History of Fraud in America

by Bob Jensen

History of Fraud in America

Bob Jensen at Trinity University

Colonial History

Earliest "business" fraud in America centered around phony heath cures.  Armstrong and Armstrong (1991) document many of the snake oil ploys that commenced soon after the Pilgrims landed on Plymouth Rock.  Medical frauds ranging from deceptive medicines to spiritual cures to bloodletting expanded over time to modern day cancer miracle cures and Internet charlatanism.

Since early America was largely agricultural, various land schemes accompanied the growing market for deceptive rural living and farming products.  As the original 13 colonies were established land was owned by men who had been granted land from the English King. They in turn sold land to individuals and established common areas.  Although many of the early dealings were legitimate, it did not take long for land swindles to commence.  Swindlers were either buyers or sellers of land. Victims were often new immigrants and Indians who lived on the land before Colonial times.  One of the best known frauds was the 1626 purchase of Manhattan Island for trinkets valued at 60 guilders (approximately $24).  In this case the Carnarsie Indians from Brooklyn perpetrated the fraud since their land was not even connected to Manhattan Island.  But in most cases it was the white men who cheated the Indians and each other.  Land swindling grew rampant as America expanded to the west and continues to be one of the major opportunities for fraud and deception. 

Accompanying fraud were various checks and balances.  Phony product hucksters were often fined and run out of town.  Disputes were sometimes settled with fists, knives, and guns.  Legal protections of deeds, claims, and land records came into existence to discourage, but certainly not eliminate, land and mineral swindles. 

Frontier History and the Saga of Corporate Fraud and Labor Abuses

Government acquisitions of land afforded expanding opportunities for legislators and government bureaucrats to accept bribes and otherwise collaborate with land swindlers.  The expansion west afforded more and more opportunity for collusive land dealings. 

The birth of business corporations expanded opportunities for government and business fraudulent exploitations.  The earliest corporations commenced in 17th-century Europe.  Nations in Europe and Russia chartered new corporations and gave them public missions in exchange for the legal right to exist, separation of ownership from management, and limited liability that protected shareholders from losses of the corporation. The United States was settled by one such corporation, the Massachusetts Bay Company, which King Charles I chartered in 1628 in order to colonize the New World.

Two features of corporations were size and political power that allowed them to become monopolies in restraint of trade.  The Boston Tea Party was a protest against the British East India Company's monopoly of imports.  However, corporations were relatively slow to expand in the frontier history of America.  In 1787, fewer than 40 corporations operated in the United States, and most of these were formed to contract with government to build roads, bridges, canals, dams, and other "public" projects.   Many of the projects were burdened with bribes, kickbacks, and inflated prices.  By 1800, there were slightly over 300 corporations but the number grew rapidly after 1807.  American venture capitalists seized opportunities to form corporations when importation from Europe was shut down by President Thomas Jefferson's embargo of France and Britain from 1807 to 1809 and by the War of 1812. 

The Marshall Court under Federalist John Marshall (1801-1835) created a national market by eliminating trade barriers between the states.  Marshall's Court resulted in the U.S. Constitution's "obligation of contracts" clause (Article 1, Section 10), which states that "no state shall ... pass any ... Law impairing the obligation of contracts." Subsequently Chief Justice Roger Taney tried to moderate the Marshall Court's iron-fisted rulings on the sanctity of contracts. In Charles River Bridge v. the Proprietors of the Warren Bridge (1837), Taney wrote for the majority:  "The continued existence of a government would be of no great value, if by implications and presumptions, it was disarmed of the powers necessary to accomplish the ends of its creation; and the functions it was designed to perform, transferred to the hands of privileged corporations."

Late in the 1800s, checks and balances began to rise up against rampant corporate fraud.  The most significant of these was the free press.  Newspaper reporting of scandals gave rise to the Populist movement that led to the passing of laws to regulate corporations and the robber barons who owned them. But the courts, using Marshall's interpretation of the inviolability of contracts, struck down repeated attempts to protect society from labor and monopoly abuses.

Jay Gould (1836-1892) was one of the most notorious "robber barons" of the 19th century. With Daniel Drew and James Fisk he waged the Erie Railroad war by issuing illegal stock and bribing state legislators.  Gould amassed a great fortune and became president of the Erie.  In 1869, Gould and Fisk almost cornered the gold market until the U.S. Treasury released some of its own gold stocks, leading to the Black Friday panic of Sept. 24, 1869. The resulting public indignation forced Gould to resign (1872) as director of the Erie.

Businesses were often victims of government frauds.  One of the most notorious was the Tweed Ring.  The end of the Civil War brought a dramatic upturn in the City of New York's need for new railroads, streets, docks, warehouses and offices. Alderman William Marcy Tweed placed several cronies-the so-called Tweed Ring-in key city posts. They included the former District Attorney, A. Oakey Hall who became Tweed's handpicked mayor. But just as important were the people he had placed on the Board of Supervisors.  Every business that contracted with city works had to have a "friend" in the Tweed Ring.   Tweed's New York began borrowing excessively and only a fraction of the money was making its way into the City's projects themselves. Banks refused to endorse new securities, and the city's credit rating plummeted. The press had a field day led by Harper's Weekly cartoonist Thomas Nast.  On October 26, 1871, Tweed was arrested.  He died in jail in 1878. 

