TCS Daily

Dregs in the SOX Drawer

By Craig S. Lerner & Moin A. Yahya - April 10, 2006 12:00 AM

According to a recent column in Business Week, many hotshots of American industry are fleeing publicly traded corporations for "the money, freedom and glamour of private equity." Among the reasons cited for their departure is the Sarbanes-Oxley Act of 2002, which not only dramatically escalated penalties for white-collar crimes, but also diluted the mens rea (or "vicious will") requirement for criminal regulatory offenses. More and more activities, especially of publicly traded corporations, fall within the potential scope of the criminal law; and whether they actually do is left ever more unpredictably to the discretion of prosecutors and juries.

When Outback's long-time and much-praised CFO, Bob Merritt, resigned less than a year ago, he criticized the multiplying regulations that have made his professional life such a misery:

"[O]ver the last two years I've found myself spending more time and resources on regulatory matters than supporting the management of the company and improving the businesses we operate. Because I'm a business-development oriented person, and administration is not my strength, I believe there are other people out there who can do a much better job at managing in this environment than I."

Merritt's suggestion, seconded by others in the journalistic and academic community, is that entrepreneurial-minded executives are being replaced by "bean counters" -- that is, those who delight in the minutia of regulatory compliance. To be sure, this is part of the story, but the truth may be more complicated.

Success in business, as in war, depends on taking calculated risks. The best people in business are "risk-neutral" in the sense that they prefer risky undertakings with high expected returns to safe endeavors with lower returns. To take an easy example, imagine that one project has a certain rate of return of 5 percent, and a second project has a ½ likelihood of a -10 percent return and a ½ likelihood of a 30 percent return. A shareholder would want the managers of a corporation to choose the second option (with an expected return of 10 percent) to the first. We, of course, can hedge the risk by owning a diversified stock portfolio.

But a caveat is now in order: From society's perspective, we do not want entrepreneurs to be completely risk-neutral. With respect to the criminal law, the "ideal entrepreneur" is risk averse. He pays the certain costs of compliance rather than risk being convicted of a crime, even when a purely rational (or risk-neutral) individual might violate the law. After all, the low probability of detection and conviction may render the expected penalty less than the cost of compliance. When it comes to the criminal law, however, the ideal entrepreneur has taken his altar vows simply to obey, thus removing compliance issues from the ordinary mix of variables that are subject to a cost-benefit analysis.

The ideal entrepreneur competes for corporate control with two other human types, which we will call the bean counters and the swashbucklers.

The swashbuckler is risk-neutral and possibly even risk-loving, through and through. He draws no distinction between business choices and compliance with the criminal law. Just as the decision to open a new store at a particular location has its potential upside and financial risks for the company, so too the decision to properly declare the latest earnings to the SEC has its potential costs and benefits. Filing inaccuracies may incur the regulators' wrath, but accurate and glum reports will impair the company's ability to raise funds from creditors and compensate executives. The swashbuckler crunches the numbers. Every opportunity to comply with or violate the criminal law is considered afresh and analyzed without any presumption in favor of compliance.

The bean counter, by contrast, is risk-averse with respect to both business decisions and legal decisions. Such persons happily avoid any possibility of legal trouble by parking capital in low-risk enterprises and then spending 80 hours a week crossing every t, and dotting every i.

The legal system should allow the ideal entrepreneur to thrive in the competition for corporate control. Unlike the bean counters, he is engaged in wealth-generating activity; unlike the swashbucklers, he is hard-wired to comply with the criminal law. A century ago, the criminal law was clearly written, and those inclined to obey it, such as the ideal entrepreneur, knew precisely what steps were necessary. But over the past few decades the regulatory and criminal law governing publicly traded corporations has become increasingly indeterminate and punitive. Many "ideal entrepreneurs" have found the atmosphere noxious and are apparently fleeing for other environments. Who will be left behind?

