being used as tools of fraud were a disease, we would have an epidemic. But corporations act only through the persons controlling them. Therefore, when seeking to hold individual persons financially responsible for the damages caused through their corporation when they knowingly participated in a fraud, just how far do you drill down the well of corporate bad actors? There is little debate when dealing with officers and directors.9 But the waters become murky when seeking to hold high- or middle-managers liable, and murkier still when rank-and-file employees become the target. Nevertheless, not only do Americans want all persons who knowingly participate in the perpetration of a fraud through a corporation to be personally liable for the damage caused, but they also want that liability to be non-dischargeable in chapter 7 bankruptcy.10

In the past, assigning personal liability for the frauds of the corporation has centered on (1) principals—corporate officers and directors who orchestrated, or at least had knowledge of, the fraud,11 and (2) employees of the corporation who breached a specific duty or duties owed to the corporation, such as a breach of fiduciary duty, of the duty of good faith and fair dealing, of loyalty, trust, confidence and the like. With respect to employees, this "duty-based" liability is direct liability, where the employee is held responsible for her own actions (i.e., breaches) in relation to her own duties. Another way to hold an employee liable is indirectly. This can be accomplished through aiding and abetting law, where the employee aids, abets or assists another person in his breach of a duty.

The Trickle-down Duty of Loyalty: The Duty to Act Responsibly

American Jurisprudence, 2d, Employment Relationship, §216, defines an employee's duty to an employer as follows:

In addition to any duties expressly imposed upon or undertaken by an employee in the contract of employment, an employee has duties and obligations to the employer which are implied by law... The law imposes an obligation on employees to perform their employment duties in good faith and to obey all reasonable rules, orders and instructions of the employer. An employee has an implied duty to act solely for the benefit of the employer in all matters within the scope of the employee's employment, avoiding conflicts between the employee's duty to the employer and the employee's self-interest. An employee must not engage in acts which could injure the employer's business or financial interests.12

Additionally, §387 of the Restatement (2d) of Agency provides that "[u]nless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of the principal in all matters connected with his agency."13 Comment "b" to §387 states in relevant part, "[the agent's] duties of loyalty to the interests of his principal are the same as those of a trustee to his beneficiaries."14

Courts have applied the Restatement's agency principles to define an employee's duty of loyalty to his or her employer. See, e.g., AGA Aktiebolag v. ABA Optical Corp., 441 F.Supp 747, 754 (E.D.N.Y. 1977) (holding employee owes a fiduciary duty to employer and is prohibited from acting in any manner inconsistent with the agency in any manner during his or her employment, and the employee is bound at all times to exercise the utmost good faith and loyalty in the performance of his duties); Las Luminarias of New Mexico Council of the Blind v. Isengard, 587 P.2d 444, 449 (N.M. Ct. App. 1978) (holding employment relationship is one of trust and confidence; employee has duty to use best efforts on behalf of employer); Maryland Metals Inc. v. Metzner, 282 A.2d 564, 568 (Md. Ct. App. 1978) (holding duty of employee to act solely for the benefit of employer in all matters within the scope of employment); Chelsea Industries Inc. v. Gaffney, 449 N.E. 2d 320, 326 (Mass. Ct. App. 1983) (holding that employee occupying position of trust and confidence is bound to act for employer's benefit in all matters within scope of employment).

Moreover, the duty of loyalty does not extend merely to officers and directors of corporations: "One standing in a fiduciary relation with another is subject to liability to the other for harm resulting from a breach of duty imposed by the relation." Restatement (Second) of Torts §874 (1977). Under Arizona law, for example, an employee owes a fiduciary duty to her employer. See Mohave Electric Cooperative Inc. v. Byers, 942 P.2d 451, 189 Ariz. 292 (Ariz. Ct. App. 1997) (holding that general manager and assistant general manager had fiduciary duties to employer electric company); See, also, McCallister Co. v. Kastella, 825 P.2d 980, 982 (Ariz. Ct. App. 1992)(citing the Restatement (Second) of Agency, holding that employee owes his employer a fiduciary duty: "[I]n Arizona, an employee/agent owes his or her employer/principal a fiduciary duty"). See, also, Graphic Directions Inc. v. Bush, 862 P.2d 1020, 1022-23 (Colo. Ct. App. 1993) (holding that fiduciary duty extends to more than corporate officers and other high-echelon employees); Cenla Physical Therapy & Rehabilitation Agency Inc. v. Lavergne, 657 So. 2d 175, 176-77 (La. Ct. App. 1995) (holding that "merely minor role-playing employees" have fiduciary duties to employers).

Lower-level Employee Liability for Acting Irresponsibly

But the liability of an employee may also be imposed indirectly, through the law of aiding and abetting. "A person who knowingly assists a fiduciary in committing a breach of trust is himself guilty of tortuous conduct and is subject to liability for the harm thereby caused." Restatement (Second) of Torts §874 (1977), cmt. C; see, also, Sovereign Partners v. Lascu, 179 B.R. 656, 662 (D. Nev. 1995) (holding that to establish the tort of "assisting in the violation of a fiduciary duty," a plaintiff must prove (1) the breach of a fiduciary duty, (2) that the defendant knowingly induced or participated in the breach, and (3) that the plaintiff suffered damages as a result). A person may be held liable for harm resulting to a third person from the tortuous conduct of another if he or she knowingly gives assistance or encouragement to the person committing that breach of duty. See Restatement (Second) of Torts, §876(b)(1977); Gemstar Limited v. Ernst & Young, 185 Ariz. 493, 498 n.1, 917 P.2d 222, 227 n.1 (Ariz. 1996) (upholding $1.5 million jury award based in part on a substantial assistance of breach of fiduciary duty claim, which was based on §876(b) of the Restatement (Second) of Torts).

