Models of Corporate Fraud - Model 3: Control Fraud by William Black
Model 3. Control Fraud by William Black
William Black, a former Federal regulator of banks and now a university professor, defines control fraud as using a corporation as both a ”weapon” and a “shield” to conduct fraudulent activity. The CEO can eliminate any checks and balances to facilitate the conduct of fraud (“weapon”) and co-opt auditors to sign off on fraudulent accounting (“shield”).
Chapter 1 Notes. The Best Way to Rob a Bank Is to Own One (William Black)
The defrauders use companies as both sword and shield. They have shown themselves capable of fooling the most sophisticated market participants and academic experts. They are financial superpredators who use accounting fraud as a weapon and a shield against prosecution.
The person who controls a company (or country) can defeat all internal and external controls because he is ultimately in charge of those controls. Fraudulent CEOs do not simply defeat controls; they suborn them and turn them into allies.
Top law firms, under the pretense of rendering zealous advocacy to the client, have helped fraudulent CEOs loot and destroy the client.
Top-tier audit fi rms are even more valuable allies (Black 1993e). Every S&L control fraud, and all of the major control frauds that have surfaced recently, were able to get clean opinions from them.
Control frauds, using accounting fraud as their primary weapon and shield, typically report sensational profi ts, followed by catastrophic failure.
These fictitious profi ts provide the means for sophisticated, fraudulent CEOs to use common corporate mechanisms such as stock bonuses to convert firm assets to their personal benefit.
In short, they camouflage themselves as legitimate leaders and take advantage of the presumption of regularity (and psychic rewards) that CEOs receive.
Control frauds frequently make (directly and indirectly) large political contributions.
This generally means investing in assets that have no readily ascertainable market value and arranging reciprocal “sales” of goods, which can transform real losses into fictional profits. It can also mean, however, targeting poorly regulated industries. They can make the fi rm grow rapidly and become a Ponzi scheme.
Control frauds have shown the ability to fool the most sophisticated market participants. They can be massively insolvent and still be touted by experts as among the very best firms in the world.
Scholars asserted that private market discipline would prevent any excessive risk taking in industries that had no government guarantee. This view was incorrect: S&L control frauds consistently showed the ability to deceive uninsured private creditors and shareholders.
The scariest aspect of control frauds, however, is that they can occur in waves, causing systemic damage.
Indeed, I write in large part to help build a new economic theory of fraud arising from George Akerlof ’s classic theory of lemons markets (1970) and Henry Pontell’s work on “systems capacity” limitations in regulation that may increase the risk of waves of control fraud (Calavita, Pontell, and Tillman 1997, 136).
Control frauds’ key skill is manipulation. Fraudulent CEOs’ ability to manipulate was limited primarily by their audacity and the leadership and moral strength of their opponents.
Morals matter, but people are capable of doing immoral acts while believing they are morally superior. It is so hard to accept that a CEO can be a crook and that, because he owns substantial stock in the company, the risk increases that he will engage in control fraud if the firm is failing
Successful control frauds have one primary skill: identifying and exploiting human weakness. Audacity is the trait that sets control frauds apart.
Control frauds create a “fraud friendly” corporate culture by hiring yes-men. They combine excessive pay, ego strokes (e.g., calling the employees “geniuses”), and terror to get employees who will not cross the CEO. Control frauds are control freaks.
The second reason control frauds are so destructive is that the CEO optimizes the firm as a fraud vehicle and can optimize the regulatory environment. The CEO causes the firm to engage in transactions that are ideal for fraud. Control frauds are accounting frauds.
A Ponzi must bring in new money continuously to pay off old investors, and the fraudster pockets a percentage of the take. The record “income” that the accounting fraud produces makes it possible for the Ponzi scheme to grow. S&Ls made superb control frauds because deposit insurance permitted even insolvent S&Ls to grow.
Control frauds are predators. They spot and attack human and regulatory weaknesses. The CEO moves the company to the best spot for accounting fraud and weak regulation.
Political contributions and supportive economic studies secure deregulation. Control frauds use the company’s resources to buy, bully, bamboozle, or bury the regulators.
