CORPORATE FRAUD AND THE IMPACT OF SARBANES-OXLEY

BRIAN OLIN MAY 9, 2005 TABLE OF CONTENTS 1. Introduction.................................................................................................................................3 2. Background.................................................................................................................................5 2.1 The Need for Corporate Governance....................................................................................5 2.2 The U.S. Approach............................................................................................................... 2.2.1 !ree "arket....................................................................................................................# 2.2.2 $irector%.......................................................................................................................1& 2.2.3 $i%c'o%ure....................................................................................................................11 2.2.( "anage)ent Co)pen%ation.........................................................................................13 2.2.5 *o+ it Shou'd ,ork....................................................................................................15 3. *o+ Corporate Governance ,a% A-u%ed And ,h................................................................15 3.1 ,hat *appened at /nron and ,or'dCo)..........................................................................10 3.1.1 /nron............................................................................................................................10 3.1.2 ,or'dCo)....................................................................................................................1 3.2 ,h. The. $id It.................................................................................................................1# 3.2.1 Short1Ter) 2ro-'e)....................................................................................................1# 3.2.2 2re%%ure to Gro+..........................................................................................................2& 3.2.3 2rotect Their ,ea'th....................................................................................................21 3.3 ,h. The. Thought The. Cou'd Get A+a. ,ith It...........................................................22 3.3.1 The Board of $irector%................................................................................................22 3.3.2 Auditor%........................................................................................................................2( 3.3.3 $i%c'o%ure....................................................................................................................25 3.3.( 3o+ 4ccurrence of 2a%t Scanda'% and "i'd Con%e5uence%........................................20 (. The $eci%ion to Co))it !raud.................................................................................................2 (.1 2re1S4A "ode'..................................................................................................................2# (.2 The Sar-ane%146'e. Act.....................................................................................................31 (.3 2o%t1S4A "ode'.................................................................................................................33 5. Conc'u%ion................................................................................................................................35 0. 7eference%.................................................................................................................................38 Appendi6 A....................................................................................................................................3# Appendi6 B....................................................................................................................................(&

1. INTRODUCTION 9It +a% one of the +or'd:% )o%t ad)ired co)panie%; +ith a )arket capita'i<ation of = & -i''ion. Toda.; it:% in -ankruptc.> ?Berardino 2&&1@. The co)pan. i% /nron; +hich fi'ed for chapter 11 -ankruptc. in $ece)-er of 2&&1 ?*ir%ch 2&&1@. /nron +a% the %eventh1'arge%t U.S pu-'ic co)pan. +ith =1&& -i''ion in revenue in 2&&&. ,hen /nron fi'ed for -ankruptc.; it reported =13.15 -i''ion in de-t; a% +e'' a% =31.2( -i''ion in de-t +hen it% %u-%idiarie% +ere accounted for ?Sender 2&&1@. "o%t of thi% de-t had -een hidden fro) inve%tor% through co)p'e6 accounting techni5ue%. 9/nron +a% vie+ed a% a co)pan. that a'+a.% )ade it% nu)-er%> ?Norri% 2&&1@. *o+ever; it i% c'ear that inve%tor% did not rea''. under%tand ho+ it +a% )aking it% nu)-er%. A% ne+ infor)ation ha% -een revea'ed; it ha% -eco)e c'ear that the co)pan. -eca)e over 'everaged1 and +a% a-'e to hide it% de-t +ith the he'p of it% e6terna' auditing fir) Arthur Ander%en. /nron u%ed %ophi%ticated financing vehic'e% kno+n a% Specia' 2urpo%e /ntitie% ?S2/%@ and other off1-a'ance %heet %tructure% to hide it% de-t fro) inve%tor% ?Berardino 2&&1@. /nron +a% a-'e to increa%e it% 'everage ?de-t to a%%et%@ +ithout having to report that de-t on the -a'ance %heet. *o+ever; the de-t eventua''. caught up to the co)pan. and it cou'd no 'onger pa. it% -i''%; cau%ing it to fi'e for -ankruptc.. /nron:% -ankruptc. ha% had far reaching con%e5uence% throughout the g'o-e. Inve%tor% 'o%t -i''ion% of do''ar% a% /nron:% %tock p'unged. /nron e)p'o.ee% a'one 'o%t appro6i)ate'. =1 -i''ion +orth of %aving% ?Brennan 2&&3@. Stockho'der% +ere -a%ica''. out of 'uck in the -ankruptc. proceeding% and 'ooked to 'o%e ever.thing the. inve%ted in /nron. A% ne+ corporate governance %canda'% have e)erged; %uch a% ,or'dCo) and Ade'phia; the need to e6a)ine corporate governance ha% a)p'ified.
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3everage refer% to the ratio of de-t to a%%et%. The )ore de-t re'ative to a%%et%; the ri%kier the -u%ine%% -eco)e%.

But +hat i% corporate governanceA In the United State%; Corporate Governance )o%t often i% referred to a% 9ho+ to en%ure the )anager% fo''o+ the intere%t% of %hareho'der%> ?Bive% 2&&&@. A% Bive% point% out; thi% can )ore genera''. -e thought of a% 9en%uring that inve%tor% get a return on their )one.> ?2&&&@. It i% a%%u)ed then; that +hat i% in the -e%t intere%t of %hareho'der% i% for the) to get a return on their )one.. Since peop'e )o%t often choo%e to -u. %tock -ecau%e of the potentia' for the %tock price to increa%e; it fo''o+% that )anager% acting in the -e%t intere%t of the %hareho'der% +ou'd tr. to )a6i)i<e the co)pan.:% %tock price. The %tock )arket genera''. ref'ect% future e6pectation% of profita-i'it.C a deci%ion in the pre%ent +i'' affect the %tock price -. ho+ the )arket vie+% the future effect% of the deci%ion. Thu%; -. )aking deci%ion% that he'p the 'ong1run hea'th of the co)pan.; the pre%ent %tock price +i'' increa%e. Becau%e of thi% re'ation%hip; the o-Dective of )anager% %hou'd -e to )a6i)i<e long-term %hareho'der va'ue ?Stern-erg 2&&(@. "anager% then act in the -e%t intere%t of %hareho'der% -. )a6i)i<ing the co)pan.:% 'ong1ter) va'ue through i)proving the %tock price. *o+ever a )ora' ha<ard pro-'e) occur% in )aking %ure that 9)anager% put forth appropriate effort and )ake deci%ion% a'igned +ith the intere%t% of %hareho'der%> ?Bive% 2&&&@. Specifica''.; %hareho'der% +orr. that )anager% )a. overpa. the)%e've%; give the)%e've% e6travagant perk%; carr. out unprofita-'e -ut po+er1enhancing inve%t)ent%; and -e re'uctant to 'a. off +orker% that are no 'onger productive ?*art 1##5@. In thi% %en%e; )anager% )a. )ake deci%ion% -a%ed on their o+n intere%t%. The )ora' ha<ard pro-'e) i% then that )anager% )a. deceive inve%tor% to pur%ue their o+n goa'%. Since )anage)ent )a. not a'+a.% act in the -e%t intere%t% of %hareho'der%; throughout the fo''o+ing di%cu%%ion corporate governance ?CG@ +i'' refer to en%uring that )anager% act in the -e%t intere%t of %hareho'der%.

In recent .ear% corporate governance ha% fa'tered; )o%t nota-'. in the /nron and ,or'dCo) %canda'%. Thi% paper +i'' de)on%trate that the %tructure of U.S. corporate governance -efore the Sar-ane%146'e. Act did not effective'. %o've the )ora' ha<ard pro-'e); and that the Sar-ane%146'e. Act ?S4A@ a'ter% the %.%te) enough to -e effective in reducing corporate fraud in the %hort1run. But to create a 'ong1run %o'ution to corporate fraud; the financia' di%c'o%ure 'a+% need to change. Before Sar-ane%146'e.; the U.S. )ode' had often -een effective; -ut there +ere %ti'' f'a+%. In %ection t+o; the -ackground of corporate governance and the U.S. approach i% di%cu%%ed. Then -. e6a)ining the pro-'e)% pre%ent in -oth the /nron and ,or'dCo) %canda'% in %ection three; it +i'' -e c'ear that )anage)ent had the )otive and a-i'it. to co))it corporate fraud; na)e'. to hide pro-'e)% fro) inve%tor%. In %ection four; the )otive% for co))itting fraud; a% +e'' a% the perceived pro-a-i'it. and con%e5uence% if the fraud +ere di%covered +i'' -e i''u%trated in a genera' )ode' +hich +i'' e6a)ine a )anager:% deci%ion to co))it fraud. Section four a'%o e6a)ine% ho+ the Sar-ane%146'e. Act; pa%%ed -. the U.S. Congre%%; a'ter% the %tructure of U.S. corporate governance %o a% to -e %ucce%%fu' in reducing the occurrence of corporate fraud in the %hort1run. 2. BACKGROUND 2.1 Th N ! "#$ C#$%#$&' G#( $)&)* *o+ are )anager% and %hareho'der% connectedA /6act'. +hat are )anager% %uppo%ed to do +ith the corporation the. )anageA In the )odern corporation; )anager% are %uppo%ed to act in the -e%t intere%t% of tho%e %hareho'der% ?A''en 1## @. /ven a%%u)ing that )anage)ent i% re%pon%i-'e to act on'. in the -e%t intere%t of %hareho'der%; +hat e6act'. i% in the -e%t intere%t for %hareho'der%A Since )anager% are %uppo%ed to )a6i)i<e %hareho'der va'ue -. i)proving the

%tock price; thi% -ring% a-out the 5ue%tion% ho+ %hou'd the )anager% go a-out )a6i)i<ing va'ueA The 5ue%tion co)e% do+n to +hether )anager% 'ook at the )ea%ured outco)e or at the econo)ic outco)e ?3o+en%tein 1##0@. There i% )uch +eight to thi% fine di%tinction. The econo)ic outco)e +ou'd -e 'ooking at 'ong1ter) financia' gro+th; %o if )anage)ent i% )anaging for the econo)ica''. -etter outco)e; then a'' effort% +i'' -e put to+ard i)proving financia' perfor)ance. *o+ever; the )ea%ured outco)e i% 'ooking at )eeting financia' ana'.%t%: foreca%t% of ke. financia' nu)-er%. If the. 'ook to )anage the measured outco)e; then )anage)ent )a. )ake deci%ion% in the intere%t of )aking the nu)-er% 'ook -etter. In addition; if the. 'ook at the )ea%ured outco)e then )anage)ent ha% the incentive to )anipu'ate the nu)-er% to hit target% if the co)pan. +i'' 'ike'. not hit the nu)-er% 'ega''.. Thi% i% -ecau%e ,a'' Street tend% to react ver. negative'. to co)panie% not reaching e6pectation%. !or e6a)p'e; +hen Co%tco ,ho'e%a'e:% earning% increa%ed -ut )i%%ed ,a'' Street:% e6pected earning per %hare -. 1 cent per %hare; it% %tock price dropped =1.0# ?3.0E@ in one da. ?Co%tco 2&&5@. $ue to the dra%tic i)pact of )i%%ing e6pected nu)-er%; it %ee)% that )anage)ent ha% the incentive to focu% on the )ea%ured outco)e rather than the econo)ic outco)e. 4ne po%%i-'e pro-'e) fro) thi% i% that it prevent% for+ard thinking deci%ion% that pro)ote 'ong1run econo)ic gro+th of the co)pan.. 4n thi% %a)e point; if the co)pan. ha% a -ad 5uarter; )anage)ent )ight fee' pre%%ure to readDu%t or fa'%if. nu)-er% to hit %hort1ter) target% if the. fee' the co)pan. +i'' re-ound. ,hi'e the goa' i% to )a6i)i<e %hareho'der va'ue; ho+ can %hareho'der% en%ure that the )anager% are in fact +orking to )a6i)i<e va'ue for the)A In rea'it. it i% e6tre)e'. hard to kno+ due to the %tructure of the %.%te). Ber'e and "ean% ?1#33@ )ade fa)ou% the phra%e 9there

