financial fraud paper

CAN WE REGULATE HUMAN NATURE? 1

Can We Regulate Human Nature?

A Study of Financial Fraud, Government Regulation, and

The Principal-Agent Dilemma

Marketa Kreuzingerova

Brescia University

Dr. Rohnn Sanderson

Business Administration

1


Introduction

In recent years, corporate fraud has seemed to permeate the workings of the private

financial markets where dishonest accounting practices and extensive financial misstatements

led to the demise of America´s brightest and most promising enterprises. As a result of these

scandals, many Americans have been materially harmed. Thousands of jobs and retirement

savings in pension funds have been lost. Because of this, investor confidence has eroded

substantially. However, the greatest impact these crises have had on the world is that they

instilled fear in the average American citizen that private markets should not, and no longer

will, be trusted. Currently, they are seen as breeding ground for greedy, dishonest

businessmen.

The Enron debacle, which unfolded in the late months of 200119, seemed to be the

trigger for an avalanche of corporate scandals to come. In 2000, Enron reported over a 1.41

billion dollars in pretax profit and a share price of 90.56 dollars20. America´s favorite

company appeared to be in great financial shape and thriving. Positioning itself in the 7th

highest ranking on the Fortune 500 List in the same year, Enron was thought to be one of the

most successful innovators in the country, and the entire market was cheering it on as

investors were realizing capital gains on stock prices they otherwise wouldn’t have dreamed

of24.

After placing so much confidence in the company, it is easy to understand why Enron

´s collapse had such a devastating and profound impact on American financial markets.

Specifically, there were around 4,500 jobs lost directly related to Enron’s failure, with all

pension accounts frozen and never recovered2. While loyal employees found themselves

struggling to recover from the shock, investors lost 64.2 billion dollars, all in a matter of a few

days2. Through the practices of mark-to-market accounting, extensive off-balance-sheet debt

financing, and organization-wide internal control overrides, Enron transformed itself from a

promising new-industry business to the largest corporate bankruptcy to that date in the United

States of America10.

In the aftermath of the scandal, many began to question the trust placed in top

executives and the checks and balances present at those positions. Absorbing the losses

resulting from Enron´s failure, the public began, naturally, calling for more extensive

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regulation. While CEO and CFO fraudulent activities within the company were at question,

the more disturbing factor was the complete failure of all external “watchdogs” to prevent, or

detect and correct, the fraud that was taking place. Indeed, none of the investor analysts, bond

rating agencies, independent auditors, or SEC oversight managed to uncover the

misstatements that some claim they simply did not want to be seen.

In either case, these failures have had grave impacts on the accounting profession,

which has lost most of its credibility, as well as American financial markets, whose

trustworthiness people stopped believing. Yet Enron was only the first of many

disappointments to come.

Tyco International, the next in line in the domino effect of failing corporations

following Enron´s collapse, did not come to its breaking point until a year later, when

substantial misappropriation of funds by Tyco’s CEO, Dennis Kozlowski, was discovered12.

Up to that point, Tyco appeared to be in perfect condition as it was constantly expanding its

market reach, from security to healthcare services, and disclosed revenues of over 36 billion

dollars in 20011.

However, when Kozlowski´s activities came to light in early 2002, additional issues

concerning the company´s honest practices started to surface. Later that year, it became clear

that the embezzlement of hundreds of millions of dollars in cash and other assets on

Kozlowski´s part was accompanied by 56 million dollars given out to employees to pay off

inter-company loans, related-party transactions that never appeared on the financial

statements, and false appreciation(insider trading) of the company stock1. After the start of the

investigation, other executives, including the CFO and the Chairman of the Board of

Directors, were accused of participating in the embezzlements and placed on trial12.

Again, the signals leading to the fraud discovery were overlooked and the very few

who saw what was coming were silenced, as in the case of Enron. The reason was simple;

Tyco International, then conducting operations in over 100 countries, reported profits that

were too good to jeopardize by unnecessary questioning1. However, in Tyco’s case, the

annual revenue growth of 48.7 percent from 1997 to 2001 was backed by real value created

through successful operation of the company12. Unlike Enron, Tyco International did not have

to face bankruptcy and managed to preserve most jobs as well as retirement funds12. While its

stock price decreased immensely, this did not prevent the company from eventual recovery.

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In fact, Tyco has made extensive changes to its internal control environment as well as

ethical standards promoted within the company. This has allowed it to reclaim its success in

recent years. Despite a 2 billion-dollar write-off in the financial statements following the

scandal, Tyco continued to grow and now operates as three separate entities, each of which

became global leaders in their respective industry. This includes Tyco Healthcare, Tyco

Electronics, and Tyco Fire and Security12.

However, the recovery of Tyco International was a unique case of corporate fraud. As

other “too big to fail” corporations, including Sunbeam, WorldCom, and Duke Energy, began

collapsing, people all over the country were on the edge of their seats calling for more

regulation to prevent these situations in the future. Consequently, this continuous pressure

from the public led to a fast adoption of the Sarbanes-Oxley Act of 2002, which appeared to

have dealt with the issues of fraud taking place at that time. Following the enactment of the

law, there was a period of time during which the public came to believe that the problems

inherent to financial markets had been solved.

Then, in the late 2000s, the “financial wizard” and genius investment fund broker

Bernie Madoff came around. He offered double-digit returns when other investor groups were

only generating single. Clients flooded to Bernard L. Madoff Investment Securities, LLC

(BLMIS) seeking greater capital gains as well as increases in annual incomes23. As in the

previous cases, many failed to question the workings behind such returns as long as their

appetite for additional funds was being satisfied. Among others, his clients included large not-

for-profit organizations, usually charitable funds, formed by affluent couples and designated

for donation purposes15.

While the clients entrusted their savings with Madoff and were enjoying the unreal

returns, the former NASDAQ Chairman was very well aware that the entire system was but a

well-orchestrated show15. In fact, the profits generated by BLMIS were nothing but numbers

printed on paper, and consequently, his clients ended up with double-digit paper profits.

Unlike the other cases, where internal control and organizational checks and balances failed to

function properly, in the Madoff scenario, there were none5.

Madoff, being the owner as well as President of the company, had unlimited access

and control over the financial statements and their issuance. In fact, Madoff himself was

responsible for creating these financial statements by selecting stock prices that would

complement his earnings projections15. While a simple confirmation of quoted prices would

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have uncovered such fraudulent practices, none dared to question a company headed by a

former NASDAQ chairman, especially when he was generating such “magical” profits5.