The Tweed-style of operating public projects lives on in government at all levels and school systems.  Fraud arises at various levels of evil.  At a minimum, some business owners run for office in an effort to secure contracts for supply of materials and services.  For example, sellers of bonds are notorious for running for office mainly to get commissions for selling city and school bonds.  Bidding for such contracts and services is often neither competitive nor fair.  At a worse level, self serving contracts are also fraudulent in terms of pricing and/or quality.  Unfortunately such frauds are commonplace in nearly every locality in the U.S.

One of the nation's terrrible frauds was perpetrated by General Motors Corporation.  Street cars were once and still would be one of the most efficient ways of moving people around urban centers.  In major U.S. cities the tracks were already in place and street cars were running efficiently up and down those tracks.  Then General Motors took it upon itself to capture the city bus sale and replacement market.  In an effort to persuade cities to abandon street cars in favor of buses, General Motors commenced a strategy to bribe or otherwise cajole cities to sell their streetcar systems to GM from the 1920s to the early  1940s.  You can read the following at http://www.stayfreemagazine.org/archives/19/generalmotors.html

When GM formed the holding company National City Lines (NCL) in 1936, Standard Oil and Firestone had already agreed privately to help fund its motorization campaign. Between 1936 and 1950, the three companies contributed $9 million to NCL, which covered the purchase, motorization, and resale of more than 100 streetcar systems in 45 cities, including New York, Los Angeles, and Philadelphia. The number of streetcars in operation over that period fell from 73,000 to 18,000, and the removal of public trolleys helped make way for the automobile and suburban explosion of the 1950s.

The strategy was an enormous success for GM and a fraudulent disaster for large cities.  Eliminating the trolleys not only helped GM make millions in sales of city busses, the public became more dependent upon buying GM cars for commuting into the cities.  This in turn enabled commuters to live further and further out in sprawling suburbia at the expense of urban decay and abandonment of central city living by the middle and upper classes.


The Rise and Fall of the 14th Amendment Corporate "Person"
Immunized From Laws and Regulation

Corporate monopoly, abuse, and fraud were greatly exacerbated by misuse of the 14th Amendment, which states that "no state shall deprive any person of life, liberty or property, without due process of law." This Amendment was adopted during Reconstruction to protect emancipated slaves in a still-hostile South. But in the landmark case of Santa Clara County v. Southern Pacific Railroad (1886), the Court, invoking the 14th Amendment, defined corporations as "persons" and ruled that California could not tax corporations differently than individuals. It followed that, as legal "persons," corporations had First Amendment rights as well.

The 14th Amendment gave rise to ever increasing fraud ranging from stock swindles to land grabs to labor exploitation to consumer product/pricing fraud.  Among the most notorious of these were ploys to create monopolies with unregulated pricing exploitation.  For example John D. Rockefeller created the Standard Oil Corporation and nearly monopolized the supply side, Tarbell (1904).  Standard Oil also sought to monopolize the demand side by a simple ploy --- sell oil products below cost in every town and city until the competitors were forced out of business.  Then Standard Oil would jack up the price to as much as the public could possibly afford to pay for oil products that were becoming increasingly important in modern agriculture and commerce.  Eventually the monopoly was forced to be broken up into "baby" Standard Oil Companies much like the Bell System monopoly was later broken up into Baby Bells.

Prior to the Great Depression of the 1930s, laissez-faire economics had little or no public regulation of business corporations and restraints on monopoly abuses. The Great Depression may well have ended the future of corporate business without some form of public protection against stock and banking frauds.  Securities legislation that provided public treasury backing of the banking system also created shareholder protections and banking regulation.  These laws created the SEC and the FDIC.  In Santa Clara's West Coast Hotel Co. v. Parrish (1937), the U.S. Court redefined the due process clauses of the 14th Amendment. Chief Justice Charles Evans Hughes wrote, "The Constitution does not speak of freedom of contract. It speaks of liberty and prohibits the deprivation of liberty without due process of law."  Later  Justice William Douglas observed in Williamson v. Lee Optical of Oklahoma (1955):  "The day is gone when the Court uses the Due Process Clause of the 14th Amendment to strike down state laws, regulatory of business and industrial conditions because they may be ... out of harmony with a particular line of thought."

Although courts now permit state and federal regulation of business, corporations have managed to retain the First Amendment rights they were granted in Santa Clara. U.S. Corporations wield vast economic and political power.  They have grown into world powers with more resources than many of the countries in which they operate.  Monopoly powers have given way to world cartel powers that can be equally abusive.  Evils include labor exploitation, price gouging, disregard for environmental protection, stealing of minerals and oil, and aiding and abetting in political corruption around the world.  Of course, all multinational corporations are not evil all of or even most of the time.  They also provide a vast amount of good throughout the world in providing improved housing, food, education, health care, and economic opportunity in many impoverished parts of the world. 


