Criminal Liability of Managers in Europe

Punishing Excessive Risk

Stanislaw Tosza

• Publisher: Hart Publishing
• Year: 2018
• Print ISBN:
  9781509944958
• Edition: 1
• eBook ISBN:
  9781509914982
• Topic: Law
• Subtopic: Criminal Law
• Index: Law

Every managerial decision is risky, at least to some extent. Conducting business is impossible without venturing into new territories and even the most ordinary daily choices could turn out to be failures. Excessive risk, however, can be very detrimental as was starkly illustrated by the most recent financial crisis. By criminalising managers' excessive risk-taking criminal law enters a sphere which is at the core of the activity it affects. At the same time it provides for criminal punishment for courses of conduct that, without doubt, can be extremely harmful. The objective of this book is to examine existing criminalisation of excessive risk-taking as well as to analyse whether such criminalisation is desirable and if yes, under which conditions.

1

Introduction

In the first weeks of January 2008, a trader of the Société Générale Jérôme Kerviel caused losses amounting to approximately €4.9 billion and almost brought one of the most important French banks to bankruptcy. This was the last act of otherwise very successful, however highly risky, strain of transactions spanning between 2005–2007. Kerviel’s task was to bet on market tendencies in such a way that while he put the money on a certain trend, he would also bet on its opposite (a technique called hedging). In theory these investments should bring the same amount of win and loss, but market inefficiencies result in small differences from which one can make the profit if one invests huge sums of money. The mechanism entailed low risk, but the wins were also limited. In order to increase the wins, Kerviel stopped hedging his transactions, which he concealed from the bank by introducing fictitious transactions into the bank computer system. These transactions allowed him to make enormous profit, but at the same time exposed the bank to very high risk of loss and breached applicable regulations.¹ Although some red flags were waved he was not caught until his last – unsuccessful – bet.² Kerviel assumed that the financial crisis, which was unravelling at the time, would be just a temporary turbulence and that the market would soon start to recover. As this was not the case, the bet resulted in a huge loss, and eventually in a criminal conviction for Kerviel.³

Every managerial decision is risky, at least to some extent. Conducting business is impossible without venturing into new territories and even the most ordinary daily choices could end in failure. Excessive risk, however, can be very detrimental, as we were grimly reminded by the most recent financial crisis. It could bring large and reputable companies or even whole economic systems to the brink of collapse. By criminalising managers’ excessive risk-taking criminal law enters a sphere which is at the core of the activity it affects. At the same time, it provides for criminal punishment for courses of conduct which, without doubt, can be extremely harmful. The objective of this book is to examine existing criminalisation of excessive risk-taking, as well as to analyse whether such criminalisation is desirable, and if so, under which conditions.

The Kerviel case illustrates crucial issues which will be at the centre of the reflection in this book. In the first place, it shows the gravity of excessive risk-taking. Each of the unhedged bets was excessively risky and could potentially damage the bank significantly. In this sense, all of these transactions deserved a sanction in the same way as the last one, which turned out to be unlucky. Would (and should) Kerviel have been punished, had he been caught when still on a winning streak? Secondly, Kerviel did not take any money for himself. All the profits he generated over the years were for the Société Générale only. His only motivation was a sort of star status he acquired within the bank and the bonus calculated in view of his performance. Is it fair to require such motivation from a manager and punish him for it only when things go wrong?