As a result, it took several years before Madoff´s Ponzi Scheme turned into a public

scandal and BLMIS came crashing down with it. Naturally, as in the previous cases, the

consequences were grave. In the aftermath of the scandal, it was estimated that Madoff´s

clients lost approximately 50 billion dollars in their investments, even though the actual losses

incurred may be higher6. Overall, about 12,000 individual investors were affected. Many of

these found their hedge funds liquidated to absorb the impacts of the fraud5. In fact, Madoff´s

Ponzi Scheme had a much more profound effect on the American economy as many funds

dedicated to medical and other scientific research were frozen and funding for these programs

disappeared4.

In response to the scandal, Congress drafted and adopted the Dodd-Frank Act, also

known as the Wall-Street Reform and Consumer Protection Act, in an effort to calm the

increasing pressures from the voting public5. While it will be discussed in more detail later in

the paper, this law was aimed at decreasing the probability of loss to financial market

consumers5. In the meantime, many started questioning the credibility of the financial markets

again and what followed we came to know as the Great Recession.

While the case studies discussed above are undoubtedly unique in their nature, we can

identify certain attributes that all of them, and many others, share. First, the uncovering of

every fraud had some negative consequences, even though the extent varied from scenario to

scenario depending on the condition of the company. As illustrated by Tyco’s case, we could

see that fraud did not necessarily cause collapse if the entity had been backed by some

intrinsic value.

Second, each fraud case ignited a public outrage that eroded much of the investor

confidence and trust in the financial markets. Moreover, many started to despise the financial

community as businessmen came to be portrayed as evil profit-seekers rather than value-

creators. In fact, some have even started questioning human nature itself as a result of these

scandals; in recent years, we have seen the emergence of the field of behavioral finance,

which attempts to describe management behavior in psychological terms.

Third, this fear and questioning of human nature instilled in much of the public the

sense that the average citizen needs to be protected from corporate executives and their

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“dirty” tricks by regulation. As we can see, each case resulted in some form of regulation,

usually called for by the general public that was meant to prevent the next case from

happening. However, it was never so.

Therefore, this paper takes a different approach to analyzing fraud; it starts by an

introduction to the economic phenomenon also known as the principal-agent problem, then

introduces the specific impacts this concept had in each one of our scenarios, and concludes

by examining the benefits and costs of the regulation that was adopted in response to these

scandals. Finally, an argument for continued trust in the credibility of the financial markets

will be made. However, as with any other market analysis, this will not be done without a call

for ever-present caution and questioning.

Analysis

In private markets, we experience several phenomena that most would refer to as

market failures, which are instances when the markets do not generate optimal results, and

inefficiencies are generated. One of these phenomena is the so-called moral hazard, in which

one market participant transfers part of the possibility of loss to another party, effectively

reduces their cost of transacting, and therefore takes actions of greater risk. Often, because of

this greater risk, the likelihood of loss increases, and these losses are partially borne by

outside parties25.

Moral hazard occurs when there is incomplete or imperfect information, meaning that

one of the parties involved in the transaction often has different or greater-quality information

than the other parties. Sometimes, not enough information is available on either side of the

market. Consequently, a transaction carried out under imperfect information results in a moral

hazard25. In private markets, we often experience a unique form of moral hazard-the principal-

agent problem21.

A common example of the principal-agent problem is illustrated by the voter-politician

relationship, where politicians (agents) do not always do what is in the best interest of the

voters (principals) 9. While the principal-agent dilemma can be found in a multitude of

everyday situations, from classroom interaction to car purchasing, the problem most

commonly associated with this form of moral hazard is the issue of corporate ownership9.

The problem inherent in the establishment and operation of every corporate business is

that the owners, who initially supply financial as well as other resources to get the corporation

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on its feet, cannot or simply do not wish to make the time commitment needed to conduct its

everyday operations. Their desired level of commitment, then, is limited to the receipt of

periodic income from earnings and perhaps maintenance of a certain level of oversight over

company performance. Because they have already invested their time and money into the

firm, these owners, also known as initial investors, are mainly looking for a stable return on

their investment11.

Eventually, additional investors, either common or preferred stockholders, provide

equity capital for the firm to satisfy its financing needs. Even though their commitment does

not seem as extensive as that of the initial founders, these shareholders, too, look for a return

on their investment without unnecessary participation. It is important to realize that while a

large portion of the U.S. stock market is occupied by professional institutional investors, these

shareholders can also be families, individuals looking for retirement income, or college

students wishing to pay off their tuition. Naturally, these market participants do not have time

to devote to everyday operations of the company11.

In order for investors to achieve their desired state of affairs, they enter into a formal

contract with another party, represented by management-in this case the corporate executives.

This agreement, also known as an agency contract, puts management in control of operations,

including planning, production, and performance monitoring. This is done in exchange for

agreed-upon compensation. Most importantly, management is expected to maximize the long-

term value of the corporation, reflected by the average stock price over time, which then

generates positive long-run returns for the owners11.

In theory, such a contract appears to provide a neat solution to a multitude of

problems. While managers are compensated for their time and skilled labor spent on running

the firm, owners agree to give up part of the company profits in order to ensure stable

investment returns. However this is where the principal-agent problem, as well as economic

theory in general, come into play. As we know, all individuals have slightly different

personalities, attributes, and characteristics. What is common to each and every man on the

planet, however, is their self-interested nature that drives every individual to pursue activities

that best meet their unique preferences. Consequently, this special, unifying feature of the

human race can cause the greatest of problems for societies all over the world.

As surprising as it may seem, self-interest not only applies to you, me, and the rest of

our community, it also applies to corporate executives. This phenomenon, then, becomes the

heart of the principal-agent problem we experience in contemporary corporations. Because

both the owners (“principals”), and the managers (“agents”) are driven by their own self-

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interest, they have entirely different incentives that can lead to misallocations or inefficient

uses of the company’s resources9. As aforementioned, the principals are looking for

maximization of the long-term stock price, while the agents, even the most selfless ones, tend

to pursue interests unique to their own needs21.

