Opinion

Why do corporate frauds happen

J Srinivasan | Updated on July 06, 2020 Published on July 06, 2020

The CEO wields too much power   -  Getty Images/iStockphoto

Weaknesses in the corporate structure are the prime driver. C-Suiters, especially in publicly-held firms where they have little skin in the game, have greater incentive to enrich themselves

Black’s Law Dictionary defines fraud as: “All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth. It includes all surprise, trick, cunning, or dissembling, and any unfair way which another is cheated.”

Yet another top businessman has been caught with his hands in the corporate till. There has been a procession of big names in India and abroad with the same condition. The list of companies affected by fraud includes Enron, Satyam, Kingfisher and Tesco.

Is this indeed a condition or just that the environment allows corporate fraud to happen? For most part, white-collar criminals are well-educated and suave. They often have wealth of their own. Yet, they do not seem to mind indulging in a practice that can bring shame.

By a Freudian construct, there are primarily three drivers of fraudulent behaviour: (a) a non-shareable financial problem (pressure/incentives to commit fraud); (b) knowledge of weaknesses in the structure and workings of a corporation which would allow the perpetrator to commit the fraud and escape detection (opportunities); and (c) ability to justify to oneself that the fraudulent actions are not necessarily wrong (rationalisations). There is also the aspect of ability to carry out such acts with confidence.

Causes for weakness

In the Indian context, however, it is perhaps the second driver that is most at play. Weaknesses abound in the Indian corporate structure despite the best efforts of various regulators and the government to curb such tendencies.

The weaknesses have three causes and these causes often coexist. First, boards of directors are not as independent as they seem to be or claim to be.

Second, audit committees are either absent or do not perform their roles. Audit committees are also often poorly composed and inappropriately compensated. As a result, their independence and oversight abilities are compromised.

Third, the chief executive officer (CEO) exerts undue control over the company’s assets and finances regardless of how much or how little of the company’s equity she/he owns. The CEO is often the founder of the company, a descendant or a close relative of the founder’s family.

The CEO is in a position to appropriate material and financial benefits at the cost of other shareholders. The behaviour of managers in such circumstances has been the subject of hypotheses and theories. The theory of agency costs gained prominence even in 1976. The world had been warned by erudite and insightful professors. But to not much avail.

Ownership structure and managerial behaviour are related. If the mangers own only a little of the company they manage, they have a greater incentive to enrich themselves. Working for the well-being of all shareholders and the organisation becomes secondary. CEOs in such circumstances are aided by friendly occupants of the C-Suite. Together, they wield power over the board or a pliant set of directors. Thus, wrongdoing can go along merrily. It becomes worse when the same individual is both the CEO and the chief financial officer (CFO).

The very nature of the publicly held form of corporate ownership structure is especially convenient for perpetrating fraud. Shareholders are not the sole victims of the rip-off. Creditors to the company are ripped off as badly. For the C-Suite, it is a simple mantra: We will share in the profits, you bear the losses. This is simply because there is no strong, centralised ownership.

Time for a relook

As Adam Smith so presciently pointed out several hundred years ago in his The Wealth of Nations: “The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”

With motivated offenders endowed with a combination of intelligence, position, ego, the availability of suitable targets, and the absence of effective controls, fraud will happen merrily till a whistleblower comes along or an external agency — in the form of a regulator — stumbles on the goings-on.

If the accounting profession and internal and external regulations have not been able to curb corporate frauds, perhaps it is time to relook how companies are structured so that the C-Suiters have enough skin in the game so as not to rip off the organisation or the shareholders.

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Published on July 06, 2020
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