Any employee of any corporation may be pressed into service as part of a fraudulent scheme. So where should the personal liability really end? With a high- or middle-manager? With a "key employee"? High-level employee? Supervisor? Executive secretary? Administrative assistant? At the end of the day, these terms are of little use because any one of them may signify a different level of responsibility (and corresponding knowledge) from corporation to corporation, or may even signify a different level of responsibility at a single corporation from time to time. All of the foregoing approaches are remedial in nature, seeking to apportion liability based on status or through the duty/breach paradigm. The problem with these approaches is that by the time we get around to employing them, the resulting judgment may never be satisfied.

A new test, with clearer application, must be fashioned. Instead of a status-based test or a "which duty did you breach" test, there should be a new, two-part test used in the corporate fraud context—the "scienteractus" test, i.e., "First, did you know that your actions were necessary for perpetration of a fraudulent scheme, and second, with that knowledge, what did you cause to be done to stop or hinder the scheme?"

The Prisoner's Dilemma and a Proposal for a New Standard: Speak Up or Get Out, or Become Personally Liable for the Harm Caused by Your Corporation's Fraud

Employees who find themselves in this situation face a modified prisoner's dilemma. If they say nothing, they may remain unscathed because the fraud may never be discovered, or because when it is uncovered there will be no factual and/or legal basis to impose liability upon them.

However, they may be found to have breached a duty and thereby become personally liable as a result. The prisoner's dilemma in the context of a corporation's ongoing commission of a fraud is this: If you speak out against your superior who is instructing you to participate in fraud, you may suffer the consequences, including losing your job and potential legal exposure. If you speak out publicly, and are wrong about the fraud, you will suffer the consequence again of losing your job and the possibility of a legal action for slander.

But there is a third option. If, because of the nature of the situation, the employee feels she cannot speak out to corporate officers and directors, and also cannot speak out publicly, then there exists only one duty. In the context of the old saying, "Lead, follow or get out of the way," there appears to be only one alternative to avoid being implicated in a fraud these days: The duty to get out. Walk away. Quit.


1 Certified in business bankruptcy by the state of Arizona. Return to article

2 "Enron and the Economics of Greed: Enron's Prosecutors Wonder Whether Greed Is Worse than Lying," The Economist Newspaper Ltd., Aug. 31, 2002. Return to article

3 Babineck, Mark, "Ex-Enron CFO Fastow Charged in Fraud," Associated Press Online, Oct. 2, 2002. Return to article

4 Barrett, Devlin, "Former WorldCom Exec Admits Guilt, Associated Press Online," Sept. 27, 2002. Return to article

5 Id. Return to article

6 Oppel Jr., Richard A., "House Panel's Investigation of Global Crossing Is Started," New York Times, Section C, March 13, 2000. Return to article

7 Berkowitz, Harry, "Adelphia Founder Indicted for Fraud," Centre Daily Times, Sept. 24, 2002. Return to article

8 Id. Return to article

9 "An officer or director of a corporation is generally insulated from personal liability for actions performed in the scope of his duties for the corporation. Without piercing the corporate veil, a corporate officer or director may, nonetheless, be personally liable for the corporation's tortious conduct, even though he is acting for the benefit of the corporation, if he knowingly participates in a tortious or fraudulent act of the corporation. Participation in a tortious act of the corporation will render the officer or director personally liable, while mere participation in a breach of a corporate contractual obligation will not. 'Participation' has been defined to include instigating, aiding or abetting the corporation's tortious conduct." Rowley, Keith A., "The Sky Is Still Blue in Texas: State Law Alternatives to Federal Securities Remedies," Baylor Law Review, Winter 1998, at pp. 192-93. "An officer or director may also be personally liable for the corporation's tortious actions if he had actual or constructive knowledge of the wrongful acts." Id. Return to article

10 "The Corporate and Criminal Fraud Accountability Act of 2002, signed into law on July 30, [2002], added a new exception to discharge—§523(a)(19). The new subsection makes an individual debtor's debt non-dischargeable if it was incurred in violation of securities fraud laws." "Corporate Scandals Spawn Bankruptcy Code Amendment," Bankruptcy Court Decisions: Weekly News & Comment, (LRP), Vol 38, No. 3, at A4 (Aug. 13, 2002). "Specifically, a debt will not be discharged if it is a debt that arises under a claim relating to the violation of any of the federal securities laws, any state securities laws or regulations issued thereunder. It will also not be discharged if it involves common law fraud, deceit or manipulation in connection with the purchase or sale of any security. To be non-dischargeable, a debt must result, in relation to one of the aforementioned claims, from any order entered in a federal or state proceeding, any settlement entered into by the debtor, or any order for damages, penalty or other payment owed by the debtor." Id. Return to article

11 Officers and directors "may be held personally accountable for actions taken outside of the scope of their agency authority, for the commission of any torts, and for failure to fulfill their fiduciary duties to the corporation and shareholders." Muir, Dana M., and Schipani, Cindy A."The Intersection of State Corporation Law and Employee Compensation Programs: Is It Curtains for Veil Piercing?" 1996 U. Ill. L. Rev. 1059, P.1077. For an excellent collection of cases related to officer/director liability, see Id. footnotes 155-158. Return to article

12 27 Am. Jur. 2d, Employment Relationship §216 (2nd e. 1996) (citations omitted) (emphasis added). Return to article

13 Restatement (Second) of Agency §387 (1958). Return to article

14 Restatement (Second) of Agency §387 cmt. B (1958). Return to article

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Friday, November 1, 2002