What Were They Thinking?

Why?

There are many motivators for those who might commit white-collar fraud:

• Financial greed
• Financial desperation
• A belief that the job requires breaking the law
• Ego or a need for fame
• Desire to appear favorably to one’s boss
• The importance of meeting Wall Street’s expectations
• The importance of supporting the stock’s price
• Inadvertence (not thinking)
• Believing that everyone does it
• A feeling of omnipotence.

Both Soltes’s subjects and the ones discussed below were basically good people who absolutely did not start out to commit fraud, do evil, or break the law. They began their careers as law-abiding businessmen, people who for some reason crossed a line and committed criminal activities. Soltes contacted a number of these individuals and asked, “Why did you do it?” The book is fascinating, and though it never really answers the question to this author’s satisfaction, this fact in itself supports the author’s suspicion that the question may be unanswerable.

The best description of the process leading to white-collar criminal activities comes from Marc Dreier’s letter to the court supporting a plea for leniency (not included in Soltes’s book). Dreier “borrowed” hundreds of millions of dollars using fraudulent documents to finance his law firm and lifestyle. After describing setting up the law firm and his personal troubles, he wrote:

While of course society cannot agree with Mr. Dreier’s solution to his problem, it may be possible to understand how he got there. More difficult to understand are those who commit financial fraud without greed, desperation, or other strong motivations. Many years ago the author was brought into a bankruptcy proceeding in which the CEO, an acquaintance, said there had been a serious inventory disappearance. After some investigation, mainly talking to the staff, the author learned that the issue was not that the inventory disappeared, but rather that it never existed. The CFO had input nonexistent inventory into the computer listings used for the financial statements in order to support the company’s borrowings. A new outside auditor required a full inventory, which revealed a shortfall. The CFO departed voluntarily as soon as the shortfall was discovered. When asked why the CFO had committed this fraud, as there was nothing in it for him, the CEO said that it was most likely to please the boss. No one likes to bear bad news, so the CFO must have felt it was easier to hide the problem, even though it meant committing fraud.

Inadvertence appears to be a significant cause of criminal activity. Society has many rules and regulations that carry risks of criminal penalties for carelessness in connection with routine activities. Even commonly followed procedures can suddenly become criminal. Up to a few years ago, it was routine for companies to issue employee stock options by backdating the dates of grant for a few days to take advantage of a lower stock price. This practice is fascinating from a fraud point of view, as 1) the benefits accrue mostly to persons other than the perpetrator, 2) using the lower price is not an issue if the transaction is reported correctly for tax and accounting purposes, and 3) it is almost impossible to determine who is damaged by such fraud. After an article written by two academics which showed that the vast portion of options were granted at the lowest possible price during the week, the SEC started pressing companies to price on the day of grant. Soltes’s book describes how one CFO spent four months in jail for backdating options. She was not doing this for any personal benefit, but rather felt she was doing what was best for her fellow employees.

A second example of fraud by inadvertence can be found at IMClone, which was developing a specialized cancer drug. The stock price was high. When the CEO learned that the FDA was withholding approval and that the drug would require more testing, he called his daughter to advise her to sell her shares. He ended up losing his position and going to jail. Soltes quotes him as saying, “I didn’t think about it. I actually thought that I wasn’t doing anything wrong because I thought that until I get the letter from the FDA and I know what’s really happening, I’m not doing anything wrong.”

A third example involves the transactions between Tyco International and its CEO, Dennis Kozlowski. He signed many documents giving him large financial benefits, almost none approved by the board of directors. Kozlowski responded to Soltes as follows: “Twice a month I had folders with yellow stickies that were this big [spreading his arms wide]. I signed everything, but it was the same thing that I had been doing since 1976 … I had the company tell me what it was and I signed it. So how’s that criminal?”

