Scandal Scholar

Jonathan Karpoff discusses his picks for the five worst cases of corporate financial fraud in the past decade

Jonathan Karpoff is no stranger to scandal. The University of Washington Foster School of Business professor of finance is one of the nation’s foremost experts in corporate crime and punishment, recently publishing landmark findings on the serious and unexpected cost to firms and executives for cooking the books. We asked him to weigh in on the worst corporate scandals of the past decade.

Foster Business: What are the most significant cases of financial fraud?

Jon Karpoff: I’ll give you my top five, á la David Letterman, in increasing order of importance:

5. HealthSouth (2003)

The prototypical financial scandal. At its heart was a kind of fraud that is easy to understand: CEO Richard Scrushy directed underlings to literally make up numbers (and fictitious transactions) to increase the firm’s reported earnings by $1.4 billion from 1996 through 2003. The fraud was so large and brazen that it leaves most of us wondering, “What were they thinking? Could they ever have thought they would get away with it?”

Amazingly, however, Scrushy did get away with it—almost. In June 2005, a friendly hometown Alabama jury acquitted Scrushy of all the accounting fraud counts brought against him. Prosecutors kept at it, however, and in June 2006 he was convicted on charges that he had bribed Alabama’s governor to receive a seat on a medical regulatory board.

4. Tyco International (2002)

CEO Dennis Kozlowski symbolizes the excesses of executive compensation at shareholders’ expense. In 2005, Kozlowski and chief financial officer Mark Swartz were convicted of stealing $600 million from the company. Kozlowski will forever be remembered for the $2 million birthday party he threw for his wife on a Mediterranean island that featured entertainers dressed in togas and an appearance by singer Jimmy Buffett—mostly at company expense.

3. Bernie Madoff (2008)

Madoff ran the largest Ponzi scheme in history until he was caught in December 2008. He makes the list for two reasons. First is the sheer size of his fraud—$65 billion missing from clients’ accounts (although actual client losses were closer to $18 billion). Second, Madoff’s fraud came to light in December 2008, when the financial world was reeling from its near meltdown in September/October of 2008. Publicity about Madoff’s Ponzi scheme fueled public perception that something was terribly and fundamentally wrong with the world’s financial system, prompting calls for new and better financial regulation.

2. WorldCom (2002)

When the WorldCom scandal hit the news in June 2002, a little known piece of legislation that had been languishing in the U.S. House and Senate was resuscitated instantaneously. Just a few weeks later, the Sarbanes-Oxley Act was approved in the House by a vote of 423-3 and in the Senate by a vote of 99-0. It introduced the most sweeping set of new business regulations since the 1930s.

1. Enron (2001)

The granddaddy of them all. If WorldCom tipped the political scales toward Sarbanes-Oxley, it was only because it was preceded by Enron. Enron was the “it” company at the turn of the century. Its success seemed to define a new kind of company for the new millennium. On October 16, 2001, however, Enron announced an earnings restatement that investors immediately recognized as a harbinger of bigger problems. In six short weeks the company that had oozed wealth, smarts and power declared bankruptcy. Thousands of employees and investors saw their retirement savings vanish with the company.

Jonathan Karpoff

Why do you rank Enron as the biggest?

Enron’s fraud included both complex financial maneuvering (e.g., hiding its debt via “special purpose entities”) and simple fabrication of numbers (e.g., its valuation of a failed venture with Blockbuster). But the reason it tops the list is because of its impact on our view of the American economic system. When the Enron scandal broke, commentator Paul Krugman called it a bigger deal than 9/11—a comment that, while fatuous, helps illustrate the shock and awe generated by Enron’s fall. The scandal shook people’s trust in the economy and fed a popular cynicism toward business that permeates many aspects of our politics and culture.

What did we learn from Enron?

In my opinion, the most amazing aspect of the Enron scandal is not how the system broke down, but rather how it worked! No one can justify the greed and mendacity of Enron’s executives. But once investors, customers and suppliers found out about the fraud, they rapidly changed their willingness to do business with the firm. Enron had many legitimate businesses and was not a complete house of cards. But once people found out that Enron’s managers were willing to sacrifice the firm’s reputation for short-term gain, even the firm’s legitimate activities suffered.

