Corporate scandals

SIGNIFICANCE: Corporate scandals have seemingly increased in the early twenty-first century, but such crimes have occurred throughout the history of the corporate form of business.

Frauds perpetrated by corporate insiders and the scandals that result are not new phenomena; they have occurred since the beginnings of the corporate form of business during the mid- to late nineteenth century. As early as the mid-nineteenth century, corporate fraud in railroads occurred with regularity. For example, during the early 1850s, the Mobile & Ohio Railroad found that a corporate engineer learned the route on which a new railroad was going to be built. He went out and bought land along that route from farmers and plantation owners and then sold the land to the railroad at inflated prices. It was his insider information that allowed him to defraud his employer. By the 1870s, one-half of the railroads in the United States were in receivership, many because of the immoral acts of corporate leaders. Many aspects of law involving corporate bankruptcy and reorganization emanated from the railroad receiverships.

Corporate scandal is known as the “agency problem.” As agents, corporate officers utilize corporation assets on behalf of the stockholders (owners). At the same time, they have a vested interest in maximizing their own well being. The result is that stockholders need some form of governance over the officers of corporations. This is theoretically accomplished through boards of directors, audit committees, and internal auditors, who oversee the activities of management.

Kreuger and the Securities and Exchange Acts

Modern government oversight of corporate dealings has grown out of one of the most notorious scandals of the twentieth century—the failure of Kreuger & Toll, a Swedish match conglomerate that had been founded and headed by Ivar Kreuger, who was supposedly the richest man in the world. During the 1920s, the most widely held securities in America—and the world—were the stocks and bonds of Kreuger’s company.

The bankruptcy of Ivar Kreuger’s empire in 1932, following his suicide, led to a national outcry that resulted in the passage by the U.S. Congress of the Securities and Exchange Act the following year. Prior to 1933, companies that depended on stockholder financing were not required to have audits. Even companies listed on the New York Stock Exchange often did not issue audited financial statements. That situation changed because of Kreuger—one of the greatest swindlers the world has ever seen.

Kreuger’s securities had been popular because they sold in small denominations and paid dividends and interest that often reached as high as 20 percent annually. Financial reporting as it is now known was in its infancy; stockholders based their investment decisions almost solely on companies’ dividend payments. However, Kreuger’s dividends were paid out of capital, not profits. Kreuger was essentially operating a giant pyramid scheme that was hidden from the investing public by his insistence that financial statements not be audited. He argued that financial secrecy was paramount to corporate success. In his defense, some secrecy was truly needed because he was often dealing with foreign powers about government monopolies and taxes on wooden matches. Subsequently, it was discovered that many of his companies’ assets were in the form of intangible monopolies.

The stock market crash in 1929 made it more difficult for Kreuger to sell new securities to fuel his pyramid scheme. Finally, he committed suicide in March 1932. Within three weeks, his companies were in bankruptcy, as it became apparent that there were few assets to support the financial statements they had issued over the years. The Kreuger bankruptcy was the largest on record up to that time and resulted in numerous changes in financial reporting. Newspaper articles kept Americans aware of the extent of Kreuger’s fraud at the same time that Congress was considering the passage of the federal securities laws. The timing of the Kreuger bankruptcy and the corresponding media coverage made it politically expedient to pass laws that would make similar schemes difficult in the future. A single event, the corruption of Ivar Kreuger, had shaken investors’ confidence and provided the media event of the decade. As a result, both the passage of the Securities and Exchange Act of 1933 and the issuance by the New York Stock Exchange of rules mandating audits of listed companies can be attributed to the Kreuger case. In fact, it might be argued that Kreuger ultimately did more good than harm to the financial community.

The federal Securities and Exchange Acts of 1933 and 1934 provided both civil and criminal penalties for perpetrators of corporate frauds. The acts also provided for civil penalties, under specific circumstances, for accountants and lawyers who were involved in the preparation, registration, or audits of financial statements hiding corporate frauds. Section 11(a) of the Securities and Exchange Act of 1933 covers the failures of experts, including accountants, who certify financial statements that contain material misstatements of facts or omission of such facts in registration statements of new securities.