Therefore, agents often take actions that are not deemed by principals as the most

appropriate; this misalignment of incentives is known as the agency problem9. Common

symptoms of such problem often include excessive risk-taking by management as they are

partially shielded from the risk of loss25. If too much risk is taken on by the agents, they do

incur losses in the form of lost compensation, impaired reputation in the marketplace, and the

opportunity cost of searching for a new job. However, their personal assets are protected and

in certain cases, sudden dismissal can often lead to substantial severance packages. However,

this does not necessarily make it beneficial for the manager to take actions that will get him

fired; it does, on the other hand, illustrate that costs incurred as a result of too much risk

taking are relatively low for the executives.

Clearly, the remaining costs spillover to other market participants, whether they are

directly involved in the agency contract, or not9. Most often, principals incur losses when part

of their returns on investment is forgone. While these costs can be material to the individual

investor, it is important to note that the personal assets of each and every shareholder are

protected by corporate law; the extent of the loss that can be borne by investors only amounts

to the size of their investment and creditors cannot make a claim on their personal property11.

In addition, costs of fraud are often borne by other stakeholders involved with the

company, such as its employees, retirees, suppliers, customers, and industry competitors. As

in the case of Enron and many others, retirement savings were forever lost for those who

worked for the company, and many found themselves struggling to find work. Moreover,

other natural gas companies, while maintaining healthy internal control and steady operations,

saw their stock price plummet alongside Enron as investors lost confidence in the entire

industry.

Finally, unrelated third parties may be forced to bear part of the cost. These third

parties, in our case the taxpaying and voting public, incurred costs in the form of lost

production but also the additional tax imposed to fund new regulation. Because third parties

absorb part of these losses, the social cost of risk-taking and fraud in general is higher than the

private cost incurred by the agents alone. This creates a negative externality, leaving the

society with a greater amount of fraud than is desired. To illustrate, let us examine how the

principal-agent problem manifested itself in each of the three case studies.

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An essential element of every principal-agent problem is the extent of controls present

to prevent or detect discrepancies or outright fraud in the system. Here, we focus on two

main forms of control relevant to our case scenarios-internal, which includes the checks and

balances as well as corporate governance and organizational culture, and external, which is

represented by a myriad of “watchdog” institutions that maintain additional oversight of the

company´s operations22. Overall, the combined operating effectiveness of these controls

determines the risk that fraud will not be prevented or detected, which in turn determines the

likelihood of fraud occurrence22.

First, internal control has several key components including the control environment,

control activities, and monitoring of the controls in place. Referring to the fraud case studies,

the control environment will be the single most decisive component in our analysis. As per

professional accounting literature, company control environment consists of appreciation for

ethical business conduct, an effective board of directors, and properly designed organizational

structure, which also includes the corporate culture22.

These components also directly relate to the theoretical framework surrounding the

classic fraud triangle introduced by Statements of Auditing Standards No.99, which defines

the conditions that must be present for one to commit fraud10. Referring to Figure 2, we can

see that for individual fraud, usually in the form of misappropriation of assets (defalcation) 22,

to occur, three conditions need to be satisfied. First, the individual must have an incentive or a

pressure to be able to commit the fraud; second, the attitude of the employee must be one that

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control environment

external auditors

investing publicregulatory oversight

Figure 1Levels of Fraud Detection

Fraud Potential

Fraud Occurence

Detection Level 1

Detection Level 2

control activities

monitoring

financial analysts, credit rating agencies

Internal Control

External Control


justifies the fraud. Last, an opportunity such as lack of or malfunction in internal controls

must allow the individual to carry the fraud out10.

Similarly, in a large corporate setting, dealing mostly with fraudulent financial

reporting on the management level22, the fraud triangle is adapted to reflect the changing

organizational scales. First, the leadership style of executives can provide incentives or exert

pressure on employees to falsely improve their performance. Second, the corporate culture

present within the organization often affects the attitudes of employees towards fraud; a

hostile, cut-throat environment may make it more appealing to justify fraudulent behavior.

Finally, management controls and their operating effectiveness should function to eliminate

most opportunities for employees to commit fraud10.

In the case-scenario discussion that follows, each of these conditions will play a key

role in determining why fraud was not prevented, and, most importantly, not detected by the

internal control systems in place. Additionally, the external watchdogs failed to report the

fraud that was slipping through the checks and balances within. Briefly mentioned in the

discussion below, the failures of banking institutions, credit rating agencies, and stock

underwriters to report unsound accounting practices contributed to the amount of loss that

stakeholders incurred when the scandals unfolded.

Referring back to the agency relationship between stockholders and managers, we can

see that management override of internal control is a symptom of the principal-agent problem

rather than its cause. While both internal and external controls play a critical role in these case

scenarios, it is the divergent incentives of principals and agents that give rise to the

phenomenon. These incentives give rise to three distinct situations that we commonly

encounter when dealing with the principal-agent problem.

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B) corporateB) attitude culture

A) incentive/ A) leadership C) management pressure C) opportunity style controls

Figure 2Fraud Triangle per SAS No.99

Individual-level Organization-wide


First, as outlined in Figure3, the agents themselves tend to break the rules of the

contract and work the systems in place to better suit their preferences. Often, this is a result of

poor incentive alignment by the Board of Directors in terms of management compensation.

While it is clear that the principals’ objective is to maximize the company’s long-term value,

it is often difficult for them to design such a compensation package that would incentivize

management to truly pursue this long-run objective11.

When studying the fraud scenarios, it is obvious that misaligned incentives were at the

heart of the problem at both Enron and Tyco International. To illustrate, Enron executives

received compensation based on meeting several performance criteria, but focusing mainly on

earnings per share (EPS). Because much of Enron´s operations’ focus was on maximizing

EPS, many ignored the fact that most company growth was done through extensive debt

financing, which did not create additional value for shareholders. The executives, however,

collected substantial amounts of compensation as long as the share price increased; and

therefore management made sure it did26.

Over the years, total compensation for the 5 highest ranking Enron executives grew

from 37.46 million dollars in 1996 to 107.67 million dollars in 2000, most of which was

allocated to bonus payments and stock grants26. Stock options, at the time, were the popular

means of aligning management values with the long-term stock price maximization goal of

shareholders. Through granting ownership at discounted prices, principals hoped that

managers would take a more long-run focus in operations and strategy-making. Enron

executives, however, had few restrictions prohibiting them from cashing the stock options

shortly after the exercise date, which defied the purpose of the stock option plan26.

