Corruption occurs when a firm violates moral codes of conduct to attain some undue advantage. Corruption is a subpart of the relatively broader concept of corporate misconduct. While misconduct includes financial restatement fraud, contract violation, bribery, kickbacks, environmental violations, and product-specific accidents, not all of these constitute corruption.
For corporate corruption to occur, three fundamental conditions must be met: (1) there must exist a party that has power, (2) the power of that party must be relevant to revenue-generating or expense-reducing activities, and (3) the legal and penal systems must be inadequate to comprehensively detect and punish wrongful use of the power. The power can be held by the corrupt firm itself, whereby the firm abuses its power to realize unfair benefits (e.g., financial misrepresentation of earnings). The power can also be held by some other party who receives bribes or kickbacks from the corrupt firm to grant the firm some unfair advantage. Moreover, for firm misconduct to be labeled as corruption, the misconduct must have an underlying intent to yield undue benefits through abuse of power, accounting for the probability of detection and punishment. This entry examines the prevalence of corporate corruption, and its dimensions, causes, and legal and reputational penalties.
Prevalence and Trend
There is no hard empirical evidence about whether companies are becoming more or less corrupt over time. However, public perception of corporate corruption’s prevalence has increased in the past two decades because of greater media coverage. While we may never know the actual prevalence of corruption over the past decades, there is hard evidence that corporate corruption is being detected and prosecuted at a steadily increasing rate since the turn of the 21st century. In fact, since the inception of the Foreign Corrupt Practices Act (FCPA) in 1977, the number of open investigations has increased at an alarming rate over the nearly 40 years since. However, even during this period, the first two decades were relatively quiet in terms of active corruption prosecutions. The large-scale corruption scandals (e.g., Enron, WorldCom, Tyco) around the turn of the century resulted in heightened regulator vigilance, which led to a marked increase in new corruption investigations.
In 2014, the U.S. Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) jointly brought and resolved 32 actions against corporations and individuals and assessed $1.56 billion in penalties, disgorgement of profits, and prejudgment interest. Included in these actions was a record $772 million fine and penalty against the French multinational Alstom, which happens to be the largest penalty ever levied against a corporation. In 2013, the DOJ and SEC collectively brought 27 actions totaling $731 million in penalties and disgorgement.
Dimensions of Corruption
Two dimensions of firm-level corruption are (1) primary beneficiary (individual vs. firm) and (2) collusion among organization members (solo vs. group effort). These two dimensions result in the distinction between organizations with corrupt individuals (OCI) and corrupt organizations (CO). An example of an OCI would be a business-licensing office where individual officers are corrupt to the point where the corrupt label is on the office, although no benefit is intended for the office. The extent to which a firm is an OCI can increase or decrease in a continuous manner. It is critical to note here that under federal sentencing guidelines, sanctions can only be imposed on a firm for OCI-type misconduct when corrupt employee behaviors are clearly intended to benefit the firm.
A CO is a phenomenon where a group within the organization, usually the management team, directs members to engage in corrupt activities that benefit the organization. Such activities would include financial restatement fraud and bribery. Whether a firm is a CO or not depends on a discrete shift in perception. A firm can be a CO with the help of external (e.g., bribery and price fixing) or internal (e.g., financial restatements, creating an environment of sexual harassment, environmental violations, and product recalls) agents.
Causes of Corporate Corruption
Given the universal disapproval of corruption, an important theoretical question that promises to generate a vast amount of research in the coming decades is why firms engage in corruption. Several scholars have attempted to answer this question, often under different contextual backdrops. However, there is no overarching framework to answer this question. The different reasons that have been recognized in the literature can be organized at four different levels: (1) individual, (2) organizational, (3) institutional, and (4) national.
All firm-level actions need to be conducted by individuals on behalf of the firm. Corporate corruption can occur if individuals, often at the helm of the company, are motivated to engage in firm-level corruption to realize personal gains. Individual greed has received more attention from the media than perhaps any other reason for corporate corruption. If certain managers resort to corruption to attain firm-level goals that result in higher compensation for themselves, then it can be said that part of the incentive for corruption was individual greed.
CEO ego is another individual-level reason for corporate corruption. On several occasions, CEOs of fallen companies have admitted that their decision to engage in corporate corruption was due to their inflated ego and a sense of indestructibility. One of the most famous admissions of this nature was by Tyco’s CEO Dennis Kozlowski. He openly admitted to being excessively greedy. And the overt display of his personal expenses using company funds suggests that his feeling of being indestructible positively moderated his greed.
A firm may resort to corrupt means to achieve its performance goals. This is more likely to happen when pressures to meet organizational goals—for example, earnings targets—are very high and senior managers are desperate to meet those targets.