i% a %eparation of o+ner%hip and contro'> ?*art 1##5@. The. )ean that the o+ner% of the corporation ?the %hareho'der%@ do not have an. contro' over the da.1to1da. operation% of the corporation. Thi% %eparation of o+ner%hip and contro' ha% e%ta-'i%hed an a%.))etric infor)ation pro-'e) +ithin corporation%. A% Bive% point% out; the contract -et+een the %hareho'der% and the )anager% 'eave% the )anager% +ith )uch di%cretion -ecau%e the )anager% have the kno+'edge and the a-i'it. to run the co)pan.. Thi% 'ead% to the )ora' ha<ard pro-'e) that )anager% )a. act in their o+n intere%t% in%tead of in %hareho'der% intere%t%. The )ora' ha<ard pro-'e) cau%e% %hareho'der% to %eek %o)e other a%%urance that )anage)ent i% fo''o+ing through on it% co))it)ent. If %hareho'der% are in fact %eeking a%%urance that )anage)ent i% acting in their -e%t intere%t; then the concerned %hareho'der %hou'd have the incentive to )onitor the corporation the)%e've%. *o+ever; *art -e'ieve% that )onitoring i% a pu-'ic good; %a.ing that 9if one %hareho'der:% )onitoring 'ead% to i)proved co)pan. perfor)ance; a'' %hareho'der% -enefit> ?*art 1##5@. The idea i% that a'' %hareho'der% +i'' 'ook to the other %hareho'der% to do the )onitoring for the). In thi% ca%e; no one inve%tor ha% the incentive to )onitor -ecau%e an. -enefit% the. receive +i'' -e received -. a'' inve%tor%; regard'e%% of +hether the. inve%t in )onitoring the)%e've%. Thi% i% a free1rider pro-'e) for )onitoring a)ong %o)e %hareho'der%C re%u'ting in none of tho%e %hareho'der% choo%ing to )onitor their co)panie%. In addition; the 'ack of infor)ation that %hareho'der% have a-out perfor)ance i% an i)pedi)ent to enforcing accounta-i'it.. Shareho'der% have on'. the infor)ation pre%ented in the financia' %tate)ent% and the %hareho'der% genera''. do not have the too'% to )ake tho%e %tate)ent% u%efu' in )onitoring. Since there i% a )ora' ha<ard pro-'e) that )anager% +i'' pur%ue their o+n intere%t% in%tead of the %hareho'der%; %o)e argue that there i% a need for check% and -a'ance% on

)anageria' -ehavior. Thu% the concept of corporate governance aro%e. Corporate governance +a% fir%t e%ta-'i%hed to co)-at the )ora' ha<ard i%%ue of en%uring that )anager% act in the -e%t intere%t of %hareho'der% that ari%e% a% a re%u't of the %tructure of corporation% and the )arket in +hich the. e6i%t. 2.2 Th U.S. A%%$#&*h In 1#32 Ber'e and "ean% %ugge%ted that the )odern corporation +a% run -. profe%%iona' )anager% +ho +ere unaccounta-'e to di%per%ed %hareho'der% ?Bive% 2&&&@. "an. -e'ieve that )anager% +ere %uppo%ed to act in the -e%t intere%t of %hareho'der%C ho+ever )anager% and %hareho'der% re%pon%i-i'itie% are %ignificant'. %eparated. "anager% have the ta%k of )aking the co)pan. run +e''; and %hareho'der% have 'itt'e inf'uence over ho+ the co)pan. i% run. Shareho'der% are then faced +ith the pro-'e) of en%uring that )anager% act in their -e%t intere%t%. A% di%cu%%ed ear'ier there i% a )ora' ha<ard pro-'e) of getting )anager% to act in the -e%t intere%t% of %hareho'der%. Since en%uring that )anager% act in the -e%t intere%t of %hareho'der i% genera''. not taken on -. %hareho'der%; the U.S. ha% adopted a corporate governance %.%te) to he'p %o've thi% pro-'e). The U.S. ha% adopted an Ang'o1A)erican vie+ of corporate governance; +hich u%e% a )i6 of a free )arket approach; %tructured co)pen%ation; and govern)ent intervention to en%ure that )anager% act in the -e%t intere%t of %hareho'der%. In e%%ence; the U.S. u%e% the free )arket approach; -ut add% on additiona' )echani%)% to co)pen%ate for the inherent pro-'e)% in the %.%te). It re'ie% on the threat of ho%ti'e takeover% a% an e6terna' contro'; +hi'e in%titution% %uch a% the -oard of director% and the di%c'o%ure 'a+% repre%ent an interna' contro' for the corporation and )anage)ent co)pen%ation a'ign% )anage)ent and %hareho'der intere%t%.

2.2.1 Free Market The free )arket argu)ent i% that a )arket econo). can achieve efficient corporate governance +ithout govern)ent intervention. Thi% argu)ent re%t% on the idea that the 9co)pan.:% founder% have an incentive to choo%e an efficient corporate governance %tructure; that i%; one that )a6i)i<e% the aggregate return to a'' c'ai)ho'der%; at the ti)e the co)pan. goe% pu-'ic> ?*art 1##5@. The rea%oning i% that %ince the. %e'' their %hare% in a co)petitive )arket; the. %hou'd receive the net pre%ent va'ue of the return on a'' the %hare%. Therefore; the co)pan. o+ner% %hou'd have the incentive to choo%e corporate governance ru'e% that +ou'd )a6i)i<e thi% va'ue. Under thi% argu)ent; there i% no need for govern)ent intervention -ecau%e it +ou'd -e counterproductive. *art argue% that that govern)ent intervention in corporate governance 9'i)it% the founder%: a-i'it. to tai'or corporate governance to their o+n individua' circu)%tance%> ?1##5@. A'%o; that govern)ent intervention i% inefficient in the )arket for corporate governance. Thi% argu)ent a'%o %tate% that ho%ti'e takeover%2 are a po+erfu' +a. of )onitoring co)panie% ?*art 1##5@. Thi% i% -ecau%e ho%ti'e takeover% a''o+ %o)eone to capita'i<e on an underperfor)ing co)pan.. If the per%on -u.% the co)pan. and rep'ace% the )anage)ent then the. %hou'd -e a-'e to reap the -enefit%. The idea i% that the po%%i-i'it. of ho%ti'e takeover% give% )anage)ent the incentive to )ake the co)pan. operate at the -e%t of it% a-i'itie%; other+i%e %o)eone +ou'd -u. it and rep'ace the )anage)ent. Critici%)% of thi% approach are that the takeover %trateg. re'ie% on the a-i'it. of potentia' -u.er% of the takeover target to have accurate infor)ation a-out the finance% of the co)pan.. If the. cannot te'' that the co)pan. i% underperfor)ing then thi% cannot -e enforced. In addition;
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*o%ti'e takeover% occur +hen %o)eone -e'ieve% a co)pan. i% underperfor)ing and decide% to -u. enough %hare% to take contro' of the co)pan.. Then the. often appoint ne+ )anage)ent to run the co)pan. -etter. B. -u.ing %hare% at a 'o+ price; then i)proving the co)pan. and %e''ing %hare% a per%on can )ake great )one..

thi% theor. re'ie% on the effectivene%% of ne+ o+ner% to change the conduct of director% and of the fir) ?Stern-erg 2&&(@. The U.S. re'ie% on free )arket force% to give the founder% an incentive to %e'ect the -e%t )ethod of corporate governance for their particu'ar co)pan. a% +e'' a% give )anager% the incentive to )anage the co)pan. to operate at high perfor)ance to prevent corporate takeover%. 2.2.2 Directors Through the -oard of director%; the %hareho'der% are a-'e to have a %)a'' group repre%ent their -e%t intere%t%. T.pica''.; %hareho'der% are a-'e to e6erci%e contro' of co)pan. affair% through the -oard of director%. "anage)ent; the -oard of director%; and %hareho'der% are %trict'. re'ated. Shareho'der% e'ect the -oard to act on their -eha'f; and the -oard in turn )onitor% top )anage)ent and ratifie% )aDor deci%ion%. Through thi% re'ation%hip; the %tructure %hou'd -e in p'ace for %hareho'der% to have the a%%urance that )anage)ent i% acting in their -e%t intere%t%. *o+ever; critic% de-ated +hether director% are in fact doing a good Do-; or even if the. have the a-i'it. to do a good Do-. The ro'e of the director% i% crucia' to Ang'o1A)erican corporate governance. The director% repre%ent an interna' contro'; +ho%e ro'e% %te) fro) the 'ega' %tructure of a corporation. The. inc'udeF %etting %trateg.; appointing )anage)ent; eva'uating )anage)ent perfor)ance; reporting )anage)ent perfor)ance to %hareho'der% ?G'ipper 1## @C the ro'e of the director% i% to )ake %ure )anage)ent i% doing a good Do- for the %hareho'der%. If director% do a good Do-; in theor. thi% %hou'd he'p %o've the pro-'e) that )onitoring i% a pu-'ic good -ecau%e if the )anager% don:t do a good Do- the director% +i'' fire the). A'%o; the )onitoring of the -oard of director% %hou'd idea''. give )anager% the incentive to do good +ork; Du%t 'ike a -o%%.

1&

In the U.S. %o)e of the director% are )e)-er% of the fir):% )anage)ent and other% are none6ecutive director% ?out%ider%@. In theor. the out%ider% %hou'd -e independentC ho+ever it ha% -een argued that )an. director% have a conf'ict of intere%t. !or e6a)p'e; %o)e director% have their o+n financia' intere%t in the co)pan.. Since the%e director% +ant to %ee the co)pan. hit it% target% %o the. can keep their o+n +ea'th; it give% the) 'itt'e incentive to point out pro-'e)% in the %hort1run. In addition; -ecau%e the none6ecutive director% are often propo%ed -. the )anage)ent tea); %o)e director% fee' that the. o+e their po%ition% on the -oard to the )anage)ent tea). A po%ition on the -oard i% ver. pre%tigiou% and can pa. fair'. +e''. A% a re%u't; the director% )a. fee' o-'igated to a''o+ )anage)ent to do a% the. p'ea%eC 'eaving the co)pan. +ithout true )onitoring ?*art 1##0@. 3a%t'.; %o)e -e'ieve that even if director% are independent; the. do not have the infor)ation to do their Do- correct'.. The infor)ation that director% receive co)e% direct'. fro) corporate e6ecutive%C )eaning director% have 'i)ited acce%% to independent infor)ation ?Stern-erg 2&&(@. In thi% +a.; it ha% -een %aid that director% do not even have the too'% to )ake the right deci%ion. 2.2.3 Disclosure 2eriodica''.; director% )u%t report a-out the condition of their co)panie% to the %hareho'der%. "o%t co))on'.; thi% i% done through the annua' and 5uarter'. report%. The%e report% give a financia' picture of the corporation at that ti)e a% +e'' a% over a period of ti)e. Thi% i% argua-'. the funda)enta' financia' )echani%) for corporate governance. Before -eing re'ea%ed; an accounting fir) i% re5uired -. 'a+ to audit the financia' %tate)ent%. The goa' of thi% audit i% to check +hether the report% have -een co)pi'ed i% %uch a +a. a% to give a Htrue and fair: picture of the co)pan. ?Stern-erg 2&&(@.

