CHAPTER 1

Accounting Scandals, a Historical Perspective

The Role of Accounting, Financial Disclosure, and Auditing

Accounting, defined broadly, includes all aspects of keeping track of monetary and other business transactions for individuals, corporations, and other institutions. These records are used internally for management control and decisions. Periodic financial statements are issued to provide information to investors and other interested outsiders. Accounting started with the use of barter by merchant traders before the dawn of history, with archaeological findings suggesting the starting point of record keeping in the Fertile Crescent some 10,000 years ago. Italian merchants in the late Middle Ages developed double entry bookkeeping. Accounting sophistication increased as business expanded and economic complexity increased. Those mastering double entry had a competitive advantage and became more likely to succeed.

Northern Europe innovations included the joint stock company, stock exchanges, and the many inventions leading to the Industrial Revolution and factory production. Factory owners typically made little use of accounting until forced by desperation to figure out costs and how they made money, usually during depressions when sales collapsed. The vast majority of the firms did not adjust and failed. Eighteenth-century British Potter Josiah Wedgwood was one who used accounting to avoid bankruptcy during the depression of 1772 and build an increasingly thriving business. He had to understand cost accounting in enough detail to know the costs of specific products, where to save money, and how to adjust prices. Wedgwood improved the record keeping in enough detail to determine expenses for materials and labor for each manufacturing step for each product. For the first time, he discovered specifically what each product cost and adjusted sales prices accordingly. Wedgwood figured out that his high fixed costs encouraged increasing volume. His markets were roughly divided between high-price high-quality products for richer customers and lower-cost lower-price products for the rest. Focusing only on the needs of the wealthy, although lucrative, did not produce enough sales to make money, given the high fixed costs.

In the United States, accounting was initially primitive (not much different from Italian counterparts of the late Middle Ages) and improved as the need arose for better information, for roughly the same reasons as Wedgwood. Progress was made in New England textile manufacturing as it became larger, integrated, and more complex. Considerable progress was made by railroads especially in cost and managerial accounting as professional managers needed considerable timely information on railroad operations that became increasingly complex and costly. Andrew Carnegie adapted many of the accounting methods developed at the Pennsylvania Railroad (where he received his initial training) to make his steel empire the most efficient and lowest-cost producer in the country. Other manufacturing companies were making similar progress. By early in the 20th century, Du Pont developed the most advanced cost accounting system around, including the use of return on investment (ROI) and the Du Pont model for decomposing income.

Industrial accounting reached its mid-20th-century zenith at General Motors (GM) under President Alfred Sloan and controller Donaldson Brown. The accounting system of Du Pont was adopted and expanded (Du Pont acquired a controlling interest in GM before 1920). GM became the biggest manufacturing firm in the world by the mid-20th century, with arguably the most efficient manufacturing system in a decentralized structure. This structure worked because of the detailed accounting records maintained at the factory floor level and quickly delivered and analyzed by the centralized staff. By the 1960s, a host of problems including the rise of efficient Japanese and other foreign manufacturers began a relative decline at GM and other American manufacturers. Japanese systems focused on quality and various forms of efficiency eventually revolutionized manufacturing literally around the world. The rise of computers, the Internet, and robots and other forms of automation again changed the nature of manufacturing accounting.

Financial Disclosure

Financial statement and other disclosures typically presented in an annual report summarize the financial position, earnings, and cash flows to allow outsiders to have a reasonable financial understanding of the underlying business for the fiscal year. While most companies viewed financial information as proprietary and refused to release information unless absolutely necessary (such as to get a bank loan), balance sheets and other financial disclosure became more common in the 19th century as railroads and other large businesses issued financial reports to attract investors into their stocks and bonds in the capital markets.

Throughout the 19th century, stock and bond investors relied on cash dividend and interest payments rather than earnings (an income statement was viewed with skepticism before formal accounting standards were developed in the mid-20th century). Standardized financial disclosures evolved as the Securities and Exchange Commission (SEC) and the private sector bodies issued accounting standards (the Committee on Accounting Procedure, Accounting Principles Board, and the Financial Accounting Standards Board or FASB) increasingly focused on the content of the annual (and later quarterly) reports.

The standard annual report was the 10-K submitted to the SEC based on the SEC format, which included Management Discussion and Analysis (MD&A) and the financial statement section. Currently, corporations subject to SEC regulations (basically those listed on stock exchanges) must submit their 10-K to the SEC within 60 days of the end of the fiscal year. MD&A explains management’s perspective of performance, financial condition, and future expectations. Included in MD&A is an extensive discussion of corporate risks and how the corporation manages those risks (especially the use of derivatives).

According to the SEC, four financial statements are required: the balance sheet, income statement, cash flow statement, and statement of equity (www.sec.gov/investor/pubs/begfinstmtguide.htm). The balance sheet summarizes the financial positions (assets, liabilities, and equity), while the income statement describes the major revenue and expense (plus gains and losses) categories to arrive at net income and earnings per share. The cash flow statement reanalyzes financial information from a cash perspective, separating cash from operations, investment, and financing. The equity statement provides additional information on changes in equity from stock issues, repurchase of shares (treasury stock), and other comprehensive income and losses (gains and losses recorded directly to equity rather than through the income statement, also called “dirty surplus”).

