Why They Do It Book Summary by Eugene Soltes

Why they do it Book Summary:

This book attempts to convey a deeper understanding of why senior executives engage in crime.

Popularised explanations focusing on greed, money, and fame are all appealing in their simplicity and certainly can contribute to myopic choices and poor decision making, but they are also superficial explanations of why some people do, and others do not, become white-collar criminals.

In fact, most of the obstacles are ones to which we are all susceptible. As Harvard Business School colleagues Max Bazerman and Francesca Gino have shown in their research, many of us regularly engage in small acts of deception.

Most business decisions are not trading off good versus evil, but managers often do confront judgments that must be made in the penumbra of gray—judgments that are difficult, imperfect, and subject to scrutiny.

New employees are often perceived as being the most likely perpetrators. Yet, when one actually looks at data on thousands of employees who violate company rules and polices—some minor and reckless, others egregious and deliberate—one observes that it is often not new employees who are the most inclined to offend. Rather, the most likely offenders are overconfident individuals who have been employed for a decade and opportunistic managers on the verge of retirement.

 

The book is broken up into 3 parts:

PART I THE STRUGGLE TO CRIMINALIZE

PART II NATURE OR NURTURE? REASONING OR INTUITION?

PART III THE BUSINESS OF MALFEASANCE

 

PROLOGUE – Managing in the Gray

It was easy to rationalise why someone deserves to be punished for breaking an accounting rule, but whether a sales contract was dated Friday or Monday doesn’t create a strong feeling of anger or indignation among many. There is an uncomfortable disconnect between what we all intuitively feel and what we intellectually believe is right and wrong.

 

Why do Executives engage in malfeasance?

Many people, federal prosecutors, scholars, and media commentators claim that executives make decisions, including criminal ones, through explicit cost-benefit calculation. This was after researchers realised that individuals were not necessarily bound by their biology, crime became viewed as a choice. Among federal prosecutors, economists, criminologists, and many in the media, cost-benefit analysis became the favoured rationale for understanding corporate malfeasance.

Although, such deliberate reasoning is consistent with the way many business decisions are made, this explanation seems at odds with how these former leaders made choices that eventually led them to prison.

Eugene found that executives expended surprisingly little effort deliberating the consequences of their actions. They seem to have reached their decisions to commit crimes with little thought or reflection. It was not that they simply believed they wouldn’t be caught and they could engage in corporate crimes with impunity, either. It was a broader lack of recognition of the consequences of their actions.

Over time, Eugene began to understand the reason for this shortsightedness. They put little effort into these decisions because they never deeply felt that the decisions were actually harmful to themselves or others. Because they didn’t perceive this harm, they had little reason to pause and reconsider their course of action. It wasn’t that these executives recognised that other people were going to be harmed and simply didn’t care. Rather, they never even stopped to consider that their actions would harm, even devastate, real people.

It may seem hard to believe that an intelligent executive could fail to see the harm created by fraud, embezzlement, or price-fixing. To victims, the negative ramifications of such crimes are readily apparent. However, while manipulative corporate conduct has the same financial effect as stealing money from an investor’s wallet, there is a crucial difference between these types of crime from the perspective of the perpetrator. Stealing money from another’s pocket involves a high degree of intimacy. The perpetrator sees the victim, physically touches his property, and witnesses his immediate reaction after being robbed. But manipulative corporate conduct lacks all these sensations associated with theft. Executives never need to get close—physically or psychologically—to their victims. Instead, the victims of financial crimes often remain distant and amorphous.

Proximity deeply affects our instinctive ability to sense and react to harm. As distance grows, our ability to empathise with others shrinks. In business, where many transactions occur at “arm’s length” among unrelated parties, there is often no natural tendency to empathise with individuals on the other side of a transaction, let alone those derivatively affected second- or thirdhand.

We are all susceptible to making the same mistakes as these former executives. Fortunately for us, the consequences are considerably less significant in most instances for ourselves and others. At the same time, by illustrating how we all share certain limitations, Eugene hopes that the lessons from this book will instill some degree of humility.

 

PART I THE STRUGGLE TO CRIMINALISE

 

Chapter 1 – Not… bucket-shop operators, dead-beats, and fly-by-night swindlers –  Pillars of the Community

Actions that today earn long jail sentences, from insider trading to the manipulation of financial statements, were not widely seen as criminal until the middle of the twentieth century, when an academic from a midwestern university began proclaiming that everybody had it all wrong.

 

Illuminating Executive Misconduct

On the evening of December 27, 1939, Edwin Sutherland took to the podium to deliver his presidential address at the fifty-second annual meeting of the American Sociological Society.

Sutherland began his speech by arguing that much of what his colleagues understood about crime was “misleading and incorrect.” By relying on public criminal records, Sutherland chided his fellow criminologists for mistakenly concluding that crime was restricted to the streets and largely committed by individuals in the lower social classes. In Sutherland’s view, much of the most serious crime was being committed not by the poor or the “delinquent” but, instead, by society’s most well-known and respected business leaders.

During his talk, Sutherland even coined a new term for this class of deviance: “white-collar crime.” He insisted that this white-collar criminality was not restricted to “ambulance chasers, bucket-shop operators, dead-beats, and fly-by-night swindlers” but, rather, was present within many of the leading corporations in America. To his surprised audience, Sutherland went so far as to compare some of these corporate practices to the “legitimate rackets” operated by Al Capone, the notorious Chicago mobster. “White-collar crime is real crime,” he contended.

 

The Criminaloids

Soon thereafter, Sutherland began taking a scholarly interest in professional deviance. Inspired by his reading of E. A. Ross’ book, Sin and Society, Sutherland came across the concept of the “criminaloid,”people who commit acts that are not necessarily illicit but nevertheless undermine societal well-being.

In Ross’ depiction, the criminaloid prospers “by flagitious practices which have not yet come under the effective ban of public opinion.” “But,” as Ross wrote, “since they are not culpable in the eyes of the public and in their own eyes, their spiritual attitude is not that of the criminal.”

 

The first step

Despite strong resistance by corporate leaders, legislators eventually recognised a need to address weak state blue-sky laws, which led to the creation of the first major pieces of federal securities regulation—the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 Act mandated the disclosure of accurate financial information to investors prior to selling securities. However this didn’t mean there was criminal prosecution for wrong doers.

Sutherland believed that this favoured administration of justice insulated corporate offenders from more serious criminal prosecution. He argued that “the crimes of the lower class are handled by policemen, prosecutors, and judges, with penal sanctions in the form of fines, imprisonment, and death.” But “the crimes of the upper class either result in no official action at all, or result in suits for damages in civil courts, or are handled by inspectors, and by administrative boards or commissions, with penal sanctions in the form of warnings, orders to cease and desist, occasionally the loss of a license, and only in extreme cases by fines or prison sentences.”

 

The criminal divide

With limited regulation of professional behaviour and even less effort to prosecute this behaviour criminally in his opinion, Sutherland compared executives to the clergy in medieval society who could act with relative impunity. According to the official statistics, criminal activity seemed to be largely restricted to street crimes such as murder, assault, and burglary. This led to one unequivocal, but misleading, conclusion—that criminal activity had a very high incidence among individuals in the lower social classes and a low incidence among people of high socioeconomic standing.

The theory that poverty caused crime simply captured the fact that regulation usually excluded deviant activities undertaken by people of the upper or professional classes. Sutherland later likened this approach by criminologists to collecting data only on criminals with red hair and then erroneously finding that red hair caused criminal behaviour.

