Has Corporate Corruption Increased?

7 June 2006 at 5:22 pm 10 comments

| Peter Klein |

Teppo Felin asks an important question: has corporate malfeasance — earnings manipulation, information distortion, and outright fraud — increased systematically in recent decades, or are Enron, WorldCom, Global Crossing, and their ilk just a few bad apples?

Despite all the sound and fury over this question, the evidence appears to be surprisingly thin. First, there is the obvious methodological problem that we don't observe corruption per se, but only responses to alleged or actual corrpution. We know when firms restate their earnings, but not when firms should have restated their earnings and didn't. We observe SEC investigations and enforcement actions, but not the (presumably many) instances of Type I or II error.

Second, the time-series evidence on even these proxies is slim. Several descriptive studies document an increase in earnings restatements over the past 20 years (especially the last 5-7 years), though as far as I know there are no studies looking at longer time periods. Moreover, this literature offers several possible explanations for the trend besides malfeasance, such as the use of options-based compensation, increased accounting complexity, changes in auditor consulting fees, and changes in SEC behavior. Finally, it is hard to discern trends from SEC actions and private shareholder litigation because of frequent regime changes (e.g., the 1995 Private Securities Litigation Reform Act, designed to curb frivolous lawsuits, the 2002 Sarbanes-Oxley Act, etc.). In short, we don't know for sure if corporations are more or less corrupt than before.

There is a large literature on these issues (search SSRN for "restatements" or "earnings management"). Perhaps readers can recommend specific articles. Baruch Lev offers a good summary of the evidence in this paper in the 2003 Journal of Economic Perspectives.

Update: Brayden King also likes Lev, but calls him a postmodernist!

Entry filed under: - Klein -, Business/Economic History, Myths and Realities.

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10 Comments Add your own

  • 1. brayden  |  8 June 2006 at 1:29 pm

    Ha – actually I don’t think Lev is a postmodernist, but his article clearly pushes us to think about the boundaries of objectivity in measuring things that we normally assume are fact-based, like earnings. It’s a very interesting article.

  • 2. JC  |  8 June 2006 at 1:39 pm

    Since I popped into this blog a couple of days ago I have been pondering Peter’s question – particularly in the light of the seminar Bernard Marr and Baruch Lev organized at NYU in December. While with them I was fortunate to hear the EU view as well as the US view.

    In cosequence I suspect Peter’s title question about corporate corruption may not be framed appropriately, and the version he suggests ‘Are firms re-stating their earnings more frequently?’ may not be a good surrogate.

    From a methodological point of view an insufficient number of alternative explanations are excluded by this framing.

    My intuition is that earnings restatement is an option that is being used for all kinds of purposes, not all associated with corruption. The core issue is whether or not the firm is ‘telling the truth’ to shareholders and regulators. They might be ‘economical with the truth’ for all kinds of reasons.

    I find myself more interested in the notion of ‘corporate corruption’. Just what does this mean? SOX suggests it means failing to meet the demands of regulators. that’s useful because it defines corruption ‘externally’ in terms of a particular socio-historical institutional contexts, what firms are not supposed to be able to ‘get away with’. If this is the case, Peter’s question needs to be re-framed also in terms of the changes in the distinction between what the regulatory system eschews and what it ignores.

    For most of us the notion of ‘corruption’ implies some personal, moral, or social-norm boundaries rather than the legal or quasi-legal regulatory constraints.

    The point here is that corruption is either contextually contingent or it is universal in the sense of a universal moral code. There’s no point in having a purely subjective code – it may well be that Lay adn Skilling really do believe they were not behaving ‘corruptly’.

    But if we are thinking of corruption as grounded in particular contexts then we must focus retro-spectively on the regulatory apparatus and ask ‘did this firm contravene this or that regulation?’. This means dealing with specifics rather than a loose term like ‘corporate corruption’. And if we think about why and how the regulatory appratus changes at any particular time then we confront several different kinds of explanation.

    The most obvious, of course, is the short-term politics. Clearly SOX would have been unlikely but of Enron’s messing with California’s electricity. In this frame Peter’s question gets turned inside out into something like ‘under what circumstances are politicians able to use the concept of corporate corruption to pass legislation that might or might not have anything to do with corporate governance?’.

    The implied cause, which this political view surfaces, is that the legislation is passed because the ‘corruption’ is hindering the proper functioning of the economy. Now this seems really interesting to me. What proof has ever been marshalled for this?

    There is an urban myth that corrpution interferes with the proper function of the economy. Is this what concerns us? Or is it that some senior managers are extracting rewards that are either undeserved or outside the terms of the agreements the shareholders know about and/or have approved? Again the presumption is that this is ‘bad’. Really? Perhaps letting people dip into the till enhances their interest in what’s in it?

    Hmm … perhaps the real empirical issue behind Peter’s question is to unpack these myths and either prove or disprove them.