What resulted, then, was a vicious cycle of constant increases in the short-term share

price, quick exercising of stock options, capital gains realization, and push for additional

share price increases. In 2000 alone, Enron CEO Ken Lay earned 123.4 million dollars while

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agents cheat the principals principals assume the role of agentsprincipals lie to themselves

Fraud-related principal-agent problem

Figure 3


former CEO Jeffrey Skilling cashed 62.5 million dollars by exercising their stock options in

time. This excessive focus on share price and EPS not only shifted management’s focus to the

short run, but it also eroded any intrinsic value the company still had27.

Share prices and stock trading played a critical role in the Tyco International, Inc.

fraud case as well. Over their years in function, top executives managed to gain 430 million

dollars at the company’s expense through fraudulent trading. This again reflected the short-

term focus that management had which, eventually, eroded Tyco’s average share price and

long-term value. Another fraud component prominent at Tyco was the misappropriation of

company assets for personal use by the CEO, Dennis Kozlowski, and his closest advisors12.

Over the years, Kozlowski managed to acquire a 16.8 million-dollar apartment on

Fifth Avenue, pay off an 80,000-dollar American Express bill, and organize his wife’s

birthday party in Sardinia for 2.1 million dollars by covering these expenses from Tyco’s

funds. Other executives, including the CFO Mark Swartz and General Counsel Mark Belnick,

received millions of dollars for personal purchases including real estate, yachts, fine arts, and

business investments. Clearly, the focus was not on long-run shareholder value maximization,

but on generating sufficient profit to allow for embezzlements of such extent to go unnoticed1.

Considering the amounts that were either falsely disclosed, as in the case of Enron, or

outright embezzled, as in Tyco’s case, one begins to wonder how such transactions remained

unnoticed for such a long period of time. Surely, there must have been some level of

suspicion when millions of dollars were misplaced. It is important to remember, though, that

in both cases, the conditions described in Figure 2 all reached an alignment that allowed fraud

to go unreported. To illustrate how the combination of poor leadership, hostile corporate

culture, and weak management controls prevented all actors involved from reporting these

fraudulent activities, we turn our attention to the environment in which both Enron and Tyco

employees operated.

First, the company culture at Enron was one that honored innovation, exceptional

performance, and individualism, but at the same time despised failure or anyone failing to

succeed in the ever-increasing race for greater profit. Jeffrey Skilling himself promoted

behavior with a razor-sharp profit focus and discouraged questioning of methods that

generated it. All Enron employees were periodically evaluated under the Peer Review

Committee (PRC) system, which eliminated the worst-performing 15 percent of employees

every six months. Through the PRC system and a set of incentives that idolized profit-

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oriented behavior, Enron´s employees quickly learned to seek gains whenever they could,

even at the expense of their colleagues. In their never-ending bonus chasing, they happily

failed to question their sources10.

Second, the leadership style instituted by Skilling only further promoted the

individualistic, short-term, performance-oriented behavior that slowly eroded the company´s

value. Since compensation in the form of stock option plans was tied so closely to share price,

most employees focused on share price maximization only, with little regard for its long-term

effects. For instance, John Arnold, one of Enron’s traders, conducted transactions that

generated over 700 million dollars in “book” profit, which earned him a 15 million dollar

bonus that he cashed and then terminated his employment10.

Finally, the ever-increasing profits and related capital gains of all Enron employees

helped loosen the integrity of everyone involved, even those charged with internal oversight.

Even though Enron championed a seemingly superior system of management controls, the

compensation-related incentives created many opportunities for control overrides. For

instance, both the Risk Assessment and Control Group charged with evaluation of new

contracts and the Board of Directors failed to report questionable practices of management

because the company’s continued profitability, not professional objectivity, was of their

primary interest. Finally, the checks and balances in place were completely circumvented by

Skilling, which was of little concern as long as the stock price was growing10.

In a similar fashion, most of the fraud taking place at Tyco International was linked

directly to its CEO, Dennis Kozlowski. From the very beginning, Kozlowski’s management

style was characterized by aggressive growth. This would not have been a problem if it was

complimented by strong internal control and oversight. However, at Tyco, this approach was

coupled with a unique form of decentralization that made such oversight difficult to exercise.

Even before Kozlowski’s time as CEO, he worked hard not only to expand the company’s

operations, but also to diversify it into separate units. As a result, Tyco International

constituted four different business units- including electronics, medical products, security

services, and flow control12.

While this approach generated immense growth for Tyco’s shareholders, it also

allowed Kozlowski to single-handedly control each of the four segments. Because the heads

of these business units reported directly to Kozlowski, who himself presented the company

performance to the Board of Directors, it was relatively easy for him to conceal true

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operations to those charged with oversight. In addition, Kozlowski enhanced this

decentralized structure with a management bonus system that seemingly reduced

compensation, but in fact gave executives greater power over their paychecks. His leadership

style did not allow questions regarding the company’s direction or its current activities, and

anyone raising them was quickly silenced. In fact, Kozlowski was responsible for terminating

his own employees who were doubting the reported numbers. Also, he exercised power over

the external environment, such as ensuring the termination of a Merrill Lynch analyst who

was questioning the company’s operating results12.

As a result, the leadership style Kozlowski had implemented granted him extreme

power over the company and its operating environment. The Board of Directors, already

weakened by decentralization, also consisted of members who were, in most cases, personally

elected by Kozlowski. These members, while not in absolute control of the Board, also held

all the critical management positions at Tyco. Most of the Board and the company was

controlled by Mark Swartz, CFO, Joseph Welch, CEO of one of Tyco’s business units, and

Frank Walsh, Jr., the director of the Board. While there were certain indicators that

Kozlowski’s behavior was unethical, and even illegal, these members, who had a major

conflict of interest, helped conceal and often participated in the fraud that was taking place12.

Clearly, the CEO’s leadership style as well as poorly functioning management controls

provided great opportunity for fraud to go uncovered. However, unlike the Enron case, Tyco

International’s corporate culture did not glorify the unethical practices that were taking place.

While Enron’s employees were encouraged to turn questionable profits to enable their lavish

lifestyles, the image that Tyco portrayed was one of modesty. Even though Kozlowski’s

actions did not match this general message, most employees were never made aware of how

the executives really lived. Quite contrarily, Kozlowski made it a point to advertise the

frugality with which management operated even in his public interviews12.

This approach, although seemingly trivial, helped Tyco recover from the losses that

resulted from the 2002 scandal. Unlike Enron, Tyco’s employees were still creating value for

their shareholders. While the executives misused some of those assets for personal use, this

value-backed approach provided a basis for a gradual recovery12.