11

The%e report% %hou'd in theor. provide a )ea%ure of accounta-i'it. and )onitoring. Idea''. the annua' report %hou'd give %hareho'der% the a-i'it. to eva'uate co)pan. perfor)ance ?3o+en%tein 1##0@. Through the di%c'o%ure re5uire)ent%; %hareho'der% %hou'd have the a-i'it. to check up and )ake %ure )anage)ent i% +orking in their -e%t intere%t%. The reporting of the financia' nu)-er% %hou'd a'%o give )anager% the incentive to keep the co)pan. perfor)ing +e''. The incentive 'ie% in the fact that )anager% are %uppo%ed to )a6i)i<e %hareho'der va'ue and that i% )o%t nota-'. done through the %tock price. Since the %tock price +ou'd -e negative'. affected -. poor perfor)ance thi% %hou'd give )anage)ent the incentive to report good nu)-er% ?idea''. -ecau%e of good perfor)ance@. $i%c'o%ure a'%o he'p% to co)-at the a%.))etric infor)ation pro-'e) inherent in the %.%te). B. re5uiring reporting it %hou'd idea''. take the -urden off of %hareho'der% to ac5uire the infor)ation. Thu%; %hareho'der% +ou'd have co)p'ete infor)ation if ever.thing +orked correct'.. In addition; thi% he'p% fue' the )arket for takeover% -ecau%e it give% potentia' -u.er% a -etter a-i'it. to eva'uate the 5ua'it. of the co)panie%. 3a%t'.; the%e report% operate a% a %igna' to the )arket. Since the. are approved -. an accounting fir) the. have -een ver. +e'' tru%ted. Strong financia' %tate)ent% genera''. indicate a high pro-a-i'it. that a co)pan. +a% in good hea'th; giving co)panie% a +a. to +ard off ho%ti'e takeover% and attract inve%tor%. ,hi'e the financia' report% %ound great in theor.; there have -een %o)e %eriou% critici%)% of their effectivene%%. !ir%t; the accounting fir)% that audit the financia' %tate)ent% have; in the pa%t; p'a.ed the dua' ro'e of con%u'tant% for the co)panie% +hich the. auditC +hich -ring% in %ignificant %u)% of )one.. Thi% create% the pro-'e) that the accounting fir) i% rea''. auditing

12

it% o+n +ork and i% financia' tied to the co)pan.. Together thi% create% a di%incentive for the accounting fir) to report pro-'e)%. In addition; the accounting ru'e% are incredi-'. co)p'e6 and therefore a''o+% for a 'eve' of interpretation. In the current accounting %.%te); revenue i% recogni<ed +hen it i% earned rather than +hen the ca%h i% received ?an 9accrua'> -a%i%@. Accrua' accounting a''o+% for a great dea' of f'e6i-i'it. and Dudg)ent in the ti)ing of inco)e and e6pen%e recognition ?3o+en%tein 1##0@. Thi% 'ee+a. provided in the accounting %.%te); ha% given inte''igent )anage)ent the a-i'it. to p'a. around +ith the nu)-er% to get the) to +ork out to their advantage or even di%gui%e i''ega' accounting ?*o''and 1###@. Becau%e of )anage)ent:% a-i'it. to p'a. +ith the nu)-er%; %o)e -e'ieve that )anage)ent Du%t )o'd% the %tate)ent% to )eet the nu)-er% that +ere predicted ear'ier -. ana'.%t%. There i% a'%o a fee'ing a)ong %o)e that the financia' %tate)ent% do not inc'ude enough infor)ation to get a good picture of the co)pan.:% perfor)ance. 2.2.4 Management Compensation An additiona' )echani%) for en%uring that )anager% act in the -e%t intere%t% of %hareho'der% i% to tie their intere%t% together. The )o%t co))on +a. to acco)p'i%h thi% i% -. %tructuring )anage)ent co)pen%ation appropriate'.. If )anage)ent i% %uppo%ed to )a6i)i<e %hareho'der% va'ue; then )anage)ent %hou'd have per%ona' incentive% to do %o. Thi% can -e done -. t.ing )anage)ent co)pen%ation to the co)pan.:% %hare price. The theor. i% that if )anage)ent:% per%ona' +ea'th i% tied to the %hare price of the co)pan.; then )anage)ent +i'' have the incentive for increa%ed effort to )ake the co)pan. do +e''; thu% a'igning )anage)ent intere%t% +ith tho%e of the %hareho'der% ?A''en 1## @. Thi% genera''. take% three different for)%F direct o+ner%hip of %hare%; %tock option%; or -onu%e% dependent on %hare price. The )o%t co))on )ethod u%ed toda. i% that of %tock option%.

13

Stock option% are financia' in%tru)ent% that give the -earer the right to -u. or %e'' the %tock at a %pecified price ?)o%t corporate %tock option% Du%t give the -earer the right to -u. though@. 4ften the%e %tock option% have %o)e ti)e ti'' )aturit.; or a ve%ting period; )eaning that once the. are i%%ued it take% a certain a)ount of ti)e for the -earer to u%e the). A %tock option +ork% 'ike thi%F %o)eone )ight o+n an option for Genera' /'ectric for 1&;&&& %hare% at =20 +hich -eca)e fu''. ve%ted in 2&&( ?the. no+ have the right to u%e the option@. 4n "arch 21; 2&&5; G/:% %tock price +a% =30. If thi% per%on e6erci%ed the %tock option on thi% date the. +ou'd have -ought 1&;&&& %hare% at =20 and %o'd the) into the )arket at =30. A% a re%u't; thi% per%on +ou'd have )ade =1& per %hare; or =1&&;&&&. Stock option% -eco)e u%efu' on'. if the %tock price continue% to ri%eC if the %tock price +a% -e'o+ the price on the option then it +ou'd not -e profita-'e to e6erci%e the option. Becau%e corporate %tock option% are on'. va'ua-'e if the %tock price ri%e%; then thi% %hou'd idea''. give the o+ner% of the%e option% the incentive to +ant the %tock price to continue to ri%e. If )anage)ent o+n% the%e option% it %hou'd then a'ign their intere%t% +ith tho%e of the %hareho'der%. *o+ever; there ha% -een )uch di%cu%%ion a-out +hether %tock option% tru'. provide the correct incentive% for )anager%. 2au' "ar%h %ugge%t% that )anager% tend to eva'uate proDect% -a%ed on the %hort1ter) profit% that t.pica''. deter)ine their o+n re)uneration ?Stern-erg 2&&(@. The i%%ue i% that )anager% )a. )ake deci%ion%; not for 'ong1ter) financia' gro+th; -ut to increa%e their o+n +ea'th. ,hi'e it %ee)% that thi% )ight -enefit %hareho'der%; the%e %hort1ter) deci%ion% can often have negative affect% in the future and are not nece%%ari'. good for %hareho'der%. In addition; %ince )anager% have )ore infor)ation a-out co)pan. perfor)ance than do %hareho'der%; there i% a fear that )anage)ent +i'' a-u%e their po+er to )ake the)%e've% +ea'thier at the co%t of 'ong1ter) financia' %ta-i'it.. Specifica''.; that 9)anager% )a. negotiate

1(

for the)%e've% %uch contract% +hen the. kno+ earning% or %tock price are 'ike'. to ri%e; even )anipu'ate accounting nu)-er% and inve%t)ent po'ic. to increa%e their pa.> ?Sh'eifer 1##8@. Sh'eifer %ugge%t% that option% are 'e%% of an incentive device and )ore of a )echani%) of %e'f1 dea'ing. 3a%t'.; t.ing co)pen%ation to %tock perfor)ance )a. a'%o give )anager% the incentive to cheat the nu)-er% to keep the %tock price high %ince the %tock price i% %o direct'. tied to the )ea%ured outco)eInu)-er%. 2.2.5 How it S ould !ork In theor.; the U.S. approach %hou'd co)-at the )ora' ha<ard pro-'e) -. -a'ancing -oth interna' and e6terna' contro'%. The )arket for corporate contro' ?i.e. ho%ti'e takeover%@ give% )anage)ent the incentive to keep perfor)ance high to prevent getting rep'aced. In addition; the -oard of director% and financia' di%c'o%ure provide a 'eve' of interna' accounta-i'it.. $i%c'o%ure a'%o he'p% %o've the a%.))etric infor)ation pro-'e) and %hou'd a''o+ %hareho'der% to pa%%ive'. )onitor the perfor)ance of their co)panie%. 3a%t'.; )anage)ent co)pen%ation %hou'd a'ign )anage)ent:% intere%t% +ith tho%e of %hareho'der%. 4vera''; )onitoring through the -oard; the threat of corporate takeover; the %tructure of co)pen%ation and reaction of the %tock )arket %hou'd idea''. give )anager% the incentive to )ake the co)pan. perfor) +e''. +. HO, CORPORATE GO-ERNANCE ,AS ABUSED AND ,HY In the ca%e% of /nron and ,or'dCo); )anage)ent did not u'ti)ate'. act in the -e%t intere%t% of %hareho'der%. In%tead the. +ere focu%ed on fi6ing %hort1ter) pro-'e)%; )arket reaction% and protecting their per%ona' +ea'th. /nron and ,or'dCo) e6ecutive% a-u%ed corporate governance -. e6p'oiting the financia' di%c'o%ure 'a+% a% +e'' a% conf'ict% of intere%t% +ith -oth the -oard of director% and the financia' auditor%. /6ecutive% at the%e co)panie% did

15

not act in the -e%t intere%t% of %hareho'der% -ecau%e the. did not focu% on )a6i)i<ing 'ong1ter) %hareho'der va'ue. +.1 ,h&' H&%% ) ! &' E)$#) &)! ,#$.!C#/ 3.1.1 "nron /nron +a% created in 1# 5 -. the )erger of *ou%ton Natura' Ga% and InterNorth; giving -irth to the fir%t nation+ide ga% pipe'ine %.%te). In 1# 0; Gen 3a. +a% na)ed the C/4 of the ne+ corporation and 'ed the co)pan. into the -u%ine%% of 'everaging it% %i<e to -u. ga% and re%e'' it to %)a''er -u.er%. In thi% ti)e /nron:% revenue% gre+ to =1&1 -i''ion. 4ver thi% ti)e /nron not on'. produced and di%tri-uted energ. -ut a'%o traded in co))oditie% %uch a% +ood fi-er; %tee'; and other% ?Jenkin% 2&&3@. *o+ever; during thi% ti)e /nron u%ed ver. aggre%%ive accounting +hich u'ti)ate'. +a% de%igned to deceive inve%tor%. 4n Augu%t 15; 2&&1; Sherron ,atkin%; an e)p'o.ee +orking for the C!4 And. !a%to+; +rote a 'etter to Gen 3a. concerned a-out /nron:% accounting treat)ent of recent dea'%. A% a re%u't an inve%tigation +a% conducted; -ut on the deci%ion of 3a. and Ja)e% $errick; /nron:% Genera' Counci'; the inve%tigation +a% 'i)ited %uch that it did not inc'ude the inve%tigation of %pecific tran%action% or accounting advice fro) /nron:% auditor Arthur Ander%en ?Jenkin% 2&&3@. The conc'u%ion of thi% inve%tigation +a% that there +ere not pro-'e)% and that that no further inve%tigation +a% needed. *o+ever; /nron:% aggre%%ive accounting +a% c'ear'. de%igned to deceive inve%tor%; a% Sherron ,atkin% +rote in her 'etter -. 9hiding 'o%%e% in a re'ated co)pan.> +ith the intent of 'ater co)pen%ating thi% co)pan. +ith /nron %tock ?Jenkin% 2&&3@. /nron +a% 'o%ing )one. on %o)e of it% tran%action% and tried to hide the) in the %hort1run; +ith the intent of 'ater covering

10

tho%e 'o%%e% +ith %tock. /nron:% act of hiding %o)e 'o%%e% %ho+% that it vie+ed thi% a% a pro-'e) that cou'd -e fi6ed a% 'ong a% it +a% kept fro) %hareho'der%. The%e tran%action% inc'uded a Doint venture +ith Ca'ifornia 2u-'ic /)p'o.ee%: 7etire)ent S.%te) ?Ca'2/7S@ ca''ed J/$I; creation of the 3J" 2artner%hip%; and hedging tran%action% invo'ving %pecia' purpo%e entitie% ?S2/:%@. A% Jenkin% ?2&&3@ de%cri-e%; J/$I +a% a Doint venture +here /nron on'. had to record it% initia' inve%t)ent on it% financia' %tate)ent%; even though it had %ignificant intere%t. The 3J" 2artner%hip% +ere part of an effort to )anage the co)pan.:% earning%. *o+ever; the. +ere de%cri-ed to the -oard of director% a% re'ative'. -enign vehic'e% /nron cou'd u%e to hedge %o)e of it% inve%t)ent%. S2/:% are u%ua''. u%ed to attract inve%tor% that +ant to inve%t in on'. a %pecific proDect rather than the +ho'e co)pan. and are not re5uired to -e con%o'idated on the co)pan.:% financia' %tate)ent% if it )et certain re5uire)ent%.3 The%e are Du%t a fe+ of the venture% in +hich /nron +a% invo'ved. The actua''. %tructure +a% incredi-'. co)p'e6 ?%ee Appendi6 A@. The nu)erou% tran%action% he'ped /nron 9re%huff'e de-t; -o'%ter %tated profit%; and financia''. re+ard e6ecutive%> ?Brennan 2&&3@. /nron even +a% he'ped -. it% auditing fir); Arthur Ander%on; +hich +a% 'ater accu%ed of %hredding docu)ent%. /ver.thing ca)e to a ha't in the third 5uarter of 2&&1; +hen /nron -egan to e6pen%e %o)e of it% pro-'e)atic tran%action%. /nron fir%t recorded 'o%%e% fro) tran%action% +ith %o)e 3J" 2artner%hip%; then 'ater re%tated it% financia' %tate)ent% fro) 1##8 to 2&&& and the fir%t t+o 5uarter% of 2&&1. The re%tate)ent% repre%ented a reduction in earning% of #1E in 1##8; 10E in 1## ; 2 E in 1###; and 13E in 2&&&. Thi% ne+ di%c'o%ure cau%ed a prover-ia' 9run on the -ank;> +here ever.one pu''ed their )one. out and drove /nron into -ankruptc. ?Jenkin% 2&&3@. B. deceiving inve%tor% and )aking -ad deci%ion%; /nron e6ecutive% did not act

The S2/ had to -e contro''ed -. an independent part. and at 'ea%t 3E of the e5uit. had to -e fro) out%ide partie%.

