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Friday, April 03, 2009

Corporations, Credit and Criminality

One of the questions asked most frequently by Americans about the financial crisis boils down to this: With over $11.1 trillion in US wealth destroyed (#1), how is it possible that Bernard Madoff seems to be the only individual yet to be sent to jail? Is it even possible for TRILLIONS of dollars in wealth to be destroyed only by incorrect but innocent mistakes and misguided optimism and greed? Millions or billions, maybe but TRILLIONS?

The short answer is NO.

The full answer requires thinking through the relationships between corporations, credit and criminality. More importantly, answering the question doesn't accomplish anything unless it drives changes in public policy.


A corporation is a legal entity that allows a collection of people to act as a single entity under the law and act like any real individual to enter into contracts, own property, pay taxes, etc. Over the past century or so, the laws of most industrialized countries have evolved to grant two crucial benefits to corporations -- limited financial liability of individual stockholders and a perpetual existence of the corporate entity beyond the life of any of its stockholders, directors or employees.

Limited liability creates a layer of indirection between claims against the corporation and its assets and the assets of individual shareholders of the corporation. With limited liability, shareholders can never lose more than the equity they invest, regardless of the size of claims against the corporation itself. Without that protection, far fewer investors would be willing to provide capital to the average business, much less gigantic multinational companies which can incur hundreds of billions in liabilities.

Perpetual life allows companies to continue operating indefinitely without having to "cash out" the assets of the company to new owners periodically like a sole proprietorship. That type of forced reorganization typically limits the size of a company due to the difficulty of finding individuals who are both financially capable of investing in the reconstituted firm AND participating in its daily operation. By eliminating the periodic re-organization and re-capitalization to new owners / operators, perpetual life allows corporations to continue aggregating market share, brand recognition and assets.

The legal fiction of a corporate entity creates complex issues in situations when corporations become involved in criminal acts. Like any human entity, the legal entity of a corporation can be sued, can lose tort cases and can face criminal charges for actions taken by the firm. In practice however, criminal charges may result in financial penalties being applied or regulatory limits being imposed upon the firm but more frequently involve an attempt to identify and prosecute wrongdoing on the part of individual employees. Very seldom (never?) is a "death sentence" applied to a corporation by directly terminating its charter and forcing it out of business.

More about corporate death sentences will be discussed shortly.


America's Founding Fathers, notoriously famous "smart guys", worried about the operation of banks and the use of money and their effect on the country. In fact, they worried and wrote a great deal about banks and money. Perhaps John Adams summarized their concerns most effectively:

All the perplexities, confusion and distresses in America arise not from defects in the constitution or confederation, nor from want of honor or virtue, as much from downright ignorance of the nature of coin, credit, and circulation.

They clearly understood the temptation and danger represented by the ability to incur long-term, trans-generational debt coupled with the ability to issue credit in the form of fiat money, even in an eighteenth century world that limited documents to quill and pen or hand-cranked printing presses and limited communication to the speed of a horse or sailing ship. Given the communication and computing tools at our disposal today, the concerns of the Founding Fathers over the ability of the tools at their disposal to produce bubbles and crashes seem almost quaint in comparison. They had no possible way to imagine the size and power wielded by modern corporations or the computerized ability we have to exchange BILLIONS of stock shares, commodities, bonds and other financial contracts on a daily basis. A great deal of information is flowing around the world amidst those billions of transactions but a great deal of mis-information also flows with it and mis-information is the lifeblood of the frauds and pyramid schemes that produce bubbles and crashes.

You may have seen this in a hundred blogs and commentaries at this point but the single most important thing to understand about credit is the origin of the very word itself -- from the Latin credere for "to trust or believe." Credit is literally an illusion. It can be useful when the relationship between borrower and lender is direct and the ability and willingness of the borrower to repay a debt is verified and when the lender has not recursively turned the promise of future payments into additional paper assets for additional loans. When these conditions aren't present and computers are used to generate BILLIONS of transactions every day and abstract those data streams down to nice Excel charts "proving" everyone's investments will grow at 7.3 percent uninterrupted, disaster is virtually assured. The combination of multi-national companies manufacturing credit at the speed of light with limited liability for insiders who benefit disproportionately from the inflation of credit is an irresistible temptation and danger.


