Publicity and Illegality in Organizations

“Corporations do not commit crimes, people do,” would be a good thing for everyone to remember but those who like to vilify the corporation too readily forget.  A valuable new research paper canvasses much of the literature about wrongdoing by people in corporations. Rosa Abrantes-Metz and Danny Sokol focus on cartels that violate antitrust laws, shifting the lens from the firm level to those within a corporation and offering a broader review of screens useful to combat illegality.  It’s a great contribution to and synthesis of the literature.  

I will draw on its lessons as I revise the current edition of my accounting textbook written for use in law schools, as well as to reflect on the corporate governance aspects of this problem, addressed in several important passages of my collection of Warren Buffett’s letters to constituents of Berkshire Hathaway.

Buffett’s writings address the tone at the top and promoting a culture of compliance. As CEO, he sends a biannual letter to his managers emphasizing that the most important job of every one of Berkshire Hathaway’s 300,000 employees is preserving Berkshire’s reputation.  For 25 years, that memo has included some version of this sentence:  “We can afford to lose money, even a lot of money, but we can’t afford to lose reputation, even a shred of reputation.”

Another point he repeats will be of special interest to lawyers among our readership.  He says it is not enough to comply with the law or letter of law. Berkshire must apply a stricter test, called the New York Times test: we would be happy to have all our activities written up on the front page of a national newspaper in an article written by an unfriendly reporter.  It is a much more poignant test than whether you comply with a particular antitrust law or accounting principle.

I call the toughest battle to fight concerning compliance the disease of the crowd. A common defense of sketchy behavior is that everyone else is doing it.  In that letter, Buffett explains that such a  response is usually an excuse rather than a reason. If so, the action probably should be avoided.  To implement such a policy, Buffett offers  senior managers a hotline to him directly if they detect even a whiff of dubious behavior. Those managers pass that message down the ranks and establish parallel hotlines from their troops to them.

Above all, once wrongdoing is detected, swift and public action is required. The worst thing managers can do when they discover illegalities by their employees is try to hide it.  In America, people are very forgiving of substantive errors or even wrongs. They are relentlessly unforgiving of attempts at evasion, duplicity, or hiding things.  (“It’s the cover up, stupid.”) Although Jonathan Macey has recently released an interesting book lamenting the decline of reputation as the constraint portrayed in economic models, it remains a powerful force. 

In addition to the general compliance climate Buffett promotes, one must appreciate the particular contexts in which deviation can occur, whether the cartel setting that Danny and Rosa address or the accounting context in which I’ve been so interested. 

In my accounting book and course, I remark that people have engaged in accounting shenanigans since modern bookkeeping was invented by Luca Pacioli in 1494. I add that there is no reason to expect that the next five centuries will stray from history’s pattern.  We cannot banish it but we can reduce it by increasing the chances that particular people will face public embarrassment and retribution.  Identifying the sources of pressure is a useful step.

There is almost always some pressure on managers to engage in accounting shenanigans. Pressure to use irregular accounting is especially acute at businesses with poor economic characteristics or facing tough competitive conditions. An entity’s contractual profile may increase pressure on managers for aggressive or irregular accounting. Many loan agreements, for example, contain promises by the borrower to maintain certain financial ratios such as minimum interest coverage ratio or maximum debt to equity ratio.

Incentive compensation agreements triggered by meeting sales or earnings targets may also encourage accounting games. Similar pressures can emerge from settlement agreements, consent decrees, or other legal obligations. Planning for additional financing can add pressure for managers to paint pretty pictures of dismal performance.   More generally, in an investment climate obsessed with short-term results, there is invariably pressure to sustain steady increases in earnings growth.

Such factors can tempt managers to engage in a range of accounting shenanigans that often start out innocently enough. Income smoothing and even off-balance sheet financing are not always unlawful and do not always violate GAAP. Often, however, they impair the integrity of financial reporting. Worse, a corporate or financial reporting culture that condones aggressive practices presents the risk of degradation of financial reporting: what starts as merely aggressive can create pressure that leads reporting over the line and into the fraudulent.

Negating such temptations requires promoting a culture of integrity accompanied by specific systems and controls tied to them, such as insisting that managers take a long term view, being open to renegotiating contractual constraints and devices, being flexible in revising a business plan and  expectations to meet changing conditions and opening channels of communication to confront challenges head on rather than by subterfuge.  

Avoiding the fallout by preventing the mischief is vital.  At Berkshire this is done by both Buffett’s New York Times test and his broader business philosophy, which includes such factors.  At Berkshire, nevertheless, some people have committed crimes and engaged in other wrongdoing.  But as Abrantes-Metz and Sokol suggest, the problem of wrongdoing within corporations can be contained by screens and systems designed with people in mind. 

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