Definition and Structures of Corporate Liability

Corporate liability is the liability of one party (the firm) for the misconduct of another party (the employee). Corporate liability can assume different forms ranging from vicarious liability to some forms of duty-based liability. Vicarious liability is a strict (absolute) form of secondary liability that arises under the legal doctrine of respondeat superior, that is the common law doctrine of agency for which a party (the principal) is responsible for the acts committed (within the scope of employment) by its agents that has the legal right or duty to control. Duty-based liability regimes are forms of secondary liability where the principal is held liable for the misconduct of the agent only if he contravenes a legal duty – that is, if he does not observe due care in preventing or reporting a violation. There may also be mixed regimes under which firms are liable, but the level of sanctions depends on whether the corporation fulfilled its policy responsibilities.

Besides being vicarious or duty-based, corporate liability may be civil or criminal. This entry addresses the theoretical reasons for corporate criminal liability by discussing the following three issues:

  1. (i)

    Under what conditions it is optimal to impose sanctions also on the firm (principal) rather than only on the employee (agents) who misbehaved, namely, why there should be joint individual and corporate liability?

  2. (ii)

    Which form of corporate liability, vicarious versus duty-based, is socially optimal?

  3. (iii)

    Whether the socially optimal corporate liability should be criminal or not. We then briefly discuss the corporate liability in the USA and Europe.

The Need of Joint Individual and Corporate Liability

To understand the optimal deterrence of corporate crimes, it is useful to keep in mind that such crimes are crimes committed by individuals working for firms, i.e., they are crimes committed in presence of an agency relationship between the firm and the employee. However, the starting point of the analysis is represented by the results of the classic model of individual criminal liability in absence of corporations when individuals are risk neutral and are not wealth constrained and sanctioning costs are zero (Becker 1968; Polinsky and Shavell 2000). As individuals will commit a crime only when the expected benefit exceeds the expected cost, the socially optimal level of deterrence requires that the state imposes a criminal fine equal to the ratio between the social cost of crime to society and the probability of crime being detected. This result also holds when the probability of detection depends on the enforcement expenditure with the caveat that the optimal deterrence scheme involves minimizing enforcement costs, which means that the probability of crime detection is at its lower bound. The analysis for unintentional crimes leads basically to same results as the state will induce the optimal individual’s level of effort to avoid the crime by choosing a sanction scheme that equalizes the expected sanction to the social cost of crime.

Once we introduce corporations into the analysis, the first issue to be addressed is whether corporate liability is necessary to optimally prevent corporate crimes. Let us begin considering a framework without imperfections, i.e., a world where the following conditions are satisfied:

  1. 1.

    Firms and employees have no wealth constraints.

  2. 2.

    There is a positive probability that the state sanctions a crime even without spending resources on enforcement.

  3. 3.

    There are no costs on imposing sanctions.

  4. 4.

    All parties are rational and there is perfect information.

  5. 5.

    Firms and employees can contract at zero cost.

In this perfect world, there is no justification for joint individual and corporate liability because crime can be optimally deterred by imposing the liability on either the individual or the firm at the same social and private costs. As the state is indifferent between individual and corporate liability (i.e., the two forms of liability are complete substitute in this framework), this result is known in the literature as the neutrality principle (Kornhauser 1982; Sykes 1984; Polinsky and Shavell 1993).

The assumptions on which the neutrality principle is based are very strong and are generally not satisfied in reality. This opens the way for an important role played by corporate liability. In particular, it is immediate that the state cannot optimally deter corporate crime using individual liability and monetary sanctions because employees do not generally have sufficient assets to pay the sanctions; corporate crimes often generate large social costs (see, e.g., the case of financial and consumer frauds), and the probability of sanction for such kind of crimes tends to be low, especially in absence of significant expenditures on enforcement. Again, while imprisonment can increase the level of sanctions imposed on the wealth constrained individuals, this is unlikely to make individual liability alone sufficient to deter corporate crime for the following reasons:

  1. (a)

    The maximal punishment, i.e., life imprisonment, is likely to imply a limited duration of this penalty given that corporate wrongdoers tend to be relatively old.

