TCS Daily

How to Avoid More Enrons: Legalize Fraud

By Jeffrey Alan Miron - May 30, 2006 12:00 AM

Last week a Houston jury found former Enron CEOs Kenneth Lay and Jeffrey Skilling guilty of multiple federal crimes arising from their fraudulent management of Enron. Lay and Skilling will likely spend most of their remaining lives in prison. That is appropriate, since both knowingly broke the law at the expense of their shareholders.

But the Enron debacle and similar scandals like World Com and Tyco raise broader issues: Should corporate fraud and malfeasance be crimes? Should the SEC dictate corporate disclosure and accounting practices? What would happen if all such matters were left to private parties?

To answer these questions, consider the following.

White collar "crimes" like fraud or embezzlement are different from ordinary crimes like murder or theft. The victims of white collar crime are not innocent bystanders; they are shareholders who willingly purchased a company's stock. That is, shareholders entered into "contracts" with the corporation.

So an alternative to the criminal / regulatory approach to corporate misconduct is private contracts. Under this scenario, shareholders would attempt to design and enforce contracts for executives that discourage fraud. This could mean organizational structures that limit the power of any one executive, checks and balances like outside audits, and deferred compensation that is conditional on good performance.

Despite clever contracts, some fraud would still occur. But under the contracting approach, this would be a civil matter between shareholders and the corporation rather than a matter of criminal law. Government would enforce these contractual disputes. But government would not criminalize executive misconduct or independently pursue white collar "crime." Likewise, government would not regulate corporate disclosures or accounting practices; it would let asset markets dictate the kind and quantity of information necessary to make investors buy shares in corporations.

Whether the contractual approach disciplines corporations more effectively than the criminal / regulatory approach is an empirical question. At a minimum, however, the criminal / regulatory approach has serious drawbacks.

To begin, reliance on criminal law and the SEC distracts attention from policy changes that would reduce corporate fraud and malfeasance by increasing the transparency of corporate accounting.

Prime among these is repeal of the corporate income tax. One way for investors to punish corporate misconduct is by bidding down the company's stock price. Investors cannot easily do this, however, without accurate information on corporate accounts. The corporate income tax complicates these accounts enormously by encouraging projects that make no sense other than tax avoidance. Such projects would disappear with repeal of the corporate income tax, and transparency would mushroom. Relatedly, regulation hinders transparency by breeding non-productive behavior designed to avoid this regulation. It is no accident that Enron's main activities were electricity, natural gas, and communications, all highly regulated sectors.

A key problem with SEC regulation is that it gives corporations an excuse for disclosing too little. When a regulator tells corporations they must disclose X, Y and Z, many disclose exactly that and no more. And, having complied with this regulation, they say to shareholders, "We've done what we're supposed to do." Without SEC regulation, investors would demand whatever information from corporations they desired, or shift their money elsewhere.

Still a further cost of the criminal / regulatory approach is giving individual investors a false sense security. Under current policy, investors can delude themselves that buying and selling individual stocks, or holding a non-diversified portfolio, is reasonable, since it seems the federal government has "taken care of" corporate fraud. In fact, no individual company is ever safe, and diversification is a key form of protection. Under the contracting approach, investors would be on notice. They would demand clear indications of honest accounting and reward firms that provided it, rather than making a blanket assumption of no misconduct.

The private approach to disciplining corporate behavior might seem heretical and speculative. In fact, it is roughly what already occurs. The corporate sector is far too immense for federal prosecutors or the SEC to monitor and discipline it effectively. Corporate misconduct is unusual now because the private mechanisms outlined above already operate to a substantial agree. Eliminating the criminalization of white collar crime would enhance these private mechanisms and thus increase corporate accountability.

Jeffrey Alan Miron is an economist at Harvard University. Find more of his writing here.



Victims and Solutions
“The victims of white collar crime are not innocent bystanders; they are shareholders who willingly purchased a company's stock..”

Shareholders are usually NOT the only victims of white collar crime. Victims can include employees, vendors, retirees, local government entities and communities. There would be less white collar crime IF the Boards of corporations competently executed their fiduciary duty of management oversight. In practice, however, most boards are controlled by Executive managers, thus weakening effective shareholder check of management abuse. Despite this weakness, enlightened self interest and individual integrity combine to minimize the instances of abuse. Yet the major failures of the past few years indicate that abuse is not a matter of IF, but only a matter of who and when. Investors of individual stocks are well advised to view the dual positions of executive and board member as a conflict of interest, and correspondingly devalue or avoid these stocks. However, even effective Board oversight will not deter all criminal activity. The proper combination of Civil and criminal deterrents is likely more effective than either alone. And when I say “proper deterrents”, I do NOT mean the fiscally burdensome and operationally misprioritized legislation that is Sarbanes-Oxley. Shareholders have invited management abuse and brought absurd solutions such as SOX upon themselves by failing to insure that their boards execute effective oversight responsibility. Until this changes, talk of eliminating criminal penalties is premature.

