The United States has undergone a wave of control fraud a term I have coined for what happens when criminals control corporations. The scale and gravity of this phenomenon is often misunderstood or, worse, denied. This is true of some of the comments in openDemocracys roundtable on corporate power and responsibility, which exemplify a form of collective insanity.
In the roundtable, Martin Wolf repeated the well-worn claim that Enrons failure demonstrates capitalisms virtues. It is a view most famously stated by Larry Lindsey, a member of George W. Bushs first (failed) economic team, when he said in January 2002 that Enrons failure was a tribute to American capitalism. The then treasury secretary, Paul ONeill, wasnt to be outdone. He insisted Enrons failure proved the genius of capitalism.
Martin Wolfs comments about Enrons failure are more disturbing than Lindsey and ONeills. They made their comments shortly after Enrons failure became public. They could be forgiven for hoping that Enron would prove unique that there were not scores of firms that had gotten away with control fraud for many years.
Martin Wolf insists it is important to remember that the market destroyed this bad company. Rather, it is more important to remember four other things.
First, Enron and its ilk have destroyed a goodly part of the market. The Nasdaq, for example, has lost up to three-quarters of its peak capitalisation and much of that loss is due to fraud.
Second, the market got around to destroying this criminal enterprise years too late after it had already caused enormous damage.
Third, it was the market that allowed Enron and its fellow control frauds to grow massively and cause so much damage to so many people. The financial markets provided billions of dollars to an insolvent, criminal enterprise. The men who controlled Enron used that money to make themselves rich and to buy, bully, bamboozle or bury politicians and regulators.
Fourth, Enron and its fellow control frauds hurt more than investors, creditors and employees. One of the reasons control frauds are so pernicious is that they can use the corporations resources to shape the environment in which they operate. As Paul Krugman wrote in his 11 December 2001 column in the New York Times: Enron used its political clout to create what one of its own executives called a regulatory black hole in which it could operate freely.
Tax Evasion Tsunami
Enron was pervasively fraudulent. It avoided virtually all Federal corporate income taxes through offshore incorporations in tax havens of ill repute part of what my colleague Jeff Kahn and I call a Tax Evasion Tsunami.
Enron was one of the most influential voices leading to the Bush administrations decision to junk President Clintons multilateral efforts to restrict these abusive offshore tax havens. Instead, the administration has announced its primary tax fraud initiative would be against those claiming the Earned Income Tax Credit that is, American workers near the poverty line.
Enron was the younger Bushs largest contributor, and was a major player in his efforts to be declared the winner in the disputed Florida election. Without Enrons fraud and its ability to fool the markets for years, it is unlikely that George W. Bush would be president.
It is true that ultimately, Enrons political connections could not save it. Corporate control frauds are, in general, Ponzi schemes that is, schemes which grow rapidly by borrowing ever greater sums and failure is inevitable. That does not mean, however, that those contributions to the administration did not pay off. Enrons record rise in stock value, which made its leaders enormously rich, was a direct result of the regulatory black hole. It is perfectly possible for a control fraud to fail and have the chief executive officers (CEOs) prosper.
I want to stress another aspect of Martin Wolfs analysis of the Enron failure that went without critical response in the roundtable. He says that because [Enron] was unprofitable it became fraudulent. But this is to ignore morality. When a corporation is likely to fail its leaders do experience moral hazard and they may succumb even though they have previously acted honestly. I call this reactive (as opposed to opportunistic) control fraud.
When I was a financial regulator, I often knew that a firm was a control fraud but I could not close it down because I could not yet prove it. I was appropriately restrained by our due process clause. Creditors and investors, however, operate under no such restraint. If they are suspicious they can sell their shares, refuse to buy shares, and refuse to make loans. Finance theory says that this is supposed to shut down control frauds promptly. This clearly did not happen with Enron.
Martin Wolfs analysis implicitly requires: one, a belief that honest CEOs are always just one financial bad quarter away from engaging in reactive control fraud; and two, that corrupt CEOs routinely fool the markets through massive accounting fraud that hides their companys unprofitability and makes them appear highly profitable. That, in turn, requires a view that control frauds are routinely able to suborn their external auditors and defeat all internal controls. In sum, Wolfs logic suggests that instead of being sanguine about the effectiveness of markets against control fraud, he should be convinced that they were grossly ineffective and that control frauds are the super predators of the financial world.