Investors and other financial statement users have more faith in the accuracy of the annual reports, primarily because of the requirements of corporations to have a financial audit based on SEC requirements and to follow generally accepted accounting principles (GAAP). The FASB was established in 1973 as an independent organization (the previous two boards were under the American Institute of Certified Public Accountants (AICPA), the professional association of certified public accountants (CPAs)). Since 2009 accounting standard changes are made through the Accounting Standards Codification. Prior to the codification, the FASB issued 168 statements of financial accounting standards (SFASs) plus many other professional standards (interpretation, concept statements, staff positions, and so on). The current codification essentially represents a comprehensive summary of U.S. GAAP.

The format of the financial statements and the composition of the notes in the 10-K are primarily determined by SEC requirements and the FASB’s codification. The first note generally is a summary of accounting principles used by the company topic by topic (e.g., describing the company and business segments, new pronouncements, revenue recognition, financial instruments). A large corporation may have 50 pages of notes and in some industries many more. Large business acquisitions are described in some detail; companies with defined benefit pension plans may have multiple pages of tables and descriptions; executive and employee compensation may be complex and also have detailed notes. And on it goes.

Users might get by with summary financial information (these are available online at sites such as Yahoo Finance). Alternatively, considerable information is available from the 10-K, 10-Q (quarterly report), other SEC reports, the company’s website, and various finance Internet sites and other business media sources. For rather large fees, several huge data bases can be accessed for additional analyses. Unlike a century ago, there is no shortage of information, from raw data to detailed financial analysis.

Disclosure is critical in economic theory. Buyers and sellers (or agents and principals according to agency theory) have different amounts of critical information; usually, the seller has the relevant information useful for the buyers. Economists call this asymmetric information, which often leads to inefficient and sometimes disastrous decision making. Financial disclosures are one mechanism to reduce the information asymmetries between market participants. Of course, executives, and other participants with a vested interest in manipulation or other illicit activities have considerable incentives to hide or massage financial information.

Auditing

A textbook definition of auditing is as follows: “a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users.”¹ Fundamentally, an audit firm reviews the financial information of the corporation based on formal audit standards to issue an auditor’s opinion on whether or not the company conforms to GAAP. Thanks to the Sarbanes-Oxley Act of 2002, the audit firm also issues a report on the effectiveness of internal controls of the firm.

The audit profession was well established by 1900 and most of the original firms that became the “Big Eight” had been established in England or the United States. A century ago auditors typically checked every transaction: from the journal entry to the ledgers and back to every voucher or invoice; this was a simple, but time-consuming process. The point was to search for fraud and clerical errors. The audit role continued to expand as investors needed reliable information from major corporations and capital markets.

Audit regulations started in New York state, which first licensed CPAs in 1896. All states had licensing requirement for CPAs by the early 1920s. A national exam (the uniform CPA exam) started in 1917. In addition to state regulations, the majority of CPAs became members of professional societies (eventually the AICPAs became the most significant). There also were attempts to standardize both accounting and auditing practices. The Federal Reserve Board published Uniform Accounting in 1917, which basically standardized the audit process using a checklist for each balance sheet account and a standardized audit report.

A major source of new auditing standards came from audit results, with the failures the most noteworthy. An audit failure occurs when the auditor’s report states the financial statements are unqualified (i.e., in accordance with generally accepted accounting principles), when, in fact, the financial statements are false or misleading. (A business failure, on the other hand, usually refers to bankruptcy.) The botched audit of McKesson Robbins in the 1930s, which did not uncover massive fraud, led to formal auditing standards established by a committee of the AICPA.

The use of the computer was perhaps the greatest business innovation of the second half of the 20th century, but it took decades for the audit profession to effectively audit around or through the computer. Of course, audit failures continued, as did continued regulations to overcome deficiencies. Sarbanes–Oxley, in response to the bankruptcies (and audit failures) of Enron, WorldCom, and the rest, included substantial regulatory changes, including the establishment of a new government- sponsored regulator, the Public Company Accounting Oversight Board (PCAOB).

What Are Accounting Manipulation and Fraud?

Fraud is defined as intentional deception for personal gain.² Accounting deception and fraud, the deliberate misstatement of financial information specifically for personal gain, has been a perpetual problem since the rise of capitalism. (Capitalism is an economic system with private ownership of production and distribution, with production levels determined by markets.) Cases of specific accounting fraud were not much of a criminal issue until accounting standards were established beginning in the late 1930s. Prior to that, with no established rules, what would now be called fraud and manipulation could be “acceptable accounting.” Samuel Insull, infamous for utility stock pyramiding in the 1920s, was indicted for fraud in the early 1930s, but not convicted. The prosecutors could not convince the jurors that the illicit practices used were illegal or fraudulent. The first major accounting fraud of the accounting regulation era (since the Securities Acts of 1933–1934), did not take long. The on-going fraud of McKesson & Robbins, a large pharmaceutical company, was discovered (by an inside whistleblower, not the auditor) in 1938.