  • 3. Bo Nielsen  |  11 June 2006 at 5:01 am

    JC – I could not agree more with you. The question of “what exactly constitutes corruption” – is it contextually bound – culturally contingent etc. is important. To me, there is a difference between corruption and ethics (or moral). Corruption seems to imply external (legal) conditions whereas moral and ethics may be more internal and firm specific. What is considered ethical in one firm/industry/country may be considered unethical in another context. I often hear the argument that “in certain countries you cannot run a profitable business unless you engage in some level of briebery etc.” – the popular press and US economy seems to be ok with this – if everyone else is doing it then so can/must we – because otherwise we cannot compete efficiently in these markets… So back to the urban legend that corruption etc interferes with market mechanisms – do they? What exactly are proper market mechanisms? Who sets the standards and conditions for these theoretically nice yet empirically messy propositions?

  • 4. Bo Nielsen  |  11 June 2006 at 7:40 am

    Here are a couple of interesting references on the link between ethics and economics – note the old date of these yet they are still relevant!!

    1. Cost-benefit analysis: An ethical critique, Steven Kelman, AEI Journal of government and society regulations, 1981. See also comments in same issue.
    2. The social responsibility of business is to increase its profits, The New York Times Magazine, September 13, 1970.
    3. Are Corporations Inherently Wicked? Dunn, Business Horizons, July-August 1991.

  • 5. Peter Klein  |  12 June 2006 at 1:25 am

    Guys, thanks for taking this conversation in an interesting direction. I was originally thinking of "corruption" in a much narrower sense, simply the use of creative accounting techniques in a deliberate attempt to deceive. But you are of course right that corruption is a much broader concept than this.

    Also, even if one agrees that "corruption" makes sense only with regard to particular institutional, or cultural contexts, one can still investigate historical trends within a particular country, industry, firm type, etc. In other words, the comments above pertain mostly to the cross-sectional evidence, not the time-series evidence. Isn't that what people have in mind when they invoke the spectre of Enron? I.e., without any change in the relevant context, US corporate behavior became "worse."

    (Of course, it's far from clear that the premise — that the context remained the same over time — is correct. Note that Enron, WorldCom, Global Crossing, etc. were all involved in newly "deregulated" (actually "differently regulated") industries such as energy and telecom. The ability to navigate such treacherous regulatory waters — as I argued previously about Ken Lay — may have been the source of these firms' rapid growth and subsequent problems.

  • 6. orgtheory.net » Blog Archive » profit with honor  |  12 June 2006 at 2:08 am

    […] Here again is a book that presumes that we live in an unprecedented era of corporate corruption (I am not so sure [though open], neither is Peter Klein at the blog Organizations and Markets).  That said, the book seems to make a somewhat different argument than other books, at least recognizing that self-interest can indeed be quite enlightened and a mechanism for creating value (something that many reject outright), but a sense of honor and stewardship has been lost. Perhaps (working on my short sentences).   […]

  • 7. Sox First  |  13 June 2006 at 3:02 pm

    Certainly the Fannie Mae scandal, issues about hedge funds and the backdating of options signals that corporate corruption continues. For more check out: http://www.soxfirst.com/50226711/looking_for_the_next_enron.php

  • 8. Eric H  |  18 November 2006 at 5:14 pm

    It has seemed to me for a long time that “corporate corruption” in the media is the result of people engaging in increasingly risky schemes as a bull market runs long, and then getting caught out when the bear returns. In other words, when things are going well, some of the risky schemes pay off and nobody, least of all the shareholders, seems to mind. But when things stop going well and some of the risky schemes are exposed to be what they are, the shareholders want blood. IIRC, this was covered in the movie The Grifters. The two examples I would offer for this is the end of the 80s bull market, the subsequent collapse of the S&Ls, and the sudden discovery of corruption, and the other is of course the recent spate of scandals that are all about activity that transpired roughly in the 1998-2001 time frame. The public forgets that the prosecution and trials publicize something that occurred much earlier.

  • 9. rtone  |  19 February 2007 at 8:16 pm

    Corporate corruption? Is this about illegality? Morality and ethics? Maybe it’s about getting caught.

    The word “corporate” seems to modify the meaning so that if the company is small, then it’s not worth the corrupt label. You have to be big enough to deserve the “corruption” tag, lol.

    What is corruption anyway? Tax avoidance? Back-handers? Blackmail? Fraud? A conspiracy, a cover-up? Rigged recruitment? Insider Trading? Favours? Persuasions? A “Rigid Supply Chain”? Is it always illegal? Can it be cultural? Can a gift or a thank-you always be corrupting?

    I only know that “corporate corruption” is a rather vague and imprecise term. Hmmm. I wonder why! lol!

  • 10. sr&ed  |  24 September 2008 at 4:00 pm

    I think that corporate culture is devoid of leadership, which has led to a culture of entitlement. These top-level executives have power because of their position, but they are horrible leaders because they have not earned authority or credibility.

    Contrast this to the culture at Southwest Airlines. Southwest Airline’s culture is to help their employees discover their true capabilities. Their social environment combines fun with responsibility. Employees are empowered to make decisions in their teams without outside supervision. A Southwest team far outperforms a traditional rank-and-file team because their executives and managers are just employees, like “one of them,” and have thus, earned their respect.

    Corporate America should strive for business models like this!

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