Executive Prison Sentences and Fraud Deterrence

One of the key parts of Sarbanes-Oxley, the legislation created to address the problem of massive financial statement fraud at public companies like Enron and WorldCom, was the increased prison sentences for executives participating in fraud.

Supporters of the legislation cheered harsher potential punishment for executives as one of the keys that would help prevent fraud.

Others weren’t so sure that longer prison sentences would really do anything to deter executives who want to commit fraud. If you’ve studied corporate fraud for any length of time, you have seen that fraud by executives is often fueled by feelings of arrogance and entitlement. These are important pieces of the fraud puzzle for executives, and they are part of the reason why executives may be unphased by penalties for committing fraud.

Tone Grant, the former president of Refco, was sentenced to 10 years in prison for his convictions on federal charges of conspiracy, securities fraud, wire fraud, bank fraud and money laundering. Refco executives hid $430 million in bad debts, which came to light in 2005, shortly after the company went public.

The total fraud at Refco was $2.4 billion, of which less than half will be recovered. Grant was the only executive at Refco to take his case all the way to trial, but he ended up losing big on his gamble. The company’s former CEO pleaded guilty to 20 criminal counts shortly before he was scheduled to go to trial, and received 16 years in prison.

In the Refco case, one has to wonder what effect longer sentences under Sarbanes-Oxley had on these executives. I’ll suggest there was little effect on them at all, much like any executive who is currently engaging in fraud. The executives got between 10 and 20 years in prison, but who really pays attention to this?

The executives engaged in significant corporate frauds are not typically thinking about the difference between 5 years, 7 years, 10 years, or 20 years in prison. They are counting on not being caught committing fraud. After all, they’re intelligent and clever.

Their schemes are so good that they anticipate they will not be caught. If they are caught, the executives tend to think they won’t be convicted.

Other executives are a bit less brazen about their crimes. They rationalize their behavior and convince themselves that they are not really committing fraud, even though outsiders would like say they are.

These executives have “reasons” for doing what they do, and they hope they can explain it someday if they’re held to account. Their ultimate goal is for the company to perform so well that the fraud is buried and never discovered. No one will have to know that the books were cooked on the company’s way up.

In either case, it is clear that the length of prison sentences is unlikely to be at the forefront of the executives’ minds. It is not so important if the prison sentence is 5 years or 10 years, and I suspect that at some point, the length of the prison sentence becomes nearly meaningless.

What might matter is whether or not the executive goes to prison, and in many cases, executives can avoid prison sentences with enough maneuvering by attorneys. The executives may instead be ordered to pay fines, turn over ill-gotten gains, perform community services, or be put on probation. Those things may be important to victims and witnesses, but who knows how much they deter would-be white-collar criminals.

It makes sense to keep upper level executives accountable for a company’s financial statements and controls over fraud. One way they are held accountable is by handing down punishment when fraud is proven. Recognizing that other executives may not be strongly deterred from committing fraud even in light of the punishment is important, however.

At the end of the day, the difference between 10 years in prison or 20 years in prison probably does not have much of an impact on the head of a company who has a plan for committing fraud. The threat of prison in general, might stop some would-be fraudsters.

But let’s not fool ourselves about the increased prison sentences under Sarbanes-Oxley.

They are probably not doing a whole lot to curb fraud by executives.

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