In the wake of Enron and a raft of other major corporate scandals early this decade, a March 2002 Fortune magazine cover voiced the widely held opinion that white collar crooks were running rampant in American board rooms. “They lie, they cheat, they steal,” the headline exclaimed, “and they’ve been getting away with it for too long.”
The facts, however, suggest otherwise, according to Jonathan Karpoff, the Norman J. Metcalfe Endowed Professor in Finance at the University of Washington Foster School of Business. An extensive new study led by Karpoff finds that the vast majority of culpable executives in cases of financial misrepresentation see significant penalties that range from job loss to jail time.
The facts defy public opinion
“The Fortune headline summarizes how many people think about this,” Karpoff says. “The popular perception is that there’s a massive breakdown in corporate governance, which would suggest a systemic problem and the need for increases in outside enforcement.”
Along with co-authors D. Scott Lee of Texas A&M University and Gerald S. Martin of American University, Karpoff tracked the fortunes of the 2,206 individuals identified as responsible parties for all 788 Securities and Exchange Commission (SEC) and Department of Justice (DOJ) enforcement actions for financial misrepresentation from January 1, 1978 through September 30, 2006. Much of the period under analysis preceded the Sarbanes-Oxley Act of 2002, which increased criminal penalties and exposure to liability for financial fraud.
The researchers found that 93 percent of the culpable executives lost their jobs by the end of the regulatory enforcement period. Most were explicitly fired. The likelihood of ouster increased with the cost of the misconduct to shareholders and the quality of the firm’s governance. Culpable managers also bore substantial financial losses through restrictions on their future employment, their shareholdings in the firm, and SEC fines. A sizeable minority (28 percent) faced criminal charges and penalties, including jail sentences that average 4.3 years.
The system works, as far as we know
These results indicate that the individual perpetrators of financial misconduct face significant disciplinary action. “It turns out that the sky is not falling,” Karpoff says. “Our research demonstrates that, on average, firms do have ways to identify and discipline rogue, cheating managers. And it supports the notion that the SEC and Department of Justice actually do have teeth in their enforcement activities, even in the days before Sarbanes-Oxley. The current mix of firm governance, managerial labor markets, and regulatory oversight does, in fact, discipline this type of illegal behavior.
“Of course, no system works perfectly. Some bad guys, for example, walk away with bundles. And we still have no reliable way of knowing how many don’t get caught in the first place. We, and others, are working to gain some insight into that problem.”
The paper, “The consequences to managers for financial misrepresentation,” is published in the May 2008 Journal of Financial Economics.
It’s the latest in Karpoff’s series of studies on corporate crime and punishment, and a follow-up to “The Cost to Firms of Cooking the Books,” which established that companies pay a significant financial penalty when their reputations are tarnished by financial fraud.