Financial markets aggregate billions of individual decisions and opinions about value and risk into numbers which then drive billions more individual decisions in a never-ending feedback loop. Can the market as a whole or major players within the market be blamed or held to be criminally liable when expectations of future values fail to come true? Clearly not. However, when players in the market create products directly BASED upon such uncertainty and claim to protect parties from losses from the uncertainty and are mathematically unable to make good on those claims, they are perpetrating a criminal fraud. When databases, web servers and emails are used to transmit information to customers touting the ability of a firm to provide insurance against such risks, collect payments for such insurance policies and provide statements about the "worth" of such contracts which cannot be fulfilled with the capital available to the firm, wire fraud is being perpetrated.

If a crime has been committed, what are appropriate next steps?

First, there is likely an unlimited amount of evidence that can be collected from all of the major financial players who dabbled in mortgage backed securities and credit default swaps that would prove numerous employees of those firms did in fact know the numbers did not add up and they were facilitating a ponzi based fraud. Dispatching trained computer forensic experts from the FBI with subpoenas in hand to the data centers of every TARP recipient and blocking the destruction of email archives would be an excellent start.

If criminal wrongdoing is found within the megabanks or any giant corporation on the multi-billion dollar scale, the real question involves the appropriate penalty for the crime. In most billion dollar corporate fraud cases like Enron or Worldcom, the criminal pursuit quickly narrows down to a search for the biggest fish with a direct tie to the alleged crimes. Seeing Bernard Ebbers, Ken Lay or Jeff Skilling at the table hearing their guilty verdict might calm public opinion but does nothing to destroy the corrupt pond in which they operated.

What's missing in the debate over punishment of corporate fraud is recognition that as a artificial creation of the law for the public good, no corporation has any natural "right" to exist. Corporations are granted charters to operate in order to efficiently and legally increase economic activity, provide a good or service or play some charitable / philanthropic role for the society. When a corporation is found to be operating in a way which reflects systemic fraud throughout the corporation and / or inflicts material harm on the larger society it is supposed to be benefiting via its special chartered privileges, society not only has a right but an obligation to terminate that charter and halt the corporation's operation.

The argument against this is that usually ALL of the employees of the firm may not have played a role in the criminal activity. Since the structure of the firm is already established, why destroy the entire company and impact its employees and customers to punish a smaller subset of employees? This argument may make sense if the firm makes candy bars and is found guilty of systematically cheating customers of a tenth of an ounce of chocolate per bar over several years to reduce costs and boost profits. The only people "harmed" are the customer who purchased the candy bar, the harm itself doesn't permanently harm the customer or disrupt the larger economy and the harm doesn't have a feedback cycle that exponentially magnifies the harm over time. Just pay a fine and promise to never to it again.

The "pay a fine and promise to never do it again" approach is NOT a sufficient dis-incentive to firms specializing in banking, insurance and credit because of the unique combination of leverage and disproportionate rewards available in the financial sector. When one bank or insurance company holds hundreds of billions in assets, operates at a three percent reserve ratio and fraudulently creates hundreds of millions / billions in additional assets, the false expansion of credit produced by the fraud ripples throughout the larger economy and harms thousands more than the first customer who signed the first derivative contract that starts the cycle. The benefits of limited liability and perpetual life granted to a firm operating in the financial sector pose a uniquely dangerous risk to society when the firm abuses the leverage available in its business to commit fraud. The unique scale of damage created by such frauds merits a penalty equal to the damage -- the corporate death penalty:

* the orderly dissolution of the firm and its assets (much like an FDIC takeover)
* board members at the time of the crime are banned from serving on the board of any public firm
* pension, healthcare and severance pay for VP or Cxx executives of a convicted firm are nullified
* return of any bonuses paid to VP or Cxxx executives based upon results during the period of the fraud

How likely is it that more corporate death penalties will be imposed? Based upon testimony provided to Congress on April 2, 2009 by former AIG CEO Hank Greenberg, Congress doesn't appear to have a clue. Greenberg is still under investigation by the Securities and Exchange Commission for alleged fraud at AIG during his tenure at the firm that ended in 2005. Greenberg was not only invited by Congress to testify on the effectiveness of the AIG bailout so far ($185 billion and counting) but to outline his recommendations. His recommendation? By all means, keep the company operating as it stands right now rather than breaking it up. Spoken like a man who lost ninety six percent of his net worth --- and is still worth $28 million dollars. (#2)


#1) http://online.wsj.com/article/SB123687371369308675.html

#2) http://blogs.wsj.com/wealth/2008/09/17/hank-greenbergs-sudden-wealth-loss/