World Cartels Can Be Politically Evil Beyond Financial Fraud

Americans were also subjected to frauds and other evils of world cartels.  German cartels created acute shortages in the medical field in the early 1900s.  Prior to World War I, more than eighty percent of surgical instruments were imported from Germany. Many medicines were under complete German control, particularly salvarsan, luminal and Novocain. Salvarsan was used at the time to treat syphilis, and luminal was used to prevent epileptic seizures. There were no replacements for these drugs and many patients went untreated.

The following is an excerpt from the State of the Union address by President Wilson on May 20, 1919:

Among the industries to which special consideration should be given is that of the manufacture of dyestuffs and related chemicals. Our complete dependence upon German supplies before the war made the interruption of trade a cause of exceptional economic disturbance. The close relation between the manufacture of dyestuff on the one hand and of explosives and poisonous gases on the other, moreover, has given the industry an exceptional significance and value.

The advantages and risks lie in the size and economic power of enormous corporations and cartels.  They have enormous capacities for good.  And they create enormous risks for abuse and exploitation.  Checks and balances reside more in the power of the free media than in the law.  The media has become much more than newspapers in the era of television, the Internet, and electronic mail.

But the media alone is not enough.  The media is reactive to damages that have already taken place.  On rare occasions whistleblowers contact the media before something bad is about to happen.  More often than not, however, the whistleblowers come forth only after investigations begin as to why something bad happened.  For example, when Enron was growing its way into the world's energy cartel, the company borrowed nearly $1 billion to build a fraudulent power plant in India.  It was fraudulent in the sense that a gas-fired plant in India made no economic sense since neither the surrounding public nor commercial enterprises in India could afford the cost of importing natural gas to run the plant.  The entire project was a ploy to force the Indian government (under a planned threat of withdrawing U.S. Aid money) to use general tax revenues in India to subsidize importing gas from Enron suppliers.  Nobody within the scheme blew the whistle until after the plant was built by Enron's Rebecca Mack.  Only afterwards when Enron lost its political clout of threatening to withdraw U.S. Aid to India (due in large part to the U.S. Government's need for India to become an ally in the Gulf War) did the scheme fail.  When Enron eventually collapsed, its Indian power plant fiasco along with other Enron frauds were belatedly discovered by the media.  By then it was too late to save the creditors and shareholders who financed the useless power plant.  Also by then, Rebecca Mack had taken her millions in salary and stock sales and departed from Enron before the scheme was uncovered.


Wall Street Rots to the Core --- http://www.trinity.edu/rjensen/fraudrotten.htm

Wall Street scandals in stock selling that led to the Crash of 1929 ended the laissez-faire policy of government toward unregulated buying and selling of corporate ownership shares.  Business even welcomed government regulation as a way of restoring investor faith in a failed system of corporate financing.  Among other things, new securities laws in the 1930s created the Securities and Exchange Commission with a charter to prevent securities frauds and to punish both companies and corporate insiders from exploitation of the investing public.  The SEC set its sights on corporate manager insider trading and for the most part has been successful in curbing major abuses.  The SEC also energized the auditing profession by requiring that companies listed on stock exchanges have annual audits by "independent" Certified Public Accounting firms.  Prior to the 1930s, corporations engaged CPA audits on a voluntary basis as a way of adding credibility to financial statements presented to the general public.  But auditing was not required.

The SEC also was granted regulatory power over stock exchanges and other securities market institutions and processes such as the selling of mutual funds.  Although the SEC gets high marks for many of its regulation efforts, it gets a solid failing grade in terms of its oversight of stock exchanges and related market institutions.  The SEC simply looked aside when it came to an ever increasing flood of Wall Street frauds of the 1980s and 1990s,  The high water mark of frauds came in the 1990s when the media finally got wind of "infectious greed" in investment banking, stock trading, bond rating, mutual fund, and other industries rooted on Wall Street.  Much credit is due to Frank Partnoy's FIASCO references noted at the end of this document. 

Especially note Frank Partnoy's, FIASCO: The Inside Story of a Wall Street Trader (Penguin, 1999, ISBN 0140278796, 283 pages).  This is a blistering indictment of the unregulated OTC market for derivative financial instruments and the million and billion dollar deals conceived in investment banking. Among other things, Partnoy describes Morgan Stanley’s annual drunken skeet-shooting competition organized by a “gun-toting strip-joint connoisseur” former combat officer (fanatic) who loved the motto: “When derivatives are outlawed only outlaws will have derivatives.” At that event, derivatives salesmen were forced to shoot entrapped bunnies between the eyes on the pretense that the bunnies were just like “defenseless animals” that were Morgan Stanley’s customers to be shot down even if they might eventually “lose a billion dollars on derivatives.”