Control frauds are human; they enjoy the psychological rewards of running one of the most “profitable” firms.
The control frauds we convicted became too greedy and began to take funds through “straw” borrowers. A prosecutor who detects the straw can win a conviction.
How do waves of control fraud endanger the general or regional economy?
Individual control frauds should be a central regulatory concern because they cause massive losses.
S&L Fraud and Framework of Systematic Fraud ~
S&L assets were long-term (thirty-year), fixed-rate mortgages, but depositors could withdraw their money from the S&L at any time. If interest rates rose sharply, every S&L would be insolvent.
Paul Volcker raised rates in 1979.
By mid-1982, on a market-value basis, the S&L industry was insolvent by 150 billion.
This maximized the incentive to engage in reactive control fraud and made it far cheaper for opportunists to purchase an S&L.
These factors ensured that there would be an upsurge in control fraud, but the cover-up of the industry’s mass insolvency (and with it, that of the federal insurance fund), deregulation, and desupervision combined to create the perfect environment for a wave of control frauds.
Criminologists call an environment that produces crime “criminogenic.”
Control frauds’ investments are concentrated and driven by fraud, not markets.
Because the control frauds grew at astonishing rates, this quickly produced a glut of commercial real estate in markets where the control frauds were dominant (Texas and Arizona were the leading examples).
Moreover, being Ponzi schemes, they increased their speculative real estate loans even as vacancy rates reached record levels and real estate values collapsed.
Systemic risk causes control frauds to occur at the same time. They concentrate in the particular industries that foster the best criminogenic environments. They also concentrate in investments best suited for accounting fraud. That triple concentration means that waves of control fraud will create, infl ate, and extend bubbles.
Moral Hazard
Moral hazard is the temptation to seek gain by engaging in abusive, destructive behavior, either fraud or excessive risk taking. Failing firms expose their owners to moral hazard.
Moral hazard arises when gains and losses are asymmetrical.
A company with 100 million in assets and 101 million in liabilities is insolvent. If it is liquidated (sells its assets), the stockholders will get nothing because they are paid only after all the creditors are paid in full. In my example, the assets are not suffi cient to repay the creditors’ claims (liabilities), so liquidation would wipe out the shareholders’ interest in the company.
Risk and reward are asymmetric when a corporation is insolvent but left under the control of the shareholders. If the corporation makes an extremely risky investment and it fails, the loss is borne entirely by the creditors.
If the investment is a spectacular success, the gain goes overwhelmingly to the shareholders. The shareholders have a perverse incentive to take unduly large risks rather tha to make the most productive investments.
Why the S&L industry suffered a wave of control fraud
Opportunistic control fraud can also occur in waves. Opportunists seek out the best field for fraud. Four factors are critical: ease of obtaining control, weak regulation, ample accounting abuses, and the ability to grow rapidly.
An industry with weak rules against fraud is likely to invite abusive accounting. Industries with abusive accounting have superior opportunities for growth because they produce the kinds of (fi ctitious) profi ts and net worth that cause investors and creditors to provide ever-greater funds to the control fraud.
Interest rate risk rendered every S&L insolvent (in market value) in 1979–1982, making it far cheaper and easier for opportunists to get control.
Owners and regulators were desperate to sell S&Ls; opportunists were eager to buy. The Bank Board and accountants used absurd “goodwill” accounting to spur sales.
The industry will lobby regulators, the administration, and Congress to aid the cover-up by endorsing accounting abuses and minimizing takeovers of insolvents.
The cover-up of the insolvency of the industry and the FSLIC
Congress wanted a cover-up. Americans loved the S&L industry because S&Ls made loans to people, not corporations, and made possible the American dream (owning a home).
Politicians loved S&Ls because Americans did, because S&Ls were large contributors, and because they had the best grassroots lobbyists.
Their trade association, the United States League of Savings Institutions (the League), was a force of nature, as were its allies the National Association of Homebuilders (NAHB) and the National Association of Realtors (NAR). (Their PACs traveled in packs.)
