Almost daily we read about another "stiff" financial penalty meted out for corporate malfeasance. This year corporations are on track to pay as much as $8 billion to resolve charges of defrauding the government - a record sum, according to the Department of Justice. Last year big business paid the Securities and Exchange Commission $2.8 billion to settle disputes.
Sounds like an awful lot of money. And it is, for you and me. But is it a lot of money for corporate lawbreakers? The best way to determine that is to see whether the penalties have deterred them from further wrongdoing.
The empirical evidence argues they haven't. A 2011 New York Times analysis of enforcement actions during the last 15 years found at least 51 cases in which 19 Wall Street firms had broken anti-fraud laws they agreed never to breach.
Goldman Sachs, Morgan Stanley, JPMorgan Chase and Bank of America, among others, have settled fraud cases by stipulating they would never again violate an anti-fraud law, only to do so again and again and again. Bank of America’s securities unit has agreed four times since 2005 not to violate a major anti-fraud statute, and another four times not to violate a separate law. Merrill Lynch, which Bank of America acquired in 2008, has separately agreed not to violate the same two statutes seven times since 1999.
Outside the financial sector the story is similar. Erika Kelton at Forbes reports that Pfizer paid $152 million in 2008, $49 million a few months later, a record-setting $2.3 billion in 2009 and $14.5 million last year. Each time it legally promised to adhere to federal law in the future. Each time it broke that promise.
The SEC could bring contempt of court charges against serial offenders, but it doesn’t. Earlier this year the SEC revealed it has not brought any contempt charges against large financial firms in the last 10 years. Adding insult to insult, the SEC doesn’t even publicly refer to previous cases when filing new charges.
We know that CEOs of big corporations never go to jail. We probably didn’t know they often benefit financially even when the corporations under their control violate the law. Glaxo Smith Kline CEO Andrew Witty recently received a significant pay boost, to roughly $16.5 million just four months after Glaxo announced it will pay $3 billion to settle federal allegations of illegal marketing of many of its prescription drugs. Johnson & Johnson Chairman and CEO William Weldon received a 55 percent increase in his annual performance bonus for 2011 and a pay raise despite a settlement his company is negotiating with the Justice Department that could run as high as $1.8 billion.
So what level of penalty might deter corporate crime? The Economist recently addressed that question using the common-sense framework proposed by University of Chicago economist Gary Becker in an influential 1968 essay. Becker proposed that criminals weigh the expected costs and benefits of breaking the law, and that the expected cost of lawless behavior is the product of two things: the chance of being caught and the severity of the punishment if caught.
Purdue University Economics Professors John M. Connor and C. Gustav Helmers examined the market impact of over 280 private international cartels from 1990 to 2005 and the fines imposed on them by various governments. They estimated these criminal conspiracies in restraint of trade raised prices by $260 billion to $550 billion. The median overcharge was about 25 percent of affected commerce.
Thus a fine about 25 percent of revenue would repay the damage done. But that’s assuming wrongdoing is caught every time. The Economist suggests that catching one in three violations would constitute a good track record for regulators. That would mean a fine of 75 percent of revenue would be needed to deter future violations. But the study found that actual fines ranged only between 1.4 percent and 4.9 percent.
Last year’s SEC settlement regarding Citigroup’s fraudulent mortgage investment practices fits that pattern. The settlement was for $285 million, less than 4 percent of Citigroup’s $76 billion in revenues.
Often federal penalties are so low they might be viewed as an invitation to break the law. According to the Times, Citigroup had cheated investors out of more than $700 million, more than twice what it paid in penalties.
As for Glaxo’s $3 billion settlement, George Lundberg, former editor of the Journal of the American Medical Association, writes, “The penalty sounds like a lot of money but that company made probably 10 times that much from its illegal actions.”
What can be done?
A first step might be for the media to stop reporting simply the gross settlement figure and instead give us the information that allows us to decide whether the punishment fits the crime. A few days ago a brief story in the New York Times business section admirably achieved this goal.
The Times reported that in 2006, Morgan Stanley entered into a complex swap agreement with the New York electricity provider KeySpan that gave it a stake in the profits of a competitor. This enabled the two companies to push up the price of electricity. Morgan Stanley broke the law. On August 7 a federal judge approved the settlement between the Justice Department and Morgan Stanley.
Here’s the cost benefit analysis: The total cost to New Yorkers in higher utility bills because of the price fixing came to $300 million. Morgan Stanley was paid $21.6 million for handling the swap agreement. And the financial penalty imposed on Morgan Stanley? An inconceivably low $4.8 million. In addition the bank didn’t have to admit any wrongdoing. There will be no further prosecution.
Anyone who read the Times story had all the facts necessary to conclude that something is terribly, even criminally wrong here. The Times is to be commended for going that extra step and providing a full cost-benefit analysis. I hope it can become a template for all political and business reporters.