Firms that cross the threshold of legal boundaries are in danger of being labeled as COs by stakeholders. The ethical quotient of the employees of such firms may decline precipitously as well. Scholars have dubbed such a condition as moral bankruptcy of the firm. A morally bankrupt firm cannot be expected to hold back on corrupt behavior to attain unfair advantages. Therefore, moral bankruptcy can be a potent cause of subsequent corrupt actions of the firm.
The rational choice framework is in play when firms assess the benefits of engaging in corruption against the costs of being detected, prosecuted, and punished. Weak regulatory institutions can create opportunities for corruption. This is because firms that may have stayed away from corruption due to fear of being detected and prosecuted can reconsider their options strictly from a rational choice perspective and engage in corrupt behavior to attain undue advantage.
Even if regulatory institutions are strong, their resource limitations can provide hints to firms of a lower probability of being investigated if they engage in corruption to gain extraordinary benefits. Thus, institutions can serve as enablers of corporate corruption by lowering the probabilities of detection, prosecution, and penalties.
Different countries have different levels of tolerance for corruption. Country-level corruption practices and tolerance levels matter because firms can experience serious pressures to play along with the existing corrupt practices in order to continue normal operations in a given country. Transparency International (TI) has been surveying and reporting on national corruption perception for more than two decades now. The TI report shows a wide range in corruption perceptions between the least corrupt countries and the most corrupt countries of the world. The pressure to engage in corruption is very high in countries that are among the most corrupt nations in the TI survey. Thus, the national corruption culture is a macrolevel cause of corporate corruption for both local firms and multinational firms operating in countries that are among the most corrupt nations.
When a multinational firm operates in a country where corruption perception is high, investors are expected to price in the possibility of corruption of that firm in that country. While a multinational firm’s expansion to any country, irrespective of its corruption perception, is based on the business opportunities that exist there, the market’s reaction to such a revelation would account not only for the opportunities but also for the liabilities of conducting business in a country with high corruption perception. When investors already price in a certain probability for the multinational firm to commit corruption, the firm may be tempted not to hold back on corruption as its valuation already reflects corruption possibilities.
This is yet another national-level cause of corporate corruption.
Legal scholars note that punishment for corporate crime including corruption has two main characteristics: It must be definite and severe such that (1) it is equivalent to the extent of the crime and (2) it deters firms from committing the crime again. Sentencing guidelines are designed to extend fairness and just punishment to organizations. These guidelines incentivize organizations to self-police and prevent criminal conduct by encouraging them to investigate alleged criminal acts and to self-report the results to federal authorities. Additionally, organizations are directed to accept responsibility for their acts. In the United States, the DOJ and the SEC are among the main law enforcement agencies responsible for upholding laws related to prosecuting criminal and civil acts perpetrated by public corporations. Violations under the FCPA fall under the purview of both the DOJ and the SEC, where the DOJ prosecutes the criminal aspect and the SEC the civil aspect. Many times, both organizations work in tandem in prosecuting corporate corruption.
Scholars have suggested that firms can be labeled as criminal firms if convicted of corruption. These negative labels or evaluations are done by stakeholders and often attach to organizations. Regulatory officials and law enforcement agencies, as one type of stakeholders, evaluate the legal transgressions of firms and associated individuals and punish the firms for committing corruption.
In addition to its antibribery provisions, the FCPA contains accounting and internal control provisions that require all public companies to maintain books and records where transactions are accurately recorded. Firms fall afoul of this requirement when corruption is hidden in the books and records so that it cannot be detected. In addition, firms must devise and maintain an adequate system of internal accounting controls so that unauthorized payments, including corrupt payments, would be detected before they are executed. This provision was designed to be a deterrent to the use of slush funds for illicit corrupt payments.
Typically, firms make corrupt payments through means such as gift giving, business travel and entertainment expenses, and charitable and political contributions. Firms mask corrupt payments in their books and records by characterizing those payments as consulting fees, commissions or royalties, sales and marketing expenses, travel and entertainment expenses, customer rebates or discounts, petty cash withdrawals, and sale of free goods.
Firms can enter into plea agreements or alternatives to settlement during sanctioning. Two types of alternatives are commonly used in the U.S. system: (1) when prosecutors file criminal charges but agree not to prosecute if the firm followed certain requirements for a stipulated period of time as mandated by the prosecutors (deferred prosecution agreement) or (2) not charging the firm if it followed these requirements during the stipulated period (nonprosecution agreement). Civil sanctions include payments of fines and penalties. At the time of sanctioning, corporate monitors may be appointed to assist the sanctioned firms in reforming their systems and processes that failed to detect the corrupt acts.
