Lawlink NSW: 7. Equity fines

7.1 An alternative sentencing option to the monetary fine is share dilution. The concept of the equity fine,¹ has been succinctly described as follows:

7.3 The upper threshold of a cash fine is limited to the value of the existing cash reserves and finite assets of a defendant corporation. Corporate offenders may have insufficient wealth to pay the monetary penalty required for effective deterrence.⁴ One of the main barriers courts encounter in setting appropriately severe fines is the corporation’s financial inability to pay.⁵ As discussed in Chapter 6, the “wealth ceiling” places an absolute limit on monetary fines.⁶ The equity fine avoids this problem, as its imposition does not depend on a corporation’s solvency.

7.4 Further, the equity fine is capable of exacting greater punishment as the additional source of value of the corporation’s expected earnings can be tapped. A sufficiently high penalty that incorporates both liquid and fixed assets can be imposed so that the infringing corporation is punished as well as deterred from future misconduct. For example, a young company with limited cash resources and high growth prospects may be tempted to commit crimes because it is essentially immune from a high cash fine.⁷ In this instance, the threat of share dilution would be entirely appropriate. In this way, the equity fine has a greater potential than the monetary penalty to prevent corporate crime.

7.5 There are however, two arguments why this potential benefit may not be realised in practice. First, it has been suggested that equity fines do not punish shareholders any more than the cash equivalent.⁸ While share dilution obviously reduces the per-share value of the corporation, an equivalent monetary fine may in the long run reduce the value of the corporation’s share even more; for example, if the fine stifles growth or brings with it a risk of bankruptcy. In contrast, an equity fine does not affect the corporation’s solvency any more than if an equivalent dividend were issued to its shareholders. Secondly, it has been argued that, despite the potential for larger fines being imposed, the introduction of equity fines might actually translate to lower penalties.⁹ Courts may view the equity fine as a penalty that has a more direct impact on so called “innocent shareholders” and consequently, they may be more cautious in setting the level of the fine to avoid any perceived injustice. In contrast, courts may be more willing to impose high cash fines on corporations because they are generally considered to fall on a faceless entity.¹⁰

7.6 As discussed in Chapter 6, a major disadvantage of the monetary fine is the phenomenon of “spillover”.¹¹ That is, the penalty is frequently passed on to “innocent” parties, such as employees, consumers, creditors and suppliers, while the corporate wrongdoers themselves go largely unpunished. The imposition of a monetary fine may prevent or delay corporate expansion, result in employee layoffs or wage freezes, and/or lead to price increases.

7.7 Share dilution avoids the problem of spillover, as the corporation’s capital is relatively unaffected by the penalty. By avoiding a short-term financial crisis that may tempt or force managers into engaging in behaviour that is harmful to external parties, the burden of equity fines impacts squarely on the corporation’s shareholders. The penalty falls more evenly across the entire class of shareholders, who assumed the risk in the first place, rather than falling disproportionately on a few, such as low level employees.

7.8 Criminal fines are channelled to the State’s general consolidated revenue. The rationale for this arrangement is that society at large is the ultimate victim of corporate crime, and hence, the State the appropriate beneficiary.¹² As such, it may be argued that the monetary fine does little to alleviate the financial harm caused to victims of corporate crime. On the other hand, the equity fine is intended to go to a fund to provide compensation to victims.¹³ The satisfaction of the ancillary sentencing goal of compensating the victim constitutes an advantage of equity fines over cash penalties.

7.9 Additionally, equity fines are capable of ensuring that the punishment fits the crime through specific targeting of compensation. Although penalty shares would typically go to a specially established victim compensation fund, it has been suggested that, in appropriate cases, share interests could go to other bodies designated by statute as alternative beneficiaries. For example, depending on the nature of the offence, shares could be issued to a suitable consumer protection organisation, or environmental organisation. Of course, this benefit is not dependent on the fine being levied in shares – the proceeds of a monetary fine could easily be distributed in the same way. However, by establishing a specific fund for victims of crime, it is more likely that the bulk of the penalty exacted will actually go towards the restitution of victims, rather than the State’s general consolidated revenue.