This book has one of the best accounts of the “fiasco” caused almost entirely by the duping of Orange County ’s Treasurer (Robert Citron) by the unscrupulous Merrill Lynch derivatives salesman named Michael Stamenson. Orange County eventually lost over a billion dollars and was forced into bankruptcy. Much of this was later recovered in court from Merrill Lynch. Partnoy calls Citron and Stamenson “The Odd Couple,” which is also the title of Chapter 8 in the book.  Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages) Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages)

Partnoy shows how corporations gradually increased financial risk and lost control of an overly complex structured financing deals that obscured the losses and disguised frauds pushed corporate officers and their boards into successive and ingenious deceptions." Major corporations such as Enron, Global Crossing, and WorldCom entered into enormous illegal corporate finance and accounting. Partnoy documents the spread of this epidemic stage and provides some suggestions for restraining the disease.

You can read the following at http://www.trinity.edu/rjensen/fraudrotten.htm#DerivativesFrauds

Michael Lewis, Liar's Poker: Playing the Money Markets (Coronet, 1999, ISBN 0340767006)

Lewis writes in Partnoy’s earlier whistleblower style with somewhat more intense and comic portrayals of the major players in describing the double dealing and break down of integrity on the trading floor of Salomon Brothers.

John Rolfe and Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle (Warner Books, Incorporated, 2002, ISBN: 0446676950, 288 Pages)

This is a hilarious tongue-in-cheek account by Wharton and Harvard MBAs who thought they were starting out as stock brokers for $200,000 a year until they realized that they were on the phones in a bucket shop selling sleazy IPOs to unsuspecting institutional investors who in turn passed them along to widows and orphans.  They write. "It took us another six months after that to realize that we were, in fact, selling crappy public offerings to investors."

There are other books along a similar vein that may be more revealing and entertaining than the early books of Frank Partnoy, but he was one of the first, if not the first, in the roaring 1990s to reveal the high crime taking place behind the concrete and glass of Wall Street.  He was the first to anticipate many of the scandals that soon followed.  And his testimony before the U.S. Senate is the best concise account of the crime that transpired at Enron.  He lays the blame clearly at the feet of government officials (read that Wendy Gramm) who sold the farm when they deregulated the energy markets and opened the doors to unregulated OTC derivatives trading in energy.  That is when Enron really began bilking the public.

Wall Street scandals were for the most part not orchestrated by common criminals or organized crime.  Sophisticated schemes for ripping off the public were devised by respected professionals with MBA degrees from Harvard, Yale, Stanford, Chicago, Wharton, and the like.  Honorable men and women started their Wall Street careers with very honorable intentions were subjected to temptations beyond belief.  Many eventually faltered and succumbed to the typical reasoning that "everybody's doing it."  And many in virtually every respected firm on Wall Street commenced to bilk the public out of billions of dollars.

And Corporate CEOs and CFOs invented sophisticated ways to get in on the Wall Street gravy train.  Corporate executives  often were afraid to make millions from inside trading of their own company's shares.  The SEC scared them in this regard.  But these executives had enormous spheres of influence on Wall Street by controlling with Wall Street firm would get their company's millions of dollars worth of financial business.  Elaborate kickback schemes emerged.  A common ploy was for the CEO of Company X to get in on the initial public offering (IPO) of Company Y shares at greatly discounted prices.  Former WorldCom President and Chief Executive Officer Bernie Ebbers made over $5 million on sweetheart stock deals offered by Salomon Smith Barney who granted Ebbers 869,000 shares in companies that were getting ready to launch their initial public offerings between 1996 and 2000. Other top executives were also given sweetheart deals in exchange for granting Worldcom business to Salomon Smith Barney.  This was by no means a rare type of kickback among virtually all leading Wall Street firms that became rotten to the highest levels of management.

The SEC did a lousy job regulating the investment banking industry whose frauds first came to light in the junk bond scandals.  In 1989 a federal grand jury indicted "Junk Bond King" Michael Milken for violations of federal securities and racketeering laws. He pled guilty to securities fraud and insider trading charges that earned him over a billion dollars. Scot Paltow wrote as follows in "The Dark Side of Wall Street: Why Scandals Continue to Erupt ," The Wall Street Journal, December 23, 2004 --- http://www.hermes-press.com/WS_dark_side.htm

Why do Wall Street scandals recur with the grim regularity of earthquakes and forest fires? The obvious answer, of course, is that Wall Street is where the money is. Beyond the inevitable appeal of billions of dollars changing hands daily, however, lie more peculiar reasons why knavery on a grand scale periodically racks the securities industry.

The $1.4 billion settlement of the Wall Street stock-research scandal marks the resolution of only the latest in a chain of scandals since the late 1980s. To mention just a salient few: the junk-bond scandals of Drexel Burnham Lambert; Salomon Bros.' fake bids for Treasury bonds; Prudential Securities' sales of worthless limited-partnership interests to tens of thousands of small investors; and the Nasdaq scandal, involving dozens of brokerage firms colluding to rig spreads at investors' expense.

While scandals are nothing new, the pain they cause is being felt more deeply. Ordinary Joes and Janes have flooded into the stock market, with an estimated 84 million individuals owning stock this year, double the number in 1983, according to the Securities Industry Association. The problem is that most lack the ability to easily detect flim-flam in balance sheets and earnings statements.