18

in the -e%t intere%t% of %hareho'der%. In particu'ar; the. did not focu% on )a6i)i<ing 'ong1ter) %hareho'der% va'ue. 3.1.2 !orldCom In 1# 5; Bernie /--er% took contro' of a %)a'' %outhern co)pan. na)ed 3$$S that +a% in de-t. /--er% -egan an ac5ui%ition %trateg. in +hich the co)pan. ac5uired %)a'' 'ong1 di%tance co)panie% +ith 'i)ited geographic %ervice area% and in %i6 )onth% the co)pan. +a% profita-'e again. A% 3$$S gre+; it re5uired )ore -u.ing po+er; %o it turned to the pu-'ic )arket for )ore funding. B. going pu-'ic in 1# #; 3$$S +a% a-'e to gain %ignificant capita' fro) the %a'e of %hare% of the co)pan.. In 1##5; /--er% rena)ed the co)pan. 9,or'dCo).> In the 'ate #&:%; ,or'dCo) had revenue% of )ore than =3& -i''ion; +a% the 'arge%t internet provider in the +or'd; and +a% a )aDor provider of net+ork %ervice% for the United State% Govern)ent ?Kekan. 2&&(@. C/4 Bernie /--er% and C!4 Scott Su''ivan 'ed ,or'dCo) +ith a gro+th through ac5ui%ition %trateg.; +ith 05 ac5ui%ition% in %i6 .ear%. *o+ever; ,or'dCo) %trugg'ed to integrate )an. of the ac5ui%ition%( and a% a re%u't; )an. did not do ver. +e''. In order to )ake it appear that profit% +ere in fact increa%ing; ,or'dCo) u%ed a 'i-era' interpretation of accounting ru'e% ?"o-erg 2&&3@. !or e6a)p'e; the co)pan. +ou'd +rite do+n a%%et% it ac5uired; +hi'e charging the) again%t future earning%. Thi% re%u'ted in -igger 'o%%e% in the 5uarter; -ut %)a''er 'o%%e% in the future; effective'. painting a picture of i)proved profita-i'it. ?"o-erg 2&&3@. ,or'dCo) a'%o perfor)ed other accounting trick% to reduce annua' e6pen%e% +hi'e %ti'' ackno+'edging revenue; artificia''. -oo%ting profit%. /ventua''.; the%e pro-'e)% caught up +ith ,or'dCo) a% it cou'd no 'onger hide the huge co%t% it had incurred in the
(

The proce%% of co)-ining the operation% and %.%te)% of the )erged co)panie%.

trou-'e%o)e ac5ui%ition%. In Ju'. 2&&2; ,or'dCo) fi'ed for -ankruptc. protection; ad)itting to a tota' of =# -i''ion in adDu%t)ent% for the period fro) 1### through the fir%t 5uarter of 2&&2 ?"o-erg 2&&3@. B. hiding their pro-'e)% fro) inve%tor% and focu%ing on the nu)-er%; ,or'dCo) e6ecutive% did not focu% on )a6i)i<ing 'ong1ter) %hareho'der va'ue. +.2 ,h0 Th 0 D1! I' 3.2.1 S ort-#erm $ro%lem !or -oth /nron and ,or'dCo); the pro-'e)% the. faced +ere not vie+ed a% 'ong1ter) i%%ue%; -ut rather pro-'e)% created -. econo)ic %'o+do+n. !or ,or'dCo); the te'eco) indu%tr. +a% faced +ith overcapacit. and unrea'i<ed de)and; +hich 'ed carrier% to 'o+er price%; %training revenue proDection% ?"ehta 2&&2@. A% a re%u't; ,or'dCo) had trou-'e )aking it% nu)-er%; 'eading e6ecutive% to 'ook for 5uick fi6e%. /--er% -e'ieved ,or'dCo) +ou'd recover fro) the%e pro-'e)%. Thi% i% evident in the fact that he on'. %o'd co)pan. %hare% %i6 ti)e% in hi% +ho'e career. In addition; he even -orro+ed again%t hi% %tock; a cour%e of action on'. %)art if .ou -e'ieve the %tock price +i'' go up ?"o-erg 2&&3@. /--er%: action% indicate that he -e'ieved ,or'dCo) %tock +a% not in trou-'e and +ou'd continue to ri%e. !or e6a)p'e; he a%ked another e6ecutive a-out 9tho%e one1ti)e event% that had to happen in order for u% to have a chance to )ake our nu)-er%;> %ho+ing that he vie+ed the pro-'e)% a% %hort ter) ?Bra. 2&&5@. *e -e'ieved that if he cou'd Du%t %)ooth out the nu)-er% for a -it; the co)pan. +ou'd re-ound. !or /nron; the pro-'e) +a% +ith %o)e if it% re'ated part. tran%action%; 'ike the 3J" 2artner%hip%. The. +ere in trou-'e; -ut /nron %ti'' needed to 9keep the face it turned to the +or'd L and to it% e)p'o.ee% L ro%. and for+ard 'ooking> in order to prevent an. negative affect on the %tock price ?S+art< 2&&3@. The co)pan. )ade %o)e -ad inve%t)ent%; -ut did not +ant

1#

tho%e deci%ion% to negative'. affect it% %tock. A% a re%u't; the. had the incentive to deceive inve%tor%. The e6ecutive% at -oth /nron and ,or'dCo) at fir%t did not vie+ their pro-'e)% a% 'ong1 ter). 7ather; the. -e'ieved that over ti)e the. +ou'd -e fi6ed. *o+ever; the e6ecutive% did not +ant to take the hit to their %tock price that revea'ing their i%%ue% +ou'd cau%e. Since it +a% vie+ed a% a %hort1ter) pro-'e); the e6ecutive% -e'ieved that a fe+ %)a'' deception% +ou'd a''o+ the) to %)ooth out earning% and keep their %tock price %ta-'e. *o+ever; the pro-'e)% did not correct the)%e've% and the e6ecutive% +ere caught in a -'ack ho'e +here ad)itting the pro-'e)% a'%o )eant ad)itting their i''ega' action%; %o the. continued to co))it fraud. 3.2.2 $ressure to &row ,a'' Street )ake% e%ti)ate% of earning% gro+th for )o%t pu-'ic'. traded co)panie% and -a%e% the %tock va'uation% on tho%e nu)-er%. If tho%e nu)-er% are not hit; the %tock price genera''. 'o%e% %ignificant va'ue. In addition; continuing to hit nu)-er% %igna'% to the )arket that the co)pan. i% in %trong financia' hea'th and +i'' enDo. 'ong1ter) gro+thC thu% )aking it a good inve%t)ent. The %tock price i% re'ated to the )ea%ured outco)e; +hich p'ace% %ignificant pre%%ure on co)panie% to hit nu)-er% in order to keep the %tock price high. Thi% pre%%ure to gro+ at ,a'' Street:% e6pectation% drove /nron and ,or'dCo) e6ecutive% to dra%tic )ea%ure%. Since it +a% -e'ieved that /nron +a% a great co)pan. that +ou'd continue to have 'ong1 ter) gro+th; it +a% pre%%ured to a'+a.% )eet it% nu)-er% in order to keep it% %tock price up. At ,or'dCo) the cu'ture +a% even re'evant interna''.; +here the pre%%ure for revenue +a% %o inten%e that 9there +a% 'itt'e incentive for an.one to put a %top to other 5ue%tiona-'e practice%. If an.one did; he or %he +ou'd )i%% 5uota% and 'o%e co))i%%ion%> ?Gri) 2&&2@. In the for)er U.S. attorne. genera' 7ichard Thorn-urgh:% report on the ,or'dCo) %canda' he %aid that

2&

)anage)ent:% )ain goa' 9+a% to )eet ana'.%t%: e6pectation% a% to earning% and %tock price> ?Stern 2&&2@. ,or'dCo) +a% under great pre%%ure to )eet ,a'' Street:% e6pectation%. The pre%%ure to 'ive up to the e6pectation% that ,a'' Street had %et gave /nron and ,or'dCo) )anage)ent the )otive to co))it fraud. In order to )eet it% e6pectation%; /nron and ,or'dCo) e6ecutive% found it in their -e%t intere%t to re+ork the -ook% in order to 9he'p> )eet ,a'' Street:% profit e6pectation% ?"or%e 2&&5@. The pre%%ure to gro+ +a% %o great that even +hen the. vie+ed the co)pan. in %hort1ter) pro-'e)% the. had the incentive to fa'%if. nu)-er% to )eet e6pectation%. The pre%%ure to gro+ at )arket e6pectation% 'ed /nron and ,or'dCo) e6ecutive% to co))it fraud. 3.2.3 $rotect # eir !ealt The incentive to )eet nu)-er% and keep the %tock price high +a% not Du%t to keep %hareho'der% happ.; -ut a'%o to protect the e6ecutive%: +ea'th. The po%ition a% a co)pan. e6ecutive can -e e6tre)e'. high pa.ing; -oth in %a'ar. and in %tock and %tock option%. Though the. had a'read. a)a%%ed 'arge +ea'th; )uch of it +a% tied to their co)panie%. If the %tock dropped the. cou'd po%%i-'. 'o%e ever.thing the. had +orked for. To concea' their -ad perfor)ance and to protect their +ea'th; co)pan. e6ecutive% had the incentive to deceive inve%tor%. "uch of Bernie /--er% +ea'th +a% tied to ,or'dCo) %tock in the for) of option% and %hare%. In addition; he had %ignificant out%ide inve%t)ent% that +ere guaranteed -. hi% %tock. *i% enor)ou% ho'ding% in ,or'dCo) %tock 9gave the co)pan.:% founder and 'ongti)e 'eader a )otive to co))it fraud to keep hi% per%ona' +ea'th intact> ?Moung 2&&5@. If ,or'dCo) had fai'ed to hit it% nu)-er%; /--er% +a% %et to 'o%e enor)ou% %u)% of )one.. !or e6a)p'e; 9/--er% p'edged va%t ho'ding% of ,or'dCo) %tock a% co''atera' for 'oan% to finance the purcha%e of hi%

