John Stuart Mill was among the foremost liberal thinkers of modern times who wrote extensively…
Lessons from Global Corporate Frauds Jayati Ghosh
As global capitalism lurches around in crisis, it seems that there is no end to the worms crawling out of the woodwork. The financial crash and economic downswings have been accompanied by more than just cyclical bad news from companies that have been engaged in bona fide business. The adverse market conditions are making it harder to disguise corporate frauds that could flourish in the earlier boom, and so more and more details of unsavoury business operations are emerging among a wide range of firms all over the world.
In India the Satyam scam may be grabbing the headlines, but corporate frauds are likely to be uncovered in many countries. In the leading capitalist economy, the United States, such corporate frauds have been rising sharply in recent years, according to data from the official investigating agency, as the accompanying chart shows. Between 2001 and 2007, the number of corporate fraud cases that were opened by the FBI (covering both corporate fraud per se and securities and commodities fraud) increased by 43.7 per cent, even though convictions barely increased. And in 2008, the number of scandals that has come to light, and the sheer extent and audacity of several of them, almost defy description.
This ought to surprise us, because after the huge corporate accounting scandals of the early part of the decade, exemplified by the Enron scandal and the subsequent exposure of significant firms like WorldCom, Adelphia, Peregrine Systems and others, the US government took steps to enact legislation that would regulate corporate markets specifically to prevent such frauds.
The Sarbanes-Oxley Act that was passed by the US Congress in 2002 (officially known as the Public Company Accounting Reform and Investor Protection Act of 2002) was meant to strengthen and tighten corporate accounting procedures. It established a new quasi-public agency to oversee, regulate, inspect and discipline accounting firms in their roles as auditors of public companies. It also specified tighter rules for corporate governance, including internal control assessments and enhanced financial disclosure.
All this, it could be supposed, would operate to prevent any future Enron-type scandals from occurring at all. Indeed, those who opposed the act argued that it created a complex over-regulated environment for US companies, which reduced their competitive edge over foreign firms. (However, a number of other countries – Japan, Germany, France, Italy, Canada, as well as developing countries like South Africa – have passed similar legislation.)
Sarbanes-Oxley, or indeed any attempts to control and regulate corporate behaviour especially in the financial realm, have been much criticised by representatives of large firms and by many market-friendly economists as well. Consider this typical academic justification for not regulating markets: “While corporate fraud can impose significant costs of the economy when left unchecked, the evidence shows that market mechanisms discipline much bad behaviour while the criminalisation of corporate behaviour, coupled with bringing highly complex cases before juries that can neither understand the issues nor their instructions, imposes significant costs on the economy by deterring socially efficient risk-taking behaviour by corporations and their executives… The result is harm to the general public, whose members depend on a dynamic, competitive economy for their welfare.” (Howard H. Chang and David S. Evans, “Has the pendulum swung too far?” Regulation, Vol. 30, No. 4, Winter 2007-2008).
Yet it now turns out that, far from being too restrictive, if anything the Sarbanes-Oxley Act was not effective enough. After the spate of corporate financial scandals that actually resulted in the collapse of several companies in the early part of the decade, corporate fraud has apparently continued almost unabated even in the US. One reason for this may have been in the design and implementation of the legislation, which did not take in to account the crucial features of such scams, and the structure of incentives that both allowed and encouraged such malpractices to occur.
A quick look at some of the more famous of these corporate frauds may illustrate this point. Consider first Enron, the gigantic scam that has unfortunately set the bar for all the other scandals that have followed since 2001. This was a financial scandal that could occur because energy sector liberalisation and financial deregulation in the US allowed for trading in electricity and natural gas futures, partly because of intense lobbying by Enron and similar firms. While the resulting energy price volatility adversely affected consumers, it delivered high speculative profits to what was originally a power generation firm but rapidly became dominantly an energy trading firm. Enron then created as number of offshore subsidiaries, which provided ownership and management with full freedom of currency movement. This also allowed any losses in such trading to be kept off the balance sheets.
