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Has the pendulum swung too far? Post-Enron responses to possible corporate crime have created a climate of fear for honest corporate officers.

Article Excerpt
The prosecution of corporate fraud has garnered increasing attention in recent years. A number of high-profile cases have captured headlines, sent the involved firms into death spirals, destroyed the careers of numerous managers, and sent many executives to jail. Several firms have jettisoned their CEOs and left dismissed employees to fight charges for themselves in return for the firms receiving relief from criminal indictments.

Enron is the poster child. It was Fortune's "Most Innovative Company in America" six years running. The ingenuity, at least in its latter years, went largely into massive accounting fraud that made the company appear far more valuable and its endeavors far more successful than they were in fact. Thus far, 20 Enron employees have been sentenced to jail after trials or plea bargains.

The smoke and mirrors were so obvious in hindsight that few doubt that at least some of those employees were guilty of reprehensible behavior. The bankruptcy proceedings recovered $9.4 billion for a company that had been worth seven times that shortly before. Thousands of employees and investors lost their savings. The debacle, and others that followed including the collapse of the WorldCom house of cards, made the public more distrustful of the captains of industry and the books they keep.

When guilt is certain, justice is easy. But prosecutors make mistakes in bringing cases--sometimes through carelessness, other times through zealotry--and judges and juries err in finding guilt. Arthur Andersen, Enron's auditor and accountant, exemplifies the nightmare with which corporations and executives now live. The U.S. Department of Justice filed criminal charges against the partnership in March 2002. The complaint did not claim that Andersen had participated in any fraudulent activities, but instead that the firm had destroyed documents relevant to the Enron investigation. The world's largest accounting firm began collapsing in the wake of the indictment. It was largely destroyed as a viable business after a jury--originally deadlocked but requested to reach a decision under an Allen charge--returned a guilty verdict in June 2002. Its partners lost much of their financial wealth and the firm itself finally closed its doors in the United States by August 2002.

The Supreme Court reversed the decision unanimously in June 2005 on the grounds that the judge's jury instructions enabled the jury to find guilt on the basis of virtually no culpability on the part of Arthur Andersen. The government prosecution went overboard to remove all mental elements from the basic charge, a deviation from basic criminal law principles that was slapped down by the Supreme Court. One cannot have too much sympathy for the Andersen partners in charge of Enron--they missed a massive fraud on their watch. But a corporate death sentence for what was a highly regarded firm, carried out for all intents and purposes before its appeals were exhausted, defies bedrock principles of justice.

Arthur Andersen and Enron are bookends that motivate the thesis we advance in this article. The pursuit of corporate fraud faces the classic tradeoff between absolving the guilty and convicting the innocent. On the one hand, when the judicial process falsely convicts companies and their executives, it reduces and sometimes destroys the value of assets ex post. More importantly, it encourages companies and their executives to behave more conservatively ex ante and thereby reduces the rate of innovation and dynamic competition. On the other hand, when the judicial process falsely exonerates companies and their executives, it not only permits wrongdoing to continue but also tends to increase the incentives for others to engage in wrongdoing. That imposes substantial costs on the economy. The judicial process needs to balance those two sources of errors and their costs.

We argue that the balance struck by the prosecutorial and judicial system has tipped too far toward pursuing criminal indictments against companies and their executives. The result is harm to the general public, whose members depend on a dynamic, competitive economy for their welfare. As a result, the United States has an increasingly hostile business environment that is likely reducing valuable risk-taking behavior and shifting entrepreneurial activity to other countries. In creating a climate of fear for corporations and their executives, Enron and WorldCom have, perhaps, imposed more significant costs on the economy at large than they foisted on their investors.

JUSTICE IS NOT PERFECT

At least since biblical times, the administration of justice has recognized that perfection is a lark and that one must balance the benefits of convicting the guilty against the costs of convicting the innocent. As the Supreme Court put it In Re...

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