Sutherland’s analysis provided sobering evidence, as he later noted, that “the ideal businessman and the large corporation are very much like the professional thief.”

 

The need for an image change

Sutherland bemoaned years earlier in his speech that business misconduct is an unattractive topic. Without the urgency that characterised most street crime, white-collar offenses usually lacked the sensational appeal that made front-page news. The lack of media interest was further compounded by the fact that most journalists lacked the technical knowledge needed to write about the intricacies that arose in complex white-collar litigation.

Sutherland, like Robert Kennedy, believed that finally punishing executives criminally would lead to public censure. What they failed to understand was that criminal prosecution was itself insufficient to lead to this condemnation. Society at large also had to view their offenses as morally reprehensible. Yet, many regulatory offenses lacked this stigma. “Without moral wrongfulness,” the legal scholar Stuart Green wrote, “one might conclude that defendants who violate such laws do not ‘deserve’ to be punished.”

It would take more time—but not all that much—before white-collar crime would be widely perceived as serious misconduct in both the United States and elsewhere. And it started when the nationally renowned periodical Life printed a photograph of a sentenced executives confined behind bars. The image of the respected, distinguished executive who was infallible was permanently shattered.

 

Chapter 2  – Guys… don’t drop out of windows for no reason – Creating the White-Collar Criminal

 

The changing tide

Foreign bribery was hardly the only type of corporate mischief that came to the fore in the 1970s. All of a sudden white-collar crime filled the news, and it seemed as though “lawless behaviour—including price-fixing, illegal political contributions to domestic and foreign governments, environmental damage, and health and safety violations—was the norm rather than the exception.”

What had changed was not just the frequency with which articles about managerial deviance appeared but also the fact that the tenor of press coverage was anything but sympathetic, in stark contrast to the coverage of the price-fixing scandal a decade earlier.

With all this media coverage focused on business misconduct, the reputation of business leaders—once revered by the public—began to plummet.

Emboldened by the growing mistrust of business practices, legislators passed new regulations significantly restricting corporate behaviour that the public felt was not just unethical but criminal.

Most prominently, Congress passed the Foreign Corrupt Practices Act (FCPA) in 1977, making bribery of foreign officials a criminal offense for the first time. Corporate executives who violated the FCPA could spend up to five years in jail, while their companies could incur fines up to $1 million. Prior to the FCPA’s passage, foreign bribery not only was not explicitly illegal but was actually tax deductible so long as the foreign government in question “acquiesced” to the payments.

 

Rudy Giuliani’s crackdown on white collar crime

Rudy Giuliani’s strategy for pursuing white-collar criminals was simple. Anyone charged with committing a corporate offense would be not only coaxed into confessing his wrongdoing but also compelled into providing evidence against his colleagues and business associates in return for leniency in sentencing.

Giuliani cast a wide net, intimidating potential white-collar offenders who faced the criminal justice system for the first time in their lives.

Giuliani realised that it would take an innovative strategy to go after the leaders of Princeton/Newport. He introduced what would be his greatest—and most controversial—contribution to pursuing white-collar criminals by employing the Racketeer Influenced and Corrupt Organisations statute (RICO) to yield prosecutions.

RICO was originally devised to prosecute members of organised crime rings like the Mafia, in which middlemen in seemingly legitimate operations made it difficult to pursue those in leadership positions. RICO allowed prosecutors to indict all individuals involved in a criminal organisation as part of a racketeering enterprise and gave regulators authority to seize assets of offenders even prior to trial. If convicted, even assets gained through noncriminal means could be seized by the government.

Applying RICO’s potency to corporate criminality enabled Giuliani, according to one legal scholar, “to drop the equivalent of a nuclear bomb on any target, at any time, no matter how trivial or harmless the underlying conduct.”

The Justice Department, however, concluded that applying RICO in the Princeton/Newport case was so extreme a step that it blocked the use of RICO in future cases involving relatively mundane tax disputes.

 

Three impediments to white-collar prosecution

In 1944, Edwin Sutherland laid out three impediments that he believed were holding back a more aggressive stance toward white-collar misconduct. He was hopeful that regulators, the public, and the business community eventually would come to surmount these obstacles.

1 – The social status of businessmen that seemed to protect them from recrimination was Sutherland’s first concern. Historically, prosecutors did not want to antagonise business leaders, because of their prominence and respectability in society. Regulators feared the accused. But these sentiments shifted dramatically, as more regulators and politicians sought to define themselves as taking a tougher stance against conduct condemned by their electorates.

In just five years, beginning in 2002, federal prosecutors in the United States secured convictions against more than 200 CEOs, 50 CFOs, and 120 vice presidents. Across the world, status and wealth, while once providing a source of protection, often now prove to be a vulnerability. Nations that historically had a reputation for not prosecuting business leaders, or suspending their sentences if convicted, have changed their sentiments.

2 – Sutherland was equally concerned that white-collar offenders, even if convicted, would not be effectively punished. He believed that sanctions against white-collar offenders were designed much like those against juvenile delinquents. Laws and procedures avoided labeling young offenders as criminals to prevent placing a negative stigma over their lives. Sutherland believed that legislators had similarly designed laws to avoid “unfairly” stigmatising executives. Here, too, the modern trend has tilted the other way.

One study found that the average CEO charged with financial misrepresentation in the United States was sentenced to nearly six years in prison. “The number of individual prosecutions has risen—and that’s not an accident,” noted Mark Mendelsohn, the Justice Department’s former chief prosecutor of foreign bribery. Once unthinkable, prison is no longer an uncommon place for wayward executives.

3 – The final hindrance, in Sutherland’s eyes, to more vigorous white-collar prosecution was the general indifference of the public toward white-collar offenders. Efforts by prosecutors and regulators to crack down on bribery, corruption, and fraud have led to significant changes in the public perception of white-collar crime.

Supreme Court, writing in 2010, noted that “economic crimes are certainly capable of rousing public passions, particularly when thousands of unsuspecting people are robbed of their livelihood and retirement savings.”

The widespread outrage at the lack of high-level individual prosecutions in the aftermath of the 2008–2009 financial crisis in the United States is further testimony to just how much opinion has changed.

THE SIGNIFICANT CHANGES in the response to corporate misconduct prompt an obvious question. If white-collar crime is punishable by prison, and those convicted are branded as social pariahs, why would people in a position of wealth and privilege risk everything to commit such a crime? Why do they do it?

 

PART II NATURE OR NURTURE? REASONING OR INTUITION?

 

Chapter 3 – “Inherently inferior organisms” –  Bad People Making Bad Decisions

 

The physical appearance of criminals

In 1870, Cesare Lombroso approached the body of a deceased felon named Giuseppe Vilella. Lombroso had just carefully begun his post-mortem examination, as he had done hundreds of times before, when he was struck by an insight.

Lombroso’s revelation wasn’t an indiscriminate hunch but, rather, one built on the enduring idea that a person’s disposition could be assessed by examining his physical appearance.

By the late eighteenth century, the practice of assessing an individual’s character based on his physical likeness had become a full-blown “science” known as physiognomy. After the Swiss pastor Johann Lavater published his book on physiognomy in 1775, it became a worldwide sensation with over one hundred and fifty editions in half a dozen languages.

Amidst this intellectual backdrop, Lombroso began his systematic investigation of identifying the physical characteristics of criminals. He conducted detailed physical examinations using an array of newly invented tools to measure every aspect of felons from the angle of their ears to their sensitivity to pain.

