The logic behind the model we designed pinpointed these as trends to look for. We didn’t know whether we would actually find these patterns in SEC filings, but we did know that they were the key to predicting fraud if our model was right.
Why these patterns? CEOs always have incentives to take actions that protect their jobs. If they see that their company is not performing up to market expectation, they are at risk and will take action to salvage their situation. Now, they can argue that the firm is the victim of unforeseeable shocks for which they should not be held accountable (this was the argument made by the CEOs of GM and Chrysler in seeking a government bailout—they pointed to the economic downturn, not management’s decisions, as the cause of the auto industry’s woes), but such arguments are risky to say the least, and may not be adequate to protect a CEO’s job.
If blaming the economy or some outside force doesn’t salvage senior management’s situation, then the top executives might misrepresent the corporation’s true performance. If they can sell the belief that the company is performing just fine, then they won’t be at risk of being fired. It is difficult for outsiders to know the corporation’s true volume of sales, revenue, costs, and profits. Market capitalization reflects these factors, and indeed these are the factors that when falsely reported and subsequently detected result in accusations of accounting fraud.
If revenues are exaggerated or costs are understated, then senior executives can temporarily lead the marketplace to misjudge the true worth of a company, making the company appear (falsely) to have met or exceeded expectations. This, the model suggests, is the essential motivation behind corporate fraud.
This wedge between lower-than-expected stock dividends and compensation for executives and seemingly normal or good growth in market capitalization is therefore an early-warning indicator of an elevated risk of fraud. Neither the SEC nor many corporations, however, seem to realize the importance of this information in detecting early signs of trouble. Sarbanes-Oxley certainly does not draw attention to analyzing the size of this benefits wedge.
The game’s logic and the evidence culled from more than a decade of corporate filings across hundreds of firms also raise questions about journalistic accounts and popular perceptions. A pretty standard journalistic view of fraud is that greedy executives act to enrich themselves at the expense of shareholders and employees, that they are little more than looters, and that the problem boils down to outrageous character flaws. This kind of thinking gets us nowhere.
Too often we look at what happened most recently and assume that earlier actions were motivated by those ends. It is easy to believe that greedy executives cook the books to enrich themselves, with self-interest tied merely to short-term gain (of course I would never argue that self-interest isn’t the key motivation, but we must examine exactly what the nature of that self-interest is). But in doing so we forget, for example, that Enron’s fraud started around 1997 and yet the senior managers did not sell off their shares until around 2000 and 2001. Why would they have waited so long, risking discovery for years, before cashing out? True, stock prices were going up, but equally true, the risk of being uncovered grew greater and greater with each passing month and year. Did they really only seek the gains to be made in the period from 1997 to 2001, or were they hoping for much greater gains five, ten, or fifteen years on?
We won’t analyze the problem properly if we look for the causes of fraud in its end result. Remember, correlation is not causation—the beginning, not the end, is where the explanation lies.
In the Enron case, it seems clear that by 2000 or 2001 the most senior leadership in the company realized that they could not fix its problems. Having reached the end of the corporate game, they cashed out. It is despicable that they did so while covering up the true state of affairs, thereby leaving their pensioners on the hook. But it seems equally evident that Enron’s senior management did not hang on for four years before cashing out just to enrich themselves and walk away. All that time, according to the game’s logic, they were trying to save the company because their longer-term interests would be rewarded if they were successful in doing so. If the numbers had to be fudged while they corrected the company’s course, so be it. In their view, the end justified the means. None of that was going to happen if the shareholders, and especially if key board members, found out what trouble Enron was in.
Give executives the wrong incentives and you can count on their taking actions with bad social consequences. Give them the right incentives and they will do what is right, not because they are filled with civic virtue but because it will serve their own interests. Remember Leopold? He had pretty good incentives in Belgium and he did good things there. He had horrible incentives in the Congo and he did horrible things there.
What, then, are the right and wrong incentives? Why do some companies commit fraud while others—the vast majority of firms—even in dire circumstances do not? In answering these questions we can gain insight into how to alter incentives appropriately and how to anticipate who has the wrong incentives and is at serious risk of committing fraud.
One clear implication of the fraud model my colleagues and I developed is that the broader the group of people CEOs rely on to keep their jobs, the more likely it is that the shareholders who put them in power will throw them out. That’s what happens to leaders of democracies, and that is what is more likely to befall underperforming CEOs in relatively democratic companies. To save themselves, they are perversely incentivized to misrepresent the corporation’s true performance so that they don’t have to explain underperformance in the first place.
This is not to say that more “autocratic” companies (fewer people to please in the power structure) are incapable of fraud. It’s just that things have to be considerably worse for those companies before management sees sufficient risk to their jobs that they are tempted to engage in fraud. Our sliding scale extends across the public/private company divide as we consider partnerships (think of them as oligarchies) and family companies (monarchies).
