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Press Release

    Moral Character and Proper Incentives

    07/09/2002

    Does anyone in America want their kid to grow up to be just like Ken Lay, Bernie Ebbers or Jeffrey Skilling? Hopefully, after the civil suits strip these and other corporate thieves of their stolen wealth and criminal courts make them spend real time in a real jail, the lasting price these people will pay is that their names are forever synonymous with sleaze.

    A free enterprise system depends upon more than just greedy rent seekers. Moral character is a necessary pre-condition to the development of a functioning, prospering economic system based on the concept of “gains from trade.” Self-interested actors will not engage in a transaction with an individual that he or she does not trust. To bind individuals to promises and establish trust between actors who do not know each other well enough to risk millions of dollars, the law of contracts has developed to legally bind parties to the performance of their promises.

    Yet for contract law to work properly, it requires a widely accepted and practiced standard of moral behavior. When one party breaches his obligations, the widely accepted assumption must be that the individual will pay his prescribed penalty. An individual who signs a contract with no intention of fulfilling his obligations is committing fraud. If fraud is a widely accepted practice, contract law is dysfunctional.

    That is why the recent corporate accounting scandals are so bothersome and why the market has reacted swiftly with such brutal efficiency. Bad actors committed fraud so pervasively that the market is now worried about the basic moral character of the individuals in the system – and that’s a huge problem.

    Accountants at Arthur Anderson breached their contract to Enron’s shareholders. They also breached their partnership agreement with their other partners at Arthur Anderson. And, most significantly, they had no intention of paying the penalty for these breaches – they committed fraud. The market (and the law) since then has asked, are there other bad actors in the accounting industry? And the answer has come back as a resounding yes. WorldCom, Merck, Tyco, Microstrategies, etc. Too many audits failed to uncover corporate wrongdoing leaving investors holding the bag. Evidence suggests the audits failed because the specific accountants were more concerned with keeping their clients happy than conducting the job they had contractually obligated themselves to do.

    America is losing faith in the basic moral character of the accounting industry. Until it is restored, individuals will remain reluctant to risk their own capital in a company whose public numbers they don’t trust.

    Bernie Ebbers, Ken Lay and the corporate Hall of Shame looked at the companies they ran and the fiduciary obligations and responsibilities that they had, and decided to breach their obligations. And rather than pay the penalty for breach, their intention was to profit by committing fraud. They lacked the basic moral character required of participants in the free enterprise system.

    So what can the government do? The root cause of the problem was a basic moral failure by some very important and prominent actors in the system. Not only were these individuals willing to break the law, they figured out how to use the rest of the system’s broad compliance with the law as the actual means for them to make their loot.

    The most important remedy has already occurred. The basic moral revulsion of the American people will eventually serve as the calming influence over the free enterprise system. As time moves on, the actions and deeds of individual after individual will remind all of us of the basic moral character of Americans. It is one of the cornerstones that sets our economic system apart from rest of the world – including many of our allies. Japan, for example, has remained in a decade long slump in both their stock market and real economy in large part because of the underlying business/government corruption that clearly has not been wrung out of the system.

    As we move forward, there are probably some actions that could better align incentives with moral character. For example, increasing the penalties, including criminal, for fraud could help raise the cost of malfeasance to make it a far less attractive risk to take.

    But with all due respect, Congress can’t fix this problem. We need a moral solution, not a legislative solution, and it’s been a long time since the American people have looked to the United States Congress for our moral leadership.