Book Review: Why They Do It

my quest to get my readers not to commit fraud

Why They Do It is a book published by a business school professor, Eugene Soltes, about his academic research. Books published by business school professors are always suspicious, because business school academia sits on a throne of lies. However, Soltes’s primary method of research was writing letters to a bunch of imprisoned white-collar criminals and then writing down what they said. After considering the subject for a long time, I haven’t been able to figure out any possible way to fake this data and not get immediately caught because Bernie Madoff complained that he didn’t say that. So I will venture forth assuming that Why They Do It is telling the truth.

So, why do people commit white-collar crimes, according to themselves?

White-collar criminals don’t say that they engaged in a rational cost-benefit analysis. Indeed, the evidence suggests they mostly didn’t engage in rational cost-benefit analyses. Many risked years in prison for small rewards. White-collar criminals often keep a fraud going long after it would be obvious to a disinterested observer that the fraud is going to collapse and they’re going to end up in prison.

Often, they don’t seem to be thinking about the fraud much at all:

Consider Dennis Kozlowski’s description of his routine of signing documents—the same ones that prosecutors argued he authorized to forgive himself over $100 million in company loans. “Twice a month I had folders with yellow stickies that were this big,” Kozlowski recalled as he spread his arms wide to indicate the immense stack awaiting his signature. “I signed everything, but it was the same thing that I had been doing since 1976. . . . I had the company tell me what it was and I signed it. So how’s that criminal?”

In general, managers don’t have a lot of time for deep thought and consideration of their actions:

After extensively studying the day-to-day activities of managers over the course of several weeks, Mintzberg concluded that managerial “activities are characterized by brevity, variety, and discontinuity, and that [managers] are strongly oriented to action and dislike reflective activities.” The majority of managerial decisions, even those that were organized, occurred rapidly and concluded within minutes. In the decades since Mintzberg’s original study, managerial life has become, if anything, even busier and more hectic. In describing the changes in managerial activities since Mintzberg’s study, the psychologist Dolly Chugh pointed out that managerial work “has gotten more, not less, messy.” In short, none of the demands on managerial time promote the kind of thoughtful, objective reasoning that is likely to overturn instinctive intuitive judgments about the appropriate course of action.

So what were people doing instead of thinking?

Incorrectly Believing They Aren’t Criminals

Some white-collar criminals sincerely believed that they weren’t committing fraud. For example, Allen Stanford protested:

The business, as Stanford saw it, was both simple and successful. Far from floundering or fraudulent when it was taken over by American regulators, he argued, the firm was thriving. “Why go after a solvent, vibrant, honest, global empire I had poured thirty years of my life into?”

The disagreement here appears to be whether Stanford’s bank had $1 billion or $9 billion in assets. Soltes thinks the number is closer to $1 billion. But it is possible for a white-collar criminal to sincerely believe that their company is not a Ponzi scheme, and to be able to make the argument in a way that takes an expert a fair amount of work to unravel.

One of the masterminds behind the KPMG tax shelter fraud said:

“I was in a good career making a couple million a year,” recalled Jones, “so it’s not that I’m going to risk everything to go do something shady or illegal. . . . There’s not a single point where I could say, you know something, I would have done something different over here, or this would have been a red flag, or, you know, I did something wrong.”

Why was he prosecuted if he didn’t commit any crimes? Well:

After being criminally prosecuted, Jones reflected on what he believed happened. “My true crime is that I democratized the tax code. These products were always available to the ultra, ultra-rich—those that make a half-billion or a billion a year. What happened in the BLIPS years is that suddenly people who only made $50 million or $20 million a year had a solution.” There would be humor in hearing someone say he helped democratize tax products by serving people who “only” make $50 million a year—if only he didn’t genuinely believe this sentiment.

Nevertheless, only a minority of white-collar criminals seem to make sincere protestations that what they did ought to be legal.

Being Delusionally Optimistic

The business model was working, Hoffenberg felt, but he just needed more time.

If you ever find yourself thinking that sentence, save everyone some time and just turn yourself in to the FBI.

Soltes: What would you change if you had a chance to do it all over again?

Hoffenberg: Nothing . . . the model was perfect. It operated on eight cylinders and if not for the income-recognition wrong call, the company would have been a Fortune 1000 company. Keep in mind that Towers wasn’t really a Ponzi. What the word “Ponzi” means is that you’re taking new money to pay old money. That’s not what Towers did. Towers invested this money and actually made a fortune on it, but we couldn’t make the fortune quick enough and we turned left instead of right on some offering documents.

Or consider Bernie Madoff:

Rather than quitting the investment advisory business as losses mounted, Madoff continued to take in even more capital from investors. “I figured that eventually things would change and then I’ll get to actually start doing the model trades. As I took in more money to work with, I’d recover. I saw this as an opportunity to earn my way out of the hole.”

