Legal Exposure

Business leaders may not be trained in law, but ignorance of the law will not shield them from a government investigation. Government investigators will rely upon a doctrine known as respondeat superior. The translation from Latin means “Let the master answer.” In other words, government agents may hold employers liable for the acts that employees perform during the course of the job.

As an example, we’ll offer insight into a case that led to imprisonment for several officers and directors of a publicly traded company. These are people that served time in federal prison, along with members of our team. We have personal knowledge from listening to their stories.

Those people have since been released from prison, and they’ve gone on to build productive lives. Since the purpose of this exercise is to help our course participants understand the risks, and not to hurt other people, we’ll change the names of the people involved.

• Those who want to research the matter may search for the U.S. Securities and Exchange Commission case: CV-03-2834 R (RNZBx) (C.D. Cal.)

While confined at the federal prison camp in Lompoc, a member of our team met James. As a young entrepreneur, he launched an Internet advertising company. James later hired other people to join his company, including Mike, who served as the company’s senior vice president of business development, Lisa, who served as the company’s vice president of finance, and Cindy, who served as the company’s controller and director of finance.

Eventually, investment bankers brought the company public and it performed well during the dawn of the Internet era. Rather than having a background in finance, James’s expertise came from selling advertising. He relied upon his team to keep track of records. The company’s compensation plan incentivized people to build higher levels of sales, as all of the company’s leaders had stock in the company. If the company performed well with growing sales, the stock price would rise. If sales faltered, the company’s stock price would drop in the market.

When a recession threatened to slow sales, Mike, Lisa, and Cindy hatched a scheme. They conspired with leaders at another company. Basically, company A agreed to purchase goods and services from company B, and company B agreed to purchase goods and services for the exact same amount from Company A. Company A sent money to company B, masquerading the transaction as a sale; then, company B sent the exact same amount of money back to company A, masquerading the transaction as a sale.

The sham purchases boosted sales so that investors would think that each company continued bringing in robust sales, even though the conspirators created those sales artificially. In reality, the conspirators understood that those transactions did not represent authentic sales from actual consumers.

As CEO and president of the company, James had direct supervisory authority over Mike, Lisa, and Cindy. James was not on the sales team, nor did he have a finance background. He lacked the requisite skill to understand how Lisa and Cindy would account for the transactions on the financial statements. Nevertheless, James bore responsibility for the actions of the people that worked for him.

Several years later, a larger company made an offer to acquire James’s company. During the due diligence phase, forensic accountants researched all of the corporate records of James’s company. When the auditors discovered the sham sales transactions, the accountants notified investigators at the Securities and Exchange Commission. Investigators subpoenaed the records, launching a government investigation.

Before the investigators began to ask questions, they had a clear understanding of the deception. Yet neither James, Mike, Cindy, nor Lisa knew that they had been under investigation. When the questions came, they did not know how to respond. Each person lied to the investigators. The people did not know that lying to a federal law enforcement officer exposed each person to a criminal conviction, and the potential for up to five years in federal prison.

As the civil investigation advanced, the agents questioned people as witnesses, as subjects, and as targets. People had to hire lawyers. When prosecutors threatened to bring criminal charges that could expose them to decades in prison, the people began to cooperate in exchange for leniency.

Our team member met both James and Mike in federal prison. Both of them said that had they known the severity of the crime, and the punishments that could follow, they would not have participated.

James and Mike spoke of their perspectives at the time of the crime. When company A purchased a product from company B, and then company A sold a product to company B for the exact same amount, James and Mike believed that it was a wash. They did not see any harm coming from the transaction. They did not consider the viewpoint of government regulators or prosecutors. In the eyes of law enforcement, James and Mike participated in a conspiracy to deceive investors. As such, they violated securities laws. By violating laws, they faced a criminal prosecution. With the government investigation and criminal prosecution, they had to spend millions of dollars in attorney fees. Further, they damaged their professional reputations, they lost their liberty, and they have to live as convicted felons.