We can see that the first manifestation of the principal-agent problem, where agents

cheat principals because of inverted incentives, can be greatly reduced by proper

implementation of strong oversight and other well-designed management controls22. In the

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cases of Enron and Tyco, however, these controls were completely subverted, which created

the environment that allowed management to commit fraud on an organization-wide scale.

The detection of this fraud and subsequent correction of related misstatements, will be in

question next.

Referring back to Figure 3, another problem we encounter in the principal-agent

dilemma is that in certain situations, the principals fail to recognize that fraud is taking place.

Rather, principals refuse to act responsibly even though the indicators of unethical behavior

are clearly present. Often, this is a result of extensive conflicts of interest that were also

present in both of our case studies. As illustrated above, the Boards of Directors charged with

internal oversight at both Enron and Tyco lost their objectivity as their personal well-being

was largely dependent on the success of the company under their control.

At Enron, the Board of Directors was generously compensated for the company’s

success in growing the share price and therefore its members’ personal stakes in the continued

operation of the company were high29. Because Enron’s stock price never stopped growing,

the incentive for Board members to report unethical practices was nonexistent. Instead, most

tended to overlook the fact that profits were being misstated because the false earnings report

often resulted in very real compensation. In fact, the average compensation of a director was

400,000 dollars in the year 2001, and bonuses for additional consulting services were

generous29. Other controls, including the finance, compliance, and audit committees, as well

as the financial disclosure director, were in a situation parallel to that of the Board, and gave

up professional skepticism for greater compensation10.

At Tyco, the Board of Directors was not only overlooking the presence of fraud;

rather, it was directly participating in it. Many, while not all, Board members received hidden

payments from the company that served to satisfy the members’ personal needs. For instance,

the director, Frank Walsh, was granted a secret 20 million dollar bonus for his services in the

acquisition sector. In addition, other companies under Walsh’s control often contracted with

Tyco, and they received generous compensation for their services12.

When Tyco’s fraud surfaced, Mark Swartz, CFO, and Dennis Kozlowski, CEO, were

accused of misappropriating over 170 million dollars in assets and realizing gains of 430

million dollars on illegal trading of Tyco’s stock12. Clearly, these related-party transactions

eliminated any objectivity of the Board, and the hidden payments helped many of its members

overlook the lack thereof.

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Moreover, Enron and Tyco experienced conflicts of interest that extended beyond the

firms’ boundaries. In both cases, outside institutions, including the bankers and financial

analysts, had little incentive to launch investigation of questionable corporate behavior of

their clients. Because these institutions had high stakes in the client’s earnings, they feared

that reporting these practices would threaten the revenue generated by servicing the client. For

instance, both Citigroup Inc. and JP Morgan Chase were fined over 225 million dollars by the

SEC in the aftermath of the Enron scandal for loaning funds to Enron in a way that improved

the appearance of the firm’s cash flows. However, Enron’s bankers were not the only ones at

fault. Financial analysts, along with credit rating agencies, were all partaking in the vicious

cycle of profit-chasing and thus failed to exercise professional judgment in evaluating the

company8.

In Tyco International’s case, the conflicts of interest were of equal proportions. As

aforementioned, Merrill Lynch failed to adjust its rating of the company stock and instead

terminated the employee raising who questioned Tyco’s transparency. This was a rational

approach for Merrill Lynch as their company’s revenue-generating abilities were closely tied

to those of Tyco. In fact, Merrill Lynch not only provided consulting services on the division

of frequent mergers and acquisitions, but it also acted as a major underwriter of Tyco’s

stock12. Clearly, downgrading the stock of one of its clients would hurt the performance of the

financial giant as well; therefore, the integrity had to go out the door to preserve the revenues.

Finally, the actors blamed the most for their shortcoming in discovering and reporting

these misstatements were the external auditors. In the wake of both scandals, much attention

was turned to the audit firms responsible for expressing unmodified opinions on the clearly

misstated financial statements. In the case of Enron, the scandal itself proved fatal to its

external auditors, Arthur Andersen & Company. At Tyco, the impact was not as extensive but

brought losses in trust and reputation to PricewaterhouseCoopers (Pwc) 12.

Naturally, the public looked to both accounting firms for independence, professional

skepticism, and objectivity that would ensure the discovery and subsequent disclosure of

fraud. However, they overlooked the fact that these external auditors, while independent in

form, faced the same conflicts of interest as any other institution transacting with their fraud-

affected clients. In fact, auditor independence was practically nonexistent in matter as revenue

ties between the client and its auditor were profound13.

16


Because accounting firms generated most of their revenue through consulting,

information system design and implementation, and management advice, the audits were

often pushed to the margin of the budget. As a result, audits were not only performed by

inexperienced staff, but the auditors themselves were pressured to perform the examination

quickly and in less detail14. Because Enron represented its second-biggest client, Arthur

Andersen was willing to overlook discrepancies in internal control as well as financial

statement presentation to preserve non-attest revenue20.

In addition, auditor independence was reduced to minimal levels as Andersen

employees in Houston were granted several offices at Enron’s headquarters and regularly took

part in company activities with other Enron employees. The lines were further blurred by

frequent interchange of personnel between both companies; indeed, Andersen auditors were

often hired by Enron to work on certain projects and vice versa. As a result, the auditors lost

their independence but also got extensive exposure to the internal practices taking place at

Enron13.

Because Andersen auditors were aware of the fraud that they failed to disclose, they

attempted to cover up their misconduct by shredding thousands of work papers and other

related audit documentation from the years 1997 to 2000. This action later resulted in an

investigation of the firm and ultimately led to its dissolution20.

When looking at the proportion of audit and non-audit revenue generated by the

accounting firms, it becomes obvious that extensive conflicts of interest prevented these

external monitors from establishing independence. While Arthur Andersen received 25

million dollars for performing the external audit, it was also paid an additional 27 million

dollars for other services13.

The audit revenues tied to Tyco that were generated by PricewaterhouseCoopers in

2001 amounted to 13.2 million dollars, which was only a small fraction of the 51.1 million

dollars paid for all of Pwc’s services12. This disproportion of fees, coupled with a direct

incentive for continued success of their client, created an environment where both quality and

accuracy of audits were secondary to revenue generation.