21

per%ona' out%ide -u%ine%% intere%t%. If ,or'dCo):% %tock price fe'' %u-%tantia''.; the co''atera' +ou'd -e of in%ufficient va'ue to %ecure hi% 'oan%; thu% forcing )argin ca''% that he cou'd not )eet> ?Kekan. 2&&(@. If the %tock price dropped; /--er% +a% %et to 'o%e )i''ion% -ecau%e he +ou'd have to pa. )one. he did not have; po%%i-'. pu%hing hi) into -ankruptc.. /--er% %tood to 'o%e hi% o+n per%ona' inve%t)ent% if ,or'dCo):% %tock price had dropped. To protect hi% accu)u'ated +ea'th; /--er% )ade the deci%ion to co))it fraud. At /nron; +hen it +a% doing +e''; )an. e6ecutive% %o'd %tock. It i% no+ c'ear that the. did thi% -ecau%e the. 'ike'. kne+ +hat +ou'd happen in the future. Stock %a'e% -. e6ecutive% and even )e)-er% of the -oard earned the) gro%% proceed% in the hundred% of )i''ion%. !or e6a)p'e; Gen 3a. )ade =1 (;(#(;(20 fro) the %a'e% of /nron %tock and And. !a%to+ ?the C/4@ )ade =33;085;&&( ?Jen%en 2&&3@5. /nron e6ecutive% )ade )i''ion%; +hi'e %hareho'der% 'o%t ever.thing. /6ecutive co)pen%ation +a% gro%%'. di%proportionate to corporate re%u't%; and gave )anage)ent the incentive to co))it fraud ?Guerra 2&&3@. /6ecutive% at /nron and ,or'dCo) he'd con%idera-'e +ea'th in their co)panie% and %tood to 'o%e )i''ion% if the %tock had depreciated. To pre%erve their enor)ou% +ea'th; the e6ecutive% deceived inve%tor%. +.+ ,h0 Th 0 Th#23h' Th 0 C#2.! G ' A4&0 ,1'h I' 3.3.1 # e 'oard o( Directors 9"an. of /nron:% pro-'e)% originate fro) the deci%ion% %anctioned -. the -oard of director%> ?Brennan 2&&3@. A% John%on %ugge%t%; /nron:% -oard of director% +a% too 5uick to approve the financia' practice% that 'ed /nron into -ankruptc. ?2&&2@. The director% fai'ed to

See Appendi6 B for )ore e6a)p'e%

22

de)and )ore infor)ation; and to pro-e and under%tand the infor)ation. The -oard )ain'. Du%t approved +hat +a% given to the) and did not 'ook to %ee if the. +ere getting the +ho'e picture. ,h. +ou'd the -oard -e %o 'a6A It +a% -ecau%e the -oard had financia' tie% to /nron. !or e6a)p'e; 7o-ert Be'for:% Be'co 4i' N Ga% Corp. -ought a -u%ine%% unit fro) /nron +ith )one. /nron 'ater u%ed to he'p fund one of the partner%hip%. Be'for even )ade =111;#(1;2&& fro) hi% gro%% %a'e% of /nron %tock ?Jen%en 2&&3@. $irector% a'%o accepted price. con%u'ting contract% or contri-ution% to favorite charitie% fro) /nron in addition to )ore than =8&;&&& a .ear for %erving on the -oard ?John%on 2&&2@. The -oard +a% a'%o %ho+ered +ith perk%; %uch a% -eing picked up for -oard )eeting% -. one of the co)pan.:% private Det% and )eeting at po%h re%ort 'ike The Breaker% in 2a') Beach; !'orida ?Br.ce 2&&2@. The -oard:% c'o%e financia' tie% to /nron +ere a+arded -. the )anage)ent of /nron. Thi% created a conf'ict of intere%t for /nron:% -oard %uch that it did not have the incentive to 5ue%tion )anage)ent:% deci%ion% -ecau%e the. +ou'd ri%k 'o%ing their financia' perk%. The %tor. i% %i)i'ar at ,or'dCo); +here the director% eventua''. paid =2&.2 )i''ion out of their o+n pocket% to %ett'e a 'a+%uit re'ated to the co)pan.:% fraud ?Moung 2&&5@. ,or'dCo):% -oard )e)-er% approved near'. ever.thing /--er% %ugge%ted; )ain'. -ecau%e the. +ere not +i''ing to confront hi) ?Kekan. 2&&(@. 'usiness!eek %u%pect% thi% i% -ecau%e /--er% %ho+ered the) +ith perk%. *a'f of ,or'dCo):% director% +ere a%%ociate% of /--er% and had 'arge per%ona' %take% in the co)pan. ?Schei%e' 2&&2; Stern 2&&2@. 3ike /nron; ,or'dCo):% director% +ere %o tied to )anage)ent financia''. that the. had 'itt'e incentive to 5ue%tion )anage)ent:% deci%ion%; for fear of 'o%ing their +ea'th. In addition; the -oard:% +ea'th +a% tied to the %tock and therefore it +a% in the -oard:% intere%t to a''o+ )anage)ent to do +hatever the. +anted to keep the %tock price up.

23

The -oard% at /nron and ,or'dCo) had c'o%e financia' tie% to the co)pan. and to )anage)ent. The%e tie% created a %ituation +here director% did not +ant to 5ue%tion )anage)ent or e6po%e an. po%%i-'e pro-'e)%. Becau%e )anage)ent had created thi% %tructure; the. kne+ the. cou'd a-u%e it. "anage)ent kne+ that the director% +ou'd not 5ue%tion their deci%ion% and therefore the. e6p'oited that. Thi% c'o%e re'ation%hip -et+een )anage)ent and the -oard )ade )anage)ent -e'ieve that the. +ou'd not get caught or fired -ecau%e the -oard +ou'd not inve%tigate deci%ion% aggre%%ive'.. A% a re%u't; )anage)ent -e'ieved there +a% a 'o+ pro-a-i'it. that the. +ou'd get caught co))itting fraud. 3.3.2 )uditors Both /nron and ,or'dCo) u%ed Arthur Ander%en a% their e6terna' financia' auditor. Unfortunate'.; -oth co)panie% +ere a'%o ver. c'o%e +ith their auditor -ecau%e of their 'ong hi%tor. together and financia' tie%. !or the indu%tr. a% a +ho'e; it +a% ver. rare that -ig accounting fir)% ditched c'ient%. $an Go'd+a%%er; a 'a+.er +ith Bedder 2rice Gauf)an N Ga))o'< %aid that 9There i% a')o%t no turnover a)ong !ortune 5& co)panie% and their accountant%C the. %ee) )erged at the hip> ?Bro+n 2&&2@. Thi% +a% no different at /nron; +here Ander%en had -een auditing /nron:% financia' %tate)ent% %ince 1# 5. /nron +a% a'%o one of Ander%en:% -igge%t c'ient%; netting Ander%en over =5& )i''ion in fee% in 2&&& a'one ?Bro+n 2&&2@. Thi% c'o%e re'ation%hip gave Ander%en the incentive to not report i%%ue% that it found; and it kne+ a-out the i%%ue% a% ear'. a% 1###. Ander%en e6ecutive% he'd di%cu%%ion% a-out conf'ict% re'ated to the partner%hip% and other pro-'e)% that eventua''. 'ed to /nron:% co''ap%e ?Bro+n 2&&2@. The fir) kne+ a-out the pro-'e)% and did nothing a-out the) -ecau%e of the co<. re'ation%hip -et+een /nron and Ander%en.

2(

/ven a% pro-'e)% %urfaced; Ander%en tried to hide it% invo've)ent -. %hredding incri)inating docu)ent%. $avid $uncan; for)er 'ead partner for Ander%en on the /nron audit; p'eaded gui't. to o-%truction of Du%tice in connection +ith hi% invo've)ent in the de%truction of /nron1re'ated docu)ent%. *e %aid that 94n 4cto-er 23; I in%tructed 'oca' peop'e at Arthur Ander%en to -egin de%tro.ing docu)ent%; +ith the kno+'edge and intent that tho%e docu)ent% +ou'd -e unavai'a-'e to the S/C and other%. I a'%o per%ona''. de%tro.ed %uch docu)ent% and kne+ the. +ou'd -e unavai'a-'e to the S/C. I accept that ). conduct vio'ated federa' cri)ina' 'a+ and a) fu''. re%pon%i-'e> ?Jenkin% 2&&3@. The co<. re'ation%hip -et+een Arthur Ander%en and it% c'ient% /nron and ,or'dCo) gave Ander%en the incentive to keep it% )outh %hut a-out pro-'e)%. "anage)ent +a% a-'e to e6p'oit thi% pro-'e) and get it% auditor% to agree to the fraud it +a% co))itting. Becau%e of the c'o%e re'ation%hip -et+een auditor and co)pan.; )anage)ent +a% under the i)pre%%ion ?right'.@ that their auditor% +ou'd not report their fraud. 3.3.3 Disclosure The co)p'e6it. of financia' accounting and di%c'o%ure ru'e% a''o+ed )anage)ent to co))it fraud +ith the thought that it +a% hidden fro) the e.e% of other%. Thi% pro-'e) )ade )anage)ent -e'ieve that it +ou'd not get caught. Accounting i% %uppo%ed to -e -a%ed on the princip'e that if it 'ook% 'ike it; then it %hou'd -e recogni<ed a% %uch. !or e6a)p'e; a 'ea%e %hou'd -e recorded a% a purcha%e if at the end of the 'ea%e the co)pan. +i'' o+n the a%%et. *o+ever; thi% a)-iguit. ha% cau%ed a need for further defined ru'e%. 7u'e% have then -een created to define previou%'. a)-iguou% i%%ue%. Co)panie% tr. to fo''o+ the ru'e%; -ut often a'%o tr. to find 'oopho'e% to get around reporting %o)ething that +i'' hurt the financia' %tate)ent% %ince )anage)ent i% often focu%ed on )eeting the nu)-er%. In regard to partner%hip%; there on'. it

25

need% to -e 3E of out%ide financing for a co)pan. to e6c'ude the venture fro) it% financia' %tate)ent% ?*ir%ch 2&&1@. !inding 'oopho'e% %uch a% thi% +a% the ca%e +ith /nron and ,or'dCo). *o+ever; the%e co)panie% +ent too far in their treat)ent of %o)e tran%action%; %uch that the. fi'ed the) i''ega''. and atte)pted to deceive inve%tor%. /nron +a% a-'e to hide )uch of it% de-t off of it% -a'ance %heet -ecau%e of ho+ it interpreted the accounting ru'e%. Becau%e the ru'e% a%%ociated +ith di%c'o%ing partner%hip% and Doint venture% are )urk.; it a''o+% for a 'eve' of interpretation. /nron u%ed thi% to it% advantage to interpret tran%action% %uch a% %pecia' purpo%e entitie% and re'ated part tran%action% %uch that the. did not have to record de-t or 'o%%e%. Idea''.; thi% +ou'd not -e a pro-'e) -ecau%e ana'.%t% %hou'd recogni<e ho+ the. recorded the%e tran%action% +hen the. e6a)ine the financia' %tate)ent% c'o%e'.. *o+ever; the ru'e% for di%c'o%ure of re'ated part. tran%action% and %pecia' purpo%e entitie% are fair'. 'o+. Becau%e there i% a 'ack of di%c'o%ure ana'.%t% are often una-'e to unearth po%%i-'e i%%ue% +ithin corporation%. The 'eve' of tran%parenc. +ithin the financia' %tate)ent% i% derived fro) a 'ack of fu'' di%c'o%ure. "anage)ent at /nron and ,or'dCo) e6p'oited the co)p'e6it. and 'ack of di%c'o%ure -. hiding their pro-'e)%. In addition; -ecau%e of the 'ack of di%c'o%ure; )anage)ent fe't that the. cou'd hide their pro-'e)% %ufficient'. to prevent the) fro) getting caught co))itting fraud. 3.3.4 *ow +ccurrence o( $ast Scandals and Mild Conse,uences In the United State%; +hite co''ar cri)e ha% a hi%tor. of -eing infre5uent'. pro%ecuted and +hen it i% pro%ecuted the con%e5uence% have often -een )ini)a'. /ven if the. get caught; -. the ti)e the. are indicted it i% 'ike'. that the. can %ta%h )an. of their i''ega' profit% a+a. in off%hore