The analysts' scandal highlights one reason some Wall Street firms in modern times can't resist treating men and women of Main Street as chickens to be plucked. With the end of fixed commissions on stock trades in 1975, individual investors -- while remaining an important source of revenue -- became progressively less important for most firms than the huge fees to be earned from underwriting and investment banking for big corporations. Over time, taking advantage of the naiveté of individual investors became a convenient way to gain and keep big corporate clients. In the analysts' case, firms disseminated falsely rosey reports to induce unwitting investors into boosting the stock price of the firms' investment-banking clients.

Indeed, the language Wall Street traders and brokers use sometimes betrays disdain toward individual investors. Nasdaq market makers commonly refer to buy and sell orders from individuals as "dumb order flow," meaning their orders are almost certain to be profitable for the market makers because small investors typically trade without any hard information that could give them an advantage over these dealers.

Investment banking became rotten to the core in derivative financial instrument bucket shop schemes that ripped off pension and trust fund managers.  Various insider whistleblowers have written very revealing books about such schemes, notably whistleblower Frank Partnoy --- http://www.trinity.edu/rjensen/fraudrotten.htm#Partnoy

Partnoy's book Infectious Greed has chapters on other capital markets and corporate scandals. It is the best account that I've ever read about the Bankers Trust scandals, including how one Wall Street trader named Andy Krieger almost destroyed the entire money supply of New Zealand.  Chapter 10 is devoted to Enron and follows up on Frank Partnoy’s invited testimony before the United States Senate Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm

The SEC did a lousy job regulating the mutual fund industry by allowing undisclosed fees and by allowing large investors to rip off small investors with after-hours trading --- http://www.trinity.edu/rjensen/fraudrotten.htm#MutualFunds

Mutual funds with poor investor return performances were commonly paying kickback schemes to large networks of investment advisors and stock brokers who, in turn, diverted customer accounts into those unscrupulous funds rather than better mutual funds who did not offer kickbacks.  Large brokerage chains such as the Edward D. Jones & Co chain succumbed to such kickbacks.  See "Why a Brokerage Giant Pushes Some Mediocre Mutual Funds," by Laura Johannes and John Hechinger, The Wall Street Journal, January 9, 2004, Page A1.


The Auditors Fiddled While Investors Burned

The majority of investor fraud is rooted in false and misleading financial performance reports of corporations.  Both shareholders and creditors have been burned over and over again even after the SEC in the 1930s granted monopoly auditing power to the profession of Certified Public Accountants (CPAs).  All companies listed on public stock exchanges are required to have annual audits by external "independent" CPAs.  Other companies, including private corporations, are often expected to do so by creditors.

When auditing was the primary bread winner for CPA firms in the decades from 1940 to 1980, the audits themselves were reasonably effective in preventing corporate-wide frauds that badly distorted the financial position and annual performance of most audited corporations.  That does not mean there were not major problems on the rise.  Increasingly, especially beginning in the 1970s, companies devised leasing and other ploys such as unconsolidated subsidiaries to keep debt off the balance sheet.  Also the CPA external auditors always insisted that their audits were not designed to detect fraud within a company such as employee looting of corporate resources.  CPA audits only certified with respect to "fairness" of the financial statement numbers and conformance of the accounting system with generally accepted accounting principles.  Supposedly the CPAs were only responsible to detect fraud that "materially" distorted the bottom line.  For example, if the CEO looted $10 million dollars from a multinational company that reported net earnings of $10 billion, the bottom line would not be materially distorted if the CPA auditor failed to detect the CEO's crime.

In the 1980s, corporations devised increasingly sophisticated financing contracts such as derivative financial instruments and revenue recognition schemes that commenced to badly distort some financial statements.  CPA firms increasingly became negligent in detecting significant distortions.  This in large measure arose because auditing was becoming a less profitable line of business for large international CPA firms.  Clients began to shop for auditors with determined intent to grant the audit to the lowest bidder.  Simultaneously, CPA firms got in on the ground floor of management and technology consulting and found that there were much higher margins in consulting.  Soon the largest international CPA firms were earning as much or more in consulting fees than they were auditing fees from the same clients.  In the year 2000, the CPA firm known as Andersen was earning over $25 million in consulting fees from Enron and $25 million in auditing fees from Enron.  And the consulting was much more profitable when factoring in costs of providing the services.  Worse yet, some clients were challenging the "independence" of the auditors by threatening to take away the consulting fees if the auditors made too much fuss about how certain items such as revenue and debt were reported in the audited financial statements.  Pressures to bend the rules became intense in many instances.

The scandals and bad audits of major CPA firms are documented at http://www.trinity.edu/rjensen/fraud.htm
Some of the schemes used by clients to fool auditors and the public are documented at http://www.trinity.edu/rjensen/ecommerce.htm

Frank Partnoy introduces Chapter 7 of Infectious Greed as follows:

Pages 187-188

The regulatory changes of 1994-95 sent three messages to corporate CEOs.  First, you are not likely to be punished for "massaging" your firm's accounting numbers.  Prosecutors rarely go after financial fraud and, even when they do, the typical punishment is a small fine; almost no one goes to prison.  Moreover, even a fraudulent scheme could be recast as mere earnings management--the practice of smoothing a company's earnings--which most executives did, and regarded as perfectly legal.