From the illustrations provided above, it is clear that those charged with oversight

within as well as outside the companies had little motivation to investigate the discrepancies

they encountered in dealing with the clients. Because the auditors’ revenues were tied to the

17


clients’, the incentive was to overlook the facts and hope that others would do the same,

which proved to be a sustainable practice for several years.

Referring back to Figure 3, the last manifestation of the principal-agent problem

emerges when principals also assume the role of agents. The Madoff Ponzi Scheme serves as

a perfect illustration of this form of principal-agent dilemma. Because Bernie Madoff acted as

both the principal, the founder and owner of BMLIS, and the agent, the chief managing

partner of the company, the incentives to cheat were even greater. First, Madoff did not face

costs in the form of repercussion from the directors or other owners, which reduced his total

costs of fraud. Second, his investment firm was organized as a limited liability corporation,

which shielded Madoff himself from creditors that would make claims on his personal assets

should losses occur6.

As a result, the objectives of the agent were perfectly aligned with those of the

principal because both resided in the same individual. Consequently, Madoff was able to

extract over 65 billion dollars from his clients through false generation of trading reports, and

this Ponzi scheme helped him realize 20 million dollars in personal gains. By accepting

clients who were looking for exceptional returns, accumulating their savings, seemingly

investing them in overseas markets, and using the accounts to pay off other clients, Madoff

orchestrated the largest Ponzi scheme to that date. Because no trading actually occurred,

Madoff was forced to create false confirmations, reports, financial statements, and SEC

filings23. In his plea allocution, he admitted to authorizing audit reports and other SEC

documentation and submitting them to be filed even though he was aware that they were

completely misstated15.

As in the two previous cases, the investors had a tendency to overlook the whole truth

about Madoff’s trading strategy. Similar to Enron’s Board of Directors, Madoff’s clients

enjoyed the profits they read in the reports and failed to question the mechanisms behind

them23. Indeed, none of his clients questioned the split-strike conversion strategy that Madoff

claimed to had invented simply because it was too good to be doubted15. Moreover, Madoff’s

clients put much trust into the BMLIS owner based on the extensive experience that he had

accumulated over the years in the financial markets. Clearly, the co-founder of NASDAQ and

SEC trading advisor took advantage of much blind trust from these clients who failed to see

beyond his public image23.

18


As illustrated above, all three forms of the principal-agent problem, whether it is

agents cheating the system, principals lying to themselves, or agents simultaneously acting as

principals, can generate outcomes with gravely negative consequences. In the wake of all

three scandals, many were startled to find that private markets gains sometimes get offset by

losses, and the negative impacts of these corporate failures caused a huge public outcry.

Consequently, there was a great push for additional regulation as many individuals lost their

faith in the stock market, or the corporate world altogether.

Because the media linked much of the losses and pain to the executives who were also

the faces of their respective corporations, many laid blame on them and came to believe that

all executives were driven by self-interest and greed. In fact, the percentage of individuals

who put “hardly any” trust in executives when asked increased from 11.7 percent to 17.3

percent after the Enron scandal3. As such, the average citizen felt the need to defend

themselves against these dangerous individuals, and naturally, called for protection in the

form of government reform. Since the Enron scandal was often linked to deregulation of the

utilities industry, it appeared that additional legislation was an appropriate solution.

In its outrage, the public failed to look beyond what was really happening in the

financial world; they focused their attention on the symptoms of the scandals instead of

addressing the underlying causes. At the time, the average investor who lost their savings due

to Enron’s failure gave little regard to the economic concepts that initially caused the

problem, and rightfully so. As a result of the public’s demand for a fast fix, Congress enacted

the Sarbanes-Oxley Act of 2002 in response to the Enron scandal16, and the Wall-Street

Reform and Consumer Protection Act of 2010, which addressed Madoff’s Ponzi scheme5.

The Sarbanes-Oxley Act (Sarbox), signed by George W. Bush on July 30 of 2002, was

only one of many regulations created to boost investor confidence in the stock markets across

the U.S. history. Drafted in hand with the Securities and Exchange Commission, the Act had

two major objectives. First, it sought to re-establish integrity in the financial markets and

therefore increase investor confidence. Second, it strived to prevent future fraud cases through

introduction of new disclosure requirements16.

While the scope of the legislation was very broad, the key issues addressed included

financial statement disclosure, external auditor independence, and integrity of the accounting

profession in general. First, the adoption of Sarbox mandated that corporate executives,

mainly CEOs and CFOs, accept direct responsibility for the content and presentation of the

19


financial statements. Under Sarbox, both the CEO and CFO must certify that the financials

are accurately stated in all material respects and full disclosure has been achieved. Because

the Act increased the penalties for false representations, the cost of committing fraud through

false financial reporting has increased for executives16.

While corporate executives were blamed for committing the fraud, the external

auditors were the second most targeted actors in all three of the scandals. As a result, much of

the Act focused its attention on enhancing auditor independence, which was so obviously

lacking in the cases discussed above. While new requirements were numerous, a few key

rules affected nearly every accounting firm in the country. First, public accounting companies

were prohibited from performing certain services for clients they were engaged in an external

audit with16. Second, the proportion of audit and non-audit fees was to be disclosed in the

financial statements, along with a Board of Directors statement acknowledging those services

and their impact on auditor independence22.

Third, all audit committees were now required to consist of outside directors only, and

all auditing matters, including planning and compensation, were to be settled through dealings

with the committee rather than company management. Finally, public accounting firms

performing more than 100 issuer audits were to be inspected every year and partners on

engagements were to rotate among clients every 5 years16.

Lastly, because the accounting profession was no longer trusted to operate effectively

under self-regulation, Sarbox created the Public Company Accounting Oversight Board

(PCAOB), which was charged with oversight over public accounting in general. Representing

a subdivision of the SEC, the PCAOB has broad implications for both accounting firms and

their clients. Among others, the Board enforces standards put in place by Sarbox, but can also

modify or completely reject any rules adopted by the Auditing Standards Board (ASB). As

such, it exercises great control over the accounting profession, and has the power to directly

affect the “rules of the game” adopted by the financial markets16.

Clearly, the scope of the Sarbox legislation is very broad. Even though the perceived

benefits include increased investor confidence, greater ease of capital acquisition by public

corporations, and future fraud prevention, a true measure of its utility will not be available for

years to come. The costs, on the other hand, have already been measured through research,

and they have proven to be immense.

