View source for How to Avoid More Enrons: Legalize Fraud

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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.


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