Lombroso argued that criminals exhibited numerous physical anomalies of a primitive origin. Preserved in modern “savages,” according to Lombroso, were elongated arms reminiscent of those used by apes for walking and climbing, hooked noses that resembled the beaks possessed by birds of prey, and supernumerary teeth like those of snakes.

All these characteristics pointed to one conclusion,” said Lombroso’s daughter: “atavistic origin of the criminal, who reproduces physical, psychic, and functional qualities of remote ancestors.” Such men were prehistoric evolutionary throwbacks who were inherently unable to abide by modern societal laws. They were simply born criminal.

While most of Lombroso’s analysis would be dismissed as pseudoscience today, his basic premise that some people are deeply and fundamentally flawed—that they are “born criminal”—continues to resonate.

 

‘Rotten apples’

The Chamber of Commerce handbook on white-collar crime describes how some individuals who commit fraud are “simply ‘rotten apples’… who have an inborn predisposition to defraud.” Bernard Madoff’s attorneys said they “represent a deeply flawed individual” at his sentencing hearing.

Ultimately, “because the public is constantly exposed to financial debacles and evidence of corporate excess and CEO greed,” argued the criminologist Sally Simpson, “a bad apple image of offenders has been cemented in the public consciousness.”

These explanations point to the idea that corporate criminality arises not from an act of mistaken judgment or some situational influence but, rather, from a deviant nature that is innate and simply waiting to exploit an appropriate opportunity.

It’s worthwhile to step back and appreciate the serious implications if there is something innate that deterministically leads people to criminality later in life. Criminal prosecution relies on establishing that the accused intended to commit a wrongful act freely and willfully. We generally believe that prosecution and punishment are reserved for those who have not only an “evil-doing hand” but also an “evil-meaning mind.”

 

A Lack of Control

Numerous prominent criminologists have also argued that crime—including the white-collar variety that Kerviel engaged in—can be explained in terms of deficiencies in self-control. Their basic premise is that people with lower self-control have greater difficulty resisting temptation and restraining reckless behaviour, and eventually some of this rash and opportunistic behaviour is likely to end up as criminal conduct.

In a well-known set of experiments from the early 1970s children were given the choice of receiving one marshmallow immediately or two if they waited until the researcher returned to the room. When experimenters reexamined children who had participated in the original experiments decades later, they found significant differences between those who immediately ate the marshmallow and those who had the willpower to wait. As adults, those who delayed gratification in childhood exhibited higher educational achievement, had better relationships, and were less likely to be overweight. Such research helped solidify the idea that those with little self-control during their youth similarly begin their professional careers with impaired self-control.

In some of the most highly cited research by criminologists, Michael Gottfredson and Travis Hirschi argued that people with low self-control are more likely to engage in deviant behaviour throughout their entire life. According to this argument, executives with impaired self-control shouldn’t just engage in corporate misconduct but their low inhibitions should tempt them to engage in all sorts of reckless behaviour.

Rather than seeing self-control as a permanent impairment, some argue that malfeasance might be better explained as caused by temporary lapses in control. Supporting this, more recent research suggests that self-control, while broadly stable throughout life, might actually function like a muscle that becomes depleted when it’s continually exerted.

However, if managerial misconduct is caused by fleeting lapses in self-control, it would be incorrect to categorise deviant managers as “bad apples.” Put another way, deviance could arise among executives endowed with normal or even above-average levels of self-control, and situational forces could dominate any innate factor in influencing their criminal behaviour. Thus, criminality would not be inevitable as suggested by the “born criminal” idea, since it would be caused by transitory lapses and changes rather than by a permanent deficiency.

Whatever the true nature of self-control, there are aspects of the theory that are compelling. But to understand the origins of executives’ malfeasance, we still need to dig deeper, since self-control is more of a label than an explanation. It is easy to assert after a white-collar crime is committed that if the executive had high self-control, he would not have engaged in the misconduct.

In the words of the prominent criminologist Gilbert Geis, the “absence of self-control causes all crimes except those that it does not cause.”

 

The differences in white collar offenses and street offenses

Many biologically rooted explanations suffer from the same problem. Whether referring to a violent street offense or to a carefully planned white-collar transgression, they generalise that all crime is caused by the same set of physical or psychological aberrations. But there is no obvious reason to suppose that white-collar and street offenses ought to be explained similarly.

White-collar offenses often require considerable planning, are not especially thrilling, and have the potential for considerable financial benefit—critical differences from many street crimes.

Executive-level offenders also tend to be driven individuals who care deeply about their success. Exploring, rather than minimising, these differences seems essential to any theory seeking to explain white-collar criminality.

With the help of William Laufer, a colleague specialising in business ethics, Raine turned his attention to examining people who engaged in white-collar crimes. From the start, Raine and his co-authors argued that white-collar offenders were likely to be less impulsive and more calculating than other criminals.

When the researchers examined brain scans of individuals, some of whom engaged in white-collar crimes and others who did not, they began to see several differences in the white-collar offenders. One brain region suggested that the white-collar offenders had greater cognitive control, useful for creating and acting on goals. Another area that differed between the groups suggested that the white-collar offenders would be driven more by abstract rewards like money.

The brain-imaging and testosterone studies provide some intriguing correlations but no definitive evidence for a biological cause for corporate misconduct

Executives who are less empathic lack the ability to appreciate the emotional impact of their actions on others. As a result, they are less likely to feel the same natural tendencies of guilt or remorse that ought to accompany wrongdoing. At its most extreme, this lack of empathy manifests itself in a clinical condition known as psychopathy.

Genetic and environmental factors each independently contributed to increasing the propensity to commit crime. But the multiplicative effect occurred only when individuals with a biological predisposition were placed in an environment that further cultivated this tendency. Innate biological characteristics were important, yet it was the surrounding cultural environment that served as the essential fuel for the fire.

Humans are complex creatures. If we want to understand why executives who otherwise seem so successful commit deviant acts, we can’t rely on simplistic labels.

One thing that makes the managerial misconduct by prominent executives like Rajat Gupta so difficult to comprehend is that these individuals not only resembled but actually seemed to be individuals who merited the admiration they received. “This is a deepening mystery in my work,” declared Judge Alvin Hellerstein at the sentencing hearing of a banking executive. “Why do so many good people do bad things?”

 

Chapter 4  – “I thought it was all going to pass”  – A Press Release with Consequences

 

Promotions and Lies

“ALL LIES ARE false statements, but not all false statements are lies,” argued the philosopher Thomas Carson. Executives, for instance, are regularly observed making exaggerated statements that are not considered lies.

It’s not hard to imagine how touting can go from the merely promotional to the deceitful. Courts usually assess this distinction on the basis of whether a statement is viewed as material or not. Materiality is assessed on the basis of whether a reasonable consumer or investor would be motivated to change his or her behaviour—which product to buy or which stock to invest in—on the basis of the statement.

Where some people see a simple piece of promotional sales talk, others sometimes see a piece of actionable data that can influence and potentially distort their decisions. Such subtle or, sometimes, not-so-subtle puffery can influence opinions.

The ability of exaggerated claims to materially influence perceptions is why regulators seek to sanction those who disseminate false or misleading promotions paraded as fact. Harm arises when individuals purchase products that they would otherwise not buy if they were more accurately informed about the quality of the products.

As the philosopher Francis Bacon put it four centuries ago, “It is not the lie that passeth through the mind, but the lie that sinketh in and settleth in it, that doth hurt.” Bacon identified the key concern regarding deceptive speech and promotions: it’s not the literal message but the impact that message has on decision making that’s the issue.

