THE SMITH CENTER

for Private Enterprise Studies

Clinton and Corporate Ethics

by Micah Frankel
Associate Director

With the stock market slumping, the mainstream media has started to search for scapegoats. The usual assortment of politically-incorrect villains - morally-challenged executives, compromised auditors, sleazy corporations, cowboy capitalists, negligent institutional investors, uninformed or indifferent directors, dishonest security analysts, and rich Republicans -- have all been cast as rogues. Here is the story as told by mainstream pundits:

The deceitful and greedy CEO class has lined its pockets at the expense of the innocent and passive market participants. They accomplished this fraudulently, in collaboration with compromised auditors and indifferent and ignorant directors, by manipulating their firm's earnings to meet the expectations of corrupt, lying and lazy analysts. This in turn artificially inflated their firm's stock prices. These overblown stock prices increased the value of the executive's stock options, which are based on the underlying value of the firm's stock. In the end, the executives went to the bank after cashing in their stock options, while the investors including retirees, widows and orphans, went to the cleaners after stock prices plummeted. Now, the story goes, the jittery, spooked and cynical investor class has lost confidence in the markets, their trust thus violated, they have dumped their shares thus further depressing the stock market. The solution we are told is more government imposed bureaucracies, regulations and reforms. Market solutions, which align managers interests with rational incentives have been ruled out, because it is precisely from unjust and arbitrary market forces that the investor class seeks protection.

When the stock market was rising, as it was during the era of "irrational exuberance," corporate corruption and accounting shenanigans were downplayed by the mainstream media, and ethics were considered academic because stock prices were high and the investor class was happy. "It's the economy stupid" was the slogan of the day. Financial reporting scandals at Cendant Corp., Waste management, Sunbeam Corp., Fine Host Corporation, and Mercury Finance Co. were lightly reported if at all. Former SEC Chairman Arthur Levitt constantly bemoaned the "noticeable erosion in the quality of financial reporting." However, because the stock market was booming, the media and investors paid little notice.

Now, all of that has changed. Lynn Turner former chief accountant for the SEC recently stated "It's a shame that corporate America has somehow gotten into the mind-set that this (fraud) is O.K." Where could these so-called ethical lapses have come from? World Com Inc, whose $3.8 billion earnings overstatement made Enron $1.2 billion restatement seem minor, is based out of Clinton Mississippi and this got me thinking

The Clinton Influence

In 1992, as a Presidential candidate William Jefferson Clinton squinted his eyes and with a straight face and a gravelly voice pledged to run "the most ethical administration in history of the republic." Unfortunately, this promise was laughably off the mark. Later on February 25, 1994, appearing on Washington Week in Review (PBS), Bill Clinton trumpeted: "There have been no scandals in this administration. And I was governor for 12 years, not a hint of scandal.

The "most ethical administration" taught us a lot. Here are some examples of what we've learned:

1. It is easier to ask for forgiveness after breaking the law, than it is to ask for permission to break the law.

2. The rule of law does not apply to the political class.

3. Self-serving legalistic wordsmithing is a substitute for honesty, dignity and the rule of law.

4. "No controlling legal interest". On March 3, 1997, prompted by allegations that he made illegal fundraising calls from the White House, Vice President Gore invoked the "no controlling legal authority" defense seven different times in a single press conference:

5. "False, but not legally false." President Clinton claimed that although he made false statements under oath, his statements were "not legally false."

6. Fraud depends on how one defines it -- e.g., "what the meaning of 'is' is" and what are "sexual relations."

7. "Inadvertence and the press of business" is a valid reason for not correcting inaccurate testimony to Congress.

8. "Selective amnesia" is an ethical response to congressional and legal inquiries about the actions of Whitehouse staff and officials.

9. The Iced Tea Defense used by Vice President Al Gore to explain to the FBI why he didn't know he was at an illegal fund raising event. "The Vice President observed that he drank a lot of iced tea during meetings, which could have necessitated a restroom break." (FBI Interview, Al Gore, August 8, 1998)

The President of the most ethical administration, Bill Clinton, was found in contempt of court by US District Judge Susan Webber Wright for giving "false, misleading and evasive answers that were designed to obstruct the judicial process."

For eight years, the most "ethical administration" assaulted our nation's collective ethical sense and ideals of conduct for a head of state, and produced more scandals involving arrests than any previous administration: For example the Whitewater investigations alone produced: 19 charges, 4 convictions, 8 imprisonments, other Clinton scandals produced 55 criminal charges and 32 criminal convictions including Webster Hubbell, associate attorney general, the No. 3 Justice Department official. The most ethical President was impeached by the House for lying under oath, disgracing his office, and betraying the American trust. During the Clinton/Gore era, the line between right and wrong, legal and illegal, acceptable and unacceptable was so little enforced that it became blurred.

The Clinton/Gore legacy is an administration which propagated not only the politics of division, class warfare and resentment, but also the belief that "ethics do not apply to us, just the other guys." Clinton paved the way for eroded personal responsibility by doing what felt good, regardless of what was right. Thus, it is not surprising that this nonchalant attitude toward ethics has permeated not only the political class but the corporate class as well. Commentators have pointed out how Clinton-style semantics have creep into the lingo of CEOs involved in financial fraud, including some verbatim reprise of the wordplay Clinton himself used in times of scandal. Our current stock market problems may, in large part be the result of our failure to fire the most corrupt CEO of all.

Yet as we have already witnessed with the precipitous decline in these unethical firm's stock prices and firings of unethical CEOs, ethics do matter. The markets impose substantial costs on both individuals and companies that engage in unethical behavior. When allowed to operate without interference from the forces of political society, these market forces provide important inducements that discourage unethical behavior, e.g., accounting fraud.

An Economic View

From an economics point of view, accounting fraud can be viewed as a choice individuals face. Rational individuals identify the expected costs and benefits of their actions, and if the expected costs of accounting fraud exceed the expected benefits than the individual will likely choose ethical behavior and not commit accounting fraud.

Viewed in this economic framework, several inferences can be drawn:

1. The higher the probability of detection, the less likely an individual is to engage in accounting fraud.

2. The higher the penalties imposed, the less likely an individual is to fudge the numbers. A company known by the market to be fudging the numbers will be penalized by a lower stock price and thus a higher cost of equity capital. In an attempt to appease the public in this regard, on July 10th the Senate voted 97-0 to pass a bill that carries new penalties for corporate fraud, document shredding, and tightens oversight of the accounting industry. The Senate bill also doubles the penalty for mail fraud from five to 10 years. Of course, enforcing stricter laws for tomorrow does nothing to help today's victims. It would have more beneficial for these victims if existing laws were enforced better.

3. The expected costs of committing accounting fraud are higher, if information regarding the accounting shenanigans is rapidly and widely distributed to potential future investors.

4. The costs imposed on a firm that is caught cooking its books depend on the market's assessment of the accounting fraud. Accounting numbers such as net income are based on a large number of assumptions, estimates and judgments. For a given firm, 100 accountants could compute 1000 different values for net income. Some accounting judgments, estimates and assumptions viewed as inappropriate or unethical by some auditors might be viewed as aggressive but justifiable by others.