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November 1, 2010
Control Fraud
I had never heard the term "control
fraud" before:
Control fraud theory was developed in the
savings and loan debacle. It explained that the
person controlling the S&L (typically the CEO)
posed a unique risk because he could use it as a
weapon.
The theory synthesized criminology (Wheeler and
Rothman 1982), economics (Akerlof 1970),
accounting, law, finance, and political science.
It explained how a CEO optimized "his" S&L as
a weapon to loot creditors and shareholders. The
weapon of choice was accounting fraud. The company
is the perpetrator and a victim. Control frauds
are optimal looters because the CEO has four
unique advantages. He uses his ability to hire and
fire to suborn internal and external controls and
make them allies. Control frauds consistently get
"clean" opinions for financial statements that
show record profitability when the company is
insolvent and unprofitable. CEOs choose top-tier
auditors. Their reputation helps deceive creditors
and shareholders.
Only the CEO can optimize the company for fraud.
This
is an interesting paper about control fraud. It's by
William K. Black, the Executive Director of the
Institute for Fraud Prevention. "Individual 'control
frauds' cause greater losses than all other forms of
property crime combined. They are financial
super-predators." Black is talking about control
fraud by both heads of corporations and heads of
state, so that's almost certainly a true statement.
His main point, though, is that our legal systems
don't do enough to discourage control fraud.
White-collar criminology has a set of
empirical findings and theories that are useful to
understanding when markets will act perversely. This
paper addresses three, interrelated theories
economists should know about. "Control fraud" theory
explains why the most damaging forms of fraud are
situations in which those that control the company
or the nation use it as a fraud vehicle. The CEO, or
the head of state, poses the greatest fraud risk. A
single large control fraud can cause greater
financial losses than all other forms of property
crime combined they are the "super-predators" of the
financial world. Control frauds can also occur in
waves that can cause systemic economic injury and
discredit other institutions essential to good
government and society. Control frauds are commonly
able to defeat for several years market mechanisms
that neo-classical economists predict will prevent
such frauds.
"Systems capacity" theory examines why under
deterrence is so common. It shows that,
particularly with respect to elite crimes,
anti-fraud resources and willpower are commonly so
limited that "crime pays." When systems capacity
limitations are severe a "criminogenic
environment" arises and crime increases. When a
criminogenic environment for control fraud occurs
it can produce a wave of control fraud.
"Neutralization" theory explores how criminals
neutralize moral and social barriers that reduce
crime by constraining our decision-making to
honest enterprises. The easier individuals are
able to neutralize such social restraints, the
greater the incidence of crime.
[...]
White-collar criminology findings falsify several
neo-classical economic theories. This paper
discusses the predictive failures of the efficient
markets hypothesis, the efficient contracts
hypothesis and the law & economics theory of
corporate law. The paper argues that neo-classical
economists' reliance on these flawed models leads
them to recommend policies that optimize a
criminogenic environment for control fraud.
Fortunately, these policies are not routinely
adopted in full. When they are, they produce
recurrent crises because they eviscerate the
institutions and mores vital to make markets and
governments more efficient in preventing waves of
control fraud. Criminological theories have
demonstrated superior predictive and explanatory
behavior with regard to perverse economic
behavior. This paper discusses two realms of
perverse behavior the role of waves of control
fraud in producing economic crises and the role
that endemic control fraud plays in producing
economic stagnation.
Posted
on November 1, 2010 at 6:02 AM • 16
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