Thursday, October 26, 2006

 

Skilling and the Dark Side of the System: Temptations, Laws, and the Importance of a Systemic View on Corporate Scandals


Earlier this week, Jeffrey Skilling, former CEO of Enron, was sentenced to 24 years and 4 month in jail for his role in what has become to be known as the one of the biggest cases of fraud in the history of the
US economy.

Coincidentally, I watched the excellent documentary on Enron “Enron: The Smartest Guys in the Room” just a couple of days before. This movie sets out in a very entertaining but still highly substantial way the history of Enron from its beginnings in the 1980s until its collapse. It is really highly recommendable!

There was just one thing that kind of bothered me: the whole film focused very much on the personality of the people that were involved in the fraud. At some point, the filmmakers suggest that the criminal activities of the Enron execs were somehow linked to their need to prove their manliness (they loved to show-off with scars they got during motorbike races etc.).

This completely blinds out the more systemic aspect of the Enron scandal. Maybe this criticism is not justified, because there are scenes in the movie that suggest that it was not just the problem of one isolated firm, but that the whole scandal implied more people then just the nerdy Enron execs. Thus, the involvement of all major US (and some Swiss) banks, of law firms, and of Arthur Andersen are discussed. This shows that such behaviour is not necessarily linked to a particularly evil and ruthless CEO, but is rather the result of the system as a whole. From the simple employee to the CEO of any industrial corporation, bank, or any other type of business enterprise, every single one has first and foremost to live up to the expectations that are set in her in order to keep her job. This creates pressures from a various sides – your boss, your colleagues, the stock market, creditors, clients etc. – and leads to situations where cheating can appear appealing. Especially the expectations of stock markets press more and more down on listed companies. Will the quarterly report satisfy the investors or will it lead to a decrease in the share price, exposing the company to the threat of hostile takeover or to me losing my job? In such a situation, it doesn’t take a Jeff Skilling to be tempted to find a way to satisfy these expectations…In the movie this is best expressed, I find, in the recordings of the taped telephone conversations between Enron traders during the Californian Energy Crisis of 2000 (the tapes can be down loaded on the movie web page). The cynicism of these conversations is just outrageous…but at the same time not very surprising.
At least since Hanna Arendt’s book on the Eichmann trial in
Jerusalem, we know that anybody has to some degree the potential to “act evil” when the circumstances are favourable to such behaviour. In a highly competitive business environment where the stakes are very high for each cog in the machinery, the circumstances are ideal to put aside ethical and legal considerations. What I’m saying here is not meant to excuse such criminal – or even “just” unethical – behaviour. My point is that it’s too easy to say that Enron collapsed because Jeff Skilling is a particular ruthless person. That was also Sheron Watkins’ – former executive of Enron – point, I believe, when she said in one scene in the movie that Enron is not an isolated case – except for the extent of the fraud maybe – but that this can happen in any company. And apparently it happens more and more often, not just in the US but all over the world. White-collar crime is on the rise...

In yesterdays’ Echo der Zeit – a Swiss radio show on DRS 1 – a study on white-collar crime in Switzerland that was carried out by PWC was quoted. It states that in 2003 25% of the Swiss companies were affected by some sort of white-collar crime (mostly though embezzlement and fraud). One year later, this proportion had risen to 33%. Another study, carried out by, KPMG finds even higher proportions.

The trend seems to be towards even more white-collar criminality in the future. Thus, the Swiss Federal Police Office identifies in its Report on Homeland Security 2005 – still according to Echo der Zeit – a particular risk of criminality in the hedge fund industry.

Recent examples of supposedly criminal behaviour by managers (most of them have not been sentenced yet) are many in Switzerland and I have alluded to several of them in previous postings (Swissair and Swissfirst notably, but others can be cited such as OZ Bank, the SUVA scandal etc.).

Again the legislator has undertaken steps in order to counter this development: A reform proposal of the Stock Corporation Law has been elaborated by the Federal Administration, a public supervisory agency on audit companies will take up its activities in 2007 and legal responsibilities concerning corporate fraud have been newly defined: since 2003, the company as a legal entity can be held responsible for crimes committed by its employees.