Under federal law, accountants may be held liable on either fraud or negligence charges. Plaintiffs do not even have to prove that they have relied on erroneous statements; they merely have to prove that the errors existed. Also, privacy of contract is not required under the securities laws. Accountants, brokers, and lawyers may assert the due diligence defense in cases involving Section 11(a) violations. The landmark U.S. Supreme Court case involving the due diligence defense is Escott v. BarChris Construction Corporation of 1968.

Whereas the 1933 Securities and Exchange Act of 1934 applies only to issues of new securities, the 1934 act applies to subsequent issues of stocks and bonds. Rule 10b-5 of the Securities and Exchange Act of 1934 is the most formidable weapon available to federal prosecutors attempting to fight corporate fraud. Rule 10b-5 outlaws fraudulent financial statements, misstatements, or omissions of material facts in the sale of securities. Unlike the provisions of the 1933 act, negligence by itself is not a crime because injured parties must prove that defendants have acted with intent. This rule was tested in the 1976 Supreme Court case of Ernst and Ernst v. Hochfelder.

McKesson & Robbins and Later Cases

In 1938, the McKesson & Robbins drug company was the victim of insider fraud in the person of Philip Musica (also known as Donald Coster). The senior management of McKesson & Robbins had used a facade of false documents to conceal the fact that $19 million in inventory and receivables did not exist. A federal Securities and Exchange Commission (SEC) investigation concluded that Price Waterhouse & Company had adhered to generally accepted auditing procedures. The auditors had obtained management assurances as to the value of the inventories and had checked the inventories to purchase orders, which had been fabricated to conceal the fraud. The Securities and Exchange Commission concluded that although generally accepted procedures had been followed, the procedures themselves were inadequate. As a result, the American Institute of Accountants in 1939 issued a statement that required auditors to observe inventories and confirm receivables. Other cases followed during the twentieth century that influenced auditors and regulators, but probably none to the extent of the Kreuger and McKesson & Robbins cases.

Corporate frauds appeared to be slightly less newsworthy during the 1940s and 1950s. During the 1960s, the news media focused on the salad oil swindle at the Allied Crude Vegetable Oil Refining Corporation and the crooked schemes of Billie Sol Estes in the fertilizer and grain industries. The salad oil swindle was perpetrated by Anthony De Angelis, the corporate president who moved a small amount of soybean oil around in hundreds of large tanks. He then got the American Express Field Warehousing Company to certify that all the tanks were full of oil, when in reality the tanks were full of water, with small amounts of oil on top. Based on the phony warehouse receipts he accumulated, De Angelis persuaded New York bankers to lend him hundreds of millions of dollars.

The fraudulent scheme used by Estes was to use the same collateral for multiple loans. When he sold fertilizer tanks to farmers, the farmers signed notes to pay for the tanks in installments. Estes then took their notes to financial institutions and used them as security for loans. However, he used each note several times to secure many more loans than there were notes from farmers. By the time his scheme was uncovered, Estes had obtained approximately 30,000 loans on only 1,800 tanks of fertilizer. Both auditors and lenders had been misled by a shell game of switching identification plates on fertilizer tanks.

The Estes case also tended to give big business a bad name as many people believed that all business deals were at least somewhat shady. Politicians, particularly then Vice President Lyndon Johnson, also suffered from public relations problems since Estes claimed that he made payoffs to many prominent individuals. In 1963, Estes received a fifteen-year sentence following his conviction for fraud.

Late Twentieth Century Scandals

The 1970s witnessed the dawn of computer frauds, with extensive news coverage of the use of computers to defraud shareholders in the huge insurance company Equity Funding Corporation of America. The company’s top management created imaginary policyholders on its computers. At that time, auditors were not widely familiar with computers, so they failed to uncover the fraud. After the imaginary policyholders were created, their policies were resold to other insurance companies. As a result of the fraud, both stockholders and other insurance companies lost money. Most of the corporate executives were eventually convicted of fraud and violations of insurance laws.

The decade of the 1970s saw the passage of two federal laws that subsequently played important roles in the fight against corporate fraud. The 1970 Racketeer Influenced and Corrupt Organizations Act (RICO) was designed to curtail the role of organized crime in corporate frauds. However, the use of RICO in civil cases not involving organized crime has been more extensive because of the all-encompassing wording of the act.