20

-ank account% or other inve%t)ent%. Thu%; even +hen caught; the%e cri)ina'% can %ti'' )ake out +ith a fortune ?Jen%en 2&&5@. In the 1& .ear period fro) 1##2 to 2&&1; ver. fe+ cri)ina' ca%e% +ere fi'ed for +hite co''ar cri)e; and of tho%e ca%e%; ver. fe+ peop'e even +ent to Dai'. In thi% ti)e period; the Securitie% and /6change Co))i%%ion ?S/C@ on'. pre%%ed cri)ina' charge% 0&# ti)e%; of +hich the U.S. Attorne. di%po%ed of 525; 'eaving 1 8 to -e pro%ecuted. 4f tho%e pro%ecuted; on'. 1(2 +ere found gui't.; -ut on'. 8 of tho%e 1(2 %pent even a da. in Dai' ?3eaf 2&&2@. And tho%e that %pent ti)e in Dai' )ain'. %pent the ti)e in 'o+1%ecurit. pri%on% +hich are 9a-out t+o %tep% do+n the co)fort 'adder fro) "ote' 0> ?3eaf 2&&2@. The )e%%age i% c'ear; +hite co''ar cri)e i% not a high priorit. and nor +i'' it -e puni%hed a% %uch. It i% under%tanda-'e fro) a pro%ecutor% point of vie+ +here there i% 'itt'e pa.off in ter)% of po'itica' i)pact and the. cou'd pro%ecute around eight -urg'arie% or drug ca%e% in the ti)e it take% to pro%ecute one +hite co''ar cri)e ?3eaf 2&&2@. Thi% )e%%age +a% further repre%ented -. regu'ator. change% in 1##( and 1##5 +hich 'i)ited %ecuritie% regu'ation; )ain'. the 2rivate Securitie% 3itigation 7efor) Act of 1##5. The act 'i)ited the %tatute1of1'i)itation% period for fi'ing 'a+%uit%; re%tricted 'ega' fee% paid to p'aintiff%; e'i)inated punitive1da)age% provi%ion% fro) %ecuritie% 'a+%uit% and e6e)pted for+ard 'ooking %tate)ent% fro) 'ega' 'ia-i'it. ?2artno. 2&&3@. B. e6e)pting for+ard 'ooking %tate)ent% fro) 'ega' 'ia-i'it.; the corporation i% no 'onger re%pon%i-'e +hat it te''% inve%tor% i% 9'ike'.> to happen in the futureC it can -e taken a% far a% giving corporation% the 'ega' ground% to 'ie to inve%tor%. The change% in regu'ation %ent the )e%%age to C/4:% that the. are un'ike'. to -e puni%hed for earning% )anage)ent; that pro%ecutor% +i'' rare'. go after financia' fraud and that the puni%h)ent +i'' often Du%t -e a %)a'' fine ?2artno. 2&&3@.

28

B. 'ooking at recent hi%tor.; e6ecutive% cou'd %ee the U.S. did not put +hite co''ar cri)e a% a high priorit.. The e6ecutive% %a+ ver. fe+ peop'e pro%ecuted and it 'ooked a% though that +ou'd continue. In addition; the. %a+ puni%h)ent% ranging fro) a% %)a'' a% apo'ogie% to on'. a fe+ )onth% in Dai'. ,hi'e the con%e5uence% a'%o inc'uded 'o%ing %o)e )one. in the for) of future co)pen%ation and 'o%% of %tock; the tota' con%e5uence% Du%t did not 'ook %ignificant. $ue the 'o+ 'eve' of pro%ecution and puni%h)ent of +hite co''ar cri)e in the ten .ear% 'eading to the /nron %canda'; e6ecutive% in the U.S. perceived the pro-a-i'it. of getting caught or puni%hed for co))itting fraud a% e6tre)e'. 'o+. 5. THE DECISION TO COMMIT FRAUD !ro) the e6a)ination of -oth the /nron and ,or'dCo) ca%e% of corporate fraud it i% ea%ier to under%tand +hat deci%ion% a )anager faced. B. genera'i<ing the%e i%%ue%; it i% apparent that an e6ecutive at a pu-'ic'. traded co)pan. facing +hat the. con%ider a %hort1ter) pro-'e) face% a %erie% of deci%ion%. !ir%t; the. face the deci%ion to di%c'o%e thi% infor)ation to inve%tor% or hide the pro-'e)% ?effective'. co))itting fraud@. If the. decided to di%c'o%e the infor)ation at thi% point; the ga)e end% +ith a 'o%% of A. If in%tead the. choo%e to co))it fraud; the. face a ne+ deci%ion; +hether to continue co))itting fraud or to %top and di%c'o%e the pro-'e). If the )anager decide% not to continue; then again; the ga)e again end%; -ut +ith a 'o%% of B. *o+ever; if the. decide to continue to co))it fraud the. face a 'eve' of uncertaint.. The. )a. -e caught and puni%hed ?pro-a-i'it. of 2@; or the fraud +i'' never -e di%covered and the co)pan. +i'' return to profita-i'it. ?pro-a-i'it. of 112@. If the )anager i% caught co))itting fraud; the. receive a 'o%% of C; -ut if the. are not then the )anager receive% a pa.off of $. Thi% i% )ode'ed a% %uchF

5.1 P$ -SOA M#! . !or the ca%e of a )anager running a co)pan. in the ti)e -efore the Sar-ane%146'e. Act; A repre%ent% a %ignificant 'o%% of %tock )arket va'ue; +hi'e B repre%ent% a )ore %ignificant 'o%% of %tock )arket va'ue; a% +e'' a% having to ad)it to %o)e for) of earning% )anage)ent. C a'%o repre%ent% a %ignificant 'o%% of %tock )arket va'ue; +ith the po%%i-i'it. of getting fired or pro%ecuted. $ repre%ent% continued gro+th of the %tock price; a% +e'' a% additiona' -onu%e% and an i)proved reputation for the )anager. *o+ever; the pro-a-i'it. and con%e5uence% of getting caught var. depending on the %tructure of the corporation and ho+ the )anager perceive% the) re'ative to each other. There i% a rea%ona-'e di%tri-ution of )anager%: choice% a-out co))itting fraud. Thi% i% evident in the fact that not a'' )anager% choo%e to co))it fraud. So)e +i'' decide to co))it fraud; %o)e +i'' not take the ri%k and other% are %o)e+here in -et+een. A )anager:% choice not to co))it fraud revea'% that the )anager vie+% the con%e5uence% and pro-a-i'it. of getting caught a% high enough to prevent the) fro) taking the ri%k. Thi% )anager +ou'd vie+ the e6pected va'ue of continuing to co))it fraud a% +or%e than that of i))ediate'. di%c'o%ing the pro-'e) or 2#

co))itting fraud once and +ou'd choo%e not to co))it fraud. 4n the other had; a )anager:% choice to co))it fraud revea'% e6act'. the oppo%ite; that the. vie+ the con%e5uence% and pro-a-i'it. of getting caught a% 'o+ enough to take the ri%k. In thi% ca%e; the )anager vie+% the e6pected va'ue of continuing to co))it fraud a% -etter than an. other choice. A )anager )a. vie+ the pro-a-i'it. and con%e5uence% a% 'o+ -ecau%e the. have created a %i)i'ar %tructure to /nron or ,or'dCo):% in their o+n corporation. The e6pected va'ue of continuing to co))it fraud depend% on the pro-a-i'it. and con%e5uence% of getting caught. Thu%; the choice of +hether to co))it fraud can -e -roken do+n into ho+ the particu'ar )anager vie+% the pro-a-i'it. and )agnitude% of the con%e5uence% of getting caught co))itting fraud. The )agnitude% of the pa.off% are vie+ed re'ative to each other. !or the )anager that choo%e% to co))it fraud; A repre%ent% a 'o%% of a low %ca'e -ecau%e the. 'o%e %tock )arket va'ue and are not %u%pected of an. +rongdoing; un'ike B or C. B and C are -oth a 'o%% of medium -ecau%e the. repre%ent a )ore %ignificant 'o%% of %tock )arket va'ue; a% +e'' a% the added po%%i-i'it. of getting pro%ecuted or fired. Since the recent hi%tor. fraud pro%ecution ha% -een )ini)a' and the )anager ha% c'o%e tie% to the -oard of director%; the )anager vie+% the 'ike'ihood of -eing pro%ecuted or fired a% ver. %)a''. The )anager vie+% $ a% having a ig pa.off -ecau%e not on'. doe% the )anager receive continued gro+th of the %tock price; additiona' -onu%e% and an i)proved reputation; -ut a'%o the )anager avoided the reduced %tock )arket va'ue that +ou'd have occurred -. ad)itting the pro-'e) in the fir%t p'ace. The )anager a'%o vie+% the pro-a-i'it. of getting caught ?2@ a% e-tremel. low -ecau%e of the )anager:% re'ation%hip +ith the -oard; the co)p'e6it. of the financia' and di%c'o%ure 'a+%; the co)pan.:% re'ation%hip +ith it% financia' auditor% and the recent hi%tor. of the co)panie% reported for cri)ina' activit..

3&

The fact that B i% a greater 'o%% than A high'ight% the i%%ue that once the )anager co))it% fraud the fir%t ti)e; if the pro-'e) doe% not fi6 it%e'f; it i% 'ike'. in the )anager:% -e%t intere%t to continue +ith the fraud in hope% that the pro-'e) +i'' fi6 it%e'f -efore the. are caught. Thi% create% a %ort of -'ack ho'e effect; +here once fraud i% co))ittedC it i% ver. difficu't to %top. !or the )anager that choo%e% to co))it fraud the e6pected va'ue of co))itting fraud over a period of ti)e i% "/ = $ ?med @ + ?1 $ @? ig @ . Since p i% e6tre)e'. 'o+; then the 'o%% re%u'ting fro) an e6tre)e'. 'o+ chance that a )ediu) 'o%% +i'' occur i% 'ike'. to -e -etter than or e5ua' to a 'o+ 'o%%C )eaning that $ ?med @ low . In addition; the e6tre)e'. high chance that a high pa.off +i'' occur re%u't% in a pa.off +ith i% greater than <eroC )eaning that
?1 $ @? ig @ & . A% a re%u't; the e6pected va'ue of co))itting fraud over a period of ti)e

?/B@ i% -etter than 1'o+. The perceived e6pected pa.off% for the )anager:% are thenF 1 1 1 A O Not co))it fraud O 1'o+ B O Co))it fraud once then di%c'o%e O 1)ed /BC P$ O Co))it fraud over a period of ti)e Q 1'o+

Thu%; the perceived e6pected pa.off of choo%ing to co))it fraud over a period of ti)e i% -etter than that of not co))itting fraud or Du%t co))itting fraud once then di%c'o%ing it ?pa.off of co))itting fraud over ti)e Q 1'o+ O pa.off of not co))itting fraud@. !aced +ith the%e deci%ion% and a %tructure %i)i'ar to that of /nron or ,or'dCo):%; a )anager +i'' 'ike'. )ake the deci%ion to co))it fraud; +hi'e )anager% +ithout thi% %tructure 'ike'. +ou'd not. 5.2 Th S&$6&) 7-O8. 0 A*' In re%pon%e to a %'ue of corporate governance %canda'% inc'uding -oth /nron and ,or'dCo); the United State% Senate pa%%ed the Sar-ane%146'e. Act ?S4A@ in 2&&2. ,hi'e the act contain% )an. ne+ ru'e%; a fe+ have a %ignificant effect on the %tructure of U.S. corporate governance. Specifica''.; the act trie% to i)prove the perfor)ance of financia' auditor% and

31

director%; increa%e the chance of detecting fraudu'ent activit.; increa%e con%e5uence%; and %trengthen the enforce)ent of %ecuritie% 'a+%. Sar-ane%146'e. %pecifica''. targeted the accounting indu%tr.; )aking the effort to re)ove %o)e conf'ict% of intere%t% and i)prove accounta-i'it.. The S4A created the 2u-'ic Co)pan. Accounting 4ver%ight Board ?2CA4B@ to )onitor the accounting co)panie% and to further enforce accounting %tandard% ?2etruno 2&&3@. In addition; the S4A -anned the auditing fir)% fro) %e''ing 'ucrative non1auditing %ervice% to their corporate accounting c'ient% ?2etruno 2&&3@. The 2CA4B i% de%igned to )ake accounting fir)% )ore accounta-'e; )aking the) )ore 'ike'. to do a -etter Do- auditing. The -an on %e''ing non1auditing %ervice% i% de%igned to re)ove the conf'ict of intere%t that +a% %o preva'ent in the /nron and ,or'dCo) %canda'%. A% a re%u't; the chance that the auditing co)pan. +i'' catch and report accounting pro-'e)% ha% increa%ed %ignificant'.. The -oard of director% and the -oard:% audit co))ittee +ere a'%o targeted -. Sar-ane%1 46'e.. B. defining the ro'e of director% )ore c'ear'. and increa%ing the accounta-i'it. of director%; the S4A %hou'd have the effect of )aking -oard )e)-er% )ore in5ui%itive. In addition; the S4A re+orked the re'ation%hip -et+een the financia' auditor% and the -oard:% audit co))ittee0. The goa' i% to have the accountant% go direct'. to the audit co))ittee if the. -e'ieve )anage)ent i% not u%ing the accounting proper'. ?2etruno 2&&3@. In addition; the ne+ re5uire)ent for +ho can %it on the -oard i% focu%ed on increa%ing the independence of director%. 4vera''; the S4A:% goa' +ith the -oard +a% to re)ove conf'ict% of intere%t% and give the -oard )ore of an incentive and a-i'it. to criti5ue )anage)ent:% deci%ion%. If the -oard ha% )ore incentive to criti5ue )anage)ent:% deci%ion%; it i% 'e%% 'ike'. that the -oard +i'' a''o+ )anage)ent to get a+a. +ith -ad deci%ion%.
0

A group +ithin the -oard that ha% the re%pon%i-i'it. to )ake %ure financia' %tate)ent% are accurate.