Government regulators and boards of directors could do a better job of protecting shareholders and employees from the risk of fraud. To do so, the focus needs to be more squarely placed on the incentives executives have to monitor themselves and their colleagues in the face of declining business performance. Knowing how to adjust governance structures to induce the right incentives is the way to regulate firms successfully. Balancing incentives in good times and bad is a major challenge for running a business in a way that attracts and retains top-quality executives and satisfies shareholder expectations. Optimal corporate governance design needs to be done on a case-by-case basis, taking the nature of the firm’s market into account. A sweeping regulation cannot facilitate the fine-tuning that is needed to get incentives right. Confidence in business requires that we move in these directions rather than putting our energies into finding greedy individuals to blame or one-size-fits-all fixes for what are manifestly corporate governance problems. Looking for greed is just like the drunkard looking for his keys under a lamppost. More often than not, what’s lost is not under the bright lights.
In a broader sense, if we truly want to make it easier for corporate executives to come clean about problems they discover as soon as they discover them, then we also ought to change the law so that they are not punished for spilling the beans on themselves.
Lots of companies discover problems with their products or their performance long before these problems become public. Indeed, it is a good bet that some serious problems never become public at all. A few years ago, for instance, the 3M Corporation pulled Scotchgard off the market. Scotchgard was one of its biggest earners, and yet one day it was in the stores and the next it was gone. A few years later, 3M introduced what it called a new, improved Scotchgard. The EPA and other firms in the chemical industry wondered whether 3M had discovered a health or safety risk associated with the main chemical in Scotchgard, a chemical not found in its “new and improved” product.
I don’t know whether 3M discovered a problem or just decided one day to change a successful product. Imagine that they did find a problem. What would they—no, better yet, what could they responsibly do? Company leaders in such situations may be eager to reveal whatever it is they’ve discovered, but they also realize that doing so would violate their fiduciary duty. They are damned if they do and damned if they don’t. A public announcement leaves them open to lawsuits by people who used the product before anyone—inside or outside the company—knew there was a problem. These suits can be devastating to shareholder value, and it is shareholder value that corporate directors are legally obliged to protect.
Probably many companies would reveal what they know when they discover trouble if the government would immunize them against prosecution for any problems in their products that were previously unknown to them. The government won’t. Litigation is the favored solution, as opposed to rewarding responsible, public-spirited actions by corporate executives in difficult straits. The result is that corporate leaders are given the wrong incentives. Remember all the litigation surrounding the problems caused by DDT? Do you also remember that the Royal Caroline Institute won the Nobel Prize for Physiology or Medicine in 1948 for developing DDT? With litigation run rampant, we fail to provide corporations and their leaders with protection for reasonable expectations and decisions that, not by any misdeeds on their parts, may simply turn out to be wrong.
In this chapter, we’ve explored how to frame questions. The main idea is to isolate the individual components of a problem that shape its resolution. Then it’s a straightforward matter of turning those isolated individual components into issues that, depending on the circumstances, may be decided separately or that may be linked to each other. Once an issue is well defined, experts have an easier time talking about who really will try to influence the decision on each item. Then we can have the computer play the forecasting and engineering game to simulate what proposals each player is expected to make to each other player on a round-by-round basis, and we can bring into relief the incentives that players have to accept or reject proposed solutions.
With the computer program at the ready, we can sort through the problem and not only predict results, as I did with the napkins, but begin to engineer results to change outcomes, as I hinted could be done to prevent corporate fraud. Engineering outcomes is the subject of the next two chapters.
6
ENGINEERING THE FUTURE
DIPLOMATS ARE CONVINCED that a country’s name is an important variable that helps explain behavior. That’s why the Department of State is organized around country desks, just as the intelligence community is organized around geographic regions. Leaders of multinational corporations take much the same view. When they have a problem in Kazakhstan they call their guys in Kazakhstan to find out what to do. That seems eminently reasonable and right. Yet it is only partly right and terribly inadequate for solving most problems, or, as I see it, for engineering the future.
Now don’t get me wrong. Knowing about places, and how different they may be, is important, but, perhaps surprisingly, it is not as important as knowing about people, and how similar they are, wherever they are. I have not arrived at this view lightly nor, I hope, in ignorance. As a matter of fact, the training that led to my Ph.D. molded me into a South Asia specialist. I even studied Urdu for five years, both during my undergraduate and graduate studies, and did field research in India—so I certainly respect and value area expertise. But I don’t think it’s the way government or business should organize itself for problem-solving purposes.
Here, as in so many other ways, I am swimming upstream against a strong current. Mine is a controversial stance in many of the circles in which I travel, and many in those circles see views such as mine as foolish at best and dangerous at worst. Still, I do not shy away from the risk of publishing predictions about things that have not happened—and by and large, those who disagree with me do not do the same.