As a result, Enron appeared to be much more profitable than it actually was. Naturally its share price also zoomed, allowing the managers to benefit from the capital gains that they received from their employee-stock options and performance-related bonuses. It is easy to see how this created a dangerous spiral: those handling the finances had major incentives (and then increasingly felt extreme pressure) to cook the books so as to show growing profits, even as the company was actually losing money.
As the dotcom boom in the US finally went bust in 2000, it became even harder for Enron’s managers to carry own with this creative accounting, until at last it became impossible to keep up the pretence. Ultimately the company could not even be restructured but had to be liquidated. Thousands of Enron employees lost not only their jobs, but also their savings and pensions, which were tied up in company stock. Fourteen of the company’s managers were accused, faced trial and sentenced on various charges of fraud, misleading the public, insider trading and other malfeasance.
The role of the auditing company – Arthur Andersen, one of the then Big-Five accounting companies – obviously came under scrutiny. Remarkably, however, it was found that it could not be held legally responsible for what was clearly criminal negligence and dereliction of duty over a prolonged period. Instead, the only charge that could be brought against it was obstruction of justice, for shredding documents related to its audit of Enron. And even that was overturned by the Supreme Court in 2005 on grounds of flaws in the instructions to the jury! However, because the US Securities and Exchange Commission did not allow it to audit public companies, it could not retain viable business and the company collapsed.
Another scandal of that period that has even more similarities to the Satyam case is that of Adelphia Communications Company, which was earlier celebrated as a rags-to-riches story of two brothers (John and Timothy Rigas) who had originally founded the company on the basis of a $300 cable license. When the company declared bankruptcy in 2003 because it was forced to disclose more than $2 billion in off-balance-sheet debt, it emerged that the Rigas brothers had used complex financial and cash management practices to transfer money to various other family-owned entities. In addition, federal prosecutors successfully accused them of salting away at least $100 million personally.
Similarly, the Refco case related to what would earlier be called straightforward embezzlement but is now seen as a complex system of sophisticated financial irregularities. Refco, a finance company that specialised in commodities and futures contracts, was a private company that went public in the August 2005. Its share prices immediately rose by more than 25 per cent because of its apparent history of high profitability. In October 2005, just before its collapse, it was the largest broker on the Chicago Mercantile Exchange. Refco’s downfall came about when it emerged that its Chief Executive Officer, Richard Bennett, had hidden about $430 million of bad debts from both the rest of the company’s board and its auditors. He was able to do this through the simple and ridiculous expedient of buying bad debts from Refco, so as to prevent the company from having to write them off, and then paying for these bad loans with money borrowed by the company itself!
What is most extraordinary about the Refco case is that this fraud was revealed only a few months after the company had made its first initial public offering (IPO) of shares. Before such a public listing, due diligence and detailed examination of accounts is required of the investment banks that manage the IPO. In Refco’s case, the IPO was handled by the top names in banking: Goldman Sachs, Credit Suisse First Boston, and Bank of America. Yet none of them had uncovered this huge hole of $430 million in bad debt that the CEO declared within a couple of months, nor had they even noticed the peculiar practice that the CEO had used to cover it up. So in this instance it was not just the auditors (the smaller accounting company Grant Thornton) that were found to be lax and inadequate to the task. While Richard Bennett was sentenced to 16 years in prison in 2008, no action was taken against any of the others involved who had been at best very derelict in their duty.
In Brian Cruver’s famous book on the Enron case, The Anatomy of Greed, a senior manager is quoted as saying “Don’t think it’s just this company. There’s hundreds of Enrons out there, a thousand, cooking the books, inflating the earnings, hiding the debt, buying off the watchdogs.” There have been so many instances of corporate fraud since then, both in the US and elsewhere, ranging from Parmalat Spa in Europe to Tyco International in the US. And this excludes the pure Ponzi schemes such as the recently exposed one run by Bernie Madoff, whereby investors are paid returns that are no more than investments by subsequent investors, rather than any actual profit.