32

A% a re%u't of Sar-ane%146'e.; )anage)ent i% )uch )ore accounta-'e for their action%. The S4A i)p'e)ented a re5uire)ent that the C/4 and C!4 of the co)pan. )u%t certif. their co)panie%: 5uarter'. and annua' financia' %tate)ent%. Thi% )u%t contain a %tate)ent of 9)anage)ent:% re%pon%i-i'it. to e%ta-'i%h and )aintain ade5uate interna' contro'%; a%%e%% financia' reporting; and di%c'o%e an. )ateria' +eakne%%e% in a co)pan.:% interna' contro'% %tructure> ?Bo'cker 2&&(@. Thi% %hou'd acco)p'i%h t+o goa'%. !ir%t; it +i'' re5uire co)panie% to i)prove interna' contro'% over their financia' %tate)ent%; +hich %hou'd increa%e the chance of detecting fraudu'ent financia' reporting ?$ona'd%on 2&&3@. Thi% %hou'd a'%o )ake )anage)ent accounta-'e for providing accurate infor)ation on the financia' %tate)ent%. B. increa%ing )anage)ent:% accounta-i'it.; the con%e5uence% for getting caught co))itting fraud e%ca'ate %ignificant'.. To increa%e the effectivene%% of the Securitie% and /6change Co))i%%ion ?S/C@8; Sar-ane%146'e. dra%tica''. increa%ed the S/C:% -udget. In 2&&3; the S/C:% -udget gre+ (8E and +i'' continue to gro+ ?2etruno 2&&3@. B. increa%ing the -udget of the S/C; it %hou'd increa%e the over%ight of pu-'ic co)panie% and increa%e the chance% the co)panie% +i'' get caught if the. co))it fraud. 5.+ P#7'-SOA M#! . !or the ca%e of a )anager running a co)pan. after Sar-ane%146'e. Act +a% pa%%ed; the deci%ion tree ha% not changed. In addition; the S4A ha% not a'tered the con%e5uence% or )agnitude% of A or B -ecau%e the )anager %ti'' face% the con%e5uence of 'o%ing %tock )arket va'ue if the. choo%e not to di%c'o%e the pro-'e) i))ediate'.. The )agnitude of $ ha% not changed a% +e'' -ecau%e the )anager %ti'' get% a'' the -enefit% of a +e''1perfor)ing %tock price.
8

The nation:% pri)ar. regu'ator of pu-'ic co)panie% and )arket%

33

*o+ever; Sar-ane%146'e. ha% %ignificant'. a'tered -oth the con%e5uence% of getting caught continuing to co))it fraud and the pro-a-i'it. of getting caught. The Sar-ane%146'e. Act increa%ed the con%e5uence% for co))itting fraud -. )aking the )anager )ore accounta-'e for the financia' %tate)ent%. No+; the )anager +i'' not on'. 'o%e %ignificant +ea'th -ut the con%e5uence% inc'ude the %ignificant po%%i-i'it. of Dai' ti)e and heft. fine%. A% a re%u't of the%e change%; )anager% )a. no+ vie+ the con%e5uence% of getting caught co))itting fraud a% %ignificant'. higher. In addition; a )anager )a. a'%o vie+ the pro-a-i'it. that the. +i'' get caught co))itting fraud ?2@ a% )uch greater -ecau%e of recent tria'% and the change% fro) the S4A. Since the /nron and ,or'dCo) e6ecutive% have recent'. -een found gui't.; the )anager no+ %ee% a recent hi%tor. of co)panie% getting caught; +hich ha% increa%ed their perception of their chance% of getting caught. "o%t i)portant'.; the S4A ha% changed the %tructure of the ga)e. The )anager:% a-i'it. to hide pro-'e)% ha% -een %ignificant'. reduced -ecau%e the S4A increa%ed the effectivene%% of -oth the auditor% and the -oard of director%; i)proved interna' contro'%; and increa%ed the a-i'it. of the S/C to regu'ate. A% a re%u't; )an. )anager% that cho%e to co))it fraud -efore )a. no+ perceive the pro-a-i'it. that the. +i'' get caught a% %ignificant'. higher. The Sar-ane%146'e. Act ha% %ignificant'. increa%ed -oth the pro-a-i'it. and the con%e5uence% of getting caught continuing to co))it fraud. Thi% +i'' a'ter %o)e )anager%: deci%ion to co))it fraud. "anager% +ho )ade the choice not to co))it fraud -efore +i'' continue to )ake thi% choice. *o+ever; %o)e )anager% +ho cho%e to co))it fraud -efore )a. no+ vie+ the pro-a-i'it. and con%e5uence% of getting caught a% %o %ignificant'. greater than -efore that the. +i'' no+ choo%e not to co))it fraud. !or tho%e )anager%; the e6pected va'ue of continuing to co))it fraud +i'' -e +or%e than that of an. other choice. Thu%; the. +i'' decide

3(

that it i% no+ not +orth the ri%k to co))it fraud. In thi% +a.; the Sar-ane%146'e. Act +i'' -e %ucce%%fu' in reducing the nu)-er of )anager% +ho )ake the deci%ion to co))it fraud. 5. CONCLUSION Through the ca%e% of /nron and ,or'dCo); it -eca)e c'ear that the United State% corporate governance %.%te) needed i)prove)ent -ecau%e it gave %o)e )anager% the a-i'it. and incentive to co))it fraud. In tho%e ca%e%; )anage)ent -e'ieved the. cou'd fi6 their co)pan.:% pro-'e)% and avoid an. )arket con%e5uence% -. deceiving inve%tor%. The. -e'ieved the. cou'd get a+a. +ith fraud -ecau%e of their c'o%e re'ation%hip +ith their -oard% of director% and auditor%; in addition to the co)p'e6it. of the accounting %.%te). The U.S. )ode' of corporate governance i% not co)p'ete'. f'a+ed though; %ince )an. )anger% %ti'' cho%e not to co))it fraud. *o+ever; the pro-'e)% high'ighted in thi% paper are %ignificant enough that the. needed to -e dea't +ith. The U.S. Congre%% %tepped in to he'p in 2&&2. The pa%%ing of the Sar-ane%146'e. Act changed the %tructure of the ga)e enough %o that )an. )anager% +i'' no 'onger have %uch c'o%e re'ation%hip% +ith their -oard% and auditor%; and it dra%tica''. increa%ed the )onitoring and con%e5uence% for corporate fraud. A% a re%u't; )an. )anager% +i'' no+ vie+ the con%e5uence% and pro-a-i'it. of getting caught continuing to co))it fraud a% too high to take the ri%k. Therefore; the Sar-ane%146'e. Act %hou'd -e effective in reducing corporate fraud. *o+ever; it i% not a tota' fi6; -ut neverthe'e%% a %hort1ter) %tep in the right direction. In the 'ong1ter); there i% %ti'' an under'.ing i%%ue that Sar-ane%146'e. doe% not co)p'ete'. addre%%F the co)p'e6it. and ru'e% of the di%c'o%ure %.%te). ,hi'e the U.S. accounting %.%te) i% argua-'. )ore effective than %.%te)% in other countrie%; it %ti'' doe% not re5uire enough di%c'o%ure; a''o+ing the e6p'oitation of financia' reporting. /nterpri%ing

35

)anager% can %ti'' hide pro-'e)% +ithin or even off the financia' %tate)ent%. Therefore; the -igge%t %tep for i)proving corporate governance +ou'd -e to increa%e the re5uired 'eve' of di%c'o%ure in the financia' %tate)ent%. Thi% +ou'd )ake it near'. i)po%%i-'e to hide pro-'e)% +ithin the financia' %tate)ent%. In the )ode'; thi% cou'd increa%e the pro-a-i'it. of getting caught co))itting fraud to near'. 1&& percent. If re5uired di%c'o%ure +a% %ignificant'. increa%ed; a')o%t no )anager% %hou'd )ake the deci%ion to co))it corporate fraud -ecau%e of the 'ike'ihood that the. +ou'd get caught.