I guess I missed the part about Enron being immune to stockholder suits
And all the other civil remedies that defrauded investors have at their disposal.

The suits are stacked up and have been. But for some reason the ability of stockholders et. al. to sue didn't keep Lay et. al from cooking the books.

But now your solution is more civil suits, instead of bringing in the cops?? This brings libertarianism to a new height of ideologiy-induced blindness.

How to Avoid More Enrons: Legalize Fraud
The process of enforcing any law or enforcing the compliance to an agreement has to include 'a jail cell' at the end of the process.
The end of a law suit also has to be 'a jail cell' for non compliance with the verdict.
How else could agreements and the laws be enforced ? There has to be a 'stick'.
Any thoughts ?
If you just talk nicely, they will not do what you want...

Parliament of Finance
"Despite clever contracts, some fraud would still occur. But under the contracting approach, this would be a civil matter between shareholders and the corporation rather than a matter of criminal law."

How would the shareholders police the executives? Would a new contract need to be written everytime a new majority interest (50.1%) is formed? That sounds like a parliament of finance, which doesn't sound good to me. Worse, for the average investor, would be the reporting and policing idiosyncracies of every investment -- as if quarterly reports aren't dense enough.

Furthermore, I could easily foresee contracts and legal clauses that would prohibit small share-holders from asking tough questions or even having a right to know. No, the best system is an open system, and government regulations are needed to keep the glass offices transparent.

How to Avoid more Serial Killings: Legalize Murder
What a powerful formula we have here!

How about making all corporate directors liable?
Perhaps that would end the buddy system where the CEO can appoint a rubber stamp board who receive 200K annually to show up for 9-12 meeetings lasting 2 hours. If they had laibility for the actions of corporate leaders decisions perhaps they would safeguard shareholders and insure the accuracy and clarity of corporate financial documents.

I'd also like to see mandatory prison time for failure to uphold the fiducuary trusts of corporate officers rather than fines. I'm sure that 25 years (which I doubt they will serve) is a more effective deterent tyhan a fine which such malefactors have demonstrated time after time they can pay because of their ill gotten gains.

Lastly, the auditors should bear a heavy burden for approving misleading or incorrect financial statements. The auditors themselves should face prison time if it can be demonstrated they knowing took part in a fraud or promoting a misleading financial picture of a corporation's health.

bond markets
The bond market has private sector regulation in the form of bond ratings. Let's use a rating system for stocks. Major independent accounting firms rather than Federal regulators would audit the company's books. An auditor's reputation would be more valuable than the business of any one firm, so the auditor would have no incentive to participate in corporate fraud. If the Enron books had been privately audited, say, by Arthur Anderson, the fraud would have come to light much sooner.

Stealing money from investors and employees should be treated like burglary, taking property without violence or threat of violence. A Burglar who took $10,000 worth of stuff from each of ten houses might get 2 years for each job, or 20 years total. Ken Lay stole more than $10,000 from more than ten people, so he should get more.

You know, this rarely happens...but you articulated my thoughts concisely and economically. What gives with these libertarian anarchists???

I love it! Exactly! And this friggin moron is a Harvard professor????

Actually it is very difficult to prevent corporate fraud. Of more concern is the way some of the top executives are being rewarded or compensated and this boil down to the quality of the recruitment. Some of the expatriates based in Asia for example in one of the recent organization whose previous CEO was indicted actually do not contribute much, coming to work late, flying around in Asia with spouse and carry the title of Director of Sales. The whole organization know about it and yet nothing can be done. To such expatriate they are just touring the world at company expense.

Those 2 guys........
destroyed many thousands of homes, financial futures, and even marriages. I would not cry to see those 2 tied to 4 horses and spread to the 4 winds of the earth...ROMAN STYLE. No single man or group of men should ever have access or the capability to destroy and rob a company of many billions of dollars as they did. They put a huge dent in the US economy and should spend their lives in prison WITH NO CHANCE OF PAROLE.