Second, you should use new financial instruments--including options, swaps, and other derivatives--to increase your own pay and to avoid costly regulation.  If complex derivatives are too much for you to handle--as they were for many CEOs during the years immediately following the 1994 losses--you should at least pay yourself in stock options, which don't need to be disclosed as an expense and have a greater upside than cash bonuses or stock.

Third, you don't need to worry about whether accountants or securities analysts will tell investors about any hidden losses or excessive options pay.  Now that Congress and the Supreme Court have insulated accounting firms and investment banks from liability--with the Central Bank decision and the Private Securities Litigation Reform Act--they will be much more willing to look the other way.  If you pay them enough in fees, they might even be willing to help.

Of course, not every corporate executive heeded these messages.  For example, Warren Buffett argued that managers should ensure that their companies' share prices were accurate, not try to inflate prices artificially, and he criticized the use of stock options as compensation.  Having been a major shareholder of Salomon Brothers, Buffett also criticized accounting and securities firms for conflicts of interest.

But for every Warren Buffett, there were many less scrupulous CEOs.  This chapter considers four of them: Walter Forbes of CUC International, Dean Buntrock of Waste Management, Al Dunlap of Sunbeam, and Martin Grass of Rite Aid.  They are not all well-known among investors, but their stories capture the changes in CEO behavior during the mid-1990s.  Unlike the "rocket scientists" at Bankers Trust, First Boston, and Salomon Brothers, these four had undistinguished backgrounds and little training in mathematics or finance.  Instead, they were hardworking, hard-driving men who ran companies that met basic consumer needs: they sold clothes, barbecue grills, and prescription medicine, and cleaned up garbage.  They certainly didn't buy swaps linked to LIBOR-squared.


Occupational Fraud

Typical occupational frauds include inflated expense claims and pilfered goods and money.  What is sad is that workers who might otherwise be honest seem to justify stealing from employers when they feel that they are underpaid or under appreciated.   In the year 2003, occupational fraud is estimated at $660 billion according to the 2004 Report to the Nation on Occupational Fraud and Abuse, The Association of Certified Fraud Examiners --- http://www.cfenet.com/resources/rttn.asp 


Fraud Explodes with Advances in Government Benefit Programs

Probably the biggest suckers in America are local, state, and federal government benefit programs.  Medicare and Medicaid frauds cost billions each year.  Social Security funds are heavily tapped into with phony claims of disability.  Farmers rip off government farm programs.  Able bodied workers claim phony unemployment and welfare needs.  Defense contractors and other contractors of government agencies rip the system off for untold billions. 

Fraud Explodes Exponentially With Advances in Technology

Opportunities to cheat companies and people out of money and other resources soared in the age of computers, networking, and off-site payments.  Corporate revenues and banking fees exploded when vendors commenced to accept credit cards over the phone and on the Internet.  But the downside was that criminals commenced to exploit this new opportunity using various schemes that entailed stealing of credit card numbers and in many instances stealing entire identities of honest people.

Phony investment, product, and charity frauds exploded exponentially with email.  Then the spammers began to clutter mail boxes hawking everything from pornography to lotteries to "free" travel.

Centralized databases have made it easier for insiders and hackers to crack into databases and either steal directly from a company or steal records that can be sold in secondary markets.  Electronic commerce between business and consumers (B to C) and business to business (B to B) have greatly improved the worldwide efficiency and effectiveness of world commerce.  But the price has been an immense rise in electronic frauds that accompany electronic commerce.  Information that used to be private is no longer private.  Computers connected to the Internet became two way streets in which evil people can get inside our computers and do very bad things without our knowledge.

Many of the schemes and ways of fighting back are documented at http://www.trinity.edu/rjensen/fraudreporting.htm


Major Underlying Causes of Fraud in the History of the United States

Obsession with Privacy
The major cause of fraud in the United States is that freedom is prized over the risk of being ripped off.  Most fraud will be eliminated if and when U.S. citizens become accountable for every dollar of value in their estates.  Such accountability would be greatly enhanced by the elimination of all cash money in society.  If all transaction payments were reported electronically in a way that audit trails on virtually every payment were reported to central authorities, then fraud opportunities would be reduced mainly to bartering opportunities.  Bartering opportunities could be reduced if items such as cars, guns, jewelry, furniture, works of art, etc.  had electronic identification numbers and ownership titles that could only be transferred by reporting transactions.  Fraud would be discouraged if citizens had to document the sources of funds used to purchase major items such as homes, travel, cars, and luxury items.  But in the United States, most citizens are not yet willing to sacrifice their privacies to such an extent in the interest of curbing frauds.