 

Chapter 5  – “If you don’t take it then you will regret it forever”  – The Triumph of Reason

 

Criminality by association

Today, it seems quite sensible to view people who commit crimes as having learned to do so from others. However, this was not always a widely held belief. As discussed in a previous chapter, biological anomalies were often relied on to explain criminal conduct.

Scholars picked up on the work of Tarde’s theory that came to be called “differential association,” because it suggested that a person’s propensity to become a criminal depended on how much one associated with other criminals. Differential association seemed well suited to explain corporate malfeasance because many, if not most, white-collar offenders grew up in stable neighborhoods, supported by good parents, and attended prestigious schools. It was only later, after exposure to crooked business practices in the course of their profession, that these same people found themselves committing criminal offenses and encouraging subordinates to do the same.

The trouble with this idea is that if criminality spreads from exposure like a virus, it’s not clear why some people heavily exposed to illicit practices behave otherwise. Why doesn’t everyone associating with white-collar offenders adopt similar criminal tendencies?

Decades after Tarde, Donald Cressey picked up on this question. Cressey, a graduate student of Edwin Sutherland—the sociologist who coined the term “white-collar crime”—focused his attention on one group of white-collar offenders, embezzlers, who were unlikely to suffer from having grown up in “broken homes” or “bad neighborhoods.”

 

The motivation to embezzle:

Drawing on his extensive conversations with more than a hundred inmates convicted of embezzlement, Cressey hypothesised that there were three conditions needed to motivate someone to embezzle.

First, the person needed a financial problem that could not be shared with others. One businessman, for example, described feeling that he could not tell his colleagues about their firm’s disappointing performance.

The second condition for Cressey was the person’s realisation that his non-shareable problem could be solved secretly.

The final condition, rationalisation, was the crucial step that Cressey said either led the individual into trouble or kept him out of it. Cressey’s subjects wanted to maintain their self-image as respected members of their firm and society.

When Cressey’s embezzlers encountered a non-shareable financial problem that they could solve secretly, they were not motivated to go ahead until they figured out how to view their actions as essentially noncriminal.

The rationalisations the embezzlers described were not explanations produced after the offense took place. Rather, Cressey believed that individuals devised rationalisations prior to perpetrating their illicit acts.

 

Fraud Detection – The Fraud Triangle:

Decades later, however, Cressey’s thesis experienced an unexpected revival. In the late 1970s, an accounting firm gave several researchers a grant to study ways to improve fraud detection.

Building on Cressey’s work, they called these three factors pressure, opportunity, and rationalization. These three forces—together called the “fraud triangle” by the authors—could explain not just embezzlement but deceptive business conduct more broadly.

It laid the foundation for what would ultimately become one of the most widely cited theories to explain managerial deviance in the twenty-first century.

Making Unethical Decisions Tarde, Sutherland, and Cressey described circumstances that led professionals to engage in crime, but their theories failed to explain the decision-making process that led people down this path.

The “fraud triangle” offered a description of the conditions—motivation, opportunity, and rationalisation—ripe for criminal behaviour to arise. Yet, why a person would choose to resolve a problem criminally when legal options were potentially available was still unclear.

Given the potential consequences, how does someone reason his way toward believing that the illegal choice is the most appropriate course of action?

To psychologists, there is something special about the decision to commit a criminal offense like the one described in this dilemma. White-collar crimes such as embezzlement, financial fraud, and bribery violate well-established social norms. Embezzlement is a professionalized form of stealing. Wire fraud uses lying to deprive other people of their property. And bribery relies on both cheating and disloyalty.

All of these violations—lying, cheating, and stealing—are offenses universally perceived as morally wrong because they affront our basic notions of fairness and honesty.

 

The moral sense:

How we develop our moral sense of telling right from wrong has long fascinated psychologists. Lawrence Kohlberg, one of the most prominent in the field, developed his own interest in understanding how human morality arises while serving in the American Army.

Kohlberg explored how people reach moral judgments by presenting vignettes of moral dilemmas to research participants.

Kohlberg hypothesised that individuals advance through six stages of moral development. They begin by evaluating actions on the basis of avoiding punishment and satisfying their own needs. Later, individuals make judgments based on societal expectations. By the sixth and highest stage of moral development, individuals would respect the rights of others by appealing to abstract principles of universal justice.

Kohlberg argued that each successive stage of moral development is superior to the stage before it. For instance, if asked why cheating on a test is wrong, one person might say that it’s because the perpetrator might be punished. Someone else might respond that cheating is wrong because it creates mistrust that can undermine societal well-being.

By placing the individual’s capacity to reason at the centre of moral decision making, Kohlberg’s thesis ignited a revolution: morality could effectively be taught.

However, the all-important question was whether more sophisticated moral reasoning actually led to more ethical behaviour.

 

Teaching morality:

In a clever series of studies, the experimental philosophers Eric Schwitzgebel and Joshua Rust decided to test the actual behaviour of moral philosophers in a variety of ethical contexts. Their conclusion: Professional ethicists behave no better than other similarly educated professionals.

These studies, along with additional empirical evidence, questioned the association of more sophisticated moral judgment with behaving more ethically. There seemed to be a discrepancy between people’s supposed moral development and their actual behaviour in ethically charged situations.

The inconsistency between moral judgment and behaviour suggested that the specifics of the situation play a far more significant role in determining behaviour. The ability to behave morally isn’t necessarily as ingrained in a person’s character as researchers once thought.

People have to successfully complete a whole series of steps—becoming aware of a problem, forming a judgment, establishing intent, and engaging in moral behaviour—to behave ethically. Those prone to succeed at one step might find themselves overlooking at others, and failing at any one step leads to failure at the end.

 

Blind to the morals:

It’s often with white collar criminals that they don’t contemplate or see any moral component in their decision, they never arrive at the stage of balancing moral considerations against other objectives when forming their opinions on what to do or how to act.

Yet, moral issues are present whenever there is the potential to help or harm another person—as there often is in a managerial context—almost every decision can be construed as a morally relevant one.

All choices inevitably involve trade-offs between competing interests and priorities that are not just moral but also economic, legal, environmental, and personal.

Perhaps we should consider the possibility that illegal business decisions—moral decisions in their own right—are actually made much like any other kind of decision.

 

Analysing the World Through Cost-Benefit

Most ‘white collar criminals’ do not actually write down a list of the potential merits and drawbacks before perpetrating a crime (or if they do, they certainly don’t leave it behind for investigators to find!). Yet, the basic idea that executives decide to commit crimes by weighing the potential benefits against the expected consequences is regularly cited in the pages of The Economist and by pundits on CNBC.

A central axiom of Bentham’s theory of punishment was that individuals were constantly maximising their well-being through rational calculation. Bentham argued that we are all constantly weighing pleasure against pain—a process he called “felicific calculus.”

By understanding how individuals weigh pleasure against pain, Bentham believed he could carefully design policies to nudge people toward better conduct.

A century and a half later Becker, too, sought a more scientific understanding of human behaviour. He dispensed with Bentham’s more arcane views about the specific pleasures and pains that individuals experience and instead focused on the basic assumption that individuals tend to maximise their own general well-being—what economists call “utility.” Individuals pursue activities that are utility increasing and avoid those that are utility decreasing.

Under this theory, crime could also be viewed as arising from the same rational calculus.