Corruption, on the other hand, the abuse of power or resources for personal gain ranging from deception and bribery to complex fraud, has a long and ignoble history. Corruption does not necessarily involve illegal acts, although corrupt activities are improper and unethical—with many successful scam artists operating on the edge between legal and illegal. As stated by business historian John Steele Gordon³: “nothing characterized American politics and thus the American economy so much as corruption.” A scandal is a widely publicized incident that involves wrongdoing, disgrace, or moral outrage. Economic activity runs in cycles—the business cycle of expansions and contractions, bubbles, and busts. Corruption differs from scandals because it may be commonplace, unreported, or even the norm. Transparency International creates an annual corruption perception index by country, with the United States in an undistinguished 19th place—just beating out Chile. Certainly corruption is the norm in North Korea and Somalia—tied for last place at number 182.⁴

A distinction can be made between explicit corruption and legal corruption. Daniel Kaufmann, president of Revenue Watch Institute and Senior Fellow at the Brookings Institute, estimated that about $1 trillion is paid annually in bribes around the world—one form of explicit corruption. Legal corruption, according to Kaufmann, represents legal actions for private gain such as lobbying, campaign contributions, and the revolving door between regulator/bureaucrat and corporate manager/lobbyist. Kaufmann’s index of legal corruption had the Netherlands with the lowest level of legal corruption (at 79.2) and the United States at a poor 30.8.⁵

Accounting manipulation is something of a special category. Companies are expected to “manage earnings,” basically trying to achieve specific financial goals such as meeting a specific earnings target—having positive net income rather than a loss or meeting financial analysts’ forecasts. Corporate executives have considerable discretion even in times of down earnings, such as reducing operating costs or lowering estimates of bad debts and hundreds of other reserves. On the other hand, company executives may be so desperate they are willing to commit fraud to achieve these ends. Enron had a not-so-illustrious history of doing exactly that, seemingly creating new categories of manipulation from one year to the next. It is difficult to determine how widespread illicit acts are within major companies or even the point at which earnings management becomes manipulation.

In an earlier book,⁶ I developed an earnings management continuum from conservative accounting through fraud, with a few examples summarized in Table 1.1. Earnings management is an expected objective of corporate management. Corporation should consistently use conservative accounting, such as recognize sales only after the goods have been received by the buyer and title passes. However, incentives exist (including executive compensation based on accounting performance) that could encourage managers to use more aggressive accounting procedures to boost current-period earnings. If quarterly earnings based on conservative accounting are 24 cents a share and analysts’ consensus earnings forecasts are 25 cents, the CFO can look for that extra penny, even if aggressive accounting is used. Based on Table 1.1, aggressive accounting and fraud can be considered earnings manipulation.

Why Do Companies Cheat?

According to Thomas Frank in Pity the Billionaire⁷ “crime pays: Wall Street, we suddenly understood, had never been a reward for ‘performance’ or a grateful recognition of what financial innovation did for the nation—it was strictly about what Wall Streeters could get away with.” More specifically: “(1) It pays to do it, (2) it’s easy to do, and (3) it’s unlikely that you’ll get caught.”⁸ Basically, it is perverse incentives versus ethical standards and regulatory effectiveness.

My first encounter with less-than-stellar business behavior came when I was a freshman in college. A friend, call him Steve, got a part-time job at a hardware store as a salesman. Early on, his commissions were close to zero and the owner almost fired him. Then the owner explained the rules. Steve’s commission depended on the business making additional money—somewhat analogous to “economic rents” (basically excess profits). If the customer wanted an item that was advertised on sale, ring up the regular price; if the customer complains, apologize for the error and ring up the sales price. When a customer asks for help, refer him or her to the dogs, overstocked or overpriced items to get rid of. And so on. Steve got the hang of it and started bragging Monday mornings on his latest scam to generate increased commissions. This was my introduction into the real world of business, or at least one of the ugly sides of business.

Lesson one on business behavior: behavior follows incentives. Steve’s incentives were obvious. If he wanted a commission, in fact if he wanted to keep his job, his boss demanded he cheat the customer. This ethically challenged policy was likely not a good strategy for long-run success of the hardware store, but that was not Steve’s problem. The basic incentive structure was not that different from new employees at Enron in the 1990s. The facts can vary in thousands of different ways, but the outcome remains the same. Adapt to the system, whether ethical or not, or leave.

Consider the Enron case, perhaps the biggest accounting scandal ever, certainly one of the most written about. The public knows a lot about Enron, because so many insiders and journalists wrote books (my personal favorite was Kurt Eichenwald’s Conspiracy of Fools). The Enron scandal proved personal for our accounting department at Texas A&M. David Duncan, Arthur Andersen’s managing partner for the Enron audit, was a distinguished graduate of our program. He was a good guy, dedicated, a church-going family man, hard-working accountant rising to the top ranks of what was then a Big Six firm.