7.10 There are however, several potential problems with the diversion of penalty shares to bodies other than a State-administered fund. First, it is possible that the channelling of fines to worthy causes may detract from the punitive nature of the penalty. Secondly, if worthy causes are the beneficiaries of penalties, courts might lessen the amount payable on the ground that the defendant’s culpability is somehow ameliorated by this “good deed”.¹⁴

7.11 Monetary penalties fail to provide an effective deterrent if the fine is so small that a company is able to treat it as mere licence fee for illegitimate corporate business operations.¹⁵ In contrast to a cash fine, an equity fine cannot be written off so easily by management as a mere expense or cost of doing business. It is argued that by their nature, equity fines provide an effective vehicle for deterrence.¹⁶

7.12 The prospect of future misconduct by the same corporation is greatly reduced where share dilution brings in new shareholders thereby altering the structure of ownership. Depending on the magnitude of the equity fine, the structure of ownership may be dramatically altered so that the new shareholders are able to demand internal reforms to ensure compliance with the law.

7.13 A further avenue for increased deterrence is that the creation of a substantial block of marketable shares might render the defendant corporation a more inviting target for hostile takeover.¹⁷ However, the equity fine would have to be quite substantial for takeover to become a serious risk to a large company.¹⁸ Even if the threat of corporate takeover remained remote, an increase in its likelihood would provide an added incentive for corporations to institute internal compliance programs as a preventive measure. Because the autonomy and tenure of senior management would potentially be compromised by the misconduct of subordinates, the equity fine would serve to impose a degree of vicarious liability on them for the actions of all employees. Individuals in management would view internal controls more favourably as the equity fine would threaten their positions more “than when the only consequence is a modest cash fine to the organization and possibly the criminal prosecution of the subordinate”.¹⁹

7.14 Equity fines would have a direct deterrent effect on both corporate management and investors, as the financial interests of each would be damaged by the imposition of a penalty.²⁰ Shareholder wealth would stand to be diluted, making it likely that shareholders would pressure management to remain within the bounds of the law despite the possible short-term gains to be made from misconduct.

7.15 Given that it is common for corporate managers to have substantial holdings of shares and share options, managerial interests would be better aligned with the interests of stockholders, as respective investments would suffer equally with the imposition of an equity fine.²¹ Of course, the efficacy of this factor as a deterrent is dependent on the proviso that managers hold shares or share options in their company at the relevant time. In time however, managers could seek to negotiate non-share remuneration packages, in which case the equity fine would provide a screen, enabling them to engage in illicit activities, knowing that only the shareholders would bear the penalty if detected. An additional consideration is that management is in a significantly better position than other shareholders to divest themselves of shares prior to the imposition of an equity fine.²²

7.16 The burden of equity fines falls evenly across the entire class of shareholders rather than falling disproportionately on a few (such as low-level employees), effectively reducing the spread of loss.²³ However, by failing to distinguish between powerful shareholders and those who exercise little or no control over the corporation’s activities, the equity fine is not necessarily fairer.

7.17 It has been argued that the indiscriminate application of equity fines on shareholders can be justified on the basis that corporations are solely comprised of shareholders and, therefore, responsibility for corporate misconduct should rightly be sheeted home to them. Further, shareholders may just as easily profit as suffer loss as a result of criminal conduct and are, in any event, in the unique position of being able to diversify their interests and liabilities. The respective guilt or innocence of shareholders is dismissed as irrelevant for the reason that, unlike employees or consumers, shareholders voluntarily expose themselves to the uncertainties of the market.²⁴

7.18 However, by holding shareholders equally culpable for the actions of management, the power imbalance between large and small shareholders is ignored and the realities of corporate behaviour misrepresented. That a corporation may be defined simply as a conglomerate of shareholders is not disputed. However, in the event of corporate misconduct, a distinction should be made between those who were culpable and responsible, on the one hand, and those who were unaware of or powerless to stop the misconduct, on the other hand. It has been said that the notions of limited liability and bankruptcy demonstrate that, in some instances, shareholders are to be taken as possessing an identity that is distinct and separate to that of the corporation.²⁵ These principles recognise that in reality, the majority of shareholders are as innocent and impotent as low-level employees and creditors, often powerless to influence policy or regulate the corporation’s conduct or bring about reforms following a corporate conviction.²⁶

7.19 A related criticism of the equity fine is that it “decreases the value of all stockholders’ common shares, yet offers no guarantee of managerial impact”.²⁷ Although it is often appropriate to apportion blame for corporate misconduct on large shareholders who either form part of management or have a degree of influence over corporate behaviour, punishing these “guilty” shareholders by way of individual sanctions would be fairer than imposing a penalty that penalises all shareholders.