White Collar Crime Leniency
Fraud in the United States is especially high because the laws and courts are so lenient on non-violent white collar criminals.  White collar crime pays big even in the rare chance that the criminal is caught.  By the time the culprit is detected and indicted, he or she has already pirated away most of the loot in an offshore bank account or some other hiding place.  After spending a very small amount of time in relatively comfortable incarceration facilities, the culprit returns to a life of luxury.  Famous white collar criminals can become rich just by selling books they write about their crimes.  The problem of white collar crime leniency is discussed further in "White Collar Crime Pays Big Even if You Get Caught" at http://www.trinity.edu/rjensen/fraudconclusion.htm#CrimePays

Whistle Blowing is Discouraged
One of the best deterrents to crime is the risk that a whistle blower will report the crime.  Even though new laws such as the 2003 Sarbanes Oxley Act offer protections to whistle blowers, the fact of the matter is that whistle blowing is a high risk undertaking.  Whistle blowers may have some clues to a crime, but they seldom have all the facts.  If the criminal is not put away for the crime, the whistle blower faces possible risks of retaliation that can be physical or financial in the form of a lawsuit or extortion.  Even if the criminal is put away, whistle blowers may be ostracized by fellow employees.  America generally prides itself in team players, and whistle blowers are generally not respected as team players by fellow employees.  Americans just do not like tattle tales.

Declining Morality and Ethics
The main problem with the decline in morality stems from changing role models from stern parents to peers who often adopt the attitude that nearly "everybody is doing it."  There are of course other causes such as the rise in opportunities to cheat in large impersonal systems such as government programs, insurance companies, credit card systems, Internet sites, and large corporations in general.  And then there is the serious problem of drug addiction.  Much of the crime in the United States is perpetrated by people desperately addicted to drugs that they cannot afford.  And drug use is on the rise, especially among white collar workers.  Narcotic availability coupled with the decline of family stability and control contribute to a willingness to take criminal risks.  Another addiction in the United States is the obsession with wealth and all the trappings of greed.  Many young people feed they have failed if they are not millionaires before they reach thirty years of age.  They are motivated more by money than honor.  This became particularly infectious on Wall Street in the 1990s.  Newly minted MBAs from top universities came to Wall Street with one thing on their minds --- get rich quick and get out!  And even though their education courses did not encourage fraud, many of these courses provided the burglary tools.  The Wharton School at the University of Pennsylvania, for example, once had 22 courses in tools of finance without one course in financial ethics.  This has changed somewhat in business school curricula after the Wall Street scandals came to light.

Unaccountable Contracting
One of the problems faced by auditors is that some really complex financing arrangements have become so complicated that they virtually cannot be audited or explained.  Complicated instruments are issued that do not fit established concepts of liabilities or equity. Enron had over 3,000 special purpose entities offshore that accountants could not fathom even after the contracts came to light.  Clauses in these and other contracts create a maze of contingencies that often confuse sophisticated analysts. In many instances the main purpose of the confusion is to complicate the accounting.  See http://www.trinity.edu/rjensen/fraudconclusion.htm#UnaccountableContracting

Incompetent and Corrupt Audits are Routine
The auditing profession has just not kept up with the rapid pace of technology change in the systems being audited.  Far too often the audit trail ends in front of a maze of networked computers or some giant black box that cannot be fathomed.  Auditors, in turn, rely upon the opinions of employees who work with the systems.  But few, if any, employees really comprehend the complete network system and its vulnerability to computing viruses and insider fraud.  Even in cases where auditors could greatly improve the quality of the audits (say by moving to continuous auditing in place of visits four or fewer times a year), the requisite resources available to the audit firm from audit fees just do not exist.  The price of a really good audit is just too high for the system to bear.

CPA Audits Have a Flawed Design
The SEC mandates that corporations must have external audits by "independent" CPA firms.  The purpose of the audit is to protect shareholders, creditors, and potential investors in the corporation from misleading or fraudulent financial statements produced by the corporation's top management.  But the audit fee is paid to the CPA firm certifying to the correctness and fairness of management's financial report by corporate management. Corporate management both chooses the CPA audit firm and negotiates the audit fee.  The audit firm that does not issue a "clean" audit report is in jeopardy of losing the client.  For example, if the CPA firm called Andersen had balked at the way Enron was accounting for some suspicious transactions, the local Andersen office in Houston stood to lose $1 million per week in audit and consulting fees being paid by Enron.  Pressures are immense to maintain great relations with audit clients.

A Failed System of Campaign Financing
Legislators in state and local governments no longer can be elected to office without running enormously expensive campaigns, especially for offices in the U.S. House of Representatives and the U.S. Senate.  Even relatively honest candidates become somewhat beholden to large donors.  Large donors generally have highly oiled lobbying machines in any legislature, and these machines are highly successful in steering votes favorable to special interest groups.  Time and time again the bills protecting the public lose out to special interests.  This system time and time again encourages rather than discourages fraud.

In recent years, the failed campaign financing system is also corrupting the court systems of many states in the U.S.  Mike France and Lorraine Woellert write as follows in "The Battle Over the Courts," Business Week, September 27, 2004, Page 40:

To win hotly contested states, some judicial candidates are building multimillion dollar war chests---often from people who might well appear in their courtrooms.  Although precise figures are hard to tally, this year's races figure to be the most expensive ever.