Viewed in this way, a criminal is not criminal by nature but, rather, someone who simply perceives the costs and benefits of illegal decisions differently from another person.

Though lauded in many circles, Becker’s theory attracted criticism in others.

Such a sentiment was expressed, for instance, by Richard Horton, editor-in-chief of The Lancet, one of the oldest and most prestigious medical journals in the world. “Economists have stripped morality from economics.… The assumption is that human beings make cost-benefit decisions based only on self-interest.”

But individuals have a rich set of motivations, and it’s clear that not all decisions are solely driven by narrow monetary or egocentric considerations.

As Becker argued, the rational choice model merely says that “individuals maximise welfare as they conceive it.”

Morality, rather than being stripped away in rational choice, is incorporated as just another motivation in a cost-benefit decision.

People often struggle to view moral decisions under the rational choice framework because they view morality as sacrosanct. The prospect of viewing the moral content of a potentially unethical decision as just some additional cost in the decision-making process somehow cheapens morality itself.

Yet, in practice, few moral tenets are actually inviolable.

The rational choice model was developed and tested as a prediction model, not as a model of human cognition. It only mattered that people behaved “as if” they calculated the costs and benefits when making decisions. This subtle but important “as if” distinction was lost in later discussions.

This transformation occurred as people interpreted the model to be one about reasoning, echoing Bentham’s early writing that “all men calculate.”

The emphasis on viewing cost-benefit analysis as a psychological model of choice rather than as simply a description of behaviour has led to a particular notion of why once successful and intelligent executives commit white-collar crime—namely, that these executives make thoughtful and deliberative calculations to break the law when doing so serves their needs and desires.

They are not making hasty decisions with clouded judgment. Their personal failure lies in reasoning that the illicit choice is the “appropriate” one.

 

Chapter 6  – “I never once thought of the costs versus rewards” –  Intuitive Decisions

The more time I spent exploring the decision-making processes of prominent leaders and executives who engaged in misconduct, the less it looked like these decisions were made with deep, thoughtful deliberation of the consequences.

This chapter explored how we often rely on intuition, not deliberative reasoned calculation, to make decisions. It turns out that even when we think we’re employing effortful analytical reasoning to reach a judgment, we are actually just searching for additional evidence in support of an earlier intuitive judgment.

 

Un-calculated decisions

Even just a brief inspection of our daily life shows that we make many decisions without any formal calculation or reflection.

The popular interpretation of cost-benefit analysis sees reflective processes as the dominant means of decision making. However, research suggests that reflective thought is much less pervasive in practice. Unless there is some specific reason to slow down and employ this more controlled and effortful system, decisions arise from intuitive processes.

 

Intuition, Emotion and Moral Decisions

If executives engage in criminal conduct by relying on their intuitions, we need to better understand how the intuitive system operates and when it may falter. Specifically, why would intuition motivate a person to choose one action—one that is potentially harmful and criminal—over another?

We often dismiss emotion as a hindrance to effective decision making. “Emotion clouds judgment” and “cool heads make wiser decisions” are common pieces of advice. But what Damasio saw in his patients was an inability to function in the most basic way when a part of their brain that dealt with emotional processing was impaired.

Without the tug of emotion, easy decisions became surprisingly difficult to resolve. Since no outcome ever felt just right for Elliot, he jostled back and forth between options. He was unable to effectively make choices and tended to make choices poorly when he came to any decision at all.

Our intuitions help nudge us to act in certain advantageous ways, but one question that remains is whether these feelings serve to strictly benefit us.

Our intuitions simply help us behave in a manner that selectively benefits and protects us personally, it would be natural to find people engaging in behaviour that offers attractive personal benefits but causes harm to others. Socially destructive conduct would be quite common, both in our personal lives and in the corporate world, if our affective judgments were driven by personal benefit and myopic financial rewards.

The idea that man has little concern beyond his immediate well-being was often bolstered by misunderstandings of Darwin’s theory of natural selection.

Metaphorically, genes can be “selfish” in seeking their own replication and survival by promoting advantageous traits that are passed on over time. From this it might seem to follow that selfish genes lead to selfish people and that even apparently altruistic acts are self-serving.

Instead, genetic forces serve to support human interaction in complex communities. As with other social species, it’s not uncommon to observe humans engaging in self-sacrificial acts that seem to be in conflict with a person’s own well-being.

Affective evaluations and gut feelings help support these altruistic tendencies. Social interaction is riddled with complexity, yet it often demands immediate decisions. Affective evaluations help us rapidly respond.

These ingrained responses also benefit others and serve as the foundation for moral behaviour. Suppose someone cheats you. When I hear about it, I’ll be less inclined to engage with that person in the future—not only because I’ll be protecting myself, but also because I will empathise and share in your resentment.

 

Why we behave badly:

Reconciling the Good and the Bad If we are innately inclined to be moral, then why are immoral acts—such as those committed by the former executives discussed in this book—so pervasive?

Although some of the affective, automatic reactions supporting moral behaviour are innate, they are also fragile. Many of the conditions under which we developed these affective reactions differ from those that we confront today.

We still rely on automatic intuitive responses to facilitate many of our decisions, but we’re now operating outside the familiar contexts in which these systems evolved to produce successful behaviour.

In today’s globalised world we are much more likely to interact with people outside our immediate community and to do so in ways other than through face-to-face encounters.

Our instinctive reactions may no longer produce the behaviour best suited to succeed in the modern business environment. The desire to avoid failure, maintain our reputation, and trounce competitors creates circumstances that challenge our tendency to behave morally.

 

Chapter 7 – “I never felt that I was doing anything wrong”  -Overlooking Harm

Adam Smith identified a fundamental dimension of human nature: our ability to empathise with others is directly related to their proximity to us. The farther away the harm, the more fleeting our emotions. As the saying goes, “out of sight, out of mind.”

The potential trade-off—one life weighed against saving five others— can be identical in scenarios, but there is often a crucial difference. Taking organs or pushing a man over a rail involves an intimate act of violence.

Even though the deliberate demise of one person will prevent the death of others, it still has all the sensation of deliberately killing someone, which rings an internal chord telling us not to proceed.

Curiously, if we take away the physical contact of pushing someone and replace it with pulling a switch, we become more comfortable with following through. The death of the man in the switch dilemma is impersonal since we feel it’s the switching of the tracks that’s causing the one man’s death—not us.

In fact, when people are placed in an fMRI machine and given these scenarios, this difference in emotional engagement is exactly what’s observed in the brain. The prospect of pushing the man over the railing sets off significant activity in the ventromedial prefrontal cortex, the part of the brain associated with emotional engagement and compassion—the same area damaged in Phineas Gage’s accident. But when individuals consider the switching case, there is comparatively little activity in this area.

Until quite recently in our history, it was difficult to cause direct harm to another person unless that individual was physically close to us. Harm was not only physical but intimate. As the ability to communicate and influence others from greater distances became possible, however, new and different ways of inflicting harm emerged as well.

 

Abstract Harms:

Economic harms fundamentally differ from other acts in that they do not trigger gut feelings of actually doing harm, as was the case with intimate, physical harm. Yet, they injure others—albeit economically rather than physically—all the same.

Like most business misconduct, the dash of a pen or the click of a mouse creates a distant and impersonal kind of harm. Yet, the deleterious consequences can be just as devastating to those affected.

It’s often from the perspective of the victim that we approach the question of why an executive would commit misconduct. Why would someone so successful seek to injure another person? But the trouble with this approach is that it assumes that the executive considered the victim’s suffering in the first place.