Another glaring example is the lawyer Marc Dreier. To attract top talent to his law firm, he offered high base compensation, didn’t make partners contribute capital to the firm, and bought fancy office space. To pay for all this, he borrowed a lot of money at high interest rates. The firm expanded rapidly. Revenue growth was slow, while expenses grew exponentially.

To pay his bills, Dreier decided to sell debt to hedge funds, while claiming it was the debt of one of his clients. But instead of buying time, he plowed the money into further expansion:

“[R]evenues were certainly growing significantly each year, but my capital expenses and operating expenses were growing even more quickly. I never let the revenue catch up to the costs because I felt compelled to keep investing in the firm so that it could have the type of impact, in terms of the lawyers and clients it would attract, that would position it eventually for sustained success.”

It was unthinkable to him to cut expenses:

“I had to be the most important reflection of the firm’s success. . . . I had to cultivate a financial reputation as someone who was reaping the rewards of my new law firm model to such an extent that there was no doubt about my financial wherewithal to continue to grow and bankroll the firm,” Dreier explained. “I attempted to do that by frequently entertaining clients and attorneys on my yacht, in my glamorous apartment, at my Hamptons beach house, and even the upscale restaurant that I bought in LA for the very purpose of showing off there. . . . This of course only added to my financial burden, but was indispensable to maintaining the image of success that was necessary to succeed.”

Soon, Dreier would have to pay back $263 million over the course of five months. The solution to this problem was to forge more notes, obviously. It got to the point where:

Dreier concluded that there was only one possible solution: “I had to impersonate an officer of the Ontario Fund at the signing [of his loan to himself].”

Is it? Is that the only possible solution, Dreier?

But perhaps the most striking case of delusional optimism is Enron. Enron used increasingly complex accounting structures to meet its unrealistic earnings growth goals (15% per quarter). Enron never admitted its mistakes; it hid the loss and kept going.

“There was always a bit of a feeling that there was some project in trouble, but we’re inventing so many new businesses—and the value of those are going to be so great,” Fastow explained, that the underperforming business wouldn’t matter in the end.

Eventually, Enron became so complexly organized that even its senior executives couldn’t understand what a bad position the firm was in. They’d developed complex accounting structures to fool investors, auditors, and regulators; eventually, they fooled themselves.

Dreier was an idiot. If a non-idiot bodyswapped into Dreier’s body, they’d quickly be able to realize what a disaster his law firm was. But Enron didn’t even have that protection. It had destroyed its own epistemics. Not only were the executives delusionally optimistic, they were structurally incapable of not being delusionally optimistic.

Doing What Everyone Else Does

Most of the time, people refrain from breaking laws not for fear of punishment but because they have internalized rules and norms that say that they shouldn’t break the law. If people spend more time with criminals, they learn different norms which make them more likely to become criminals.¹ White-collar crime is taught.

As such, white-collar crime is often downstream of firm culture. Even seemingly neutral aspects of firm culture can promote white-collar crime. For example, the consulting firm McKinsey has a strong norm of putting the client first—which caused one partner to leak confidential information to a client. The partner saw himself as giving the client what he needed.

Many white-collar criminals see the law as making distinctions that don’t matter in the real world. Even if they broke the law, they didn’t violate social norms.

Consider the case of Computer Associates International. The licensing fees for a multiyear software contract are all recorded as revenue in the quarter in which the contract is signed. If a contract is signed at the beginning of the next quarter rather than the end of this quarter, Computer Associates International’s revenues would be far lower than its targets, its stock prices would crater, and everyone would lose their bonuses—or their jobs. Clients, knowing this, would play for time, gambling that Computer Associates International would accept a contract that underpaid them rather than risk signing the contract in the wrong month. Computer Associates International responded by backdating contracts so they looked like they were signed in the correct quarter, even if they weren’t. This is, of course, super illegal.

But other tactics aren’t illegal—

one of the executives [at a competitor] thought of an alternative that allowed the company to achieve the exact same effect without violating any accounting rules. The solution he proposed was quite simple: during the final week of the quarter, members of the sales staff who normally refunded customer orders were sent out for “training.” Because these employees were “training,” they were not available to cancel orders until the following week when a new quarter began. In effect, the executives at this software firm temporarily lifted income for the quarter by postponing these cancellations, thereby allowing them to hit their earnings target. By engineering this scheme, the firm achieved the same effect as would have been accomplished by illicitly manipulating earnings by backdating contracts, but in a manner that would neither be detected by any outside investor nor be punished as a violation of GAAP.

Richards said that he was being punished for not being clever enough in his earnings manipulation, which honestly strikes me as a reasonable complaint.

For a less reasonable case of the same logic, consider Bernie Madoff:

“The disclosure always stayed the same. When I was doing a strategy—whether it was with convertible bonds, covered options, or the split-strike conversion—I was disclosing exactly what I was doing,” Madoff said. “What I did not disclose was the point that I wasn’t doing the strategy anymore—I was just shorting the strategy to them and not actually doing the physical trading.”