Andersen was indicted for destroying evidence, shredding documents related to the Enron audit. It was Duncan’s decision (seemingly encouraged by top executives). As were many previous audit decisions allowing various aggressive Enron antics to continue. Duncan was fired by Andersen in 2002 and pled guilty to obstruction of justice charges. How was he caught up in this (at best) ethically ambiguous environment? I would not presume to know what specifically motivated him, but there was an obvious incentive structure and cultural environment. He had a prestigious job and was well-paid, apparently over $1 million annually. Andersen had a reputation for “aggressive auditing,” approving procedures that another audit firm may have denied. Enron’s culture certainly pushed the envelope on illicit activities, including pressuring auditors, attorneys, regulators, analysts, and banks to go along.

Lesson two involves regulations and regulators. Illicit behavior might be controlled if it is declared illegal, if the penalties are severe enough for perpetrators to take pause, and if the regulators actively enforce the law. The Securities Acts of the 1930s, for example, proved to be reasonably effective for decades and regulations were enforced by the relatively well- funded SEC. The same claim can be made for many if not most federal regulators. Effective enforcement involves well-written laws and regulations, adequate funding of agencies, dedicated leadership, and a culture of public service. Agencies can be crippled by changing regulations, reduced funding, and placing people in charge unwilling to enforce the rules (in part, associated with industries “capturing” the agency). There is pretty good evidence, for example, that the banking industry captured the Treasury Department and other banking regulators.⁹

An interesting question is to what extent government, and especially government regulators, take responsibility for fraudulent acts of corporations. In the Subprime Meltdown of 2008, at least hundreds of people committed illegal acts involving predatory lending and thousands of unethical (and perhaps illegal but never prosecuted) acts in the process of packaging mortgages into mortgage-backed securities and selling them around the world as AAA-rated securities—all with the blessing of the banking chief executive officers (CEOs). Alan Greenspan was Chairman of the Federal Reserve until he retired in 2006; in other words, during the development and peak of the mortgage bubble, which he encouraged in various ways and refused to regulate activities for which he had direct responsibilities. He committed no illegal acts, did not benefit financially from the mortgage bubble, and believed in what he was doing. Nevertheless, a case can be made that he bears more responsibility than anyone else for the catastrophe.¹⁰

Finding Cheaters

Incentives change over time; therefore, fraud and manipulation will also change. When foreign goods were taxed heavily during the 18th century, smuggling (transporting goods when prohibited by law) increased. When Prohibition outlawed liquor in the 1920s, organized crime moved in to provide illegal spirits. When tax rates went down in the post–World War II period (the top personal income tax rate was 91% in the 1950s and dropped to 28% with tax reform in 1986), executive pay exploded. CEOs in the 1950s wanted perquisites and other non-taxable benefits. In the 1990s and ever since, CEOs wanted stock options and big cash bonuses. Although they paid less in taxes, they wanted more income—much more. Because executive pay followed corporate earnings, “making the number” (increasing earnings per share based on rising analyst expectations) became job one—whether legitimate or not.

A basic assumption of financial analysis is predictions of future behavior of key actors can be made if the incentive structures are known. A good rule of thumb, for example, is to look at the compensation of the CEO and other top executives, which are detailed in the annual proxy statement. CEOs at companies with extremely high compensation levels, especially if they are not the largest or the most profitable in the industry, are more likely to engage in manipulation and unsavory practices. The premise is that an income-obsessed culture focuses on short-term profit over long-term performance, often with little if any interest in customers and other stakeholders. David Johnston¹¹ referred to electrical utility Entergy as just such a firm; J. Wayne Leonard was the highest paid CEO in the industry in 2008, while Entergy overcharged customers and skimped on infrastructure spending (including upgrading the electric grid). In other words, high billing rates but poor service. Entergy had plenty of competition: “Telephone, natural gas, water, and sewer utilities have been caught overcharging. … According to a New York Times report in 2007, every fifth dollar the state of New York pays doctors, hospitals, and other providers is for care either not rendered or not needed.”¹² The companies with the high-paid CEOs were the most likely to ignore high ethical standards.

In Detecting Earnings Management,¹³ I focused on signals of bad behavior. An analysis using annual reports and other public documents can spot signals of manipulation, but not specific illicit events; that takes the inside information of an auditor, regulator, or whistleblower. Potential signals include companies that hand out excessive amounts of stock options and other forms of compensation and have large underfunded pension plans (extra unfunded pension plans for executives is a prime reason for overall underfunding). Companies can manipulate various allowance accounts—there may be hundreds of these on the books. Unfortunately, the only reserve account that companies must report is the allowance for doubtful accounts (related to bad debts of accounts receivable). Big changes in this account that don’t match changes in receivables balances and sales are a potential signal. Presumably, if companies are manipulating this account, which is disclosed, they may be manipulating the hundreds of other allowance accounts big time.

