Confronting the Two Faces of Corporate Fraud

Professor Miriam Baer

The following post comes to us from Miriam H. Baer, Associate Professor at Brooklyn Law School. It is based on her recent paper entitled “Confronting the Two Faces of Corporate Fraud,” which is forthcoming in the Florida Law Review and is available here.

Some people hurt others by failing to follow through on their best-laid plans. Corporate managers who sincerely promise to implement new programs, but then welsh on their promises several months later fall into this category.  These individuals harm society, both by failing to execute their plans, and often by attempting to hide these failures.

Other individuals carry out their evil intentions with an alarming amount of discipline.  The murderer who plans a mass killing down to the exact type of weaponry is such a person.  A well-orchestrated Ponzi scheme, in which an individual persuades unwitting victims to invest their money in nonexistent funds, is the white-collar version of such wrongdoing.  For both the murderer and schemer, the problem is not that an individual failed to carry out her promise, but rather, that she executed it with meticulous precision.

Thus, some individuals quite ably and opportunistically take advantage of others, whereas others harm people through their temporal inconsistency, their inability to carry out their long-term plans.  As several scholars have begun to recognize, this dichotomy poses a significant challenge for law enforcers.

Confronting the Two Faces of Corporate Fraud explores this enforcement challenge in the corporate context.  In particular, it focuses on corporate fraud, in which corporate managers defraud the corporate entity and its shareholders through some combination of deliberate misrepresentations and false statements.

The traditional law and economics canon views corporate fraud as a species of agency cost, which can be solved through some combination of sanctions and increased enforcement. By contrast, the temporal inconsistency literature suggests a different role for government actors.  Instead of manipulating incentives for good behavior, government actors should help individuals find ways to control their short-term selves, presumably through promulgating or encouraging the adoption of precommitment devices.   A precommitment device is a mechanism that an individual adopts in order to restrain himself in the future.  The device – which includes everything from a gym membership to our difficult-to-amend Constitution – commits an individual to law-abiding behavior by eliminating certain options in advance of some foreseen event.

Legal academic scholars, most notably Manuel Utset, have begun to recognize temporal inconsistency’s implications for government regulators and criminal law in general.  This Article expands on this scholarship, first by considering how both opportunism and temporal inconsistency interact within the corporation, and then by considering how this interaction challenges the corporation’s internal compliance department, the internal unit that stands at the center of the corporation’s efforts to detect and reduce corporate fraud.

The Article then hypothesizes a simplified world in which individuals simultaneously occupy positions on two different spectra at any given time.  The first spectrum refers to the individual’s motivation towards others, and the second identifies his tendency to act consistently over successive periods of time.  Crossed together, the two spectra create the following typology of employees:

(a) well motivated and temporally consistent;
(b) well motivated and temporally inconsistent;
(c) poorly motivated and temporally inconsistent; and
(d) poorly motivated and temporally consistent.

From this typology, one can see why corporate fraud so often mixes planned and impulsive conduct and why the corporate compliance department is likely to have its hands full: With the exception of the employees in category (a), everyone within the corporation has the potential to contribute to or perpetrate a fraud.

How should a compliance department respond to these prototypes? The latter half of the Article concludes that much of the compliance officer’s work falls within two categories: corporate policing and corporate architecture.  The policing approach is the most familiar one: It reduces corporate crime by empowering internal corporate policemen to identify and punish actual and would-be transgressors.  The latter approach is different in feel and effect: It encourages corporate personnel to seek out and mitigate problematic situations by adopting different decision-making structures and systems, thereby reducing the opportunity and temptation for fraud. The policing approach is more judgmental and punitive, while the architectural approach is more regulatory and intrusive.

As the Article explains, neither approach can completely counteract opportunism and temporal inconsistency. To confront fraud’s “two faces,” compliance officers must acquaint themselves with both the policing and architectural approaches.

As the Article concludes, however, our current legal enforcement environment renders unlikely the corporate compliance department’s fulsome embrace of both approaches.  To the contrary, our legal and corporate governance institutions tend to place a greater emphasis on policing, to the detriment of corporate shareholders and society as a whole.

The Article thus concludes with a renewed emphasis on structural compliance efforts.  If corporate fraud is truly a two-faced problem, then corporate compliance departments must adopt sophisticated and integrated responses.  Effective compliance ought to focus on architecture as much as – if not more than – on policing.   For compliance officers to do this, however, government actors must grant corporations the necessary space and encouragement to experiment with more structural approaches to wrongdoing.