For all the business advantages offered by the rise in dispersed ownership, this financial innovation marked the demise of the personal relationship between executives and investors. Not only did managers and investors not physically interact, but executives were often shielded from even knowing who their investors were.

Executives whose business was once supported by communal and even familial ties now found themselves working for investors and with employees with whom they shared no relationship other than a contractual one.

Harmful conduct committed by an executive was no longer against a specific group of individuals known to the executive but, instead, against an ill-defined and little-known mass.

Mother Theresa once supposedly said, “If I look at the mass I will never act. If I look at the one, I will.” She was moved to help the gravely ill because of the emotional impact their suffering had on her.

Harming investors or employees is not the intention behind engaging in misconduct but, rather, an inevitable corollary or externality. This distinction is important since it helps explain why, from the standpoint of the executive, misconduct doesn’t necessarily lead to the sensation of taking or stealing anything from anyone.

 

A Temporal Gap

With business malfeasance, it’s not just that those who are economically injured are physically and psychologically distant. Victims, too, are temporally removed from the actual acts. This occurs because of the lag between the time when the executive engages in the malfeasance and the time when the negative consequences are experienced by those affected.

Financial crime lacks this instantaneous feedback. The harmful consequences of such crime may follow months, even years, after the initial actions, so it’s easier for the perpetrator to be ignorant of the harm he caused.

Many perpetrators often go on to win business accolade or universal recognition for succeeding. Receiving these accolades while at the same time engaging in misconduct is analogous to getting positive reinforcement after striking someone. Rather than getting a negative response, you are encouraged by this feedback to do it again and again.

So to summaries, it’s easy to imagine that we should have some strong intuition telling us “No!” when faced with the choice to engage in wrongdoing. Yet this impression overlooks our basic human nature, which can easily fail to recognise distant and temporally offset harms.

 

Chapter 8  – “If there was something wrong with this transaction, wouldn’t people have told me?” – The Difficulty of Being Good

 

Moral Intuitions

Even without legal ramifications, the overwhelming majority of people would not kill another human being. Our intuitions tell us that murder is wrong and we don’t need a law to prevent us from engaging in

In contrast, there are many illegal acts, some with potentially serious consequences and a high likelihood of being caught, that people routinely commit. Illicit substances, for instance, are consumed widely in the United States.

At first glance, the choice between which laws to follow and which to break is inconsistent. In some instances, people will voluntarily follow laws even when there is little prospect of being caught. In other cases, individuals will flagrantly violate laws even when doing so poses significant risks to themselves and others.

Tyler’s research suggests that merely prohibiting something doesn’t stop people from seeking to engage in that behaviour. To be effective, legal prohibitions need to be consistent with individuals’ moral intuitions.

How do these values arise? The decision to avoid illegal acts such as price-fixing or bribery is not evolutionarily hard-wired or innate. The abstract and often ambiguous nature of the harm created by such conduct—types of harm that became possible only recently—must make aversion to this conduct something new.

People naturally comply with laws when breaking them violates their internal sense of right and wrong.

 

Manufacturing Morals

Being a United Nations diplomat has a number of perks. Among these privileges is immunity from parking violations in New York City. Park anywhere you want in the Big Apple—in a loading zone, doubled-up in front of your favourite restaurant, in front of a fire hydrant—and an orange violation will likely appear under your front windshield wiper. But for a United Nations diplomat, the ticket could simply be ignored.

But when two economists looked at the number of tickets received by United Nations diplomats, they found that some had virtually none while others had many.

There was also a clear pattern describing which diplomats received the most violations. Diplomats from high-corruption countries—Chad, Sudan, Pakistan, Mozambique, Bulgaria—received the most parking tickets. Diplomats from low-corruption countries like Norway and Canada received the least.

 

How Workspace Culture Develops:

Consider some predicaments that commonly arise in corporate life whose responses are shaped by workplace culture. If asked for a side payment to win a lucrative contract, would an employee be willing to pay it? When quarterly sales targets are reached a few days before a quarter ends, does a manager wait to officially book new contracts until the next quarter begins? When results from a recent product test are disappointing, does an engineer describe the failure openly or seek to hide it within some fine print?

Responses to dilemmas like these are usually consistent among people operating within a subculture.

The response that immediately strikes a manager as the “right one” is a product of the environment that the person belongs to and identifies with.

Culture thus provides a set of norms that guide groups of individuals toward particular practices and away from others.

These norms consist of tacit rules that guide conduct and create cohesiveness among individuals. People appeal to these norms to figure out how to appropriately respond—by the standards of the group—when a particular dilemma or problem arises.

When existing norms conflict with laws and regulations, people can seek to inculcate new ones.

When this perception becomes widely shared and viewed as part of the basic routine by members of the organisation, the practice becomes an organisational norm. Through persistence and reinforcement over time, some norms become especially powerful and begin operating at a visceral level. These deep-seated norms that operate automatically and affectively are intuitions.

Yet it’s important to recognise that many corporate norms are superficial. They are simply rules and policies that lack an affective component and are never internalised as intuitions.

Our views of appropriate conduct are shaped by the varying subcultures that we belong to and identify with. We’re influenced by our colleagues, people we meet at social gatherings, and competitors. As we interact more frequently with others who have different practices and values, we may begin adopting their norms.

 

Copying others:

Executives often seek to emulate the behaviour of other prominent business leaders whom they perceive to be successful. Depending on the target of their admiration and how they see them achieving their goals, executives may develop intuitions that lead to compliance with the law or incline them toward illicit conduct.

Emulating the financial practices of business leaders, even when as renowned and respected as those at GE, does not necessarily guide managers toward conduct that is acceptable and legal.

As with GE, there is often a lag between the time managers engage in potential misconduct and the time when regulators crack down and help clarify appropriate norms of conduct. The challenge is that during this period, mangers at other firms can mistakenly develop the impression that such conduct is appropriate and ought to be emulated within their own firms.

 

The mindlessness of business

We often imagine business leaders acting like philosophers who employ reasoning to ponder decisions thoughtfully and objectively in search of the most appropriate actions. However, like most people, their reasoning is often used not to search for the truth but, instead, to support preexisting intuitive views.

The inattentive engagement of behaviour that often characterises managerial life has been described by the social psychologist Ellen Langer as a state of “mindlessness”—actions and behaviour without thoughtful awareness of one’s behaviour or its consequences. Mindlessness arises when people fail to actively engage and critically evaluate their actions.

 

PART III THE BUSINESS OF MALFEASANCE

Unlike burglary or assault, white-collar crimes usually lack videotape or wiretap evidence depicting the crime as it occurred. Viewed in isolation, any individual piece of evidence can often be dismissed as circumstantial or explained away as misinterpretation.

White-collar criminal cases generally need to be built by the tedious and laborious accumulation of documentation and the triangulation of facts. But every once in a while, a recording clearly captures malfeasance as it unfolds.

Despite the inevitable limitations of oral history, what emerges is a far rawer picture of corporate malfeasance. In viewing their own actions, the executives exhibit a consistency across their accounts that begins to reveal what underlies their conduct. In many of these cases, there isn’t any elaborately sinister plot. Instead, the crime might more aptly be described as a mundane sequence of “everyday” decisions.

In a sense, it’s the routine unremarkableness of their actions, even to themselves, that makes this malfeasance all the more important to understand.