  2. (b)

    Imposing long prison sentences for nonviolent crimes, such as corporate crimes, may not be possible because this reduces the room of appropriate sanctions for violent criminal offences.

  3. (c)

    Imprisonment entails very large costs to society both because of the standard reasons associated to the detention of individuals (e.g., removal of productive individuals from the labor market, expenditures for guards, protective services, and equipment) and the losses suffered by risk-averse agents who face the risk of being liable also when they have not committed the crime.

Another important reason behind the failure of the neutrality principle and the need of corporate liability is related to the complexity of corporate crime as such crimes may involve many individuals and determining those responsible for the wrongdoings is often a difficult task. This means that optimal deterrence requires that both the state and the firm spend resources on prevention and enforcement. In particular, the firm can play an important role in deterring corporate crimes by:

  1. (i)

    Adopting measures of crime prevention that reduce the incentives to commit a crime; this can be made by adopting policies, such as those related to compensation and promotion that influence the extent to which the employee benefits from the crime (e.g., firms may limit the adoption of high-powered short-run compensation policies who generally provide an incentive to managers to commit crimes; Arlen and Carney 1992); corporations can also make committing crime more costly by promoting a culture of legal compliance within the firm so to increase the likelihood that employees report suspect wrongdoings or that wrongdoers bear higher direct psychological costs (Conley and O’Barr 1997; Tyler and Blader 2005).

  2. (ii)

    Implementing policing measures that increase the probability of crime detection and conviction; this can be done ex ante through the adoption of compliance (monitoring) programs that allows the firm to detect crime and to collect evidence on wrongdoers more easily and ex post (i.e., after the crime is committed) by reporting detected crimes and by cooperating with the authorities to investigate the crime (Arlen 1994; Arlen and Kraakman 1997).

In sum, corporate crimes are committed in presence of an agency relationship between the firm and the employee and optimal deterrence needs to take into account that the firm has a comparative advantage in the collection of information relative to the state. Therefore, optimal deterrence of corporate crimes requires that the state not only has to invest optimally in enforcement and to impose the optimal sanctions on individuals but also has to provide the optimal incentives to firms to undertake policies of prevention and policies. In other words, corporate liability is essential (Arlen and Kraakman 1997; Arlen 2012). Of course, there are many factors affecting the decision of the firm to prevent crimes for a given structure of corporate liability; for example, variables such as the firm’s size, its productivity, and its market power as well as the profitability of illegal activities end up being important determinants of whether (and how) the firm prevents manager wrongdoings (Polidori and Teobaldelli 2016).

Individual liability in presence of corporate liability, and therefore the joint liability, is necessary because under various circumstances, the firm may be unable (or find it not optimal) to impose the optimal level of sanctions on employees. One of these situations, especially relevant for closely held firms and smaller publicly held firms, is when the firm has insufficient asset to pay the optimal corporate sanction. In this case the firm may find it optimal to impose a suboptimal level of sanctions to the employees (Kornhauser 1982; Kraakman 1984; Sykes 1984); moreover, pure corporate liability is likely to create other kind of distortions as managers have the incentive to keep the firm undercapitalized. In larger publicly held firms, individual liability is necessary because of the agency problems characterizing these firms where there is a separation of ownership and control. Large corporations may be unable to impose the optimal level on sanctions to their employee because managers can often influence the decisions of the board of directors, directly or by controlling the information available to the board (Arlen and Carney 1992). In all these cases, individual liability ensures that the state can impose larger (monetary and nonmonetary) sanctions than the firm to the employee responsible of the wrongdoer and improve social welfare (Segerson and Tietenberg 1992; Polinsky and Shavell 1993).