However, and that’s the point I want to get at, it seems that the problem – in Switzerland – is not so much the legal framework than its implementation. In fact, in yesterday’s Echo der Zeit, Christof Müller – a lawyer and specialist in white-collar crime – stated that Switzerland lacks behind other countries not so much concerning the legal framework, but concerning the implementation of these rules. As an example he compared Enron, the Parmalat case in Italy to the Swissair case. All three scandals happen approximately at the same time. However, whereas the in the Enron case the trial court has rendered its judgement and the Parmalat case is well undeway as well, the Swissair case has barely begun. This is precisely what Julien was suggesting in one of his comments on my previous post on corporate scandals: rather than talking about the number of legal rules that exist, we should talk about the resources that are provided for the achievement of a certain goal. In Switzerland, the judicial system seems to lake the necessary resources in order to implement the laws that already exist. What good could new laws do in such a situation? The problem is not just one of efficiency but touches the question of justice directly. In the Swissair case for instance several of the accused are almost sure that there crimes will be prescribed by the time the process will begin. Again, this suggests that talking about new laws may not be the decisive issue after all…


Comments:
No doubt systemic factors are important; Enron would not have been possible without the deregulation of the energy and other sectors introduced by the Clinton government. As Joseph Stiglitz (former economic advisor to Clinton) underlines in his book "The Roaring Nineties", abolishing of state legislation had adverse effects. The Enron managers profited from the new opportunities made possible by the liberalization of the US energy sector, and also of the creative possibilities offered by US-style accounting. But, even though it is difficult to evaluate (for political scientists at least) what the exact importance of personality is, the episode with the scars shows that the social environment in which people like the Enron managers lived may have contributed to the severity of their crimes. "Manliness" is something which, I guess, is not without important in a male society such as it exists around Wall Street and other business areas. It would be interesting to ask whether manliness does also belong to the systemic factors which determine many economic decisions?
 
ML,
Thanks for the comment. Yes, liberalisation was indeed an important factor in the Enron story. Its initial success in the 1980s was very much linked to liberalisation and new trading technics. Also, the changes in the regulation of the Californian energy market was one major factor in explaining Enron's fall. Again, the movie gives an impressive account just how traders found loopholes and arbitrage possibilities in the Californian regulations.

Concerning the role of individuals and "psychological" factors in explaining the "misbehaviour" of execs I agree with you as well. In fact, if you look at Agency theory (Jensen and Meckling 1976), which suggest that it is just human to try to extract private benefits from situations where one has more information or more control over assets than others do. This view suggests, hence, that the individual matters very much: a very greedy person will be more eager to take advantage of its information advantages than a very integer person.
As a political scientist from the "Lausanne school" I'm reluctant, however, to attribute too much importance to psychological explanations. I'm probably wrong in doing so, but one reason is just that such factors are extremley tricky to handel in empirical research. "Manliness" for instance can be seen as a value that belongs to a certain system of values or to a culture. In that sense you're right, it actually is part of the systemic factors. Yet, such factors are very difficult to measure.

Anyway, there is some kind of renewed interest for what is called "leadership" or "personality" in political science. This approach puts the individual and its characteristics in the center of the analysis. Maybe these approaches could enrich the analysis of corporate scandals.

Best,
GS
 
Just one more thing: in the comment I just posted, I talked about agency theory, which states that individuals will be tempted to abuse of their positions within a organisation that provides them with information advantages.
I just wanted add that this theory of action based on self-interested, opportunistic behaviour aiming at maxising one's personal (most often material) utility is not the only one. In organisational psychology and organisational sociology, theories of action have been developed that see non material factors such as personal satisfaction, recognition by peers etc. as main driver of managers action. In this perspective, it is harder, it seems to me, to explain managers' criminal behaviour. In fact, agency theory, suggests that people behave par défaut in irrespective of rules and values as long as they don't risk punsihment. In otherwords a manger will not care about legal and ethical values as long as the risk of being caught is outweighed by the benefits that he gets from his behaviour.
In the second approach, however, one would rather think that people would per se behave with integrity and opportunistic behaviour is rather the exception, which has to be explained by exceptional circumstances (such as important pressures for instance). Again, this doesn't mean that personality is not important in the latter view, but its just a bit more optimistic way of seeing people...
 
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