The Big Scandals

The big scandals are those that make the history books, can be catastrophic to the economy, and often lead to increased regulation and oversight. Historically, the biggest and most disruptive scandals have been financial, usually after economic euphoria causing an asset pricing bubble and then the crash. The first recorded collapse was Tulip Mania in 17th-century Holland, literally over the love of tulips. The next century saw the South Sea Bubble and the Mississippi Bubble toppling the economies of England and France, respectively. The first American scandal was the Panic of 1792, when the country was exactly four years old. This involved the speculation of William Duer, a former Treasury official bidding up bank stocks based on insider information. His information proved to be wrong, he failed and went to debtors’ prison, and the economy fell into a mercifully short recession.

19th-Century Scandals

The 19th century could be considered the first American century, with the United States rising from what today would be called a Third-World agrarian state to the industrial giant of the world. There was no secret formula, just a sundry cast of inventors, entrepreneurs, speculators, bankers, and assorted others building on a growing infrastructure and new ideas, within a relatively free market. The connivers were just as innovative as the inventors and entrepreneurs, but did not and had no interest in benefiting the public. A free market with few regulations benefits the crooks at least as much as the entrepreneurs.

Banks were chartered and regulated by states and each state was something of an experiment in finance. Relatively little regulation existed in many states, especially in the “wildcat banks” of the west. With banks issuing their own paper currency, a rising money supply periodically led to speculation, an asset bubble usually in real estate, and panics and depressions. Beginning with the Panic of 1819, major panics driven by speculation occurred about every 20 years plus various minor ones in between. The biggest banking event was President Andrew Jackson’s ability to destroy the Second Bank of the United States in 1836 (essentially, America’s central bank), which helped fuel the Panic of 1837.

A major development in government was the political machine associated with a political party within a city, county, or state. New York’s Tammany Hall was the first, the most corrupt (but with plenty of competition), and the longest lasting. Aaron Burr’s run for president in 1800 from his New York base introduced Tammany members to Burr’s conniving political tricks. The Grand Sachems (the Tammany leaders) learned fast, including how to control votes, how to use patronage for power, and how to skim money from the city’s taxpayers, business people wanting licenses and permits, and various job seekers. Police department jobs were for sale with the price going up from beat cop to captain. The biggest Tammany villain was William “‘Boss’ Tweed,” the Grand Sachem after the Civil War. His level of corruption was so vast that he became one of the few 19th-century crooks actually sent to jail.

The major industry of the 19th century was railroading, getting its start in the late 1820s, becoming important by mid-century, and dominating the economy during the second half. Four major truck lines developed from the East Coast; the Pennsylvania became the biggest and developed many of the management and accounting techniques necessary for industrial success. The Erie proved to be the most corrupt, led and manipulated by speculators Daniel Drew, Jay Gould, and others. It would earn its epithet, “The Scarlett Woman of Wall Street.” The great railroad scandals were Cornelius Vanderbilt’s Raid on the Erie in 1868—he failed—and Credit Mobilier, the construction company building the Union Pacific half of the Transcontinental Railroad. Credit Mobilier involved stock payoff to politicians, which led to Congressional hearings, investigations, and indictments, but no convictions. Despite no slammer time for the culprits, it was still considered the biggest scandal of the century.

A multitude of scandals concerned the consolidation of industrial America by entrepreneurs such as John D. Rockefeller at Standard Oil and the Wall Street Bankers (“The Money Trust”), led by J.P. Morgan. To what extent these industrial leaders were heroes or villains has been hotly debated ever since. The success of industry concentration and growing monopoly power led to the Sherman Antitrust Act and other federal legislation to limit the powers of big business.

20th-Century Scandals

Although half the workers in the country still toiled on farms, America was an industrial giant by 1900 and many industries were big and dominated by a few firms. Monopoly power and related economies of scale became a key part of business strategy. After the Panic of 1907, the Congressional Pujo Hearings unearthed a whole host of illicit Wall Street practices of “the Money Trust” and various forms of stock manipulations. The 1920s became a decade of wanton abuses. This was the period of Charles Ponzi creating the infamous Ponzi scheme, the Teapot Dome scandal involving the federal government and oil tycoons, and a new set of Wall Street abuses. After the 1929 market crash the international match company Krueger and Toll failed and the Insull utility empire crashed, exposing additional fraud and corruption. By the end of the 1930s the McKesson & Robbins fraud exposed specific audit failures.

The post–World War II period brought economic success and new scandals. General Electric, Westinghouse, and smaller companies were involved in a government price conspiracy for turbine generators. For the first time ever, white collar criminals were sent to jail. The Penn Central Railroad went bankrupt after hiding information from investors and the public about the lack of liquidity, the biggest bankruptcy up to that time.

Conglomerates and other types of mergers were fueled by accounting manipulation, especially “dirty pooling,” summarized by Abraham Briloff as “cleverly rigged accounting ploys” (CRAP). Michael Milken’s junk bonds funded hostile takeovers and leveraged buyouts. A vast hostile takeover-insider trading-savings and loan scandal broke in the 1980s, sending Milken, Ivan Boesky, and others to jail and leading to the destruction of much of the savings and loan industry—requiring a federal bailout.