1.Financial Crisis and Excessive Risk

The Kerviel case is a good exemplification of an excessively risky rogue trader. However, the problem is not limited to cases of ‘black sheep’. The detrimental character of excessively risky policies led to the collapse of such banks as the Royal Bank of Scotland in the United Kingdom and Hypo Real Estate in Germany, which then needed to be nationalised, engaging large sums of public money.⁴ John J Mack, the CEO of Morgan Stanley at the time when the financial crisis of 2007–2008 started, explained that what triggered the financial crisis was that:

In retrospect, many firms … took on too much risk and did not have sufficient resources to manage those risks effectively in a rapidly changing environment.⁵

It is an almost universal opinion that the essential cause of the crisis was ‘the combination of a credit boom and a housing bubble’,⁶ in particular linked with extending credit to borrowers, whose credit ratings were low.⁷ This was coupled with financial market innovation and the practice of rating agencies of granting excellent ratings to financial assets based on underlying credit claims, turning them into very attractive investments in view of their risk-return profiles.⁸

While the crisis began in the United States with the collapse of the Lehman Brothers Bank, it spilled into Europe as European banks had also invested intensively in the American mortgage market. Moreover, European markets and institutions were affected by distressed financial markets in the United States and the resulting limited access to capital.⁹ This evolved into a sovereign debt crisis due to the costs of the efforts of governments to rescue systemically important financial institutions together with already existing high government debts and in view of the deterioration of the lending climate in general.¹⁰

When discussing the causes of the financial crisis, excessive risk-taking is mentioned in various contexts, which include external market factors and internal business culture factors. The following reasons were named: imprudent mortgage lending;¹¹ amassing of vast highly correlated housing risks;¹² problems regarding sophisticated credit derivatives instruments;¹³ failure of risk management systems,¹⁴ in particular ‘[g]reedy and potentially incompetent executives and senior managers, who have been blamed for encouraging or at best turning a blind eye to excessive risk taking’;¹⁵ homogenisation of assumptions about risk among financial actors;¹⁶ limited information on risk exposure as regards over-the-counter derivatives;¹⁷ short-term incentives in the form of annual bonuses; while risky strategies may become failures in the much longer run.¹⁸ Another factor is connected with the longevity of the economic boom. In general, the longer it lasts, the more there are persons in decision-making positions not having experienced a serious downturn and thus showing a tendency to favour riskier strategies.¹⁹ Some of these risks were linked with individual decisions; some are more systemic.

Whilst the consequences of excessive risk-taking are not solely linked to the most recent or any other financial crisis, it powerfully highlighted the potentially disastrous results when this phenomenon gets out of hand. Moreover, excessive risk-taking is not limited to the financial market as managerial decisions in any domain of business may be overly daring. An example of the disastrous consequences of careless management has been recently provided by the collapse of British Home Stores (BHS), which gravely affected not only its existing, but also former employees. Therefore, although the financial crisis was an inspiration for this monograph, the problems presented here are not limited to the times or aftermaths of financial crunches.

2.Business Decisions and Excessive Risk-Taking

Risk-taking is at the very beginning and at the very core of business activity. Since time immemorial, one of the typical business activities has been bringing merchandise from one region to another. Once arrived at their destination, the goods were sold at a higher price than that for which they were acquired. This surplus was the merchant’s gain and at the same time his compensation for the risk he took while transporting the goods, which was the risk of being robbed by brigands or pirates or having the merchandise destroyed by a natural disaster. It is a truism that today’s much more sophisticated businesses also carry an element of risk. An investment can always turn into a financial disaster, be it because of the action of others (criminal or legal) or because of unexpected events (eg change of prices or natural catastrophes), or simply because of miscalculations (as to costs, demand, supply, etc). Many successful businessmen make bad investments and one can say that failure is as much a part of business as is success.^*

The nature and level of risk can vary. It can be very limited if one invests in government bonds, although it is not impossible that the government goes bankrupt. The risk can be much higher if one invests in sophisticated financial instruments. One may risk less by investing in the production of commodities that are in common use, while investing in commercial scientific research carries the risk because it can bring no result or not be useful in practice. Even investments that look at first instance bound to be successful may turn out to be failures. In one of his short stories, the Hungarian writer Sándor Márai writes of an investment that appeared to guarantee a success and for no explicable reason failed. A waiter, tired of his profession, acquires a restaurant that had always attracted clients. Although he makes no particular mistake, from the moment he takes over the restaurant, clients stop coming without any rational explanation and at the end he is forced to sell the place. When the new owner reopens it, the flow of clients begins immediately.²⁰

