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What If Companies Fessed Up?


When companies settle big lawsuits, they rarely own up to having done anything wrong. Instead, officers sign a carefully worded legal document in which the corporation neither admits nor denies misconduct. This vague language paves the way for the charade of CEOs spending hundreds of millions of dollars to make regulators and plaintiffs' lawyers go away -- then holding press conferences in which they suggest that, despite the enormous payoff, the company was victimized by overzealous opponents.

Massachusetts Secretary of the Commonwealth William F. Galvin wants to put an end to this now-familiar legal fiction. He's calling on fellow regulators to forgo the "neither admit nor deny" language in cases of clear fraud and strike tougher deals in which companies are forced to admit that they engaged in unlawful conduct. That's just what he did in the fall with Franklin Templeton Investments (BEN) and last April with Putnam Investments (MMC) -- two mutual-fund companies that allowed privileged investors to make rapid-fire trades that worked to the disadvantage of long-term stakeholders.

This is a potentially revolutionary idea. For companies, the difference between admitting misconduct and fudging the issue is vast. If more regulators start following Galvin's lead, it would be easier for plaintiffs' lawyers to win fraud lawsuits. Insurers might balk at providing coverage for directors and officers. And managers at the periphery of illegal activity would have a harder time holding on to their jobs.

REFORMIST IMPULSE

Galvin's goal is to inflict a punishment that truly stings -- unlike monetary fines, which can be a fraction of illicit profits and thus can easily be waved off by aggressive execs as a cost of doing business. It's the same reformist impulse that earlier this month motivated New York State Comptroller Alan G. Hevesi, trustee of the New York State Common Retirement Fund, the lead plaintiff in an investor lawsuit against WorldCom Inc. (MCIP), to insist that the company's directors use personal funds to settle the case. "How seriously are you going to take securities law if it's going to be a game of touch football?" says Galvin. "The only way you're going to get significant change is when you start treating things seriously -- and an admission of guilt is serious."

The Securities & Exchange Commission is now studying whether it should press harder for companies to acknowledge wrongdoing. Commissioner Harvey J. Goldschmid expects the five SEC commissioners to discuss the issue by March. But while Goldschmid is no fan of the current system, he worries that corporate defendants would fight far more aggressively if they were routinely forced to acknowledge breaking the law. That in turn would drive up the cost of investigations and limit the agency, which brought 639 cases in the last fiscal year, to pursuing a fraction as many of them. If the SEC had to push for broad admissions, "it would be a terrible waste of government resources," says Goldschmid. "We'd have to go to trial. The stakes would be so large."

Indeed, the whole cost-benefit calculation for most corporate fraud cases would change if regulators ceased allowing defendants to dodge liability. Under long-standing legal rules, admissions made in governmental proceedings can be entered as evidence in private litigation. This reduces the burden of proof for plaintiffs' lawyers -- and in some cases would render companies essentially defenseless as to their underlying liability in related cases. "It's a road map for private lawsuits," says Joel Seligman, dean of the Washington University School of Law in St. Louis.

READ THE FINE PRINT

In the Putnam and Franklin cases, the degree to which their admissions will help cheated customers is unclear. Despite Galvin's claims about his innovative settlements, both deals contain fine print intended to make it harder for plaintiffs' lawyers to use the confessions in court. Specifically, there are clauses stating that the admissions are solely for the purpose of settlement in the Massachusetts cases. Still, this language does not provide the companies with ironclad protection, according to John P. Freeman, a professor at the University of South Carolina School of Law.

Above and beyond liability, an equally important concern for companies is insurance. Typical directors and officers (D&O) policies cover some regulatory fines, private settlements, and legal defense costs. But they also contain exceptions for executives who commit crimes or frauds. While insurers are usually willing to pay up in the typical case in which executives avoid a finding of liability, they would have a good argument for withholding payment from managers who acknowledged that they violated the law.

Thus, the consequences of admitting wrongdoing can be severe. But Galvin and others insist the fallout is nothing more than defendants deserve. What's more, the potential benefits of corporate admissions might in some cases outweigh the costs of obtaining them. For one thing, they would put more pressure on boards and top managers to clean house. More important, they would send a clear signal to employees that malfeasance is unacceptable -- a message that is all too often undermined when the CEO fails to acknowledge that anybody has done anything illegal. Coming after an era of unprecedented corporate crime, such candor might be a welcome change.

By Adrienne Carter in Chicago, with Amy Borrus in Washington


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