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.