Criminalizing Corporate Behavior

“Entrepreneurs who hoard their wealth or seek governmental protection from rivals or revel in vain consumption or retreat to selfish isolation betray the very essence of their role and responsibility in the world.” That’s how writer and technologist George Gilder describes the harsh reality of what happens to entrepreneurs who stop creating wealth. During the past year, we have seen several high-profile examples of exactly what Gilder was talking about — corporate executives and former entrepreneurs who cooked the corporate books to inflate company earnings and keep firms’ stock prices artificially high in order to hoard the value of their stock options.

By all means, executives who committed crimes must go to jail, but we must not allow ourselves to get carried away criminalizing corporate behavior that is at worst poor management. First, instances of corporate fraud and misconduct are quite rare, occurring in less than one-quarter of 1 percent of all companies. Second, contrary to how the media portrays corporate scandals, accounting fraud and sweetheart financial deals are not the result of too little government intervention into the marketplace and insufficient government oversight of an unfettered capitalist system.

The media engage in their own kind of accounting shenanigans to keep ratings artificially inflated by focusing incessantly on a few sensational instances of real accounting fraud and routinely tying those scandals to dramatic declines in the stock market. Media sensationalism created a false public impression that corporate fraud is rampant and people’s retirement investments are widely being jeopardized by white-collar criminals lining their own pockets. While this media fairy tale might be great for selling newspapers and propping up TV ratings, it has little to do with reality.

What really constitutes a widespread threat to people’s retirement investments are ill-conceived government policies that undermine economic growth. Ironically, such policies frequently are the result of ill-fated attempts to correct a rare problem that has been exaggerated and embellished upon by the media.

Political opportunists exploit the media fiction to play the politics of envy and convince the public that stringent, far-reaching government action is required to stop this “epidemic” of corporate criminality. Rather than a dispassionate examination of the problem, Congress hurriedly enacts ill-advised legislation like the Sarbanes-Oxley Act, which essentially criminalizes accounting mistakes and poor management.

The Sarbanes-Oxley Act subjects chief executive officers and chief financial officers to enormous fines and lengthy prison sentences if their companies’ financial statements contain any material mistake requiring an eventual restatement of earnings. Exposed to such draconian penalties for what are essentially managerial mistakes, the cost of officers’ and directors’ insurance will go through the roof, it will become increasingly difficult for companies to find and retain top quality people to serve in these positions, and the officers and directors who do serve will divert their attention from building the company and making a profit for stockholders to covering their own posteriors against unreasonable regulatory demands. The greatest harm caused by Sarbanes-Oxley, though, will be to small firms that are pushed over the edge into oblivion or nascent public firms that are never born because of legal fees, accounting fees and other exorbitant costs piled on by the regulators!

The political demagogues who have used the collapse of Enron, Global Crossing and a few other high-profile business failures as an excuse to criminalize corporate mistakes and poor management ignore the fact that over the last two years there have been more than 70 major bankruptcies in the communications industry, with at least 23 more expected. There have been more than $100 billion in corporate defaults and $7 trillion worth of losses in asset values. A few of these bankruptcies may have resulted from accounting shenanigans, and a few more may be explained by poor business judgment, but with bankruptcies running through an entire industry, and indeed, an entire sector of the economy, the evidence is clear that we confront a problem beyond telecom monopolies or greedy and shady corporate executives. Moreover, in 2001 more than 60 percent of all corporate defaults were outside the telecom sector.

By focusing on accounting scandals and criminalizing corporate mistakes, we divert attention away from the fact that in most cases it was excessive taxation, deflationary monetary policy, and overbearing regulatory policy that undermined companies and entire industries that otherwise were thriving and had a bright future. Political demagogues who play the politics of fear and envy confuse cause and effect when they blame catastrophic business failure on accounting gimmicks. In fact, it was usually the prospect of catastrophic business failure brought on by horrible government policy that created the pressures to cut corners, engage in accounting irregularities and commit outright fraud.

By all means, we should promote corporate responsibility, but we should not criminalize business failure or poor management. When government attempts to codify ethics and best practices, it is counterproductive. Not only does it virtually always fail, it also undermines the authority and capacity of other institutions in society — from the church to professional associations — that are best positioned to define and enforce social norms, practices and mores.