Some Thoughts on the Porous Boundary between Ordinary and Extraordinary Corporate Fraud (Book Review of Ensuring Corporate Misconduct by Tom Baker and Sean J. Griffith, 2010)

Abstract

This is a book review of Tom Baker and Sean Griffith’s 'Ensuring Corporate Misconduct'. Their book provides an exhaustive and illuminating analysis of how corporations contract for director and officer (D&O) liability insurance. Based on extensive interviews with insurance carriers and corporate risk officers, Baker and Griffith conclude that D&O liability insurance has created a moral hazard within the public corporation. Managers, who have incentives to take advantage of shareholders, are inadequately deterred by civil liability for securities fraud because D&O insurance effective shields them from any payout. Accordingly, Baker and Griffith argue for reforms that would reduce this moral hazard.

Baker and Griffith’s arguments are persuasive and should make any reader think twice about the value of D&O insurance. Their critique, however, seems to make light of the fact that corporate fraud can trigger criminal investigations, and ultimately criminal penalties for individuals who engage in or conspire to commit fraud. Although the authors agree that D&O insurance provides no protection against criminal penalties and investigations, they nevertheless presume that much of the conduct that gives rise to civil securities fraud litigation (so-called “ordinary fraud”) is unlikely to trigger criminal and public enforcement proceedings. This Review questions whether there in fact exists such a distinct boundary between “ordinary” and “extraordinary” corporate frauds. To the contrary, one would expect the rational corporate officer to be wary that any fraud case might trigger an investigation by public enforcers. If that is the case, then the porous boundary between criminal and civil fraud may lessen Baker and Griffith’s rightful concerns about moral hazard. With these thoughts in mind, the Review then addresses several of Baker and Griffith’s proposed reforms.

Keywords: corporations, agency costs, securities fraud, insurance, deterrence