20


However, even such extensive regulation as the Sarbanes-Oxley Act did not prevent

the financial world from experiencing another fraud-related scandal. Only a few years later,

the world watched as the Madoff scandal unfolded and the subprime mortgage loan market

bubble burst. In an attempt to calm the public outrage that followed, the government rushed to

the rescue again with additional regulation, the well-known Dodd-Frank Act of 20105.

Enacted on July 21 of 2010, the Wall-Street Reform and Consumer Protection Act was

adopted in response to the failures in the financial sector, particularly affecting the every-day

operations of banking institutions and trading companies. While the implications are nearly

impossible to summarize, the contents of the Act itself can be divided into several key

sections. Financial Stability Reform, Agency Oversight Reform, Securitization Reform,

Derivatives Regulation, Investor Protection Reform, Credit Rating Agency Reform,

Compensation and Corporate Governance, and the Volcker Rule are all components of this

seemingly all-encompassing legislation. Rather than focusing on regulating the actors charged

with outside oversight, this Act seeks to directly regulate the financial institutions

themselves17.

Relevant to the problems addressed in this paper, the Dodd-Frank Act seeks to impose

extensive restrictions on derivative trading as well as securitization by banking institutions.

Through the establishment of the Financial Stability Oversight Council, the legislation

imposes rules ranging from risk retention by securitizers to prohibition of proprietary trading

by bankers. In essence, the Derivative and Securitization sections of the Act aim to amend

previous regulation by strengthening the oversight, disclosure, and documentation in these

respective industry segments17.

Further, the Investor Protection Reform focuses on improving investor understanding

of financial markets through additional disclosure requirements enforced by the SEC. This

new function also mandates that periodic studies be conducted by the SEC on reporting

standards or lack thereof, self-regulation of certain organizations, analyst-related conflicts of

interest, and so forth. Finally, the creation of the Investor Advisory Committee, a sub-section

of the SEC, is aimed at further increasing investor confidence and thus bringing capital back

into financial markets17.

In addition, a portion of the Act is devoted to addressing corporate governance

structures as well as the compensation packages that executives receive. Mostly focusing on

additional disclosure by corporations, the Compensation and Corporate Governance section

21


also requires that executive compensation be reduced in the event that accounting

misstatements occur. Further, independence issues are addressed through new rules imposed

on corporate compensation committees17.

Similar to the Sarbanes-Oxley Act of 2002, the main objective of the Dodd- Frank Act

of 2010 was to boost the falling investor confidence in the financial markets17. In theory, an

increase in investor trust in the markets would also enhance the ease of capital formation and

acquisition as investors would become more likely to provide their savings to corporations.

While the objectives were clearly designed with good intentions in mind, it will be very

difficult to evaluate the actual benefits provided by these Acts. First, the benefits will be

nearly impossible to quantify because of the nature of the industry; second, the Acts may

produce unwanted secondary effects that might completely offset any benefits created.

While no exact measures can be provided at this time, many researchers set out to

estimate the impacts that both Sarbox and Dodd Frank have had on the financial community.

When looking at the research conducted, we find that while the benefits are questionable, the

costs are very real, and indeed have been measured to be extensive.

First, the costs related to the Sarbanes-Oxley Act have been relatively easy to observe

because the legislation has been in place for over a decade. While researchers differ in the

exact estimations of the Act-related costs, we can use these figures to at least approximate the

scope of Sarbox´s impact. In general, the costs associated with the implementation of Sarbox

can be divided into direct, or auditing and administration costs, and indirect, or opportunity

costs. According to the Academy of Management Perspectives, in the years following the

Act’s adoption, the audit fees amounted to 8.5 million and 1.25 million for large and small

firms, respectively. While this figure represents about 0.1 percent of all sales for large

companies, the toll on earnings is even greater for small firms28.

Researchers at Texas A&M also found that from 2001 to 2007, the absolute costs

related to the implementation of the Act were 39 million, 7 million, and 6 million for large,

medium-sized, and small firms, respectively. This increase in costs also affected the

companies’ cash flows; on average, cash flows from sales declined by 1.8 percent while cash

flows from assets declined by 1.3 percent. Overall, Sarbox costs eliminated about 0.5 percent

of total cash flows in large corporations and up to 3 percent in small companies28.

22


Finally, a study by Financial Executives International addresses the first-year costs

incurred by companies to stay in compliance with the Act´s provisions. For companies

generating, on average, 5 billion dollars in revenue, the expenses included 1.34 million in

internal administration (27,000 work hours), 1.30 million in auditing expenses, and 1.72

million spent on information technology and consultants7. Unfortunately, most studies

indicate that while the impact on large corporations is significant, the firms picking up most

of the costs are relatively small businesses28. As a result, the indirect costs of the legislation

might have a lasting negative impact on the economy as business activity contracts under such

prohibitive costs.

Second, the Wall Street Reform and Consumer Protection Act was signed into effect

only recently; therefore, the process of cost estimation has proven to be more difficult.

Nevertheless, the extent of the Act itself suggests that the absolute costs might be so great that

they will never be truly accounted for in their entirety.

To illustrate, the first four years of compliance alone have imposed over 21.8 billion

dollars of additional costs on the financial industry, which translated into human capital costs

of 60.7 million hours in administrative work. The expenses incurred are not only significant,

but are growing at an increasing rate as well. From 2013 to 2014, when this research was

published, the costs grew by 6.4 million dollars, which is an increase of 41 percent in a single

year18.

Perhaps because of the extent of the regulation and the fear that the public might not

approve of the additional costs to taxpayers, the government failed to disclose the full

amounts incurred; indeed, some cost analyses were released months after the Act was passed

and most were greatly understated. Moreover, certain costs were never made public. For

instance, a number of sections in the Dodd-Frank Act responsible for new rules were

completely omitted from the cost estimation process. When evaluated by researchers, these

sections added up to 1.2 billion dollars in additional costs18.

Moreover, the indirect costs imposed on the financial industry are profound and

perhaps more damaging than the cost related to administration. Because the cost of

conducting business has increased for many financial institutions, especially smaller banks, it

is possible that we will experience a real increase in the cost of capital, and perhaps a decrease

in its availability.

23


This secondary effect, then, might have very real implications for the individual

citizen as banks and other financial intermediaries might be reluctant to provide certain

services. Since the adoption, the most eliminated business units were residential mortgages,

home equity lines of credit, and lending in general. To illustrate, a study conducted in 2014 by

the American Bankers Association revealed that two-thirds of the institutions involved would

decrease the volume of lending18.