Mutual back scratching
"Investors of individual stocks are well advised to view the dual positions of executive and board member as a conflict of interest, and correspondingly devalue or avoid these stocks."

Are there companies whose executives sit on their own boards? I wasn't aware that this practise was permitted in any company.

Instead what we have is interlocking boards, where Executive A sits on Board B, Exec B sits on C and Exec C sits on Board A. All these guys know each other, and none is likely to rock the boat.

Particularly in the matter of executive compensation. A hundred mil for doing a good job? Of course. That sounds reasonable. While we're at it, let's raise him another fifty mil, and remove that onerous requirement that he do a good job. Maybe he'll remember me when he sits in review of my own comp package next quarter.

This is a recipe for corporate malfeasance, since no one on any board has any incentive to punish excess. They've got the investor buffaloed. Instead when the next Enron is uncovered they should indict every member of the company's board as co-conspirators-- as they have the fiduciary duty to have detected and prevented corporate chicanery.

Hear, hear!
Right. The proper response to corporate crime is just to let all behavior be permitted. Then it would be up to one's guilty conscience to determine behavior. Besides, stealing money from an investor by deceit isn't really a crime. Nor is requiring employees to hold stock in the company. Nor is rigging the financial markets to defraud one's customers. Let the buyer, and the employee, and the public at large beware!

I would propose a codicil to this excellent plan, just in case the moral character of the corporate officer is still insufficiently developed to discourage his taking advantage of people who may have less than their perpetual full attention available to the guarding of their investments. Let's make it legal for any investor to shoot an executive officer of a company he invests in, no questions asked.

Re: Legalizing white collar crime
Shareholders are hardly the only victims (and, in fact are not even the group most devastated). Many of the long time Enron employees (if not most of them) lost all of their retirement with the collapse of Enron. Now you have thousands of older Americans who will not have time to recoup their retirement savings and will end up being mostly supported by Social Security at a fraction of the retirement income they should have had.
Ken Lay et al is the worst sort of criminal in our society, a person who destroys the dreams of thousands of people while passing the burden of their crimes to others. Even if Ken Lay is jailed for the remainder of his life (unlikely), it will not compensate for the destruction of the lives of the people he screwed.

No Subject
"Are there companies whose executives sit on their own boards? I wasn't aware that this practise was permitted in any company."

Most CEO's are on the board of the company they manage...many are even Chairman. They are what you call "inside" directors. It is not unusual for the CFO and the President to also be on the board. This is why before I buy any stock (or do business with any vendor), I carefully review both the Board and the Management of my potential investment/vendor.

My Response to this nonsense of legalizing fraud

I wrote a response to this nonsense on my blog and also sent it to Mr. Miron in an email. I welcome any comments you may have.

Inside Directors
"Are there companies whose executives sit on their own boards? I wasn't aware that this practise was permitted in any company."

Many Fortune 1000 companies have "Inside Directors"...directors who are also executive managers. In some companies, the insiders control the board.

Invasive federal involvement in corporate governance
Maybe I'm simply misunderstanding the point of your article. Are you suggesting that the government should be involved in determining the compensation agreements of executive officers and the corporation?

If so, do you not see this as MORE of a federal invasion on corporate governance then prosecuting executives under existing anti-fraud laws, laws prohibiting acts that most Americans consider criminal and immoral?

Contracts and their complexities, loopholes and vagaries can easily be designed and thwarted with clever wording and "fine print". In the immortal Danny Devito words in the movie "other people's money": "You can change the rules but you can never change the GAME."


Interlocking boards
I'm amazed. I had this same conversation with Mark-- the person who calls himself "the Great"-- and he had me convinced that the practise was illegal.

Oh well. Maybe he's great but fallible.

What about the Tyco robbers Dennis Kozlowski and Swartz
Remember those two punks that got off at first because that one jury gave them the "OK" finger sign....

...and then later, they got put behind bars for a GOOD long time.

The same should happen here.

Insist on dividends! Cash in the hand is real. The greater fool mode of investing is risky and will always be.

Scary Article
Scary Article if the author has followers. Letting companies and corperations get away with destroying pension plans of their employees.
The good line about " eliminating corperate income tax" give me a break. Do they pay any now? 50 years or more ago, the tax burden was borne mostly by business, now the tax burden largly is borne on the backs and of the ordinary people. Who does the government give large grants, preferential taxes, land zoning and numerous other perks that you and I don't get from our governments.
The author is a puppet for big business.

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