While Márai’s is a work of fiction, it points out that an element of luck is inevitably present in every investment. When contemplating the criminalisation of excessively risky decisions by managers, one has to bear in mind that risk is always present in business and doing business is a question of measuring, accommodating and preventing risk according to the rules of the domain in question. However, even when done properly, there will always be a margin of unknown factors and their appreciation and how to evade them is left to those who take the decisions. Furthermore, risk, regardless of whether its source is natural or human created, is a social phenomenon, ie depending on dynamic factors (cultural, economic, legal, etc). The answer to the question of whether risk is excessive depends on a variety of factors and perception thereof and will thus be subject to change over time.²¹

In their pursuit of profit for the company, managers could go as far as committing acts which could turn out to be administrative irregularities or even criminal offences. In the middle of 2015 it has been revealed that, for many years, Volkswagen had been manipulating tests as regards the emission of polluting substances in various Diesel models of its cars. The manipulation consisted in furnishing the cars with software able to detect whether the car was being tested and alter its performance and pollution in comparison to situations of normal driving. The case can be understood as an exemplary case of excessive risk-taking. The managers of Volkswagen, apparently, took a decision to install the software altering the results of the tests and permitting the company to sell concerned models, while presenting them as less polluting and more powerful. However, this decision exposed the company to various risks in case the manipulation was discovered, in particular, the costs of a variety of sanctions, costs of calling back the cars and making necessary changes, as well as the damage to reputation. All these risks could be considered excessive.

In an older scandal concerning the German industrial giant Siemens, the managers were found to have paid bribes in order for Siemens to obtain lucrative contracts. Although the contracts were potentially beneficial for the company, they carried a risk that, once corruption is uncovered, it may result in significant reputational damage and in substantive losses due to fines (as well as in other expenses such litigation costs, etc). Regardless of the liability for the offence of bribery, the managers were also prosecuted for abuse of trust in managing the assets of the company. In a controversial court battle which included judgments of the Federal Court of Justice (BGH), the accusation was based on the creation and use of slush funds (which served to pay the bribes), which assets were hidden and therefore not correctly entered into the company’s books.²² According to the BGH, the company would no longer be able to use such funds,²³ an argument only theoretically plausible according to commentators, as it was the management of Siemens who controlled the slush funds.²⁴ This case demonstrates a similar problem to the one in Kerviel: the difficulty faced by the courts in addressing in a straightforward way the problem of excessive risk-taking. The essence of the problem was not so much in the hiding of the funds, but in the dilemma whether exposing the company to the risk of negative consequences by committing acts infringing the law (including criminal), but undertaken for the benefit of the company, should be assimilated to other abuses of trust in managing the company’s assets.

3.Excessive Risk-Taking and Criminal Liability

The crucial context in which criminal liability for excessive risk-taking comes into play is the divide between capital and management, which is the common model of limited companies. Investors entrust their money to professionals who are supposed to manage the company’s affairs in a way that brings profit. The relationship between the company (and the shareholders) and the managers relies on trust in that the managers are expected to use the assets in the best interests of the company. Managers to whom the company assets have been entrusted are accountable vis-à-vis the investors according to rules provided for by company law, their contracts and a plethora of other rules regulating the particular domain of business.

For the most serious breaches of law, managers may be held criminally liable. However, there is a conse...

Table of contents

• Cover
• Title Page
• Acknowledgements
• Contents
• Table of Cases and Legislation
• List of Abbreviations
• 1. Introduction
• 2. England and Wales
• 3. France
• 4. Germany
• 5. Comparative Analysis
• 6. Criminalisation of Excessive Risk-Taking by Managers?
• 7. Conclusions
• Bibliography
• Index
• Copyright Page