First of all, there will be the bean counters. This type thrives in a world that prioritizes the meticulous filing of voluminous government-mandated forms to the messy give-and-take of the business world. Every newly minted government regulation delights the bean counter manager, affording him with ever more convoluted boxes to be pointlessly checked off.

But also thriving in a post-Sarbanes Oxley world will be swashbucklers, those who are risk-neutral and possibly even risk-loving with respect to business matters and legal compliance. Either throwing caution to the winds or coolly crunching the numbers, swashbucklers may discount even draconian penalties due to a perceived low rate of detection and conviction. As every increase in criminal penalties more thoroughly drives away the ideal entrepreneurs, the swashbucklers more completely dominate the field.

What can we expect if Congress, regulators and prosecutors continue amorphously to expand the white-collar criminal law, enforce the law in an unpredictable manner, and seek penalties that are more appropriate for serial murderers? Over and over again, one hears the prediction that this will make American business more law-abiding. If our analysis is right, this prediction is wrong.

The irony, rich for those inclined to savor it, is that the modern proliferation of white-collar criminal laws may simply send many of America's most talented -- and reverently law-abiding -- entrepreneurs fleeing for less regulated environments, either in private equity or overseas completely. Left behind at the helm of large publicly traded corporations will then be the bean counters, who have little entrepreneurial spirit, and the swashbucklers, who have no instinctive regard for the criminal law.

Mr. Lerner teaches at George Mason University School of Law and Mr. Yahya teaches at University of Alberta School of Law.


Spot on
“Success in business, as in war, depends on taking calculated risks.”

The author, perhaps inadvertently, made a salient point. The military is enduring the same stupidity that corporate America is being subjected to. Bob Merritt made the same decision that many like-minded military officers are making today. Most think that the military is enduring unusually high officer attrition because of the operational tempo. I think it is because of the increasingly burdensome paperwork and regulations dreamed up by people who wouldn’t know the difference between a rifle and a grenade launcher.

The administrative overhead associated with conducting our jobs has gotten ridiculous. As an Infantry Officer, I am not the best person to be doing inquiries, 15-6 investigations, collecting sworn statements, or recreating instances of enemy contact (or civilian casualties) on PowerPoint slides. My Soldiers, most of whom have never used PowerPoint or typed anything more than a chat room instant message in shorthand, are no better trained for this. And it is only getting worse. The military, like the rest of the government's bureaucracies, is falling prey to this notion that systems administered by desk jockeys, lawyers, and hoardes of paperwork is a viable substitute for strong and moral leadership. Just as business leaders are choosing to pursue other options rather than endure the increasingly painful stupidity, so are our military officers (me, included). Peers and superiors ask why I don't want to stay in longer to command a company on the next deployment. Considering all of the paperwork and administrative crap the goes with the territory, I can do similar work and get more time off if I were to become an accountant... or to work for the SEC.

this argument is always about draconian penatlies in this case "suitable for serial killers." where a serial killer's victims number in the 10's or 100's the business malfactor's victims can mumber in the 1000's, 10,000's or even in the 100,000's, with real life changing impacts no less profound than the serial killers.
so why not have penalties that are clearcut and unalterable so those who cross into the gray area know they will be caught and punished?
would'nt this let the bob meritt's of the world build their companies and put the bean counters out of business?
also thanks to Schmedlap for his service and i wish him well in whatever he choose's to do.

spot check
Here's today's blooper from the endless stream of right wing paid apologist wanabees this site caters to:

> "The best people in business are "risk-neutral" in the
> sense that they prefer risky undertakings with high
> expected returns to safe endeavors with lower returns."

This refers to a technical theory of financial decision making called "utility theory". In this theory, people make decisions to optimize their expected utility under uncertainty. The investor's "risk aversion" is modelled by the concavity of the utility function. Very curved means highly risk averse. Linear (zero curvature) means fisk neutral. Risk neutral investing is an extreme that leads to paradoxes and therefore usually is excluded in theoretical treatments.