From his perspective, Madoff was simply selling—in his parlance, “shorting”—the investment strategy to his clients. As a market maker Madoff was in the position, under certain circumstances, to sell securities to clients without actually holding them. “Selling short was an everyday occurrence with me, so when I started going short the strategy, it wasn’t something that I looked at as being particularly unreasonable. There was no violation in shorting to customers—market makers do it every day. It’s part of the business.”

“The only thing that I did do that wasn’t legal was when I shorted I did not put it on my books as a short sale. So I would have had a ‘books and records’ violation,” Madoff explained. He viewed what happened as something closer to oversight than to recklessness. He continued, “Everything on the customer side was being reflected properly.” In particular, as Madoff explained, the trades shown on clients’ statements were the trades he wanted his clients to take to generate the desired level of return. The clients thought Madoff was placing their trades in the open market, but in reality they were only “trading” with him.

For what it’s worth, I read the chapter and I am also unclear on how a Ponzi scheme is a form of short selling. Matt Levine, help!

Compounding the problem, the line between fraudulent behavior and non-fraudulent behavior is often blurry. For example, preparing financial reports involves a lot of subjective judgment, allowing executives leeway to alter the accounts to make their companies look better:

More than a quarter of the executives surveyed said they would use their professional discretion to make accounting adjustments to hit their desired earnings target. These actions included drawing down on reserves previously set aside (28 percent of respondents), postponing taking an accounting charge (21 percent), and altering an accounting assumption on an allowance or pension rate (8 percent).

Normally, these adjustments are allowed if they fit within generally accepted accounting principles, but there is a point where “kind of dubious" becomes “felony fraud.”

Many fraudsters start with normal practices, gradually escalate to dubious practices, and then gradually escalate to outright fraud. Each individual step is small. As the gap between how much money they have and how much money they’re supposed to have grows, they become increasingly desperate. They have to do more and more dishonest practices or the entire house of cards would fall apart.

Let’s return to our friends at Enron. “Off-balance sheet financing" was a common, if moderately dubious, accounting strategy. Enron's creativity with off-balance sheet financing was limited by regulations, so they worked around them. As one example, Enron wanted to put some wind farms into a special purpose entity (SPE) in such a way that it didn't own the wind farms but still got the tax benefits from owning wind farm. Normally, SPEs were supposed to be completely separate from the company they're linked to. The person who runs the SPE couldn't be an employee or family member of an employee of Enron.

...but it was 1997. Legally, gay relationships weren't marriages. So Enron got the male partner of one of its leaders to run the SPE.²

"People always asked me whether transactions followed the law. No one ever asked me about the intent of what I was doing,” Fastow explained. “It was precisely the innovative and aggressive structuring that I was getting awards for. People thought this stuff was frickin’ brilliant.”

Fastow didn’t see anything he did as criminal. Why would he? Everyone around him approved. He was winning awards!

In the most extreme cases, white-collar criminals justify their crimes by saying that everyone else is also a criminal. Bernie Madoff again:

“Find me an owner in the manufacturing field that didn’t cheat on his inventory counts or his taxes and I will be willing to change my opinion. . . . Find me an individual who has not written off personal expenses on his tax returns as business expenses. Find me a person that has not padded or filed false insurance claims. I acknowledge there are different degrees of these activities and I am not suggesting that all are acceptable. My point is simply to state that I believe that this is the reality of life, and those that don’t accept this are either delusional or less than honest.”

“As an example, look at the present state of Social Security and the government debt worldwide. Talk about a Ponzi scheme. All they do is keep printing money to pay off the existing bond holders and creditors. Please explain to me what the difference is.”

By creating a social norm of universal dishonesty—even a social norm that only he believed in—Madoff justified his behavior to himself.

How To Avoid Committing Fraud

Soltes suggests a simple plan for avoiding committing fraud:

1. Regularly explain your work life to someone—your spouse, your best friend, your mom—whom you trust, who has good judgment, and who doesn’t work at the same company as you.

2. If the person says “what the fuck? what are you doing? that’s fraud!”, believe them.

That’s what happened in the only case Soltes found of someone stopping their fraud before it all collapsed around them. You need an outside voice: someone who isn’t as delusionally optimistic as you are and who isn’t socialized into your company’s dysfunctional norms. Most fraud is—at least in broad strokes—obviously bad to someone you’re explaining it to. The complicated part is all the justifications that what you’re doing is secretly all right.

If you are hesitant to tell someone about your work life because you’re worried that it looks like fraud out of context, but actually if you have all the context it’s fine, then you should definitely get an outside view. That’s an even worse sign than “the business model is working but I just need more time.”

Most people are not exceptionally ethical. They live up—or down—to the standards set by those around them. Structurally, the best way to prevent white-collar crime is to maintain high standards in which white-collar crime is unacceptable: something that many industries are unlikely to do as long as dubious practices are so profitable. Individually, the best way is to find someone whose standards aren’t distorted the same way yours are.

1. This is called differential association.

2. Be gay, do crimes!