By Henry T. C. Hu
Published with the author's permission;
The New York Times, January 30, 2006
Can Enron happen again? Yes. Does this mean our corporate governance system isn't doing enough to deter fraud? Not necessarily.
Fraud happens. The recent collapse of Refco, the futures broker, is a case in point. In August, Refco raised $583 million in an initial public offering. Two months later, Refco announced that a company owing it $430 million was controlled by its chief executive and that its financial statements should no longer be relied upon. A week later, Refco was bankrupt.
The fraud was crude and huge. There were no difficult-to-comprehend derivatives of the Enron variety. Federal securities law had imposed stringent due diligence responsibilities on Refco's directors and underwriters to ensure accuracy in the I.P.O. disclosure materials. In contrast, no such responsibilities applied to Enron's directors or bankers because no public offerings were involved. While Enron boasted of excellence and integrity, Refco warned investors of deficiencies in its internal controls. Market discipline, like the other mechanisms, failed to deter fraud.
Well, maybe fraud isn't completely inevitable. A corporation's assets could be liquidated and the proceeds invested in Treasury bills guarded around the clock. The board could consist solely of former F.B.I. agents. No fraud here.
Like it or not, a certain amount of fraud is optimal. Shareholders want management to take steps to deter fraud, but they also want management to use the same benefit-cost calculus in determining how much time and money to devote to fraud control that it uses to engage in activities that may enhance profits.
Obviously, shareholder welfare cannot be the sole touchstone. Corporate fraud hurts not only the shareholders but also, among other things, general market confidence. Through the Sarbanes-Oxley Act and other means, it makes sense for government to require more in terms of deterring fraud than may necessarily be optimal for shareholders.
Still, there are real costs associated with forcing corporate directors to spend too much time playing sentry. Focusing on fraud diverts directors from activities like choosing and monitoring management, devising compensation systems and offering strategic advice — all things that are important to shareholder welfare. And as it turns out, concentrating less on fraud control and more on overseeing management may not only enhance corporate performance but can sometimes also reduce fraud.
During the Enron trial, which starts today, Kenneth Lay will probably claim that he understood neither the effects nor the intent of key suspect financial arrangements. Let's assume this is true. A board vigorously monitoring Mr. Lay's performance would surely have concluded that anyone who didn't understand these basic matters wasn't qualified for the job (much less worth millions of dollars in compensation).
Just think how much fraud might have been deterred if a board had replaced Mr. Lay with someone more qualified.
Henry T. C. Hu is a corporate and securities law professor at the University of Texas Law School.
About Professor Hu: http://www.utexas.edu/law/faculty/huht/