7.20 In conclusion, although the equity fine would shift the burden of the penalty for corporate crime away from some innocent parties towards those more directly responsible for the violations, the sanction’s indiscriminate impact on shareholders seems equally unsatisfactory and unfair in light of the limited capacity of the average shareholder to influence managerial conduct. In determining questions of responsibility and punishment for misconduct, a sanction that impacts on shareholders alone necessarily fails to fulfil the concurrent sentencing objectives of punishment, deterrence and rehabilitation.

7.21 Equity fines share the same problem as monetary fines, in that they do not require the organisation to correct any systemic faults that may have given rise to the offence in the first place.²⁸ In short, the fine is a non-interventionist sanction, as it does little to rectify a corporation’s defective internal procedures or ensure that individuals in the company are disciplined.²⁹ Share dilution does not automatically necessitate any investigation into individual accountability, so there is no direct link between the sanction and prevention, its intended effect.

7.22 The desire or ability of shareholders to bring about fundamental change in a corporation’s structure or conduct is critical to the rehabilitation of non-financial values. Although shareholders should, in theory, take an interest in ensuring that internal mechanisms are sufficient to prevent misconduct, many are simply focussed on short-term profit, and are no more likely to be concerned about an equity fine than they would an ordinary cash fine. Where the shareholder remains remote, the equity fine is little more of a deterrent than the monetary fine. Perhaps the more substantial the shareholder’s holding and the more severe the potential loss, the greater the interest the shareholder would take in ensuring compliance.

7.23 In the previous chapter, we noted that fines might trivialise the seriousness of corporate crime because they create the impression that corporate crime is permissible provided the offender pays the going price.³⁰ The same argument applies to equity fines: it emphasises the price of crime. Rather than deterring corporate crime, it makes it a share market commodity.³¹ Equity fines fail to reconfigure corporate crime as non-marketable, instead upholding the notion that corporate offences are merely regulatory and not truly criminal.

7.24 Various regulatory agencies opposed equity fines in their submissions to the Commission, citing a number of administrative difficulties. Some agencies highlighted the problem of a government agency managing and investing the funds of a private company. A potential perception of a conflict of interest arises.³² For example, having an agency like the NSW Department of Fair Trading or the Australian Tax Office manage the shares of a corporation³³ that has contravened the laws that these agencies enforce raises issues relating to the proper relationship and dealings between them and convicted corporations.³⁴

7.25 The Australian Stock Exchange expressed concerns that the liquidation of securities to maximise their return would be a difficult topic on which to draft satisfactory and effective legislation. By their nature, securities increase and decrease in value. They will never have a definite value as opposed to a fixed fine amount. The ASX queried how one would decide when best to sell to maximise return.³⁵

7.26 Equity fines may not be appropriate for private companies. These companies often involve closely held securities in a family-type arrangement where it would be inappropriate to force a widening of the share base. There is also the difficulty of valuing the shares of these companies. Equity fines are therefore only possible for a limited number of companies.³⁶

Table of contents

1. This term is used in the American literature. “Securities fine” is a better description in the Australian context.

2. J C Coffee, “‘No soul to damn: no body to kick’: an unscandalized enquiry into the problem of corporate punishment” (1981) 79 Michigan Law Review 386 at 413.

3. For an explanation of the practical issues that this sanction raises, such as how the equity fine is calculated, see Coffee at 414-415.

4. See United States v Danilow Pastry Co (1983) 563 F Supp 1159; Castro, “Texaco’s Star has fallen; facing a $10 billion penalty, the company chooses bankruptcy”, Time (20 April 1987) at 50, cited in B Fisse, “Sentencing options against corporations” (1990) 1 Criminal Law Forum 211 at 217.