RICO allows the awarding of treble damages in civil cases. In 1977 the corporate environment changed when Congress passed the Foreign Corrupt Practices Act (FCPA). Although the media emphasized that the purpose of the new law was to eliminate payments by U.S. corporations to foreign officials, a secondary purpose of enhanced internal controls was more important to corporate management.

Congress included in the new law a provision that companies should have controls to ensure that illegal payments are uncovered by the accounting system. Thus, if a corporation is guilty of making an illegal payment, management could not escape conviction by claiming lack of knowledge of the payments. If management did lack knowledge, then they were guilty of having a system that could not uncover illegal payments. As a result of this law, corporate management began placing more emphasis on internal controls. The result was the hiring of more internal auditors by corporations with internal audit departments and the establishment of new audit departments by organizations that did not have them. This increase in internal controls resulted in a reduction in corporate fraud. Although the intent of the law was to target a single type of fraud, the fact that companies now have more internal auditors and better systems of control means that all types of fraud can be uncovered.

During the 1980s, hundreds of financial institutions, primarily savings and loan associations, failed due to insider fraud, leading to a congressional investigation headed by Michigan congressman John Dingell. The conclusions of the Dingell Committee included recommendations that large corporations should all have internal auditors and audit committees of the boards of directors. The oddity about the cases of the 1980s was that so many companies were involved, and most of them were all in the same industry. Technically, the savings and loan fraud of the 1980s was the worst fraud in history—totaling well over $200 billion in losses. However, these losses were the result of hundreds of similar frauds at financial institutions throughout the country.

Twenty-First Century Cases

During the first years of the twenty-first century, the scandal at HealthSouth, as well as scandals at Global Crossing, Tyco, Enron, and WorldCom were in the news; however, these scandals are simply modern extensions of the nineteenth century railroad schemes and the Kreuger debacle of the early 1930s. In every case, corporate governance systems broke down or simply did not exist, and greedy individuals took corporate assets for their own personal use and manipulated stock prices to defraud stockholders.

In most of these cases, external auditors were blamed for either agreeing to questionable accounting practices or failing to uncover the transactions recorded by management. Enron Corporation was a highly publicized failure uncovered in late 2001. When Andersen & Company (formerly Arthur Andersen & Company), an external auditor that had approved some questionable transactions, was discovered to have shredded thousands of documents related to its audit of Enron, the once revered firm was destroyed. By the spring of 2002, Andersen essentially ceased to exist—not because it had failed in conducting an audit, but because it attempted to hide its audit coverage by shredding key documents. One Andersen audit partner eventually pleaded guilty to obstruction of justice for ordering the documents to be shredded.

As media coverage of Enron receded, a new fraud was uncovered at WorldCom, a major telecommunications firm in Clinton, Mississippi, that was also audited by Andersen & Company. The internal auditors at WorldCom discovered that its chief financial officer, controller, and other accounting employees had recorded expenses as assets, which resulted in higher income and generated huge bonuses for top employees. WorldCom was essentially the straw that broke the camel’s back; the investing public insisted that Congress do something about the amoral acts of corporate executives.

The result was the passage on July 31, 2002, of the Sarbanes-Oxley Act, which set limits on the types of nonaudit work that external auditors are allowed to perform for their clients and required corporate executives to certify the accuracy of their companies’ financial statements. Several WorldCom accountants, including chief financial officer Scott Sullivan and controller David Myers, pleaded guilty to accounting fraud under the Securities and Exchange Acts of 1933 and 1934. The company’s chief executive officer, Bernard Ebbers, was also indicted.

A similar story unfolded at HealthSouth in Birmingham, Alabama, where the government quickly worked out plea deals with corporate financial officers. However, prosecution of the company’s chief executive officer was less of a certainty. Thus, at WorldCom, Enron, and HealthSouth the chief executive officers all claimed their own innocence by trying to place blame on lower-level workers, whom they claimed were trying to inflate corporate earnings in attempts to profit from stock options and bonus agreements.