Despite all these differences, the FDIC adopted phony accounting for savings banks to hide their insolvency and stopped closing them, showing how strong the pressures were for cover-ups in the 1980s.
The S&L cover-up optimized the industry for control fraud
There are five central facts that explain why the Bank Board’s implementation of the cover-up proved so harmful.
First, it came from the top, and it came via consensus.
Second, the design and implementation of the cover-up guaranteed a disaster. Moral hazard theory unambiguously predicts that if you greatly weaken restraints on abuse at a time of mass, intense moral hazard, you will suffer severe abuses.
Third, no economist contemporaneously predicted that the administration’s policies would produce a disaster. (there were “no Cassandras” among economists).
Fourth, although no economist spotted the problems, roughly two hundred opportunistic control frauds promptly spotted the opportunities and rushed to enter the industry.
Fifth, the Bank Board lost vital moral capital when it abused accounting practices to cover up the industry’s and the FSLIC’s insolvency. A regulator succeeds largely on the basis of moral suasion.
The cover-up led the Reagan administration to oppose Gray’s war on the frauds
First, closure of the frauds would reveal the industry’s insolvency just when the Administration was pronouncing it cured.
Second, The administration designed, implemented, and praised the deregulation that attracted the control frauds and made them superpredators. Reregulation would have been an admission of guilt.
Why did economists and the administration get the debacle so wrong?
Economists know almost nothing about fraud. The dominant law-and-economics theory is that there is no serious control fraud, so it is not worth studying. There is no coherent theory of fraud, though there is fi nally some interest in developing one
Second, prominent U.S. economists generally believe that regulation is the problem and deregulation is the solution. The deregulators’ ideology was the initial problem, but the fact that their policies led to disaster also brought on acute embarrassment.
Third, economists (and the administration) were like generals preparing to fight the last war. In the S&L context, this meant concentrating on interest-rate risk. Thus, traditional S&Ls were the problem and high fliers the solution. The high fliers, unfortunately, were frauds.
Fourth, economists missed the problem because of social class and self-interest. Few economists are prepared to see business people, particularly patrons, as criminals
Fifth, economists developed a conventional wisdom about the debacle and have not reexamined it. The conventional wisdom is that moral hazard explains the debacle, that control fraud was trivial, and that insolvent S&Ls honestly made ultrarisky investments (and became high fliers) that often failed. All aspects of the conventional wisdom proved false upon examination. Traditional S&Ls gambled for resurrection by continuing to expose themselves to interest-rate risk in 1982–1984.
The many fronts in Gray’s war against the control frauds
There was no real controversy about how to deal with the 1979–1982 crisis in interest-rate risk. There was uniform belief that the twin answers were a cover-up and deregulation.
It did not occur to anyone involved in making policy that combining the mass insolvency of an industry, deposit insurance, extraordinarily inadequate examination and supervision, a cover-up based on accounting abuses, and deregulation would create an ideal environment for control fraud.
The control frauds did not create this optimal environment for fraud. They exploited the criminogenic environment and led the campaign to maintain and even improve it.
The incredible hours they had worked for years were worse than useless: they had made things worse. The goodwill mergers did not resolve failed S&Ls; they created fictitious income and hid real losses.
Whereas the control frauds knew our strategy, we knew little about theirs. We could learn about them through whistle-blowers or effective examination. There were virtually no whistle-blowers at the control frauds. I cannot remember any. Control frauds are control freaks: they hire yes-men and yes-women and get rid of people who ask tough questions.
Economic hindsight proves 20:2000
First, control frauds will cause the worst losses. The markets will not detect them timely. Outside professionals will aid, not restrain, control frauds. Directors provide camoufl age for frauds. Stock options further misalign the interests of shareholders and control frauds because CEOs structure them to maximize their self-interest and use them as a means of converting firm assets to personal use.
Control frauds use accounting fraud to deliberately make everything appear brilliantly transparent. They are like the side mirrors that seem to refl ect so normally that the government requires a permanent warning to be affi xed to them: “Objects in this mirror are closer than they appear.” Massive insolvency is far closer than it appears for control frauds.