Luigi Zingales, the former president of the American Finance Association and a professor of finance at the University of Chicago, aptly described this misconduct more broadly while reflecting on the LIBOR fixing. “There is no attempt to hide what they are doing, no sense of guilt,” Zingales wrote. “It is ordinary business.”

 

Chapter 9  – “You can’t make the argument that the public was harmed by anything I did”  – Misleading Disclosure

PEOPLE MISSTATE, MISREPRESENT, and exaggerate all the time in business. Sometimes these practices are tolerated as acceptable—as in negotiations for a new car—and sometimes they’re fraudulent and possibly constitute crimes—as in the bond market.

The legal ramifications are radically different, but the distinction between these different kinds of deception isn’t always so clear.

How do executives view such misstatements? Do they see them as simply part of how business is done, much like a car dealer does? Do they regard them as actually misleading? Do they see such statements as causing harm?

Lying is easier when it is viewed as having some prosocial motivation, something we are all familiar with in our personal lives. When receiving a gift we do not want or like, we feign happiness. Or when friends ask whether they look good in a new outfit, we might offer a compliment even when it’s not exactly to our taste.

In these cases dishonesty can feel acceptable, even honourable, because those affected appear to be beneficiaries, not victims.

There are also personal benefits to deception. A politician who misstates details to facilitate passage of legislation will gain greater political legitimacy from its enactment. Similarly, when we compliment a friend in a manner that is not forthright, it can help us maintain a positive self-image as a kind, appreciative, and thoughtful person.

Our views of what makes other people feel better may differ from what actually does. We are presumptuous to believe that we know what’s in the best interests of those we’re deceiving. And even when people do benefit from deception in its immediate aftermath, victims can arise later when other acts of deception go awry. Successful deception helps rationalise further dishonesty, but the mere fact that it worked in one instance does not mean it will again.

Deception can feel harmless when it appears necessary and no one is immediately made worse off. When viewed as fostering some greater beneficial purpose, it can even feel righteous.

 

Chapter 10  – “Unfortunately, the world is not black and white” –  Financial Reporting Fraud

 

Accounting rules often offer some guidance, but the subjective nature of estimates ultimately leaves considerable room for individual discretion.

Executives make accounting choices surrounded by the relentless expectations created by Wall Street analysts, media, and institutional investors. They are pressured and incentivised to meet targets, or “the numbers.”

To the extent that managers have discretion in their financial reporting choices, it’s not surprising that many use their discretion to nudge estimates toward meeting their desired benchmarks.

At the same time, deliberately dressing up a firm to satisfy market expectations strikes many investors—and, certainly, regulators—as deceptive. Making a firm appear better off than it actually is fits the common sense notion of fraud.

 

Backdating and financial Fraud:

Estimates must be produced with reasonable judgment, but “reasonable” is not the only criterion to evaluate whether it is appropriate. It turns out that an estimate can be both reasonable and fraudulent.

WHY REGULATORS PROHIBIT backdating contracts is quite clear. By obscuring investors’ ability to accurately interpret the performance of a firm at the time the financial reports are prepared, adjusting the contract dates amounts to deception. Such actions undermine faith in reported earnings and can lower trust in financial markets. As a result, regulators punish executives who backdate contracts and manipulate earnings.

Managers engage in a variety of earnings management techniques, some legal and some likely illegal. “Ultimately the lines between legal and illegal, as it relates to some of the practices above, become very blurry and are subject to individual interpretation,” explained Richards. “The intention of all this behaviour is to meet expectations.”

 

The conundrum:

Herein lies the conundrum. Taking action with the intent to manage earnings is sometimes regarded as prudent management and at other times seen as improper manipulation. Sometimes it will land you in prison, while others times it will be celebrated.

The trouble is, when the intent behind legal behaviour and illegal behaviour is the same, the illicit behaviour is unlikely to engender a feeling of wrongdoing or creating harm.

Managing Within the Gray In a murky world where earnings can be managed both legally and illegally, managers can readily find themselves engaging in acts on the wrong side of the law. “Unfortunately the world is not black and white,” Richards lamented. “A senior manager spends most of their life in the gray regardless of their responsibility and that can be a dangerous and hard place to be.”

 

Chapter 11 – “You go from just being on top of the world” –  Insider Trading

To appreciate the complexity of the harm created by illicit insider trading, we need to understand the kinds of information that people have always relied on to legitimately trade in markets. People have always traded on privileged access to information.

According to a 1915 survey conducted by the New York Times, 90 percent of firm directors traded on information acquired from the firms they served. Such trading was legally permitted, and most directors expressed few qualms about using their firsthand knowledge of upcoming dividends, earnings, and other corporate events to profit in advance of other shareholders.

Yet, the basic question of who is actually harmed is often overlooked. In most instances, identifying the victim of fraudulent activity is not especially difficult. With embezzlement, it’s the individuals who lost property. With a Ponzi scheme, it’s the individuals who deposited funds into a nonexistent investment program. But who are the victims of insider trading?

Some people say it’s investors who unknowingly buy or sell shares from an insider. Others argue that it’s the integrity of the market. Still others claim it’s a victimless crime. Respected regulators, prosecutors, and judges cite each of these groups, but who is the actual victim?

 

The market is the victim?

The argument that the integrity of the market is the victim of insider trading follows a simple logic. If you thought that someone whom you were about to purchase shares from had significantly better information than you, you’d naturally have a greater reluctance to trade with him.

There are many ways to effectively and legitimately become more informed than other investors in securities markets. And despite the fact that certain privileged investors have a significant information advantage over others, securities markets continue to thrive. Thus, befuddling the often-cited “market as victim” argument is the peculiar way that the law restricts certain kinds of insider trading and not others.

While significant differences in investors’ access to information are often viewed as unfair and detrimental to the market, they can also be seen as crucial to the maintenance of that market’s efficiency.

The challenge with identifying victims for insider trading is that less-informed investors—often precisely those cited as harmed by insider trading—are an inevitable and critical component to making markets function effectively.

In most cases, there is little difference between a victim of illicit insider trading and someone else who simply traded with someone more informed than he was. Yet, the fact that some people trade in securities markets with individuals who are better informed than they are doesn’t make them victims.

Investors always know that there may be some investors who are better informed than they are. The source of the information advantage doesn’t really matter from their perspective.

 

Chapter 12  – “I thought we were freakin’ geniuses” –  Deceptive Financial Structures

The collision of business practices with regulation has an even longer history than the automobile, mobile phone, or the Internet. In

How should executives respond when they encounter a prohibition that seems to prevent some business practice they wish to engage in?

One option would simply be to accept the regulation. When legislation spells out that some practice is forbidden or subject to heavy fines and penalties, entrepreneurs should just avoid doing it. But advising entrepreneurs to operate within the confines of the law presumes that the regulations in question are fundamentally well constructed and fair. However, these are many examples of regulation that seem to exist largely to protect the interests of a particular group at the expense of others. “Preventing harm” to one constituency might well be viewed as legalised entrenchment or protectionism by another.

For would-be entrepreneurs who view a particular regulation as a hindrance that needs to be overcome, the challenge is to figure out how to avoid a regulatory impediment in a way that is acceptable. The following sentence summarises their though process. Regulation avoided, problem “solved.”

DECEPTION, MAKING MISLEADING statements, and lying are all practices that regulation seeks to curtail. But since laws create specific rules regarding what people can and cannot do, it is often possible to follow the literal rule of law while simultaneously violating its underlying spirit against lying, cheating, or stealing.

Some of the most innovative businesses rely on aggressive interpretations of outdated regulation to provide better, lower-cost, or more efficient services.