5. Courts will not impose a high penalty on a company if the penalty will be too oppressive or cause undue hardship on the company, or render its business unviable: WorkCover Authority of NSW (Inspector Reynolds) v PF Thearle & Co Pty Ltd [2001] NSWIRComm 105; WorkCover Authority of NSW (Inspector McMartin) v Milltech Pty Limited [2001] NSWIRComm 192.

7. J C Coffee, “‘No soul to damn: no body to kick’: an unscandalized enquiry into the problem of corporate punishment” (1981) 79 Michigan Law Review 386 at 414.

8. C Kennedy, “Criminal Sentences for corporations: alternative fining mechanisms” (1985) 73 California Law Review 443 at 468.

12. C Kennedy, “Criminal sentences for corporations: alternative fining mechanisms” (1985) 73 California Law Review 443 at 455.

13. Market advantages gained by illegal conduct necessarily have negative consequences for competing corporations and society in general. Market growth may be stunted, employees made redundant and competition lessened, resulting in a lowered gross national product, an increased demand on social welfare, and less choice and possibly higher prices for consumers.

14. See Kennedy at 463, where the examples of United States v Prescon Corp (1982) 695 F2d 1236 and United States v Wright Contracting Co (1983) 563 F Supp 213 are cited.

15. United States v Wise (1962) 370 US 405. See also para 6.2, 6.7. Cash fines may be perceived by much of the business community as “a kind of public morality tax, but not … a deterrent threat”: J C Coffee, “‘No soul to damn: no body to kick’: an unscandalized enquiry into the problem of corporate punishment” (1981) 79 Michigan Law Review 386 at 407.

18. B Fisse, “Sentencing options against corporations” (1990) 1 Criminal Law Forum 211 at 232.

20. A criticism of this potential improvement to deterrence of shareholders and management, is that such a benefit is entirely attendant on a perceptible increase in the per share loss suffered. Some commentators (such as C Kennedy, “Criminal sentences for corporations: alternative fining mechanisms” (1985) 73 California Law Review 443 at 468) dispute that an equity fine would in fact affect a corporation’s share value any more than an equivalent fine in cash.

21. J C Coffee, “‘No soul to damn: no body to kick’: an unscandalized enquiry into the problem of corporate punishment” (1981) 79 Michigan Law Review 386 at 413-414, 417-418.

22. B Fisse, “Reconstructing corporate criminal law: deterrence, retribution, fault and sanctions” (1983) 56 Southern California Law Review 1141at 1237.

24. C Kennedy, “Criminal sentences for corporations: alternative fining mechanisms” (1985) 73 California Law Review 443 at 453-454.

25. C Stone, “A slap on the wrist for the Kepone mob” (1977) 22 Business and Society Review 4 at 9.

26. C Kennedy, “Criminal sentences for corporations: alternative fining mechanisms” (1985) 73 California Law Review 443 at 451.

27. B Fisse, “Reconstructing corporate criminal law: deterrence, retribution, fault and sanctions” (1983) 56 Southern California Law Review 1141 at 1238.

28. C Wells, Corporations and criminal responsibility (2nd ed, Oxford University Press, 2001) at 36.

29. C Wells, Corporations and criminal responsibility (2nd ed, Oxford University Press, 2001) at 36. See also, B Fisse, “Sentencing options against corporations” (1990) 1 Criminal Law Forum 211 at 232-233.

31. B Fisse, “Reconstructing corporate criminal law: deterrence, retribution, fault and sanctions” (1983) 56 Southern California Law Review 1141 at 1236.

32. Department of Fair Trading, Submission at 7; Australian Taxation Office, Submission at 8.

33. The examples assume that the agencies may acquire, hold and dispose of personal property, ie, shares.

34. Commercial Law Association, Consultation. One instance when a regulatory agency can hold shares is under the Corporations Act 2001 (Cth) s 601AD, which provides that on de-registration of a company, all its property vests in the Australian Securities and Investment Commission. However, as a matter of policy, ASIC prefers not to hold shares during the course of an enforcement action against a corporation: Information from L Macauley, ASIC (15 April 2003).