A multitude of derivative-related financial scandals started with the market crash of October 19, 1987. The market dropped 23% in a single day, with so-called portfolio insurance (a derivative play) the major culprit. Big derivative losses and scandals occurred throughout the 1990s, with the failure of hedge fund Long-Term Capital Management the major one. A mini-real estate bubble developed and popped in the 1990s, fueled by predatory lending and the start of structured finance. Apparently, the level of corruption and losses was not enough to actually cause new regulations or regulatory interest—that had to wait until the really gigantic real estate crash of 2008. A major financial scandal was Bank of Credit and Commerce International (BCCI), a global banking empire with a criminal corporate structure centered in Abu Dhabi, which collapsed in 1991.

Over the last half of the 20th century, several major frauds occurred at small companies. Equity Funding (1972) was involved in a computer fraud at an insurance company. ZZZZ Best was an insurance restoration company in the 1980s; its stock price growth was fueled by bogus restoration projects. EMS Government Securities defrauded Home State Bank of Ohio, in one of the few cases where a company bribed the auditor (a CPA) to cover up the fraud. Bigger corporate frauds occurred at the end of the 20th century. Rite Aid was a drugstore chain manipulating cost of goods sold, capitalizing operating expenses, refusing to write off obsolete inventory, and other accounting frauds. Consumer products company Sunbeam under a new CEO temporarily stayed afloat in the 1990s using aggressive and fraudulent revenue recognition and expense manipulation. Waste Management was another 1990s company with fraudulent accounting, including understating expenses, while violating environmental and antitrust laws.

21st-Century Scandals

It did not take long for major scandals to pop up in the 21st century. The tech bubble of the 1990s burst in 2000, followed by a whole series of accounting scandals: Enron, WorldCom, Adelphia, Global Crossing, Tyco, and others. Most were major failures at big companies, where the chief executives directed (or at least tolerated) the accounting fraud. All practiced long-term manipulation mainly to boost short-term earnings and stock prices to benefit executive compensation. It took the tech crash and recession to expose their misdeeds. Enron was the largest bankruptcy up to that time and likely was the major corporate fraud scandal in American history. Enron’s failure sent shock waves throughout Wall Street and Washington; Congressional hearings were called almost immediately after Enron declared bankruptcy in December 2002. Legislation was written but languished in committee. Then WorldCom failed after an attempt to fraudulently misstate operating expenses amounting to billions of dollars. WorldCom became the new biggest bankruptcy and within weeks Congress passed the Sarbanes-Oxley Act reforming financial and accounting practices.

The major financial scandal of the century (and perhaps in world history) was the Subprime Meltdown of 2008, when investment bank flim-flam nearly brought down the world’s financial economy. Mortgage lending and repackaging mortgages by investment banks created high- risk debt rated as investment-grade securities. Predatory banking practices and financial manipulations became increasingly widespread, with accounting fraud playing a secondary role. Major investment bank Lehman Brothers failed, Bear Sterns bought by J.P. Morgan in a “shotgun acquisition” with government support, Fannie Mae and Freddie Mac (government-sponsored enterprises created to guarantee and buy mortgages) seized by the feds and insurance giant American Insurance Group (AIG) and most major banks bailed out with federal funds under the Troubled Asset Relief Program (TARP). Despite a massive financial reform bill (Dodd-Frank), the wicked ways of the Wall Street banks continued.

Economics of Bad Behavior

Economists generally assume that humans are rational and selfish, and economic theory can certainly justify bad behavior. Even worse, this economic position seems to have the law on its side. Classical economic thought begins with Adam Smith’s Wealth of Nations (1776), which incorporates free markets and laissez faire, plus the magic of the invisible hand, generally limiting government involvement in the corporate sphere to enforcing property rights. Neoclassical economics developed the formal economic models of pure competition and maximizing profits, assuming rational behavior, complete information, and other factors that made the models elegant but not realistic.

The role of regulation and free markets has been debated ever since, given centuries of incredible economic success, but also extreme examples of fraud, panics, and market collapse—not to mention safety and other worker-rights issues, environmental damage, and tax evasion. Unfortunately, regulatory failures abound and cognitive capture of regulators exists. What is an economist to think? Perspectives run the gamut from libertarianism to socialism, with libertarianism seeming to have the best arguments to justify potential corporate bad behavior.

Pragmatic Perspectives of the Robber Barons

Nineteenth century industry is filled with names of ruthless businessmen developing gigantic corporations and vast wealth. The typical claim of the barons, such as steel magnate Andrew Carnegie (who wrote about it) focused on ruthlessness as necessary to stay in business; giving in to social consideration (such as employee welfare) would result in higher costs, inability to compete effectively, and, ultimately, failure.