 

Reducing Tax:

Taxpayers have long engaged in planning exercises to minimise their tax burden.

Although there is no universally agreed-upon definition of what constitutes a tax shelter, it is usually characterised by shifting, exempting, or deferring income to effectively lower an individual’s tax burden. Some forms of sheltering create an “investment” that produces greater tax savings than the associated economic loss.

It’s why Yale Law School professor Michael Graetz has colorfully described a tax shelter as “a deal done by very smart people that, absent tax consideration, would be very stupid.”

Once accounting firms decided to begin marketing tax products, the packaged-shelters business took off.

R. J. Ruble gained prominence as a tax attorney for arguing that the tax system is an adversarial process: tax attorney versus the government. “You’re supposed to be an advocate for your client. You’re not an advocate for the government,” argued Ruble. “I do not believe that these rules mandate an overriding duty to the tax system.”

By viewing financial structuring problems as complex puzzles or difficult riddles to be solved, many executives avoided confronting the harm they had done to government coffers and the well-being of other taxpayers.

 

Rules vs Principles:

Exploiting loopholes distances executives from the underlying harm by making it seem more acceptable. If you figure that you’re not breaking a rule, then it’s easier to feel that you are not harming anyone and are therefore not subject to any adverse consequences.

Executives seek loopholes to improve the profitability of their firms rather than the quality of their souls, but the superficiality of reasoning that something is acceptable if it “technically” doesn’t violate a prohibition is similar.

A manager might infer that a transaction is acceptable and appropriate because he cannot find an explicit rule forbidding it. But relying on this logic leads to the calamitous and incorrect notion that regulation has managed to restrain all adverse conduct.

What makes fields like structured finance and tax challenging is that those who succeed often do so by being focused on rules rather than on principles. Individuals who are clever and figure out more creative solutions to “problems” are quickly rewarded.

 

Chapter 13 – “You couldn’t stop because you would wreck everything” –  The Ponzi Scheme

NONE OF THE former executives I spoke with saw himself as a fraud. Some, of course, clearly recognised that they had committed a crime, but the person they saw in the mirror was successful, entrepreneurial, and ambitious. They didn’t see themselves as the kind of people who would create fraudulent enterprises and swindle others.

IT’S A SLIPPERY slope once you surrender to ambition,” Dreier commented. “I did not set out to steal hundreds of millions of dollars, but ended up doing so incrementally after crossing a line I could not retreat from.… Once I started, there seemed to be no way out other than to continue.

Steven Hoffenberg  viewed running a deceptive enterprise as a pragmatic issue rather than a moral one. Steven Hoffenberg: Once you start a Ponzi scheme and go into the cash register, you can’t get out. You eat up so much money going into the cash register that you need more and more money to feed it—so you’re stuck. They were throwing money at me and the more business we did, the more losses we had.… You couldn’t stop because you would wreck everything.

 

Questions around Ponzi Schemes:

What is it like to manage a Ponzi scheme? What ramifications does running a fraud have on the rest of a person’s life? How does an executive proceed with “normal” business, knowing that their enterprise will eventually fail?

At what point does a legitimate business become a Ponzi scheme? Many businesses sustain losses during their initial years, but their executives continue raising money.

Whenever new capital is raised to pay off prior obligations to investors for a faltering enterprise, the company begins to slowly take on the characteristics of an illusionary scheme. The question is, when does a business go from legitimate but unsustainable to being a Ponzi? And should the intentions of the executives matter in making this determination?

 

Chapter 14  –“When I look back, it wasn’t as if I couldn’t have said no”  – Bernie Madoff

Given the duration of Madoff’s fraud, many are quick to place Madoff in the first category, as someone whose objectives were nefarious from the very beginning. But such an interpretation gives him too much credit.

Much of the emphasis in prior chapters has been on how the particular circumstances faced by executives facilitated their ability to overlook the harm of their actions.

Like some of these cases, Madoff’s victims praised, even celebrated, him while he was defrauding them. It was only later, once his deception was revealed, that his investors would react as victims. This difference in timing helped Madoff avoid the need to directly confront the harm of his actions while he was perpetrating his fraud.

Madoff’s failure is a tragic amalgamation of character and circumstance.

Madoff used lots of Euphemistic labelling which is used to mitigate the uncomfortable feeling people experience when engaging in harmful conduct. For instance, military pilots describe bombing missions as “serving the target” and civilians killed are called “collateral damage.” Using terminology that routinises an uncomfortable activity makes it easier to proceed without dissonance.

Madoff sees his own dishonesty—while larger in magnitude—as not so different from that of many others in financial services.

Madoff also points to the same attitude in politics and government. “As an example, look at the present state of Social Security and the government debt worldwide. Talk about a Ponzi scheme. All they do is keep printing money to pay off the existing bond holders and creditors. Please explain to me what the difference is.”

Madoff sees tax evasion as rife among virtually all those who’ve achieved some degree of success.

 

CONCLUSION Toward Greater Humility

With the benefit of hindsight, it’s easy to see decisions that deserved more attention. But the consequential nature of our decisions is not always clear at the time they are being made. In fact, when decisions are made intuitively, it’s easy to largely ignore or even entirely overlook their possible consequences.

The cues that tell us to slow down and think more deeply about the potential effects of a choice are often absent. It’s only later, when the effects are revealed, that we appreciate that some decisions should not have been made so quickly.

It also takes some kind of uncomfortable dissonance, an external influence or event that conflicts with your intuition, to motivate a behavioural change.

Since morally questionable decisions are often made in relative isolation with few outsiders expressing opposing viewpoints or judgments, some firms have created hotlines that employees can call to discuss dilemmas they encounter.

 

The downside of punishment:

The best way to reduce the incidence of white-collar crime—argue many prosecutors, judges, and scholars—is through vigorous enforcement. Through the imposition of lengthy prison sentences and large fines, according to this theory, executives ought to be dissuaded from engaging in illicit conduct.

Although there is much enthusiasm about the supposed deterrent effect of imprisoning executives who commit wrongdoing, evidence demonstrating the efficacy of this approach is far more elusive.

Sanctions, even when incredibly severe, are often just too far removed and remote to become relevant to executives in their everyday decision making. It is only when the sanctions begin to influence everyday norms that avoiding certain types of undesirable conduct becomes ingrained within business culture.

 

Humble Conclusion

With ever-growing psychological distance separating people engaged in commerce, our antiquated moral intuitions are not well designed for the modern business world. And, unfortunately, there are no courses or preparatory materials that can immediately update and adapt intuitions for all the challenges that managers may confront during their careers.

Maintaining new intuitions requires continual renewal and reinforcement. For these moral intuitions, there is no such thing as permanence.

The simple fact is, most of us think that we are better and more moral than we actually are. No one, especially those who have achieved success, believes that they are likely to stumble and err. It is this sense of invincibility that has felled leaders across a range of fields—including the cyclist Lance Armstrong, the writer Jonah Lehrer, and the NBC news anchor Brian Williams.

Virtually every one of the former executives I spoke with pointed out, even complained, that it was not he who was the true villain—it was always someone else.

Perhaps Marc Dreier, the former graduate of Harvard and Yale who engineered a Ponzi scheme, actually had it right when he reflected on this conundrum. “It is easy to say you would never cross the line, but the line is presented to very, very few people,”Dreier explained. “How many could say for sure that they would never do what I did if they had the opportunity and thought they wouldn’t get caught?”