30

9. REFERENCES
AIC2A. 9Su))ar. of Sar-ane%146'e. Act of 2&&2.> Aker'of; George. 9The "arket for H3e)on%:F Rua'it. Uncertaint. and the "arket "echani%).> The Ruarter'. Journa' of /cono)ic%; Bo'u)e (; I%%ue 3F Aug. 1#8&. A''en; !rank'in and $oug'a% Ga'e. 9Corporate Governance and Co)petition.> 4ct. 1## . A% inc'uded in Corporate &o0ernance -. Savier Bive%. A%care''i; Si'via. 9Co)panie% Sho+ 3itt'e Inc'ination to $i%c'o%e "ore.> The ,a'' Street Journa'; !e-. 5; 2&&3. Atkin%; 2au'. 9Speech -. S/C Co))i%%ionerF 7ecent /6perience +ith Corporate Governance in the USA.> S/C.govF June 20; 2&&3. Berardino; Joe. 9/nronF A ,ake1Up Ca''.> The ,a'' Street Journa'; $ec. (; 2&&1. Berton; 3ee. 9Infor)ation 2'ea%e; Truthfu''..> The ,a'' Street Journa'; Aug. 22; 2&&2. Bra.; Chad and Chri%tine Nu<u). 9/--er% Jur. Seek% $ocu)ent% a% it% $e'i-eration% Co))ence.> The ,a'' Street Journa'; "ar. 8; 2&&5. Brennan; $avid. 9/nron and !ai'ed !uture%.> Socia' Te6t; Bo'. 21; No. (; ,inter 2&&3. Bro+n; Gen and *enr. Sender. 9,hen 7u'e% Geep $e-t 4ff the Book L $id Ander%en Act 2roper'.A> The ,a'' Street Journa'; Jan. 1 ; 2&&2. Br.ce; 7o-ert. 92ipe $rea)%.> 2u-'ic Affair%; Ne+ MorkF 2&&2. Burn%; Judith. 9/ver.thing Mou ,anted to Gno+ A-out Corporate GovernanceT TBut didn:t kno+ to a%k.> The ,a'' Street Journa'; 4ct. 28; 2&&3. 9Co%tco:% 2rofit Short of /%ti)ate%.> The Ne+ Mork Ti)e% ?3ate /dition@; "ar. 3; 2&&5. $ona'd%on; ,i''ia). 9Septe)-er 1&F $ona'd%on:% Te%ti)on. Concerning I)p'e)entation of Sar-ane%1 46'e. Act.> 7i%kCenter.co)F Sept. 1&; 2&&3. /)%h+i''er; John and Joann 3u-'in. 9In Boardroo); HIndependent: I% $e-ata-'e.> The ,a'' Street Journa'; "ar. 2; 2&&5. !o6; "erritt. 97e5uired $i%c'o%ure and Corporate Governance.> 3a+ and Conte)porar. 2ro-'e)%; Bo'. 02; No. 3; Su))er 1###. Guerra; Jorge. 9The Sar-ane%146'e. Act of 2&&2 and /vo'ution of the Corporate Governance 2roce%%.> I)akno+'dege.orgI%o6; 2&&3. *art; 4'iver. 9Corporate GovernanceF So)e Theor. and I)p'ication%.> The /cono)ic Journa'; Bo'. 1&5; No. (3&; "a. 1##5. *enne%%e.; 7a.)ond. 9I24 4ut'ookF I24 2rice Setter% $on:t 7e'. on the 2ro%pectu%.> The ,a'' Street Journa'; $ec. 2#; 2&&3. *ir%ch; Jerr.. 9/nron:% Co''ap%e% Uncover% 2itfa''% of *idden $e-t.> 3o% Ange'e% Ti)e%; $ec. 23; 2&&1. *o''and; John. 9!inancia' 7eporting; 2rivate $i%c'o%ure and the Corporate Governance 7o'e of !inancia' In%titution%.> Journa' of "anage)ent and Governance 3F 1###. Jenkin%; Gregor.. 9The /nron Co''ap%e.> 2ear%on /ducation; Upper Sadd'e 7iver; Ne+ Jer%e.F 2&&3. Jen%en; Bo-. 9/nron:% Ca%t of Character% and Their Stock Sa'e%.> Trinit. Univer%it.; 2&&3. Jen%en; Bo-. Trinit..eduIrDen%enI(15+pIa)ericanhi%tor.offraud. Apr. 3; 2&&5. John%on; Carrie. 9After /nron; a Ne+ !ocu% on Board%C Ca%e Spa+n% a Nu)-er of 7efor) 2ropo%a'%.> The ,a%hington 2o%t; "ar. ; 2&&2. Ga)e%a); Bepa. 9Cad-ur. Co))ittee on Corporate Governance.> Inaugura' Addre%% at HGovernance of Bank% and !inancia' In%titution%: at Ad)ini%trative Staff Co''ege of India; Nov. 20; 2&&1. Gir%hna)urth.; Ba'aDi. 9Corporate GovernanceC The Naked Truth.> The ,a'' Street Journa'; 4ct. 28; 2&&3. G'ipper; "iria). 9The governance of privati<ed fir)%F authorit.; re%pon%i-i'it. and di%c'o%ure.> /cono)ic% of Tran%ition; Bo'u)e 0F 1## . Gri); Jonathan. 9!a%t and 3oo%e at ,or'dCo).> ,a%hingtonp%t.co); Aug. 2#; 2&&2.

38

3eaf; C'ifton; $ori% Burke; /''en !'orian; 2atricia Neering; Nicho'a% Barchaver. 9/nough i% /nough.> !ortune; Bo'. 1(0; I%%ue 0F "ar. 1 ; 2&&2. 3o+en%tein; 3oui%. 9!inancia' Tran%parenc. and Corporate GovernanceF Mou "anage ,hat Mou "ea%ure.> Co'u)-ia 3a+ 7evie+; Bo'. #0; No. 5; Jun 1##0. 3u-'in; Joann. 9The Naked TruthF To Counter inve%tor %keptici%); %o)e C/4:% are )aking pu-'ic +hat +a% once con%idered private.> The ,a'' Street Journa'; 4ct. 28; 2&&3. "ace.; Jonathan and Geoffre. "i''er. 9Corporate Governance and Co))ercia' BankingF A Co)parative /6a)ination of Ger)an.; Japan; and the United State%.> Stanford 3a+ 7evie+; Bo'. ( ; No. 1F Nov. 1##5. "cGough; 7o-ert and 2ui1,ing Ta). 9Bog'e Urge% 7o'e in Corporate Governance.> The ,a'' Street Journa'; 4ct. 21; 1###. 9"i'e%tone% in UG Corporate Governance.> UU"AN3U"ANI!/STU7eport%U; Nov. 10; 2&&(. "ehta; Stephanie. 9,or'dCo):% Bad Trip.> !ortune; "arch (; 2&&2. "o-erg; $enni% and /d+ard 7o)ar. 9,or'dCo).> "arkku'a Center for App'ied /thic%; 2&&3. "or%e; $an. 9Scru%h. Tria' "a. *inge on !or)er /6ecutive%.> The ,a'' Street Journa'; "ar. 8; 2&&5. "or%e; $an. 9,itne%% Sa.% Scru%h. ,a% Up%et on *earing of Shredding G'itch.> The ,a'' Street Journa'; "ar. (; 2&&5. Nad'er; $avid. 9$on:t A%k; $on:t Te''.> The ,a'' Street Journa'; Nov. 25; 2&&3. Norri%; !'o.d. 9$id Gen 3a. Under%tand ,hat ,a% *appening at /nronA> The Ne+ Mork Ti)e%; Nov. 10; 2&&1. 94/C$ 2rincip'e% of Corporate Governance.> 4/C$F 2&&( 4'%tein; Bo-. 9So)eti)e% It Take% a Sher'ock.> The Ne+ Mork Ti)e%; Nov. 1(; 2&&(. 94n'ine 4ffering%.> The ,a'' Street Journa'; !e-. 2(; 2&&3.

4rr; $e-orah. 9"a6+e'':% Gho%t.> !or-e%.co); Sep. 2; 2&&2. 2artno.; !rank. 9Infectiou% GreedF ho+ deceit and ri%k corrupted the financia' )arket%.> Ti)e% Book%; Ne+ MorkF 2&&3. 2etruno; To) and Tho)a% "u''igan. 9Corporate 7efor):% Ba-. Step%.> The 3o% Ange'e% Ti)e%; Ju'. 28; 2&&3. 7a.; $e-raD. 9$eve'op)ent /cono)ic%.> 2rinceton Univer%it. 2re%%F 1## . Schie%e'; Seth. 9"o%t ,or'dCo) $irector% 7e%ign.> The Ne+ Mork Ti)e%; $ec. 1 ; 2&&2. Sh'eifer; Andrei and 7o-ert Bi%hn.. 9A Surve. of Corporate Governance.> The Journa' of !inance; Bo'. 3II; No. 2F June 1##8. Sender; *enr.. 9!a'' of a 2o+er Giant.> The ,a'' Street Journa'; $ec. (; 2&&1. So))er; Jr.; A. A. 9The I)pact of the S/C on Corporate Governance.> 3a+ and Conte)porar. 2ro-'e)%; Bo'. (1; No. 3; Su))er 1#88. Stern; Chri%topher. 9/--er% $o)inated Board; 7eport Sa.%.> ,a%hingtonpo%t.co); Nov. 5; 2&&2. Stern-erg; /'aine. 9Corporate GovernanceF Accounta-i'it. in the "arketp'ace.> The In%titute of /cono)ic Affair%F 2&&(. Stig'it<; Jo%eph. 9Incentive% and 7i%k Sharing in Sharecropping.> The 7evie+ of /cono)ic Studie%; Bo'. (1; I%%ue 2F Apr. 1#8(. Bive%; Savier. 9Corporate Governance.> Ca)-ridge Univer%it. 2re%%F 2&&&. Bo'cker; 2au' and Arthur 3evitt Jr. 9In $efen%e of Sar-ane%146'e..> ,a'' Street Journa'; Jun. 1(; 2&&(. Moung; Sha+n. 9/61,or'dCo) $irector% 7each 2act.> The ,a'' Street Journa'; "ar. 21; 2&&5. Moung; Sha+n and A')ar 3atour. 9/--er% !ee'% 2inch on !inance%.> The ,a'' Street Journa'; !e-. 23; 2&&5. Kekan.; Ga.; 3uca% Braun and Kachar. ,arder. 9Behind C'o%ed $oor% at ,or'dCo)F 2&&1.> I%%ue% in Accounting /ducation; Bo'. 1#; No. 1F !e- 2&&(.

APPENDIX A

3#

APPENDIX B /nronV% Ca%t of Character% and Their Stock Sa'e% NAME POSITION AT ENRON SHARES SOLD 01#; # 2;&05;138 21;2&& 1(&;23( 2& ;#(& ;&&& 23&;00& 35;&&& 0 8;((5 3 ;10& # 0; # 1&;32 Unkno+n 1;&11;(30 (83; 38 3&;((( 13;30& 0(;#32 12#;153 (;&&2;25# 18;3(( 1; #5;031 32;#0& 3#;03& 3;1 3 3;#12;2&5 GROSS PROCEEDS =3(;83(; 5( =111;#(1;2&& =1;8&5;32 =1&;050;5#5 =13;3 0; #0 =338;2&& =12;503;#2 =2;&&#;8&& =33;085;&&( =1;03#;5#& =5(; 31;22& =28 ; #2 Unkno+n =85;(10;030 =35;10 ;821 =(8;381;301 = (1;(3 =5;100;(1( =#;11&;(00 =1 (;(#(.(20 = (1;80 = 2;530;838 =2;5&0;311 =2;83#;220 =0;5&5; 8& =28&;280;&05 (&

J. C'ifford Ba6ter Bice1Chair)an 7o-ert Be'fer Nor)an B'ake 7ick Bu. 7ick Cau%e. 7onnie Chan Ja)e% $errick John $uncan And. !a%to+ Joe !o. "ark !revert ,end. Gra)) Gevin *annon Gen *arri%on Joe *irko Stan *orton 7o-ert Jaedicke Steve Gean "ark Goenig Gen 3a. 7e-ecca "ark "ichae' "cConne'' Jeff "c"ahon Cind. 4'%on 3ou 2ai "e)-er of Board of $irector% "e)-er of Board of $irector% Chief 7i%k 4fficer Chief Accounting 4fficer "e)-er of Board of $irector% Genera' Coun%e' "e)-er of Board of $irector% Chief !inancia' 4fficer "e)-er of Board of $irector% Chief /6ecutive 4ffice; /nron /urope "e)-er of Board of $irector% 2re%ident; /nron Broad-and Service% "e)-er of Board of $irector% C/4; /nron Co))unication% C/4; /nron Tran%portation "e)-er of Board of $irector% /6ecutive Bice 2re%ident; Chief of Staff /6ecutive Bice 2re%ident Chair)an; /nron Corp. Chief /6ecutive 4fficer; A<uri6 /6ecutive Bice 2re%ident Trea%urer /6ecutive Bice 2re%ident C/4; /nron /nerg. Service%

Char'e% 3e"ai%tre "e)-er of Board of $irector%

Gen 7ice Jeffre. Ski''ing Joe Sutton Greg ,ha''e.

C/4; /nron Broad-and Service% Chief /6ecutive 4fficer; /nron Corp. Bice1Chair)an Chief 4perating 4fficer; /nron Corp. T4TA3S

1;23(;&&# 1;3&8;08 0 ;##0

=80; 25;1(5 =8&;0 8;1## =(2;231;2 3 Unkno+n =1;1#&;(8#;(82

Unkno+n 2&;8 ;#58

:A'' 'i%ted %a'e% occurred -et+een 4cto-er 1#; 1## and Nove)-er 28; 2&&1. The nu)-er %ho+n under gro%% proceed% indicate% the nu)-er of %hare% ti)e% the price of /nron %tock on the da. the %hare% +ere %o'd. It doe% not ref'ect an. co%t% the /nron officia'% incurred in e6erci%ing the %a'e of the %tock. Therefore; the net proceed% to the 'i%ted individua'% i% 'ike'. 'e%% than the a)ount %ho+n. S4U7C/SF Mark 1ew%.2 et al. 0s. "nron Corp.2 et al.2 Securitie% and /6change Co))i%%ion fi'ing%; Congre%%iona' te%ti)on.; /nron Corp. pre%% re'ea%e%.

(1