In so many of these cases, the auditors involved have been among the major accounting firms in the world. In addition to the now-dissolved Arthur Andersen, all the following firms have been implicated several times in corporate fraud: Deloitte and Touche, Ernst and Young, KPMG, and of course PriceWaterhouseCoopers, made infamous in India because they were the auditors of Satyam Computers. Yet the system as a whole continues to rely upon these incompetent companies.
This completely contradicts the “efficient markets hypothesis” that underlies so much financial liberalisation. This argument, along with the doctrines of the mainstream “law and economics” discussion, generally underplays the possibility and significance of fraud, because of a perception that “market discipline” will prevent it and a belief that mala fide actions cannot subvert the market mechanism beyond a point.
So then how can these frauds happen? And what is the economic logic of such a system that is so completely susceptible to fraud? This is explained beautifully by William K. Black in his brilliant expose of the Savings and Loan scandal in the US in the early 1980s, “The Best Way to Rob a Bank Is to Own One: How corporate executives and politicians looted the S&L industry” (University of Texas Press 2005).
This book has been described as a classic by the Nobel Prize-winning economist George Akerlof. Black’s analysis is a dissection of “control fraud”, when the organisation is the vehicle for perpetrating crime against itself. This calculated dishonesty to loot a company in pursuit of personal profit by those at the helm of corporate affairs could also be termed “collective embezzlement”.. He shows how this is much more pervasive than is generally suspected, and indeed could be endemic to the system, especially when it is characterised by lax regulation and casual oversight. He shows how such frauds tend to occur in waves that make financial markets deeply inefficient.
Therefore, control fraud is a major, ongoing threat in business that requires active, independent regulators to contain it. Yet neoliberal market-oriented policies have typically operated to reduce the capacity for effective regulation in four characteristic ways. His argument is so plausible and still so unnervingly relevant that it deserves quotation in some detail:
“First, the policies limit the number and quality of regulators. Second, the policies limit the power of regulators. It is common for the profits of control fraud to greatly exceed the maximum allowable penalties. Third, it is common to choose lead regulators that do not believe in regulation (Harvey Pitt as Chairman of the SEC and, more generally, President Reagan’s assertion that “government is the problem”). Fourth, it is common to choose, or retain, corrupt regulatory leaders. Privatisation, for example, creates ample opportunities, resources, and incentive to corrupt regulators.
Neo-classical economic policy further aggravates systems capacity problems by advising that the deregulation, desupervision and privatisation take place very rapidly and be radical. These recommendations guarantee that even honest, competent regulators will be overwhelmed. Overall, the invariable result is a self-fulfilling policy – regulation will fail. Discrediting regulation may be part of the plan, or the result may be perverse unintended consequences.
Neo-classical policies also act perversely by easing neutralisation. Looting control frauds are guaranteed to produce large, fictional profits. Neo-classical proponents invariably cite these profits as proof that the ‘reforms’ are working and praise the ‘entrepreneurs’ that produced the profits. Simultaneously, there is a rise in Social Darwinism. The frauds claim that the profits prove their moral superiority and the necessity of not using public funds to keep inefficient workers employed. The frauds become the most famous and envied members of high society and use the company’s funds to make political and charitable contributions (and conspicuous consumption) to make them dominant.
In sum, in every way possible, neo-classical policies, when they are adopted wholesale, sow the seeds of their own destruction by bringing about a wave of control fraud. Control frauds are a disaster on many different levels. They produce enormous losses that society (already poor in many instances) must bear. They corrupt the government and discredit it. They inherently distort the market and make it less efficient. When they produce bubbles they drive the market into deep inefficiency and can produce economic stagnation once the bubble collapses. They eat away at trust.”
Does this sound familiar and relevant to the present times? Yet this insightful argument has been in the public domain for several years, and has still been ignored by those involved in pushing the neo-liberal policies that create the potential for such frauds. This has been one of the main reasons why the Sarbanes-Oxley Law has not worked to control corporate malpractice in the US.
Ultimately the lack of public awareness, and therefore of systematic political pressure to prevent it, has allowed the cosy relationship between regulators and corporate leaders to create this fraudulent crony capitalism. And it is also why the rest of us in other countries are also more and more exposed to the negative effects of such fraud.
