Trials and errors

Jan 14th 2005
From The Economist Global Agenda

Bernie Ebbers, Dennis Kozlowski and other former bosses of scandal-hit American companies are about to have their day in court—in Mr Kozlowski’s case, for the second time. They face lengthy jail terms if convicted. But do they deserve them? And is American business served well by the clampdown?

NEW YORK’S celebrity-trial watchers are about to find themselves as torn as they were when the court cases of Martha Stewart and Frank Quattrone opened on the same day in the city last year. On Tuesday January 18th the retrial of Dennis Kozlowski, former boss of Tyco, begins in a Manhattan court. He is charged with looting the coffers of the industrial conglomerate to the tune of $600m. Mark Swartz, his chief financial officer, joins him in the dock. On the same day, Bernie Ebbers, former head of WorldCom, goes on trial. He is charged with fraud, conspiracy and false accounting for his role in the collapse, under debts of $11 billion, of a firm he built into America’s second-largest long-distance phone company.

A week after the erstwhile Tyco and WorldCom deities enter court, Richard Scrushy, former chief executive of HealthSouth, is set to stand trial in Alabama in connection with a $2.6 billion accounting fraud at the health-care firm that he founded. And on February 23rd John Rigas and his son face sentencing for looting $100m and hiding debts of $2.3 billion at Adelphia Communications, the cable-TV company founded by the Rigas family. Another son awaits a retrial.

All the accused intend to plead their innocence. If found guilty, they can expect long prison sentences judging by the jail terms handed out to lesser corporate miscreants in 2004. Among the second-tier bad boys, Andrew Fastow, Enron’s chief financial officer, pleaded guilty to fraud for his role in the collapse of the Texan energy-trading giant and agreed to help prosecutors going after the top bosses, including Kenneth Lay and Jeffrey Skilling (both of whom could stand trial later this year). Despite having his sentence reduced in return for co-operating, Mr Fastow still received a ten-year jail term.

In another case, Martin Grass, chief executive of Rite-Aid, earned himself an eight-year stretch after pleading guilty to fraud. The pharmacy chain’s shares collapsed after a $1.6 billion revision to profits. Franklin Brown, the firm’s ex-chief counsel, was sentenced to ten years in jail last October. Meanwhile, Jamie Olis, a mid-ranking manager at Dynegy, another scandal-struck Texan energy-trading company, was sentenced to a whopping 24 years for his part in a $300m fraud.

More lengthy prison sentences are set to reopen the debate about the appropriate punishment for white-collar criminals. Public uproar in the wake of the spectacular collapse of Enron and other scandals, and the bursting of the technology bubble, pushed Congress into overreacting, say critics of the new regime. Politicians are accused of rushing decisions and deliberately pressing for overly weighty sentences to assuage public opinion rather than satisfy the requirements of justice. The introduction in 2002 of the Sarbanes–Oxley act, designed to overhaul and tighten corporate governance, was coupled with a controversial review of sentencing guidelines. America’s Sentencing Commission upped the penalties for cases of “serious” fraud by at least 25% and in some instances far more.

It was widely agreed that the punishment of offenders in America’s previous wave of white-collar crime, in the 1980s, had shown that corporate miscreants could expect modest jail terms for misconduct that held out the prospect of huge ill-gotten rewards. Michael Milken, the junk-bond king, served just 22 months in prison after pleading guilty to several counts of fraud, though he paid a fine of $200m. Ivan Boesky, part of the same insider-dealing scam, was sentenced to three and a half years and paid $100m.

But what is a reasonable sentence for a serious corporate crime? A few months inside may seem too little and several decades too harsh, though shareholders who saw fortunes evaporate and ex-employees who lost jobs and pensions may disagree. Clearly, America now takes a far dimmer view of corporate crime than other countries do. Britain typically jails fraudsters for four years and never for more than ten. Germany operates a similar regime. Nick Leeson, whose dodgy foreign-exchange deals cost Barings $1.3 billion and sank the British bank, was sentenced to six and a half years after pleading guilty in a Singapore court.

The armed robbers of the corporate world?

But though sentences have increased sharply in America, it is unclear how far white-collar criminals have been singled out to receive severe penalties. Admittedly, lengthy jail terms such as that handed to Mr Olis are comparable to those for murderers and armed robbers. But the trend in America is towards harsher sentences for a wide range of crimes, not only corporate ones. Sentences for drug offences have also been raised in the recent past, for instance. More generally, four times more people are in prison than 30 years ago—America now has over 700 people in every 100,000 under lock and key, five times the proportion in Britain. Unease over stiff penalties may simply reflect disquiet that white middle-class Americans are now falling victim to the country’s taste for incarceration.

Nevertheless, comparisons between corporate and non-corporate crimes can be erroneous. White-collar criminals are likened to robbers. But errant executives, unlike burglars and muggers, are no danger to other people, are unlikely to reoffend, and are a good bet for rehabilitation (Mr Milken is now a noted philanthropist). And whereas a robber’s haul is clear and quantifiable, a corporate fraudster’s is often nebulous, or even non-existent. For example, Mr Olis’s lawyers claim that he stood to make no direct financial gain from his actions (though he might have hoped to reap some rewards in terms of pay and status). The concept of “loss”, now taken into account in American corporate-fraud trials, is also difficult to assess. Losses connected with a firm’s falling share price are hard to link to individual fraudulent acts as many other factors can drive down a company’s worth.

Will America’s tougher approach help to clean up business? The Corporate Fraud Task Force, established in 2002 in the wake of the Enron scandal, says it is running out of targets and that its future role will be one of fraud prevention now that prosecutions have been brought in the big cases. Some argue that the strictures of Sarbanes-Oxley will damage American business by punishing the vast majority of honest companies with hefty compliance costs for the sake of a few bad apples. Others go further, arguing that disproportionate sentences will engender a climate of fear among bosses which will ultimately stifle the risk-taking that drives American capitalism. The real problem is that it is hard to judge the efficacy of measures to clean up corporations. At least until the next spate of scandals comes to light.

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