The second form of insanity is those who are in denial about large-scale financial criminality. Tom Burke said in openDemocracys roundtable that: No multinational company in my experience would knowingly operate in any way that was illegal. No one responded directly to this rather startling claim. But the major control frauds that have been exposed to date in the US are overwhelmingly multinational companies.
Multinational companies frequently bribe government officials. The Elf trials going on in France have made clear that it engaged in pervasive crimes in Africa. Halliburton (vice-president Dick Cheneys company) has just admitted to bribery in Nigeria. India has its Bofors scandals and Japans scandals involving the warplane manufacturer Lockheed led to passage of the Foreign Corrupt Practices Act in the US. Until very recently, French companies could deduct bribes as a business expense in calculating their taxes.
Moreover, at the very time of the initial discussions among Martin Wolf and Tom Burke, it was widely reported that New Yorks Attorney General, Eliot Spitzer had found evidence of widespread fraud at virtually all of the top US and some foreign investment banking firms. All of those firms are multinationals.
The thing I find most valuable about the roundtable discussion is that it serves as a diagnostic. Wolf and Burke accurately reflect the dominant law and economics view of corporate fraud and governance in the US and the UK; their co-discussants Malini Mehra and Sophia Tickell, who do not challenge this dominant paradigm, reflect with equal fidelity the lefts failure to use economics and finance to demonstrate that the paradigm is as pernicious as the control frauds it assumes away.
Condemned to repeat history the Savings & Loan debacle
The current crop of control frauds matches used techniques honed to perfection in the Savings and Loan (S & L) scandal in the United States in the 1980s. That scandal caused cost US taxpayers $150 billion according to the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) the most expensive US financial institution failure in history. This can be demonstrated in three ways.
First, every S&L control fraud, as with all of the largest current crop, was able to get a clean opinion from a top tier audit firm, usually for a period of several years. Indeed, a top tier audit firm is the leading ally of virtually every control fraud. Accounting fraud is the weapon of choice for control frauds. It allows the CEO to convert company assets to his personal benefit through normal corporate mechanisms (salaries, bonuses, stock options and perks). That minimises the risk of prosecution. The corrupt CEO choses which outside auditor to hire and can fire them if they get too independent.
Control frauds are invariably big users of their audit firm as consultants they deliberately exploit the resultant conflict of interest. The audit firm knows it will lose the valuable consulting work (which often generates more fees than the audit) if it gives the company a hard time on the audit. Control frauds also decide what business lines the company will operate. Corrupt CEOs work with accomodating auditors to find what operations provide for the most favorable accounting treatment and have the best loopholes.
I will return to the reputation interest in a moment. For now, I note the obvious agency problem. The firm should indeed have a strong interest in its reputation. The individual audit partner, however, is under enormous pressure from the firm to attract lucrative clients and control frauds pay much better than similarly-sized honest firms.
The corrupt CEO uses the auditor as a shield to deflect regulators and prosecutors. He always relies on the auditor.
Second, it is untrue that stock ownership by the CEO aligns his interests with that of shareholders. CEOs in the United States characteristically structure stock options, for example, to misalign those interests. US stock options for senior management are almost invariably based on short term performance the thing most susceptible to manipulation by the CEO through accounting fraud.
Moreover, contrary to the claims of Frank H. Easterbrook and Daniel R. Fischel, the co-authors of a highly influential study titled The Economic Structure of Corporate Law, it was clear in both the S&L debacle and the current wave of control frauds that corrupt CEOs were adept at gaining money from failing companies. Control frauds use abusive accounting to create record large false profits and increased income to the CEO.
Third, Easterbrook and Fischel are also wrong in claiming that high debt leaves the CEO with only the two options of earning high profits to meet the interest obligations or failing. Control frauds employ a third option they use accounting fraud to report high profits (blessed by large investment banking firms and audit firms). That allows the Ponzi scheme cycle to operate. High leverage for a control fraud translates into more opportunities to defraud the creditors.