Is America Winning or Losing Its War on Fraud?

Fraud rolls across American history like waves move onto a beach.  Fraud rises and falls with new innovations and ultimate corrections.  For example, prior to the 1930s one innovative type of accounting fraud was to exaggerate the value of inventory on hand by reporting non-existent inventory.  External auditors were not required to verify the physical presence of inventory on hand.  The corrective measure came as a result of the famous McKesson Robbins scandal in which this company even reported inventory stocks in nonexistent warehouses.  As a result of the lawsuit and intense media reporting of the bad audit, the CPA profession instituted an auditing rule that required auditors to physically test for the existence of warehouses and inventory stocks within warehouses.

Each new corporate ploy to get around accounting and auditing rules eventually results in corrective accounting and auditing rules, which of course is why the exponentially growing set of such rules is becoming almost incomprehensible.  The same thing happens with consumer and investor protection laws.  When fraud finally gets so out of hand and has intense media exposure, U.S. democracy generally works.  Corrective laws are eventually passed, and criminals are forced to seek newer and more innovative frauds.

On at least two occasions fraud got so out of hand that there were immense tidal surges that threatened the entire financial system.  One of these was the Wall Street Crash of 1929 followed by the Great Depression that threatened the entire equity market and banking system in the United States.  Extreme corrective measures had to be taken that included greater regulation of capital markets and government backing of national banks.  Another tidal surge took place following the Enron debacle in the 1990s.  The resulting meltdown of Enron's auditing firm (Andersen) proved that bad auditing could destroy one of the largest and most successful international accounting firms in the world.  The resulting exposures of Wall Street's "infectious greed" coupled with Wall Street's smoking guns uncovered by NY Attorney General Elliot Spitzer might have toppled the major financial houses in America unless corrective measures were imposed.  And we have seen some of those corrective measures, but many more are needed to restore investor confidence in the ever-greedy market insiders.

The battle is still being lost over corporate governance.  None of the legislation to date has had a major impact on restraining excessive executive salaries and perks.  None of the legislation to date has substantially shifted corporate boards to seriously challenge management rewards for mediocre and lackluster performance.

The major deterrent to fraud, apart from freedom of the press, is worry over immense civil lawsuits.  This has led to really serious efforts to improve occupational safety, reduce sexual harassment, improve equal employment opportunities, improve accountability, improve internal controls, and increase professionalism.  But it has also threatened some companies with frivolous and greedy lawsuits such as the saga of asbestos lawsuits where monetary damages are far in excess of the harm actually caused by rare forms of asbestos.  Sometimes the lawsuits themselves are frauds that drag down good companies.  Investors and their attorneys should not believe that they can sue whenever a risky investment loses money.  Risky investments by definition have higher odds for failure, and investors taking on risk should not be able to turn risky investments into sure things with lawsuits.  Lawsuits should be reserved for gross negligence and fraud, not for inherent business risks.

Newer technology that creates opportunities for fraud also creates opportunities to deter fraud.  The rise in international fraud, especially on the Internet, has served to unite virtually all the industrial world to combat such fraud.

The future of some professions are in doubt.  The auditing profession in particular is at a very fragile juncture at this moment in time.  There is worry that the rise in multimillion dollar judgments against auditing firms might bring down these firms.  For more on the bright and dark sides of the future of auditing firms, to http://www.trinity.edu/rjensen/fraudconclusion.htm

The weakest front in the war on fraud is the political front where holders of political office, including judgeships, are increasingly dependent upon donations from interest groups that often oppose adoption of the most powerful laws and procedures for combating fraud.  For example, the extremely powerful corporate lobby resists many promising efforts to curtail corporate and government fraud.  Agribusiness resists efforts to curtail farm program fraud.  The medical industry resists efforts to protect Medicare, Medicaid, and medical insurance companies from fraud.

And so the waves of fraud continue to move across time in the life of the United States.


Armstrong, David and Elizabeth Metzger Armstrong (1991), The Great American Medicine Show (Prentice-Hall, ISBN: 0133640272 )

Lewis,  Michael (1999), Liar's Poker: Playing the Money Markets (Coronet, ISBN 0340767006)

Rolfe, John and Peter Troob (2002), Monkey Business: Swinging Through the Wall Street Jungle (Warner Books, Incorporated, ISBN: 0446676950)

Tarbell, Ida (1904), The History of Standard Oil Company (McClure, Phillips, and Co.) --- http://www.history.rochester.edu/fuels/tarbell/MAIN.HTM

Special Mention:  The Works of Frank Partnoy
See http://www.trinity.edu/rjensen/fraudrotten.htm#DerivativesFrauds

Senate Testimony by Frank Partnoy --- http://www.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony 

Article by Frank Partnoy
"The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit Reporting Agencies" (Washington University Law Quarterly, Volume 77, No. 3, 1999) --- http://ls.wustl.edu/WULQ/ 

Books by Frank Partnoy Published in Various Years


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