It is "almost certainly" (a technical term that means the probability is one) a financial disaster. In most market models (e.g. the lognormal distribution) used in modern finance theory, high expected return is achieved at the price of high probability of failure. As the expected return goes to infinity in the risk neutral limit, the probability of not going bankrupt goes to zero.

Different people have different risk preferences, just as different people have different threshholds for pain. But the person who doesn't feel pain at all is in serious danger.

False sense of security
Every regulation written that is supposed to prevent illegal activity is one more false level of security added to the pile.
If investors have not figured it out yet, if it is too good to be true, it is.
Risk aversion has shut down civil aviation production in this country. People are developing personal aircraft that do not need a runway, but who will invest when there is so much risk?

For the apparent Leftist Liberal Wannabe
In the financial world of realtime--i.e., NOT the one of your aseptic theories--an investor who is "risk neutral" only concerns himself with an investment's expected return. That is, once he has decided that a certain investment is a good one and has a realistic chance of delivering what he considers to be a high yield, he lays his money down and no longer pains himself with worry over the potential risk. But, he "feels no pain" over the potential risk because (it is rational to take as a given) he has already taken that into consideration when deciding whether or not the investment is a good one to begin with. You have confused one who is "risk neutral" with one who is a "risk lover", the latter being someone who will take big risks even to invest in something with a low expected return.

Additionally, you missed the point that the authors were not using "risk neutral" as technical terminology. In the context, they used the phrase tangentially. You chose to compare apples and beans.

The best part is the loser is the exactly the person the regulators are trying to help.
I find it silly that in all these stupid regulations that make it a criminal offense to take risk when the owners are fully informed about such risks. The only folks hurt are the small investors who need public companies to provide the widest possible range of investment but do not have the money to invest in large private investment pools.

So just think about every large company that goes private and every small high risk company that never goes public. What a loss.

The US HAD the most efficient financial markets in the world. Now the players are running from public trading to the back rooms of large private investment pools to skip not only the risk but also the paperwork.

get it straight

> Mr. Lerner teaches at George Mason University School of
> Law and Mr. Yahya teaches at University of Alberta
> School of Law.

The writers are lawyers. When they go out of their way to use a technical term, they should use it in its correct technical sense. We would expect no less of a legal term. The tag line "spot check" showed that I was not analysing their whole piece, only their competence and good faith.

Now to you.

> In the financial world of realtime--i.e., NOT the
> one of your aseptic theories--an investor who is
> "risk neutral" only concerns himself with an
> investment's expected return.

which is exactly what I and the authors said was the definition of risk neutral. But then

> That is, once he has decided that a certain
> investment is a good one and has a realistic chance
> of delivering what he considers to be a high yield,

An investment need not have a high probability of high yield to have a high expected return. For example, if you could pay a dollar for a one in a million chance to win two million dollars, that would be a 100% expected return with one chance in a million of having any yield at all.

But the post is wrong in its main point as well as its details. SOX is to protect investors from fraud, not risk.

Get a Clue
SOX is to protect people from themselves--as in what Communist nations try to do.

Get real and quit splitting hairs.

The lawyers in this case were writing a story, not a white paper.

Go do some investing and get your nose out of your text books.

The Nature of Risks in Business
A team of German economists has found that the risk of punishment is an essential factor in a money-making venture. Common sense already tells us this is true. But it is nice to see it confirmed in an academic study. The economists designed a set of investment games in which participants could join one of two groups: Group A, which never penalized its members, or Group B, which did. Initially, more participants joined Group A, but when they saw that the returns were higher in Group B, they switched. This would seem to have all sorts of interesting implications in the areas of cooperation, free riding, and incentives. “The bottom line of the paper is that when you havepeople with shared standards, and some who have the moral courage to sanction others, informally, then this kind of society manages very successfully,” says Bettina Rockenbach, the study’s senior author.

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