William Vanderbilt, railroad tycoon and son of Commodore Vanderbilt, famously stated: “The public be damned. I am working for my stockholders.” Given that little financial information was provided and accounts seldom audited, it was not clear that stockholders were given that much consideration. Barons achieving monopoly power showed little regard for customers, such as railroads charging maximum rates to farmers and manufacturers delivering tainted foods and inferior products to customers. Timber interests, mining, petroleum, and chemical production decimated the environment, seemingly not of much interest to anyone except radical environmentalists, most notably future president Theodore Roosevelt, successful politician and bad businessman.

Employees typically were treated as another commodity. Wages, usually little above subsistence for unskilled workers in the best of times, often went down during depressions so companies could maintain interest and dividend payments. Worker safety was close to a non-issue as thousands of workers were killed each year and hundreds of thousands injured. Developing unions had little success, largely because governments enforced the property rights of business. Labor conditions periodically became bad enough to cause severe riots. Labor ultimately lost, but caused substantial economic damage in the process—both business and labor typically lost the public relations battle. Andrew Carnegie was a modest champion of labor rights; his contracts, for example, typically allowed salaries to rise and fall with the sales price of steel (in other words, about as close to a softy on labor rights as any robber baron can get). However, his name remains in labor infamy after the bloody Homestead Strike of 1892.

Business tycoons faced government officials on the take at every level, with extortion plans and bribes necessary to conduct basic operations. Progressive movements (political movements to provide social and economic reform) late in the 19th century resulted in governments becoming more of a friend to labor and the environment. Government corruption was reduced, although never eliminated. The role of government and regulation shifts over time, from periods favoring business (the 1920s) to period clamping down on business (the 1930s). The proper functions of rules and regulations continue to be debated, attempting to find the right balance of business versus public rights and responsibilities.

Social Responsibility Versus Libertarianism

Corporate social responsibility focuses on an ethical approach of executives to act in the best interests of all stakeholders: stockholders, creditors, customers, employees, and the public. Under this view, social responsibility is part of corporate governance and a major concern of the board of directors as part of the board’s stewardship and long-term planning roles. The Business Roundtable developed a “Statement on Corporate Responsibilities” in 1981, including the potential benefits to reduce environmental activists and other nonmarket threats and various ethical considerations that could actually increase long-term profitability.

Libertarianism considers individual liberty as the greatest political good with only a limited role for government. This view is roughly consistent with Smith’s laissez faire, although Smith had a somewhat greater role (and respect) for government. Noble prize-winning economist Milton Friedman was a proponent of libertarian economics and in an article conveniently called “The Social Responsibility of Business is to Increase its Profits,”¹⁴ espoused that limited role of social responsibility. The executive, according to Friedman, is the agent of the investors of the corporation and has the responsibility to make as much money as possible.

Friedman also notes that the company must conform to basic rules of society established by law and “ethical custom.” However, Friedman makes clear that spending on, say, pollution control generally should not exceed that required by law. Of course, libertarians, with little regard for government to behave effectively, would oppose most of these regulations: “I share Adam Smith’s skepticism about the benefits that can be expected from ‘those who affected to trade for the public good’.”¹⁵ Thus, Friedman viewed social responsibility as a “fundamentally subversive doctrine.”

Alan Greenspan, Chairman of the Federal Reserve (1978–2005), was a disciple of Ayn Rand, who preached objectivism, with many of the tenants of libertarianism. Despite bailing out Wall Street time and again (mainly because of the abuses of that most free market contract, the derivative), Greenspan was a believer in deregulation—an ironic perspective for the leader of one of the federal government’s major regulators. He apparently believed that competitive banks and other corporations would regulate each other and ensure no fraud or other bad behavior happened. Thanks in part to his support, major deregulation bills passed, removing the separation of commercial and investment banks and effectively deregulating all over-the-counter derivatives. Greenspan’s Fed also ignored the Fed’s responsibility for financial consumer protections. These actions greatly assisted the creation of the subprime bubble.

The libertarian perspective in politics is alive and well, especially in the Republican Party. Proponents include the father–son team of Ron Paul (former Congressman from Texas) and Rand Paul (Senator from Kentucky). The basic mantra is cut taxes, cut spending, and cut government regulations.

Duty of Loyalty

In addition to economic theory, there is the corporate law duty of loyalty. Board members, executives, and other fiduciaries must act in the best interests of the corporation, not in their own interests. Self-dealing is out of the question. An open question is whether this requires them to promote profit maximization above all else. If so, public interest be damned. As stated by Rosenberg¹⁶:

For decades, commentators and students of American business have accepted the basic premise that corporate leaders should make decisions that they reasonably believe to be “in the best interests of the corporation, with a view towards maximizing corporate profit and shareholder gain” and not to achieve any other social good.

Again, the interests of other stakeholders are not the concern of the executives and directors.