Firms can mitigate sanctions through certain actions during the investigations that are within their control. Firms are given credit in terms of lower fines if they take actions such as self-disclosing the corrupt activities to regulatory officials, cooperating with the regulatory officials during the course of the investigation, and instituting effective compliance programs to prevent corruption from occurring. In addition, firms that terminate employees culpable of committing corruption might receive lesser sanctions.
Academics have suggested that the market also penalize and deter firm misconduct. Integral to understanding market penalties is the concept of reputational capital. Reputational capital embodies the quality of the relationships a firm has established with its stakeholders, such as investors, customers, and employees. This capital is a part of the market valuation of the firm that is triggered when an event of misconduct is unexpectedly revealed to the market. A public corporation risks its reputational capital as a result of its interactions with its stakeholders. When corruption or other misconduct is divulged, stakeholders lose confidence in the firm and withdraw their support. Reputational penalty is determined by deducting the direct costs such as fines, penalties, and investigation costs from the lost market value. In other words, the residual, or the portion of the market loss that cannot be explained by such direct costs, is a measure of the firm’s reputational penalty.
Research on reputational penalties shows that for some types of misconduct, like financial statement fraud, the penalties are large while for other types, such as environmental violations, the penalties are negligible. The reasons ascribed for this large range is that for the former, a firm’s direct stakeholders, such as consumers and investors, are affected; on the other hand, for the latter, the parties that are harmed do not have direct business relationships with the firm. Based on the type of misconduct studied, the factors affecting reputational penalties include contextual and firm-level factors.
As mentioned earlier, the national corruption culture plays an important part in determining investor sentiments when multinational firms operate in jurisdictions where varying perceptions of corruption exist. In the United States and other Organisation of Economic Co-operation and Development (OECD) countries, corruption is considered to be morally objectionable. These countries prosecute firms headquartered in their jurisdictions and/or trade securities in their public markets even when the corruption takes place in foreign jurisdictions where corruption may be the accepted norm. Thus, the particular nation where the firm commits corruption may have different effects on investors. That is, the market may punish firms more if they commit corruption in less corrupt countries, and vice versa.
Other contextual factors include the number of regulators investigating the firm, the industry in which the firm operates, and the mode of entry of the firm into the host nation. Since multinational enterprises can commit corruption in many nations, coordinated enforcement by regulators from the countries involved can result in different reputational penalties. Investors impute the occurrence of investigations and/or enforcement actions by multiple regulators to the firm in terms of distracting management from carrying out the firm’s business. Certain types of industries are prone to corruption, such as oil and gas, pharmaceutical and medical devices, and financial services firms; regulators tend to focus more on firms that operate in these industries.
Investors tend to price in the industry, reflecting the possibility of firms in those industries participating in corruption. With regard to mode of entry, firms that enter nations by making greenfield investments or by acquiring wholly owned subsidiaries may be punished less than other firms that form joint venture partnerships or agency relationships because they have more control over the operations in the host countries and can take steps to detect and prevent corruption.
Firm-level factors include management/board involvement and corruption entrenchment in accounting systems. Over the years, the SEC has named the CEO and/or the chief financial officer for some involvement in financial misbehavior in more than 80 percent of the enforced cases. When a top management team is involved in corruption, it connotes that the team may have fostered a corporate culture where corrupt behavior was permitted. When board members are involved, it implies that the oversight function is suspect in that the board is not appropriately carrying out these functions. Therefore, involvement of corporate management and/or board members in corruption makes the corruption look worse. This would result in greater reputational penalties.
Researchers have found that accounting violations are indicative of problems embedded in corporate structures and IT systems. When allegations of improper payments to foreign government officials come to light, it may illustrate that the accounting systems and internal controls were ineffective in catching the corruption and in thereby preventing the corrupt payments from being made. The market will punish firms for accounting infractions because these infractions would show that defects exist in the underlying books and records and/or internal control weakness issues are present.
Notwithstanding the increasing numbers of corporate corruption cases thus far in the 21st century, stakeholders are generally gravely concerned about corruption because of its contagious nature. Corporate corruption scandals not only adversely affect the corporate reputation of the focal firm but may also harm the reputation of the parties that are engaged in transactions with the focal firm. Thus, when a firm faces a corruption scandal, its reputational capital loss is explained in terms of stakeholders no longer willing to continue their business with the firm. As a collective body of work, extant research on corporate corruption offers many valuable insights about detecting and deterring corporate corruption. As stakeholders become more aware of and concerned about reputational penalties in addition to legal penalties, firms are more likely to discover that the cost-benefit analysis does not support corruption as a means of achieving corporate goals.
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