Corporate Crime

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday March 30, 2009 at 12:44 pm
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Editor’s Note: This post comes from Wallace P. Mullin of George Washington University and Christopher M. Snyder of Dartmouth College.

Our chapter, “Corporate Crime,” (to appear in the handbook Criminal Law and Economics, edited by Nuno Garoupa, Edward Elgar, 2009) provides a new survey of the law and economics literature on corporate crime. We focus primarily on the relevant theoretical research but also touch on empirical research and policy issues.

We set the stage by updating some stylized facts about prosecuted firms. The data come from various tables in the U.S. Sentencing Commission’s Sourcebook of Federal Sentencing Statistics. Our descriptive analysis is similar to earlier studies using this data source, but we update these earlier studies with the most recent data. The most up-to-date of these earlier studies (Cohen 1996) used data for the 1984-90 period, while our analysis covers the period 2002-06. We also focus on facts that relate to the theory which we go on to survey.

We find that around a third of the cases involved fraud, 20 percent involved environmental violations, around 7 percent involved antitrust, and about an equal fraction involved a general “product” category which includes food, drugs, other consumer products, and agriculture. Around a third of the cases (40 percent in 2006) involved managerial tolerance of behavior of lower-level employees. This figure sheds some light on the theoretical and empirical controversy over whether criminal agents are acting in the interest or against the interest of principals higher up in the organization (firm owners or managers). The figure suggests that different models of corporate crime may apply to different cases. While there are some cases in which the criminal employee may have been acting as a maverick against the interests of the firm’s owners and upper-level management, in a substantial minority of cases the other cases the criminal agent may have been benefitted his principals (at least in the absence of sanctions).

We then proceed to a survey of the theoretical literature, organizing the discussion within a unified framework provided by the principal-agent model. Our model follows closely on Garoupa (2000), since his comprehensive analysis nests much of the previous work.

We distill several core principles from the theoretical literature concerning the optimal sanction level (should the sanction be set equal to the harm caused?) and the optimal sanction target (should the employee, shareholders, or both be sanctioned?). The chapter further addresses more nuanced questions including among others whether the state should consider corporate misdeeds a civil or criminal violation and whether the state should forbid corporations from indemnifying employees.

A final section concentrates on securities fraud, a topic of ongoing academic interest in the wake of corporate scandals (Enron and WorldCom) and resulting policy reforms (Sarbanes-Oxley Act). Although written before the financial crisis and the Madoff scandal, the chapter should be helpful to students of corporate governance. We survey both theoretical and empirical papers on securities fraud appearing in economics, corporate finance, and accounting journals.

Securities fraud presents some unique issues that do not arise with other corporate crimes. In the case of an environmental crime, for example, harms might be easy to quantify (the extent of the environmental damage) and harmed parties easy to identify (residents and other users of the environment). This may not be the case with misreporting of financial statements. In theory the harmed parties are the outside investors who are induced to buy debt and equity at perhaps inflated prices. But these inflated prices are just transfers between sets of investors. Are there any real social welfare losses from misreporting? We organize our analysis of these issues around a discussion of the model of Bar-Gill and Bebchuk (2002). Among other sources of inefficiency, the corporation may waste real resources on the act of misreporting, and the misreporting may lead to an inefficient allocation of capital toward bad projects and away from good ones.

We go on to survey the empirical literature on securities fraud. The literature seeks to find what attributes of the corporation lead to more misreporting. The theory suggests, and the empirical work confirms, that fraud is more likely the less stringent legal and accounting controls, the more stock a manager owns, and the more secrecy surrounding the manager’s insider trades. Unfortunately, the empirical literature faces severe problems in proving a causal link behind these correlations (i.e., in proving that corporate attributes cause an increase in misreporting fraud). Some of the recent work, especially that which seeks to evaluate the effects of the Sarbanes Oxley Act, take some sophisticated approaches to identifying causation, which we discuss in detail.

The full paper is available for download here.

 

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