Reputation and circular reasoning
One of the advantages that Easterbrook and Fischel have in establishing their paradigm is precisely that the former is a Federal Circuit Court judge who gets to declare what the law is. That means that when he denies the possibility that partners in audit firms can act against their own companys interests, people listen. No one summarises the resulting problem better than my colleague Robert Prentice, in his article on a ruling by Judge Easterbrook titled The Case of the Irrational Auditor:
The complaint does not allege that [the audit firm] has anything to gain from any fraud by [its client]. An accountants greatest asset is its reputation for honesty, followed closely by its reputation for careful work. Fees for two years audits could not approach the losses [the auditor] would suffer from a perception that it would muffle a clients fraud. And although the interests of [the audit firms] partners and associates who worked on the audits may have diverged from the firms, covering up fraud and imposing large damages on the partnership will bring a halt to the most promising career. [The audit firms] partners shared none of the gain from any fraud and were exposed to a large fraction of the loss. It would have been irrational for any of them to have joined causes with [the client] (emphasis added).
The truly scary part of this is that a number of other Federal courts have adopted this line of reasoning. I trust it is apparent that we are dealing with theology here. The plaintiffs case was dismissed he was not allowed to attempt to prove his allegation that the auditors assisted a fraud. If the case cannot be brought, then the claim that auditors never assist a fraud cannot be falsified.
Again, the argument has been shown to be false in hundreds of situations. Hundreds of S&L control frauds were massively insolvent and engaged in pervasive accounting fraud. All of them received clean opinions, usually for several years, from top tier audit firms. Indeed, the S&L control frauds used the (then) Big 8 exclusively.
Why is this? There are only two possibilities. One, the top audit firms in the US are so incompetent that they cannot spot pervasive accounting fraud in a single control fraud even when the S&L regulators pointed the fraud out to them. Two, they assisted the control frauds.
It is second verse, same as the first, in this regard in the ongoing wave of control frauds in the US. They virtually all use top tier audit firms and every single one of them was able to get a series of clean opinions for years. Enron doesnt involve one area of accounting fraud, it involves dozens of areas. WorldCom is the ultimate example. How can a top tier audit firm miss well over $5 billion of expenses improperly capitalised?
Judge Easterbrooks rhetoric, for example, decides the matter for him. He talks about whether the auditor joined cause with the fraudulent client. Control frauds almost invariably succeed in suborning the outside auditor. They do so because their area of expertise is human weakness. They shop for auditors until they find one who will aid innovative accounting.
Beyond theology to the real world
The Powers Report on Enron captures the real world that disappears under the law and economics paradigm. It discusses a clear example of fraudulent accounting, the creation of special purpose entities (SPEs) called Raptors:
The creation, and especially the subsequent restructuring, of the Raptors was perceived by many within Enron as a triumph of accounting ingenuity by a group of innovative accountants... We believe that perception was mistaken. Especially after the restructuring, the Raptors were little more than a highly complex accounting construct that was destined to collapse.
The dominant paradigm of corporate governance in the US and the UK claims to rest on rationality, but seeks desperately to avoid any examination of its precepts. It consistently produces embarrassing predictions in the context of control frauds. Indeed, all of its predictions about control fraud have proved false. The public policies that have sprung from the paradigm financial regulation and fiduciary duties should be weakened are major contributors to the ongoing wave of control frauds.
How to deal with control frauds
We need to take control fraud seriously if we want to stop the corporate super predators. The fact that they tend to follow best (fraudulent) practices makes them vulnerable. Knowledgeable regulators can distinguish them from honest firms. That means we can target the control frauds and spend our scarce investigative resources on them.
Indeed, we have an aiming point that allows us to hit the frauds at their Achilles' heel. Any Ponzi scheme must grow rapidly or die. Our re-regulation of the Savings and Loan industry was successful because it restricted growth. We can employ the same strategy against other waves of control fraud.
We know what factors have to come together to create waves of control fraud; we can use that knowledge to avoid those factors coming together so long we think strategically about risk. Ask yourself why virtually every US government agency has a chief economist but none has a chief criminologist or, indeed a junior criminologist.
No Federal agency has an office that requires the holder to ask the following types of questions: will the proposed deregulation increase the risk of control fraud? Is the industry we regulate headed toward a wave of control fraud? What lessons should we draw about control fraud from the S & L scandal? As long as these questions are not asked, we are condemned to repeat the past.