Vicarious Versus Duty-Based Liability

The optimal structure of corporate liability requires that the firm deters crime by adopting measures of crime prevention and by undertaking policing activities at the optimal level. This result cannot be obtained under vicarious liability because the activities of prevention and policing generate a liability enhancement effect, namely, an increase of the firm’s expected liability for the crimes that the firm does not deter (or that cannot be deterred), which reduces the firm’s incentive to pursue such polices. Indeed, under strict liability, the activities of crime prevention (such as the adoption of monitoring programs) increase the probability that crimes will be detected and the firm sanctioned (Arlen 1994); similarly, the ex post policing (self-reporting and cooperation with the authorities) may reduce crime ex ante, but it increases the probability that committed crimes are sanctioned so that the net effect on the firm’s expected sanctions may well be positive (Arlen and Kraakman 1997).

While strict corporate liability may provide to the firm too little incentive for measures of prevention and policing, a multitiered duty-based sanction regime may overcome this problem and induce the firm to monitor and police optimally (Arlen 2012). More precisely, the state should induce the firm to:

  1. (i)

    Employ crime-preventing measures by imposing a penalty if it has not monitored optimally (e.g., it has not adopted appropriate monitoring programs); the penalty can be avoided by the firm choosing the optimal monitoring.

  2. (ii)

    Engage in ex post policing by imposing additional sanctions that can be avoided if the firm self-report the crime and fully cooperate with the authorities to convict the wrongdoers.

Although some authors (e.g., Weissmann 2007) argue that the firm should not be liable if it prevents and police optimally, others argue that the optimal structure of corporate liability also requires that the state imposes a residual strict corporate liability. This residual liability (that should be civil, not criminal) is required to eventually impose additional sanctions equalizing the firm’s expected sanction, net of the costs beard by the firm through market sanction, to the total social cost of crime (Polinsky and Shavell 1993; Shavell 1997; Arlen and Kraakman 1997). The main market sanction is generally represented by the reputational penalties which reflect the greater difficulty of criminal firms in contracting with other parties on favorable terms; the market’s anticipation that the firm will produce lower profits – owing to either higher costs or lower revenues – may lead to a reduction in the firm’s value (Klein and Leffler 1981; Karpoff and Lott 1993).

The works on reputational penalties suggest there are large variations in the size of these penalties depending on the type of crime. In particular, parties contracting with the firm will react negatively to news that the firm committed crimes if those crimes (such as fraud) harm them or other contracting parties; however, theory also suggests that firms should not be punished by the market for crimes committed by noncontracting third parties as may occur in cases of regulatory or environmental violation (Karpoff and Lott 1993; Alexander 1999). The available empirical evidence provides support to these theoretical arguments (Karpoff et al. 2005, 2017). Higher reputational penalties clearly provide an incentive to the firm to prevent crime, and this effect is likely to be larger when the firm operates in more competitive markets (Polidori and Teobaldelli 2016).

Civil Versus Criminal Corporate Liability

The doctrine of corporate criminal liability is controversial for various reasons. One of these reasons is the conceptual difficulty of imposing criminal liability on a corporation, an artificial and collective entity, given that criminal liability requires a culpable mental state or mens rea (Alexander 1999; Hamdani and Klement 2008). At the same time, one of the main advantages of the criminal law system, that is, the sanction of incarceration as a punishment, is unavailable against enterprises as these are not physical entities and, therefore, cannot be imprisoned (Khanna 1996; Fischel and Sykes 1996). This consideration leads to the second critical issue concerning the rationale for imposing criminal liability on a corporation given that the criminal and civil corporate sanctions are quite similar in nature (as they are mainly monetary) and can have the same magnitude.

Despite the similarity between corporate criminal and civil liability, they differ along some dimensions. First, there are important procedural differences; criminal cases require a higher burden of proof for the conviction of the wrongdoers, but the authorities have more powerful tools of investigation. Second, whereas corporate criminal and civil liability share the form of monetary sanctions, those levied for criminal behavior are much stronger and can lead to enormous collateral sanctions (e.g., debarment and de-licensing); furthermore, criminal sanctions are not only higher than civil penalties but can also be imposed in addition to them. Third, criminal sanctions are generally associated with much larger reputational losses than civil penalties.