While knowing the exact amounts of the costs imposed on both the corporate entity

and the consumer is impossible, the process of estimation provides us with a clear idea of the

size of the impact that will sweep through the financial markets. Being made aware of these

costs, the only question left to ask is whether the adoption of such costly laws can be

economically justified.

Conclusion

In correctly assessing the situation, it is important to ask why the public asked for

additional regulation in the first place. Essentially, the reason behind most of the public

pressure was the desire for fraud prevention in future years. Because they were concerned

about the losses that had to be absorbed in the aftermath of these scandals, the average

citizens wished to see the risk of such loss eliminated. Being rationally ignorant, the persons

would look to government regulation as the optimal solution to such a seemingly complex

issue.

While the intentions of most people involved in the regulation-crafting process were

undoubtedly honorable, in the eyes of the economist, these intentions are ultimately irrelevant.

Instead, the focus of proper economic analysis is on the outcomes generated by each

respective solution, which is what ultimately affects the individual consumer. Therefore, to

arrive at an accurate conclusion, it is necessary to consider the factors relevant to both fraud

prevention and related business regulation, and the outcomes they generate in private markets.

First, it is essential to understand that fraud is, and always will be, a component of

private markets, whether they are regulated or not. Because all individuals act in self-interest,

the temptation to commit fraud is an inherent part of human nature. Under conditions where

incentives are misaligned, whether through compensation or other mechanisms, individuals

will tend to undertake fraudulent activities because it is the rational thing to do. While

statistically rare, a few individuals with above-average risk appetite will gain control of key

24


resources and such instances will likely lead to losses. Finally, gains will always be offset by

losses in private markets, whether due to fraud or natural market activity, and this self-

equilibration cannot be prevented by any outside mechanism.

As a result, it is clear that the principal-agent problem introduced in this paper will

always be present; indeed, no solution has yet been found to eliminate the problems

associated with this dilemma. Therefore, as long as principals act in self-interest, agents will

act in self-interest as well, and their interaction will cause inefficiencies in markets.

Second, while such notions are romantic in theory, the presence of regulation in

private markets will not prevent or eliminate fraud. Apart from establishing property rights

and enforcing contracts, there is not much more the government can do to improve the

efficiency of private markets. Looking at the number and scope of financial regulation we

have, ranging from the Securities Acts of 1933 and 1934, through Insider Trading and

Securities Fraud Enforcement Act of 1988, to Dodd-Frank Act of 2010, it would seem

reasonable to expect no additional fraud to occur16.

However, as evidenced by new scandals emerging every year, this is not so. In fact,

adoption of additional regulation might have quite the opposite effect; because investors often

regain trust in the financial markets when new regulation is introduced, they begin to have a

false sense of security which, in turn, makes them less observant and more susceptible to

losses. In essence, government regulation reduces the apparent need for questioning, which

increases the potential for fraud and risk of investor loss.

Further, even with the best intentions in mind, it would be impossible for the

government to solve the principal-agent problem because like any other market entity, the

government faces such a problem as well. As illustrated above, the agencies responsible for

cost estimation and disclosure of the Dodd-Frank act failed to report to the public the true

amounts of expenses that taxpayers would bear18. It is questionable, then, if the government

should oversee proper disclosure by other institutions when it fails to exercise proper

disclosure on its own.

After examining both sides of the issue, one is tempted to ask whether the costs of

regulation outweigh the losses incurred as a result of fraud. In the principal-agent problem, we

encounter the so-called agency costs, which are costs borne by principals when agents fail to

follow the agency contract and take actions different from those preferred by principals. The

25


agency costs represent the suboptimal results illustrated in the case studies, and such costs

should not be taken lightly, whether in their extent or nature9.

However, the costs of regulation are also high; taxpayers bear the immense costs of

implementation and they must also face the unexpected secondary effects of regulation on

markets across time. Often, these secondary effects can have more profound consequences

than any fraud could; decreases in overall productivity and reduction of business activity are

just two of many examples.

While the question of whether regulation is too costly to be used as a form of fraud

prevention will be left to each individual and their personal preferences, there are certain

factors that prove regulation to be a suboptimal solution to the problem of fraud. First, as

mentioned above, fraud will never truly be eliminated, no matter the number of Acts Congress

passes or the extent of each law. Second, in an attempt to regulate, governments and their

citizens often forget to see the underlying causes of the problem and focus on symptoms

instead, thus producing unwanted secondary effects. Last, it is impossible to regulate human

nature to such an extent as to eliminate fraud without imposing limitations on basic human

freedoms.

In the concluding paragraphs, an alternative is presented that should allow each

individual to evaluate the situation in terms of their own preferences. Referring back to the

basic goal of every corporation, maximization of shareholder value, it is clear that no long-

term goal-oriented corporation desires fraud to occur. Ultimately, neither managers nor

owners want fraud present in their workplace as it inhibits the company’s ability to generate

future profits, and often endangers its ability to continue as a going concern.

This, in turn, has very real effects on the stakeholders’ well-being, and therefore there

is a strong incentive to engage in activities that ensure fraud prevention. Even without

government regulators, companies design extensive internal control systems and undertake

monitoring activities that will protect them from losses from fraud.

Tyco International, Inc. is a prime example of the fact that although fraud may occur, a

company´s primary objective is to create value for the consumer and stay fraud-free. At Tyco,

Edward Breen, who became CEO after Kozlowski´s infamous step-down, restructured the

company and its internal control to prevent future misappropriations12.

26


In the first few years, Breen ensured that 90% of the headquarters’ employees were

replaced, severance payments increased for executives, and a new Guide to Ethical Conduct

was adopted. Even without the guidance from Sarbanes Oxley, Breen required that the Board

chairman be independent of the company and a new Board of Directors be elected by the

shareholders. These and other measures illustrate Tyco´s natural desire to prevent fraud

without the presence of regulation12.

In conclusion, the argument that each of us faces is very simple; is it more beneficial

to accept private markets with their inherent inefficiencies and risks of loss, and enjoy the

ability to exercise our freedoms in making decisions, or are the costs of doing so too high?

Similarly, do the benefits of increased government control, such as greater perceived degree

of safety, outweigh the costs, such as the lack of freedom to choose? Do we, as rationally

ignorant, self-interested market participants, willingly overlook the additional inefficiencies

generated by government to create a false sense of security for ourselves? Finally, how

willing are we to regulate our own human nature?

27


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