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A Case For Legalizing Fraud

If there's anything the growing scandal over options backdating seems to demonstrate, it's that the brute force approach to dealing with corporate malfeasance is failing. In other words, you can't just ban stuff and make it go away. Boards and executives will simply delve deeper into accounting exotica in order to avoid scrutiny. Harvard economist Jeffrey Alan Miron thinks the answer is to legalize fraud:

Should corporate fraud and malfeasance be crimes? Should the SEC dictate corporate disclosure and accounting practices? What would happen if all such matters were left to private parties?
To answer these questions, consider the following.
So an alternative to the criminal / regulatory approach to corporate misconduct is private contracts. Under this scenario, shareholders would attempt to design and enforce contracts for executives that discourage fraud. This could mean organizational structures that limit the power of any one executive, checks and balances like outside audits, and deferred compensation that is conditional on good performance.
Despite clever contracts, some fraud would still occur. But under the contracting approach, this would be a civil matter between shareholders and the corporation rather than a matter of criminal law.

Now it's easy to anticipate the response among the opposition. "Well why don't you just make all crime 'legal', which would technically reduce the crime rate to zero". But this response is easily dismissed. For one, there's a clear utilitarian argument to prosecuting criminals; usually it has something to do with deterrent, preventing them from ever harming again. But in the world of business law, no such external deterrent is necessary. Would any business ever hire Lay or Skilling again? Would any investor give them money if they launched a startup? All in all, the utilitarian case for prosecuting white-collar crimes is rather weak. Put simply, which has been a greater destroyer of value, options backdating or Sarbanes-Oxley? And while many people bemoan the lack of shareholder participation in corporate matters, there's no better way to discourage said participation than by creating a false sense of security. Thus Miron points out:

A key problem with SEC regulation is that it gives corporations an excuse for disclosing too little. When a regulator tells corporations they must disclose X, Y and Z, many disclose exactly that and no more. And, having complied with this regulation, they say to shareholders, "We've done what we're supposed to do." Without SEC regulation, investors would demand whatever information from corporations they desired, or shift their money elsewhere.
Still a further cost of the criminal / regulatory approach is giving individual investors a false sense security. Under current policy, investors can delude themselves that buying and selling individual stocks, or holding a non-diversified portfolio, is reasonable, since it seems the federal government has "taken care of" corporate fraud. In fact, no individual company is ever safe, and diversification is a key form of protection. Under the contracting approach, investors would be on notice. They would demand clear indications of honest accounting and reward firms that provided it, rather than making a blanket assumption of no misconduct.

Of course, the prognosis for radical changes to the legal code is rather poor. If anything the government's success against Lay and Skilling will only re-enforce the cycle. What lucky politicians will get to have their names hyphenated and attached to the next bill protecting shareholders? Schumer-Graham? Kerry-McCain?
How to Avoid More Enrons: Legalize Fraud [TCS Daily]


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