The key distinctive feature of criminal liability of imposing larger sanctions on convicted firms may allow the state to structure a multitiered duty-based liability that induces the firm to prevent and police optimally more efficiently than a pure civil liability regime. However, criminal penalties may also create the risk of overdeterrence of crimes which in case of corporate crimes may have important negative effects on social welfare. Therefore, a well-structured duty-based liability is essential to produce socially efficient outcomes.

Corporate Criminal Liability in the United States and in Europe

Corporate criminal enforcement in the United States is characterized by joint individual and corporate criminal liability for business crimes and firms are formally subject to a strict de jure liability regime for employees’ crimes. However, criminal liability is de facto duty-based as firms can avoid indictment if they self-report wrongdoing and cooperate with government authorities to convict individual wrongdoers. This Department of Justice policy was initiated in 1999 by Eric Holder (then the US Deputy Attorney General) who issued guidelines to federal prosecutors on when firms should be indicted for employees’ crimes committed during the scope of their employment. The Holder memo encouraged prosecutors not to indict firms for employee crimes if they adopted compliance programs, self-reported the wrongdoings, and fully cooperated with the federal authorities. In the existing regime firms that report and cooperate are still subject to some form of expected monetary sanction; prosecutors impose both monetary and nonmonetary sanctions by means of deferred prosecution and non-prosecution agreements (DPAs and NPAs, respectively). These agreements often impose also nonmonetary performance mandates on the firm; for example, they may require the firm to adopt prosecutor-approved compliance programs or to appoint an outside corporate monitor who reports to federal authorities (Garrett 2007; Arlen and Kahan 2017). Arlen (2012, p. 152) concludes that US enforcement practice is consistent with the optimal level of corporate liability.

Even though formal conditions governing leniency are quite broad and could apply to all firms, large and publicly held firms typically avoid formal conviction (by way of DPAs and NPAs), whereas small owner-managed, closely held firms are usually convicted (Arlen 2012). The most likely reason for this difference is that cooperation with prosecutors is the key element determining whether prosecution is avoided or not, and closely held firms tend to cooperate less because they are inclined to protect their owner/managers. In contrast, in large publicly held firms, the owners are rarely directly involved in day-to-day management, and decisions to cooperate with the authorities are often delegated to outside directors who have strong incentives to cooperate in return for leniency.

At the European Union level, after a number of harmonization efforts, there is a general trend in almost all the Member States toward the adoption of corporate criminal liability regimes. With the exception of the UK and the Netherlands, where there is a long history of recognizing corporate criminal liability, the concept of corporate criminal liability is relatively recent in Europe. The first European country that introduced corporate criminal liability was France in 1994, followed by Finland in 1995, Denmark in 1996, Belgium in 1999, Italy in 2001, Poland in 2003, Austria in 2005, Romania in 2006, Portugal in 2007, Luxembourg and Spain in 2010, Czech Republic in 2012, and Slovakia in 2016. Germany represents a remarkable exception, since corporate criminal liability is considered incompatible with the essence of German criminal law based on the notion of individual culpability; however, in late 2013, the Department of Justice of North Rhine-Westphalia presented a first draft of a Corporate Penal Code, although this remained under discussion (Clifford Chance 2016).

Despite harmonization efforts, relevant differences still exist between the Member States, due to different legal tradition and, also, to different approaches followed in the implementation of the proposed EU legislation. While most countries applied criminal procedure rules, others have imposed quasi-criminal administrative liability regimes. In some jurisdictions, the category of employees which can activate corporate liability is restricted to those with management responsibilities, and the employee’s misconduct must be done in the interests of or for the benefit of the company. Similarly to the USA, also at the EU level, a common feature characterizing the legal framework is the possibility for the corporation to have a reduction of the potential penalties in case of adoption of adequate compliance systems to prevent the crime and of cooperation with the authorities. While penalties vary across countries, many of them complement the standard monetary sanctions with nonmonetary sanctions such as judicial supervision of a corporation’s affairs, exclusion from public procurement tenders, limitations on the use of checks and credit, confiscation of assets gained from the offence, posting of notices throughout the media, publication of the judgment in a registry, and even the dissolution of the corporation, in the most severe cases (Sun Beale and Safwat 2004).