For example, some of Enron’s counterparties were electric utilities. They had to trust that Enron would hold up its end of its deals and to deliver electricity when it promised. After the scandal broke, many former customers went elsewhere because they no longer trusted Enron. This—and not the financial misconduct in and of itself—is the main reason Enron’s value dropped so quickly and the firm declared bankruptcy in December 2001.

In light of such high-profile cases of fraud, is corporate behavior evolving or devolving ethically?

We cannot observe all bad business behavior, only that which is caught. Nonetheless, we know a couple of things about how much it happens. First, the amount of scandalous behavior surely fluctuates over time. It probably reached peaks around the dot-com bubble and, more recently and in isolated sectors of the economy, around the housing bubble. Second—and here is the surprising thing—the rate at which opportunistic cheating occurs almost certainly has declined over time, and declined substantially! Think about the amount of backroom deals, rip-off artists, and outright theft that characterized many transactions in the United States in the late 1800s. Or consider the rampant growth of financial frauds in the 1920s.

We also have international evidence that points to the decline of business misconduct over time. Countries with rampant corruption and opportunistic behavior have poorly developed financial markets and low economic growth. As countries become wealthier, the amount of corruption and opportunistic behavior declines. There is a lot of argument about which causes which, and probably the direction goes both ways. But, to use economist’s lingo, we observe that fair dealing and honesty are “income normal goods”—they increase as a community becomes wealthier. This indicates that, compared to say, a century ago, when people in the U.S. were less wealthy than they are today, there almost surely is less lying, cheating, and stealing in the typical business transaction.

Is regulation or reputation the most effective deterrent to fraudulent behavior? 

There are three main forces that discipline and control opportunistic behavior. You can think of them as the three legs of a stool.

The first leg is our legal system and the penalties it imposes for bad behavior. The threat of a stiff fine or jail time no doubt discourages a lot of people from committing frauds.

The second leg is one’s individual moral code. Virtually all cultures include stories in which some version of the Golden Rule and “do the right thing” are central lessons. Certainly, many business people treat their employees, customers, and investors well because they try to act ethically.

The third leg of the stool is what I call reputation. This is the penalty imposed by the people with whom a firm does business—its customers, suppliers, employees and investors. Such people may or may not intend to impose a penalty on cheating firms. Rather, acting in their own interests, they simply change the terms with which they are willing to do business with cheating companies. For example, firms that sell defective products lose customers. Think of Toyota right now.

Reputation is a powerful inducement to act honestly. I and other researchers have measured the costs imposed firms and individuals for various types of bad behavior. We find that, in general, reputation losses—the lost value from losing customers, suppliers, and investors—are several times greater than all their regulatory and legal penalties, including class action settlements. This is an important takeaway for managers: the big hammer for bad behavior typically is not the fine from such regulators as the SEC— rather, it is the higher costs and lower sales your firm will have as others find out that you are willing to act opportunistically, and you lose their trust.

What are the next questions you plan to tackle in this area of corporate crime and punishment?

Bad behavior—lying, cheating and stealing—is fun to examine. That’s why bad guys are the main drivers of many Hollywood movies. But looking at business activity is important for another reason as well. By studying bad behavior, we can better understand how economic processes work in general.

Understanding the role of reputation, for example, can tell us what firms do, and what they can do better, to signal their trustworthiness to customers. It can help us design better legal penalties that encourage good behavior without diverting too many resources into wasteful compliance activities. And it can focus a manager’s attention on the ways in which value is generated and lost.

With this in mind, I am working on several projects that examine the causes and consequences of corporate misconduct. For example, why do some managers decide to cheat on their financial statements? Many conjectures have been forwarded, but so far no one has tested these many conjectures in a single set of comprehensive tests. I also am interested in the role that reputation plays in different areas of the world. We are gaining insight into its importance in U.S. markets. Reputation helps to solve the potentially crippling effect of fraud and corruption on the well-being of a nation. But does it play a similarly important role in less developed economies? Understanding the role of reputation could help us understand why and when some nations and communities thrive while others do not.

Ed Kromer Managing Editor Foster School

Ed Kromer is the managing editor of Foster Business magazine. Over the past two decades, he has served as the school’s senior storyteller, writing about a wide array of people, programs, insights and innovations that power the Foster School community.