The US housing crisis that began in 2007 provided additional examples of corporate fraud. Seemingly stalwart companies such as Bear Sterns, Lehman Brothers, and AIG were caught in the net of the subprime mortgage scandal that coincided with a global financial recession that shook the economy. The seemingly endless string of financial frauds in public corporations has cast public doubt on the credibility of even untarnished corporations. Such trust, once lost, is slow to return. The results have been slowdowns in the financial markets during the 1930s, 1960s, 1980s, and the early years of the twenty-first century. However, there are now more tools available for prosecutors to use against corporate fraud perpetrators. In addition to common law, there are the Securities and Exchange Acts of the 1930’s, the Racketeer Influenced Corrupt Organizations Act of 1970, the Foreign Corrupt Practices Act of 1977, and the Sarbanes-Oxley Act of 2002.

In September 2015, the Environmental Protection Agency ordered the vehicle manufacturer Volkswagen to recall over 482,000 diesel passenger cars sold in the US when it was discovered that several Volkswagen models emitted illegally high levels of poisonous nitrogen oxides. In addition, eleven million of the vehicles contained illegal software that changed the performance of the car to pass the emissions tests while the cars were being tested. The company was ordered to pay more than $25 billion in fines.

Later that year provided another example of corporate fraud in the health technology corporation Theranos. In August, the company raised more than $700 million in venture capital, based on the claim that Theranos had developed technology that could perform a variety of lab tests with just a drop of blood, without publishing any scientific research papers. In October 2015, however, the Wall Street Journal exposed that the company had lied about their technology; the founder, Elizabeth Holmes, was charged with massive fraud in March 2018. She was convicted in 2022 and sentenced to more than eleven years in prison, although her sentenced was later reduced by two years.

One of the most widely documented examples of corporate fraud in the 2010s, was the celebrity-promoted music festival Fyre Festival in April 2017. Cofounded by rapper Ja Rule and CEO Billy McFarland, and promoted by supermodels like Bella Hadid and Kendall Jenner, the festival was touted as a luxury music festival with top-tier performers on the Bahamian island Grand Exuma. Over 5,000 people purchased tickets priced between $500 and $1,500, with VIP packages costing $12,000. When attendees arrived at the festival, they found half-built FEMA disaster relief tents and cheese sandwiches in place of the luxury villas and gourmet food that was promised. Thousands of people were trapped on the island with little food and water, and no air conditioning while they waited at the airport to leave. McFarland, who organized the Fyre Festival, was convicted of two counts of wire fraud, and was sentenced to six years in prison and ordered to pay $26 million in restitution.

Bibliography

Akst, Daniel. Wonder Boy: Barry Minkow—the Kid Who Swindled Wall Street. New York: Scribner’s, 1990. Print.

Comen, Evan, and Thomas C. Frohlich. "The Biggest Corporate Scandals of the Decade." 24/7 Wall St, 15 Jan. 2020, 247wallst.com/special-report/2019/12/20/the-biggest-corporate-scandals-of-the-decade/5. Accessed 25 June 2024.

Cruver, Brian. Anatomy of Greed: The Unshredded Truth from an Enron Insider. New York: Carroll, 2002. Print.

Fox, Loren. Enron: The Rise and Fall. Hoboken: Wiley, 2003. Print.

Giroux, Gary A. Business Scandals, Corruption, and Reform: An Encyclopedia. Santa Barbara: Greenwood, 2013. Print.

Jeter, Lynne. Disconnected: Deceit and Betrayal at WorldCom. Hoboken: Wiley, 2003. Print.

Keats, Charles. Magnificent Masquerade: The Strange Case of Dr. Coster and Mr. Musica. New York: Funk, 1964. Print.

Miller, Norman C. The Great Salad Oil Swindle. New York: Coward McCann, 1965. Print.

Minkow, Barry. Clean Sweep. Nashville: Thomas Nelson, 1995. Print.

Pilzer, Paul Zane, and Robert Deitz. Other People’s Money: The Inside Story of the S&L Mess. New York: Simon, 1989. Print.

Rapoport, Nancy B., Jeffrey D. Van Niel, and Bala G. Dharan. Enron and Other Corporate Fiascos: The Corporate Scandal Reader. 2nd ed. New York: Reuters, 2009. Print.

Shaplen, Robert. Kreuger: Genius and Swindler. New York: Knopf, 1960. Print.

Valinsky, Jordan. "Elizabeth Holmes Shaves More Time Off Her Sentence." CNN, 7 May 2024, www.cnn.com/2024/05/07/tech/elizabeth-holmes-prison-release-date/index.html. Accessed 25 June 2024.