A final example of inadvertence is the leak of information received by Raj Rajaratnam, who ran a large hedge fund. Rajaratnam befriended two individuals, Rajat Gupta and Anil Kumar; both were or had been McKinsey partners and were well aware of insider trading rules. Both

leaked important information to Rajaratnam, who traded on the information. Based on Soltes’s descriptions, the information was conveyed more for reasons of personal friendship than any monetary reward. Gupta and Rajaratnam ended up serving jail sentences; Kumar received a two-year suspended sentence after aiding the prosecution. In Kumar’s case, Judge Denny Chin stated that “greed wasn’t the motive in [Kumar’s] case” and that “this was aberrational conduct … Mr. Kumar has led a law-abiding and productive life” (Chad Bray, “Kumar Avoids Jail for His Help in Insider Crackdown,” Wall Street Journal, Jul. 19, 2012, http://on.wsj.com/2lYnZPG). Both Gupta and Kumar were seduced by Rajaratnam and therefore let down their guard against disclosing inside information.

The author believes that if the individuals above had sat down and thought about their situation, they would have never acted in the way they did.

Accountants’ Role

Of significance to outside auditors are those in the accounting department who aid or abet financial statement fraud for no reason other than that they like their jobs. The following are examples from the author’s experience and the financial press:

• The author was an expert witness defending an auditor of Phar-Mor, Inc., a retailer of health and beauty aids. The financial department set up an elaborate system to overstate earnings and inventory for millions of dollars to present a financial picture that showed profits and equity rather than losses and a deficit. The fraud involved the COO, the CFO, the controller, and a number of subordinates. When the subordinates were questioned as to why they were willing to aid and abet the fraud, the most prevailing motivation was “I had a high mortgage and needed my job.”
• In connection with an audit in 1996 of Valley Systems, Inc., an SEC reporting company, the author found a fraud perpetrated primarily by the CFO, assisted by the controller. Getting nervous, the controller gave hints as to where to find the fraud. He then requested that his assistance be kept secret, as he was physically afraid of the CEO and CFO. (He agreed that the SEC could be told after it was made clear that otherwise the SEC would want to send him to jail.)
• Enron is the most famous 21st century fraud. No one knows whether the accounting staff believed that the financial statements were fraudulent, but there is no evidence that the internal accounting staff at Enron ever raised a question as to whether what they were doing was appropriate. As seen elsewhere, the corporate culture dictates finding a way to report high earnings and keep the outside auditors happy.

Soltes does not address the issue of white-collar crime without a strong motive. It appears in the above cases, however, that the employees’ motivation was both to keep their jobs and to please the boss. Often, including with the three companies noted above, management commits fraud to support the price of the stock or meet investor expectations. The above examples, as well as many others in the media and the SEC enforcement releases, demonstrate many financial executives are willing to commit fraud to aid the company, even though they are helping someone else and risk going to jail.

No Way Out

In dealing with certain of these frauds, as well as Ponzi schemes, the question always arises: “How did they expect to get out of this mess?” The typical answer goes like this:

• In the beginning it was a small adjustment that they expected to be able to correct in the next period when things got better;
• Then in the next period they had to make a bigger adjustment to cover both the first one and the fact that operations were not supporting what they were doing;
• After that, producing fraudulent results became their way of life. They were too busy committing fraud to contemplate their dishonesty.

Once one is engulfed by a fraud, there appears to be no way to reverse the process. None of the people the author has spoken to, nor any of the individuals in Soltes’s book, had an explanation as to how they expected to work themselves out of a financial statement fraud or a Ponzi scheme.

Soltes inquired of his subjects about the victims of the frauds; none of them seemed to care. Admittedly, in some cases the identity of the victims is difficult to ascertain. In cases such as the stock option pricing issue and the insider trading cases, there may be no identifiable victims, other than the integrity of the markets. In Ponzi schemes, generally the biggest losses are in unrealized and inappropriate gains, and the only true losers may be those who invested just before the collapse. Regardless, the perpetrators all appeared to be too sorry for themselves to regret what they had done to others.

No Easy Answer

In the end, neither Soltes nor the author understands why these good people turned bad. The author has certainly made his share of inadvertent errors and errors, but he did not commit fraud to cover them up (no matter how much he may have wished to). While Soltes’s book is definitely a recommended read, the answer to the question of, “why do they do it?” remains elusive, and perhaps unreachable.