Leo Strine¹⁷ looked to the courts on the importance of corporate stockholders. Early on, he talked about a famous 1919 case against Henry Ford (brought by the Dodge brothers, competitors of Ford and stockholders):

Ford brazenly proclaimed that he was not managing Ford Motor Company to generate the best sustainable return for its stockholders. Rather, he announced that the stockholders should be content with the relatively small dividend they were getting and that Ford Motor Company would focus more on helping its consumers by lowering prices and on bettering the lives of its workers and society at large by raising wages and creating more jobs.¹⁸

Ford lost the case; the Michigan Supreme Court held “he could not subordinate the stockholders’ best interest.”¹⁹

Court cases continued. In a 2010 case eBay (once again, stockholder and competitor) sued Craigslist because Craigslist founder Craig Newmark focuses on a “community-oriented and community-driven corporation, not a cold-blooded profit-machine.”²⁰ The court favored eBay and, once again, a cold-blooded profit machine. As summarized by Strine²¹ :

In the corporate republic, only stockholders get to vote and only stockholders get to sue to enforce directors’ fiduciary duties. …Precisely because it is ultimately the equity market that is the primary accountability system for public firms, efforts to tinker around with the margins of corporate law through initiatives like constituency statues, the so-called Corporate Social Responsibility movement, and antitakeover provisions have been of very little utility in insulating corporate boards from stockholder and stock market pressures.

Extreme Cases of Bad Behavior

Perhaps the classic case to “defend” the economics of bad behavior is the Ford Pinto in the mid-1970s. The subcompact Pinto had this nasty habit of burning up in a crash. The answer according to the economics of profit maximization and duty of loyalty was cost-benefit analysis, which was actually conducted at Ford (based on an internal document later called “the Ford Pinto Memo”). The cause of the fires was a gas tank that could be punctured in a rear-end collision and, because of a lack of reinforcement between the rear panel and gas tank, the vehicle went up in flames. The cost to fix the problem was $11 per vehicle.

Fixing seems like a no-brainer, but it was not. Ford projected a number of deaths and injuries and multiplied these by expected damage (projected at $200,000 for one death and so on). That was the cost, compared to the “benefit” of saving 11 bucks per vehicle times the millions of Pintos expected to be sold. The conclusion was that the so-called benefits at over $100 million far exceeded the costs at less than $50 million. Ford was sued by crash victims in California and had to pay both compensatory and punitive damages in millions of dollars. (Juries were apparently swayed by Ford’s brilliant cost-benefit analysis.) The actual number of deaths due to the design flaw was disputed, but hundreds of people died and Ford was forced to settle claims and eventually recalled the Pinto to fix the problem.

A recent example of corporate risk-taking was the British Petroleum (BP) Deepwater Horizon oil spill in 2010, caused by a wellhead blowout—the largest marine oil spill in history. BP had a history of taking shortcuts on maintenance and safety (30 workers were killed and over 200 injured in two previous disasters), a case study of corporate callousness and the focus on short-term profits over long-term risks. In 2012 BP pled guilty to 11 counts of manslaughter (for those dying at the Deepwater site), plus lying to Congress and other misdemeanors, with other cases still outstanding—total costs to settle this and other cases: over $40 billion. Strine²² makes the case for bad behavior:

It is to be expected that a corporation that stands to gain large profits from aggressive drilling activities would less than optimally consider the environmental risks and occupational hazards that novel drilling activity posed. BP, after all, stood to gain all the profits from its activities, while the risks to the environment would be borne largely by others.

In this perspective, the bankers and others responsible for the 2008 subprime meltdown do not seem evil; instead, they were pragmatic executives attempting to maximize short-term profits for shareholders.

The Role of Regulators

Regulations are the formal rules and requirements for controlling social and human interactions. Business rules have been on the books since ancient times and American regulations started from British precedents, common law, and colonial and state laws. The American Constitution split various responsibilities between the federal government and states with the federal government responsible for trade with foreign countries, coinage of money, and levying taxes. Most regulation of business was initially left up to the states. This worked reasonably well when commerce and travel were mainly local, but expanding business meant conflicting rules across states and the inability of states to deal with interstate commerce—a federal responsibility. Business regulation evolved from the dynamic patchwork of state and federal attempts at appropriate legislation, under judicial oversight. Businesses lobbied for regulations in their own interest, often against the public interest. The interests of politicians (getting reelected and often indulging in bribery and extortion—now called campaign funding) and regulators (initially patronage) were not necessarily in the public interest.

Economic-related regulations became increasingly important to meet the legitimate constituent needs. Rules change with new demands—often settled by lobbying effectiveness (which, early on, usually meant cash payments); regulations also go through periods of diligent versus lax enforcement for various reasons. When Britain increased and enforced regulations on taxes and trade after decades of lax enforcement, the result was the American Revolution. An interesting point is that lax enforcement are more likely during the boom times, partly because regulators do not want to disrupt prosperity—often encouraged by politicians on the dole from lobbying beneficiaries. New laws are put in place after economic collapses and the budgets and regulatory mandates expanded to increase enforcement (part of the “solution”). The most recent example was the Dodd-Frank bill of 2010, passed after the Subprime Meltdown. Bankers lobbied against the bill, then lobbied to reduce its effectiveness with both legislators and agencies writing and enforcing the provisions of the bill. Conveniently, banks (and other affected groups) often have lucrative jobs waiting for accommodating regulators and politicians.