Academic

I would like to offer a big thank you to the Conglomerate and to Christine for inviting me to comment on Urska Velikonja?s interesting and provocative paper, Leveraged Sanctions.  Urska revisits the issue of entity liability for accounting fraud and argues that a system of ?leveraged sanctions? will correct what she believes is an under-deterrence of accounting fraud among corporate officers.  Urska?s scheme is one in which the firm and/or ?knowledgeable insiders? suffer less liability provided they report wrongdoing and ?cooperate? by aiding in the investigation and sanctioning of culpable corporate officers.

The paper comes at an interesting time.  Although financial institutions have been roundly attacked for causing the financial crisis and economic downturn, it is not at all clear (as indicated by Brian Cheffin?s paper up on SSRN here) that accounting fraud and related corporate governance issues remain the problem that they were in the early 2000?s.  To the extent the Enron-type scandals were caused by poor gatekeeping and auditor conflicts-of-interest, the Sarbanes-Oxley Act arguably has reduced some of these issues.  (Either that, or the capital markets have found ways to correct for fraud, depending on where you fall on the ideological spectrum).  So it?s a question ? at least for me ? whether deterrence of accounting fraud is the order of the day when in fact other issues (properly judging risk, allocating power between shareholders and management, shaping the future of financial regulation) have become so important in contemporary scholarship.

According to the paper, accounting fraud remains important because corporate officers are under-deterred from accounting fraud.  Urska bases this opinion on both theory and empirical evidence.  First, she theorizes that officers who otherwise might lose their jobs for failure to meet performance goals, and who have the most knowledge about the firm?s financial status, have little incentive to disclose their own malfeasance to either the market or to public enforcers.  It seems largely unassailable that: (a) fraud can be a substitute for performance; (b) corporate managers have incentives to commit fraud; and (c) managers who intentionally commit fraud have every reason to cover it up when gatekeepers, shareholders and public enforcers investigate the firm?s financial performance.  However, Urska also relies on the two relatively recent empirical studies reported by Jonathan Karpoff et. al in both the Journal of Financial Economics and the Journal of Financial and Quantitative Analysis to come to the conclusion that officers routinely escape detection and liability.  I do not think these articles can be said to support this conclusion.

First, Karpoff et al?s papers did not conclude that officers walk away from accounting fraud without penalty.  To the contrary, they found that, of those corporations whose frauds were detected, 93% of the top officers either were forced to leave or explicitly fired.  A significant number (above 20%) were prosecuted criminally, and even those who escaped prosecution still had to deal with potential SEC fines and penalties, as well as difficulties in securing new jobs.  Moreover, as Karpoff et al show, the market reacts to fraud allegations quite badly.  Now, there may be an argument that there are many frauds left undetected, but I don?t think these studies establish pervasive underdeterrence.  Moreover, the studies cannot and do not capture the intangible costs of securities fraud investigations and prosecutions ? the endless meeting with corporate counsel, the resulting distrust both within the firm and between the firm?s management and its Board, the difficult relationships with regulators and the SEC, etc. 

Moreover, when corporate managers are prosecuted criminally, we know quite well that in the corporate context, their resulting sentences are likely to be very long.  Why? Because in the federal system, the United States Sentencing Guidelines measures criminal culpability in fraud cases  in terms of the attempted loss, which for a public corporation can very quickly range in the tens or hundreds of millions of dollars, even when the CEO?s participation in the fraud is relatively slight.  As a result, despite the fact that the Guidelines are now advisory, federal judges are now quite accustomed to handing out 15 and 20 year sentences to white collar corporate offenders.  Given the media?s reporting on such sentences, it is difficult to conclude that corporate officers who commit fraud are sitting in their offices, laughing at the possibility of going to jail.  If the sanction is extremely high, and 20% of the corporate managers investigated for fraud are going to jail, then perhaps something other than rational cost-benefit analysis is propelling them towards fraud.  Perhaps, indeed, the problem is that they are boundedly rational and either convince themselves that they aren?t really committing fraud or they irrationally believe they won?t get caught.  In sum, psychology tells us that in ambiguous circumstances, we are very talented at rationalizing our actions.  Leveraged sanctions will not necessarily cure this problem. 

I also had some trouble with the real-world implications of Urska?s proposed liability scheme.  Urska contends that her proposal is broader than the one made by Jennifer Arlen and Renier Kraakman in their 1997 NYU article (see SSRN link here), in which they explained that the corporate liability regime that would most optimally control misconduct was a ?composite liability? scheme.  The composite scheme holds all firms strictly liable for their employees? conduct, but then imposes an additional penalty on firms that have failed to monitor and report misconduct. 

Urska?s ?leveraged sanction? scheme is similar, except that she applies it beyond the criminal context (where arguably, the DOJ?s approach on prosecuting business organizations imperfectly tracks the Arlen/Kraakman composite liability scheme) to the civil context, and also applies it beyond firms to ?knowledgeable insiders.?

I enjoy reading theoretical papers, but it is not at all clear to me that this proposal ?fixes? the under-deterrence problem without imposing other, unintended costs.  Chief among them is figuring out which person or persons are ?knowledgeable insiders.?  Surely, the shareholders of the firm are not likely to be in this group.  They have little knowledge of, or rights to participate in, the corporation?s daily affairs.  Nor is it clear (and I credit Urska for conceding this in her article) that the Board or Audit Committee would have this knowledge.  Independent directors receive information from the corporation?s officers.  They might pick out discrepancies and provide a safe space for whistleblower employees to talk, but they also are likely to be in the dark when managers set out intentionally to defraud them.  Indeed, the groups that most likely might fall within the ?knowledgeable insider? label are attorneys and compliance officers.  I can?t imagine too many lawyers or compliance personnel who would willingly work at a firm whose insiders were collectively subject to ?leveraged sanctions.?  Moreover, I cannot imagine too many corporate managers or employees would want to talk to those persons who were identified as ?knowledgeable insiders.?  Finally, it is not all that clear to me that there exists some category of ?enforcer? who would accurately and intelligently impose an optimal schedule of sanctions.  One need not be a total cynic to conclude that enforcers, be they public or private, impose a number of agency costs on the people they are charged with protecting.  Although Urska?s paper touches on this problem, I think she can and should do much more here.

In sum, Urska?s paper is interesting and returns us to the perennial topic of how best to reduce wrongdoing within the corporate world ? in this case, accounting fraud.  Where she could greatly improve her proposal, however, is by providing a far more fine-grained analysis of the institutions she assumes will be implementing such a scheme, and the likely effects her proposal would have on the real-world human beings who populate such firms.