As valuable as area studies is, it is by itself a poor substitute for the marriage of expertise about places and the expertise of applied game theorists about how people decide. Yet we seem to think that knowing the facts is sufficient. Some even contend that it is ridiculous to rely on something as abstract as mathematics to anticipate what people will do. Speaking of ridiculous things, we surely would think it ridiculous if chemists believed that oxygen and hydrogen combine differently in China than they do in the United States, but for some reason we think it entirely sensible to believe that people make choices based on different principles in Timbuktu than in Tipperary (we might be different from mere particles, but we’re not all that different from one another). Country expertise is no substitute for understanding the principles that govern human decision making, and it should be subordinate to them, working in tandem to provide nuance as we actively seek to engineer a better future.
To explore how this view informs the predictioneering process, in this chapter we’ll turn to a group that lives and feeds on human conflict: lawyers. Lawyers share with diplomats, academics, and business leaders a conviction that country names matter, but—let’s give them some credit—they believe this for better reasons. Different countries have adopted different rules of law. Some assume innocence until guilt is proven, while others assume the opposite; some make the loser pay the costs of litigation, while others do not. But that difference aside, lawyers, like diplomats and statesmen, spend much of their time negotiating the resolution of disputes—and almost none of them ever learn any game theory or study negotiation strategies. Lawyers study law, and diplomats study countries. Both groups may read popular books from which they get some useful insights, but collections of clever anecdotes and off-the-shelf recipes for success are no substitute for the serious study of game theory or for getting the assistance of people with expertise on how decisions are made.
When diplomacy is successful, wars are fought with words, the combatants sitting around a table, drinking Perrier until a resolution is reached and celebrated with fine wine. Lawsuits are wars too. Just as most international disputes are settled long before they get to the battlefield, so are lawsuits played out in meeting rooms, boardrooms, lawyers’ offices, and only rarely courtrooms. Lawyers prepare arguments, investigate precedents, amass documents, and study the other side’s paper trail. In big corporate suits, millions, even tens of millions of dollars are spent on armies of attorneys. I’ve worked on lawsuits involving so many lawyers and so many law firms that it was almost impossible to keep track of them. My consulting company has frequently advised on lawsuits in which the defendant—usually our client is a defendant—holds uncountable meetings with one or two dozen lawyers at each meeting, all senior partners in major law firms, each one billing $400, $500, $600, $700, or more per hour. A typical meeting running just one workday with a dozen lawyers in attendance costs about $57,600—and that doesn’t include the vastly higher costs of preparation for that day’s discussion. Multiply that by dozens of meetings, and then two or three times more to reflect the costs of preparation, and you begin to see how quickly lawsuits become phenomenally expensive. I’ve advised on cases where my client spent tens of millions more on lawyers than they paid in settlement.
Of course, all that lawyer money is not spent without some reason. It’s generally spent for two purposes. First, the money is buying preparation to improve the prospects of victory. That is, of course, the lawyers’ job. Second, the money is spent to signal the other side that they are up against deep pockets that can endure high costs to fight the good fight. The message: “We will keep you embattled in motions, countermotions, and delays until we break the bank. We can spend more than you.” Naturally, the other side is spending tons of money with the same two purposes in mind. The two sides are playing the game called the war of attrition.1 It’s great for lawyers, and awful for everyone else.
Armies are the diplomat’s analog to the prodigious spending on lawsuits. Having more and bigger guns discou
rages others from picking fights with the well-armed. Deterrence works much of the time, but sometimes, just as with the deterrent threat of costly litigation, arms fail to protect the peace—and war results. Wars and litigation are inefficient ways to resolve problems. They almost never end in a decisive victory. Instead, they usually end in a negotiated settlement. Both sides find a deal they could, in principle, have arrived at without all the costs that finally brought them to the negotiating table.2
One reason that diplomats and attorneys do not avoid the huge costs of their pre-settlement minuets is that they simply don’t know bargaining theory. They’re reduced to working out the complexities of each situation on their own. Seat-of-the-pants wisdom and experience help, and some lawyers and diplomats are quite good at it, but for most, an awful lot gets overlooked, delaying settlement and rendering the resolution of disputes more costly than it needs to be.
In the dance that precedes negotiations, attorneys and diplomats tend to center their arguments on the merits of the case. Rarely do they really think through the motivations and incentives of their opponents, the people they represent, and themselves. After they form an opinion about the strengths and weaknesses of their case—which is what lawyers are trained to do—they try to impose some reality check on what their clients think, whether the clients are plaintiffs who think themselves terribly harmed or defendants who think themselves exploited. The positions the defendants (or plaintiffs) discuss among themselves in terms of money or other factors in a lawsuit reflect their judgment about the merits of the case. They know this is true for the other side as well. It is no different with international negotiations, whether they concern land for peace, the abandonment of nuclear weapons, or basic principles of governance and human rights.
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